Central Banks Under the Gold Standard

Abstract

The gold standard served as the lynchpin of the international monetary system from the 1870s to 1914 and from 1925 to 1936. To maintain a fixed price of a currency against gold, central banks had to defend the parity by buying and selling gold against other currencies. And domestically central banks had to pay out gold to those presenting their banknotes for conversion. Since gold losses were a warning signal, central banks usually raised their policy interest rate as a first line of defense. Higher rates attracted foreign capital and slowed down the economy. Under the informal rules of the game, central banks had to focus singularly on maintaining the link to gold at parity. It delivered automatic balance of payments adjustment, as well as price stability over time and strong growth of international trade. On the downside, central banks ignored low economic growth and high unemployment when their gold reserves were falling. Facing these conditions, Britain abandoned the gold standard in1931. By 1936 all of Europe had followed. The United States alone remained on the gold standard.