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What is Gold Standard and How Does it Work?

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Before the modern paper currency system was introduced in the world, there existed a gold exchange system now known as the gold standard. The holders of paper currencies could exchange their money with gold using an authenticated process. The main importance of gold lies in the fact that it was used for many financial purposes.

If you want to understand the gold standard and how the process of the gold standards works at present, do give this blog post a read.

Did you know? In 1850, the percentage of the world’s gold in the form of coins and government reserves was about 27%, and at present, the percentage is nearly the same.

What is Meant by Gold Standard?

The gold standard is a fixed monetary system according to which the standard economic unit of account (currency) is dependent and can be easily converted in exchange for gold. The gold standard definition also refers to an independent and competitive monetary regime where gold or gold certificates could be used as the main medium of exchange or a standard for international trade. In this regime, the countries used to set their exchange rate on the relative consistency of gold values between the currencies of the participating country.

Also read: Understanding Gold ETFs And How to Invest in Best Gold ETFs

The gold standards are believed to adjust the inflow and outflow of money in the country because the government controls the supply and issuance of gold at the time of exchange. Also, the price of gold was monitored and controlled by the government.

History of Gold Standard

Gold was transformed into coins for monetary exchange in around 650 B.C. Before this time, gold was directly weighed, checked for purity and used for trading products and services. These gold coins system was not perfect since these coins could be clipped and melted down into bullion. England automated coin production in 1696, which led to the end of the clipping of coins. 

The US Congress held the sole right to mint money and regulated the value of money in 1789, and this promoted a standardised monetary system. Because of the greater availability of silver compared to gold, a bimetallic standard was adopted in 1792. When the value of silver plummeted in 1793, gold was pushed out of circulation. 

After 1819, many western countries fixed their currency value according to a specific weight of gold. This exchange rate was used in international trade, and many countries soon adopted it to trade with the west. But soon the countries started experiencing difficulties in maintaining the relationship between gold and their currency. Hence, the standard weakened towards the end of the 20th century.

After the second world war, the allied countries accepted the US dollar as a reserve currency rather than gold. The US administration discontinued the exchangeability of US dollars to gold, thus creating a regime of Fiat currency.

In 1926, the gold bullion standard was established along with the introduction of a gold standard for the rupee. India’s paper money and gold reserves were combined and the central bank (RBI) was founded. Consequently, a currency backed by gold and sterling was formed by the Currency Act of 1927. The rupee was pegged to sterling starting on September 24, 1931, after the British home government decided to stop using the gold standard. However, the unchanging rupee-sterling ratio resulted in a depreciation of the rupee in terms of gold and an increase in the price of gold in terms of rupees, which caused India to export huge amounts of gold during the following ten years, reversing its prior role as a constant buyer of gold.

How Does the Gold Standards Process Work?

You must now understand what is meant by the gold standard. The system put a standard price on gold which the government regulated to monitor the monetary supply in a country. In simple words, the government regulated the gold prices, and the people were allowed to convert their currency money to gold (which held a lot of value at the time). Hence, the price of gold set by the government was imposed on everyone as a standard.

Types of Gold Standard

The types of Gold Standard are as follows:

  • Gold Exchange Standard
  • Gold and Fiat Money Standard
  • Gold Bullion Standard
  • Gold Coin Standard

Does Gold Back the Indian Rupee?

Even though the Indian Rupee is not completely back by Gold, India has stocked up some quantities of gold. It is estimated that as of 2018, the Reserve Bank of India (RBI) stocks about 558 tonnes of gold as foreign exchange reserves. The exact value of this gold reserve fluctuates with the market price of gold in the international market. Most of this gold is located in the city of Nagpur, while some of it is held in London. 

The RBI Act, 1956 defines the Minimum Reserve System (MRS) that helps in governing the flow of the Indian Rupee. The MRS mandates that the Reserve Bank of India must hold resources worth ₹200 crores to back its paper currency. RBI can hold ₹115 crores worth of gold, and the rest can be other types of resources.

India has also started holding online gold as a means of investment. Online gold does not exactly define India’s stand on the gold standard, and it cannot be utilised to back the Indian Rupee. 

Also read: Digital Gold – Things You Need to Know Before Investing in Digital Gold

Abandoning the Gold Standards

Even though the gold standard was considered a good system by economists, many countries discontinued the gold standard in their economics.

One of the main reasons for discontinuing the gold standard was that it could not elevate the value of the currencies since the circulation of the gold was limited by the government and couldn’t be accessible to the whole economy.

The gold standards are also believed to adjust the inflow and outflow of money in the country because the government controls the supply and issuance of gold at the time of exchange. Also, the price of gold was monitored and controlled by the government, and hence, only domestic financial transactions were feasible. When the financial transactions had to be done with other foreign countries, the two countries didn’t agree with the price of gold set by each other. This led to a difference in the supply and demand in many countries and finally led to the cessation of the gold standard system.

The United States Government came up with the new fiat money concept, which was considered a good alternative. The new system also established equality in the sales economy. It was because of all these reasons that the Gold System was abandoned.

Impact of Gold Standard

The gold standard had a mixed impact on the global economy. Some limited sections of the population enjoyed the advantages of the gold standard, whereas the rest had a hard time dealing with the disadvantages of the gold standard. It was initially adopted to result in uniformity in the economy. Ideally, the money was well under control, and inflation couldn’t begin because of the government’s control over the economy.

As discussed in the above sections, most countries wanted to improve their economy, which led to the rise of the fiat money regime.

Present Monetary System in India

Numerous monetary standards have been used throughout India’s history. The Reserve Bank of India oversees and controls the current Indian monetary system, also known as the Inconvertible Paper Currency Standard. Every transaction in India is done using rupees, which are considered the country’s official unit of money.

Advantages of Gold Standard

Some advantages of the gold standard are as follows:

  • It aided the government in controlling the regional and national economies.
  • Governments find it more demanding to inflate prices by increasing the money supply because of the gold standard. Thus, It helps to manage inflation in a country more efficiently. When the gold standard system is in place, inflation and hyperinflation are rare events because the supply of many can only increase if the reserves of gold increase with the government.
  • All the export from a country was carried out in exchange for gold. As a result, a country’s gold reserves increased by exporting a lot. This also reduces the uncertainty in international trade.

Disadvantages of Gold Standard

Some disadvantages of the gold standard are as follows:

  • The countries that produce gold are at a higher advantage than the ones that do not produce gold.
  • The gold standard definition and norms were inflexible, discouraging a country’s business growth.
  • Due to differences in the gold rates of different countries, the gold standard lost many chances to conduct trade and export with other countries.
  • The standard doesn’t bolster inflation; hence, the economy has a condition of recession.
  • It has led to some major economic destabilisation.
  • It is recommended that countries improve their reserves of gold, leading to a lower flow of currency in the market.
  • The system does not benefit the economy as a whole.

Also read: Sovereign Gold Bond Scheme – Why to invest in Sovereign Gold Bond Scheme, Advantages, Eligibility & Features

Conclusion

To define the gold standard, you must understand the value of gold in the past times. Gold coins were very common in ancient times, and soon after, modern currency notes replaced them. The government regulated the value of the currency notes in accordance with the national gold reserves. This is a simple gold standard meaning. The gold standard was advantageous to some sections of society while others didn’t benefit from the standard. And hence it was replaced by the modern Fiat Money Regime. 

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