Under the Gold Standard, a government defines its currency in terms of a specific weight of gold and maintains rules for converting currency into gold at the official rate.

For example, suppose a country establishes:

1 unit of currency = 1 gram of gold

A person holding 100 currency units would have a claim to 100 grams of gold, subject to the system’s conversion rules.

The Gold Standard can provide:

• A fixed monetary reference
• Greater exchange-rate stability between participating countries
• Limits on discretionary money creation
• A framework for international payments

When two countries fix their currencies to gold, their exchange rate can be calculated from their respective gold values.

For example:

• Country A: 1 currency unit = 2 grams of gold
• Country B: 1 currency unit = 1 gram of gold

The implied exchange rate is:

1 unit of Country A’s currency = 2 units of Country B’s currency

However, the Gold Standard also creates limitations:

• Money supply flexibility is constrained by gold availability and the rules of the system.
• Governments may find it harder to respond to recessions or financial crises.
• Gold outflows can put pressure on domestic prices and economic activity.
• Maintaining convertibility can require higher interest rates or other restrictive policies.

A Gold Standard is different from a modern fiat currency system, in which money is not generally convertible into gold at a fixed official rate.

Gold Outflows Put Pressure on an Economy

Suppose Country A operates under a Gold Standard and experiences a prolonged trade deficit.

Businesses in Country A make more payments to foreign suppliers than they receive from overseas customers.

To settle international obligations, gold may flow out of Country A.

Assume the country’s monetary authorities initially hold 100 tonnes of gold, but reserves fall to 85 tonnes.

To protect the currency’s fixed gold value, the authorities may raise interest rates or tighten monetary conditions.

These measures can reduce borrowing and domestic spending, but they may also slow economic growth and increase unemployment.

This shows how the Gold Standard can support exchange-rate stability while limiting a country’s ability to respond independently to economic difficulties.

1821 – UK Becomes First Country on Gold Standard
When it happened: Post-Napoleonic War era
How it happened: Fixed value of British Pound to gold; other nations followed suit over time.

1944 – Bretton Woods Agreement Re-establishes Gold Link
When it happened: 1944
How it happened: USD fixed to gold; all other currencies fixed to USD.

1971 – Nixon Shuts the Gold Window ("Nixon Shock")
When it happened: August 15, 1971
How it happened: US unilaterally ended dollar-gold convertibility, ending the gold standard globally.