1. 1
Was there room for monetary discretion under the gold standard?
The gold standard, which dominated international monetary arrangements for the last quarter
of the nineteenth century and up to the First World War, was not set up at a conference like
Bretton Woods or Maastricht. Countries adopted it one at a time, Germany in 1871, the US in
1879 for example. As such the “rules of the game”, as John Maynard Keynes retrospectively
named them, upon which the gold standard operated were never authoritatively laid down.
What we know about the functioning of the gold standard and what it meant for national
monetary policy comes from theory and hindsight.
The gold standard was based on two pillars; convertibility between paper and gold at a fixed
value and the free export and import of gold.With a currency convertible into gold at a fixed
parity price any monetary expansion would see the value of the currency relative to gold decline
which would be reflected in the market price. Thus, if there was a parity price of 1oz gold = £5
and a monetary expansion raised the market price to 1oz = £7, it would make sense to take a £5
note to the bank, swap it for an ounce of gold and sell it on the market for £7. The same process
worked in reverse against monetary contractions. A fall in the market price to 1oz = £3 would
make it profitable to buy an ounce of gold, take it to the bank and swap it for £5.
These expansions and contractions of a countries money supply could come about from the
policy of the currency issuer or from persistent trade deficits or surpluses. In both cases the
convertibility of currency into gold and vice versa and its free import and exportability would act
the offset the monetary expansion or contraction.
In the case of a monetary expansion, as described, gold would flow out of banks forcing a
contraction in the currency if banks wished to maintain their reserve ratios. Likewise a
contraction would see gold flow into banks which, again, in an effort to maintain their reserve
ratios, would expand their issue of currency.
If a country ran trade deficits it would lose gold, sending it abroad to pay for its excess of
imports over exports. In this case, as per the price-specie flow mechanism of David Hume
(1752), its money supply would contract and prices would fall. This would make imports more
expensive and exports cheap, restraining one and stimulating the other. This would reverse the
gold flow. The exact same process would work in reverse in a country running trade surpluses,
supplying goods and services abroad and receiving gold in return.
Robert Mundell (1963) argued that of the three policies, capital mobility, fixed exchange rates,
and monetary policy autonomy, it was only possible to pursue two at any one time. Under the
gold standard capital needed to be mobile for the price-specie flow mechanism to work. With
currencies fixed as amounts of gold they were effectively fixed against each other. If $10
exchanged for 1oz of gold and £5 exchanged for 1oz of gold then $10 exchanged for £5. But if
Mundell was right this means there was no scope for a national monetary policy. The interest
rate could not be used to fulfill domestic macroeconomic goals but, instead, was the dependent
variable dictated by the need to maintain the convertibility of the currency.
However, there was a cost to shipping gold which had to be set against the arbitrage gains that
could be made from trading it. A currency would not only have to fall below par value before

2. 2
traders shipped it‟s gold abroad but it would have to fall far enough so that the profits made
would cover the shipping cost. There was a band around the par value defined by the cost of
shipping gold, the „gold points‟ in which the currency could fluctuate giving scope for monetary
discretion. “Hence the actual exchange rate, as determined by supply and demand, could stand a
little higher or lower than the par value…The range of variation was defined by what were called
the „gold points‟” (Drummond 1987)
As Drummond writes, monetary authorities were able to find in this „target zone‟ around the
parity value some leeway to pursue an independent monetary policy. Looking at the core
countries; Britain, France and Germany, Bordo and MacDonald (2005) found that “a credible
zone” (emphasis added) gave a monetary authority “some independence in the operation of its
monetary policy” (Bordo and MacDonald 2005, p. 325)
Flandreau and Komlos (2006) illustrate with the example of Austro-Hungarian policy in
November 1907. In response to a financial panic Germany raised interest rates. This should have
prompted interest rate rises in Austria-Hungary, pegged to the German mark, to keep gold from
flowing to Germany. Instead, the Austro-Hungarian monetary authorities held off. But, because
investors expected those authorities to do what it took to maintain the florins peg with the mark,
they predicted an appreciation of the florin and bid it up. The florin-mark peg was protected
without interest rate rises and the attendant domestic economic adjustment. As Flandreau et al
wrote “This can happen because, provided that speculators trust the monetary authorities‟
commitment to go on paying their notes in gold, they will bet on an eventual appreciation of the
currency” (2010, p. 98)
Confidence that monetary authorities would maintain gold-currency convertibility was key to
the ability of those authorities to take advantage of the leeway provided by the gold points.
Flandreau and Komlos found that “foreign exchange market efficiency and credibility” were “the
key reasons for the success of the Austro-Hungarian experiment” (2006, p. 1980)This echoes
Bordo and MacDonald who found that “the scope for violation was limited by the size of the
bands and could only be temporary because the exchange rate must eventually revert towards
central parity” (2005, p. 309) Credibility was vital.
Flandreau et al, discussing the Austro-Hungarian case, also highlight another factor enabling
the functioning of these target zones, “a deep and liquid market for Austro-Hungarian bills as
well as a well-functioning market for forward exchange” (2010, p. 100) Where these conditions
did not hold or where there were other adverse circumstances, such as a primary producing
economy and debtor nation rather than an industrial creditor nation like the core countries
studied by Bordo and MacDonald, as in Argentina, monetary authorities might even find
themselves unable to operate a gold standard.
This was Ford‟s argument (1960). However, in the case of Argentina‟s exit from the gold
standard in 1885, it is not clear that its difficulties were of a totally different order as those
elsewhere. Bordo and Rockoff (1996) class Argentina‟s problem as “Lax fiscal policy” (Bordo and
Rockoff, p. 401) Indeed, Ford writes that “The domestic convertibility of notes for gold…was not
such a point of honour and morality” and notes that “Other primary exporters, such as Australia

3. 3
and New Zealand, maintained exchange-rate stability” (Ford 1960, p. 73). Again, the issue of
credibility is vital.
Another way monetary authorities could exercise monetary discretion was to sterilize inflows of
gold (Bloomfield 1959). This meant gold inflows would not be allowed to become part of the
money stock; they would simply disappear from circulation. Of course, as Mundell noted, this
“will ultimately lead to the breakdown of thefixed exchange system” (Mundell 1963, p. 485)and,
while they could be regular and substantial,Selgin (2012)argues that sterilizations were not
significant.
The gold standard required capital mobility and fixed exchange rates. In doing so, as per
Mundell, it largely ruled out monetary discretion. Such discretion as there was came from the
gold points and sterilization. Sterilization was of limited use and what scope monetary policy
found between the gold points depended on the credibility of the monetary authority‟s ultimate
maintenance of parity.That was the crucial difference between the experience of Austria-
Hungary in 1907 and Britain in 1992; Austria-Hungary was expected to maintain its peg with
the mark, Britain was not expected to.
Short term flexibility was bought at the price of long term commitment. Ironically, the
authorities with most scope to deviate from the rules of the game were those most expected to
adhere to them.

4. 4
References
Bloomfield, A. 1959.Monetary Policy Under the International Gold Standard, 1880-1914. New
YorkFederal Reserve Bank of New York
Bordo, Michael D., and Ronald MacDonald. 2004. “Interest rate interactions in the classical
gold standard, 1880-1914: was there any monetary independence?” Journal of Monetary
Economics 52: 307-327
Bordo, Michael D., and Hugh Rockoff. 1996. “The gold standard as „Good Housekeeping Seal of
Approval”. Journal of Economic History 56: 389-428
Drummond, I. 1987. The Gold Standard and the International Monetary System 1900-1939.
London: Macmillan
Flandreau, Marc, and John Komlos.2006. “Target zones in theory and history: Credibility,
efficiency, and policy autonomy” Journal of Monetary Economics 53: 1979-1995
Flandreau, MarcJuan Flores, Clemens Jobst, and David Khodour-Casteras. 2010. “Business
Cycles, 1870-1914” In The Cambridge Economic History of Modern Europe Volume 2: 1870 to
the Present, edited by Stephen Broadberry and Kevin H. O‟Rourke, 84-107. Cambridge:
Cambridge University Press.
Ford, A. G. 1960. “Notes on the working of the gold standard before 1914” Oxford Economic
Papers 12: 52-76
Mundell, Robert. 1963. “Capital mobility and stabilization policy under fixed and flexible
exchange rates” Canadian Journal of Economic and Political Science 29 (4): 475–485
Selgin, G. 2012. “The rise and fall of the gold standard in the United States” Paper presented at
the Hillsdale College Free Market Forum on Markets, Governments, and the Common Good.
Houston, Texas, October 4-5, 2012.