THE GOLD STANDARD
For the nearly 200 years prior to the Great Depression, most of the in-
dustrialized world was on a gold standard. This meant that, for ex-
ample, the U.S. government was obligated to exchange dollars for a
fixed amount of gold. To do this, the U.S. and other governments had
to keep gold reserves in sufficient quantity to assure money holders
that they would always be able to make good on this exchange. Since
the total quantity of gold in the world was fixed—new gold discov-
eries were relatively small and contributed insignificantly to the
world’s total gold supply—prices of goods generally remained rela-
tively constant.
The only times the gold standard was suspended was during crises,
such as wars. Great Britain suspended the gold standard during both the
Napoleonic Wars and World War I, but in both cases it returned to the
gold standard with the original parity price. Similarly, the United States
temporarily suspended the gold standard during the Civil War, but it re-
turned to the standard after the war ended.^5
The adherence to the gold standard is the reason why the world ex-
perienced no overall inflation during the nineteenth and early twentieth
centuries. But overall price stability was not achieved without a cost. By
equating the money in circulation to the quantity of gold available, the
government essentially relinquished control over monetary conditions.
This meant that the central bank was unable to provide additional
money during economic or financial crises or when the economy grew
in size. In the 1930s, adherence to the gold standard turned from being
an exercise in government restraint and responsibility to being a strait-
jacket from which the government sought to escape.THE ESTABLISHMENT OF THE FEDERAL RESERVE
Periodic liquidity crises caused by strict adherence to the gold standard
prompted Congress in 1913 to pass the Federal Reserve Act that created
the Federal Reserve System (the Fed) to be the country’s central bank.
The responsibilities of the Fed were to provide an “elastic” currency,
which meant that in times of banking crises the Fed would become the
lender of last resort. In trying times, the central bank would provideCHAPTER 11 Gold, Monetary Policy, and Inflation 191
(^5) When the government issued non-gold-backed money during the Civil War, the notes were called
“greenbacks” because the only “backing” was the green ink printed on the notes. Yet just 20 years
afterward, the government redeemed each and every one of those notes in gold, completely revers-
ing the inflation of the Civil War period.