Stability of Gold Standard and

its Selected Consequences

Michal Kvasnicka

Masaryk University Brno, Faculty of Economics

qasar@econ.muni.cz

http://www.econ.muni.cz/ qasar/

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Rationale for Presentation

Sound money is of key importance for good performance of the free

market system.

Austrians prefer gold standard and free banking.

most difficult for the government to manipulate

historically very stable

low price inflation / deflation

mild trade cycles

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Question

Does the historical stability guarantee its present stability?

Answers:

Rothbard, Hulsman, Hoppe, Selgin, White, . . .—Yes, without

questioning

Me: No—we need an analysis

This is the analysis.

The message to be delivered is simple, but sad.

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Structure of Presentation

Rationale for the presentation

Model of gold standard

Dynamics of gold standard

Selected consequences

for fractional free banking

for monetary reconstruction

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Model of Gold Standard

Many standard models:

Barro (1979)

Dowd–Sampson (1993)

Chappell–Dowd (1997)

White (1999)

We will use White’s simple graphical model.

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Assumptions

We assume:

stationary economy

closed gold economy or international gold standard—gold can

flow without any cost

money is piece of gold or redeemable claims on banks

bank money is money substitutes or fiduciary media

money multiplier is unity or higher

money measured in troy ounces

gold used as money and for non-monetary use

gold can flow between these uses freely

(free coinage, free melting down)

purchasing power of gold is the same everywhere and in every

use

purchasing power of gold is ppg = 1/P

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Purchasing Power of Gold

Purchasing power of gold (ppg = 1/P ) is determined by the demand

for money and supply of money.

Or: by demand for monetary stock of gold and supply of monetary

stock of gold.

Md = Ms, Gdm = Gsm (1)

tr. oz.

ppg

Gdm

Gsm

ppg∗E

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Demand for Monetary Stock Gold

Demand for money is

Md = P ·Φd(Y(+)

, π(−), . . .) (2)

Demand for monetary stock of gold is derived from the demand for

money

Gdm = Md/µ = P ·Φd(Y

(+)

, π(−), . . .)/µ (3)

Demand for monetary stock of gold

rises with price level (decreases with ppg)

rises with aggregate product

decreases with inflation

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Demand for Non-monetary Stock of Gold

Demand for non-monetary stock of gold is demand for its non-

monetary non-consumptive use.

Gdn = Gdn (P(+)

, . . .) (4)

Demand for non-monetary stock of gold

rises with price level (decreases with ppg)

(may depend on aggregate product, . . . )

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“Supply of Monetary Stock of Gold”

There is stock of gold G at the economy at a moment.

The part of the stock of gold that is not demanded for stock non-

monetary use is supplied for monetary use:

Gsm = G − Gdn (P(+)

, . . .) = Gsm(P(−), . . .) (5)

“Supply of monetary stock of gold”

decreases with price level (increases with ppg)

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Changes of Total Stock of Gold

Total stock of gold G is not constant over time.

New gold is mined at every moment:

gs = gs(P(−), . . .) (6)

and some gold is consumed at every moment (production of com-

puter circuits etc.; wear and tear of coins):

gd = gd(P(+)

, . . .) (7)

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Changes of Total Stock of Gold (continued)

If more gold is mined than consumed, the surplus is added to the

total stock of gold G; in opposite case it is subtracted from it.

tr. oz./year

ppggs

gd

ppg∗e

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Stationary Equilibrium

Under our assumptions there exists a stationary equilibrium.

tr. oz./year

ppggs

gd

eppg∗

tr. oz.

ppg

Gdm

Gsm

E

“Stock market” determines the actual price level.

“Flow market” determines the stationary price level.

At the stationary equilibrium one price level clears both “markets”.

tr. oz./year

ppggs

gd

eppg∗

tr. oz.

ppg

Gdm

Gsm

E

tr. oz./year

ppggs

gd

eppg∗

tr. oz.

ppg

Gdm

Gsm

(Gdm)′

E

tr. oz./year

ppggs

gd

eppg∗

tr. oz.

ppg

Gdm

Gsm

(Gdm)′

E

tr. oz./year

ppggs

gd

eppg∗

tr. oz.

ppg

Gdm

Gsm

(Gdm)′

E

tr. oz./year

ppggs

gd

eppg∗

tr. oz.

ppg

Gdm

Gsm(Gsm)′

(Gdm)′

EE ′

g f h � � � � � � �

Change in “Stock Market”

A change in the “stock market” changes price level only temporarily.

Let us assume a decrease of the demand for monetary stock of gold.

tr. oz./year

ppg

gd

gs

(gs)′e

ppg∗

tr. oz.

ppg

Gdm

Gsm

E

tr. oz./year

ppg

gd

gs

(gs)′e

ppg∗

tr. oz.

ppg

Gdm

Gsm

E

tr. oz./year

ppg

gd

gs

(gs)′e

ppg∗

tr. oz.

ppg

Gdm

Gsm(Gsm)

′

E

tr. oz./year

ppg

gd

gs

(gs)′e

ppg∗

tr. oz.

ppg

Gdm

Gsm

(Gsm)′

E

tr. oz./year

ppg

gd

gs

(gs)′e

e ′

ppg∗

(ppg∗)′

tr. oz.

ppg

Gdm

Gsm

(Gsm)′E

E ′

g f h � � � � � � �

Change in “Flow Market”

A change in the “flow market” changes price level for ever.

Let us assume an improvement in mining technology.

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Dynamics of Gold Standard

We are interested in the speed of the transition from one equilib-

rium to another one.

The speedier the transition, the higher problems caused.

Speedier transition is associated with

higher price inflation

higher relative (percentage) change in the stock of money

⇒ more severe trade cycle

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Determinants of Speed of This Transition

Determinants of the speed of the transition form one equilibrium to

another one are many (price elasticities, . . . ).

Nothing can be said in general in most cases—it is an empirical

question.

One determinant is systematic—the size of the monetary stock

of gold.

We will concentrate on it.

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Why Size of Monetary Stock of Gold Matters

It is important because it is independent of the surplus (or deficit)

of gold at the “flow market”.

tr. oz./year

ppg

gd

gs

(gs)′e

ppg∗

tr. oz.

ppg

Gdm

Gsm(Gsm)

′

E

The lower the monetary stock of gold, the higher the percentage

change of the stock of money (ceteris paribus).

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Numerical Case

Let us assume a non-monetary shock that causes a surplus of newly

mined gold over its consumption 1 mil. tr. oz.

gs − gd Gm %∆Gm (aprx.) π (aprox.)

1 mil. 1 mil. 100 % (less) 100 % (more)

1 mil. 1 bil. 0.1 % 0.1 %

Monetary stock of gold acts like a cushion—it stabilizes economy

against non-monetary stocks.

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Formal Analysis (For Those Who Like It)

Price level at a moment is

P =µ · Gm

Φd(Y, π, . . .)(8)

Then rate of inflation is

π =P

P=gs − gd − Gn

Gm−Φd(Y, π, . . .)

Φd(Y, π, . . .)(9)

The lower the monetary stock of gold, the higher the price inflation.

(The second term destabilizes price level further.)

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Conclusion

The higher the monetary stock of gold, the higher the percentage

change of the stock of money caused by an imbalance at the “flow

market”.

The higher is the percentage change of the stock of money the faster

is the transition form one equilibrium to the other.

And

the higher price inflation / deflation

the more severe trade cycle

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Consequences

Let us explore consequences for

fractional reserve free banking

monetary reconstructions (attempts to resume the gold stan-

dard)

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Mature Fractional Reserve Free Banking

Free banking of the Scottish type proposed by White and Selgin

economizes on gold reserves.

It lowers reserve ratio from 100 % to 2 % or smaller (White, 1999).

It cannot make permanent inflation when the final reserve ratio is

attained.

It can undermine stability of the gold standard (if widespread)

because it lowers the monetary stock of gold (50×).

⇓

Historical evidence from time with much higher reserves is not suf-

ficient to prove this kind of banking would be stable enough.

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Monetary Reconstruction

Rothbard, Hulsmann, . . . proposed plans to reestablish the gold

standard. (Hulsmann: independently.)

Finding the first stationary equilibrium may be painful problem—we

will neglect it.

Problem: If the gold standard is reestablished only in a small open

economy, it would be horribly unstable—its monetary stock of

gold would be tiny in comparison to the world gold flows.

It would be even worse nowadays because

central banks have a lot of gold—they may sell it

non-monetary demand for gold stock includes foreign private

reserves to hedge against inflation—it can be highly unstable

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Monetary Reconstruction (continued)

Monetary reconstruction must be done at once in many countries

of a significant economic power.

(Which makes it even more improbable in the near future.)

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Thank you for your kind attention.

Any questions, comments, or hints?

Michal Kvasnicka

qasar@econ.muni.cz

http://www.econ.muni.cz/˜qasar/wp.html