Too embarrassed to ask: what is the gold standard?

These days, most currencies are "fiat" currencies backed by the economies of the countries that issue them. But in days gone by currencies were on the "gold standard". Here's what that means.

What makes the pound in your pocket – or your bank account – money? Why are people willing to accept currency in exchange for goods and services?

These days, there is nothing physical underwriting the value of the pound or the dollar, or any other currency for that matter. Such currencies are popularly known as “fiat” currencies. Put simply, they are backed by the strength of the economies and the governments that issue them and that demand taxes be paid in them.

However, this wasn’t always the case. In the past, commodities of various sorts were often used as money. The most popular such commodities have been the precious metals, and gold in particular.

The “gold standard” describes a monetary system where paper currencies are exchangeable for gold at a fixed rate. Put very simply, the idea behind the gold standard is that it prevents countries from living beyond their means. If a country needs to hang on to enough gold to back its currency, then it makes much harder for governments to manipulate the money supply.

However, the rigidity of the gold standard also has drawbacks. An inflexible money supply in theory makes it harder for central banks to adjust for economic conditions. Perhaps more pertinently, history shows that when the gold standard has proved overly restrictive, governments simply abandon it. For example, most countries abandoned the gold standard between the First and Second World Wars.

After the Second World War, the world went back onto a form of the gold standard. Under the Bretton Woods agreement, the US dollar was backed by gold, and the rest of the world’s currencies traded at fixed exchange rates against the dollar.

However, in the late 1960s, mounting US spending – partly on the Vietnam war – threatened to cause a run on America’s gold reserves as foreign countries lined up to swap their dollars for gold.

As a result, in 1971, president Richard Nixon severed the link between the dollar and gold. By 1973, most major currencies were free floating and the US dollar was no longer tied to the yellow metal.

Of course, the monetary system is constantly evolving. As the prospect of fully digital currencies becomes reality, we may see another shift in the near future.

To learn more, subscribe to MoneyWeek magazine.

Recommended

When will interest rates go up?
UK Economy

When will interest rates go up?

New interest rates will be announced this month – we look at whether they will go up and what the impact will be.
5 Dec 2022
Heated airer vs tumble dryer – which is cheaper?
Personal finance

Heated airer vs tumble dryer – which is cheaper?

What is the most cost effective way to dry your clothes – a heated airer or a tumble dryer? We compare the costs.
5 Dec 2022
Best savings accounts – December 2022
Savings

Best savings accounts – December 2022

Interest rates on cash savings are making a comeback. We look at the best savings accounts on the market now
5 Dec 2022
Scottish Mortgage managers reassure investors about its recent poor performance
Investment trusts

Scottish Mortgage managers reassure investors about its recent poor performance

After a spectacular couple of decades, the Scottish Mortgage Investment Trust has fallen by 40% this year. As its managers address shareholder concern…
5 Dec 2022

Most Popular

Is it cheaper to leave the heating on low all day?
Personal finance

Is it cheaper to leave the heating on low all day?

The weather is getting colder and energy bills are rising, but is it really cheaper to leave the heating on low all day or should you only turn it on …
1 Dec 2022
Radiator vs electric heater – which is cheaper?
Personal finance

Radiator vs electric heater – which is cheaper?

We compare the costs, pros and cons of radiators and electric heaters and see which one will help keep your energy bill as low as possible.
28 Nov 2022
State pension errors – why tens of thousands of mothers could be missing out on millions in state pension payments
State pensions

State pension errors – why tens of thousands of mothers could be missing out on millions in state pension payments

LCP launches Mothers Missing Millions campaign amid DWP state pension errors.
3 Dec 2022