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Unit 2: International Monetary System

pounds. It would be reasonable for the US importer to pay $4.88 for each British pound but no Notes
higher than that.
By the same token, the pound could not fall below $4.84 – the lower limit known as the ‘gold
import point’. If the pound fell below $4.84, a British importer would be better off converting
pounds into gold for payment. The cost of shipping gold would be less than the high cost of
buying dollars for payment. In doing so, the importer would export gold and the United States
would gain more gold for its reserves. In actual practice, governments always stood ready to
buy and sell gold to make certain that the exchange rate would not move outside of the established
limits.

Price-Specie-Flow Mechanism

The gold standard functioned to maintain equilibrium through the so-called ‘price-specie-flow
mechanism’ (or more appropriately the specie-flow-price mechanism), with specie meaning
gold. The mechanism was intended to restore equilibrium automatically. When a country’s
currency inflated too fast, the currency lost competitiveness in the world market. The deteriorating
trade balance due to imports being greater than exports led to a decline in the confidence of the
currency. As the exchange rate approached the gold export point, gold was withdrawn from
reserves and shipped abroad to pay for imports. With less gold at home, the country was forced
to reduce its money supply, a reduction accompanied by a slowdown in economic activity, high
interest rates, recession, reduced national income and increased unemployment.

The price-specie-flow mechanism also restored order in case of trade surpluses by working in
the opposite manner. As the country’s exports exceeded its imports, the demand for its currency
pushed the value toward the gold import point. By gaining gold, the country increased its gold
reserves, enabling the country to expand its money supply. The increase in money supply forced
interest rates to go lower, while heating up the economy. More employment, increased income
and subsequently, increased inflation followed. Inflation increased consumers’ real income by
overvaluing the currency, making it easier to pay for imports. It should be remembered that an
inflated country with the exchange rate held constant is an advantageous place to sell products
and a poor place to buy. With inflation, prices of domestic products would rise and become too
expensive for overseas buyers. At the same time, foreign products would become more
competitive and the balance of payments would become worse. Next would come a loss of gold
and the need to deflate and the cycle would be repeated.

Decline of the Gold Standard

There are several reasons why the gold standard could not function well over the long run. One
problem involved the price-specie-flow mechanism. For this mechanism to function effectively,
certain “rules of the game” that govern the operation of an idealised international gold standard
must be adhered to. One rule is that the currencies must be valued in terms of gold. Another rule
is that the flow of gold between countries cannot be restricted. The last rule requires the issuance
of notes in some fixed relationship to a country’s gold holdings. Such rules, however, require
the nations’ willingness to place balance of payments and foreign exchange considerations
above domestic policy goals and this assumption is, at best, unrealistic. Thus, the operation of
the gold standard was not as automatic or mechanical as the price-specie-flow mechanism might
lead one to believe.
Because gold is a scarce commodity, gold volume could not grow fast enough to allow adequate
amounts of money to be created (printed) to finance the growth of world trade. The problem
was further aggravated by gold being taken out of reserve for art and industrial consumption,
not to mention the desire of many people to own gold. The banning of gold hoarding and public

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