What is inflation?
I love how my economics professor described it in class. “It’s a sustained increase in the price level” they will tell you, as if prices are subject to arbitrary increases. A more accurate definition would be to say. Inflation occurs as a result of an increase in the supply of money, sufficient to decrease the worth of this currency. This would happen if the rate of growth of the money supply was superior to the rate of growth of the economy. That’s basically how it works. The supply of money is increased, but this does not match the increase in the amount of goods produced. The result of this, is that we have more money, more notes and bills running around, chasing relatively less goods than before. In effect, each one of those paper notes we call currency has been devalued. The currency has been devalued, but goods are worth the same, so prices increase. This is inflation. Always a monetary phenomenon, as said by Milton Friedman.
But like I said, not any increase in the money supply will cause inflation. If the currency were to be left the same, while more goods are being produced we would see appreciation and deflation. Currency worth more, and prices falling. The growth of money has to be on par with the growth of the economy . Currencies should have a stable measure of value now and always. The best known way to achieve this? The gold standard.
The gold standard worked for hundreds of years to keep currencies as stable stores of wealth. Let’s have a look at how a gold standard would work with fiuciary media(paper notes).
In this case, the fiat currencies (paper notes) are linked to a certain value in terms of gold. If such a system were to have a system of redeemability the management would function like this:
The State, or issuers of the currency, are committed to exchanging it on demand for its established gold parity.
If the value of the dollar(for example), were decreasing, maybe because the Federal Reserve is printing notes, people could go and redeem their currency into gold. The State would exchange the notes for gold at its parity price.The notes it receives it would destroy. In this way the money supply is reduced, bringing the value of the dollar back up.
The value of the dollar is increasing, maybe because, as I said before, there is more goods in the economy. The private market participants would take their gold to be converted into notes, which the state can freshly print. This then, would take the price of the dollar down in terms of gold.
By implementing this mechanism you can achieve a currency that is stable in value.
It is simple to think about it in microeconomic terms. The price, is fixed by the currency issuer. The amount of money in circulation is the residual effect of maintaining the price, given the supply and demand.
Conversely, you can also achieve this via Open market Operations, this would work without redeemability, so you don’t even need to have any gold in the country to have a gold standard. Also, here would come the argument between automaticity, in the first case, and discretion, in the second.
A more recent example of this mechanism put into practice is currency-boards. Currency boards are used when a country wants to maintain a “peg”(fixed exchange rate) with another currency. The gold standard is simply a currency board linked to gold.
Most economists know little about this subject and you may hear them say some strange things.
Dispelling some myths:
Not enough gold in the world to run a gold standard. Wrong. The U.K. ran the worlds premier currency during a gold standard era. It had about 1.5% of the above ground gold in the world
Supply of money depends on gold mining. Wrong again. The supply of money is neither determined nor limited by the amount of gold in the world. Even so, the amount of gold is pretty stable. Which is one of the reasons it’s price is also stable. Like I said before the supply of money is determined by the intersection of supply and demand at the parity price.( The exchange price set between gold and the currency)
Creates inflation or deflation. Nope. In fact by pursuing and achieving a stable value of the currency, the gold standard achieves zero inflation and zero deflation, in monetary terms. There would be a tendency for prices to fall given increases in competition and bettering of technologies and production over time.
Money supply is subject to changes in the price of gold. That’s true, which is precisely why we choose gold. Historically, gold has always been the same price, like I’ve said a stable measure of value. The reason for this is that gold is in excess. 95% of the above ground gold is in reserve. This means that changes in demand don’t affect the price of gold
So there you have it. The most perfect monetary system devised by man.