MCQs and Answers

The gold standard suffers from the following defects:

1. Not Always Simple:

Gold standard in all its forms is not simple. The gold coin standard and, to some extent, gold bullion standard may be regarded as simple to understand.

But, the gold exchange standard which relates the currency unit of a country to that of the other is by no means simple to be comprehended by a common man.

2. Lack of Elasticity:

Under the gold standard, the monetary system lacks elasticity. Under this standard, money supply depends upon the gold reserves and the gold reserves cannot be easily increased. So money supply is not flexible enough to be changed to meet the changing requirements of the country.

3. Costly and Wasteful:

Gold standard is a costly standard because the medium of exchange consists of expensive metal. It is also a wasteful standard because there is a great wear and tear of the precious metal when gold coins are actually in circulation.

4. Fair-Weather Standard:

The gold standard has been regarded as a fair-weather standard because it works properly in normal or peaceful time, but during the periods of war or economic crisis, it invariably fails.

During abnormal periods, those who have gold try to hoard it and those who have paper currency cry for its conversion into gold. In order to protect the falling gold reserves, the monetary authority prefers to suspend the gold standard.

5. Sacrifice of Internal Stability:

The gold standard sacrifices domestic price stability in order to ensure international exchange rate stability. In fact, under gold standard, inflation and deflation respectively are the necessary companions to a favourable and an unfavourable balance of payments.

Give the world’s total monetary gold stock, an individual country’s monetary gold stock, and consequently, the money supply and the internal price level, changes by the inflow or outflow of gold as a result of international trade.

Thus the presence of external trade almost guarantees price instability under gold standard mechanism.

6. Not Automatic:

The automatic working of the gold standard requires the mutual cooperation of the participating countries.

But, during the World War I, because of the lack of international cooperation, all types of countries, those receiving gold as well as those losing gold, found it necessary to abandon the gold standard to prevent disastrous inflation on the one hand and even more disastrous deflation and unemployment on the other.

7. Deflationary:

According to Mrs. Joan Robinson, gold standard generally suffers from an inherent bias towards deflation. Under this standard, the gold losing country is under the compulsion to contract money supply in proportion to the fall in gold reserves.

But the gold gaining country, on the other hand, may not increase its money supply in proportion to the increase in gold reserves.

Thus, the gold standard, which necessarily produces deflation in the gold losing country, may not generate inflation in gold receiving country.

8. Economic Dependence:

Under gold standard, the problems of one country are passed on to the other countries and it is difficult for an individual country to follow independent economic policy.

9. Unsuitable for Developing Countries:

Gold standard is particularly not suitable to the developing economies which have adopted a policy of planned economic development with an objective to secure self sufficiency.

Before World War I, gold standard worked efficiently and remained widely accepted. It succeeded in ensuring exchange stability among the countries.

But with the starting of the war in 1914, gold standard was abandoned everywhere mainly because of two reasons: (a) to avoid adverse balance of payments and (b) to prevent gold exports falling into the hands of the enemy.

After the war in 1918, efforts were made to revive gold standard and, by 1925, it was widely established again. But, the great depression of 1929-33 ultimately led to the breakdown of the gold standard which disappeared completely from the world by 1937.

The gold standard failed because the rules of the gold standard game were not observed. Following were the main reasons of the decline of the gold standard.

1. Violation of Rules of Gold Standard:

The successful working of the gold standard requires the observance of the basic rules of the gold standard:

(a) There should be free movement of gold between countries;

(b) There should be automatic expansion or contraction of currency and credit with the inflow and outflow of gold;

(c) The governments in different countries should help facilitate the gold movements by keeping their internal price system flexible in their respective economies.

After World War I, the governments of gold standard countries did not want their people to experience the inflationary and deflationary tendencies which would result by following the gold standard.

2. Restrictions on Free Trade:

The successful working of gold standard requires free and uninterrupted trade of goods between the countries. But during interwar period, most of the gold standard countries abandoned the free trade policy under the impact of narrow nationalism and adopted restrictive polices regarding imports.

This resulted in the reduction in international trade and thus the breakdown of the gold standard.

3. Inelastic Internal Price System:

The gold standard aimed at exchange stability at the expense of the internal price stability. But during the inter-war period, the monetary authorities sought to maintain both exchange stability as well as price stability.

This was impossible because exchange stability is generally accompanied by internal price fluctuations.

4. Unbalanced Distribution of Gold:

A necessary condition for the success of gold standard is the availability of adequate gold stocks and their proper distribution among the member countries.

But in the inter-war period, countries like the U.S.A. and France accumulated too much gold, while countries of Eastern Europe and Germany had very low stocks of gold. This shortage of gold reserves led to the abandonment of the gold standard.

5. External Indebtedness:

Smooth working of gold standard requires that gold should be used for trade purposes and not for the movement of capital. But during the inter-war period, excessive international indebtedness led to the decline of gold standard.

There were three main reasons for the excessive movement of capital between countries:

(a) After World War I, the victor nations forced Germany to pay war reparation in gold,

(b) There was movement of large amounts of short-term capital (often called as refugee capital) from one country to another in search of security,

(c) There was plenty of borrowing by the underdeveloped countries from the advanced countries for investment purpose.

6. Excessive Use of Gold Exchange Standard:

The excessive use of gold exchange standard was also responsible for the break-down of gold standard. Many small countries which were on gold exchange standard kept their reserves in London and New York.

But, rumors of war and abnormal conditions forced the depositing countries to withdraw their gold reserves. This led to the abandonment of the gold standard.

7. Absence of International Monetary Centre:

Movement of gold involves cost. Before 1914, such move­ment was not needed because London was working as the international monetary centre and the countries having deposit accounts in the London banks adjusted their adverse balance of payments through book entries.

But during inter-war period, London was fast losing its position as an international financial centre. In the absence of such a centre, every country had to keep large stocks of gold with them and large movements of gold had to take place.

This was not proper and easily manageable. Thus, gold standard failed due to the absence of inter-national financial centre after World War I.

8. Lack of Co-operation:

Economic co-operation among the participating countries is a necessary condi­tion for the success of gold standard. But after World War I, there was complete absence of such co-operation among the gold standard countries, which led to the downfall of the gold standard.

9. Political Instability:

Political instability among the European countries also was responsible for the failure of gold standard. There were rumours of war, revolutions, political agitations, fear of transfer of funds to other countries. All these factors threatened the safe working of the gold standard and ultimately led to its abandonment.

10. Great Depression:

The world-wide depression of 1929-33 probably gave the final blow to the gold standard. Falling prices and wide-spread unemployment were the fundamental features of depression which forced the countries to impose high tariffs to restrict imports and thus international trade. The great depression was also responsible for the flight of capital.

11. Rise of Economic Nationalism:

After the World War I, a wave of economic nationalism swept the European countries. With an objective to secure self-sufficiency, each country followed protectionism and thus imposed restrictions on international trade. This was a direct interference in the working of the gold standard.

While under constant cost conditions, there is com­plete specialisation of a country in the production of a commodity, under increasing cost conditions, complete specialisation is not possible.

In Figure-2 P_iP_i is the production possibility curve of India and is the production possibility curve of England. The production possibility curve represents the maximum amount of one good that the country can produce for given amount of other good.

Under the increasing cost conditions, the production possibility curve is concave to the origin which indicates that in order to produce more of one good, increasing amount of other good are to be given up.

From the different shapes of P_iP_i and P_eP_e curves, it is clear that in India, conditions favour the production of wheat rather than cloth, while, in England; the conditions favour the production of cloth rather than wheat.

Point A is the autarky point for India and point B is the autarky point for England. In other words, in the absence of trade, India is producing and consuming at point A (i.e., OW_i of wheat and OC of cloth) and England is producing and consuming at point B (i.e., OW of wheat and OC_e of cloth).

The slopes of lines II and EE represent the domestic exchange ratios in India and England respectively. These exchange ratios show that wheat is cheaper in terms of cloth in India and cloth is cheaper in terms of wheat in England.

Under such conditions, both the countries will gain by entering into trade. India has the comparative advantage in the production and export of wheat and England in the production and export of cloth.

India will gain by producing more of wheat and less of cloth, while England will gain a producing more of cloth and less of wheat. Trade between the two countries will continue until the opportunity cost (as represented by the slope of production possibility curve) in each country is equal to the international exchange ratio.

In this case, the international exchange ratio is given by line TT which is tangent to the two production possibility curves (PP. and P_eP_e) at points A’ and B’. Thus, A’ and B’ are the points of specialisation for India and England respectively.

After trade, India will expand the production of wheat from OW_i to OW_i‘ and contract the production of cloth from OC to OC’. Similarly, England will expand the production of cloth from OC_e to OC’_e and contract the production of wheat from OW_e to OW_e‘. The results of trade are summarised below:

Gains from international trade are clear from the fact that India now obtains more cloth for every unit of wheat surrendered than before trade; the slope of TT is greater than II.

Similarly, England now obtains more wheat for every unit of cloth surrendered than before trade; the slope of TT is less than EE.

As long as each country is able to consume along the line of international exchange ratio (TT) rather than its own line of domestic exchange ratio (II for India and EE for England), both the countries will gain in welfare.

The concept of terms of trade refers to the rate at which a country exchanges exports for imports. It expresses a comparison of two values: the export prices and the import prices. In other words, the concept of terms of trade is defined as the ratio of export prices to import prices.

If the prices of imports rise more that the prices of exports, then the terms of trade become unfavourable to, or move against, the country in question because to obtain the same volume of imports, greater volume of exports are to be sold abroad.

Similarly, if the prices of exports rise more than the prices of imports, the terms of trade become favourable to the country.

Types of Terms of Trade

G.M. Myer has classified various concepts of terms of trade under three broad groups:

(i) Those terms of trade that relate to the ratio of exchange between commodities. They are:

(a) Net barter terms of trade (NBTT)

(b) Gross barter terms of trade (GBTT)

(c) Income terms of trade (ITT)

(ii) Those terms of trade that relate to the interchange between productive resources. They are:

(a) Single factoral terms of trade (SFTT)

(b) Double factoral terms of trade (DFTT)

(iii) Those terms of trade that expresses the gains from trade in terms of utility analysis. They are:

(a) Real cost terms of trade (RCTT)

(b) Utility terms of trade (UTT)

In order to overcome the deficiency in the net barter terms of trade, Prof. Tausig devised the concept of gross barter terms of trade. He pointed out that instead of relating import and export prices, quantity of imports and exports should be related.

Thus, the gross terms of trade are the ratio of the total quantities of imports to the total quantities of exports of a nation in physical terms. Symbolically,

Where,

GBTT = Gross barter terms of trade

Q_m = Total quantity of imports

Qx = Total quantity of exports

If Q_m > Q_x, terms of trade will be unfavourable; and if Q_m < Q_x, terms of trade will be favourable.

To measure the changes in terms of trade over a period of time, the index numbers of the quantities of imports and exports in the base year and the current year are related to each other. Then the formula becomes:

Where the subscripts 1 and 0 indicate the current year and base year respectively.

A rise the current year’s gross barter terms of trade means a favourable change. It indicates that more imports are obtained from a given volume of exports than in the base year.

Tausig’s concept of gross-barter terms of trade is also criticised on the following grounds:

(i) It incorporates various types of unilateral payments like tributes, immigrants’ remittances, etc. These payments remain unaffected whether there is any trade or not

(ii) It reflects less price movements than changes in the balance of payments and capital movements.