The Gold standard performs two important functions:
1. To Regulate the Volume of Currency:
Internally, gold standard forms the basis of the currency and acts as a regulator of the volume of currency in the country. This function is called the domestic aspect of the gold standard since it is concerned with stabilising the internal value of the currency.
Under gold standard, currency notes are exchangeable on demand for gold of equivalent value. Thus, note issue is fully backed by “old reserves and the growth of fiduciary note issue (without gold backing) are checked.
Moreover, since the amount of cash in the country is limited by the gold reserve held by the central bank and there must be a cash basis for credit creation, the capacity of the banks to create credit is also limited by the gold reserve. Thus under gold standard, total currency of the country is regulated by its gold reserves.
2. To Maintain the Stability of Exchange Rate:
Externally, gold standard aims at regulating and stabilising the exchange rate between the gold standard countries. This function is called the international aspect of the gold standard because it is concerned with stabilising the external value of the currency.
Under gold standard, every member country fixes the value of its currency in terms of certain weight of gold given purity.
Moreover, there is an undertaking given by each country’s monetary authority to purchase or sell gold in unlimited quantity at the officially fixed price.
Under these conditions, a stable relation exists between the money units of different gold standard countries and free movement of gold helps in maintaining the stability of exchange rates.
Thus, under gold standard, a gold reserve is maintained for two purposes: (a) as backing for note issue; and (b) to cover a deficit in the balance of payments and thus to maintain the stability of exchange rate.
While distinguishing between the two aspects or functions of gold standard, Crowther writes: “The cardinal point in the Domestic Gold Standard is clearly the proportion of volume enforced by the law between the gold reserves and the currency.
The essence of the International Gold Standard is the convertibility of the currency into gold- that is the fixed proportion of value between a unit of gold and a unit of currency.