Demystifying the economy | The Role of Gold in the Global Financial System

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Posted at 11:00 a.m.

Andre Dubuc

Andre Dubuc
The Press

Would it be possible to have a fairly detailed article on the role of gold in the stability of Canadian, American or other currencies?

J. Damphousse

Nowadays, gold serves mainly as reserves of the central banks of the main economies of the world with the notable exception of the Bank of Canada, which did not have a single ingot in its vaults as of April 8, 2022. .

Reserves are used in particular to intervene in the foreign exchange market to influence the value of the national currency. When a central bank sells gold in exchange for its currency, it supports the value of its currency. The reverse causes the supply to rise, which can weaken its price.

In fact, gold ceased to play a role in the global monetary system on August 15, 1971, when then-President Richard Nixon ended the convertibility of the US dollar into gold. The major economies then moved to a system of floating exchange rates.

From 1870 to the First World War, the global financial system was based on a gold standard system, as the Banque de France explains in a reference document available on its website.

In such a system, the value of the national currency is attached to a fixed quantity of gold, and each national currency is convertible into gold. The amount of money issued by the central bank is limited by its gold reserves. Settlements between countries are made in gold. As each national currency is fixed to a quantity of gold, the exchange rate between two currencies is fixed.

The money supply of the country depends on the amount of gold it has in its reserves. If gold leaves the country, the money supply contracts, which leads to lower prices. If gold, on the contrary, goes into the coffers, the money supply of the country increases, and there is therefore inflation.

The gold standard promotes great exchange rate stability, which stimulates international trade. In such a regime, governments have handcuffs that prevent them from artificially increasing their money supply in order, for example, to finance public expenditure.

Quite the opposite, in short, of what we saw during the COVID-19 pandemic, when countries like Canada and the United States printed money like never before to keep the economy alive for that the country was on pause. Result: inflation has never been so high in 40 years.

In contrast, the gold standard promotes deflation, a general decline in prices, which is catastrophic for the economy, as people stop consuming in the hope of profiting from future price declines.

This is because growth in the global supply of gold, which determines the global money supply, is limited by nature to 1-3% per year and struggles to keep up with growth in global gross domestic product.

After World War II, the gold standard was replaced by the Bretton Woods system. The parity with gold was replaced by a parity of national currencies with the dollar, which was initially convertible into gold until that fateful day of August 15, 1971.

Today, few people argue for a return to the gold standard because of its drawbacks.

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