9 - Summary of Part 1

Before we introduce the impact of an imprudent government on the stability of the gold-backed system, let’s recap...

The Barter Society & Direct Exchange

Early man had simple needs: food, water and shelter. As society progressed, man entered into barter transactions - the direct exchange of goods and services - in order to better fulfil his needs. However, the barter system is limited by “indivisibility” and the “lack of coincidence of wants”.

Indirect Exchange

For society to leap forward, man required a commodity which was divisible into small units without loss of value, durable over long periods of time and transportable over large distances. Over time, by trial and error and in competition with all other commodities, gold and silver emerged as the preferred media of exchange. They became referred to as “money”.

Gold & Silver as Money

As a commodity, the unit of account for money is the weight of gold and silver. The supply of money is therefore the total weight of gold and silver existing in society. It makes no difference what the money supply is, since a rise in the money supply reduces the purchasing power of each gold or silver ounce, while a fall in the money supply increases the purchasing power of each ounce. There is therefore no need for the supply of money to be regulated.

Money Substitutes

It is cumbersome to deal with stocks of metal moving between parties in return for a particular good or service. Instead, we could deposit our gold and silver at a bank and receive a receipt of our holding in return – a bank note. These bank notes can then pass between parties during economic transactions, shifting the entitlement to the gold and silver money without the need to move the physical metal. In this way, receipts for money come more and more to function as money substitutes. Under a gold-backed system, money substitutes do not impact the money supply since they are simply receipts for deposited gold. The notes are a convenient stand-in for the gold, not an increment.

A Gold Standard

The above is basically a simple form of a “gold standard”. The money substitutes are backed by gold and are convertible “on demand” back into the money metal. Many countries have previously existed under some form of gold standard for centuries. The limited supply of gold money forces discipline on nations, ensuring that the economy of a particular country does not overheat and that the country’s economic relationship with other countries remains stable.

Price Setting Under a Gold Standard

We have seen that the money supply has no bearing on our wealth and that one money supply will do as well as any other money supply. We have also seen that if the supply of money does change, the free market will simply adjust prices by changing the purchasing power. So what stops us raising prices to whatever level we wish? Buyers and sellers of any one kind of thing, such as food or medical care, do have some freedom to increase the prices, but every dollar more that a buyer spends for food or medical care is a dollar less that he can spend for something else, and every increased price of one thing must come out of a decreased price of something else. Prices therefore remain generally stable.

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