Gold standard
Also written Gold standard system · Gold exchange standard · Gold peg
The system, dating from around 1870, under which a central bank held gold against its paper currency, so the rate between any two currencies followed from their gold prices instead of from trading.
In plain language
Money did not start as paper. People bartered goods, then used metals, then settled on gold and silver coins. Paper currency came later. A person deposited gold coins with a bank. The bank handed back a paper promise worth a fixed number of those coins.
Cross-border trade then raised a hard question. What is one country's money worth in another country's money?
Around 1870 countries agreed on an answer. Each would value its currency against gold. A central bank issued paper currency and held an equal amount of gold in reserve. The rate between any two currencies then fell out of their two gold prices.
That is the gold standard. Notice what it means. Nobody had to trade to find a rate. The rate was arithmetic.
The system did not last. Wars, political upheaval and trade deficits and surpluses pushed countries off it. Britain stopped in 1931. The United States followed in 1933 and dropped the last remnants of the system in 1973.
No government uses the gold standard today. What took its place is fiat money — money that works because the state orders that it be accepted.
How it works
The mechanism, as Chapter 1 sets it out. Central banks issued paper currency and held an equivalent amount of gold in reserve. The value of each currency against another was derived from the gold exchange rate. So the rate was not a market price at all. It was the ratio of two gold prices.
Why it killed the need for an FX market. The workbook makes the point bluntly: during the gold standard there were no exchange rates to determine. The forex market came into prominence only when the world went off gold, because only then did currencies have to be valued against one another continuously, on the information flowing through markets in real time.
What came after. The sequence in the workbook runs gold standard, then floating rates with heavy central bank intervention, then the Bretton Woods System for 1944 to 1971, then free choice of regime from 1973 — with one bar. After Bretton Woods collapsed, countries could link a currency to another currency, to a basket, or let it float, but they could not peg its value to the price of gold.
| Milestone | Year |
|---|---|
| Countries agree to value currencies against gold | around 1870 |
| Britain leaves the gold standard | 1931 |
| United States leaves the gold standard | 1933 |
| Bretton Woods System in force | 1944 to 1971 |
| US abandons the remnants; gold pegs barred | 1973 |
Do not merge it with Bretton Woods. Under the gold standard every currency was valued against gold. Under Bretton Woods only the dollar was pegged to gold, and every other currency was pegged to the dollar within a plus or minus 1% band.
A worked example
The workbook's own arithmetic. One unit of gold is valued at INR 10,000 and at USD 500.
| Step | Working | Result |
|---|---|---|
| Rupee price of one gold unit | given | Rs 10,000 |
| Dollar price of one gold unit | given | USD 500 |
| Rupees per dollar | 10,000 / 500 | 1 USD = INR 20 |
No dealer quoted that 20. It is forced by the two gold prices.
What it meant for an Indian importer. Suppose a Mumbai trader owed USD 5,000 for machinery.
| Under the gold standard | Under a floating rate | |
|---|---|---|
| Rate used | Rs 20, fixed by gold | Whatever the market quotes that morning |
| Rupees payable | 5,000 x 20 = Rs 1,00,000 | 5,000 x 83.00 = Rs 4,15,000 at a rate of 83 |
| Risk of the rate moving before payment | None while the peg held | Real, and the reason currency derivatives exist |
That first column is the whole appeal of the gold standard, and the reason it kept breaking. To hold the rupee at Rs 20 a dollar, the Reserve Bank would have had to hold gold against every rupee it issued, whatever was happening to India's trade balance. The discipline is the benefit and the discipline is the flaw.
And the modern consequence. Because the rupee is no longer pegged to anything, the same USD 5,000 payable is an exposure. That is the exposure a USDINR futures contract of USD 1,000 a lot is built to hedge — 5 lots for this importer.
Why NISM asks about it
Chapter 1, section 1.1 (Brief History of Foreign Exchange Markets), is the only place the gold standard is taught, and it is taught as history with three examinable hooks: the 1870 start, the INR 10,000 / USD 500 gives 1 USD = INR 20 calculation, and the abandonment dates (Britain 1931, US 1933, remnants 1973). The chapter's sample question asks which term best describes the euro, with "pegged to gold" as a distractor — the answer is free floating, because no currency is pegged to gold any more.
Common exam traps
- The gold standard is not Bretton Woods. Gold standard: every currency valued against gold. Bretton Woods (1944 to 1971): currencies pegged to the dollar within ±1%, and only the dollar pegged to gold.
- No government uses it now. A question offering "pegged to gold" as an option for any live currency is offering a distractor.
- Britain 1931, US 1933. The US 1973 date is the abandonment of the remnants, not the exit.
- The rate under gold was derived, not traded. That is why the workbook says there were no exchange rates to determine.
- After 1973 a country could peg to another currency or a basket, but not to gold.
- Gold standard was replaced by fiat money, not by the Bretton Woods System — Bretton Woods came in between and was itself a blend of the two.
Check yourself
1.Under the gold standard, one unit of gold is valued at INR 10,000 and at USD 500. What is the INR versus USD exchange rate?
- a)1 USD = INR 20
- b)1 USD = INR 50
- c)1 USD = INR 0.05
- d)1 USD = INR 5,000
Show the answer
Answer: (a) 1 USD = INR 20
"As per this process, central banks issue paper currency and hold equivalent amount of gold in their reserve. The value of each currency against another currency was derived from gold exchange rate. For example, if one unit of gold is valued at Indian Rupees (INR) 10,000 and US dollar (USD) 500 than the exchange rate of INR versus USD would be 1 USD = INR 20."
10,000 ÷ 500 = 20.
INR 0.05 is the inverse — the value of 1 INR in USD.
INR 50 and INR 5,000 are arithmetic slips.
Timing: "at some time in 1870 countries agreed to value their currencies against value of currency of other country using gold as the benchmark for valuation... This mechanism of valuing currency was termed as gold standard."
2.Which term best describes the EUR currency?
- a)Free floating
- b)Managed float
- c)Pegged to USD
- d)Pegged to gold
Show the answer
Answer: (a) Free floating
The most traded currency pairs in the world are called the Majors. The list includes following currencies: Euro (EUR), US Dollar (USD), Japanese Yen (JPY), Pound Sterling (GBP), Australian Dollar (AUD), Canadian Dollar (CAD), and the Swiss Franc (CHF). These currencies follow free floating method of valuation.
A clean float, also known as a pure exchange rate, occurs when the value of a currency, or its exchange rate, is determined purely by supply and demand in the market.
Option B describes India's position, not the euro's. The currency regime in place for the Indian rupee with respect to the US dollar is a de facto controlled exchange rate. This is sometimes called a "managed float". A dirty float (managed float) is an exchange rate regime in which the exchange rate is neither entirely free (or floating) nor fixed.
Option C is wrong — pegging is what developing countries did: developed countries gradually moved to a market determined exchange rate (For e.g. USD, EUR, JPY etc.) and developing countries adopted either a system of pegged currency or a system of managed exchange rates.
Option D belongs to a system that no longer exists anywhere. The gold standard is not currently used by any government. Britain stopped using the gold standard in 1931 and the U.S. followed suit in 1933 and abandoned the remnants of the system in 1973.
The euro is managed by the Frankfurt-based European Central Bank (ECB) and the Eurosystem, and is the second-largest and second-most traded currency in the international markets... after the United States dollar — with a 30.5% share of global daily turnover.
3.Under the Bretton Woods System (1944–1971), how were exchange rates organised?
- a)All currencies floated freely against gold
- b)All currencies were pegged directly to gold within plus or minus 5%
- c)All currencies were pegged to USD at a fixed rate, USD was pegged to gold, and countries kept rates within plus or minus 1% of the parity with the US dollar
- d)USD was pegged to a basket of currencies, and others floated against USD
Show the answer
Answer: (c) All currencies were pegged to USD at a fixed rate, USD was pegged to gold, and countries kept rates within plus or minus 1% of the parity with the US dollar
"During 1944-1971, countries adopted a system called Bretton Woods System. This system was a blend of gold standard system and floating rate system. As part of the system, all currencies were pegged to USD at a fixed rate and USD value was pegged to gold... Countries also agreed to maintain the exchange rate in the range of plus or minus 1% of the fixed parity with US dollar."
The result: "With adoption of this system, USD became the dominant currency of the world."
Free floating came after its collapse — "By 1973 the Bretton Woods System had collapsed."
Other currencies were pegged to USD, not directly to gold, and the band was 1%, not 5%.
Its institutions: "the International Monetary Fund and the World Bank."
Where this is taught
Free preparation for NISM Series IRelated terms
- Bretton Woods SystemThe 1944–1971 exchange rate system in which currencies were pegged to the US dollar within ±1% and the dollar was pegged to gold; it collapsed by 1973, giving way to floating rates.
- Clean floatAn exchange rate regime in which a currency's value is set purely by supply and demand in the market, with no government rule or central bank action affecting its price.
- Fiat moneyGovernment-issued currency that is not backed by a physical commodity such as gold or silver; its value rests on supply and demand and on the stability of the issuing government.
- Exchange Rate RiskThe risk that an investment’s value, measured in the home currency, changes because foreign exchange rates move. A falling rupee raises returns on foreign assets; a rising rupee cuts them.