Under the gold standard, the exchange rates of the major industrial countries were firmly pegged within narrow bands ('the gold points') in an environment free of significant restrictions on international flows of financial capital. The breakdown of the Bretton Woods system following the liberalization of international capital markets in the 1960s and the collapse of the narrow-band EMS on the heels of the removal of Europe's residual capital controls in the 1980s demand the question: how did the pre-1914 gold standard manage to avoid the same fate. The literature on this subject can be separated into two strands: one focuses on the stabilizing nature of the policy rules followed by central banks and governments during the gold standard years; the other looks instead at the nature of the underlying economic environment, particularly the structure of commodity and factor markets. The maintenance of the gold standard could be attributable simply to a favourable environment. This strand of literature has been lent new impetus by recent developments in time-series econometrics, with a number of investigators applying recent techniques to extract aggregate supply and demand disturbances and speeds of adjustment to shocks from time series on output and prices.

In Discussion Paper No. 1248, Research Associate Tamim Bayoumi and Research Fellow Barry Eichengreen reassess the evidence on the incidence of macroeconomic disturbances and the speed of adjustment under the pre-1914 gold standard. They introduce linkages between domestic and foreign prices, an extension which proves sufficient to resolve the empirical difficulties experienced by other authors. They find that shocks were no smaller or less frequent under the gold standard than in the post-war period, but that the adjustment of prices and quantities was faster. Now, however, they find that responses of prices to aggregate supply disturbances ar e generally correctly signed. Lastly, they analyse shifts across international monetary regimes in the slopes of the aggregate demand and aggregate supply schedules. They find that these slopes did in fact shift over time in directions consistent with the predictions of standard models. Aggregate demand curves were flatter under the quasi-fixed exchange rates of the gold standard than the pegged but adjustable rates of Bretton Woods, and flatter under Bretton Woods than the post-Bretton Woods float. This analysis provides a unified explanation for the historical evolution of the international monetary system.

The Stability of the Gold Standard and the Evolution of the International Monetary System
Tamim Bayoumi and Barry Eichengreen

Discussion Paper No. 1248, October 1995 (IM)