You have probably heard about the "gold standard" and how some advocate that the United States ought to return to it in order to strengthen the economy, stop terrorists dead in their tracks and even enhance the cleaning power of your favorite laundry detergent. In 1971, the U.S abolished the gold standard, and since then, the value of the dollar has had no correlation to the value of gold. The gold standard may have been ideal for a simpler world, but a floating rate system that pegs exchange rates in relation to other world currencies fuels today's global economy.
The gold standard connects a country's currency's value to the value of gold, while the floating exchange rate system measures a country's currency's value against other currencies' values.
Definition of Gold Standard
Under the gold standard, a country's currency is pegged to the value of gold as determined by that country. A unit of currency is also redeemable for the amount of gold that it is considered to be worth, and a country cannot issue amounts of currency that exceed its gold reserves. "All the gold in Fort Knox" refers to the gold that the United States Treasury stored in Fort Knox in order to back the dollar during the years that it adhered to the gold standard.
Definition of Floating Exchange Rate
Today, the United States dollar follows a floating exchange rate system. Its value is measured against the values of other freely traded currencies, most particularly the euro, the Japanese yen and the British pound. The exchange rate fluctuates according to investors' confidence in each of the currencies, and this confidence is at least theoretically based on economic performance in each country.
Gold Standard: Pros and Cons
The gold standard prevents countries from printing more currency than they can back with physical gold. This prevents inflation that is caused by printing money to cover national debts, but it also stifles growth. While the gold standard can be a stabilizing factor, the price of gold also fluctuates, and this affects currencies backed by gold.
Changes in the price of gold due to the discovery of new gold mines or increased demand from industry can seriously affect the value of a gold-backed currency. Such was the case with the dollar during the California gold rush.
Floating Rate: Pros and Cons
A floating rate is extremely sensitive to even the most minor economic changes. An earthquake in Japan that disrupts industry can cause ripples in other currencies, ranging from the rand to the ringgit. However, it is also the most flexible system and the most conducive to economic growth. It allows governments to determine their money supply according to the needs of their economies and to respond with changes in policy if the exchange rates become unfavorable.
The floating dollar rate is here to stay, regardless of some who think the gold standard will bring America back to the glory days of Teddy Roosevelt.