From the Gold Standard to the Fractional Reserve System

Once the world was run by gold, now it’s by paper and plastic. But how did this transition happen? Why is it important? Why does it affect our lives and did the world make the right choice in this switch?

Which Financial System is the Better Choice Today?

By Pawan Shamdasani, Staff Writer
Design by Mary Zhao, Staff Designer

Once the world was run by gold, now it’s by paper and plastic.  But how did this transition happen?  Why is it important?  Why does it affect our lives and did the world make the right choice in this switch?

To start, the gold standard was a monetary system where each participating country fixed the value of its currency to a specific amount of gold.  Most developed countries adopted this system during much of the nineteenth century and early twentieth century.

Meanwhile, the Fractional Reserve system—the most current monetary system—has existed since the early nineteenth century.  This system involves banks keeping a fraction of their deposits as reserves while lending out the remaining and having the obligation to redeem all these deposits upon demand.

Amid this latest financial downturn, there has been a lot of heated debate by economists about whether the Fractional Reserve system is the still most appropriate for the current financial system.  Now it’s our turn to join that debate.

Golden History

Before World War I, the world economy operated under the gold standard.  The standard was adopted by England in 1717, the United States in 1834, and by other major countries in the 1870s.  During 1880 to 1914, most countries adhered to the “Classical Gold Standard”; this was also a period of unprecedented economic growth and relatively free trade in goods, labour and capital.

But WWII changed everything.

The gold standard collapsed as countries demanded monetary flexibility to finance the war.  Only after Germany’s defeat did developed countries initiated the “Gold Exchange Standard”, where all countries fixed the value of their currencies in terms of the U.S. dollar.  Likewise, the U.S. Central Bank fixed the value of the dollar in terms of gold.  But this system was no better than the last, as it broke down in the early 1930s.
Then came “the Bretton Woods System” around 1944.  This system was based on the convertibility of U.S. dollars into gold (for foreign governments and central banks only) at thirty-five dollars per ounce.  With this system, the majority of countries settled their international balances in U.S. dollars.  However, continuous U.S. balance-of-payments deficits steadily reduced their gold reserves, thus lowering the ability of the United States to redeem its currency in gold.

Finally, on August 1971 the gold standard was abolished.

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