Chapter 10

The Gold Standard

Money, we have seen, begins as a commodity—otherwise people would not know what value to give it. But, what commodity? As mentioned in the previous chapter, this is not something we can determine by a priori reasoning. Many different goods

have served as money—including cows and cigarettes.

But, I am sure you will recall, although we cannot figure out which good a society must adopt as money, we can establish some general principles that narrow the range of choice. A good can become money only if it is widely accepted by people in a society. Further, people must believe that it will be accepted if offered in exchange.

1.Why is the latter requirement needed? Why isn’t it enough

if the members of a society accept a good in exchange? Why must people also believe that it will be accepted?

2.	It’s easy to understand how a society could adopt cows as	?
	money: think of an agricultural community where cows

feature prominently. But how can cigarettes get to be money?

AN UNUSUAL CHOICE

The group that chose cigarettes was in an extraordinary situation. It consisted of soldiers in a prisoner of war camp. Since everyone

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realized that (nearly) everyone else wanted cigarettes, then, no doubt to the dismay of the American Medical Association, cigarettes were a highly demanded good. They became money in the way the money regression theorem indicates.

	1.	“Doesn’t the cigarette example really disprove the regres-
?		sion theorem? Didn’t people in the camp agree among
		themselves that cigarettes would be considered money?
		But the regression theorem says money isn’t established
		by agreement.” What is wrong with this objection? Hint:
		does it follow from the theorem that the evolution of
		money must take place slowly?

THE USUAL CHOICE

Were you able to figure out the answer to the last question? Remember, the regression theorem says that the value of the money commodity cannot be determined just by decision. But if people know that cigarettes will be generally accepted, and are aware, through trades, of the price of other goods in terms of cigarettes, things can move very fast.

In most societies, cigarettes are not the medium of exchange. As mentioned before we digressed onto cigarettes, there are some general principles that limit the range of goods that will be chosen as money. These principles, as you will recall from the previous chapter, have led most societies with access to gold or silver to adopt one of these metals, or both, as money.

?1. Review the properties of money that make gold and silver desirable mediums of exchange.

Chapter 10: The Gold Standard 165

2.If gold and silver are in fact so useful as money, why isn’t the United States on the gold standard?

Sometimes, a society will use both gold and silver as money. Usually, silver will be used for smaller transactions, gold for larger. A monetary system with two metals at once poses a problem. We will have some prices of goods given in gold and others given in silver.

1.	How may these prices be compared with each other?	?
2.	Extra-credit: Why does the answer to the first problem
	suggest a further problem about the prices of other

goods? How can this difficulty be resolved?

THE MARKET SOLUTION

The key to our first problem is straightforward. Gold and silver are commodities, just like apples and oranges. They can then trade against each other. For example, the market may establish this price: 1 ounce of gold exchanges for 16 ounces of silver. Suppose this ratio is chosen, will it always remain constant? That is, will gold and silver always exchange according to the formula just given?

As I hope you have realized, the answer is no. The ratio is a price; and just like other prices, it is determined by demand and supply. These, in turn, depend on the utilities of the buyers and seller. (Go back to the chapters on utility and demand and supply for a

166 An Introduction to Economic Reasoning

review. You cannot go over these basic principles too many times. To understand economics, you must know demand and supply.)

Let’s assume that more silver is mined while the amount of gold stays the same. As more silver enters the market, the marginal utility of silver decreases. (Why?) What will be the effect on the exchange ratio of gold and silver?

People will now have to give up more silver than before to get an ounce of gold. We will have a new ratio of exchange, e.g., 1 ounce of gold exchanges for 16.5 ounces of silver.

?1. Draw supply and demand diagrams to illustrate the change just described. (Of course, I could have put them in the book! But it’s much better that you, the student,

construct them for yourself. Besides, it’s easier for me.)