Chapter 10: The Gold Standard 167

2.Draw supply and demand diagrams showing the effect of an increase in the supply of both metals; a decrease in both; and an increase in one accompanied by a decrease in the supply of the other. I really make you work, don’t I?

?

OTHER GOODS

The market has established an exchange ratio, say 16 to 1, between ounces of silver and gold. Is everything now all right?

No, not necessarily. Some goods will be priced in gold and others in silver. These prices, of course, will be determined by the demand and supply of these goods, relative to the demand and supply of gold and silver, respectively. For example, 1000 oranges may exchange for 2 ounce of silver.

1. What do you think the gold price of 1000 oranges would	?

be, given the silver price just quoted?

OTHER GOODS CONTINUED

In the market, we will have all sorts of different exchange ratios, or prices, some stated in terms of gold, some in terms of silver. All these prices must “match” the gold–silver exchange ratio.

What does this mean? Suppose someone wants to buy oranges but doesn’t have any silver. He asks the orange grower, “How much gold must I give you for your 1000 oranges?” (Speakers in economics

168 An Introduction to Economic Reasoning

textbooks often express themselves in stilted sentences.) Our Orangeman is no dummy; he replies, “c ounce of gold.” The owner of gold, eager to secure the oranges, accepts. Can you see the problem that now arises? We have the following exchange ratios:

16 ounces of silver exchanges for 1 ounce of gold 2 ounce of silver exchanges for 1000 oranges

c ounce of gold exchanges for 1000 oranges

As Lord Tennyson the great British poet, says, in “The Charge of the Light Brigade,” “Someone had blundered.” You should easily discern who it is: it’s the sap who gave up c ounce of gold to get 1000 oranges.

The fortunate Orangeman now has c ounce of gold. We can now obtain 2 ounces of silver for his gold. (Why?) After doing so, he can buy 4000 oranges. (If he is even more lucky, he can start the round again, this time getting 2 ounce of gold from the sap for 4000 oranges.)

Unfortunately for the Orangeman, but fortunately for the sap, this situation will soon come to an end. Other Orangemen will attempt to get in on the good deal. They want the gold for themselves: they will not act as United Orangemen. But the sap has only a limited amount of gold to offer for oranges. How can each Orangeman get as much as possible for himself? He will offer the sap a better deal. He will, say, offer 2000 oranges for c ounce of gold.

?1. Why will he do so? The sap will give up 1/8 ounce of gold for 1000 oranges. Why offer an extra 1000?

Chapter 10: The Gold Standard 169

THE SAP GETS WISE

If he didn’t offer more oranges, what would happen? He might be shut out of the market. His fellow Orangemen would all be trying to get the gold; and there is not enough to go around. If he offers 2000 oranges, his chances to get gold increase. The sap prefers to get 2000 oranges rather than 1000 oranges for his c ounce of gold. (He isn’t that idiotic.) The Orangeman will make less profit than before, but it is still well worth it for him to up his offer.

1. Work through the exchange ratios to show why it is still to the advantage of the Orangeman to get 1/8 ounce of gold for 2000 oranges. How high do you think the bidding will

go?	?

2.What do you think the sap will do when he sees Orangemen bidding up the price?

THE SAP GETS WISE, PART 2

More and more Orangemen will see the opportunity to make a killing in the market. And perhaps others, who do not now own oranges, will see the advantage to be gained by purchasing them. Once they have the oranges in hand, they can attempt to secure gold from the sap.

Meanwhile, the sap sees that his gold is in demand. (Even idiocy is usually not of infinite extent.) He will suspect that he has been offering too much gold and will lower his offer.

170 An Introduction to Economic Reasoning

Thus, our exchange ratio of c ounce gold for 1000 oranges faces pressure on two fronts. Orangemen offer more oranges and the sap offers fewer ounces of gold. How long will this go on? Until no profits from a series of trades can be obtained. Gains from a series of trades, based on price discrepancies, are called arbitrage gains. We considered them in an earlier chapter, where we discussed the law of one price. Here we see that there is nothing special about money. Gold and silver, just as much as oranges and apples, obey the law of one price.

?1. If gold and silver behave like regular commodities, why do you think that many people regard money as subject to completely different economic laws from other goods?

ENTER THE STATE

Suppose, once more, that silver and gold exchange at a 16 to 1 ratio. In the way I have just explained, all prices of goods on the market “match”: no gains are to be had from arbitrage transactions.

“All well and good,” certain economic reformers will say, “but the balance is easily upset. As soon as the quantity of gold or silver changes, the ratio of 16 to 1 is outdated and must be altered. But it takes time to do so. Meanwhile, the possibility of arbitrage is present. Why not make calculation of prices easier? To do so, let us make the 16 to 1 ratio permanent. Then, we never have to worry about arbitrage in money again.”

?1. What ethical assumptions about arbitrage and calculation does our imagined reformer make? Are these assumptions justifiable?