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Money, gold and inflation:

Publication: ALM Gafoor Research

Provider: A L M Abdul Gafoor

June 22, 2009

Money, Gold and Inflation:

Some history and observations


A.L.M. Abdul Gafoor

Appropriate Technology Foundation

Groningen, the Netherlands

Gold and money

From time immemorial gold was money. Valuable goods were priced in terms of gold:
this product is worth so many ounces of gold. People paid the price in gold. But
assessing the fineness of the metal and weighing it each time a transaction took place was
a tedious and wasteful exercise. This led to the invention of the gold coin. Mints, which
produced the coins, certified to its fineness and weight, and its accuracy was attested to in
the name of the ruling monarch. This made the process of using gold as a medium of
exchange in payment for goods and services much easier. Although the values stamped
on the coins were generally taken at face value, if necessary, their real value could still be
easily ascertained. Therefore a gold coin minted anywhere and issued in the name of any
king was acceptable everywhere in the world, for it had an intrinsic value as well. It was
universally accepted that gold was money and gold coins were currency. Silver and
copper were also similarly used.

The reputation of a coin depended on the integrity of the issuing monarch and the
stability of his reign. Sometimes people chipped away a tiny piece of the coin and passed
it off for the face value. Sometimes the mints themselves used less fine material or less
weight – often on the orders of the king – but stamped it otherwise. Yet verification of
the true value was easy and the debased coins quickly acquired the reputation they
deserved. Each country determined the size, shape and name of its own coin, but the real
worth of the currency depended on the actual gold content of the coin. This state of
affairs continued till the invention of the paper currency.

Paper currency and the gold standard

Paper currency began its existence in Europe[1] when the goldsmith issued a receipt for
the gold coins deposited with him by a merchant and this receipt began to be accepted by
other merchants in the city as good as the coins themselves. For the merchants it
eliminated the risk and trouble of carrying large amounts of coins, and they were willing
to pay a price for the service. The goldsmith always honoured his receipts by redeeming
them in real gold coins, whenever and by whoever they were presented to him. This
reputation of trust was the foundation of his business.

In course of time, he discovered that only a fraction of the gold coins deposited with him
were reclaimed at any given time and that a good portion always lay idle in his vaults.
This realization prompted him to issue his own “I-owe-you” notes (of course for a price)
on the strength of the idle coins.[2] These too acquired the same credibility among the
merchants as his deposit receipts. This made him a moneylender as well.

When the goldsmith and moneylender became a bank, the bank issued bank notes in
convenient denominations (such as one, five, ten, hundred, etc) instead of in specific
amounts as in the goldsmith’s receipts. These then became a more convenient
alternative form of currency and acquired credibility among the general populace as
well. Each bank issued its own notes, and its popularity depended on the bank’s
reputation as to its credibility in redeeming its notes in real gold coins at all times. But a
bank’s reputation did not extend much beyond its own city and its environs. So notes of
several banks came into circulation.

Multiplicity of banks, bank failures (due to excessive credit creation and failure to
redeem bank notes in gold coins), and fraud compelled the central government to step in
and to declare itself the sole authority to issue currency notes. This was the beginning of
the national paper currency and it began in England in the eighteenth century. Gold was
still money, but the paper represented money. People used the paper proxy, but this
paper currency was guaranteed (by the crown/government/central bank) to be equivalent
to a certain fixed weight of gold, and it could be converted into that fixed weight of gold
(or silver) anytime at designated outlets. Therefore the perception that the paper was as
good as gold got ingrained into the minds of people.

However, the paper currency was eventually declared legal tender by law, meaning that
refusal to accept it as a means of payment was punishable by law. Since the law held
within the country, people held less and less gold coins in their hands for use in domestic
transactions. For international transactions, however, gold bullion or gold coins (readily
exchanged for the paper currency) were used. Over time, the long-standing British
practice (since 1717), the strength of her economy, and the vastness of her colonial rule
augmented the “paper is as good as gold” mind-set throughout a good part of the world.

By the end of the Napoleonic Wars (1815), many currencies of the world were based on
either gold or silver. By the end of the nineteenth century, gold replaced silver as the
basis of monetary arrangements in practically all of the major trading nations. The
readily convertible, fixed-ratio gold-currency relationship, along with the private citizen’s
right to freely hold, export and import gold, came to be known as the gold standard.
Between 1880 and 1914, the gold standard prevailed on a global scale, and gave the
impression that international gold standard was the normal state of affairs. The benefits
included price and exchange-rate stability, which in turn helped to conduct local and
international trade and investment with minimum risk of capital loss. This further
strengthened the trust in the paper currency and the gold standard.

The metal content of the coins gave them a readily verifiable amount of intrinsic value.
The paper currency, however, was in fact only an “I-owe-you” promissory note whose
validity depended entirely on the issuing bank’s promise to abide by the gold standard.
However, the gold standard’s fundamental conditions, i.e. (1) fixed-ratio gold-currency
relationship, (2) the ready convertibility and (3) a private citizen’s right to freely hold,
export and import gold, were not always fulfilled. There were devaluations, restrictions
and suspensions. For example,

First, Britain departed from the readily convertible, fixed gold-currency relationship.

Britain was on a full legal gold standard from 1821 and on a de facto standard from
1717. But during the Napoleonic Wars Britain experienced severe inflation which
necessitated the suspension of convertibility. To prevent a recurrence of inflation, a law
of 1819 required the Bank of England to make its notes redeemable in gold at the market
price prevailing in May 1821 [as opposed to the fixed official rate].[3]

Second, the U.S. departed from a private citizen’s right to freely hold, export and import
gold. They also gradually reduced the gold content of the dollar.

In March 1933 President Roosevelt restricted foreign-exchange dealings and gold and
currency movements, and in April he issued an executive order requiring individuals to
deliver their gold coin, bullion and gold certificates to Federal Reserve Banks. By setting
progressively higher dollar prices for gold, the Administration engineered a series of
devaluations, leaving the dollar with 59 percent of its former gold content.[4]


By 1936, when France and other countries of the Gold Bloc had suspended convertibility,
only the US maintained a link between domestic currency and gold. But with
international gold flows restricted and the US$35 gold price a matter of convenience
rather than law, American monetary arrangements embodied none of the basic elements
of the gold standard.[5]

Things changed drastically between the two World Wars, especially since the depression
of the thirties. By 1936, nearly all countries had broken the link between gold and
currency, and all currencies were on a free-float. This broke the international exchange-
rate stability and, together with the restrictions on the free flow of gold between
countries, the basic conditions of the gold standard ceased to exist. Consequently,
international trade and balance-of-payments experienced unprecedented difficulties. This
led to some serious concerns and to the Bretton Woods Conference, held in the US
towards the end of the Second World War.
The Bretton Woods Agreement

In 1944, the Bretton Woods Agreement was negotiated and in 1945, forty countries – that
is, practically all the countries then in existence – signed the Agreement. Its main
sponsors were the United Kingdom and the United States. One of the main purposes was
to bring about exchange rate stability in order to help world trade. This was to be
achieved by fixing the value of the US dollar as equivalent to a certain weight of gold and
then fixing the values of all other currencies of the world in terms of the US dollar. Thus
every currency was theoretically equivalent to a certain weight of gold, albeit via the
dollar. So gold provided the basic unit for all currencies, and the stability of the
international exchange-rate was to emanate from this basic unity. This meant that every
product anywhere in the world had a unique price in terms of gold, though it may be
expressed differently in different national currencies.

Previous to this each currency was directly anchored to gold – every currency was
equivalent to a certain weight of gold – but now only the US dollar was directly anchored
to gold. And, all other currencies only through the US dollar. It was sometimes called
the gold-dollar standard. This was the second major shift in the gold-currency

Under the Bretton Woods Agreement, the US dollar was fixed as equivalent to 1/35 fine
ounces of gold (i.e. one ounce of gold was set equivalent to 35 US dollars) and the US
Government guaranteed to maintain this ratio, and to exchange every US dollar presented
to it (at the “gold window”) into the equivalent weight of gold at anytime. All other
countries promised to peg their own currencies at a fixed ratio to the dollar. The
International Monetary Fund was established to maintain this regime. From now on no
national currency could be presented to the issuing central bank for conversion into gold.
While gold was still held as reserve, the US dollar became the major reserve currency at
the central banks, and almost all foreign exchange dealings took place through the US
dollar. Only central banks (and some industrial users of gold) could present their US
dollar holdings at the US “gold window” for exchange into gold.

But the US Government financed its growing budget deficits by printing dollars, without
regard to its gold reserves (especially in the 1960’s), and began to use exchange controls
and moral suasion[6] to discourage central-bank conversion of American financial assets
into gold. By the end of 1970, official US dollar claims of foreigners had mounted to
more than twice the US gold reserves. Fearing an imminent run on her gold reserves,[7]
the US Government made a decision that changed the course of history. Suddenly, on
Sunday 15 August 1971, it closed its “gold window”, severed the US dollar’s link with
gold, and unilaterally broke its promise under the Bretton Woods Agreement. Evidently,
all other signatories to the Agreement put together could not have the Agreement
enforced. Only 26 years after its birth, the Bretton Woods Agreement died a sudden and
early death. Now the US dollar floated freely, and all other currencies floated even more
freely. This was the third major shift in the gold-currency relationship, and a final break
from the time-honoured principle of paper currency representing gold.
Post-1971 currencies

The currency is still a promissory note, but all issuing authorities have absolved
themselves of any obligation (legal or otherwise) of redeeming it in gold (or any other
thing of value), nor even in another currency.[8] Now it is the citizen’s expectation that
other citizens will honour the printed paper he holds in his hands that keeps the currency
afloat. The moment one citizen refuses to honour the promise that nobody promised
anybody, it will trigger a complete collapse of the currency system. But that right of
refusal is denied by law, because the paper note is designated as “legal tender”. Money
has become an illusion – a very rare kind of illusion that is imposed, legalized and

In 2002, Europe replaced one illusion with another illusion – the currencies of 12
European nations were replaced with a single currency, the Euro. Literally overnight, 31
December 2001 / 1 January 2002, one of the world’s most valued “hard currency” – the
German Mark – along with its counterparts from France, the Netherlands, Belgium, Italy
and others, became mere used paper worth nothing; while another mere printed paper that
was worth nothing the previous day suddenly became “legal tender”. It was done
“legally” and “democratically”.

The world watched on its television screens truck-loads of the old currencies being
shredded and made into pulp, to be turned later into toilet paper! The coins were also
melted for re-use, but their metallic value remained intact.

The US dollar is officially designated as “Federal Reserve Note” and has printed on it
(1985 series) the name of the country (The United States of America), name of the
currency (Dollar), denomination (one, ten, etc), a serial number, a statement (This note is
legal tender for all debts, public and private), and the signatures of the Treasurer of the
United States and the Secretary of State.

The Canadian dollar is issued in the name of the Bank of Canada, signed in Ottawa by the
Governor and Deputy Governor of the Bank of Canada, and has the statement, “This note
is legal tender” (1973).

The British Pound is issued in the name of the Bank of England, signed in London by the
Chief Cashier “for the Governor and Company of the Bank of England” and carries the
promise, “I promise to pay the bearer on demand a sum of … pounds”. But what is a
“pound”? Is it a pound of gold, copper, paper, fish or meat? How is it defined, and
where? Whatever it is, will the Bank of England keep the promise and hand it over to the
bearer in exchange for their note in his hand?

The Indian Rupee is issued by the Reserve Bank of India, signed by the Governor,
guaranteed by the Central Government, and carries the promise, “I promise to pay the
bearer the sum of … rupees”. What is a rupee? Another kind of “circular argument”?
Most currency notes have similar formulations, have intricate designs and often carry the
portrait of the present head of government or an important personality or symbol of the

But the newest of all currencies – the Euro – has the most economical formulation. It has
a serial number, denomination, a copyright line, “© BCE ECB EZB EKT EKP 2002”,
and nothing else! There is apparently a signature, but whose and on whose behalf? What
is this intricately designed piece of modern art, what does it signify, and what is it to be
used for? It does not even promise to be legal tender! Is it then possible to refuse to
accept it in settlement of a debt, without legal consequences?

Price of gold

From 1945 to 1971, every currency had a fixed relationship to the US dollar and the US
dollar, in turn, to gold at the rate of 35 dollars per ounce of fine gold. Consequently,
every product anywhere in the world had a unique ultimate price in terms gold. But gold
itself did not have a price in any currency. For gold was money, currency. It was
measured by weight. An ounce of gold was an ounce of gold; any number of units of
gold was that number of units of gold. 35 US dollars was equivalent to one ounce of
gold, not that the price of gold was 35 US dollars.

However, gold was no longer legal tender (currency), the dollar was. No gold coins were
minted anymore. If you are in the US and your tax bill was 350 dollars, you could not
pay 10 ounces of gold at the counters of the tax department; you have to pay in dollar
bills. Neither was gold acceptable at the supermarket cash counter for the goods in your
trolley. But until 1971 you could still (in theory) exchange gold for US dollar and US
dollar for gold at the US “gold window”, at the fixed ratio of 35 dollars per ounce of
gold. However, since no one transacted business in terms of gold any longer and
everyone used the dollar (because it was the only legal tender) gold could be obtained
commercially only by paying for it in dollars. This amount of dollars paid per ounce of
gold became the price of gold. Even though its official rate was still 35 dollars per
ounce, for ordinary purposes, gold was bought and sold at commercial outlets, and on
account of their expenses such as handling charges, trading costs and business profit, it
was sold at a different “price”.

Gold has now acquired a price and has become just another commodity. People got used
to thinking of it as a commodity, and it had a price just like any other commodity. Yet, it
did not vary much from the official rate. The real break came in 1971, when the official
rate was ended with the stroke of a pen. From then on there was no holding back. Now
we talk about the price of gold! Currently (January 2008), it is over 900 US dollars per

Was it gold going up in price or the dollar going down in value? This question is rarely
asked. The price goes up because of high demand for gold (or its short supply), or is it
the currency depreciating? Is anybody in control? Obviously not any government or
central bank; neither the IMF. If it is laissez-faire, then freedom from government
control for whose benefit?

A simile

The question of gold going up in price or the dollar going down in value can be expressed
by a simile. Suppose we are at a railway station, and there is a train standing at the
station. Suppose there are two observers, P and T, one on the platform (P) and the other
on the train (T). Since the train is not moving, whether one stands on the platform or sits
in the train he is at rest. Now, suppose there is a car moving on a road parallel to the
track. Whether you measure its speed from the platform or from the train, the car will
have the same speed. If P and T made the observations, both their observations of the
speed of the car will be identical, because they are both fixed relative to the ground.
Now, suppose P also got into the train and both made their separate observations. Their
measurements will still be identical – whether they stood on the platform or sat in the
train their observations showed the same results. Seeing this, say, they decide to sit
together in the train and make their observations.

Now, suppose, unnoticed by our observers, a driver got into the train and moved it. What
will happen to the measurements of our observers? Their observations of the speed of the
car moving along the road will be identical, and they will believe that it was the true
speed. But, is it? It will not tally with the observations of another observer on the ground
or on the platform. The difference will be the speed of the train. P and T may still argue
that their observations gave the true speed of the car; they might even genuinely believe
that the station was suddenly moving away from them! If there was no one on the
platform and all the people were on the train, everyone will believe so too. The station
and the platform are moving away from us! Our saying that the price of gold is going up
is exactly the same.

When the driver reverses the train, the station and the platform will move towards us.
Gold price is going down! The earlier we get off the train and get out of this illusion the

But somehow people seem to have been mesmerized into forgetting that standing on the
platform (i.e. gold is the standard by which everything is measured) is the normal state of
affairs. On the platform you have the ability to move whichever way you liked and at
whatever speed you wished. But when you sit in a moving train with all the doors locked
it is the driver who decides the speed and direction of your movement.

Currency and price

Money or currency is expected to serve three basic purposes: unit of account, medium of
exchange, and store of value. The unit of account function allowed every product to be
priced in terms of the currency. This was an important step in the development of
commerce. Now every product can be given a unique price and, since the currency unit
was common to the whole country, the price of any given product could be compared
across the country or the worth of any product could be compared with that of any other.
The medium of exchange function allowed products to be easily bought and sold for
money at competitively determined prices, rather than bartered with the attendant
cumbersome search for matching products. The store of value function enabled the
money earned by selling a product or service to be kept in store until another product or
service was actually needed. This also enabled delayed payments for goods and services
and the taking and returning of loans with a time delay, without any loss to either party.

Every product has a price in terms of the currency of the country. This chair is 5 dollars,
this book is 10 riyals, this shirt is 15 rupees, etc. What is the price of currency? What is
the price of a dollar, a riyal, a rupee? It is one dollar, one riyal, one rupee. The
difference is: the price of a chair may vary from day to day, depending on supply and
demand, but the price of one dollar remains one dollar at all times. So is the value of
every currency, in its own terms. Price change – inflation or deflation – affects the price
of products, but it has no effect on the value of currency, because it is measured in its
own units. Why? Because that is how we have defined money. One dollar (riyal or
rupee) is always one dollar (riyal or rupee); that is our common unit in which we have
decided to measure all our prices.

It may look absurd, but consider the following scenario. Say, the price of the chair went
up from 5 dollars to 10 dollars. Now, suppose we decided to make the chair our
currency. Then, we will have a price for the dollar in terms of chairs! And, the price of
the dollar in the above scenario would be 1/5 of a chair! Consequently, when the price
changed, instead of the chair going up in price it would be the dollar going down in price
– the value of dollar goes down from 1/5 of a chair to 1/10 of a chair, from 0.20 ch to
0.10 ch.

Currency – dollar or chair – so long as we unambiguously define and identify it and agree
on what constitutes one unit of it, will serve the purposes of unit of account and medium
of exchange. Present-day paper currencies, whatever their names, serve these purposes
very well. There is no dispute over it. So the paper currency is still useful, viable,
valuable and indispensable.

Inflation and currency depreciation

However, it is in its third function – that of store of value – that modern paper currency
fails miserably. It does not keep its value from year to year, sometimes even from month
to month. The same dollar (or any other currency) that bought a loaf of bread last year
does not buy a similar loaf of bread this year. We can say the dollar has depreciated in
value. But others would say the price has increased (due to inflation).[9] Since there are
tools to measure inflation (e.g. the consumer price index),[10] and none to measure
currency depreciation (depreciation against what?),[11] the failure of modern paper
currency to store value remains a well hidden secret.

Inflation was defined as positive change in price, and this change was assumed to be
brought about by supply/demand interaction. A negative change was called deflation.
When inflation/deflation was defined, money was still anchored to gold, and there was
currency stability. And, prices changed positively and negatively. But, today’s price
change includes currency depreciation (of monetary value) as well.

To illustrate, suppose the price of a loaf of bread was 50 cents last year and has changed
to 60 cents this year. This is a 20 percent price increase which is defined as 20 percent
inflation. This can be expressed as: current price = old price + currency depreciation (i.e.
60 = 50 +10). To put it another way, one cent which bought 1/50 of a loaf of bread last
year buys only 1/60 of it today. That is why your 50 cents now buys only 50/60 of the
loaf and you must pay 10 cents extra to obtain the full loaf. If we assume the quality and
quantity of the bread as well as the demand and supply remained the same, then it must
be the currency that has changed its character. In other words, the currency has
depreciated by 1/6 or 16.7 percent. This requires extra money to be paid for the same
bread, and this is reflected in the new price. We have no tools to measure currency
depreciation but have an index to measure the price change. Therefore, we talk about the
latter and call it inflation.

Since currency depreciation is the major part of today’s (post-1971) price change, it has
become a one-way street – always positive, i.e. inflation. Any deflation – due to excess
supply, low demand, or increased efficiency – is masked by currency depreciation.

Currency depreciation could be brought about in many ways, but the major enduring
cause could be traced to deficit financing.[12] Other sources of currency fluctuation (and
depreciation) include government expediency, currency trading raids, bank credit
creation, gold price fixing, and interest rate manipulations. Since the main players in all
these actions are a powerful few, currency depreciation is a manipulated affair. And,
since currency depreciation is the major component in the recorded price change, today’s
observed inflation has little to do with free-market competition. The people, in whose
name most of today’s governments are run – of the people, for the people, by the people
– have no say in the matter, except to bear the consequences.

Interest and inflation

In Christendom, till 1545, usury was prohibited. In that year the British parliament was
persuaded to pass the Usury Law. This law introduced an innocuous word called interest,
and usury was defined as high rate of interest. Usury was still prohibited, in deference to
the Church, but “reasonable” interest was made permissible. What is reasonable and
what is high was to be determined by the Parliament, and in 1545 it was decided to fix it
at ten percent per annum. Eventually interest was accepted in all countries of Europe and
the Americas. Over time the limit ceased to exist and even the word usury went out of

Now that interest was legal, money was available only at a price. Those who had savings
and were unwilling to take risks deposited their money in the bank and demanded
interest. The bank, in turn, lent it to those who needed money and charged them at a
higher rate. A good portion of the nation’s savings filled the vaults of the bank and the
owners made money out of other peoples’ money. They grew rich and powerful –
sometimes even more powerful than their government.

The law recognizes interest but not inflation. When currency depreciation was
engineered and passed off as inflation the bank got its second chance. It adjusted its
interest rates to accommodate inflation and compensate for value loss of capital. The
new rate was called nominal interest rate and was set equal to the real interest rate plus
the inflation rate. Inflation began to eat into the value of currency, and it ate even while
the money was held in one’s own hands. People panicked and sought to protect their
savings. The bank’s new offer seemed a good option and they went for it. If you cannot
be induced by interest to surrender your wealth to the bank, you will be driven to it
through inflation!

More money filled the bank’s vaults and the owners became richer and richer, and
globally powerful. That seems to be the end result of moving from gold to paper and
dumping the gold standard. The old owl said, “I used to see you carrying sacks of gold,
now you have bundles of paper. Where has all the gold gone?”

The bank is the stronger party in any lending/borrowing transactions, and it used inflation
rate projections too to its advantage. Savings deposits and loans are by nature future
commitments, and forecasts of inflation rates will have a range. The bank used the lower
rate when paying interest to the depositors and the higher rate when charging the
borrowers, profiting both ways. What a bonanza!

Muslim dilemma

The bank’s offer was a good option to those who had no qualms about paying or
receiving interest. But Muslims are prohibited by their religion to deal in interest in any
manner. That lands them in a dilemma. If they hold their savings or wealth in the form
of currency its value is slowly eroded by inflation, and if they go to the bank for
protection against it they will be dealing in the prohibited interest. This is a specifically
Muslim problem and therefore they alone have to find a solution. Others are not so
affected by it and therefore cannot be expected to seek one.

A solution may become available if the real interest rate and the inflation rate combined
in the nominal rate could be separated from each other. Here too what needs to be
computed is the realised inflation rate and not the speculative one used by the bank. It is
no easy task, but what we are really after is not the inflation rate but the currency
depreciation that brought it about. So, one has to begin by inventing a tool to measure
currency depreciation. Such an approach has been employed and a solution offered in
Gafoor (1999 and 2006). Interested readers are referred to the literature.


1. Eichengreen, Bary, The Gold Standard in theory and history. New York: Methuen,
Inc. 1985.
2. Gafoor, A.L.M.Abdul, Commercial Banking in the presence of Inflation,
Groningen, the Netherlands: Apptec Publications, 1999. Published in Malaysia by A.S.
Noordeen, KL.

3. …………., Attacking inflation on capital. Islamic Banking and Finance magazine

(London), issue #9, Spring 2006.

4. Kurtzman, Joel, The Death of Money. New York: Little, Brown and Co. 1993.


© A.L.M. Abdul Gafoor, 2002.

31 December 2002.

Revised February 2008


Note: An edited version published, under the title “The Nature of Paper Money: Some
history and observations”, in Islamic Finance Today, February 2008, Colombo.

[1] The Chinese are reported to have used paper currency since 800 AD.

[2] This process would later become known as “credit creation”.

[3] Eichengreen (1985), p.4.

[4] ibid., p24-25.

[5] ibid., p25.

[6] Bankspeak for quiet persuasion.

[7] “The straw that supposedly broke the camel’s back was a British request in August
1971 that the Federal Reserve swap a portion of the Bank of England’s dollar holdings
for sterling, which was perceived in the US as the beginning of a general run on the
dollar.” Eichengreen (1985), p.28.

[8] “The dollar has become a circular argument. It is still a promise to pay. But to pay
what to whom?” R.David Ranson, quoted in Kurtzman (1993), p.61.

[9] The claim that prices increase because of inflation while inflation is measured by
price increase is another kind of circular argument.
[10] See for example, Gafoor (1999) for how price indexes are constructed and

[11] See Gafoor (1999) for a new measure of capital (currency) depreciation.

[12] Why governments got into deficit in the first place and why the gap keeps widening
every year are altogether different issues.