GOLD STANDARD:

From 1876-1913 exchange rates were dictated by the gold standard. In gold standard each
country have fixed the amount of gold against their unit of currency. In mid-1870’s Payment for
items bought from another country was often done in gold. When the amount of trade increased
during the industrial revolution more convenient means of financing was needed. Shipping large
quantities of gold around the world to finance international trade seemed impractical. The
solution adopted was to arrange for payment in paper currency and for governments to agree to
convert the paper currency into gold on demand at a fixed rate. Through gold standard countries
who are involved in trade achieved balance of trade equilibrium in which the income earn from
exports is equal to imports.

In 1914 when World War 1 started countries abandon the gold standard and financed their
military by printing money which results in increase in inflation. After war US, Great Britain and
France went back to gold standard. GB pegged pounds to gold at the pre-war gold value. Due to
this price country fell into deep depression. When foreign holders lost confidence in GB
currency to maintain their value they started to convert their pounds into gold. The government
started to lose their gold reserves so they suspended convertibility in 1931. US increased the
price of dollar to convert into gold. People now need more dollar to convert it into gold. The
government was trying to generate a trade imbalance by lowering the price of US exports while
raising the price of imports.

Other countries uses same tactics which result in competitive devaluation of currency. How
much gold a certain currency could purchase was no longer known. As a result, several nations
were forced to stop the convertibility of their gold holdings. The gold standard was no longer in
use by the World War II began in 1939.