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My current limited understanding is that the gold standard was a system in which there was a fixed currency amount per unit of gold. For example, 1 ounce of gold might be 100 USD. Another country like UK might peg their currency to be 1 ounce of gold for 50 GBP.

  1. This means that GBP and USD would also be fixed at 1 GBP for 2 USD?

  2. What would be an example of how trade would occur between these two countries? Say that the US had oil that the UK wanted to buy. Would the UK give the US GBP in exchange for the oil? Then in return, the US would use this GBP and return it to the UK government in exchange for some predetermined amount of gold? So in the end US gold reserves would increase and UK gold reserves would decrease? But doesn't this then mean that the US would have to print more money to keep the gold/USD exchange rate fixed?

  3. In today's fiat currency, how does trade occur? I understand that different factors like interest rates and inflation can affect exchange rates.

  4. But why do countries hold currencies of other countries in "reserve"? Why is this necessary?

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The gold standard in the US was actually kind of complicated.

You had the government issuing notes off of gold, and private banks issuing bank notes off of gold...but also banks issuing notes/deposits off governments notes as well. A pyramid on a pyramid.

Neither was 100% backed and both were vulnerable to runs.

In 1933, FDR no longer let the public redeem gold for dollars. A default of sorts...but we were never on a true gold standard! We always had more promises than gold. The same with the banks. Given that gold used to be equivalent to dollars (as the Fed used to exchange the two), banks would use dollars as reserves for convenience...but soon they became the monetary base.

Now the US still maintained an international gold standard. But this too was fractional and had more promises than assets. Countries (most notably) the French did not like how "overbooked" the dollar was to gold and started redeeming their gold in mass. There was a run by international central banks on the dollar and Nixon had no choice but to take us off the international gold standard as well.

So it is confusing, but we went off the gold standard twice. Once to the public (FDR) and once to international central banks (Nixon).

So how did this work before 1972? Gold was the international reserve currency, but on top of this the dollar was the means by which gold would be commonly traded between countries. It was much more difficult to clear transactions in gold than paper (or accounting) dollars, which led to its popularity as a reserve currency. On occasion of course individuals would demand gold for dollars and you would have physical transfers take place (as in load the gold onto the ship and send it over the high seas).

If you are interested in the history of the American gold standard, I highly recommend the book A History of Money and Banking in the United States: The Colonial Era to World War II by Murray N. Rothbard:

mises.org

So what is the difference between the old system and the current system? Not much as we were never on a true gold standard. But in a nutshell, banks used to be able to redeem dollar bills or central bank deposits for gold. Now dollars are not redeemdable for anything. You can see on the Fed balance sheet a holdover for this as gold is still considered an asset and dollars (paper and electronic) as liabilities.

en.wikipedia.org

So how would trade occur pre-Bretton Woods? Mostly through banks. The receiver bank would obtain credit for gold, or a national currency that was convertible to gold (dollars or say pounds). If one party wanted to convert currencies they could but it mostly took place as a transfer from say "pound deposits" to "dollar deposits". If the new party demanded their payment in gold they could obtain this but it rarely happened.

After Bretton Woods, international trade was mostly facilitated by dollar deposits with the promise of gold redemption of a foreign central bank demanded it (which Nixon ended).

Now when gold reserves were physically demanded, did this cause problems? Yes! Remember, all countries and banks issued more notes/deposits for dollars than they had (somewhat dishonest but that is another matter). Say the pound (during the standard) lost a bunch of reserves...so they go from a ratio of say 1000 central bank deposits to 200 gold to 900 central bank deposits and 100 gold. A serious blow to credibility which could lead to a run on the currency. Do they have to print or destroy more notes/deposits...no because they do not 100% back gold.

So why do countries hold reserve currencies today? They kind of don't need to, but there is a reason. Basically private banks operate by maturity mismatching (balancing short term debt against long term assets). When a currency is not stable (like from a small nation) short term interest rates are too volatile for banking and in fact bank runs can be initiated from clever predator foreign inverters (like George Soros). Politicians like banks...and for some reason they think they are important to the economy, so go to great ends to prop them up. For a small nation this means their currency must be somewhat stable for their banking system to survive...and the nation achieves this by maintaining a peg. You can only maintain a peg if you can manipulate the market, so countries hoard foreign assets like dollars so they can buy and sell their home currency (like say the Peso) so it achieve its peg rate.

As for clearing of international transactions this is mostly done with bank money, but dollars are a common facilitating base for these transactions (although certainly many other currencies are being used now).

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You made some assumptions which are rather unreal: 1st - government is a party of sales contract, 2nd - GBP is used to pay for oil. Assumptions are unreal because oil as other products are rather sold by private owned (or at least government owned) companies than governments. USD (not GBP) is unit of account to price oil in the international market (petrocurrency). I can, however, stick to your assumptions to explain the case described.

  1. Let's assume that US has 50 units of oil. UK buys those units for 50 GBP. US Federal Reserve exchanges 50 GBP for 1 ounce of gold. Reduction of UK's gold is not important, since unit of currency was (in times of gold standard) backed up by unit of specie. The unit of specie was ascribed to the unit of currency. If someone exchanged banknote for gold, the obligation incorporated within the banknote was cancelled. The function of specie was to make central banks unable to emit banknotes without needed amount of specie. In our case US Federal Reserve obtained ounce of gold and is now able to produce 100 USD. Creation of more than 100 USD would have been illegal.

So in the end US gold reserves would increase and UK gold reserves would decrease? But doesn’t this then mean that the US would have to print more money in order to keep the gold/USD exchange rate fixed?

No, because banknote/gold ratio had not changed. The overall change of gold is not important. What is important: relation of unit of specie to unit of money.

I sketched briefly the answer above to provide you with basic understanding of the specie-based currency. I have to emphasize that Bretton Woods system was different. Overseas dollars were pegged to gold and other currency pegged to overseas dollars. So, GBP was pegged to gold indirectly. Bretton Woods combined gold standard (USD) with fiat money (other currencies). US Federal Reserve started to lose amounts of gold from 1959 to 1969 because of monetary inflation. Dollar was overvalued e.g. in 1960. There were simply more USD banknotes than units of specie pegged to those dollars. This was impossible then to exchange all dollars for predefined amount of gold, for USA started to break Bretton Woods regulations.

By 1966, non-US central banks held 14 billion USD, while the United States had only 13.2 billion USD in gold reserve. Of those reserves, only 3.2 billion USD was able to cover foreign holdings as the rest was covering domestic holdings (IMF).

It costs only a few cents for the Bureau of Engraving and Printing to produce a 100 USD bill, but other countries had to pony up 100 USD of actual goods in order to obtain one (Wikipedia) as Barry Eichengreen posited.

GBP was backed up by goods and services (fiat money). Since GBP was pegged to USD, UK has to produce goods and services worth x GBP (where x GBP was equal to 100 USD) to change it for 100 USD. Vice versa US has only to print banknote to acquire predefined sum of GBP. As gold standard was broken it cost only few cents to create such sum of paper.

In today's fiat currency, how does trade occur? I understand that different factors like interest rates and inflation can effect exchange rates. However, why do countries hold currencies of other countries in "reserve"? Why is this necessary?

Fiat money is backed up by sum of goods and services. As number of banknotes, goods and services changes, so the value of banknote does.

Central banks hold foreign currencies for open market operations. Via open market operations, central bank can affect supply of given currency, changing its value.

Further reading: Jesús Huerta de Soto, Money, Bank Credit, and Economic Cycles, LvMI, Auburn (Alabama).

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  • $\begingroup$ You said "If someone exchanged banknote for gold, the obligation incorporated within the banknote was cancelled. " Does this mean that in that example if the US Fed exchanged the 50GBP for one unit of gold, then the currency is no longer used? Like what happens to the physical currency? How do they keep track of what has been exchanged for gold and what hasnt? You also mention that "Central banks hold foreign currencies for open market operations." Why is it important that banks in different countries hold foreign currency? Is this a hedge in case the domestic currency loses value? $\endgroup$ – qwer Aug 7 '15 at 17:19
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    $\begingroup$ 1. Imagine that banknote is warehouse receipt. You deposited something in warehouse and obtained receipt. Then you come and take your stock. The receipt has to be invalidated. $\endgroup$ – Christianus Aug 7 '15 at 17:49
  • $\begingroup$ 2. What happens to the physical currency? Banknote is deposited in bank. Bank knows how much gold is left and knows as well the money supply (it is measured: [Wikipedia][en.wikipedia.org/wiki/…). It can do the math, and release only backed-up money. $\endgroup$ – Christianus Aug 7 '15 at 17:49
  • $\begingroup$ 3. In case when domestic currency loses value to USD, central bank can sell USD to increase the supply. Central bank can also buy USD to stop USD from falling. It is important because x:y exchange ratio can influence the export/import. E.g. Chinese Central Bank bought dollars to stop USD from falling down. Stronger the dollar:yen relation, greater the export from China to USA is. $\endgroup$ – Christianus Aug 7 '15 at 17:50
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A gold standard is when a country tries to maintain a fixed rate of exchange between their currency and the value of gold. So, for example, the United States attempted to maintain an exchange rate of about $20 to the troy ounce starting in 1862 with the so-called "greenback" dollar which is the ancestor of our current dollar. This is difficult to do because gold has an inherent value which fluctuates, so any government offering a fixed rate of exchange can be arbitraged and will lose money as a result. For example, when greenbacks were first issued, the US Treasury almost immediately defaulted on them.

The only reliable way to maintain a gold standard is to issue gold certificates in which there is a one-to-one relationship between the gold in the treasury and the corresponding currency issues. Historically, few governments have had the discipline to achieve this. They instead tend to maintain a fractional reserve and as a result their currency depreciates until eventually they default. In the United States this default occurred in 1934.

To answer your specific questions:

How did trade work in former times?

In former times foreign trade worked in basically two ways: cash and kind. To trade in cash, the trader would bring whatever money was used in the foreign place with them. So, for example, China used silver, so the trader would bring silver to buy something. To trade in kind, the trader brings goods, sells the goods for the local money, then uses that money to buy a new good. For example, in the opium trade, the merchants would bring English textiles, sell them in India for rupees, then use the rupees to buy opium. The opium would then be brought to China and sold for silver. The silver would then would be used to buy silk and tea which would be brought back to England.

In today's fiat currency, how does trade occur?

Some transactions are resolved in cash. The buyer buys the needed currency from their local bank and then buys the foreign good. In this case the buyer risks a default by the seller. The other method is via an acceptance. This process is too complicated to easily describe. Basically banks act to negotiate the trade. Look up "Bankers Acceptance" for details. In both cases, the banks must resolve any imbalances in the currency trade.

I understand that different factors like interest rates and inflation can affect exchange rates. However, why do countries hold currencies of other countries in "reserve"? Why is this necessary?

It's not necessary. A bank can always resolve an imbalance using gold. For example, if I am the Croatian National Bank and I am long Kunas and short Forints, I can buy gold locally with Kunas, ship the gold to Hungary and I will be credited Forints and this resolves the imbalance. However, the disadvantage is that buying and shipping gold is costly and time-consuming. It may be faster and cheaper for me to buy US Dollars with Kunas, then use the dollars to buy Forints. Thus, I solve my imbalance much more conveniently by dollars instead of gold. This works as long as both the kuna dealers and forint dealers accept dollars. USD is called a "reserve" currency because people hold it in reserve because it is widely accepted by currency traders.

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  • $\begingroup$ Why not replace Hungary and Croatia in the last para. with GBP or Yen? They're in the EU: so wouldn't they use Euros? $\endgroup$ – Greek - Area 51 Proposal Sep 8 '18 at 5:14

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