How did the gold standard help countries rectify the balance of payment problem? What were the problems associated with the gold standard?
What will be an ideal response?
Under gold standard, all currencies were defined in terms of gold. When a nation ran a balance of payments deficit, it had to sell gold to finance the deficit. Because the domestic money supply was based on gold, losing gold to foreigners meant that the money supply fell automatically, thus raising interest rates. Those higher interest rates attracted foreign capital. At the same time, this restrictive “monetary policy” pulled down output and prices, which discouraged imports and encouraged exports. The balance of payments problem quickly rectified itself.Under the gold standard no nation had control of its domestic monetary policy. An analogous problem is that under fixed exchange rates, monetary policy must be dedicated to pegging the exchange rate. It cannot, therefore, be used to manage aggregate demand. Another difficulty was that the world’s commerce was at the mercy of gold discoveries.
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