Question

In the modern world, central banks are free to increase or reduce the money supply as they see fit. However, some people harken back to the "good old days" of the gold standard. Under the gold standard, the money supply could expand only when the amount of available gold increased. a. Under the gold standard, if the velocity of money were stable when the economy was expanding, what would have had to happen to keep prices stable? b. Why would modern macroeconomists consider the gold standard a bad idea?

Short answer

Answer: For prices to remain stable during the expanding economy under the gold standard with a stable velocity of money, the money supply should expand at the same rate as the real output. Modern macroeconomists consider the gold standard a bad idea because it lacks flexibility, can lead to deflationary pressures, business cycle fluctuations, international imbalances, and encourages hoarding during economic crises.

Step-by-step solution

Part A: Condition for stable prices under gold standard

To determine the condition required to keep prices stable during the expanding economy under the gold standard, we first need to consider the QTM equation (MV = PQ). Here, we are given that the velocity of money, V, is stable, and we need to find out what should happen for the price level, P, to remain stable. Since we are considering the gold standard, the money supply, M, could only expand when the amount of available gold increased. Let's assume that the economy is expanding, which means that the real output, Q, is increasing. Now, MV = PQ can be written as M1V = P1Q1 (Initial scenario) and M2V = P2Q2 (After the economy expanded, and gold supply increased). If price level P should remain stable, that means P1 = P2. To keep prices stable, the increase in the money supply (M2 - M1) should be proportional to the increase in real output (Q2 - Q1). So, (M2 - M1) / M1 = (Q2 - Q1) / Q1, or M2 / M1 = Q2 / Q1. In conclusion, under the gold standard, for prices to remain stable when the velocity of money is stable, and the economy is expanding, the money supply should expand at the same rate as the real output.

Part B: Reasons gold standard is considered bad by modern macroeconomists

Some reasons why modern macroeconomists consider the gold standard a bad idea are: 1. Lack of flexibility: Under the gold standard, the money supply depends on the availability of gold. Running monetary policy becomes difficult, and central banks cannot expand or contract the money supply as needed to combat inflation or recession. 2. Deflationary pressure: The economy can grow faster than the gold supply. Under the gold standard, this can lead to a deflationary spiral, causing prices to fall, real debt to rise, and overall demand to decrease. 3. Business cycle fluctuations: Gold discoveries can cause sudden expansions in the money supply, leading to booms, while gold shortages can contract the money supply, causing recessions. 4. International imbalances: Gold flows between countries can lead to trade imbalances and currency instability. 5. Hoarding: During economic crises, households might hoard gold, further restricting the money supply and exacerbating the crisis. In conclusion, the gold standard limits the flexibility of monetary policy and can lead to severe economic problems like deflationary pressure, business cycle fluctuations, international imbalances, and the hoarding of gold during crises. This is why modern macroeconomists mostly regard the gold standard as an undesirable policy.