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could use several instruments to separate the supply of reserve money
(currency bills in circulation and deposits of the commercial banks in the
central bank) from movements in their stock of gold.
Two of these instruments related to the manipulation of interest rates.
In the absence of a central bank, interest rates would increase when gold
flowed out of the country and decline when it flowed in. This would au-
tomatically equilibrate the market, as higher rates would attract capital in-
flows when gold flowed out and lower rates would encourage capital
outflows when gold flowed in. Countries with central banks, however,
had the power to manipulate rates independently of gold flows. They did
so in two primary ways.
The first was fixing the rate of interest at which they were willing to
lend money to commercial banks. This effectively established rates in the
market. In Britain, the central bank lending rate was called  the Bank
158 MONETARY SOVEREIGNTY AND GOLD
Rate, or simply  the Rate. It had other names in other countries, most
commonly  the discount rate. Central banks also engaged in so-called
open market operations. Selling government securities into the market re-
duced the amount of money in circulation, increasing interest rates, and
buying government securities increased the amount of money in circula-
tion, reducing interest rates.9 The use of these instruments empowered
central banks to increase rates even as gold was flowing into the country,
or reduce them even as it was flowing out. They could, however, only go
against the natural tendency of the gold standard in the very short term. If
a country was losing gold and market rates were rising, for example, a cen-
tral bank pushing down rates would accelerate the speed at which the
country was losing gold, further encouraging the trend of market rates to
increase.
The system also allowed for monetary creation by the various commer-
cial banks. The broadest measure of money, commercial bank deposit
money, could move up and down almost independently from gold move-
ments. Peel s Act established no constraints on the creation of deposits by
commercial banks and the granting of credit with the proceeds of the de-
posits, so that banks could multiply the money issued by the Bank of En-
gland.10 Thus, commercial bank deposits and transactions could grow at
rates different from that of the supply of gold because of the influence of
the multiplication of deposits carried out by the banking system. For ex-
ample, reserve money could be contracting along with gold exports, yet
the amount of deposit money could be growing if the multiplier of the
banking system was increasing. When this happened, the ratio of reserves
to deposits naturally declined because more deposit money was created
out of the same amount of gold.
 The traditional representation of the gold standard takes it to be au-
tomatic, nondiscretionary adjustment, write Rudi Dornbusch and Jacob
Frenkel.  Bullion flows are matched one-for-one by changes in the
amount of currency outstanding. [But] this is, of course, not the case
once the reactions of the [central bank] are taken into account. Changes
in the reserve-deposit ratio of the [central bank] affect the money stock
independently of the existing stock of bullion. 11 Dornbusch and Frenkel
examined the accounts of the Bank of England during a financial crisis in
1847, and found that the Bank sterilized substantially the effects of the
MONETARY SOVEREIGNTY AND GOLD 159
gold outflows that were taking place as a result, first, of trade deficits and,
then, of capital flight. This resulted in a substantial reduction in the ratio
of gold reserves at the central bank to bank deposits from 46% in Janu-
ary to 19.6% in April, and then from 32% in June to 11.6% in October. Re-
ducing this ratio allowed the Bank to create more money than allowed by
the gold reserves it kept. Thus, the Bank was able to carry out monetary
policy by allowing the ratio of reserves to deposits to vary over time, at
least during crises. Students of a longer period, from the 1870s to the start
of World War I in 1914, have also found that the Bank engaged in some
countercyclical monetary policy, although within the context of main-
taining currency convertibility (that is, people could convert currency
into gold and export it).12
The discretionary power of the central banks was, however, very lim-
ited in the longer term. The creation of discretionary money could result
in one of two outcomes. If the economy needed the additional liquidity, it
would absorb the newly created money with little or no inflation. If it was
not needed, however, there would emerge an outburst of inflation, and
the price of gold would rise in the market relative to its official price (that
is, the price the central bank was committed to for redemptions). People
would then exchange currency for gold, melt it, and sell it in the domestic
market or export it.13 The falling stocks of gold in the central bank would
contract the money supply, which in turn would lead to higher interest
rates. The higher rates would encourage deposits and discourage credits,
which would then result in a decline in demand for goods, including gold.
This would result in deflation, which would continue until the market
price of gold went down to the official level.
While it was therefore possible to carry out monetary policies, the sys-
tem automatically compensated for any excess in their implementation,
leading prices back to their initial equilibrium. It guaranteed the long-
term stability of prices and established incentives for central banks not to
tamper with the supply of money, because any excess in one direction
meant a subsequent adjustment in the other direction.
Such adjustment, however, could be upset by either of two problems.
First, the supply of gold available for minting could vary because of shifts [ Pobierz całość w formacie PDF ]