10. On the Function of Gold Standard in Idealism and Reality

The gold standard system did not function as was expected between the mid-1920s and the early 1930s. This study explores why the system brought about such a devastating consequence as a deep worldwide depression. Two main reasons are identified. First, the income effect caused by product differentiation, which is entirely excluded in the purchasing power parity theory, played a key role. A depression in overseas territories cannot be canceled out simply by the adjustment of international commodity prices. Second, people are confident in the intrinsic value of gold in the sense that they rationally expect that gold is always convertible to commodities at some fixed ratio. This implies that gold or fiduciary money is non-neutral, and that the outflow of gold substantially contracts financial conditions, and thus economic activities. These important factors are completely neglected in the traditional “specie flow” theory, which originated from Hume.