In many ways, the period of the classical gold standard was a remarkable time in world history. Trade flourished and empirical studies have estimated that the gold standard contributed positively (on the order of 20 percent) to the growth of world trade in the 1880 to 1910 period (López-Córdova and Meissner, 2003). Exchange rates and prices were generally stable, and there was a free flow of labor and capital across political boundaries. In general, the world was at peace.<sup>12</sup> Nevertheless, the world economy suffered from a major depression during the 1890s<sup>13</sup> and a severe contraction in 1907, as well as a number of smaller-scale recessions. This was largely due to the fact that policy makers and central banks gave priority to the achievement of external balance, often at the expense of internal balance and goals such as full employment.

**Interwar Period (1914-1939).** The gold standard broke down during World War I (19141918)14 and was briefly reinstated from 1925 to 1931 as the Gold Exchange Standard. Under this system, the US and the UK could hold gold reserves, but other nations could hold both gold and dollars or pounds sterling as reserves with the aim of avoiding the problem of gold shortage that had plagued the system before.   The onset of the Great Depression in 1929 was quickly followed by massive bank failures throughout the world.  Britain was forced off the gold standard in 1931 when foreign holders of pounds sterling began converting their holdings into gold.  As the Depression continued, countries sequentially decided to go off the gold standard and allowed their currencies to float in the foreign exchange market.

In reviewing the experience in the United States, one stylized fact is fairly uncontroversial: there was a dramatic reduction in the money supply of about 33 percent between 1929 and 1933,15 and this had a major impact in the transmission of a financial shock into a full blown economic depression. Where scholars’ views vary is in explaining the monetary contraction. As noted in Hsieh and Romer (2006), there are two general views on what actually happened: (1) the monetary contraction was the result of the international monetary system’s adherence to the gold standard; and (2) the United States could have enacted expansionary monetary policy despite the gold standard, so the contraction was a monumental policy blunder.<sup>16</sup> Under the gold standard, expansionary monetary policy via low interest rates had the potential to spur a speculative attack on a currency and to force an adjustment in gold parity—or even a full blown abandonment of gold convertibility. Hsieh and Romer (2006) use data on forward exchange rates and cross-country interest differentials—as well as the “narrative record” — to see if there was in fact an 12 There is a general view in the literature that the gold standard, with its implied fixed exchange rates, worked relatively well in terms of macroeconomic stability during the pre-World War I period, but this changed during the Inter-War period (discussed below). Chernyshoff et al (2009) provide empirical evidence on this view, with a driving force being the change in the degree of nominal price rigidities between the two periods.

13 Given data limitations, DeLong (1999) uses US data on railroad construction to show the magnitude of the depression. The crisis included an international finance dimension due to the collapse of Barings bank and its exposure to Argentine and Brazilian sovereign debt. DeLong (1999) and Fishlow (1989), among others, have drawn comparisons between this crisis and the debt crises in emerging markets of the 1980s and 1990s. Mitchener and Weidenmier (2008) provide a more detailed analysis of the 1890s financial crisis’ impact on Latin America. 14 According to Eichengreen and Timmer (2010), the United States remained on the (fractional) gold standard during the war. The Federal Reserve Act of 1914 required reserve banks to maintain gold stockpiles equivalent to 40 percent of all federal reserve notes issued.

> 15 The size of the decline is from Milton Friedman and Anna J. Schwartz, _A Monetary History of the United States_ , as cited in Hsieh and Romer (2006).

16 The first view could be called the “golden fetters” view laid out by Eichengreen (1992a), while the policy blunder view is developed in Friedman and Schwartz, cited above. A contemporary update on “golden fetters” is found in Eichengreen and Temin (2010). With respect to the latter – and also in reference to later empirical work—the authors do not maintain that it was impossible to conduct expansionary monetary policy; however, they argue that the “gold-standard _mentalité_ ” prevented policy makers from even considering this option.

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