At the time of London’s first Olympics in 1908, the amount of money in circulation in the UK was tied to the amount of gold in the economy.
The gold standard had prevailed for most of the previous two centuries and was to continue until WWI began in 1914.
The UK was not the only country whose monetary system was based on gold. From 1880-1914, almost all of the world’s leading economies had followed suit.
So how did it work? Each country fixed the price of gold in their local currency. In the UK, the price of one troy ounce of gold was £4.25. In the US it was fixed at $20.67. This implied a fixed exchange rate between pound sterling and the dollar ($4.87 per £1), and all the other countries on the gold standard. To enhance the credibility of the arrangements, authorities guaranteed that paper money was fully convertible into gold. Anyone could request to convert their pounds into the equivalent value of gold.
Because it limited the ability of governments to print money, the gold standard stopped countries from deliberately devaluing their own currency in order to improve the competitiveness of their exports or pay off their debts. As a result, membership of the gold standard was seen as a commitment to sound government finance. By constraining the growth in money supply, the gold standard was also believed to contribute to stable prices. Over long periods this was generally the case: price levels in the UK were much the same in 1914 as they were in 1880.
However, the gold standard’s inflexibility had major disadvantages. Changes in the world’s money supply were dependent not on economic conditions, but on the amount on new gold that was mined. This meant that on the one hand, monetary policy could not be used to respond to recessions and booms; but on the other, significant rises in gold production would lead to faster money supply growth and ultimately inflation, regardless of a country’s underlying economic conditions.
In the Bank. The chart shows the quantity of gold reserves held by the Bank of England, in tonnes.
WWI saw the end of the gold standard as governments suspended the convertibility of their currencies into gold in order to freely finance rapidly escalating military expenditure. It was briefly reintroduced in some countries after the War, including the UK from 1925-1931, but fell apart again during the Great Depression. After WWII, a form of gold standard under the Bretton Woods system – involving the dollar being fixed to gold and other currencies being fixed to the dollar – was in operation until 1971.