Maintain the Internal Balance of the Metallic Standard
The term internal balance refers to full employment with price stability, which is a tall order. Full employment does not refer to 0 percent unemployment. It implies a positive unemployment rate at which the country uses its available human and physical resources and produces output at its long-run capacity consistent with a well-functioning labor market.
Therefore, the full employment level of unemployment (also called the natural rate of unemployment) mainly consists of frictional unemployment (people looking for better-paying or more suited jobs, or people between jobs).
The one piece of the internal balance is full employment, the other is price stability. Price stability implies that the changes in the price level are small, gradual, and expected, so that the financial decisions of households and businesses aren’t materially affected by the changes in the average price level.
In other words, the country sees no substantial amount of expected or unexpected inflation (an increase in the average price level), disinflation (a decline in the inflation rate), or deflation (a decline in the average price level).
Monetary policy can be used to stabilize prices and affect employment. However, a metallic standard makes monetary policy useless for both of these purposes. Suppose a country is under the gold standard and the central bank of the country wants to decrease unemployment and promote growth. An increase in the money supply might achieve this goal by raising prices.
But if prices rise in the country, gold is worth less in that country and gold would flow out, lowering the money supply and the price level. In short, the central bank cannot change the money supply to pursue domestic goals.
Whenever you read about a change in monetary policy, you should understand the kind of monetary policy that can have an effect on the price level.
Because monetary policy is ineffective under a metallic standard, the burden of promoting economic growth and full employment falls on fiscal policy. This task is no easy one, either. Policy makers have to be aware of the fact that tax or expenditure policies can improve the country’s productive capacity.
Therefore, in a fixed exchange rate system, the government needs to focus on policies that increase the productivity of the country, such as education reform, tax reform, and, generally speaking, incentive-compatible institutions.
The fact that monetary policy isn’t effective under a metallic standard may be helpful in achieving price stability. Avoiding large changes in the growth rate of money supply also avoids large changes in the average price level, unless changes in the supply of the precious metal change the average price level.
Monetary policy under a commodity standard is useless for maintaining internal balance with a fixed value of the money in terms of a precious metal.