Introduction to Finance

Before World War I 
Prior to the start of World War I in 1914, the international monet-
ary system operated mostly under a 
gold standard
 
whereby the currencies of major countries 
were convertible into gold at fi xed exchange rates. For example, 1 ounce of gold might be 
worth 20 U.S. dollars, or $1 would be worth one-twentieth (or .05) of an ounce of gold. At 
the same time, 1 ounce of gold might be worth 5 French francs (FF), or FF1 would be worth 
one-fi fth (or .20) of an ounce of gold. Since $20 could be converted into one ounce of gold that 
could then be used to purchase 5 FF, or 20 U.S. dollars, the exchange rate between the dollar 
and franc would be 20 to 5, or 4 to 1. Alternatively, .20 ÷ .05 equals 4 to 1.
Recall from Chapter 2 that the American colonies relied primarily on the Spanish dollar 
to conduct business transactions prior to the 1800s. In 1792, the fi rst U.S. monetary act was 
enacted and provided for a 
bimetallic standard
based on both gold and silver. A standard based 
solely on gold was not adopted until 1879. In those days, coins were 
full-bodied money
in that 
their metal content was worth the same as their face values. Paper money then was 
represent-
ative full-bodied money
, because the paper money was backed by an amount of precious metal 
equal to the money’s face value.
During the 1800s most other developed countries also had their own currencies tied to 
gold, silver, or both. By the end of the 1800s most countries had adopted just the gold standard. 
However, coinciding with the start of World War I, most countries went off the gold standard. 
For example, the Federal Reserve Act of 1913 provided for the issuance of Federal Reserve 
Notes, called 
fi at money
because they were not backed by either gold or silver. Recall from 
Chapter 2 that the government decreed the notes to be “legal tender” for purposes of making 
payments and discharging public and private debts. Fiat money has value that is based solely 
on confi dence in the U.S. government’s being able to achieve economic growth and maintain 
price stability. Most foreign governments also moved to monetary systems based on fi at money. 
A major criticism of the gold standard was that as the volume of world trade increased 
over the years, the supply of “new” gold would fail to keep pace. Thus, without some form of 
supplementary international money, the result would be international defl ation. A second cri-
ticism of the gold standard was a lack of an international organization to monitor and report 
whether countries were deviating from the standard when it was in their own best interests.