ABSTRACT

Although the gold standard era has long passed, central banks continue to hold large quantities of gold. At the end of the 1990s, central banks owned about one billion troy ounces of gold, with a market value of US$270 billion.1 Using an interest rate of 4 per cent, the cost of fi nancing these gold holdings was US$10.8 billion. Why do central banks invest in gold at great economic cost? A popular view holds that offi cial gold reserves make a currency more secure. The idea is that central banks are unable to infl ate a currency that is covered by gold because, unlike paper money, gold is a physical commodity for which the supply is not contolled by monetary authorities. In this chapter it is demonstrated that this argument goes astray by applying principles that were true under the gold standard to the modern monetary system. Section 4.1 reviews the monetary role of gold during the gold standard. Section 4.2 ascertains that central bank gold holdings do not provide effective protection against infl ation in the modern paper standard. In section 4.3, the analysis is extended to other physical assets. In section 4.4, it is found that central bank gold holdings, far from being an innocuous relic, do indeed compromise fi nancial markets and monetary policy. Consequently, central banks should dispose of their gold reserves because they are costly, they are an ineffective cover of the currency, they interfere with the operation of fi nancial markets, and they are detrimental to the conduct of monetary policy.