Eli5 what it means when a currency is said to be backed by gold


I see this all the time, mostly when references are made about the dollar and how it was once backed by gold

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The US government used to have an equivalent value of gold stored somewhere for every dollar that was in circulation. So if there was $1 billion of currency, the US government had $1 billion of gold backing it up. This can help build confidence as to what the “value” of a dollar is, since it is tied to the value of a widely priced, liquid asset. Gold was just convenient — you could tie it to whatever price you want to. A person could take a dollar bill and exchange it for a dollar’s worth of gold.

Compare that to today, the US dollar is not backed by a physical commodity. Instead, it is backed by the full faith and credit of the US government. Basically, the US government (generally) determines the value of a dollar based on the actions of its central bank. This type of currency is known as fiat currency.

There are positives and negatives to both forms of currency, although most countries have moved to fiat because it gives the government more control over the economy. For example, during COVID the US government “printed” trillions of dollars to give people and businesses so they could stay afloat, simply because they wanted to. If we were still on the gold standard, we would have needed to somehow mine or acquire enough gold to give currency to people.

When a currency is backed by gold, every dollar is equivalent to some unit of gold that the government owns. Your dollar has a physical interpretation: you can, in theory, go to the treasury and redeem your money for a fixed amount of gold.

When a current is off the gold standard, money isn’t backed by a physical asset held by the government. The dollar is backed by the “full faith and credit of the United States”, i.e how much people trust the United States. The buying power of a dollar will depend on how much people trust the government and economy.

It basically means that every dollar represents 1 dollar’s worth of actual gold hidden in a vault somewhere.

Because gold is really expensive, it’s not convenient to use for small, daily transactions like buying groceries, so you use a proxy as currency instead, like paper money. But what gives the person confidence in accepting paper money is believing in the gold.

That’s basically what the first cheques were. Goldsmiths would have vaults full they held for people and instead of me going there, getting gold, and giving it to you, I would write a note explaining to the smith to give you some of my gold. You could then sign that over to someone else, and *they* would then have permission to go get the gold.

If you find someone 60+ years old they might say something like “back in my day, you could go to the bank and get an ounce of gold for $35”. Gold backed currency means that the currency is just a ticket it for gold and you trade the tickets because no one wants to lug around a pound of gold in their wallet when $420 is alot lighter.

You sell stuff and I want that stuff, so I give you some pieces of paper that we both agree are worth the same value of that stuff, so you give me the stuff. But why are you OK with accepting pieces of paper which are very clearly just pieces of paper and *definitely* not worth the stuff you gave me?

Your trust in the paper comes from your trust in the government which promises to give *you* stuff. We both agree that we can take our papers, hand it to the federal government, and get stuff in return.

A gold standard means that the government is specifically promising to give anyone an amount of gold in exchange for their paper money. Gold is intrinsically valuable: it’s rare, it’s shiny, it lasts forever, it is useful for many things. Nobody has to convince you that gold is worth having. So, you trust the paper money because you know that somewhere in a big vault the government has a shit ton gold. You don’t need gold. You don’t even really want gold. But you know that *if* you ever wanted to get rid of your papers which are not intrinsically valuable or useful for anything, you could go get some gold. And that’s why you are OK with accepting pieces of paper in exchange for stuff.

However, there are some pretty big downsides to this. One is that the government has less control over the value of the money. It’s tied to how much gold they have, and how much gold exists in the world, and how much people want gold. That’s not great when there’s an economic problem like high inflation or deflation or stagflation.

Instead, money is tied to more abstract concepts like international exchange rates and international credit ratings. You are willing to accept US dollars because you trust that you can take those US dollars pretty much anywhere in the world and exchange them for Euros or Pesos or Yen or whatever. The EU and Mexico and Japan and other governments take dollars because they trust that they can continue buying things that only the US government can provide like military aid and trade agreements and whatnot. And, they believe that the US government will continue to pay its debts on money that it borrows.

Compare that to, say, the Russian ruble which is crashing because people aren’t particularly confident that their government will be able to pay its debts and give things in exchange for rubles, since it’s spending so much money sending tanks to get stuck in the mud in Ukraine.