The Reagan administration's monetary policy remains unclear. The monetary plank of the 1980 Republican Party platform, which Reagan supported, clearly implies the dollar should be linked to gold or some other commodity.
During the first months in office, however, the new administration has given little attention to the gold issue. Instead, the White House has ambiguously urged the Federal Reserve Board to pursue a "stable" monetary policy.
The issue of dollar convertibility will, nonetheless, surface quickly with the appointment of a Treasury commission to study the role of gold in the domestic and international monetary systems. Its recommendations are slated to be submitted to Congress on or before Oct. 6, 1981.
In the conventional view, inflation is a consequence of increases in the supply of money; the price of money falls and the prices of goods and services rise. Thus, the conventional solution to inflation is to restrict the growth of the money supply.
The demand for money is equally important to inflation in the classical model. A reduction in the demand for money reduces its price and raises the prices of goods and services.
The demand for money arises from at least two of the essential functions it performs. Money serves both as a medium of exchange and a store of value. The more useful a particular money -- say, US dollars -- in performing these functions, the greater the demand for that money.
A commodity standard is the route to price stability in classical economics. While gold is not the only commodity that could be used, historically, gold has performed quite well as a standard of value for currencies. Under the gold standard the price level in the United Kingdom was, for example, the same in 1930 as it was in 1718.
Tying a currency to a gold standard has the same effect on inflation that a governor on a car engine has on speeding. Before March 1968 the dollar was convertible into gold and the average rate of inflation between 1960 and 1968 was about 1 percent annually. A return to convertibility would cause little disruption in the financial market and the market for goods and services. Yet one serious problem is how to determine the appropriate price of gold once the dollar is convertible.
At present, the price is around $430 per ounce. If the government were to reestablish convertibility at this price, an enormous inflation would follow, as other prices sought parity of gold. The current price of gold has been bid up to such heights because inflation is expected to continue at high rates. In a free market these changed anticipations would sharply reduce the current price of gold.
The first step in restoring dollars to gold convertibility would be to announce the intention to consider a gold standard. A period of transition and a specific date for the reestablishment of convertibility should be set.
During this transition period, the monetary authorities should take an uncompromising posture and be prepared to sell a substantial portion of the government's gold holdings. Whatever the market price of gold at the specified date, that would be the price the monetary authorities would choose as the price of conversion.
The price of all commodities would not, therefore, be forced to adjust the price of gold. The price of gold would do the adjusting. Thereafter, the dollar price of gold would be fixed through substitution of gold for dollars (or dollars for gold) by the monetary authority.
Intervention to maintain dollar convertibility, once the price is established , is a critical feature of any gold-exchange standard. Perhaps the single most successful episode was that conducted by the British from the beginning of the 18th century to the beginning of the 20th century. The British simply adjusted the UK monetary base to maintain gold's predetermined price.
The essential point of Britain's monetary policy was not to control the quantity of money, or interest rates, but to balance the supply and demand for money at a fixed price of that money in terms of gold. Gold is a good proxy for all goods and services, so prices were stabilized. The approach worked, and worked well.