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The Fed Explains Good versus Bad Standards

We rely on standardized measurements every day. They tell us precisely what time it is, how heavy something is, how fast we are going, and what the temperature is. For example, suppose your friend is coming to visit and wants to know what the weather is like so he can pack the right clothes. You might tell him, "It's chilly." But if he's from Alaska and you're from Florida, "chilly" might have a different meaning to each of you. "Chilly" isn't a standardized measurement. Let's try this again, but this time we will use a widely accepted standardized measurement. It's 50 degrees; that's better. Degrees are a standardized measurement. As long as everyone understands what a degree is they'll know exactly what the temperature is outside.

Why are standardized measurements important? They help us communicate with others about temperature, time, well, just about anything that needs to be exact. You can describe precisely how much something weighs or its length, but what if you want to describe its value? You'll need another standardized measurement. In the United States the standard measurement for value is the dollar. Using a standard measurement lets everyone talk about value in a very precise way. So when your friend tells you her jacket cost $50, you know exactly what that means.

So what happens when a standard of measurement isn't very standard? We take them for granted today, but things like weight, length, time, and temperature were not always exact, and that caused a lot of trouble. In the old days, the foot measurement was based on the length of the king's foot. This was a bad idea. What happened when the king died? The country would need a new ruler, and if his eight-year-old son became king and his foot was smaller, the measurement would get smaller, too. If some people measured length using the old king's foot and others used the new king's foot, well, that could cause some serious problems.

Congress has the authority to set our nation's measurement standards and many of our standards have been in use for a long, long time, but the first standard set by Congress was our measure of value. What would be our national money? They called it "dollars" and defined its value as the weight of a certain amount of precious metals. By the late 1800s, that standard was gold.

But was the gold standard a good way to measure value? As it turns out, not really. For a dollar to be a good measure for value, its purchasing power needs to be stable; that is, it needs to be able to purchase about the same amount of goods or services from day to day and from week to week. Under the gold standard a dollar could always buy you the same amount of gold, but if you wanted to buy anything else, the number of dollars you needed depended on the purchasing power of gold. Why was that a problem? Every time more gold was discovered, the value of gold went down because there was so much more of it. Since the purchasing power of the gold went down, the purchasing power of dollars went down. Each dollar could buy fewer goods. And if the value of gold went up, the opposite would happen; the purchasing power of a dollar would shoot up. Each dollar could buy more goods. Fluctuations to the purchasing power of gold made gold a poor standard on which to base our measure of value, and that made trade difficult since no one knew what a dollar would buy from day to day.

Eventually, the United States separated from the gold standard and Congress tasked the Federal Reserve to set its policies in order to maintain price stability. Now, the Fed is in charge of keeping the purchasing power of a dollar stable so that when people want to buy or sell something everyone has a clear understanding of the measure of value.

Weight, distance, time, temperature. Over the years, we have come to appreciate the importance of maintaining consistent standards in our measurements, and the measurement of value is no different. Keeping that standard stable is vital to keeping our economy operating at its maximum efficiency.

For more information about the Federal Reserve Bank, check out our website at frbatlanta.org.