Gold has been used as the currency of choice throughout history. The earliest known use was in 643 B.C in Lydia (present-day Turkey). Gold was part of a naturally occurring compound known as electrum, which the Lydians used to make coins. By 560 B.C., the Lydians had figured out how to separate the gold from the silver, and so created the first truly gold coin.
In those days, the value of the coin was based solely on the value of the metal within. Therefore, the country with the most gold had the most wealth. That's why Spain, Portugal and England sent Columbus and other explorers to the New World -- to get more gold so they could be wealthier than each other.
Introduction of the Gold Standard
When gold was found at Sutter's Ranch in 1848, it inspired the Gold Rush to California. This helped in the exploration and unification of western America. In 1861, U.S. Treasury Secretary Salmon Chase printed the first U.S. paper currency.
In fact, by the mid-1800s, most countries wanted to standardize transactions in the booming world trade market. They adopted the gold standard, which guaranteed that any amount of paper money could be redeemed by the government for its value in gold. This meant transactions no longer had to be done with heavy gold bullion or coins. It also increased the trust that was needed for a successful global trade since paper currency now had guaranteed value tied to something real.
This worked so well that, by World War I, most countries were on the gold standard. Despite a few recessions, it worked pretty well until the costly war began. Between 1914-1919, most countries suspended the gold standard so they could print enough money to pay for their military involvement. Unfortunately, printing money created hyperinflation. So much money was printed that it devalued each dollar, and prices skyrocketed. After the war, countries realized the value of tying their currency to a guaranteed value in gold. For that reason, most countries returned to a modified gold standard.(History.com, "Gold Standard")
How the Gold Standard Made the Great Depression Worse
Once the Great Depression hit with full force, countries once again had to abandon the gold standard. When the stock market crashed in 1929, investors began trading in currencies and commodities. As the price of gold rose, people traded in their dollars for gold. It worsened when bank began failing. People started hoarding gold because they didn't trust any financial institution.
The Federal Reserve kept raising interest rates, trying to make dollars more valuable and dissuade people from further depleting the U.S. gold reserves. These higher rates worsened the Depression by making the cost of doing business more expensive. Many companies went bankrupt, and record levels of unemployment.
In 1933, newly-elected President Roosevelt sent out a notice ordering people to bring gold back to the Federal Reserve in exchange for dollars. Although he didn't formally state the U.S. was off the gold standard, he no longer allowed people to exchange their dollars for gold. He did this to prohibit hoarding of gold, and the redemption of gold by other countries. This created the gold reserves at Fort Knox, and made sure the U.S. held the world's largest supply of gold.
On January 31, 1934, the Gold Reserve Act prohibited private ownership of gold, except under license. The Act also allowed the government to pay its debts in dollars, not gold. The President was authorized to devalue the gold dollar by 40%. He increased the price of gold, which had been $20.67 per ounce for 100 years, to $35 per ounce. The government's gold reserves increased in valued from $4. 033 billion to $7.348 billion. This effectively devalued the dollar by 60%. (Source: Bloomberg, How Franklin Roosevelt Secretly Ended the Gold Standard, March 21, 2013; FEE.org, Gold Policy in the 1930s)
The outbreak of World War II ended the Depression, allowing countries to go back on a modified gold standard. Most countries adopted the Bretton-Woods system, which set the exchange value for all currencies in terms of gold. It obligated member countries to convert foreign official holdings of their currencies into gold at these par values. However, since the U.S. held most of the world's gold, many countries simply pegged the value of their currency to the dollar, thus making the dollar the defacto world currency. Gold was remained at $35 per ounce. (Source: National Mining Association, History of Gold)
The Bretton Woods agreement meant that central banks had to maintain fixed exchange rates between their currencies and the dollar. They did this by buying their own country's currency in foreign exchange markets if their currency became too low relative to the dollar. If it became too high, they'd print more of their currency and sell it. Even though the dollar was still worth 1/35 of an ounce of gold, most countries no longer needed to exchange their currency for gold. The dollar had replaced it. As a result, the value of the dollar increased --- even though its worth in gold remained the same.
End of the Gold Standard
The strong dollar led to inflation and a large balance of payments deficit in the U.S. which in turn helped to create stagflation. The U.S. started to deflate the dollar in terms of its value in gold to curb double digit inflation.
In 1971, gold was repriced to $38 per ounce, then again to $42 per ounce in 1973. As the dollar devalued, it motivated people to sell their greenbacks for gold. Finally, in late 1973, the U.S. government decoupled the value of the dollar from gold altogether. The price of gold quickly shot up to $120 per ounce in the free market. (Source: Time, Fuss Over Dollar Devaluation, October 4, 1971)
Once the gold standard was dropped, countries began printing more of their own currency. Inflation usually resulted, but for the most part abandoning the gold standard created more economic growth.
However, gold has never lost its appeal as a currency of real value. Whenever recessions or inflation looms, investors return to gold. By 2011, the price of gold was over $1,600 an ounce. It reached its record high of $1,895 on September 5, 2011.(Article updated November 5, 2013)