From 1 August 1854 when the Currency Act was proclaimed, until the outbreak of World War I in 1914, the Province of Canada, and subsequently the Dominion of Canada, was continuously on a gold standard. Under this standard, the value of the Canadian dollar was fixed in terms of gold and was convertible upon demand. It was also valued at par with the U.S. dollar, with a British sovereign valued at Can$4.8666. As noted earlier, both U.S. and British gold coins were legal tender in Canada.
(Canada, $10, 1912
Although Newfoundland issued gold coins as early as 1865, the Dominion of Canada did not do so until 1912–14, when the recently established Royal Mint in Ottawa struck $5 and $10 pieces. When the redemption of Dominion notes into gold was suspended at the beginning of the First World War, the production of Canadian gold coins ceased.)
With the gold standard in place, monetary policy was largely "on automatic pilot.” Paper money was freely convertible into gold without restriction, and there were no controls on the export or import of gold. This implied that there was virtually no scope for the authorities to manage the exchange rate or to conduct an independent
Fluctuations in market exchange rates between the Canadian dollar and the U.S. dollar and the pound sterling, respectively, around their official values were generally limited by the gold "export” and "import” points. These points marked the exchange rates at which it was profitable for individuals to take advantage of price differences between the market and official exchange rates through the export and import of gold from the United States or the United Kingdom. The difference between the export and import points and the official rates reflected the cost of insuring and shipping gold to and from New York or London and Montréal, Canada’s financial centre at that time. Given the proximity of New York, the margins against the U.S. dollar were very narrow around parity with a gold export point of Can$1.0008 and a gold import point of Can$0.9992. The margins around the $4.8666 par value of the pound sterling were somewhat wider, ±1 per cent, given the greater distance to be travelled. On rare occasions, the Canadian dollar traded outside the gold points for periods of several weeks, much longer than one would have expected if arbitrageurs were efficient. This suggests that obstacles, probably imposed by governments in an effort to protect their gold reserves, might have impeded their activities. While not a particularly significant phenomenon prior to 1914, government-erected impediments to the cross-border flow of gold became common during World War I and even more so through the late 1920s and early 1930s in order to conserve the country’s gold reserves.
With monetary policy essentially on autopilot and little in the way of active fiscal policy, there was nothing to buffer economic swings and the impact of large international capital movements. In his 1867 pamphlet arguing in favour of government-issued fiat currency, Robert Davis contended,
Such a currency, moreover, freed from the constraint of convertibility at the bank counter, would not be subject to the fluctuations to which our present circulation is constantly liable, and the injury to trade from its contraction, at the time its extension was most needed, would no longer exist . . .
The price-specie flow
Classical economists explained international economic adjustment under the gold standard using a theory developed in part by David Hume—the price-specie flow. Under this theory, an economic shock that led to increased demand in one country, and rising prices, would trigger an increase in imports and a countervailing outflow of specie to the rest of the world. The drain in gold from the country experiencing the shock would reduce the quantity of money in that country, leading to higher domestic interest rates (which, in turn, would slow demand), lower prices (relative to those elsewhere), and higher exports. Increased net exports and capital inflows attracted by relatively high domestic interest rates would restore equilibrium to the balance of payments. The opposite process would happen simultaneously in the rest of the world. The successful functioning of this adjustment mechanism depends critically, however, on the sensitivity of demand to price changes in the countries affected. If the "price-elasticity of demand” was low, it would be possible under the fractional gold standard that prevailed during this period for a country’s reserves of specie to be exhausted before adjustment was completed.
This opposition remained a minority position, however, with the weight of orthodox economic views and conventions in support of the gold standard prevailing until the 1930s. Accordingly, Canada experienced booms and busts during the gold-standard years. For example, between 1870 and 1900, Canada suffered several economic contractions with falling prices. In contrast, between 1900 and 1913, Canada g rew rapidly, and inf lationar y pressures mounted as huge amounts of foreign capital (as a percentage of Canadian GDP) entered thecountry.