Inflation targeting is a much better monetary policy than the gold standard. But that's not what this post is about.
Is there any fundamental theoretical difference between how monetary policy worked under the gold standard and how monetary policy works today for a modern inflation-targeting central bank? That's what this post is about.
If you believe that monetary theory fundamentally changed, or needed to change, when modern central banks abandoned the gold standard, then this post is for you.
[Update: on thinking it over last night, and reflecting on my own beliefs over the years, I should probably add that the question in this post ought to be directed at myself, as well as directed at others. I had always thought "Oh yeah, dropping gold changed everything". But other than making the basket much more representative and sensible, which matters massively in practical terms, did it really change things theoretically?]
1. Start with a monetary system where the central bank's paper money (or an electronic equivalent) is 100% backed by gold reserves, and each note can be redeemed at a fixed price for gold.
2. Now relax the assumption of 100% gold reserves. The central bank holds fractional gold reserves, with the rest of its assets being something else, like government bonds. If there's a demand to redeem notes, the central bank might have to sell bonds to redeem some of the notes, if it fears it might run out of gold reserves. And interest rates might rise if it does this.
3. Now take the limit of that system, as the percentage of gold reserves approaches 0%. There is indirect convertibility of paper money into gold. The central bank never actually buys or sells gold, but it buys or sells bonds to keep the equilibrium price of gold pegged, so that people can still swap their notes for gold in the open market at a fixed price.
4. Now replace the fixed peg with a crawling peg. The central bank allows the paper currency to depreciate at 2% per year against gold. The target price of gold rises at 2% per year.
5. Now replace that target price of gold with a target band. The price of gold can fluctuate either 1% above or 1% below that target price, at the central bank's discretion. The exchange rate of paper money for gold is a snake in an upward-sloping tunnel.
6. Now allow some base-drift. If the price of gold rises towards the top of the tunnel, the central bank may re-base the tunnel upwards. If the price of gold falls towards the bottom of the tunnel, the central bank may re-base the tunnel down. But any such re-basing is unbiased, so the expectation is always that the price of gold will rise at 2% per year from now on.
7. Now add silver to the gold. The central bank targets a weighted average of the price of gold and the price of silver. There's a synmetallic standard.
8. Now add a lot of other goods and services to the basket, along with gold and silver.
9. Now remove any goods and services that are not included in the CPI basket of goods, and weight the remaining goods according to their weights in the CPI.
[Update: Maybe add 10: Since some goods in the CPI basket have sticky prices, that need time to change, the central bank switched to pegging the expected future price of that basket.]
We now have a modern inflation-targeting central bank.
(For a price level path targeting central bank you can delete step 6.)
At what point in the above steps did monetary theory need to fundamentally change?