What it is:
The gold standard is a monetary system in which the representative currency is based on a fixed amount of gold held by the central government.
How it works (Example):
Paper currency is actually a "legal note," i.e. a debt between the currency holder and the government. In theory, currency represents the obligation to make a payment of the stated amount when presented to the government. When the gold standard was in place, an individual could present a $10 bill to a federal bank and receive $10 worth of gold in return. Gold was used as a base, because it was durable, rare, and almost universally valued.
The price of gold became a barometer for the underlying value of an economy. But because gold is a tangible asset, the price of gold can rise and fall rapidly. It's also subject to speculation, discovery and theft. As a result, the value of currency based on gold depends on the value of gold.
In the last century, the world's economies grew too quickly to be accurately represented by the world's reserves of gold. Therefore, gold standards have been abandoned by almost all economies. The United States abandoned the gold standard in 1971.
Why it Matters:
While the gold standard regulates the value of exchanges throughout the economy, it also limits a central government's ability to make monetary adjustments in the current global economy.
After the abandonment of the gold standard, governments gained more ability to affect economies through monetary policy. Monetary policy is contingent upon the central government's ability to adjust an economy's demand for money through interest rates and the supply of currency. This is especially important during times of emergency such as war or natural disaster.