In essence, the introduction of the gold standard requires each participating country to convert its currency to gold (and carry out the reverse procedure) at a fixed exchange rate. For example, the value of the dollar can be set as equaling 1/20 of an ounce of gold, and that of a pound sterling as one-fourth of an ounce of gold. The foreign exchange rate determined using the conversion of the gold content sets the gold parity for each currency circulated in external foreign markets. In this example, the exchange rate parity between the dollar and the pound sterling is set at the level of 5 dollars per pound sterling, which is equivalent to 0.2 pounds per dollar. In the 19th century, gold was circulated in domestic markets as coinage. Additionally, it served as form or reserves for commercial banks, which secured term deposits. In the era of domination of the gold standard, an American firm wishing to import wool from Britain, could sell dollars in the external foreign exchange market, buy pounds sterling and pay for the goods. This transaction would be the same today. However, while at the time the demand for dollars was lower than their supply on the market, and the exchange rate dropped below 0.2 pounds sterling per dollar, this company had a different way out of this situation. The company could use its cash balance with a local bank to buy gold at 20 dollars per ounce, ship this gold to Britain and sell it at English banks at 4 pounds sterling per ounce. This transaction made sense when the foreign exchange rate shifted relative to the gold parity by an amount exceeding the cost of shipping the gold (normally this cost was 1%).

As long as each country participating in the gold standard is prepared to convert its currency to gold, exchange rates cannot deviate considerably from the gold parity. Any pressure on foreign exchange rates shifting them away from parity values will be adjusted by the influence of transnational gold flows on the money supply circulating within any particular country.

Assume that American consumers have all of a sudden experienced an inexplicable appeal to English woolen overcoats. The resulting growth in the supply of dollar in current accounts of foreign trade transactions lowers the exchange rate of the dollar. As soon as the foreign exchange rate of the dollar drops below parity by an amount exceeding the gold shipping cost, gold will flow from the US to Britain. This process will deplete the reserves of the US banking system and fill the reserves of English banks. In this way the money supply in the USA will shrink, which that in Britain will rise.