Money ; Monetary theory ; Foreign exchange ; International finance

Michael M. Hutchison

English

Research Papers in Economics

April 27, 1984
World Money
Traditional monetarism prescribes that each
nation best guarantees economicstabilityby
keeping its national money stock growing
along a steady, non-inflationary path. In re-
cent years, this view has been challenged by
the "world money" hypothesis which states
thattheworldwide moneystock is the single
most importantdeterminant ofprices and
output for each nation.
Unlike conventional monetarists, advocates
oftheworld moneyviewdonotbelieve that
control over the growth ofdomestic money
aggregates is sufficienttostabilizeanational
economy. They argue instead thattight
control ofworld money growth is the only
means ofachieving stability in both individ-
ual national economies and the interna-
tional economy. To this end, several world
money advocates have proposed close
monetary coordination among major
central banks with the hope of stabilizing
exchange rates. This Letter critically
evaluates the world money hypothesis and
its policy prescriptions.
Portfolio shifts
. There are several variants of"world
monetarism", buttwo basic approaches
may be identified. The first approach holds
that demandfor an individual country's
money is highly unstable in afloating
exchange rate regime, with increases in
money demand associated with countries
whose currencies are appreciatingand
decreases with countries whose currencies
are depreciating. This tenet presumes that
the demand for money in each country is
heaVily influenced by international
investors' preferences for holding assets in
particular national currencies, and that
these preferences are speculative and
unstable. Furthermore, it assumes that shifts
in money demand across countries offset
each other, leaving aggregate money
demand, or world money demand, stable.
To take an illustrative example, a rise in
inflationary expectations abroad may lead
foreign investors to desire more U.s. assets,
and less oftheirown, at given interest rates
and exchange rates. This coyld increase the
demand for U.S. monE!y directly. Demand
for U.S. money also could increase indirect- .
Iy because the increased foreign demand for
U.S. securities bids uptheir prices and
lowers interest rates. Lower interest rates, in
turn, increase the demand for U.S. money
balances.
The result ofthe portfolio shift toward u.s.
assets creates an excess demand for money
in the United States and raises the value of
the U.s. dollar in the foreign exchange
marketas investors sell offforeign assets and
purchase dollarassets. Associated with the
portfolio shift toward U.S. assets is acorre-
sponding shift away from foreign assets that
results in excess money supply abroad and
foreign currency depreciation. World
money demand remains stable, however.
Hence, world money advocates argue that
demand for individual national monies is
very unstable and is negatively correlated
across countries because ofthe alleged pre-
dominance oferratic and frequent investor
portfoliO shifts. Unstable demand for indi-
vidual national monies, in turn, undercuts
the traditional monetarists' argument that
steady growth in the national money stock
will ensure economic stability.
World money
The second basic approach taken by
world money advocates holds that the
nature ofthe present international monetary
system necessarily links the U.s. money
supplywith thatabroad, ineffect, coordinat-
ing and exacerbating swings in business
cycles across countries. This arises because
the United States has the largesteconomy in
the system andbecausethe U.S. dollar is the
primary reserve currency used by foreign-_.__._----_._----_._._-_.._--------
central banks to intervene in the foreign
exchange market.
Consider again a portfolio shifttoward U.S.
assets that induces an appreciation ofthe
dollar. Ifforeign central banks attempt to
prevent the dollarfrom appreciating, they
would sell U.S. Treasury securities for
dollars (foreign central bank reserves
employed in exchange market intervention
operations are primarily held in U.S.
government securities) and purchase their
own currency with the receipts. This process
drains commercial bankreserves abroad
and lowers the money supply offoreign
countries, but it leaves the U.S. money
supply unchanged. (This assumes that
foreign central banks are either unwillingor
unableto offset the effects offoreign
exchange market intervention operationson
their own money supply.)
Therefore, in the world money view, dollar
appreciation is assumed to cause a decline
in the composite average growth ofvarious
national money supplies-so-called world
moneygrowth-andto produce adeflation-
ary effect ontheworld economy. Deprecia-
tion ofthe dollar, in contrast, leads to an
increase in the rate ofworld money growth
and has an inflationaryeffect on the world
economy.
In sum, advocates oftheworld moneyhypo-
thesis believe that the present managed-
floating, dollar-standard exchange rate
system is inherently unstable because
monetary disturbances and erratic portfolio
shifts affecting the dollarexchange rate are
transmitted abroad, linking and coordinat-
ing business cycles across countries while
exacerbating their deflationary or inflation-
ary effects on the world economy. To
achieve stable world money growth and,
presumably, both national and international
economic stability, they propose that major
central banks fix national money growth
trends individually at rates consistent with
domestic price stability, and then adjust
national money growth around those trends
2
to stabilize exchange rate parities. Countries
feeling downward pressure on their
exchange rates would slow money growth
and countries feeling upward pressure
would accelerate money growth. Monetary
authorities would thereby accommodate
portfolio shifts that create moneydemand
disturbances across countries. World money
growth would be stabilized as a result.
Facts and fiction
At first pass, certain aspects ofthe world
money hypothesis appearquite plausible.
Marketcommentaries seem to supportthe
view that investor portfolio preferences
readily shift and appear unstable in our
present exchange rate regime. In addition,
as the chart illustrates, swings in world
money growth seem to be coordinated with
U.S. money growth and to magnifythat
growth.
Empirical support for these points is difficult
to find, however. First, there is littleevidence
to suggest that national money demand
instability is related to shifts in the
preferencesofinternational investors. More-
over, empirical studies have found no
compelling evidence thatthe currencies of
the major industrial countries are highly
substitutable for one another.
Second, although U.S. and world money
growth rates are correlated, it is notclear
that this link is caused by massive foreign
exchange market intervention operations
that are allowed to influence domestic
money supplies. In fact, most studies show
that foreign central banks generally donot
allow exchange market intervention opera-
tions to affect their domestic money signifi-
cantly. It appears more likely that major
central banks face a common set of
problems, e.g., oil price shocks, unemploy-
ment cycles, inflation, and so on, and react
in similar ways to produce common cycles
in money growth. Thus, world money advo-
cates are correct in pointingouttheundesir-
able consequences ofcoordinated business
cycles that resuItwhen central banks followU.S. and World Money Growth
po,conl Chango
14
12 """"-
\ World M1 Growlh A
10
\ //''y/ \
8 V \
6
u.s. M1 Growlh
4
1972 1974 1976 1978 1980 1982
similar policies. They err, however, in their
analysis ofthe process by which these
policies are linked.
Evaluation
Itthereforeappears prematureto propose an
internationally coordinated monetary
policydesigned to stabilize exchange rates
on the basis ofthe world money hypothesis.
Admittedly, the rigidexchange rates favored
by world money advocates will tend to
insulate the domestic economy better than
flexible rates in the face oflarge and erratic
portfolio shifts across currencies. Ifthe
premise ofunstable investor preferences for
individual currencies were correct, greater
exchange rate stability may well be
preferable to ourcurrent managed floating
regime. But, ifthe shocks comesubstantially
from other sources, a system with greater
exchange rate flexibility may be better.
For example, consider our present circum-
stances. Most economists believe that the
exchange value ofthe dollar remains strong
because ofhigh u.s. real interest rates
associated with the large credit demands of
the federal government. This is a "real" dis-
turbance and not necessarily a portfolio
shift. Underthe modified fixed exchange
rate regime proposed by world moneyadvo-
cates, the Federal Reserve would purchase
Treasury billsand expand themonetary base
to finance government debt. In the short
term, this expansionary policy may well
hold down U.S. nominal and real interest
rates and the value ofthe dollarin exchange
markets. But this short-term gain likely
would be bought at the expense ofover-
heating the economy and would eventually
cause higherdomestic inflation. In this case,
the exchange rate alone provides a mis-
leading signal to the monetary authorities.
Dollarappreciation is a result ofcredit
market conditions and not a shift in money
demand. Therefore, increasing the money
supply to lowerthe dollar's value is the
wrong policy response. In short, in the face
offiscal shocks, exchange rate flexibilitywill
probably maintain stability in both prices
3
and real output better than stable exchange
rates.
Indeed, nominal exchange rate flexibility is
preferable to stable rates under awide
variety ofcircumstances, includingother
"real" shocks to the economy (e.g., a
permanentoil price hike faced bya country
heavily dependent upon oil··imports). The
choice over the degree ofexchange rate
flexibility therefore will depend cruciallyon
whattypes ofshocks dominate the interna-
tional economy, and this remains an unre-
solved empirical question.
These arguments do notdeny that it is
important for central banks to remain aware
ofeach other's policies, and to coordinate
their actions to some extent, in order to
avoid exacerbating world business cycles.
However, they do shed doubton the desira-
bilityofthe exchange rate as the·sole
indicator ofmonetary policy, and on the
desirabilityof limitingexchange rate
flexibility.
Beyond these theoretical and empirical
concerns, the practical aspects ofthe world
money proposal must be questioned.
Namely, how likely is itthat the world's
majorcentral banks would bewillingtogive
up discretionary national monetary policy
and employ a policy rule fixed to aworld
standard? The recurring financial crises that
eventually led to the breakdown ofthe
Bretton Woods system offixed exchange
rate parities suggests that economic shocks
that cause national policies to diverge are
not uncommon. The historICal record does
not encourage optimism toward the world
money prescriptions.
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollaramounts in millions)
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SelectedAssets and Liabilities
Large Commercial Banks
Amount
Outstanding
4/11/84
Change
from
4/4/84
Change from 12/28/83
Percent
Dollar Annualized
loans, leases and Investments1 2 177,391 - 582 1,366 2.6
lba.ns and leases1 6 157,420 - 556 2,065 4.6
Commercial and Industrial 46,949 - 98 986 7.4
Real estate 59,551 - 10 652 3.8
loans to Individuals 27,602 45 951 12.3
leases 5,007 - 4 - 56 - 3.8
U.S. Treasury and Agency Securities2 12,313 72 - 194 - 5.3
Other Securities2 7,658 - 99 - 505 - 21.4
Total Deposits 189,866 794 - 1,131 - 2.0
Demand Deposits 46,639 895 - 2,598 - 18.2
Demand Deposits Adjusted3 31,253 2,194 - 78 - 0.8
OtherTransaction Balances4 12,932 - 101 157 4.2
Total Non-Transaction Balances6 130,295 0 1,310 3.5
Money Market Deposit .
Accounts-Total 40,638 - 90 1,041 09.1
Time Deposits in Amounts of
$100,000 ormore 38,042 81 - 123 - 1.1
Other liabilities for Borrowed MoneyS 17,208 88 - 5,799 - 87.3
Two Week Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+)/Deficiency(-)
Borrowings
Netfree reserves (+}/Net borrowed(-)
Perrod ended
4/9/84
273
53
220
Perrod ended
3/26/84
188
44
144
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading accountsecurities
3 Excludes U.S. governmentand depository institution deposits and cash items
4 ATS, NOW, Super NOWand savings accounts with telephonetransfers
5 Includes borrowing via FRB, IT&l notes, Fed Funds, RPs and other sources
6 Includes items notshown separately .
Editorialcommentsmaybeaddressedtotheeditor(GregoryTong) ortotheauthor..••Freecopiesof
Federal Reserve publicationscanbe obtainedfrom the Public InformationSection, Federal Reserve
Bank ofSan Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 974-2246.

World money

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