The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
ffi) Jl cD) ©\fffi n If ©11ffi (C. CGJ March 31, 1978 Money andExchange Rates Eight major industrial countries now establish annual targets for the growth of their monetary aggregates: the U.S., Germany, Japan, Canada, the U.K., France, Italy and Switzerland. In many cases they have done so because of their concern with controlling domestic rates of inflation, in the aftermath of the 1973 breakdown in the system of fixed (or almost fixed) exchange rates. Under the earlier Bretton Woods system, fixed exchange parities required countries with balance-of-payments surpluses to their surpluses; that is, central banks essentially converted the surplus foreign exchange into centralbank assets, thereby expanding that country's domestic money supply. In the absence of fixed exchange rates, countries could, in theory, pursue different monetary policies, allowing the exchange rates to adjust to bring about an equilibrium between the supply and demand for a country's currency by its trading partners. But by the same token, countries which desired to pursue more rapid monetary growth than their trading partners would over time have to expect a depreciation in their currencies. Central bankers have been very mindful of the potential for conflict between exchange-rate objectives and money-supply objectives. Dr. Otmar Emminger, President of the Deutsche Bundesbank, wrote recently in the Princeton University series, Essaysin International Finance(No. 122),"'It is significant that more and more countries have in recent years adopted a monetary policy emphasizing the quantitative control of monetary aggregates. Any commitment to intervene in the foreign-exchange markets in order to maintain fixed exchange rates is bound sooner or later to conflict with such controls of the money stock. '" While the major central banks have stated time and again that they have little desire to "'fix'" exchange rates, conflicts can still arise between money-supply objectives and any existing configuration of exchange Where "'inconsistencies'" arise among moneysupply objectives, some currencies could appreciate and others depreciate. The only question is: which ones? Alternative framework Most U.s. academic economists argue that domestic monetary policy ought not to be aimed at achieving a given objective for either the balance of payments or the foreign-exchange value of the dollar. They argue that the "'tail does not wag the dog, '" where the domestic economy is the dog and the foreign sector, the tail. While this is admittedly true, there are times in which the tail contains a good deal of information which the dog is ignoring. To analyze what the tail is trying to tell the dog, we need an alternative perspective on the balance of payments and exchange rates. Under any such approach, we should focus attention on the entire balance of paymentstrade account and capital accountand not simply on the trade account, as has been done recently in discussions of the U.s. dependency on imported energy sources. This alternative approach - the monetary approach to the balance of payments - has two basic propositions. First, international m'oney flows are the (continued on page 2) it (Q) <:2" P 0 i r 1f ©11 TI1 CC::11 CD) Opinions expressed in this newsletter do not necessarily the views of the management of the FederalReserve Bank of San Francisco, nor o-rthe Board of Go\/ernors of the Federal Reserve Systern. consequence of money stock disequilibria - that is, differences between desired and actual stocksof domestic money - and are in essence transitory and self-correcting. Secondly, domestic money can be created either by domestic monetary policy via domestic credit expansion or by international policy via a balance-of-payments surplus. In a world of fixed exchange rates, an excess supply of domestic money leads to an outflow of funds - a balance-of-payments deficit - thereby restoring equilibrium in the domestic money market. This outflow is then absorbed by foreign central banks, 'who monetize it and thereby expand their money supplies. In a world of flexIble exchange rates, the incipient balanceof-payments deficit leads to a decline in the foreign-exchange value of the domestic currency. Thus, equilibrium in the domestic money market is restored by a price change - a decline in the international value of the domestic currency. Hence, the adjustment which restores equilibrium in the domestic money market may take place by a quantity adjustment (under fixed exchange rates) or a price adjustment (under flexible exchange rates). In either case the domestic money market is stabilized by eliminating the stockdisequilibrium - that is, the excess demand or supply of domestic money. What about oil? This "new approach emphasizes a point which is often ignored - namely, that the adjustment of desired to actual stocks of money may occur through either the trade account or the capital # 2 account. The financial press, in contrast, has tended to emphasize only the trade account, in the form of 1977's massive $31-billion merchandise trade deficit. While oil imports and the resultant trade-balance deficit help explain the declining value of the dollar, they are by no means the whole story. Indeed, " it is quite conceivable that the " could solve its energy problem and still be confronted with an exchangerate problem. For if the U.s. did not have an excess supply of money, the deficit on trade account would be appropriately matched by an equivalent surplus on" capital account. According to the monetary argument, equilibrium in the balance of payments is equivalent to the equilibrium between the desired demand and actual supply of the existing stock of nominal money balances. C;onsequently, overall balance-of-payments equilibrium will be restored only when the U.S. reduces the excess supply of nominal money balances. This, of course, is not an easy task, but the Federal Reserve's establishment of long-run targets is designed to help eliminate any excess money supply without sacrificing domestic economic considerations, such as output and employment. u.s. Price story Over long periods of time, excess money growth feeds into prices, and price-inflation differentials across countries are reflected in exchangerate adjustments. This can be demonstrated by the wholesale-price performance since 1972 of the and West Germany (see chart). During u.s. 1973, for example, the U.s.-German. inflation differential was a wide 7.2 percentage points. Given that similar traded goods tend to sell for the same price (adjusted for exchange rates) in different countries, this wide a differential would suggest the necessity for a major exchange-rate realignment between Germany and the U.S. - as indeed occurred during the switch to floating exchange rates in the spring of widened inflation diffeiential.) In terms of the monetary approach, the worsening U.s. price picture and the improved German price performance implied an excess supply of the u.s. money stock, precipitating a U.s. balance-of-payments deficit, and an excess demand for the German money stock, precipitating a German balanceof-payments surplus and an appreciation of the D-Mark. 1973. The U.s.-German inflation differential remained high during 1974 but then almost disappeared during the 1975-76 period. However, during 1977 this differential widened to 4.3 percentage points, suggesting the need for a further exchange-rate adjustment between the dollar and the Deutschemark. (Admittedly, the Deutschemark appreciation during 1977 was much larger than the widened U.s.-German inflation differential. This may represent discounted expectations of a future increase in differential price behavior, or "over-adjustment''" to the Consequently, according to the monetary approach, stable exchange rates and a balance-of-payments equilibrium will be restored only when each country eliminates any disequilibrium (excess supply or demand) in its own money stock and, in the long-run, when consistency is achieved between both countries' money-stock targets. Otherwise, the balance of payments will not be in equilibrium for either country, and the exchange rate will continue to fluctuate as attempts are made to restore equilibrium in each country's domestic money market. JosephBisignano Percent 20 Wholesale Price Change (4th qtr. to 4th qtr.) 15 5 1972 3 1973 1974 '1975 1976 1977 !!l?MPH • • uo8aJO • l?pE'l\aNoOLjE'PI l?! UJoJ!IPJ. PUOZ!JV P)ISPIV CD) ·l!ITe:)'o:>sPUTeJ:I U1?S C;SL·ON llW1 Bd OIVd :J9¥lS Od ·s·n 'IVW SSVl:) JJ. BANKING OATA-TWE LfTH fEDERALRESERVE DBSTRDCT .(Dollar amounts in millions) Selected Assetsand liabilities large Commercial Banks Amount Outstanding 3/1 5/78 Loans(gross,adjusted)and investments* Loans(gross,adjusted)- total Securityloans Commercialand industrial Realestate Consumerinstalment U.s.Treasurysecurities Other securities Deposits(lesscashitems)- total* Demand deposits(adjusted) U.s. Government deposits Time deposits- total* Statesand political subdivisions Savingsdeposits Other time depositst LargenegotiableCD's 108,356 84,864 2,137 26,074 28,588 15,033 8,784 14,708 106,173 29,026 861 74,353 6,395 31,610 33,539 15,347 Weekly Averages of Daily Figures Week ended 3/15/78 Member Bank ReservePosition ExcessReserves(+)/Deficiency(-) Borrowings Net free(+)/Net borrowed (-) FederalFunds-Seven LargeBanks Interbank Federalfund transactions Net purchases(+)/Net sales(-) Transactionswith U.s. security dealers Net loans (+ )/Net borrowings (-) Changefrom year ago Dollar Percent Change from 3/8178 + + + - + + - + + - + + - + + + 500 319 147 30 210 64 146 327 822 616 642 827 61 107 723 700 + 13,416 + 12,526 59. + 2,724 + 6,392 + 2,629 493 + 1,383 + 12,214 + 2,202 131 + 9,812 + 1,003 49 + + 8,004 + 14.13 17.32 - 2.69 + 11.67 + 28.80 + 21.19 5.31 + 10.38 + 13.00 8.21 + - 13.21 + 15.20 + 18.60 0.16 + + 31.35 + 71.88 + + - - - Week ended 3/8/78 Comparable year-ago period 40 16 56 + + 106 9 97 + 1,059 + 1,328 + 79 529 + 657 + 461 + 3 1 4 *lncludes items not shown separately.tlndividuals, partnershipsand corporations. Editorial comments may be addressedto the editor (William Burke) or to the author.••. Information on this and other pUblicationscan be obtained by calling or writing the Public Information Section,FederalReserveBankof SanFrancisco,P.O. Box 7702,SanFrancisco94120.Phone(415) 544-2184.
@FedFRASER