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April 27, 1984
World Money
Traditional monetarism prescribes that each
nation best guarantees economic stability by
keeping its national money stock growing
along a steady, non-inflationary path. In recent years, this view has been challenged by
the "world money" hypothesis which states
thatthe worldwide money stock is the single
most important determinant of prices and
output for each nation.
Unlike conventional monetarists, advocates
of the world money view do not believe that
control over the growth of domestic money
aggregates is sufficient to stabilize a national
economy. They argue instead thattight
control of world money growth is the only
means of achieving stability in both individual national economies and the international 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", but two basic approaches
may be identified. The first approach holds
that demand for an individual country's
money is highly unstable in a floating
exchange rate regime, with increases in
money demand associated with countries
whose currencies are appreciating and
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 assetsin
particular national currencies, and that
these preferences are speculative and
unstable. Furthermore, it assumesthat 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 of their own, at given interest rates
and exchange rates. This coyld increase the
demand for U.S. monE!ydirectly. Demand
for U.S. money also could increase indirect- .
Iy because the increased foreign demand for
U.S. securities bids up their prices and
lowers interest rates. Lower interest rates, in
turn, increase the demand for U.S. money
balances.
The result of the portfolio shift toward u.s.
assets creates an excess demand for money
in the United States and raisesthe value of
the U.s. dollar in the foreign exchange
market as investors sell off foreign assetsand
purchase dollar assets.Associated with the
portfolio shift toward U.S. assetsis a corresponding shift away from foreign assetsthat
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 of the alleged predominance of erratic and frequent investor
portfoliO shifts. Unstable demand for individual 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 of the present international monetary
system necessarily links the U.s. money
supplywith that abroad, in effect, coordinating and exacerbating swings in business
cycles across countries. This arises because
the United States has the largest economy in
the system and because the U.S. dollar is the
primary reserve currency used by foreign
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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.
central banks to intervene in the foreign
exchange market.
Consider again a portfolio shift toward U.S.
assetsthat induces an appreciation of the
dollar. If foreign central banks attempt to
prevent the dollar from 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 bank reserves abroad
and lowers the money supply of foreign
countries, but it leaves the U.S. money
supply unchanged. (This assumes that
foreign central banks are either unwilling or
unableto offset the effects of foreign
exchange market intervention operations on
their own money supply.)
Factsand fiction
At fi rst pass, certai n aspects of the world
money hypothesis appear quite plausible.
Market commentaries seem to support the
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.
Therefore, in the world money view, dollar
appreciation is assumed to cause a decline
in the composite average growth of various
national money supplies-so-called world
money growth -and to produce a deflationary effect onthe world economy. Depreciation of the dollar, in contrast, leads to an
increase in the rate of world money growth
and has an inflationary effect on the world
economy.
Empirical support for these points is difficult
to find, however. First, there is little evidence
to suggest that national money demand
instability is related to shifts in the
preferences of international investors. Moreover, empirical studies have found no
compelling evidence that the 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 not clear
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 do not
allow exchange market intervention operations to affect their domestic money significantly. It appears more likely that major
central banks face a common set of
problems, e.g., oil price shocks, unemployment cycles, inflation, and so on, and react
in similar ways to produce common cycles
in money growth. Thus, world money advocates are correct in pointingoutthe undesirable consequences of coordinated business
cycles that resuIt when central banks follow
In sum, advocates ofthe world money hypothesis bel ieve that the present managedfloating, dollar-standard exchange rate
system is inherently unstable because
monetary disturbances and erratic portfolio
shifts affecting the dollar exchange rate are
transmitted abroad, linking and coordinating business cycles across countries while
exacerbating their deflationary or inflationary 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
U.S. and World Money Growth
po,conl Chango
14
12
""""
\
World M1 Growlh
A
10
\ //' ' y/ \
V
8
\
6
u.s. M1 Growlh
4
1972
1974
1976
1978
1980
1982
and real output better than stable exchange
similar policies. They err, however, in their
analysis of the process by which these
policies are linked.
rates.
Indeed, nominal exchange rate flexibility is
preferable to stable rates under a wide
variety of circumstances, including other
"real" shocks to the economy (e.g., a
permanent oil price hike faced by a country
heavily dependent upon oil··imports). The
choice over the degree of exchange rate
flexibility therefore will depend crucially on
what types of shocks dominate the international economy, and this remains an unresolved empirical question.
Evaluation
It therefore appears premature to propose an
internationally coordinated monetary
policy designed to stabilize exchange rates
on the basis of the world money hypothesis.
Admittedly, the rigid exchange ratesfavored
by world money advocates will tend to
insu late the domestic economy better than
flexible rates in the face of large and erratic
portfolio shifts across currencies. If the
premise of unstable investor preferences for
individual currencies were correct, greater
exchange rate stability may well be
preferable to our current managed floating
regime. But, if the shocks come substantially
from other sources, a system with greater
exchange rate flexibility may be better.
These arguments do not deny that it is
important for central banks to remain aware
of each other's policies, and to coordinate
their actions to some extent, in order to
avoid exacerbating world business cycles.
However, they do shed doubt on the desirability of the exchange rate as the·sole
indicator of monetary policy, and on the
desirability of limiting exchange rate
flexibility.
For example, consider our present circumstances. Most economists believe that the
exchange value of the dollar remains strong
because of high u.s.real interest rates
associated with the large credit demands of
the federal government. This is a "real" disturbance and not necessarily a portfolio
shift. Under the modified fixed exchange
rate regime proposed by world money advocates, the Federal Reservewould purchase
Treasury bills and expand the monetary 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 of the dollar in exchange
markets. But this short-term gain likely
would be bought at the expense of overheating the economy and would eventually
cause higher domestic inflation. In this case,
the exchange rate alone provides a misleading signal to the monetary authorities.
Dollar appreciation is a result of credit
market conditions and not a shift in money
demand. Therefore, increasing the money
supply to lower the dollar's value is the
wrong policy response. In short, in the face
offiscal shocks, exchange rate flexibility will
probably maintain stability in both prices
Beyond these theoretical and empirical
concerns, the practical aspects of the world
money proposal must be questioned.
Namely, how likely is it that the world's
major central banks would bewillingtogive
up discretionary national monetary policy
and employ a policy rule fixed to a world
standard? The recurring financial crises that
eventually led to the breakdown of the
Bretton Woods system of fixed exchange
rate parities suggeststhat economic shocks
that cause national policies to diverge are
not uncommon. The historICal record does
not encourage optimism toward the world
money prescriptions.
MichaelM. Hutchison
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B AN KI NG DATA-TWELFTH FEDERALRESERVE
DISTRICT
(Dollar amounts in millions)
Selected Assetsand Liabilities
LargeCommercial Banks
loans, leases and Investments 1 2
lba.ns and leases 1 6
Commercial and Industrial
Real estate
loans to Individuals
leases
U.S. Treasury and Agency Securities 2
Other Securities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances 4
Total Non-Transaction Balances 6
Money Market Deposit .
Accounts -Total
Time Deposits in Amounts of
$1 00,000 or more
Other liabilities for Borrowed MoneyS
Two Week Averages
of Daily Figures
ReservePosition, All Reporting Banks
Excess Reserves (+ )/Deficiency (-)
Borrowings
Net free reserves (+ }/Net borrowed( -)
Amount
Outstanding
4/11 /84
Change
from
4/4/84
177,391
1 57,420
46,949
59,551
27,602
5,007
12,313
7,658
1 89,866
46,639
31 ,253
1 2,932
1 30,295
-
40,638
-
38,042
1 7,208
Perrod ended
4/9/84
273
53
220
Change from 12/28/83
Percent
Dollar
Annualized
582
556
98
10
45
4
72
- 99
794
895
2,1 94
- 101
0
-
-
90
1 ,366
2,065
986
652
951
56
1 94
505
1,131
2,598
78
1 57
1 ,31 0
-
-
-
1,041
-
81
88
123
5,799
2.6
4.6
7.4
3.8
12.3
3.8
5.3
21.4
2.0
18.2
0.8
4.2
3.5
09.1
-
1.1
-
87.3
Perrod ended
3/26/84
1 88
44
1 44
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading account securities
3 Excludes U.S. government and depository institution deposits and cash items
4 ATS, N OW, Super N OW and savings accounts with telephone transfers
5 Includes borrowing via FRB, I T&l notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
.
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