Full text of Economic Review (Federal Reserve Bank of San Francisco) : Spring 1975

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World Inflation
. . . Editorial Summary

International Money and
International Inflation: 1958-1973
. . . Edward S. Shaw

Towards an Explanation of Simultaneous
Inflation-Recession
. . . Michael W. Keran

Central-Bank Policy Towards Inflation
. . . Hang-Sheng Cheng and Nicholas P. Sargen

The Interdependence of National
Monetary Policies
. . . Joseph Bisignano

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2

Inflation seriously undermined the world
economy in the first half of the 1970's. In the
industrial areas of the world, consumer prices
increased at a 5-percent annual rate in the 197172 period, and later accelerated even further,
eventually rising by 13 percent in 1974. The
price performance was even worse in developing
countries, where the average rate of consumerprice inflation rose from 10 percent in 1971 to
30 percent in 1974. The severity of this problem, in both practical and analytical terms, thus
has stimulated economists to make new efforts
to link the two worlds of theory and policywitness the articles in this issue. These papers
are built around a common theme-the factors
which have made the inflation worldwide in
nature. Although providing no final answers,
they highlight the crucial inflation issues and
thereby help extend the current dialogue on one
of the world's most intractable problems.
In the first article, Edward S. Shaw argues,
"The inflation was a monetary phenomenon.
Money was supplied in excessive quantities
everywhere, and its value or purchasing power
decayed." He formalizes his analysis with a
model of world inflation, wherein government
deficits of the reserve-center country (the U.S.)
generate an excess supply of dollars, which under a system of fixed exchange rates then inflate
the money supplies of other countries. The
model is first used to explain the overall price
stability of the 1958-65 period, and then to explain the collapse of the fixed-exchange-rate system in the following decade.
Shaw also notes the potential difficulties for

price stability under the new regime of floating
exchange rates. With no change in policies, the
United States could release through its budget
deficits the inflationary pressures that were previously absorbed, under Bretton Woods, by
growth in worldwide demand for dollar reserves.
He concludes that the result could be inflation
at rates even faster than those recently experienced in this country.
Michael W. Keran highlights those elements
in the current body of economic theory which
might help explain the unusual combination of
inflation and recession which now besets the
world in general and the U.S. in particular.
First, the inflation. An unprecedented expansion
in international reserves-the dollar-overhang
problem - occurred prior to the early-1973
breakdown of the system of fixed-exchangerates. This led to a simultaneous increase in the
domestic money stocks of most of the world's
industrial nations, resulting in a massive worldwide boom and then a massive worldwide inflation. Yet because of the worldwide nature of
this process, the magnitude of inflation in any
one country was greater than it otherwise would
have been-because in addition to the traditional impact of an expanding domestic money
stock on domestic prices, there was also the impact of rest-of-the-world inflation on domestic
prices through the mechanism of internationallytraded goods. On the basis of data for six industrial countries (including the U.S.) Keran
presents evidence that the recent inflation phenomenon can only be explained by considering
both international and domestic monetary de-

3

velopments.
Rest-of-the-world inflation also helps explain
the recession phenomenon, operating through
existing relationships between the domestic
money stock and domestic income. Given the
growth in the domestic nominal money stock, a
larger - than - expected domestic inflation imported from outside will reduce real money balances by more than otherwise expected, and
thus will temporarily reduce real income. With
this unprecedented (if temporary) gap between
real and nominal income, we experience simultaneous inflation and recession. "How long will
this state of affairs contiQ-ue? As long as the
growth rates of real and nominal money are on
divergent courses"-which depends today on
the course of world inflation.

Cheng and Sargen test their model by analyzing 1948-73 data for eight Pacific Basin
countries with varying degrees of dependence on
trade, levels of development, and rates of inflation. The results suggest that imported inflation
contributed significantly to domestic inflation in
nearly all of the countries in the sample, with
the impact more apparent in developed countries than in the developing countries of the region. At the same time, independent monetary
policy appears to have been less feasible for the
developed countries than for the developing
countries.
Joseph Bisignano in his contribution emphasizes the increasing monetary interdependence
among nations. First, a high degree of correlation exists among short-term interest rates of
various countries, reflecting the rapid rise and
integration of capital and money markets. In
addition, changes in the U.S. monetary base
significantly influence the money supplies of almost all major industrial countries. This finding
appears logical, given the acceleration in the rate
of growth of the U.S. monetary base, and given
the commitment by most nations (until recently)
to a system of fixed exchange rates.
Bisignano then proceeds to develop a monetary interpretation of the balance of payments.
This approach requires a money-demand equation, a money-supply equation, an equation
positing the equality of those two variables, and
an equation defining the balance of payments as
the change in the foreign-asset component of
the monetary base. This monetary approach is
essentially a theory of equilibrium restoration
between money demand and supply in open
economies. The anaiysis hinges crucially on the
empirical stability of monetary-base demand,
which was statistically verifiable over the 196673 period.

In another paper, Hang-sheng Cheng and
Nicholas P. Sargen develop a monetarist model
to examine the effectiveness of central-bank policy for combatting imported inflation. They note
that the impact of imported inflation on domestic
prices depends critically on the degree of openness of the economy, which in turn is determined
by the substitutability between domestic products and foreign products on the one hand, and
the ratio of imports to domestic expenditures on
the other. Depending on the degree of openness,
the central bank can exert at least partial control
over the domestic money supply. Even in the
case of a highly open economy, domestic credit
expansion or contraction will affect the domestic
money supply, as a result of induced changes in
the domestic demand for money which are
brought about by changes in real expenditures
and domestic prices. Hence, the central bank
could, under specified circumstances, utilize domestic credit policy for combatting imported
inflation.

4

1
Edward S. Shaw*
bank. Every monetary system expanded its national money supply on the basis of accumulating reserves. Then holders of money responded
as they always do to excess money supplies, by
speeding up their turnover rate or velocity of
money expenditure. The pace of growth in these
expenditures was progressively faster than the
pace of growth in real outputs of goods and
services. Accelerating inflation and the collapse
of Bretton Woods were the only possible outcomes.
The first section below develops a model that
formalizes the fiscal-monetary explanation of
world inflation in a context of fixed foreign-exchange rates. There is a center country that
imposes inflationary shocks, and there are small
countries that contribute their shares to the upward sweep of price levels. The model is
adapted to the regime of Bretton Woods. The
second section explores briefly the experience
of the United States as center and of eight other
countries as satellites during 1958-65. In those
years, by good luck or sound judgment, growth
of nominal money hewed quite closely to growth
in real money demanded by private sectors, and
the result was stability in markets for goods,
securities, and foreign exchange. The third section has to do with the years 1966-73 that terminated in the collapse of Bretton Woods. The
fourth section explores briefly potentials for inflation in the center country after foreign-exchange rates have been floated.

Inflation on an international scale was negligible or modest into the early 1960's. Then it
accelerated, slowly through 1965, progressively
faster to the explosive climax of 1973-74. The
eclipse of price-level stability has been explained
in a variety of ways. One explanation blames
traumatic phenomena of commodity supply, including crop failures and aggressive policies of
the petroleum oligopoly. Another points to social conflict. Factors such as these did generate
blips or bubbles in price levels, but they do not
account for the prolonged surge of inflation.
The inflation was a monetary phenomenon.
Money was supplied in excessive quantities
everywhere, and its value or purchasing power
decayed. Prime responsibility for excess money
lies with the fiscal-monetary policies of the
United States. Fiscal deficits of the American
government generated an increasing stock of
Treasury debt. Market prices bid for the debt
by the Federal Reserve and other national monetary authorities drew virtually all of the debt
into the authorities' portfolios, and "high powered" or "reserve" money increased correspondingly. The linkage of monetary systems by the
arrangements of Bretton Wood guaranteed the
subservience of "small" monetary systems to
policies of the American Treasury and central

*Edward S. Shaw was Visiting Scholar at the Federal Reserve Bank of San Francisco (1974-75), following his retirement as Professor of Economics at Stanford University.

5

I. Elements of the Inflationary Process

t

The equilibrium growth path of the world's
price level depends on the relative growth paths
of nominal money supplied and real money demanded.

p

=:;

W

= rate of change in the world
nominal money supply in
terms of the center numeraire

fu~

= rate of change in real money
demanded in the world economy.

U

r = actual and desired ratio of
domestic non-reserve assets to
reserves in the monetary system
of the center country.
r°

pW = [su(m~) + so(m~)]

- [su (m~

) +

So

(m~

)]

(4)

Su and So = country weights, summing to unity.

°

°

t=e+pw

1

e = growth rate of the real debt of the
center government.

Equation (3) elaborates upon (2), presenting
the determinants of growth in nominal money. *
u
u
(3) su(m~) +so(m~)= su(t + d(r ) )
+ so(t + ~ )
I +ro

actual and desired ratio of
domestic non-reserve assets to
reserves in the monetary systems
of the satellite countries.

It is assumed that monetary systems, in acquiring reserve and non-reserve assets, issue only
money-or that issues of money are in constant
proportion to issues of, say, time and savings
deposits and certificates of deposit. International reserves may include physical stocks of
gold, priced in the center's numeraire, and
SDR's as well. However, the analysis below
takes it for granted, in general, that these reserve
components do not grow. The component that
will concern us most is (T), interest-bearing
debt of the center's government at nominal
value. This is a policy variable, its growth rate (t)
depending on growth in the center government's
real deficit and the rate of inflation.

A relative rise in the growth rate of nominal
money increases the rate of inflation though, in
the short run, some of the adjustment occurs in
growth rates of output and of real money demanded.
Equation (2) elaborates upon (1), distinguishing the growth paths of the center or large
country (u) and the satellite or small countries
(0). Equilibrium is assumed for every member
of the bloc; foreign-exchange rates are normalized at unity; and all goods are classified as
tradeables.
(2)

growth rate of international
monetary reserves held by the
monetary authority of the center
country.

to = growth rate of international
monetary reserves held by the
monetary authorities of the satellites.

rate of change in the world
price level in terms of the
center numeraire

m;

U

The ratios (r) of domestic credit to reserves
are also a policy variable. The assumption will
be that (r u ) is constant but that (ro) may be
changed by monetary authorities in small countries. Their decisions may be explained in this
fashion:

1+ r"

"'The term d ( ) in the following equations is the differential of the function ( ).

6

r

(5)

o

+
0

0

0

nent income.

w

r (y , v , p )

=

response of growth in real money
demanded to inflation.
The (T) y) in this equation is the income elasticity
of demand for money, and (7] p w) is the inflation
elasticity. We suppose that real rates of interest are constant and that expected inflation is
equal to actual inflation. Nominal rates of interest, suppressed in this model, vary with (pW).
If one were to trace a temporal path defined
partly by (8), he would observe a redistribution
of the world's real money balances, a larger
share accruing in countries with high growth
rates of real income, and with low sensitivity, on
the part of the money-holders, to inflation.
We have now a very small model to guide
analysis of inflation in 1958-73· There are three
equations. One is equation (2), expanded by
(3), (4), (5) and (8). The others are (6) and
(7) . The three endogenous variables, determined by the model, are (pW), (to), and (tu ).
Instruments of policy are the fiscal-monetary instrument of the center country (t) and the portfolio-choice instrument of the satellites (rO).
Other instruments will be introduced informally,
including the foreign-exchange rate between
center and satellites and the issuance of SDR's.
Compression of the model to only three equations has its analytical costs. For example, one
does not observe explicitly that the nominal
money stock and its growth rate in the center
country are not determined exclusively by the
monetary authority of the center. Given (t)
and the international pattern of demand for real
money, (m:) is determined partly by the portfolio choices of foreign monetary authorities.
High values of (ro) imply relatively large stocks
of money in the center, low values of (ro) relatively small stocks in the center. The world's
nominal money supply and the supply in each
country are at the mercy of decisions by all
monetary authorities.
In an harmonious monetary world, with constant foreign-exchange rates, monetary authorities would wield their control instruments in a
mutually satisfactory way. The center would
manage (t) and (r u ) ; the satellites would manT) p W

yO = growth rate of permanent income in
the satellite countries.
U

V

= growth rate of real imports into the

satellite countries.
Equation (5) suggests that portfolio preference
on the part of smali monetary systems shifts
away from reserve assets to domestic credit accordingly as the negative yield (pw) on the former increases and as positive yields on the latter
are generated by speedier growth of output (yO).
It. suggests also that demand for reserve assets,
relative to domestic credit, tends to increase with
growth of international trade (v).
Equations (6) and (7) complete specifications for the supply component of equation (2).
(6)

(7)

to = m~ t

U

=t

4L!:.l
1+ r

O

- s (to)

°
s:
---s:allocate growth

These equations
in monetary
reserves between satellite and center monetary
systems. Equation (6) indicates that satellite
monetary authorities may accommodate as little
or as much as they wish of the center government's deficit finance. They may resist importation of reserves, displacing reserves with domestic credit and raising (rO) in the manner, say,
of Japan. They may welcome reserve inflows
and economize on domestic credit, at low values
of (ro), in the style of The Netherlands. Equation (7) indicates that the monetary authority
of the center country is the residual buyer of its
government's debt issues. It establishes and defends a rate of interest for government securities
that is low enough, relative to other rates of
interest, to repel demand for (T) by the nonmonetary sector of the world economic system.
Equation (8) elaborates upon the demand
element of equation (2).
(8)

T) y

Su

y

(iii~)+

=

So

(iii~)=

su

(T)~yU - T)~wpW)

response of growth in real money
demanded to growth in perma-

7

PW

=

age (ro); and everyone would be satisfied with
paths taken by nominal money and the price
level. The rate of inflation everywhere is at the
mercy of monetary expansion anywhere, but a
consensus about the optimal inflation rate can
hold the monetary community together. 2
There is some risk of excessive instability in
the integrated monetary world when the monetary authority of the center watches over (r u )
only and neglects changes in the constellation
of reserve and domestic-credit ratios in small
countries. If its conception of its role is myopic,
fixed only upon domestic monetary developments, the possibility is not negligible that concerted changes abroad in desired portfolio ratios
of small monetary systems will induce important
changes in world growth rates of money and
prices. When foreign-exchange rates are fixed,
the center ignores monetary policies in small
countries at some peril to world stability.3
The source of instability that concerns us
most originates with the center, mainly through
an increase in (t) but potentially as well through
an increase of (r u ) . One recalls that (t) is the
growth rate for primary debt (T) of the center's
fiscal authority, the variable reserve asset of the
world's monetary system." The initial disturbance on the markets for reserves and money
caused by an increase in (t) may be absorbed
smoothly by the world's monetary system. Perhaps as the result of coincidental increases in
world trade flows (v), there may be reductions
in desired domestic-credit ratios of small countries that limit the multiplicative impact on
money supplies. Again, concurrent growth of
permanent incomes (y) may draw increments
of nominal money into real money balances at
an essentially stable rate of price inflation. That
is to say, declines in (r ' ) and increases in (m~)
may neutralize acceleration of (t).
Sustained and accelerated growth in (T),
combined with unfortunate but not improbable
monetary policies in the center and its satellites,
however, has ominous potentialities for the
world monetary system. 5 Growth in the nominal
value of international reserves has been described in equation (4), repeated here:

(9)

t=e+pw

With (pW) initially at zero, the center government may be driven by political considerations,
perhaps by a war, into acceleration in growth of
its real debt (e) and correspondingly in (t). The
center monetary authority, trying to inhibit an
upward sweep of domestic rates of interest, can
be expected to increase open-market purchases
and (to). Inevitably international balances of
payment would transmit some of the growth in
(t) to small monetary systems. The effect can
be to reduce their domestic-credit ratios below
desired levels and so to accelerate their monetization of domestic credit. Some increase in the
rate of inflation must occur, and then (t) must
increase again. Nominal rates of interest, responding to growth in (pW), must rise and induce faster monetization of deficits in the center,
given the illusion of the center monetary authority that there is no difference between real and
nominal rates of interest. The likelihood of dramatic growth in the world's money supply and
price level is not small for any large increase in
(e). Needless to say, an initial reduction of (e)
could precipitate cumulative deflation. The real
fiscal objectives of the center and its monetary
policies, together with portfolio preferences of
small monetary systems, have a common and
interacting bias toward monetary instability.
This scenario of fiscal and monetary instability is still incomplete. Growth of (e), (t),
(m~), and (pW) must be expected, on the basis
of equation (8), to induce some decline in the
world growth rate of real money demanded and
some increase in the growth rate of money's
velocity. Moneyholders respond to the inflation
tax by the obvious strategem of demanding
slower growth in real money balances. Any decline in (fii~) must push inflation along still
faster, according to equation (1), and contribute
to the quickening growth of nominal fiscal deficits, nominal reserves, and nominal money supplies. Money-holders, too, have a role in the
explosive sequence.
The stage now is set for the collapse of international monetary arrangements. Monetary systems of small countries cannot give vent to their

8

portfolio preference for domestic over international assets by accelerating domestic credit expansion, because the inflationary outcome would
be intolerable. Specific interventions on capital
markets, goods markets, and the foreign exchanges are too costly in investment and trade
distortions. The only acceptable way of preserving relative price-level stability and desired portfolio balance is simultaneously to depreciate the
center
currency at some rate
and
to raise (ro). We may introduce the new instrument of monetary control (f) into our model:
(10)

(12)

.
f

-i

0

P

(11 )

=
0

m,

ary
the center reduces the
rate of its real budget deficit. Fixed foreignexchange rates provide an opportunity for the
center country to induce world-wide inflation.
Floating exchange rates permit small countries
to choose their own
paths and may
induce the erstwhile center country not to heap
inflationary abuse upon its own monetary system.
It may be
to reiterate the real aspects
of inflation and monetary crisis. The crisis we
have synthesized is initiated by a fiscal decision
in the center country for a real budget deficit,
financed by seignorage and inflation-tax revenues. Excess real money balances induce substitutions by private sectors against money in
favor of wealth in other forms and perhaps of
consumption. Unbalanced portfolios induce substitutions by small monetary systems against international reserves in favor of claims on domestic wealth, and they may induce changes in the
relative price of the center currency. The crisis
is a real phenomenon. However, it could not
happen except for one capitulation to moneyillusion, the "low" interest-rate policy of the
center's monetary authority. That policy prevents the diversion of
away from mcmetm'Y
systems and the monetary base.

_

0

0

m ,- m d
0

•

t -f+
1+r

rate of change in price of the center
money in terms of the numeraire of
the small economy.
The moves for
of the small economy reduce accumulation of reserves there and
increase (t"), the rate of growth of high-powered
money in the center. The consequence for the
center, given budgetary policy, is necessarily still
more rapid inflation. Presumably the time must
come when, out of despair over its own inflation=

Ii. Bretton Woods in Bloom: 1958-65
In this section, we undertake an informal
analysis of international monetary experience,
applying the model of the preceding section. The
analysis relates to just the United States and
eight "small" countries. It covers the period
when monetary experience was serene, 1958-65,
that
and when only a few factors were in
might disturb that serenity. Table I provides a
few insights into the real and monetary contours
of the period.
Growth in real incomes and in trading during
these years induced growth in real money demanded: the velocity data suggest that the
growth rate of real money balances exceeded the
growth rate of real income in most cases. This
meant, of course, that the international mone-

tary system was realizing efficiency gains from
money-deepening. Stability of nominal rates of
interest suggests that demand for real money was
not damped by accelerating inflationary expectations. Such expectations were missing, of course,
because monetary authorities, including the
United States as center and others as sat,ellites,
constrained growth of nominal money to modest
levels. Demand - pull by money - holders for
accommodated
monetary expansion was
by monetary authorities at essentially stable
price levels.
Patterns of
in
among monetary systems, between international
reserves and domestic credit, are suggested in
Table II.

9

Table I
Growth Experience in Nine Countries: 1958-19651
United
States

Belgium Canada

1958-61
1962-65

1.7
3.3

3.5
7.6

1958-61
1962-65

2.4
5.6

2.9
5.2

1958-61
1962-65

1.8
1.5

1.0
3.4

1958-61
1962-65

+
+

+
+

1958-61
1962-65

2.3
10.3

5.2
11.4

France Germany

Italy

Growth Rates of Nominal Money
5.8
11.1
12.2
10.8
9.0
8.9
13.6
13.1

Japan

Nether- Switzer~nds
land

16.1
19.4

6.8
8.7

8.7
8.4

Growth Rates of Real GN P
3.0
5.2
7.7
6.5
6.3
6.0
5.0
4.5

11.0
8.8

4.0
5.4

4.6
4.8

Growth Rates of GNP Deflator
1.3
6.1
2.9
1.7
2.2
4.3
3.9
6.1

3.3
4.5

2.2
5.5

2.9
4.7

+

+

5.5
10.1

8.4
8.1

4.6
3.9
5.2

3.6
3.0
4.0

Change in Money's Velocity

1957
1961
1965

3.5
3.9
4.2

+
0
Growth Rates of Imports
9.8
9.2
0.1
2.0
8.8
11.7
12.4
9.0

Government Bond
6.0
4.2
5.9
5.1
6.4
5.2

7.9
8.9

Rates of Interest (end of year)
5.9
7.5
6.8
8.4
5.1
6.0
5.2
7.3
5.3
6.7
6.7
5.5

'Federal Reserve Bank of St. Louis, Rates of Change in Economic Data for Ten Industrial Countries; International
Monetary Fund, International Financial Statistics.

Monetary systems of the small countries supplied growth domestically in nominal money by
acquiring both foreign assets, primarily gold and
U.S. dollars, and domestic assets. Evidently
there were substantial differences among countries in their relative tastes for reserves, on the
one hand, and claims against domestic wealth,
on the other. At the extreme, Japan may have
economized on reserves because its growth rate
of output and, correspondingly, rates of return
on domestic wealth were high, while The Netherlands, facing lower opportunity costs of holding
reserves and having a higher proportion of imports to national output, preferred a lower (ro).
Between 1958-61 and 1962-65, there was a
small shift, on the average, away from reserves.
However, since the only significant adjustment
in a foreign-exchange price of U.S. dollars during the second interval was positive (Canada),
appreciating the U.S. dollar, one does not sense
a growing aversion to reserves.
The role of the United States, as center of the

Table 111
Ratios of Foreign Assets to Domestic
Credit in the Monetary Systems of
Nine Countries: 1958-1961 and 1962-1965
1958-1961 1962-1965 1958-1965

United States
Belgium
Canada
France
Germany
Italy
Japan
Netherlands
Switzerland

9.2%
37.3
17.2
8.6
21.3
16.3
4.0
85.0
25.6

Average excluding
United States 26.9

5.6%
29.8
20.3
17.8
16.1
10.8
1.6
64.6
23.1
23.0

25.0%

Source: International Financial Statistics. The percentages
are four-year averages of end-of-year data.

10

international monetary system, is indicated in
goods abroad were financed by growing supplies
Table III.
of securities to the center.
Growth in permanent income, imports, and
Deficits and debt-issues of the American fedreal money balances induced demand by small
eral government supplied to the Federal Recountries for international reserves, and the
serve, through its open-market operations, the
United States responded by export of $15.6 bilassets that it demanded in replacement of gold
lion, 60 percent of it in gold and the remainder
lost to abroad ($9.4 billion) and the assets that
in liquid external liabilities. Catering to demand
it demanded for creation of domestic currency
abroad for reserves, the United States permitted
and reserves of commercial banks in this counits own reserve base of gold to erode. The vetry ($9.5 billion). They supplied, too, growth
hide for international reserve transfers was, of
of $6.2 billion in reserves of small monetary
course, the international balance of payments.
systems. Some $25 billion of debt were floated
Net demands by small monetary systems upon
by the Treasury of the United States to domestic
the United States for reserves were associated,
and foreign monetary authorities, $15 billion
during 1958-65, with net demands upon the
to other lenders: interest-rate policies of the
United States for goods and services. Economic
Federal Reserve did not preempt, for the portfolios of monetary authorities, the entire issue of
growth abroad and military objectives as well
required not only an input of high-powered
Treasury debt. One notes that there was no upmoney but an input too of goods and services
ward drift of fiscal deficits during 1958-65. Defor consumption and investment. Inevitably
mands for money, gold, and debt of the United
these net demands for reserves, goods, and servStates government were stimulated by growth of
ices were associated with net supplies, through
the world's economy, and the demands were
"bond" markets, of securities to the United
satisfied at relatively stable prices for goods, securities, and foreign exchange.
States. Demand for these securities in the center
The smooth accommodation of world monecountry is explained by the relative attractiveness of investment opportunities abroad that one
tary expansion to economic growth yielded a
can sense in the relatively high growth rates of
variety of gains in economic efficiency. For one,
output and income there and in the relatively
stable expectations regarding price levels and
high rates of interest on government bonds.
foreign-exchange rates encouraged the use of
Growing demands for real money, reserves, and
dollars as a vehicle for settlements in world
Table liP
International and Fiscal Position of the United States:
1958-1961 and 1962-1965
($ billions)
1958-1961 1962-1965
Total
International
Change in international reserves
-6.1
-3.3
-9.4
Change in external liquid liabilities to monetary
authorities and ,governments
2.7
6.2
3.5
Total export of reserves

8.8

6.8

15.6

Fiscal
Deficits of the federal government
Increase in debt of the federal government

18.3
25.0

19.4
14.2

37.7
39.2

Monetary
Federal Reserve purchases of federal debt

6.0

12.9

18.9

'International Financial Statistics,

11

Table IV1
Growth Experience in Nine Countries: 1966-1973
United
States

Belgium Canada

France GermanY

Italy

Japan

Nether- Switzerlands
land

Growth Rates of Nominal Money

1966-69
1970-73

5.4
6.3

5.5
10:2

1966-69
1970-73

4.1
3.7

4.3
5.2

1966-69
1970-73

3.7
4.7

3.7
6.0

1966-69
1970-73

+
+

+
+

1966-69
1970-73

13.6

11.4
21.7

9.7
14.3

6.4
9.0

6.4
9.5

14.2
21.3

15.7
23.0

8.2
12.8

7.4
10.2

12.5
9.1

4.2
5.8

3.6
4.7

4.2
7.1

4.8
8.0

4.0
7.8

+

+
0

+
+

16.4
26.4

10.3
22.4

9.4
21.7

5.5
6.3
9.0

5.2
7.5
7.8

4.0
4.9
5.6

Growth Rates of Real GNP

5.4
5.2

5.7
5.8

4.4
4.1

6.2
3.8

Growth Rates of GNP Deflator

4.0
5.1

4.3
5.9

2.7
7.4

2.6
6.8

Change in Money'S Velocity

+
+

+
+

Growth Rate of Imports

18.2

12.7
15.5

9.3
21.6

13.9
21.2

14.0
22.2

Government Bond Rates of Interest
(end of year)

1965
1969
1973

4.2
6.1
6.3

6.4
7.2
7.4

5.2
7.6
7.6

5.3
7.6
8.3

6.7
6.8
9.3

6.9
6.9
7.4

'Federal Reserve Bank of St. Louis, Rates of Change in Economic Data for Ten Industrial Countries; International
Monetary Fund, International Financial Statistics.

trade: economies of a common currency were
realized. Again, growth in international capital
flows at stable price levels and exchange rates
induced substantial reform in the capital markets
of small countries, presumably with greater
efficiency of allocation for savings in the monetary area. Third, a market developed among
savers in small countries for non-monetary
claims against American financial institutions.
This country performed as a financial intermediary, buying foreign investments at risk and
absorbing foreign savings in its own issues of
assets that appeared to be safer, at stable foreignexchange rates. Fourth, stable monetary growth,
investment opportunities in small countries, and
imperfections of capital markets there opened
the Eurodollar route to better savings alloca-

tions. Some dollar payments to abroad did not
accumulate in reserve bases of monetary systems. Instead, private holders deposited them
with commercial banks, where they provided the
reserve base for Eurodollar loans and a superstructure of term deposit accounts.
There were a few clouds in the generally clear
skies of 1958-65. Each represented a problem
of portfolio distortion. There was potentiality
of excess demand for gold in monetary portfolios, but steps were taken to satisfy this demand by isssuance of SDR's. There was concern in some small countries that the flow of
their securities to the United States, in payment
for goods as well as for monetary reserves, would
compromise too much national ownership of

12

national wealth. It worried the United States
that capital outflow would impede domestic capital accumulation and impose unacceptable
losses of gold. It is not clear that American

m.

authorities understood the role of fiscal deficits
and of capital outflows in satisfying external demands for money and for monetary reserves.

Bretton Woods Plowed Under: 1966-73

and actual domestic-credit ratios increased. The
latter cannot be explained by the paths of permanent income and imports. The explanation
must be expectations of decay in the dollar's
foreign-exchange value and resistance against
the flow of seignorage and inflation-tax revenues
to the United States.
Distaste for international reserves, on the part
of small countries, is attested by declines in the

In this second interval, the United States
sharply increased (e), the growth rate of its real
fiscal debt, and (t), its supply of government
debt to monetary reserves. Moreover, it adopted
a number of inefficient interventions in flows of
international trade and payments. The only possible outcome was collapse of the international
monetary system.
Table IV, an extension of Table I, reports a
few aspects of 1966-73.
There is no mistaking the acceleration of
growth, from 1958-65 to 1966-73, in nominal
money for all countries, save Germany, represented in Table IV. At the same time, growth
rates of real GNP were giving little or no lift
to growth in real money demanded, and paths of
interest rates indicate that inflationary expectations were damping demand for real money. On
balance, money's velocity rose. The only possible outcome, of course, was higher rates of
growth in GNP deflators. During 1966-73, demand-pull upon growth of nominal money at
stable prices was diminishing. Supply-push took
over, with faster inflation the result.
Faster growth in nominal money emanated
from both satellite countries and the center. For
the former, as Table V suggests, there was a
notable shift of portfolio preference away from
reserves to domestic credit: desired and actual
(rO) increased. It is useful to compare Tables
V and n.
Data for money's velocity tell us that private
sectors in small countries were economizing on
real money balances, shifting to other forms of
wealth. The data of Table V tell us that monetary systems in small countries were trying to
economize on international reserves-and succeeding. Both low-powered and high-powered
money were in disfavor: the growth rate of
(ffi~) declined and the growth rates of desired

Table V1
Ratios of Foreign Assets to Domestic
Credit in the Monetary Systems
of Nine Countries: 1958-1913
(percent)

19661969

19101913

19661913

19581965

United States
Belgium
Canada
France
Germany
Italy
Japan
Netherlands
Switzerland

3.7
21.3
18.2
11.1
13.8
10.5
1.8
30.6
20.4

2.3
19.8
17.6
5.9
13.9
5.7
4.4
26.7
20.8

3.0
20.5
17.9
8.5
13.8
7.1
3.1
28.7
20.6

7.4
33.6
18.6
13.2
18.7
13.5
2.8
74.8
24.4

Average
excluding
United
States
(unweighted)

16.0

14.3

15.1

25.0

'International Financial Statistics. The percentages are
averages of end-of-year data.

13

ratios of foreign assets to domestic credit. It is
attested also by extensive adjustments in foreignexchange rates for the dollar during 1966-73.
Each of the eight countries in Table V reduced
the price of the dollar in terms of the domestic
numeraire. Germany was the first, in 1969·
Canada and The Netherland followed in 1970.
The others revalued repetitively in 1971-73. The
portfolio shift against dollars became a flight.
It will be recalled that, during 1958-65, changes
in the prices of dollars were few and all but one
were positive. In the earlier years, (ro) and (f)
were stable, while in the later years (ro) rose
and (f) fell.
Table VI, an extension of Table III, bears on
the role of the United States in the inflation of
1966-73. It explains in broad terms the growth
of (t) that small countries attempted to resist.
Deficits and debt of the American federal government increased by roughly the same order of
magnitude during 1966-69 as during the eight
years 1958-65, but these increases were modest
in comparison with those of 1970-73 when
growth of both (e) and (pw) accelerated. All
of the growth in federal debt found its way into
portfolios of monetary authorities during 196673, with the Federal Reserve absorbing $43
billion and foreign authorities $51 billion.

Private sectors wanted none of it at the monetary
authorities' support prices. Aside from its exports of federal debt, the United States shipped
to its satellites close to $3 billions in gold and
SDR's. Additional increments to high-powered
money abroad as well as in this country included
growth in balances of SDR's, from initial allocations, and capital gains on gold stocks as official prices of gold increased. "Avalanche" is
rather too mild as a description of growth that
occurred in reserves of the world's monetary
system.
One criterion of efficient monetary policy in a
center country is moderation in the average
growth of reserves that it supplies. The Uniteg
States satisfied this criterion in 1958-65 and
violated it in 1966-73. A second criterion is
stability in the growth rate of reserves. The
United States satisfied this criterion in 1958-65
and violated it in 1966-73. During the two intervals of eight years each, average annual increases of America's external liquid liabilities to
monetary authorities and governments were,
successively, $8 billion and $16 billion. The
average annual deviations from mean growth of
external liquid liabilities were, successively, 40
percent and 68 percent. Stop-go policies in the
United States during the later interval produced

Table VI1
International and Fiscal Position of the United States:
1958-1965 and 1966-1973
($ billions)
Total
1966-1969 1970-1973 1966-1973

International
Change in international reserves
Change in external liquid liabilities to
monetary authorities and governments

-1.5

Total export of reserves

Total
1958-1965

-2.6

-4.1

-9.4

50.8

51.4

6.2

53.4

55.5

15.6

Fiscal
Deficits of the federal government
Increase in debt of the federal
government

34.4

63.5

97.9

37.7

23.0

65.5

88.5

39.2

Monetary
Federal Reserve purchases of
federal debt

16.1

26.6

42.7

18.9

Source: International Financial Statistics.

14

an erratic pattern of growth in international reserves, money supplies, and actual relative to
desired levels of (rO). It may be a fair presumption that the collapse of Bretton Woods reflected,
in part, an attempt by small countries to escape
not just the escalation of monetary reserves but
instability in growth of reserves and in the impact of monetary pressures on growth in price
levels and output as well.
It is a third criterion of efficient monetary
policy that the monetary authorities abstain
from specific interventions in various markets as
ways of preventing or undoing damage done by
policies affecting money. This criterion was violated with increasing frequency by both the
United States and the small countries during
1966-73, and awkward results of the specific
interventions appear to have been one more reason for the demise of the Bretton Woods. The
intervention that comes first to mind is the imposition of price controls, through successive
"phases," over goods and labor in the United
States from 1971. Its monetary effects are patent
in equations (13) and (14), written for this
country only:
u

ue

_ u

_ ui

d

d

(13) m-p=m+m
S

(14 )
m Us

==

p

ue

=p

u

p

(pur). At ceiling prices, real money balances
demanded increased at the rate of (m~). Because real money balances supplied increased
even faster, involuntary holdings increased at the
rate (m ~). Repressed inflation and excess real
money are twin aspects of the same distortion.
Of course, growth in real money demanded was
reduced by price controls accordingly as they
inhibited growth in real income.
Inevitably, given the pace of growth in nominal money, the interventions in goods and labor
markets failed. When they were withdrawn, step
by step, money-holders set about to eliminate
undesired real balances by spending them. Then,
of course, inflation repressed became inflation
realized. This burst of growth in the price level
must have done its bit to diminish growth in real
money demanded, so that inflation realized overcompensated for repression. The mean rate of
inflation has been higher since 1970 than it
would have been in the absence of price and
wage controls.
Federal Reserve administration of Regulation
Q was another destabilizing intervention. When
rapid growth in motletary reserves and domesticcredit ratios generated inflation, expectations of
inflation, and rising open-market rates of interest, ceilings upon deposit rates in the United
States generated substantial flows of short-term
capital, private and governmental, to small
monetary systems and the Eurodollar markets.
The accumulations of dollar claims abroad were
sensitive not only to interest-rate differentials
but also to anticipations regarding change in
foreign-exchange prices of dollars. They shifted
between countries and, within anyone country,
between central bank and commercial banks.
Administration of Regulation Q aggravated instability in the Bretton Woods regime.
Other interventions were applied on markets
for goods, capital and foreign exchange by both
the center and its satellites. There were "voluntary" credit restraints on capital exports, interest
equalization taxes, discriminatory taxes and deposit-rate regulations on capital imports, twotier foreign-exchange markets for current and
capital transactions, and other specific measures

ur

rate of growth in nominal money.

_ u

md
-

rate of growth in real money demanded.

md

ui

= rate of growth in excess real
money balances.

pu

rate of inflation without price
controls.

pUC

== rate of inflation with price controls.

pur

= repressed inflation.

Fiscal and monetary policy, without price
ceilings, would have produced a rate of inflation
(pU). Interventions reduced the rate of inflation
temporarily to (pUC), and repressed inflation was

15

foreign-exchange price for the dollar, would inhibit
toward inflation. These authorities may have chosen the
lesser of two evils, imported inflation rather than
indigenous inflation. Another answer might be
export sectors in small countries were opposed to revaluations of domestic currencies
against the dollar. If some small countries did
have selfish interests in staying with .l:3retton
Woods, why should the burden of guilt for world
inflation be put upon the United States? The
appropriate rejoinder seems to be, "Why is
credit due to the United States for exploiting the
gullibility and vulnerability of its trading partners?"

with the general malaise of monetary
Authorities of small monetary
terns speculated overtly on the foreign exchanges. The result, of course, was to sacrifice
gains in efficiency that had emerged from monetary unification under Bretton Woods. As these
gains were sacrificed, the social benefit of staying
with stable exchange rates and tolerating unstable inflationary pressures evaporated.
As one reviews the sorry tale of Bretton
Woods, he may wonder why the small countries
with the
as
as they did. One
answer might be a stubborn faith of monetary
authorities in some small countries that the balance-of-payments constraint, imposed by a fixed
to

IV. A Sequel to Bretton Woods
A dour pessimist might generate a bleak foreGrowth of the foreign-exchange rate is the link
cast of inflation for the United States, using an
between "local" inflation rates:
•
adaptation of the model in Section I. With no
change in its fiscal-monetary policies, the United
(16) f = pU _ pO
States could release within its own boundaries
The growth rate of (t) depends on the real
the inflationary pressures that were absorbed,
under Bretton Woods, by growth in demand for
expenditure objectives of government in the
dollar reserves worldwide. The result would be
United States and on the rate selected for the
inflation here at rates faster than the rates of
inflation tax (pU). If (t) is no less in the new
1970-73.
regime than in the old, the level of Cpu) can be
In the new world of floating foreign-exchange
notably higher. No longer is there growth demand abroad for some part of (to) of (t). No
rates the singular inflation paths, we may suppose, (to) falls to zero and each small country
longer is growth abroad in real money demanded
selects some domestic asset, with growth rate
a "leakage" for (t). The full force of fiscal(x), as the monetary base. Then price levels for
monetary indiscretion hits the American monethe United States and any small country, (pu)
tary system, its price level, and the price of doland (pO), behave as follows:
lars on the foreign exchanges.
(14) pu

_u

(t +
1+r

)
u

(x + d(ro)
l+r °

-m d

)-

rn°
d

16

FOOTNOTES

critical role by raising (t) or (TU) or both. Either instrument of world monetary control can clear excess demands
for money and reserves, provided that no special obstacles
are put in the way of adaptative adjustments in international balances of payments.
A "large" disturbance can originate in markets for goods
as we know from the petroleum episode of 1973-74. One
effect is to reduce the growth rate of income (y) and of
real money balances demanded (md)in petroleum-importing countries and, as a result, to generate excess supply of
monev with potentialities for accelerated inflation. In principle, -growth in real money demanded by petroleum exporters could sustain monetary equilibrium on the initial
price-level path, but that would be an improbable coincidence. OPEC might prefer monetary reserves so that,
given (r o ), the world would be threatened with a deflationary episode. One solution would involve an increase in (t)
by the center monetary authority. Since OPEC demand
for reserves could be unstable, the preferred solution may
be to supply OPEC or any comparable oligopolist with a
non-monetary financial asset. Then the outcome would be
some increase in the world's inflation rate and some transfer of the world's non-monetary wealth.
4. The primary debt of the center's fiscal authority (T) is
an obvious source of fiscal revenues. Disposal of (T) into
portfolios of the world's monetary system yields seignorage
to the center's fiscal authority. If the monetary expansion exceeds growth in real money demanded, there are
revenues from an inflation tax. These revenues are
a temptation to fiscal-monetary indiscretion in the center
country when government expenditures have risen along a
steep incline and when there is resistance to increases of
conventional tax bases and tax rates as well as to increases
in interest rates paid on (T). They flow not from domestic
money-holders alone but also from money-holders in small
countries whose monetary systems accumulate (T) through
international balances of payments with the center.
Collection of seignorage and the inflation tax by the
center need not be deliberately exploitative. Fiscal deficits
may be financed initially on the security markets of the
center. The increments of (T) may flow to the center
monetary authority when interest rates are driven above its
target levels. Then monetary expansion in the center induces the disequilibria in markets for goods and securities
which drive abroad the share of growth in (T) that small
monetary systems desire on the higher expansion path of
the world's money supply. The fiscal authority of the
center issues debt and the center monetary authority, abiding by a policy guideline without exploitative intent, eollects domestically and abroad the revenues of seignorage
and the inflation tax.
5. If growth in (T) is sustained and accelerated, resistances
develop. Monetary authorities in small countries may express preference for transfers of gold from the center in
substitution for transfers of (T). One expects the center
monetary authority to respond by closing its "gold window." Small countries may demand higher interest compensation from the center for their portfolios of (T) so that
the center receives smaller flows of seignorage and inflationtax revenues. Authorities, both in small countries and the
eenter, may impose micro-interventions that tend to inhibit
growth in real ineomes. These can include specific controls
over trade in goods, securities, and foreign exehange. Their
net monetary effects, through reductions in (m';;) are
inflationary.

1. Country weights may change over time if real growth
rates differ between countries. If the satellite is Japan and
the United States is the center, (so) rises and (su) declines. Then a larger share of growth in nominal and real
money accrues to the satellite. The formal analysis here
neglects the role of international balances of payments in
changing allocations of growth in nominal money.
2. A "small" disturbance may be initiated by a satellite.
Its portfolio preference may sbift from reserves to domestic
credit: it prefers to direct more of national savings to
domestic wealth and less to reserve accumulation and so to
finance of the center's fiscal deficit. The effect is to repel
reserves from the satellite to other parts of the monetary
community, to raise the average level of (r o ) of domestic
credit ratios, and to increase the world growth rate of
nominal money. Assuming a constant growth rate of reserves (t), one can indicate the expansionary impact in
this adaptation of equation (3) :

d(m:)= d(ro)
1+ro
An increase in any (ro) would be damped, one imagines,
by a subsequent increase in imports (v o ) that would shift
portfolio preference in the small country back toward reserves. In the context of stable monetary policies by the
center country and other satellites, the one small economy
is unlikely to change its desired domestic credit ratio
substantially.
It is imaginable that a "large" disturbance of the world's
money supply could be touched off by simultaneous impulses in a number of small countries. Their monetary
authorities would set targets for (r o ) above actual levels,
inducing domestic excess supplies of reserves and excess
demands for goods and securities. Their excess supplies
of reserves would spill into the monetary systems of other
small countries and of the center country. Then actual
levels of (r o ) would rise to the target levels. In time, the
disturbance would be absorbed in higher growth rates of
the world's money supply and price level. Of course, the
disturbance might have a deflationary tilt, with desired
domestic-credit ratios falling relative to existing ratios.
Then reserves would be drawn to the economies that express demand for reserves and, unless other economies
simultaneously increased their desired domestic-credit ratios or unless the center increases the growth rate of reserves, growth rates of the world money supply and price
level would decline.
3. A "large" disturbance could also originate on the market
for money rather than on markets for reserves and
domestic credit. For whatever reason, perhaps an increase
in the growth rates of real income, accelerated growth in
real money demanded could impose excess demand for
money. The result would be a decline in the inflation rate,
accompanied by more or less prolonged instability in output and employment, unless monetary authorities responded
to the public's "demand-pull" with faster growth of the
money supply. For stability of the inflation rate, the
appropriate response, of course, is an increase in (t) or
(r o ) that adjusts (m,;) to (ill,;;). If monetary systems
in small countries prefer not to increase domestic-credit
ratios, perhaps because of concurrent growth in international trading, the center authority should acknowledge its

17

Michael W. Keran
The present circumstance of simultaneous
inflation and recession cannot be fully explained
by either the standard Keynesian or the standard
monetarist analyses. The Keynesian model can
handle the recession, but not the inflation; while
the monetarist tools can handle the inflation but
not the recession. The Keynesian models failed
to anticipate the depth of the recession and the
monetarist models the heights of the inflation.
Indeed, the developments of the past two years
were totally unforeseen by economic forecasters
of both the Keynesian and monetarist persuasions.
Faced with this apparent vacuum, a number
of ad-hoc explanations have been put forward
to explain the current inflation-recession. The
most widely repeated explanation concerns "special supply conditions" associated with the exercise of monopoly power by Arab oil producers, the shift in the Humboldt current and
consequent disappearance of Peruvian anchovies, and the series of bad harvests in Europe
and the United States. This explanation essentially says that the aggregate supply of goods
and services available to the world has been reduced, leading to both higher prices and a
smaller output. This explanation is consistent
with the facts we have observed. However, the
decline in aggregate supply has amounted to no
more than 1-to-2 percent and has been only a
relatively short-term phenomenon, while the increase in inflation has been in the 6-to-8 percent

Economics is a behavioral science. As such,
there is a close interactive relationship between
economic fact and economic theory. At present,
there is some disarray in the economics profession because of the apparently large gap which
exists between fact and theory. The emergence
of unprecedented worldwide inflation in conjunction with unprecedented worldwide recession appears to be inconsistent with the theoretical apparatus which economists use to analyze
the economy and provide policy advice.
There have been other periods in history when
an equally large gap has arisen between fact and
theory. Indeed, such periods have usually been
followed by major developments in economic
theory which have explained the phenomena,
thereby closing the gap and advancing the science of economics. For example, the Keynesian
theory of national-income determination arose
in response to the apparent inability of the thendominant classical theory to explain the Great
Depression of the 1930's. Simultaneously, the
Keynesian theory provided a rationale and incentive to develop and expand the nationa1income accounts, thus giving us such useful
statistical concepts as GNP, the price deflator
and real income. More recently, the re-emergence of elements of the classical theory of income determination under the monetarist banner
has grown out of the apparent inability of the
now dominant Keynesian theory to explain the
inflation since the mid-1960's.

18

cession is consistent with the existing body of
economic theory. There are three links in this
argument. First, the new monetary theory of the
balance of payments provides the basis for explaining world inflation. Second, the importance
of internationally-traded goods in determining
domestic price levels is far more important than
had previously been believed. Third, given one
and two above, the monetary theory of national
income determination explains the recession.
This paper does not present a formal theoretical integration of the three elements mentioned above. Rather, it suggests the lines of
causal relationships which are consistent with
the theory and presents evidence which supports
this type of linkage. The first section summarizes the theoretical elements in the simultaneous
inflation-recession case, and that is followed by
a section which examines the empirical evidence.

range over a two-year period. It would seem
that these supply phenomena are simply not
large enough to explain the magnitudes of either
the inflation or the recession.
A second ad hoc explanation concerns the
impact of wage and price controls. This argument asserts that the inflation rate in the U.S.
was below what it otherwise would have been in
1971-72 because of wage and price controls, and
that the spurt in inflation was higher than otherwise would have been the ease in 1973-74 because of the unwinding of those controls. But
this explanation, while consistent with U.S. data,
does not explain the worldwide inflation-recession phenomenon we are currently experiencing.
The approach in this paper is to see if existing
economic theory is capable of explaining the inflation-recession phenomenon. The conclusion
is that the simultaneous worldwide inflation-re-

1. An Explanation of Inflation-Recession Phenomenon

Preceding the early-1973 breakdown of the
international monetary system of fixed exchange
rates, there was an unprecedented expansion in
international reserves - the so-called dollar
overhang problem. This led to the simultaneous
increase in the domestic money stocks of most
of the industrial nations of the world. The result
was a period of unprecedented worldwide business-cycle boom, followed by an unprecedented
worldwide inflation. The magnitude of the inflation in any given country was greater than
it would otherwise have been because of the
worldwide nature of the inflation. Two forces
contributed to inflation in each country. First
was the traditional impact of an expanding
domestic money stock on domestic prices. Second was the effect of the rest of the world's inflation on domestic prices, operating through the
mechanism of internationally-traded goods. The
latter element had not been significant in earlier
postwar periods because the industrial nations

of the world had not previously exhibited a pattern of synchronous business-cycle expansion.
This worldwide inflation element had a substantial impact even in the U.S., which has a relatively small share of its product prices determined in world markets.
This "rest of the world" element in domestic
inflation also helps explain the unprecedented
size of the domestic recession. First of all, the
monetary theory of national-income determination links domestic money and domestic income.
Changes in the nominal money stock, operating
through the equation of exchange and a stable
velocity function determine nominal income. In
the short run-a business cycle of two-to-three
years duration-the real money stock determines real income. (In the long run, real output
depends upon real inputs of capital, labor, and
technology. )
Given the growth in the domestic nominal
money stock, a larger than expected domestic

19

supply and demand for money. The demand
for real money balances is a positive function of
the growth in world income. The supply of
world nominal money balances is a function of
the collective decisions of the world's central
banks. If, the nominal money stock grows at a
faster rate than the real demand for money balances there will be an increase in the world price
level. On the reasonable assumption of a relatively constant grow(h in the world demand for
real money balances, variations in the growth of
the world nominal money supply would lead to
proportional variations in world prices.
In order to convert this theory into a testable
hypothesis we must distinguish between internationally traded goods, whose prices are determined by world supply and demand factors,
from domestic non-traded goods whose prices
are determined domestically. With this modification, it can be asserted that the (properly defined) world price level will move proportionally
with world money.

inflation-in this case because of inflation in
the rest of the world-will reduce real money
balances by more than would have otherwise
been expected, and thereby will temporarily reduce real income. Put another way, the unprecedented gap between real and nominal money
balances induced in part by inflation elsewhere
will lead to an unprecedented (if temporary),
gap between real and nominal income in this
country. Thus we have simultaneous inflation
and recession.
How long will this state of affairs continue?
As long as growth rates of real and nominal
money are on divergent courses. This divergence in the current circumstances depends upon
the course of world inflation. Present evidence
suggests that the world inflation rate has come
down substantially since last year and that it will
not be renewed in the foreseeable future, that
is, in the next 18 months or so. This implies that
the unprecedented period of inflation-recession
is at least temporarily coming to an end. The
remainder of this section develops this explanation in greater detail.

The world money stock exploded between
1970 and early 1973, and this was followed by
an upsurge in world prices from 1973 through
early 1975. The reason for the 1970-73 explosion in world money has been well documented
and explained in other studies. 1 It is only necessary to point out here that it was not due to the
collective madness of the world's central banks,
but rather because of their following a behavior
pattern which had been wholly reasonable in the
previous two decades but which became unreasonable only in the special circumstances of the
early 1970's.
In the Bretton Woods era of fixed exchange
rates (1945 - 71 ) , countries other than the
United States maintained the international
values of their national currencies by buying and
selling dollars in the foreign-exchange market.
This worked well when the world demand for
dollars as an international currency was matched
by only a moderate increase in the supply of
dollars. However, starting with the acceleration
of the U.S. inflation rate in the mid-1960's, the
supply of dollars to the rest of the world increased relative to the demand for dollars (espe-

World inflation
The factor which makes this inflation different
from other 20th-century inflations is its pervasive international character. No country in the
worl'd has been exempt from its effects. Thus,
it would seem logical that an international monetary approach to analyzing this inflation experience might prove promising. This is especially
so considering that the traditional national
monetarist approach has not appeared to explain
the present case.
Fortunately, in recent years a monetary theory
of the balance of payments has arisen to provide an analytical framework for viewing inflation in an international context. The principal
authors of this approach are Robert Mundell of
Columbia University and Harry Johnson of the
University of Chicago. It is beyond the scope
and intent of this paper to explain the theory,
except to emphasize that, within the context of
this model, internationally traded goods prices
are determined in a world market.
The theory is presented in terms of the world

20

cially by private foreigners). The problem came
to a head in 1971 when the United States suspended dollar convertibility into gold. But
throughout this period, most central banks attempted to maintain the fixed dollar value of
their national currency by absorbing an increasingly larger amount of dollar assets, in response
to the actions of private citizens (American as
well as foreign) as they shifted their portfolios
out of dollars and into foreign currencies, beginning with the stronger currencies such as the
German deutschemark and the Japanese yen.
The foreign central banks' monetization of this
dollar inflow expanded both their holdings of
international reserves and their domestic money
supplies.

money supply but also the world money supply.2
There are a number of dimensions to this
argument, both theoretical and practical, which
must be considered before the proposition
sketched above can be accepted. First, the
practical considerations. In the past, equations
estimating domestic prices have been relatively
successful without including international money
as an independent argument. Why must such
variables now be incorporated to have a successful price equation? The answer is that the variance in international money growth has only
become significant in recent years. Its trend
growth has been just sufficient to meet growing
international transactions demand with no price
increase. Thus, in models which estimated
prices before 1973, the exclusion of international
money did not result in a serious misspecification because that source of variance in prices
was insignificant.

Central banks collectively abandoned the
fixed-rate regime only in March 1973 at which
point the growth in international reserves
abruptly ended. They each took this step in
order to regain control of their domestic money
supply. However, the action was so long delayed that it could not forestall the inflation in
internationally-traded goods which we are now
experiencing.

There is a more substantial theoretical question about including foreign money in a domestic price equation. If world money is rising
faster than domestic money and, therefore,
world prices are rising faster than domestic
prices, this should lead to a balance-of-trade
surplus-and thus, in the current period of flexible exchange rates to an appreciation of the
domestic currency which offsets the influence of
the world price rise. In this context, while world
money determines prices of internationallytraded goods, it would not have any effect on
prices stated in the domestic currency in a period
of flexible exchange rates.

From world to domestic inflation

How does the world inflation affect the domestic inflation in individual countries? The link
is both straightforward and complex. In each
country the domestic price level is, by definition,
a weighted average of first, the prices of internationally traded goods which are produced
and/or consumed in that country, and second,
the prices of domestic goods which cannot be
traded internationally because of transportation
costs or other reasons. The weights depend
upon the size of the country and its proximity
to its trading partners. The argument presented
here asserts that just as world money growth
determines the prices of internationally-traded
goods, so domestic money growth determines
the prices of domestic non-traded goods. The
weighted sum of traded and nontraded goods
determines the domestic price level. Thus, the
appropriate specification of a domestic price
equation should include not only the domestic

While this argument has theoretical merit, it
has not been important during the period under
consideration. 1) The exchange rate responds
not only to trade but also to capital flows. The
latter were especially important in determining
the international value of the dollar (and therefore of other currencies as well) after the introduction of floating rates in March 1973. The
demand for dollars as an element in the international stock of money was then reduced as foreign dollar holders attempted to move out of
dollars and into other currencies. This has been
a significant element in at least temporarily al-

21

tering the value of the dollar. 2) The nature of
world inflation is such that-except for oilprices of both exports and imports of most industrial countries have risen roughly in proportion. Thus, the (non-oil) terms of trade have
not shifted substantially since floating exchange
rates were adopted.
1'1..s a result of these two factors, the accelerating world rate of inflation did not lead to offsetting exchange-rate movements, so that most
of the effects of the inflation in internationallytraded goods could be transmitted to the domestic economy. In the empirical section of this
paper, a separate test for the effects of exchangerate movements on domestic prices is estimated.
The results indicate that such movements did
not have a significant influence over the period
tested (1965-74).

MV=PX
where M is money
V is velocity
P is the price index
X is the level of real income
All values are measured in terms of the domestic currency. The desired level of cash balances
can only be satisfied with domestic money holdings, as such holdings represent both the de jure
numeraire and the de facto unit of account.
The equation of exchange can be rewritten in
log terms.
Log M + Log V = Log (PX)
Taking first differences and rearranging terms
we have
L1Log (PX)

=

L1Log V + L1 Log (M)

By definition the percent change in nominal
GNP (6.Log PX) is equal to the percent change
in velocity (6.Log V) plus the percent change
in money (6.Log M).
If the secular and cyclical movement in velocity is stable, then there will be a stable relation between money and income. This relationship can be estimated by the following reducedform equation:

Money and income

Monetary theory assigns a strategic role to
the domestic money stock in determining aggregate demand. The discussion presented above
and the evidence presented in the next section
in regard to the role of world money on domestic
prices do not invalidate those relationships. The
dollar is still the medium of exchange within
the confines of the United States and all transactions must be cleared in the market place in
terms of that numeraire.
The financial constraints on an economy imposed by the availability of the domestic money
supply can only be changed if for legal or practical reasons an increasing share of transactions
in any given country are carried out with something other than the domestic numeraire. The
influence of world money and world prices on
the domestic economy will operate only through
their effects on the supply of, and demand for,
internationally-traded goods-not through their
effects on the desired or actual cash balances
available in a particular country.
The monetary theory of national-income determination can be summarized by the equation
of exchange.

n

L1Log (PX),

=

ao

+ al L1Log EM'_i

where the change in nominal income (6.Log
PX) in the current period (t) is a positive function of the weighted sum (};) of the change in
nominal money supply (6.Log M) in current
and past (n) time periods.
We would expect that the equation would be
as statistically significant in the last two years
of accelerating inflation as it was in previous
periods. We would also expect that adding the
the change in world money (6.Log Mw) would
not be statistically significant or improve the fit
of the equation.

22

II. The Evidence

In this section propositions developed above
are examined with the aid of standard statistical
testing procedures. First we consider the evidence relating world money to world prices.
Second, we consider the evidence of the effects
of world and domestic money on domestic
prices, and third, the effects of world and domestic money on domestic income.

of internationally-traded goods is the sum total
of international reserves held by developed
countries. This series, measured in dollars, is
published monthly by the International :Monetary Fund. In addition to providing a useful
summary of the international sources of domestic money expansion in industrial countries, this
series has the advantage that central banks traditionally follow easy money policies in periods
when reserves are rising and tight-money policies in periods when reserves are falling. This
means that central banks will not usually attempt
to offset completely the effects of international
reserves on the domestic money stock.

World inflation
To test the international-monetary explanation of world inflation, we need to have measures
of both world money and world prices. To limit
the discussion we will rather arbitrarily confine
ourselves to examining developed countries, because in view of their dominance of international
trade, it is their behavior which collectively determines the prices of internationally-traded
goods.
We define world prices not as the weighted
average of the domestic prices of all countries,
but rather as the average of the prices of goods
which are traded in international markets. This
measure is designed to focus attention on the
markets which are worldwide in nature, and
which thus represent a common influence on
the domestic prices of all countries. The statistical series which most closely approximates
this concept is the export price (unit value) index of industrial goods of developed countries
measured in dollars, as published by the United
Nations.
Our measure of world money is influenced by
similar considerations. One can make a number
of plausible approximations of an appropriate
world money variable; however, the criteria for
selection should be first, a time series which can
be measured in the same unit of account as the
price series (that is, dollars) and second, a time
series which can be associated with prices of
internationally-traded goods.
The time series which most closely measure
the effect of world monetary influences on prices

On balance, then, it is reasonable to test
whether the international-reserves series is an
appropriate measure of world monetary influence on prices of internationally - traded
goods. 34
An equation linking the quarterly rates of
change in "world money" and "world prices"
was estimated in log linear terms with data from
1962.1 to 1974.3. The results are summarized
below and the actual and estimated values are
plotted in Chart 1.
L'1Log Pw,

=

1.48 +
(1.0)

~

1.04 L'1Log
(7.2)

MW'_12

(t values below coefficients)

R2/SE DW/DF
.57/6.7 2.18/46
6Log Pw

Percent change in internationallytraded goods prices, as measured
by export prices of developed
countries

6Log Mw = Percent change in international
money as measured in international reserves of developed countries.

23

no-growth trend in world money-a reasonable
assumption in this era of flexible exchange rates
-then there are encouraging implications for
the near-term outlook for prices of internationally-traded goods. The forecast values through
the end of 197Sare shown in Chart 2. Yet
given the long lags between money and prices
and the rapid rise in international money
through early 1973, the deceleration in prices is
starting from a very high rate, and some element of world inflation will continue through the
end of 1975.

Export Prices of Developed Countries
Chart I
PERCENT

CHANGE

40

30

From world to domestic inflation
20

In the preceding Section I, it was argued that
the domestic inflation rate in anyone country
can be influenced by the rate of inflation in the
rest of the world. Specifically, internationallytraded goods, whose prices are determined in
world markets, can either increase or decrease
what would otherwise be the domestic inflation
rate.
Focussing on the monetary side, the proper
specification of an equation explaining domestic
inflation would in this context include both
domestic and world money as explanatory
variables. In addition it would be useful to test
the possibility that variations in exchange rates

Actual

"

10

o
J962

J964

1966

1968

1970

1972

1974

This equation explains 57 percent of the variance in the quarterly percentage change in world
prices as a distributed lag of the current and
twelve past quarterly changes in values of international money. A 1.0-percent increase in international money over the past twelve quarters
leads approximately to a 1. I-percent increase
in world prices. The length of the lag period
(12 quarters) is consistent with the lags observed in equations relating domestic money to
domestic prices.
It is interesting to note that prices of internationally-traded goods rose less than 4 percent
over the entire 1965-69 period. But thereafter,
from 1970.1 through 1974.3, such prices rose
by almost 90 percent. This pattern was preceded
by a similar movement in international money,
with an average lag of six quarters. World
money grew by a very modest 7 percent from
1963.2 through 1968.2 but then exploded in a
sharp 98-percent rise in the period 1968.2
through 1973.1. World money thereafter has
shown no significant growth.
If we assume a continuation of the current

Chorf 2

1959.1=100
300,...-

..,

200

o L-1..-J-..l.-1.-l....J......L....I-....I-..L.-.l.-L....J-..l.--L-l....J....J
19591960

24

1964

1968

1972

1976

and lagged values of domestic money as the determinant of domestic prices; 2) current and
lagged values of domestic and world money as
the determinant of domestic prices; 3) current
and lagged values of domestic and world money,
and the effective exchange rate of the domestic
currency in foreign exchange markets, as the
determinant of domestic prices.
All three equations were estimated with quarterly data from 1965.1 to 1974.2 for each country. The results for the U.S. are summarized in
Table 1. In equation 1, U.S. prices are estimated
as a function of U.S. money supply alone. For
every 1.0-percent increase in the U.S. money
supply in the current and twelve preceding quarters, the consumer price index rises by approximately 1.9 percent in the current quarter. However, if the money supply does not grow at all
the CPI falls at a 5.2-percent annual rate per
quarter. The low Durbin-Watson (DW) statistic (.53) means that there are systematic errors between actual and estimated values of
U.S. prices. One possible interpretation is that
U.S. prices are also affected by another variable

might offset all or part of the effects of world
money on domestic prices. (The exchange rate
is not, strictly speaking, an independent variable. Rather its value is strongly influenced by
the differential growth rates of world and domestic money.)
Since the assertion of the influence of world
money on domestic prices is a new proposition,
evidence of its impact on other countries than
the U.S. would strengthen the case. The influence of world inflation on domestic prices
should be even more apparent abroad than in
the U.S., which is one of the most closed economies in the world. A total of six countries are
investigated in this study-Belgium, France,
Japan, Germany, the United Kingdom and the
United States. The results for the U.S. are presented first and discussed in detail. The results
for the other countries are presented in summary
form here, with details available on request from
the author.
Three different empirical tests were made to
explain the inflation rate, measured by the consumer price index, in each country: 1) current

Table 1
Factors Determining U.S. Prices
(Quarterly Percent Change in CPI from 1965.1 to 1974.2)

Constant
Term

Quarterly Percent Change
U.S.
World
Exchange
Money
Money
Rate

OW/OF

12

Equation 1

-5.2
(3.2)

n.86
(6.5)
2.08
12

Equation 2

Equation 3

.53/1.84

.58/33

.90/.86

2.24/29

.90/.87

2.32/27

16

-4.9
(1.0)

2:1.78
(8.9)
1.99

2:.098
(2.5)
.66

12

16

-4.6
(4.6)

2:1.74
(8.4)
1.94

2:.089
(2.2)
.60

Note: The first number in each box is the estimated coefficient.
The second (in parentheses) is the t value.
The third is the beta coefficient.

25

I
4

2:-.136
(-1.3)
-.36

sured by the Durbin-Watson statistic) is eliminated. World money thus clearly satisfies the
conditions of the omitted variable in equation 1.
Equation 2 has superior statistical properties to
equation I-and as shown in Chart 3, Equation
2, accurately forecasts both the slowing in U.S.
inflation in 1971-72 and the sharp acceleration
in U.S. inflation in 1973-74."
The final question to be considered is whether
the movements in the international exchange
value of the dollar tended to reduce the impact
of world inflation on the U.S. price level. As
discussed above, when prices of internationallytraded goods rise relative to domestic goods the
United States tends to shift towards the consumption of domestic goods and the production
of internationally-traded goods. This then tends
to improve our trade balance-appreciating the
international value of the dollar and offsetting
the effects of world inflation on the domestic
price level. This possibility is tested in equation
3 of Table 1 where the value of the dollar against
eleven major trading partners is added as an
additional explanatory variable. G The exchange
rate does not contribute significantly to explaining U.S. prices over the estimated period. The
sign on the exchange rate coefficient is as expected-negative-but it is not statistically significant. In addition, it does not reduce the unexplained variance in the equation or lower the
standard error after adjusting for the degrees of
freedom consumed by this additional variable.
To summarize, it seems clear that the virtual
explosion in the prices of internationally-traded
goods has had a major upward effect on the
U.S. price level, and this effect has not been
significantly mitigated by exchange-rate movements during the period under review.
The same three equations estimated with U.S.
data were also estimated with data from five
other industrial countries. The effect of world
money on domestic prices was even more substantial in these other countries than in the U.S.
The results are indicated in the following table,
which shows the sum coefficient for world money
in equation (2) for each country and the associated t values.

which has been omitted from the equation.
As a result, the next stage in the analysis was
to incorporate the growth in world money as
well as the U.S. money supply in estimating
U.S. prices. These results are summarized in
equation 2 of Table 1. They indicate that the
effects of U.S. money on U.S. prices are approximately the same as in equation 1. However,
adding world money improves the statistical
significance of the equation, and interestingly
enough also improves the statistical significance
of the coefficient on U.S. money. The explained
variance (R") is increased from 53 percent to
90 percent while the standard error is reduced
from 1.84 to .86. Of even greater importance,
the degree of systematic error between actual
and estimated values of U.S. inflation (as mea-

U.S. Infiation Rate

Chart 3

PERCENT
CHANGE

14

12

10

8
Actual

/
6

4

2

0 ...........-

.......-""--'----1.-.....--'--"'"'---'-.....

1965 1966

1968

1970

1972

1974

26

Effects of World Money on Domestic Inflation
Sum Coefficient "t" Values
Belgium
.570
4.2
France
.640
4.9
Germany
189
2.1
Japan
312
3.1
United Kingdom
.936
2.8
United States .
.098
2.5

All sum coefficients were estimated on the basis
of a 16-quarter lag of world money on domestic
prices and, as indicated by the t values, were all
statistically significant at the 95-percent confidence level. The pattern of the lag structure
(not shown) was also quite similar for all six
countries-a relatively small effect in the first 8
quarters and a larger effect for the second 8
quarters. The striking difference among the
countries was in the size of the sum coefficients
relating world money to domestic inflation. The
largest country, the U.S., had the smallest coefficient. Germany and Japan had the next
smallest coefficient, while the U.K., which has
been historically open to foreign trade, had the
largest coefficient. France and Belgium were in
the middle but closer to the U.K. results. This
finding is roughly as one would expect. The
largest national economy is the least affected
and the most open economy the most affected,
by world inflationary developments.
Another measure of the impact of world
money on domestic prices is obtained by comparing the DW statistics, with and without world
money-that is, by comparing equation 2 with
equation 1.

The relatively low DW statistic in equation 1
suggests that there is systematic error between
actual and estimated values of domestic inflation when world money is left out of the analysis. This systematic error suggests the absence
of a significant explanatory variable in equation
1. When world money is added (equation 2),
the DW statistic is increased for all six countries,
which suggests that this variable has reduced
the degree of systematic error in the equation
explaining domestic inflation. In all but one case
(Germany) there is a substantial degree of systematic error when world money is excluded.
Only in Belgium's case is there any indication
that systematic error continues to be present
with the inclusion of world money-and even in
that case there is substantial improvement in
the DW statistic with the addition of the world
money variable. On average for all six countries,
the DW statistic increased from approximately
1.0 to approximately 2.0 by including the world
money variable.
A final significant measure is the increased
amount of domestic inflation explained by the
addition of the world money variable. This is
shown by comparing the R2 statistic for the
equation without world money (equation 1) to
that with world money (equation 2).
Percentage of Explained Variance (R2) With
and Without World Money

With
World Money
(Equation 2)

Durbin-Watson (OW) Statistics

With
World Money
(Equation 2)

Without
World Money
(Equation 1 )

Belgium
1.45
France
1.75
Germany
2.08
Japan
2.40
United Kingdom .. 1.93
United States .... 2.24

.83
.79
1.86
.40
1.34
.58

Average DW ..... 1.98

.97

Without
World Money
(Equation 1 )

Belgium
.74
France
76
Germany
72
Japan
93
United Kingdom .. .55
United States . . . .. .90

.46
.37
.72
.40
.28
.53

Average

.46

77

On average the degree of variance in domestic
inflation which is explained is increased from 46
percent without world money to 77 percent with
world money. In all but one case (Germany),

27

there is a substantial improvement in the explained variance of domestic inflation. 7
In summary, we can say that the inclusion of
a world money variable satisfies three important
conditions with respect to domestic inflation.
1) Its effect is as expected-positive and
statistically significant.
2) It substantially reduces or eliminates the
systematic error between actual and estimated values of domestic inflation.
3) It substantially improves the amount of
variance in domestic inflation explained
by the equation.
On the basis of these three propositions, which
are satisfied for a group of major industrial
countries we can tentatively accept the proposition that domestic inflation is explained by
world as wen as domestic monetary influences.

4

(1) f::,.Log(PX),=3.55 +.877 f::,.Log ~(M)'-4

(3.0)
R2/SE
.30/2.91

(2) f::,.Log

(PX), = 3.56 = .837 f::,.Log
(4.0)
(4.3)

4

~ (M)'-4

4

Equation 1 relates to U.S. money to U.S. income, both in nominal terms. For every 1.0percent rise in U.S. money stock there is approximately a 0.9-percent rise in U.S. income
measured by GNP. This equation explains
approximately one third of the change in GNP
since 1960.
Equation 2 is identical to Equation 1 except
that the' percentage change in world money is
an additional explanatory variable. The world
money coefficient in this case is not statistically
significant. In fact, the addition of world money
to the equation slightly reduces the amount of
variance in GNP explained by the equation.
The relation between money and income can
also be estimated in real terms. While it is recognized that over the long term real GNP is
primarily a function of capital, labor and technology, its utilization over the business cycle is
influenced by monetary factors. In equation 3,
U.S. money is related to U.S. income (measured
by GNP)-both in real terms, i.e. divided by
the GNP price deflator. In equation 4, U.S. and
world real money are related to U.S. real income.
Real world money is equal to nominal world
money divided by the world price index. 8

The third and final relationship to be tested
is that between money and income. In Section
I it was shown that the relationship between
domestic money and domestic income could be
tested by the following reduced-form equation:

n
a o + a j f::,.Log ~ M'_i

Where (PX) is domestic income (in nominal
value) and M is domestic money. To test
whether world money affects domestic income,
it is only necessary to add an additional explanatory variable. The reduced form equation in this
case would be as follows:
n

f::,.Log (PX), = a o + f::,. Log i~O (M),

DWIDF
1.66/56

+ .022 f::,.Log ~(Mw)t-4
(0.6)
R2/SE
DWIDF
.2812.95
1.65/54

Money and income

f::,. Log (PX),

(5.1)

i

n
+ a 2 f::,.Log i~o(Mw)"

(3)

f::,. Log (X)

Where Mw is the measure of world money.
The results of estimating these two equations
are presented below on the basis of quarterly
percentage changes from 1960.1 to 1974.4.

2.20 + 1.37 f::,.Log
(4.8) (6.5)
R2/SE
.43/2.92

28

4

~

(M/Pus)

DW/DF
1.79/56

'-4

4

(4)t>LogX = 2.18 + 1.37 LiLog
(4.7)
(5.5)

~(M/Pus)

t~4

4

+ .01 t>Log
(0.1)

~

(Mw/Pw)

R2/SE
.42/2.97

t~4

DW/DF
1.80/54

The results for equations 3 and 4 in real terms
are similar to the results in equation 1 and 2 in
nominal terms. The real world money variable
is not statistically significant, and it reduces the
variance in real GNP from that explained by
real U.S. money alone.

III. Summary and Conclusions

a period of ~exible exchange rates. Now, flexible
rates permit the Central Bank to control the
domestic money stock and therefore the level
of nominal domestic income. However, in a
period of substantial world inflation, the split
between nominal and real income will be
strongly dependent on developments outside the
domestic economy. If an increase in world
prices leads to a rise in the domestic price level
in excess of what would have been expected on
the basis of strictly domestic considerationsas during 1973-74-this situation will cause a
contraction in the real volume of transactions
which holders of U.S. dollar balances can conduct. The counterpart of this is that when prices
rise faster than nominal income there will be a
contraction in real income, leading to a contraction in real spending and real output. The result
will be an unprecedented gap between nominal
and real income, so that the country experiences
a period of simultaneous inflation and recession.
Specifically, the inflation has come from the high
level of domestic and world money growth experienced over the last three to four years, while
the recession has occurred because of the inflation-related contraction in real money growth
experienced over the last few quarters.
We live in an increasingly interdependent
world, as reflected in the rise of multinational
corporations and international banking institutions. This development has added significantly
to the ability of the world economy to provide
a better standard of living for all. However, this
increased degree of interdependence has reduced
the ability of individual national governments to
control economic developments within their own
borders. In a world of increased specialization
among countries, the influence of internation-

The purpose of this paper has been to consider whether the simultaneous inflation-recession can be explained on the basis of current
theoretical and statistical tools. The results presented here suggest that it can. Without in any
way going beyond the current state of the arts,
either in economic theory or statistical estimation techniques, this paper shows that the rate
of inflation in prices of internationally-traded
goods can be explained by the worldwide expansion in international money as measured by the
reserves of the major developed countries. This
inflation in turn has a direct effect on the domestic price level. Thus the appropriate specification of the monetary source of domestic inflation must include not only domestic but also
world monetary influences. The magnitude of
the world monetary influence on domestic prices
is roughly proportional to the degree of openness
of the economy in terms of its dependence on
internationally-traded goods.
In spite of the strong influence which world
money thus exerts on domestic prices, it does
not have a statistically significant effect on domestic income-at least with respect to the
United States. The domestic money stock continues to be the medium of exchange within the
confines of each individual country, and all
transactions must be cleared in the market place
in terms of this numeraire. The influence of
world money on world prices operates only
through its effect on the supply and demand for
internationally-traded goods-not through its
effects on desired or actual cash balances available in the domestic economy.
This study suggests that when there is a major
shift in the world inflation rate the domestic
economy cannot remain isolated from it even in

29

these goods, the impact on individual countries
can be substantial. We have been observing
such an impact for the past two years.

ally-traded goods on the domestic economy is
rapidly expanding. Thus, when world monetary
developments lead to an explosion in prices of

FOOTNOTES

1. See for example, M. W. Keran: "An Appropriate International Currency-Gold, Dollars, or SDR's?," Federal
Reserve Bank of St. Louis Review, August 1972.
2. An alternative specification would have domestic prices
determined by internationally-traded goods (directly) and
the domestic money supply. Estimates made on this basis
explain the data about as well as the results reported in this
paper. However, since it is assumed that domestic prices
include prices of internationally-traded goods and also
affect international prices, the estimates suffer from simultaneous-equation bias. The reduced-form specification
with world and domestic money explaining domestic prices
does not suffer from this defect.
3. If the world stays on a flexible-exchange-rate regime for
a substantial period of time (say beyond 1975), then international reserves will show little change and the information
content of this series as a measure of monetary influences
on prices of internationally-traded goods may be lost. In
that case we would have to move toward an alternative
measure of international monetary influences, such as the
sum of domestic money growth of all developed nations.
4. Another reasonable measure of world money would include the assets of the Eurodollar market. Conceptually,
Eurodollars should be included if they are a monetary
asset-primarily a means of payment. But Eurodollars
should not be included if they are primarily a form of credit
-a financial intermediary between savers and investors. In
practice, Eurodollars have the characteristics of both money
and credit, so it becomes essentially an empirical question
as to which dominates. Our tests on the U.S. price data

did not support the addition of Eurodollars as an element
of world money.
5. The natural question which these results raise is whether
the underforecasting of inflation during the last two years
is simply the mirror image of overforecasting inflation during the previous two years. The suppression of inflation in
1971-72 can be explained by wage and price controls. Now
that controls have been eliminated, it could be argued that
we are merely observing the market adjustment in prices
which was suppressed during the control period. This explanation ignores the fact that the 1973-74 inflation was
worldwide in scope. In this context, an explanation which
fits a wide range of country observations is superior to one
which is unique to the United States.
6. The U.S. dollar devaluation in percentage terms is computed on the basis of the changes in the exchange rates
between the U.S. dollar and eleven major foreign currencies
since ¥ay 1970. These currencies are those of the United
Kingdom, Canada, France, West Germany, Switzerland,
Netherlands, Belgium, Italy, Japan, Australia and Sweden.
Changes in these exchange rates are weighted by the respective countries' shares in U.S. foreign trade during 1969,
using both exports and imports.
7. The exchange rate effect on domestic income was not
significant in any of the six countries except Japan. Even
in this case the exchange rate added little to the explained
variance of domestic inflation.
8. Real world money was also divided by the U.S. GNP
price deflator. The results (not shown) were almost identical to those reported in equation 4.

30

Hang-Sheng Cheng and Nicholas P. Sargen
Two basic approaches to the question of imported inflation can be found in the recent literature. The first, which might be called costpush, views the rise in import prices as raising
the cost of imports and, hence, domestic prices. 1
The second approach, which might be called
world-monetarist, regards the world price level
as determined by the world demand and supply
of money. To the extent that national economies
are closely integrated through trade, capital
flows, and fixed exchange rates, world inflation
will spread to all such economies and result in
general price increases." Both approaches reach
a common conclusion: a national central bank
cannot do much to stabilize the domestic level,
in the absence of a freely floating exchange rate
of the national currency.
This paper calls attention to the special assumptions upon which the validity of that policy
conclusion depends. In general, when the assumptions are relaxed, the central bank is no
longer viewed as totally helpless in coping with
imported inflation. Instead, under certain specified circumstances, it could be quite effective
in stabilizing domestic prices in the face of price
increases abroad.
By equating cost increases with price increases, the cost-push approach focuses exclusively on the supply side of the market, and thus
ignores any (domestic or foreign) adjustments
on the demand side. In failing to distinguish between individual price increases and generalprice-level increases, this approach also ignores
the aggregate-budget constraint on market de-

mand. Rising import prices lead to a general
price increase only if permitted by central-bank
policy, which influences aggregate demand
through its control over the domestic money supply. Cost-push thus implicitly assumes an accommodating monetary policy, which validates
any tendency for domestic prices to rise as a
result of import-price increases. Since the costpush approach does not present a complete
theory, dealing as it does with only one side of
the market, we shall ignore it in the rest of this
paper and consider only the monetarist approach.
The world-monetarists argue that in an open
economy the national central bank has no control over the domestic money supply, so long as
exchange rates are not freely flexible. The conclusion follows from the assumption of homogeneous products throughout the world, so that
the domestic price level in an "open economy"
cannot diverge very far from the world price
level. 3 The homogeneous-products assumption,
thus, defines away the very problem this paper
is focused upon.
At issue is not the theoretical validity of the
monetarist approach, which we do not dispute,
but rather its general applicability. Despite the
rapid integration of the world economy in the
last thirty years, inflation rates have varied widely from country to country even during an era of
relatively stable exchange rates. The following
table shows the dispersion of consumer-price
changes in two selected periods for 41 major industrial and developing nations:

31

take into account both product differentiation
and its implications for domestic monetary
policy.
The next section presents a simple monetarist
model that attempts to incorporate some of these
considerations. It shows that the national central bank is not necessarily helpless in coping
with imported inflation, and that the effectiveness of domestic monetary policy for price stabilization depends critically on the degree of
openness of the economy-measured by the
elasticity of substitution between domestic and
foreign products on the one hand and by the
ratio of imports to GNP on the other. 5 Secondly,
it decomposes the impact of imported inflation
on domestic price level into a "monetary effect"
and a "resource effect," and shows that mere
sterilization of reserve increases in order to offset the "monetary effect" would be insufficient
for domestic-price stabilization, as it ignores the
"resource effect" of imported inflation.
Finally, by generalizing the world-monetarist
model to the case of differentiated products, the
analysis provides an explanation of the international dispersion of national inflation rates in a
way not accounted for in the version of the
model which assumes homogeneous products.
The final section presents a series of empirical
tests of the model, utilizing data for eight Pacific
Basin countries for the period 1948-73. The
model provides a satisfactory explanation of the
domestic inflation in most of those countries,
with imported inflation playing a significant role
in nearly all eight. The results lend support to
the view that the developing nations have a
greater monetary independence for combating
imported inflation than the developed countries
do.

A verage annual rates of change (% )
All Countries"
1950-63
1963-72
1. Weighted mean .... 3.85
5.08
2. Coefficient of
variation
1.29
1.04
3. Range of variation .-0.6 to 38.1 1.2 to 35.2
Industrial Countries (14)
1. Weighted mean .... 2.79
3.96
2. Coefficient of
variation
0.55
0.20
3. Range of variation .1.8 to 5.4 3.1 to 6.0
Developing Countries (27)
1. Weighted mean .... 9.41
10.74
2. Coefficient of
variation
1.47
1.43
3. Range of variation. -0.6 to 38.1 1.2 to 35.2
Source: Based on data in International Monetary Fund,
International Financial Statistics, various issues.

The data indicate a high degree of variation
of inflation rates among the 41 countries in both
periods, 1950-63 and 1963-72. However, this
variation was much smaller among the industrial
countries than among the developing countries.
Moreover, between the first and second periods,
national inflation rates converged markedly
among the industrial countries, but not among
the developing nations. It appears that, at least
for developing countries, international economic
integration is far from perfect, and international
product differentiation is the norm rather than
the exception.
These observations point to the need for a
further elaboration of the world-monetarist approach so as to account for this wide dispersion
of national inflation rates. We should explicitly

I. Two-Sector Monetarist Model of Imported Inflation

A) The model and analysis

(1)

M

The model consists of nine equations, six
definitional and three behavioral. Readers who
are interested only in the policy implications,
· may sk'Ip th'IS su b-secnot the formaI anaI ySIS,
tion and go to the next. The symbols used are
explained along with the equations.

(2)
(3)
(4)

P == (dly*)Pct + (m/y*)EP m
M == R + C
R
== R o + Pctx - EPmm

(5)
(6)

x = x(T)

32

m

=

=

ky*P

meT)

(7)

T_

(8)

y == y*

(9)

dP

+ x - mIT
y* == d + miT

dy*/y* 0 '

(11)

dC

m'
x'<o and m'>o,

Equation (1) states that in equilibrium the
money supply is equal to the nominal amount of
money demand, the latter being proportional to

+m'-

the nominal amount of domestic expenditure.

(13) dT

It is a variant of the familiar quantity equation
where V is the income velocity of
money, and Q the national output. Equation
( 1) sets k= 1/V and changes Q to real domestic
expenditure. 6 Equation (2) defines the index of
domestic-expenditure prices as a weighted average of the domestic-product and foreign-product
prices, the weights being the proportions of
domestic expenditure spent on the respective
products.
(3) abstracts from the
fractional-reserve system and defines the money
supply as the sum of the foreign reserves and
domestic credits in the central bank's portfolio.
Equation (4) states that the foreign reserves at
the end of the period equal the amount at the
beginning of the period plus the trade balance
during the period, assuming no net international
capital flows. Equations (5) and (6) assume
both national output and world output to be
given, so that the world's demand for the nation's exports and the nation's demand for im'ports are functions only of the terms of trade.
Equation (7) then defines the terms of trade as
the ratio of the price of the domestic product to
that of the foreign product, both stated in terms
of the national currency. Equation (8) defines
national output to be equal to domestic expenditure plus exports minus imports, all stated in
equivalent units of the domestic product.
Equation (9) defines domestic expenditure as
the sum of domestic spending for both domestic
product and foreign product, both in equivalent
units of the domestic product.
To facilitate analysis, set the units of measurement and initial conditions such that initially
P = Pa
Pm
E = 1, and the trade balance
is zero. Then, by assuming a fixed exchange
rate, and upon differentiating and substituting,
we obtain the following relations:

=

+

and

dP

=

+ (m/y*)o

(d/y*)o

where x' and m' are the derivatives of x and m
with respect to
and the
0 indicates
the initial value.

Imported
credit expansion

in the absence of

By setting dC
0, eqtlatlons (
can be solved to obtain:
dP
where (
and (17) re

+
+
- m' +

- mI

d(Hne~;tic

14)

- dPm )
)/
) / y\ .

Equation (1
shows that the "terms-oftrade effect" of imported inflation on the domestic
level
be
into a "monetary effect"
and a "resource effect"
The former indicates the
in central-bank
foreign reserves as a ratio of the initial domestic
money supply
from a
in the
terms of trade. The result is positive in the normal case where the elasticities of export demand
and import demand are sufficiently large such
that the trade balance improves with a fall in the
terms of trade. 7 The latter equation measures
the net proportionate change in the nation's real
domestic expenditure, measured in equiv'ahmt
units of domestic product, resulting from
changes in exports and
induced by a
change in the terms of trade. s Thus, a trade surplus resulting from a rise in
would
be inflationary, because of the induced domestic
monetary expansion coupled with a resultant
drain of resources from the economy.
Equations (14) and (15) can be solved
jointly to obtain dP and
as functions of
dP m only:

=

33

(18) dP d

=

(19) dP

=

where (20) A

which state that expansions (or contractions) in
central-bank domestic credit will be partially
effective in expanding (or contracting) domestic
money supply-but not fully effective, because
of the resultant reserve loss (or gain) .10
If the central bank has at least partial control
over the domestic money supply, how should
domestic credit be adjusted to check imported
inflation?
By setting dP=O, we obtain from equation

VA) dPm

(1
[1

(lIA) (d/Y*)J dPm ,

:; ME + re + (d/y*)o'

Equations (18)-(20) indicate that the impact of imported inflation on the domestic prices
depends systematically on the extent of the
"monetary effect" and "resource effect" on the
one hand, and the size of the import ratio (i.e.
imports divided by domestic expenditure) on
the other. The former effects are directly related
to the elasticities of substitution between foreign and domestic products such that when these
products are highly homogeneous-i.e. when
the elasticities of substitution between the two
products in the import-demand and export-demand functions are both very large-dP and
dP d will both approach dPm' The same result is
obtained in the world-monetarist approach under the assumption of perfectly homogeneous
products worldwide.
The import ratio (m/y*) 0' or its complement
(d/y*), also enters into Equations (18) and
( 19). Other things being equal, the larger the
import ratio, the larger will be the impact of imported inflation on domestic prices.
Equations (18) and (19) enable us to distinguish between the determination of the nationaloutput price (say, the GNP deflator) and the
determination of the national-expenditure price
(say, the consumer-price index). This distinction is significant to an open economy with domestic products that are not perfectly homogeneous with foreign products.

(10)-(14) :
(23)

and (22) dR

=

-(ME/A)dC,

dP

m

The analytical results, stated in equations
(19), (20), (21), and (23) above, may be

summarized as follows:
a) In the absence of domestic credit expansion or contraction, the impact of imported
inflation on domestic prices depends systematically on the "degree of openness" of the economy, which in turn is determined by the substitutability between domestic products and foreign
products on the one hand, and the ratio of imports to domestic expenditures on the other.
Operationally, product substitutability is reflected in the size of the induced change in the
country's trade balance relative to both its domestic money supply and domestic expenditures.
The larger the sum of these two ratios, and the
larger the ratio of imports to domestic expenditures, the larger will be the impact of importprice increases on domestic prices. Only in the
extreme case, where both the induced change
in the trade balance and the import ratio are
very large, will import-price increases be fully

ME/A)dC > 0,

(1

ME+re
)
dly*

B) Policy implications

To what extent can a central bank in an open
economy effectively control the domestic money
supply and thereby maintain domestic price
stability in the face of imported inflation? By
setting dPm=O, equations (10)-(14) can be
solved to obtain:
=

= - (

o

which states that in the normal case where a
trade surplus results from inflation abroad, the
central bank should be able to maintain domestic price stability by contracting domestic credit.
Moreover, the required credit contraction is the
larger, the more closely the domestic product
and the foreign product are substitutes, and the
larger is the ratio of imports to domestic expenditures.

Effectiveness of national monetary policy

(21) dM

dC/M s

34

reflected in domestic-price increases.
b) The central bank in an open economy can
have at least partial control over the domestic
money supply, again depending upon the "degree of openness" of the economy as defined
above. However, even in a highly open econamy, domestic credit expansion or contraction
will affect domestic money supply as a result of
induced changes in the domestic demand for
money which are brought about by changes in
real expenditures and domestic prices.
c) Hence, the central bank could effectively
use domestic-credit policy for combating imported inflation. However, the usual prescription of a simple "sterilization policy"-whereby
central-bank domestic credits are adjusted merely to offset fluctuations in its foreign assetswould not be sufficient for achieving domestic
price stability. The reason is that this prescription fails to take into account the "resource
effect" of imported inflation (i.e. the reduction
in supply of goods to the domestic economy).
The above analysis deals only with the efficacy
of central-bank price-stabilization policy in an
open economy. Its feasibility and desirability
are separate matters.
First, the duration of inflation abroad may be
critical in determining a central bank's ability
to continue using domestic-credit policy for offsetting imported inflation. Such a policy is apt
to be more viable when the problem of foreign
inflation is short-run rather than long-run in
nature.
Second, central-bank policy instruments are
still quite rudimentary in many developing
countries. Open-market operations are often
infeasible where central banks hold few marketable domestic assets, especially in countries
where the development of domestic money mar-

kets has been stifled by an official low-interestrate policy. Central-bank discount policy is
often ineffective at a time when the banking
sector is already awash with liquidity arising
from balance-of-payments surpluses. Adjustments in reserve requirements are sometimes
subject to statutory ceilings. For lack of alternatives, many central banks have relied largely on
moral suasion to control the growth of domestic
credit. Altogether, the room for maneuver is
frequently limited.
Thirdly, even if a central bank is well endowed with flexible policy instruments, a policy
of systematic sterilization of foreign assets
through domestic-credit contraction is tantamount to a deliberate switch from domestic
assets to foreign assets in the central bank's portfolio. Given the amount of national savings, this
implies a substitution of investments in liquid
foreign assets for domestic capital formationY
The desirability of such a policy may be questioned, especially where national savings are
very limited and act as a constraint on economic
development.
The effectiveness of central-bank policy for
price stabilization thus depends upon circumstances. Central banks generally should be able
to use domestic-credit policy to maintain domestic price stability a) when inflation abroad is of
relatively short duration, b) when the economy
is relatively "dosed" in the sense defined in this
paper, and c) when the central bank is able to
employ flexible domestic-credit policy. However, both the feasibility and the desirability of
such policy action may be doubtful when none
of these conditions is fulfilled. In this situation,
domestic price stability may not be feasible without adjusting the exchange rate of the national
currencyY

II. Empirical Tests for Pacific Basin Countries

sion procedures, we attempted to answer these
questions:
( 1) Is inflation in the Pacific Basin countries a
monetary phenomenon consistent with the quanPQ?
tity equation MV
(2) Has imported inflation significantly affected
inflation rates in those countries? That is to say,

How well does the monetarist model we have
described explain the inflationary experiences of
countries with fairly open economies? To answer this question, we analyzed 1948-73 data
for eight Pacific Basin countries with varying
degrees of dependence on trade, levels of development, and rates of inflation.1:J Using regres-

35

in terms of the (1n<:lnj-,t" eqlIation, have changes
in
affected P?
(3) Can central banks control the money supply and thereby combat imported inflation, if
the exchange rates for their respective currencies
floating-i.e., is M controllable
are not
by the monetary authorities?
To test the first
we rearranged
terms in the
to obtain
P
MV /0. Taking logarithms and differentiating with respect to time, we obtain14
(24)

equation explains between 40 to 80 percent of
the variation in inflation rates; all the variables
have correct signs; the constant term is insignificant (implying no changes in velocity); and the
Durbin-Watson statistics are reasonably good.
At least one money-supply variable is statistically significant in every case but New Zealand,
and a lag of t\VO years typically generates the
best results. Not surprisingly, the regression results with the real-income or real-expenditure
variables do not differ significantly, and in subsequent regressions we only report the results
using real output as the explanatory variable.
To test the imported-inflation hypothesis, we
added an import-price term to equation (25) to
obtain

P

one would expect changes in the money
supply to have a positive effect on domestic
prices, and changes in real domestic expenditure
(or output) to have a negative effect. Since
changes in the money supply may be offset by
changes in velocity, however, it is also important
to test our assumption of stable velocity.
The first set of regressions reported in Table
1 is based on equation (10), which is a variant
of equation (24), and is of the general form:

.

.

P = a o + aiM_I +
P

.

+ ... +aPm+ay,

.

where:
Pill - annual percent change in the import
price index in the current period (or in
some cases lagged one year).
C annual percent change in central-bank
domestic assets.
Part (b) of Table 1 reports the results when
the money supply is included as an explanatory
variable. The import-price variable is highly
significant and positive for the three developed
countries (Australia, Japan, and New Zealand)
as well as for the Philippines; it is significant
about the lO-percent level for all remaining
countries except Malaysia. Thus, imported inflation appears to have been a significant factor
contributing to domestic inflation in nearly all
these countries during the 1948-73 period.
Moreover, the addition of the import-price
term tends to reduce the coefficients of the money-supply variables as well as the values of the t
statistic associated with them. This is not surprising, since we would expect rising import
prices normally to increase a country's foreignexchange reserves, and thereby lead to an expansion in its money supply-provided no offsetting action were undertaken by the monetary
authorities. Thus, changes in import prices and

-2+ ... + aJr*(ory)

= annual

change in the CPI index,
annual percent change in domestic
money supply (currency and demand deposits; subscript denotes number of years
lagged),
=

y* ::= annual percent change in real domestic
expenditure (measured in constant 1963
. dollars),
y
annual percent change in real GNP
(measured in constant 1963 dollars).
With this format, any change in velocity will
be captured by the constant term. In addition,
this specification permits the money supply to
affect prices with lags, whereas our formal model
posits instantaneous adjustment." 5 Both real
GNP and real domestic expenditure were tried
as explanatory variables, and the best results
are presented in Table 1.
On the whole, this very simple specification
works quite well for all countries except New
Zealand. Except for the latter, the regression

=

36

Table 1
(a) Regression Results With

.

.

Prices Excluded

P = 0: 0 + 0: 1 M. 1 + 0: 2 M. 2 + ...+O:n Y(or y*)
R2jD.W.

COUNTRY

Australia
Republic of China

.23
(.43)

.43**
(5.44)

6.18*

.09

-.08

.41**
(5.30)
.22**

.79

(.68)
-.77**

Korea
Malaysia
New Zealand
Philippines
Thailand

19
1.61

17

.41
2.22

(l

Japan

D.F.

.14**
16)

-.49
(.26)

.19**
(2.74)

3.51
(.50)

.07
(.47)

.32**

.83
(.12)

.11*
(1.93)

.16**
(2.94)

4.16**
(5.09)

.06
(.61)

.05
(.50)

.43**
(5.00)

.15**
(2.27)

.18
(1.36)

.35**
(3.38)

2.22
(1.44)
-.66
(.33)

-.05

.45

16
1.47

.51

-2.55
(.57)

16
1.84

-.15**
(2.94)

.54

12
2.60

-.02
(.57)

19

0
.72
-.51**
(3.67)

-.11

.77

18
2.06
18

.50

(.91)

1.83

(b) Regression Results with Import Prices Included
p =0. +0:IM. +0:}\1. + ... + 0: m Y+0: n Pm
1
0
2
COUNTRY

0: 0

Y

Pm

D.F.

Australia

-.13
(.22)

.21**
(3.89)

.18**
(2.98)

.19**
(2.19)

.58** .93
(6.03)
2.52

Republic of
China

13.9**
(3.81)

-.02
(.21)

.08
(.84)

-1.11**
(4.66)

(1

Japan

2.44
(1.27)

.13**
(2.05)

.14**
(2.05)

-.20
(1.58)

.32**
(6.32)

.70

9.87
(1. 26)

-.09
(.64)

.14
(1.24)

-.22
(.80)

.35
(1.74)

.43

.11

-.22**
(2.73)

.04

.49

(1.67)
-.03
(.35)

.08
(.62)

.40** .44
(3.98)
1.81

17

.27**
(2.45)

.23**
(3.53)

-.38**
(2.49)

.25** .77
(2.97)
1.52

17

.16
(.95)

.39**
(2.48)

Korea

.79
(.94)

New
Zealand
Philippines
Thailand

2.53**
(2.62)
1.19
(.80)
-1.16
(.56)

.08
(1
.11
(1.48)

t statistics in parentheses
Statistically significant at the 5% level
Statistically significant at the 10% level

**
*

37

.10

.55

18
15

1.96
18
.96
8
1.57
2.53

-.10

.20

(.74)

(I. 73)

.35

15
1.85

in the money supply are not truly independent of
each other.
The critical issue for policy purposes is
whether the money supply can be controlled. If
changes in domestic credit ate fully offset by
changes in international reserves, monetary policy is ineffective in combating imported inflation.
As a simple test of this proposition, we ran the
following regression for each country:16

The domestic-credit variable had large negative coefficients which were statistically significant for the three developed countries (Australia, Japan, and New Zealand). For the developing countries, either the variable was statistically
insignificant (China, Malaysia,Philippines), or
its coefficient wa,S positive (Korea) or negative
but small (Thailand). The world-reserve variable was also highly significant for the developed
countries, but not for the developing countries.
Thus, the results suggest that independent monetary policy under a fixed-exchange-rate regime
may be more difficult for developed countries
where:
Ri = percent change in central-bank foreign than for the developing countries. 17
In conclusion, the following inferences may be
• assets of country i.
drawn from the regression results:
R = percent change in world international
reserves.
( 1) A monetarist model helps explain the
C = percent change in central-bank domesmagnitude of inflation in the Pacific
tic assets.
Basin region.
(2) During 1948-73, imported inflation apB- 1
percent change in the exchange rate
pears to have contributed significantly to
(domestic currency units / U.S. dollar)
domestic inflation in nearly all Pacific
lagged one year.
Table 2
Regression Results For Reserve Changes

...

.

R

=0: 0 +0: 1 R w +0:2C;

COUNTRY

Australia
Republic of China
Japan
Korea
Malaysia
New Zealand
Philippines
Thailand

+0:3E~1

R2/D.W.

C

5.69
(1.27)

.93**
(2.74)

-.79**
(5.91)

-.15
(.63)

.87

32.4**
(2.68)

.24
(.25)

-.25
(.95)

-.32
(.57)

0

13.35**
(2.13)

3.64**
(7.15)

-.89**
(5.39)

6.82**
(3.77)

.82

38.5*
(1.81)

-2.18
(1.46)

1.09**
(3.17)

-.43*
(1.91)

.29

2.91
(.88)

.21
(1.18)

.07
(1.57 )

-2.9**
(2.3)

.30

4.32
(.52)

2.43**
(3.48)

.64*
(1.83)

1.08**
(2.17)

.46

8.50
(1.29)

1.69
(.40)

-.93
(.35)

0

-.12
(.57)

-.12*
(2.06)

-4.26
(1.07)

.24

-94.90
(1.03)
11.74**
(4.18)

t statistics in parentheses
** Statistically significant at the 5% level
* Statistically significant at the 10% level.

38

D.F.
10

1.64
17
1.95
16
2.40
19
2.13
10

2.20
20
2.40
20
1.97
13
1.37

Basin countries examined.
(3) Imported inflation appears to have affected domestic prices more strongly in
the developed countries than in the developing countries in the region. Since
the latter countries tend to have larger
import ratios than the former, this finding illustrates the danger of relying on
the import ratio as the sale measure of
the degree of "openness" of a national
economy.

(4) Independent monetary policy also appears to be less feasible for the developed
countries than for the developing countries in the sample. This finding helps
explain the wider dispersion of inflation
rates among the developing countries
than among the developed countries, to
the extent that the developing countries
are less well integrated into the world
economy.

FOOTNOTES
1. Turnovsky, S. J. and Andre Kaspura, "An Analysis of
Imported Inflation in a Short-Run Macroeconomic Model,"
Canadian Journal of Economics, 7 (August 1974).
Kwack, Sung, "Price Linkages in an Interdependent
World Economy: Price Responses to Exchange Rate and
Activity Changes," paper prepared for the NBER Conference on Research in Income and Wealth, "Price Behavior:
1965-1974," November 21-23, 1974 in Washington, D.C.
2. Shinkai, Yoichi, "A Model of Imported Inflation,"
Journal of Political Economy, 81 (July-August 1973).
3. The world-monetarist approach dates back to David
Hume in the eighteenth century. Its modern revival arises
from the writings of Harry G. Johnson and Robert A. Mundell. It is important to note that Johnson's model is a
balance-of-payments model, and the focus of Mundell's
analysis is on the "seigniorage" problem. Neither of these
articles expressly dealt with the determination of the domestic price-level.
Johnson, Harry G., "The Monetarist Approach to Balance of Payments Theory," in his Further Essays in Monetary Economics (Harvard University press, 1973).
Mundell, Robert c., "Seigniorage and the Optimum
World Central Bank," in his Monetary Theory: Inflation,
Interest, and Growth in the World Economy (Goodyear:
1971).
4. The 41 countries are Austria, Belgium, Canada, Denmark, France, Germany, Italy, Japan, Netherlands, Norway, Sweden, Switzerland, The United Kingdom, The
United States (industrial countries); Argentina, Australia,
Brazil, Chile, China (Republic of), Colombia, Egypt, Finland, Greece, Iceland, India, Iran, Ireland, Israel, Korea,
Malaysia, Mexico, New Zealand, Pakistan, Philippines,
Portugal, South Africa, Spain, Sri Lanka, Thailand, Turkey,
and Venezuela (developing countries).
5. Intuitively, the product-differentiation concept should be
extended to cover differentiation between domestic and
foreign financial assets. That, however, has not been accomplished in this model, which for simplicity abstracts
from international capital flows. The implicit assumption is
that, for the majority of countries today, the substitutability
between foreign and domestic financial assets is so small
that the domestic capital market may be considered virtually insulated from foreign capital markets. Nevertheless,
the abstraction from international capital flows remains a
major shortcoming of the model for application to other
CIrcumstances.
6. Note that the traditional monetary theory assumes the
demand for real balances to be a function of real income or
wealth, not real expenditures. In equation (1), we emphasize the motive for holding domestic money as for antici-

pated or potential expenditures at home, including those
on both domestic and imported products, but excluding
foreigners' purchases of the country's exports. The shift
in emphasis will have implications on the type of price
indices dealt with in the model, as to be shown below.
7. The "monetary effect" becomes negative, i.e., a reserve
drain instead of a reserve gain, when the initial volume of
imports is sufficiently large such that the enhanced import
cost resulting from higher import prices exceeds the sum
of the induced increase in exports and reduction in imports. An illustration of the case is the large trade deficits
sustained by many countries as a result of the 1973 increases in oil-import prices. In such instances, since the
"monetary effect" and the "resource effect" must always
be in the same direction, the import price increases are
deflationary, rather than inflationary to the economy.
8. Note that although the measurement of changes in real
income is beset with the index-number problems, the "resource effect" as defined in this paper-being a ratio of
the trade balance to the initial domestic expenditure----cis
devoid of such problems. It is, thus, a concept as fully
operational as that of the "monetary effect." The outflow
of real resources induced by inflation abroad corresponds
to the "seigniorage effect" in Mundell's model. See Mundell
(1971).
9. Formal relationships between the "monetary effect" and
"resource effect" and the elasticities of substitution may be
derived. as follows: From aggregate-utility functions of a
constant-elasticity-of-substitution type (CES function), both
the export demand and import demand can be expressed
as functions of the terms of trade. Their partial derivatives
with respect to the terms of trade are positively related to
the elasticities of substitution.
10. Equation (21) suggests that domestic credit expansion
will have a positive effect on domestic money supply, regardless of the degree of openness of the economy. The
result is at variance with that obtained from world-monetarist models, which hold that the national central bank
cannot control the domestic money supply in an open
economy, since domestic credit expansion will be exactly
offset by foreign-reserve losses. The difference arises from
the fact that (i) we assume product differentiation, whereas
the world-monetarist models assume homogeneous products; and (ii) the demand for real balances is a function
of real domestic expenditure in our model, but a function
of real national income in the world-monetarist models.
The result is that a domestic-credit expansion in our model
brings forth a rise in the nominal demand for money
through an import surplus (i.e. dy"'/dC>O) and a rise in
the domestic-expenditure prices (dP/dC>O), both of which
will induce the public to hold a larger amount of the

39

(1oJtne~;uc

money. In contrast, by assuming homogeneous
prC)OUCLS, the world-monetarist models rule out any induced
the domestic-price level; by relating demand
for real balances to real income, rather than real expenditure, they also preclude any effects changes in trade balance might have on the demand for real balances.
11. Shaw, Edward, "International Money and International
Bank of San FranInflation: 1958-1973,"
cisco, Business Review,
issue.
12. It can be shown, by letting E to vary so as to set dR to
zero, that a nation can be completely insulated from inflation abroad under freely floating exchange rates.
13. The eight countries included in the sample, along with
three key eeonomie indicators, are listed below:
Per Capita
cn Inflation
Rate
Imports/GNP Income
(1972)
(1960-72)
Country
(1972)
US $2,980
3.0%
Australia
0.15
490
3.3
Republic of China .. 0.43
2,320
5.8
Japan
0.08
320
13.0
Korea
0.26
430
1.2
Malaysia
0.45
2,560
4.6
New Zealand
0.23
220
6.5
Philippines
0.17
220
2.2
Thailand
0.21

SYlmbols used in

model.

Endogenous variables
M: money supply.
y*: real domestic expenditure expressed in units of domestic
product.
P:
index of domestic-expenditure
prices.
d:
real national expenditure on the
domestic product.
m: volume of imports.
x: volume of exports.
Po: price of domestic product.
R:

foreign reserves in the central
bank's portfolio.
T:
the nation's terms of trade, i.e., the
ratio of its export price to its import
both in terms of the national
currency.
Exogenous variables:
y:
real national output in units of
domestic product.
central bank's foreign-reserve holding at the beginning of the period.
c: domestic credits extended by the
central bank.
E: exchange rate of the national currency per unit of foreign currency.
Pm: price of foreign product.

Sources: International Monetary Fund, International Financial Statistics, March 1975; Asian Development Bank,
Key Indicators of Developing Members Countries of ADB,
October 1974; and International Bank for Reconstruction
and Development, World Bank Atlas, 1974.
14. Harberger, Arnold C., "Some Notes on Inflation," in
Inflation and Growth in Latin America, Werner Baer and
Isaac Kerstenetsky, eds. (Yale University Press, 1964).
Vogel, Robert c., "The Dynamics of inflation in Latin
America, 1950-1969," American Economic Review, 64
(March 1974).
Meiselman, David, "Worldwide Inflation: A Monetarist
View," Ameriean Enterprise Institute paper, 1974.
In each case the authors were interested in explaining
inflation in Latin America and assumed that the domestic
money supply was subject to the control of the national
monetary authorities.
15. Current changes in the money supply are not included
as an explanatory variable, since the data on prices are
annual averages, whereas the money-supply data are for
end-of-years. Inclusion of the current period's money supply
would be equivalent to having changes in prices lead
changes in money supply by six months on average.
16. Johnson's specification actually compares growth in
domestic credit in the individual country to that in the rest
of the world, and includes a comparable real income
variable. We found the latter variable to be insignificant in
most cases, however.
17. The results, however, are suggestive but not conclusive,
since an equally plausible explanation might be that the
developed countries pursued a deliberate sterilization policy,
whereas the developing countries did not. See, for instance,
the articIe by Joseph Bisignano in this issue.

Parameter
k:
positive constant

40

Joseph Bisignano *
Of all commodies money is the most fungible.
Consequently, the price of money-which is the
rate of inflation - and the price of credit
(money's liability counterpart) which is measured by interest rates-"tend" to similar val~es
across domestic and international boundanes.
With the increasing integration of domestic and
international money and capital markets, it is
unusual to see financial assets with similar risk
characteristics trading at different interest yields
for any length of time. A related, but different,
result of money's fungibility is the fact that central bank monetary actions in one country can
affect the money supply in another country under a system of imperfectly flexible exchange
rates.
This article will outline some of the monetary
interconnections among nations and specify in
a simple fashion the results of these interrelations. We will first consider the degree of correlation among short - term interest rates of
several countries. Next we will describe the composition of foreign monetary bases, and the connection of this composition to the monetary
theory of the balance of payments. Finally-:e
will consider the degtee of impact of changes III
the U.S. monetary base on changes in foreign
money supplies, along with estimates of the demand for monetary-base money.

Some obvious interdependencies

The rapid rise and integration of capital and
money markets in the postwar period, combined
with the spectacular growth of the Eurocurrency
market since the early 1960's, have led to interrelated movements among financial assets of like
maturity and risk elements. Table 1 presents a
simple correlation matrix for the pcriod 1959..1
to 1973.4, depicting the correlations among vanout types of short-term interest rates-Treasury
bill rates for eight countries as well as the threemonth Eurodollar rate. The interest rates used
are quarterly averages. In most cases we see
very high correlation between foreign interest
rates and the interest rate on U.S. Treasury bills.
As we might expect, changes in U.S. and Canadian interest rates are highly correlated, but
changes in U.S. and U.K rates are equally highly
correlated and the same is only slightly less true
for rates in the U.S. and Germany.
There are a number of reasons for this close
correlation. The most important is that in a
world of relatively free capital markets assets
denominated in different currencies serve as potential substitutes in the portfolios of private
wealth-holders. In addition, countries may be
pursuing similar monetary policies, which result
in similar impacts on market-determined interest
rates. Indeed, the balance of payments represents, in one definition, the change in a nation's
international reserves, and domestic monetary
policies are often undertaken in response to

*1 wish to thank Scott Nason for his research assistance.

41

dollar liabilities to foreign official institutions
from $17 billion in 1968 to $71 billion in 1974.
Because foreign-exchange reserves represent a
major component of the monetary bases of foreign central banks, foreign money supplies necessarily had to expand, except where central
banks could offset inflows of foreign-exchange
reserves.

changes in the balance of payments. The predominant reasons for this interrelationship
among international interest rates include the
growth of international capital markets and the
relaxation of constraints on capital flows. In
cases where governments have instituted domestic impediments to capital flows, international
offsets to these impediments have then arisen,
viz., the Eurocurrency market.
In addition to the interest-rate correlation,
price indices also are correlated internationally.
Because other countries formerly pegged their
exchange rates to the dollar (within narrow
bonds), any significant U.S. balance-of-payments deficits-caused, say, by an increase in
price inflation within the U.S·-had to result in
other countries purchasing dollars in the foreignexchange markets. But, as we shall see below,
such purchases of dollars added to the foreignexchange reserves of foreign central banks.
Table 2 displays the rapid upswing in official foreign-exchange holdings of eleven developed nations between 1968 and 1974. Germany and
Japan, with their rapid real economic growth,
experienced large demands for real money balances, which were at least partially satisfied
through the accumulation of foreign-exchange
reserves. The share of domestic money demand
satisfied from foreign sources in a regime of fixed
exchange rates depends upon the growth in the
world money supply. (See the companion article
by Shaw for details.) The U.S., as the major
source of international reserves increased its

Composition of foreign monetary base

The money supply is similarly defined in this
and most other countries. In the U.S., the narrowly defined money supply (M 1 ) is composed
of currency and coin plus demand deposits held
by the public. In the U.K, the M 1 money supply
is composed of notes and coin plus sterling current accounts held by the public. However, the
assets of the respective central banks-the Federal Reserve and the Bank of England-which
support the reserves held by the commercial
banks, are different in one important respect.
The principal foreign component of this monetary base in the U.S. is the gold stock, while in
the U.K. and other foreign countries the central
bank's holdings of foreign assets make up a
significant share of the sources of the monetary
base. Since the money supply used by the public is "supported" by the central bank's monetary
base, control of the monetary base is essential if
a country is to control its money supply and its
rate of inflation.
This simple point provides a monetary connection through the balance of payments to other

Table 1
Correlation Matrix
for Change in Eurodollar Rate and Treasury 8ii1 Rate of Various Countries

United States
United Kingdom
Canada
Italy
Germany
Japan
Australia
Netherlands
Euro

NetherUnited
United
States Kingdom Canada
Italy
Germany Japan Australia lands
1.000000
.801860 1.000000
.788500
.599957 1.000000
.471451
.395329
.122251 1.000000
.645567
.545940
.299815
.632305 1.000000
.334773
.200238
.624185 -.104926 .295214 1.000000
.389175
.501618
.700282
.364275 1.000000
.164727
.638102
.670903
.691753
.719916 1.000000
.690429
.608011
.350920
.686181
.923835
.518629
.704486
.717829
.711332
.537490
.682429
.318161

Euro

1.000000

Note: Euro is the 3-month Euro-dollar rate. All other figures are the Treasury bill rates for the country indicated.

42

countries. Consider the assets of a foreign central bank, composed of domestic assets (e.g.,
government securities, loans to commercial
banks) and foreign assets-which are counterbalanced by central bank liabilities, the equivalent in the U.S. of member-bank reserves, in
some countries called "central bank money."
Hence we have

0)

D

R

where 6. represents the incremental change in
each variable. 6. R represents the change in a
country's holdings of foreign-exchange reserves
and corresponds to one definition of the balance
of payments. Thus for a given time interval, say
a quarter, 6.R would be the balance of payments
in a given quarter, 6.B the change in the monetary base in that quarter and 6.D the change in
domestic assets held by the central bank. If the
monetary authorities have complete control over
D, the domestic asset component of the monetary base-for example, through control over
open market operations or lending to commercial banks-they may attempt to offset movements in the foreign-exchange-reserve component of the monetary base. This would obvi-

B

where D
domestic assets of the central bank,
R
foreign assets of the central bank
(usually denominated in dollars)
B = monetary base of the central bank (central bank money) .
The monetary base (B) is linked to the domestic
money supply (M) by the relationship

=

(2)

M

Table 3
Dependent Variable
Change
in Domestic Assets
Sample Period = 1966·1 - 1973·IV

mB

where m is the money multiplier, which can be
decomposed into its components which reflect
financial preferences of the public and the banking system.
Consider a change in equation (l), that is
(3)
6.D+ 6.R= 6.B
or
(4 )
6.R = 6.B - 6.D
Table 2
Official Foreign Exchange Reserve Holdings
and U.S. Official liabilities
(Billions of U.S. Dollars: End of Period)
1968 1969 1970 1971 1972 1973 1974

U.K.
Canada
Germany
Japan
France
Italy
Australia
Netherlands
Sweden
Norway
Denmark

0.9
2.0
3.9
2.3
0.3
1.5
0.9

1.1
1.8
2.7
2.6
0.3
i.2
0.7

1.2 5.1 4.1
4.7 4.9
3.0 4.1 4.4 3.9 3.8
8.5 12.6 17.2 25.1 24.0
3.2 13.8 16.5 10.2 11.3
1.3 3.6 5.1 3.7 3.8
2.1 3.0 2.2 2.2 3.2
1.1 2.7 5.4 4.9 3.6

0.3
0.4
0.6
0.2

0.4
0.4
0.6
0.3

0.8
0.4
0.6
0.4

0.4
0.7
1.0
0.5

1.4
1.1
1.1
0.6

3.3
2.0
1.3
1.0

c
126.06
(2.30)*

6Foreign
Assets
9 R2 D.W.
-1.1307 .4844 .8533 2.26
(-8.79) (3.03)

Canada

.1486
(3.77)

-1.0466 .5703 .8808 2.09
(-15.1) (2.80)

Italy

315.17
(5.61)

-.60699 .2336 .2498 2.11
(-2.65) (1.32)

Germany

1.0256
(1.64)

-.5906 .0784 .5823 1.98
(-6.46) (.431)

Japan

626.97
(2.03)

-.87039 .9446 .9673 1.94
(-24.6) (15.8)

France

2.1286
(3.19)

-.86465 -.3929 .2493 1.90
(-3.58) (-2.34)

.090681
(3.13)

-.98522 .4475 .8943 2.04
(-14.7) (2.74)

Netherlands

.08310
(1.48)

-.80451 -.5542 .8099 1.66
(-9.59) (-3.65)

Sweden

.19822
(7.98)

-.87293 -.2509 .9099 1.82
(-19.2) (-1.42)

Norway

.12940
(3.03)

-1.001 0 -.2394 .7372 2.18
(-8.59) (-1.35)

Denmark

.03127
(.299)

-.8203 .1579 .5357 2.05
(-5.71) (.8758)

Australia

3.5
1.2
1.7
0.6

U.S.
Official
Liabilities 17.3

Country
U.K.

9

= serial correlation coefficient
D.W. = Durbin-Watson statistic
c = constant term
R' is adjusted for degrees of freedom.
*t-statistics in parentheses

16.0 23.8 50.7 57.5 69.6 70.8

Source: International Financial Statistics, various issues.

43

ously imply a negative correlation between 6D
and 6R.
The causal relation could work in the other
direction. That is, capital flows may offset the
conscious central bank decision regarding the
desired change in D, the domestic component
of the monetary base. Assume, for example,
that the monetary authorities decide not to satisfy all the apparent demand for money. This
would imply that the increase in the domestic component of the monetary base would be
sufficient to satisfy only part of the demand for
money, driving up domestic interest rates. The
resulting increase in interest rate differentials,
however, would cause the excess demand for
money to be satisfied from abroad through an
induced capital inflow and a balance of payments surplus. In this case the balance of payments would reflect the fact that domestic money
demand exceeded domestic money supply.
When the excess demand for money was satisfied the balance of payments would revert back
to zero. Thus a negative relationship between
6R and 6D is consistent with either of the in-

terpretations presented above.
Table 3 indicates that for the period 19661
to 19731V, the change in the domestic component of the monetary base of eleven industrial
countries was very significantly and negatively
related to the movement in their foreign component. The overall goodness of fit in these
simple regressions is generally very good, in
most cases explaining over 70 percent of the
variation in the change in the domestic component of the eleven foreign monetary bases. In
several cases also, the coefficients on the change
in the foreign-asset portion of the respective
monetary bases are very close to unity. This
gives the optimistic impression, if we take these
regressions at face value, that foreign monetary
authorities were able, within a quarter, to offset
a very substantial portion of the change in their
monetary bases induced by balance-of-payments movements. However if we reverse the
relationship, explaining the change in the foreign component, we obtain very similar results, indicating that changes in the domestic
component of the base give rise to offsetting

Table 4
Dependent Variable

liM (Change in Money Supply)

T-Bill Rate lIU.S. Base

Sample Period 1966-1 - 1973-IV

c

DUM

SPEC

-80.8449
(-4.46)

163.926
(2.51)

102.087
(.623)

141.445
(1.20)

517.711
(3.48)

.0064
(.035)

.5210

2.00

-.1381
(2.76)

.4520
(2.87)

-.3127
(-.835)

-.597
(-2.48)

.7018
(1.78)

-.2195
(-1.23)

.4313

2.04

288.302
(3.86)

378.412
(1.50)

-300.803
(-.728)

511.224
(1.30)

-889.030
(-2.33)

-.4089
(-2.45)

.4675

2.18

-.4410
(-1.74)

2.6359
(2.75)

1.4270
(.494)

-3.3346
(-2.01)

.8345
(.538)

-.4174
(-2.52)

.2035

2.06

Japan

-554.445
(-2.17)

118.114
(.566)

-4705.2
(-11.029)

213.613
(.580)

3875.15
(2.63)

.5671
(3.77)

.8624

1.78

France**

(-.58895)
(-1.18)

3.2251
(2.15)

8.7882
(2.13)

4.6724
(1.30)

4.5642
(.987)

.00437
(.024)

.2721

1.98

Australia

-.02342
(-.783)

.01319
(.300)

-.23557
(-2.66)

.23268
(2.84)

.20845
(1.56)

.1621

.5342

1.85

(.900)

-.15157
(-2.12)

.71778
(3.69)

-1.1637
(-2.52)

-1.1910
(-3.75)

.66528
(1.40)

-.2277
(-1.28)

.5398

1.85

-.009529
(-4.52)

.096892
(1.17)

-.43853
(-2.67)

.11949
(.736)

.27643
(1.42)

-.5332
(-3.45)

.2998

2.13

Norway**

.03212
(1.19)

.24352
(2.83)

.5515
(2.56)

1135
(-.453)

-.4110
(-2.47)

.3875

2.46

Denmark**

-.00904
(-.088)

.6601
(2.04)

.01617
(.020)

.07305
(.077)

-.2836
(-1.62)

.0560

1.97

Country

U.K.

Canada
Italy
Germany

Netherlands
Sweden

**Interest rates

=

3-mo. Euro. dollar rate.

()

D.W.

movements in the foreign component. Thus,
we cannot infer to what extent central banks
were successful in offsetting foreign-exchange
flows by simply observing the high correlation
between the domestic and foreign components
of the monetary base. We need additional information to determine the direction of causality.

variables. 1 The change in the U.S. monetary
base is statistically significant in the majority of
cases. U.S. monetary base changes should not
be consistently significant for nations which were
successful in repelling dollar inflows throughout
this period, a period in which there was a sharp
upward increase in the trend rate of growth in
the U.S. monetary base.
Our results suggest that changes in the U.S.
monetary base significantly influenced the money supplies of most major industrial countries except Japan. If the equations in Table 4 are
appended to include changes in foreign as well
as U.S. monetary bases, the U.S. base still remains significant. In several cases-the U.K.,
Canada, and France in particular-the foreign
country's monetary base fails to be significantly
significant (Table 5). These results would indicate that foreign countries were less than completely successful in sterilizing the foreign influence on their monetary bases and money
supplies.

If foreign central banks during the 1966-73
period were indeed capable of sterilizing foreign-exchange influences on their monetary
bases, we should not expect changes in the
monetary base of the United States, the country
to which other countries pegged their exchange
rate for much of the sample period, to strongly
influence those foreign money supplies. Yet
this is not the case. Table 4 relates the change
in the money supplies of eleven industrial countries to their own short-term interest rate; the
change in the U.S. monetary base (measured in
U.S. dollars), a constant and several dummy
Dependent Variable
Country

6Base

Table 5
6M (change in money supply)
Sample Period 1966-1 - 1973-IV
6U.S.*
rT.BILLS
Q
Base
DUM
SPEC
c
=

D.W.

.0854
(.28)

-84.43
(3.56)

155.12
(2.04)

141.263
(.63)

130.941
(1.07)

543.992
(2.85)

-.019
(-.107)

.5023

2.01

Canada

1.0794
(1.43)

-.1307
(2.84)

.3618
(2.16)

-.0371
(.09)

-.6314
(2.83)

.6237
(1.71)

-.336
(-1.95)

.4468

2.13

Italy

1.5611
(4.02)

188.966
(3.12)

317.959 -487.583
(1.56)
(1.68)

377.916
(1.28)

-722.835
(2.53)

-.521
(-3.35)

.6641

2.17

Germany

.3944
(3.15)

-.3896
(1.88)

2.0224
(.83)

-4.00
(2.91)

1.0712
(.84)

-.506
(-3.21)

.4083

2.32

Japan

1.0119 -453.401
(1.89)
(1.99)

123.333 -475377
(.61)
(11.35)

94.4863
(.26)

3014.66
(2.20)

.429
(2.60)

.8728

1.78

U.K.

1.6937
(2.00)

France**

-.10863
(-.763)

-.63288
(-1.13)

2.9810
(1.84)

10.294
(2.45)

4.8985
(1.26)

5.3583
(1.04)

1229
(.678)

.2544

2.03

Australia

.5351
(3.20)

-.0196
(.85)

.0058

-.2103
(2.67)

.1829
(2.69)

.1579
(1.57)

-.057
(-.312)

.6509

2.04

(. i7)

.7161
(6.10)

-.1124
( 1.98)

.6402
(4.39)

-.9163
(2.62)

-I. 1661

.4525
(1.24)

.051
(.277)

.8034

1.99

(4.69)

Sweden

.60767
(2.03)

.003736
(.183)

.03947
(.485)

-.53809
(-3.41)

.07778
(.513)

.14435
(.758)

-.5783
(-3.88)

.3759

2.25

Norway**

.3976
(1.68)

.07349
(2.94)

.4218
(3.88)

-.2552
(-1.35)

-.6275
(-2.49)

-.038
(-2.28)

.321 I

2.23

.7267
(1.19)

.2805
(.337)

-.041
(-2.48)

.0839

2.16

Netherlands

Denmark**

.2635 -.01434
.4568
(.71 I)
(-.174)
( 1.29)
*U.S. Base measured in U.S. dollars.
**r = 3-mo. Euro-dollar rate.
SPEC = dummy variable for periods 1972IY-197311.

45

It should not be surprising to find that changes
in the U.S. monetary base were significant in
explaining changes in foreign money supplies.
Given the commitment by most nations to a system of fixed exchange rates, and given the continual rise in the rate of growth of the U.S.
monetary base (from 2.0 percent in 1959-62 to
8.1 percent in 1973) it was not simply chance
that most industrial nations experienced rapid
increases in the rates of growth of their money
supplies. The evidence seems to indicate that
while these nations in the short run could sterilize some of the undesired increase in the monetary base induced via the balance of payments,
they could not achieve long-run sterilization.
Academic opinion also shifted during this period, bringing on a revival of primarily monetary
interpretations of balance-of-payments phenomena. To that subject we now turn.

through which equilibrium in the money market is restored. What then determines whether
a country will have an excess demand or excess
supply of money?
The functional components of the monetary
base demand and supply determine the balance
of payments and, simultaneously, the existence
of excess demand or supply in the money market. Note that when we refer to "money" here
we are referring to the monetary base. However,
since money used by the public-say, demand
deposits plus currency-is institutionally linked
to the monetary base, our analysis implicitly
concerns the excess demand and supply of money in the hands of the public.
Table 6
Dependent Variable = log (Monetary Base)
Sample Period = 1966-1 - 1973-IV

Money and the balance of payments

log Y

In its most rudimentary form, a monetary interpretation of the balance of payments requires
a money demand equation, a money supply
equation, an equation positing the equality of
money demand and money supply (that is,
money market equilibrium) and lastly, an equation defining the balance of payments as the
change in the foreign asset component of the
monetary base. The balance of payments,
either through the flow of goods or the flow of
capital, augments or diminishes the stock of
foreign-exchange reserves of a nation, and hence
the nation's monetary base. In equilibrium the
demand for money must equal the supply, thus
the balance of payments must also be zero. If
the balance of payments is in surplus there must
be excess demand for money; if it is in deficit,
there is an excess supply of money. The balance
of payments is the mechanism through which
equality of money demand and supply is
achieved.
The thing to be emphasized in this interpretation is that a non-zero balance of payments is a
disequilibrium phenomenon. Variations in the
balance of payments represent the flood gates

log r

Q

R2

D.W.

------

U.S.

.8409 -.0424 -1.368 .2192 .9907 1.97
(39.1) (-3.00) (-9.44) (1.67)

U.K.

.6692
(9.78)

Canada

1.0625 -.0443 -3.0014 .8548 .9937 2.03
(12.0) (-1.87) (-7.38) (9.02)

Italy

.2063 -.0441 7.6100 .9662 .9937 1.90
(3.16) (-1.04) (9.94) (20.5)

Germany

1.3358 -.01758 -4.5014 .7901 .9793 2.31
(8.33) (-.348) (-4.38) (7.06)

Japan

1.2418 .09842 -7.1474 .8155 .9975 2.25
(2l.5) (1.34) (-9.48) (7.72)

France

-.1085
(-.784)

Australia

1.0918 -.0544 -2.6408 .8136 .9902 1.84
(11.4) (-.874) (-8.60) (7.66)

.1880
(4.54)

.5616 .6270 .9628 1.88
(.749) (4.41)

.1135 ,. 5.7253 .9740 .9503 2.00
(1.95) (5.22) (23.5)

Netherlands .4864 -.0690
( 17.3) (-4.55)

.1567 .3483 .9625 2.03
(1.15) (2.03)

Swedent

.7898-.04780-1.4830 .4014 .9766 1.73
(17.7) (-2.22) (-6.87) (2.06)

Norway

.7592 -.0569":....00550 .2550 .9683 1.94
(21.9) (-2.39) (-.056) (1.41)

Denmark

.1636 .09161 * 1.0352 .8065 .7677 1.84
(.807) (I. 10) (1.06) (7.47)

tFor period 1966.1-1971.4
*3-mo. Euro-dollar rate

46

c

r
y

domestic short-term interest rate
aggregate output (GNP or GOP)

Base money demand can be simply stated as
a function of aggregate income and some summary measure of interest rates. Base money supply is composed of a domestic credit component
which is determined by the central bank, and a
foreign asset component for the non-reserve center country. The domestic component of the

in domestic interest rates and a rise in income
generating a capital outflow and a trade deficit.
The consequent decrease in international reserves will then offset the increase of domestic
credit on the monetary base. When, after some
period of time, equilibrium is restored to the
money market, it will have been achieved

monetary base may be thought of as the variable

through the avenue of the balance of payments.

the monetary authorities control in order to influence domestic credit market conditions and
the public's holdings of money. The primary
means by which the monetary authorities control this domestic component vary from country
to country, some using discount-rate policy,
others open market operations or reserve requirements.
Consider an example where we begin with the
equality of base money demand and supply. The
balance of payments is zero. (Recall that we
are assuming a world with imperfectly flexible
exchange rates.) The central bank, desiring to
achieve some income or interest rate or even balance-of-payments objective (the objective is of
little significance), increases the domestic component of the monetary base. There now exists
an excess supply of base money. The increase
in base money, operating through central-bank
domestic credit operations, will result in a fall

Indeed, the decline in the country's reserve holdings would be exactly equal to the conscious increase in the domestic component of the monetary base.
Ultimately, then, the money supply of the
country under consideration does not change.
However, what does increase is the world money
stock, for now other countries hold the reserves
that were lost by the domestic-credit-expanding
nation. 2 A non-reserve center country can determine the composition of its monetary base,
but its total monetary base and money supply
are determined by their interactions with other
countries-thus, its money supply becomes an
endogenous variable, rather than a variable determined by the nation's own monetary authorities. 3
Monetary base demand

As we normally think of an aggregate demand
for money by the public as a function of income,
interest rates and other explanatory variables,
we can similarly conceive of a demand for monetary base. The demand for monetary base
money can be thought of as a "derived demand,"
in the sense that it derives from the demand for
money held by the public. This derived demand
for monetary base also relates to the stability
of the multiplier connecting the monetary
base to the money supply used by the public,
this multiplier capturing a large number of money and reserve preferences of the public and the
banking system.
The statistical validity of the monetary theory
of the balance of payments depends crucially
on the stability of its underlying behavioral equations-in its most rudimentary form, the demand
and supply functions for monetary base. We
will consider here only the demand for monetary

Table 7
Tests of Stability Of Regression Coefficients
for Monetary Base Demand Equations·
Country
U.S.

U.K.
Canada
Italy
Germany
Japan
France
Netherlands
Sweden
Norway
Denmark
Australia

F-statistic
2.48
2.96
7.74
3.71
3.34
7.63
4.98
2.66
1.66
0.97
2.28
3.07

*The critical value of the F-statistic at the 99% confidence
level is 4.31 for all except Sweden.
Tests conducted by splitting sample pound in half and testing for statistical changes over the two sub-sample periods.

47

Ih,edlerrwnd for monetary base was spefuncticlfl of th~ level of ~ggregate
most cases,gross dom~~stjlc
in others-and a representative
~hort-term interest rate (r). A log-form demand
~quationwas estimated for eleven countries,
\Vitl1the results appearing in Table 6. The resUlts for Italy, France and Denl1l.ark were poor,
in the sense that the. coefficient on the income
;lBf'mwas either extremely small,statistically insignificant, or both..... However, these fesults
should be. discounted to some extent because we
did not have quarterly GDP data fOf those and
several other countries, so. that quartedy data'
wefe generated by inte~polating from annual n'l';'
gressionsof GDP(jl1retail sales and industdal
production, wl'fighted by prices.
For th~;remaining monetary base demand
equati(l;l.1s, we found that the coefficients on the
.incOme and interest-rate variable were not very
different from those found for demand equations
for money held by the public (demand deposits
and currency). Income elasticities, measured
by the coefficient on the aggregate-output variable, were in most cases between 0.75 and 1.25,
about what would be expected a priori. The
coefficient on the interest fate variable was genefally negative (as expected) but positive and
significant in the cas~ of the U.K. For the majority of cases, the elasticity of base-money demand with fespect to interest rates wa~ felatively
small, a result not atypi~~l of those seen for the
dyPlal1d for money helel by the public.
To test the stability of the Plonetary base demand equations, the sample period was divided
eveplyand separate regressions were estimated
over these subsample periods. The conventional
F-testfor stability of the eqllati9n over the entire
sample period Was performed, as seen in Tabl~
7. Regressions were also run llsing multiplica:
tive and additive dummy variables in addition
to the original.explanatory variables, permitting
us to test shifts in a particular coefficient. These
fegressions (not reported here) show~d
significant differences in the income elasticity of
Illonetary base demand between the periods
1966,.69 and 1970-73 for Canad~, France, Ger,.

and inparticulaf about the
data, the
n~1rti~rlhJ
the hypothesis th~t monetary
tions remained stable over
Monetary.theories of the balall(:~
afe essentially;theories of equilibrium restofatioll between money demand and supply in open
eoonomies. As we have seen, this analysis
hinges cfUcially on the empirical stability of
monetary-base demand. Our analysis thus lends
empirical support to monetary intefpn~tations of
balance-of-payments phenomena.
Conclusion

The monetary theory of the balance of payments has revived interest in explaining balance
of payments phenomena by concentrating on the
means by which equilibrium between demand
and supply for money is achieved under a system of less than pedectly floating exchange
rates. In addition, it has emphasized the relationship between domestic credit creation by a
central bank and the simultaneous creation of
world" money-those international resefves the
domesticcfedit expanding country loses which
are absorbed by the rest of the world. This paper
concludes that there is some statistical evidence
to support such interpfetations.
FOOTNOTES
The' dummy variable SPEC is unity for the period
1972.4-1973.2. The dummy variable DUM is different for
different countries; for example, it is unity for the period
of the French civil turmoil in 1968.2.
2. As Michael Keranhas shown in his article, the world
stock of forei~n exchange reserves, one measure of a.world
mgnllY'stock, contributed significantly to the increase in
world prices in the last several years.
3. This poi~t is dllv;eloped in thll companion article. by
Edward S. Shaw.
4. Tn most cases monetary-base data were obtained from
the}MF'SlIltlfrnational Financial Statistics, and were sea. ~on~nYadjustlldusing thllCensus X-ll program.

48