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FEDERAL RESERVE BANK OF DALLAS
FOURTH QUARTER 1995
Sources of Money Instability
john V. Duca
Argentina, Mexico, and Currency
Boards: Another Case of Rules
Versus Discretion
Carws E. larazaga
Should Bank Reserves
Earn Interest?
Scott Freeman andjoseph H. Hastag
This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)
Economic Review
Federal Reserve Bank of Dallas
Robert D. McTeer, Jr.
President and Chief Executive Otlicer
Tony J. Salvaggio
First Vice Presidenf and Chiaf ppernting onicer
Harvey Rosenblum
senior Vice President and Direclor of Research
w. Michael COl
Vice President and Economic Advisor
Stephen P. A. Brown
Assistaot VICe President and senior Economist
Research Officers
John Duca
Robert W. Gilmer
William C Gruben
Evan F. Koenig
Economists
Kenneth M. Emery
Beverly J. Fox
David M Gould
Joseph H Haslag
D'Ann M Petersen
Keith R. Phillips
Stephen D Prowse
Fiona D. Sigalla
Lori l. Taylor
Lucinda Vargas
Mark A. Wynne
Mine K. YUcel
Carlos E larazaga
Research Associates
Professor Nathan S. Balke
S<iutt1ern MethOOisl University
Professor Thomas B Fomby
Southem MeItlodist University
Professor Gregory W Huffman
Southern Methodist UniV1lrsity
Professor Finn E. Kydland
Unive<sity of Texas at Austin
professor Roy J. Ruffin
University of Houston
Editors
Stephen P.A. Brown
Evan F. Koenig
Managing Editor
Rhonda Harris
Copy Editor
Monica Reeves
Graphic Design
Gene Autry,
Laura J. Bell
The ECDfIomic Review is published by the Federal
Reserve Bank of Dallas. The views expressed are those
of the authors and do not necessarily reflect the positions of the Federal Reserve Bank of Dallas or the
Federal Reserve System
Subscriptions are available free of charge. Please
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Contents
Sources of
Money Instability
John V. Duca
Page 2
Argentina, Mexico, and
Currency Boards:
Another Case of Rules
Versus Discretion
Carlos E. Zarazaga
Page 14
Should Bank Reserves
Earn Interest?
Scott Freeman and Joseph H. Haslag
Page 25
This article by John Duca discusses how shifts in technclogy,
transactions, and asset preferences can weaken the relationships
between monetary aggregates, the opportunity cost of money, and
nominal output. Observed shifts in these general relationships are
shown to be consistent with plausible changes in technology and
preferences. Evidence indicates that technological advances have
reduced the costs of shifting across assets and have lowered the
precautionary need to hold monetary assets as a means of conducting transactions. Aside from technological changes, demographic
and employment shifts have boosted the role of households in
directing investments earmarked for funding their retirement and
may have thereby increased their tolerance for investment risk. In
turn, these factors may have induced households to shift their
portfolios from monetary assets toward riskier assets with higher
expected long-run yields.
This article discusses currency boards in light of the recent
economic experiences of Mexico and Argentina. Carlos Zarazaga
argues that currency boards do not solve the important time inconsistency problem pointed out in the rules-versus-discretion literature. Because of this failure, even the quasi-currency board established
by law (the so-called convertibility law) did not protect Argentina
from one of its most severe financial crises in modern times.
In addition, there is the normative issue of whether an ironclad rule such as a currency board rule is superior to a noncontingent
one. Zarazaga argues that is not the case, except perhaps when the
distinction between these two kinds of rules has become blurred in
countries with poor reputations for following policy commitments.
In such circumstances, ironclad rules theoretically might be desirable, although this conjecture has yet to be proved formally and
verified empirically. Zarazaga argues that the study of the recent
economic experiences of Mexico and Argentina could be useful for
addressing both issues.
This article examines the effects and desirability of paying
interest on required reserves. Scott Freeman and Joseph Haslag
demonstrate that a policy of paying interest on reserves can make
everyone better off, even if the interest must be financed by a tax on
capital. An essential part of this policy is an open market operation
that offsets any changes in the value of money.
During the early post–World War II era, the
relationship between money and nominal output was stable, which encouraged many analysts
to use money as an economic indicator. This
reliance can be discussed using the equation of
exchange:
Sources of
Money Instability
John V. Duca
Research Officer
Federal Reserve Bank of Dallas
R
(1)
M × V = P × T,
where M = money, V = velocity [nominal gross
domestic product (GDP)/M ], P = the price level,
and T = transactions (usually measured by inflation-adjusted GDP). Money holdings typically
fall as the spread between a riskless short-term
market interest rate and the average yield on
monetary assets rises. As a result, the velocity of
money rises as this spread, or opportunity cost
of money, increases. If velocity is predictable,
then money and its predicted velocity can be
used to infer nominal GDP (P × Y ). Under these
conditions, money is a useful indicator because
data on GDP are available after a long lag,
whereas information on money and interest rates
is more timely.
Among active researchers, confidence in
the M1 monetary aggregate (currency plus
checking deposits) peaked with the publication
of a money demand study by Goldfeld (1973).
This study found that M1 reflected movements
in nominal GDP and, to a smaller extent, changes
in the three-month Treasury bill rate. These
results implied that nominal GDP growth roughly
equaled M1 growth, with a small adjustment for
interest rates. Shortly after that study was published, M1 grew unusually slowly relative to
nominal GDP, giving rise to Goldfeld’s (1976)
“case of the missing money.”
In the early 1980s, the interest sensitivity of
M1 jumped as financial innovations and deregulation created new deposits that combined
savings and transactions features (see Hetzel and
Mehra 1989) and helped firms avoid holding
non-interest-bearing demand deposits (see Tinsley, Garrett, and Friar 1981). Partly as a result,
attention shifted to M2, a less interest-sensitive
and broader aggregate that was created in 1980
(see Simpson 1980). M2 was defined to include
money market mutual funds (MMMFs) and overnight instruments, which became important in
the late 1970s, and was redefined in 1982
to include money market deposit accounts
(MMDAs). M2 had a reasonably stable relationship with interest rate spreads and nominal GDP
during the 1980s (see Moore, Porter, and Small
1990 and Small and Porter 1989). However, this
relationship broke down in the 1990s as M2
became more sensitive to long-term interest rates
ecent studies generally conclude
that the link between nominal
output, interest rates, and
conventional definitions of broad
money has weakened or shifted.
By reviewing the recent literature
in the context of a microtheoretic
model of money, this article attempts
to shed light on why these
relationships have changed.
2
(see Duca 1995, Feinman and Porter 1992, and
Koenig 1995a) and as households shifted toward
bond and stock mutual funds (see Collins and
Edwards 1994; Duca 1995, 1994a, 1994b; and
Orphanides, Reid, and Small 1994) and toward
direct holdings of Treasury securities (see Feinman and Porter 1992).
These breakdowns in the link between
money and nominal output have spurred efforts
to redefine money (for example, Collins and
Edwards 1994, Duca 1995, and Hess and Morris
1995) or revise money models to account for
changing behavior (for example, Koenig 1995a).
Understanding why the money–income relationship has shifted is critical to finding new
ways of deriving useful information from money
and is the subject of this article.
The next section presents a simple theoretical model to illustrate three sources of change
in the link between money and nominal output, followed by a section presenting evidence
on shifts in this relationship. The subsequent
three sections then review evidence on each
potential source of money instability. The conclusion speculates on how likely changes in
financial practices will affect money demand in
coming years.
accounts or from bonds. Milbourne assumes
that rd < rs < rb (or more liquid assets yield lower
pecuniary returns) and that the fixed cost of
transferring funds from bonds into transactions
accounts (β) is greater than that of shifting
funds from savings to transactions accounts (α).
Owing to the latter assumption, Milbourne’s
model implies that households will hold a portfolio of all three financial assets and that transactions deposits (D), small time deposits (S ),
and total M2 deposits (M2 ≡ S + D) equal
D = (4/3) 2 /3 σ 2 /3 (α/[rb – rd ]) 1/3,
(3)
S = (4/3) 2 /3 σ 2 /3 (β/[rb – rs ]) 1/3, and
(4)
M2 = (4/3) 2 /3 σ 2 /3 [(α/[rb – rd ]) 1/3
+ (β/[rb – rs ]) 1/3 ],
respectively. Milbourne shows that with rb > rs,
a rise in the cost of transferring funds from
bonds to transactions accounts will, by making
bonds more costly to hold, cause money balances to rise (∂log(M2)/∂log(β) > 0), which
implies that a fall in β will lead to slower M2
growth.
This model can be modified in two ways to
make it more relevant. First, note that, by definition, the standard deviation (volatility) of net cash
flow (σ) rises with the average or expected level
of transactions:
How the relationship of nominal GDP,
interest rate spreads, and money can shift
In the early 1990s, households increasingly
viewed nonmonetary assets as more attractive
than M2 deposits for a given spread between
expected yields on nonmonetary and monetary
assets. As a result, conventional econometric
models that use income and yield spreads to
account for movements in money generally
overpredicted M2 growth in that period, giving
rise to “the case of missing M2.” Theoretical
models of money imply that the breakdown of
such econometric models likely stems from
their failure to control for other factors affecting
money holdings. With respect to M2, these
factors can be illustrated using a modified version
of Milbourne’s (1986) model of financial innovation and liquid assets.
Milbourne’s framework is a modified Miller–
Orr model (Miller and Orr 1966) in which households face uncertain net cash flows in a world
with three financial assets: transactions accounts
yielding a return of rd , bank savings accounts
yielding rs , and bonds —which have virtually
no credit risk—yielding rb .1 Changes in net cash
flow are stochastic, with a mean of 0 and a
variance of σ 2. Whenever transactions balances
hit zero, funds are transferred at a fixed cost
into transactions accounts from either savings
FEDERAL RESERVE BANK OF DALLAS
(2)
(5)
σ = γT,
where γ is the coefficient of variation. Equation
5 reflects that as the average levels of cash inflow
and outflow rise with transactions in magnitude, so will the magnitude of the expected
volatility (standard deviation) of net cash flow.
To show a link with output (Y ), assume that
transactions are typically proportionate to output
with some temporary deviations:
(6)
T = Y (1 + ),
where has a mean of zero and a variance of
var.
The second major change is to treat bonds
and equity as the alternative asset to D and S.
Because bonds and equity carry price risk, replace rb with a risk-adjusted expected return on
bonds and equity (rq ):
(7)
rq = E (rb ) – bvarrb ,
where the parameter b is the risk adjustment
factor and varrb is the variance of returns on
3
ECONOMIC REVIEW FOURTH QUARTER 1995
stocks and bonds. The additive adjustment in
equation 7 is consistent not only with the quadratic utility function used by Tobin (1958), which
exhibits increasing risk aversion in wealth, but
also with utility functions that are characterized
by constant relative risk aversion, which is more
consistent with empirical research (for example,
Friend and Blume 1975) and with the common
perception that risk aversion tends not to increase as wealth levels rise. As households become more risk averse, b rises in magnitude.
Substituting equations 5 –7 into equation 4
yields
Omitted Variable Bias
According to the model presented in the article, the elasticity of transactions
deposits with respect to their opportunity cost is constant (–1/3), as is the elasticity of
small time deposits with respect to their opportunity costs.1 However, the elasticity of
M2 with respect to the opportunity cost of transactions deposits should be smaller in
magnitude as the cost of transferring funds from small time deposits to transactions
deposits (α) falls. In addition, a decline in the cost of transferring funds from
nonmonetary assets to transactions deposits (β) will lead to a decline in the size of
the elasticity of M2 with respect to the opportunity cost of small time deposits.2
The intuition for the first result is that as the cost of transferring funds between
small time and transactions deposits falls, the transactions share of M2 falls. As a
result, a given percentage increase in the opportunity cost of transactions accounts
has a smaller impact on overall M2, even though it has the same percentage effect
on transactions accounts. The same logic extends to the impact of a decline in β on
the elasticity of M2 with respect to the opportunity cost of small time deposits. If both
costs fall, the net effect on both elasticities is, a priori, ambiguous. Only if technological change is balanced, in the sense that the percentage changes in α and β are
equal (that is, ∆α /α = ∆β/β), will the net change in each elasticity be zero.3
However, because econometric models do not, as of yet, have good time
series measures of α, β, and b, a decline in one of these parameters will, over time,
boost the estimated sensitivity of M2 to the spread between returns on nonmonetary
assets and money.4 Since most conventional models constrain the income elasticity
of money to be constant when the models are estimated, the models will try to
account for the negative impact of recent declines in transfer costs and risk aversion
by boosting the size of the estimated negative coefficients on interest rate spreads.
As a result of constraining the income coefficients to be constant over time, M2 will
likely appear more sensitive to opportunity cost spreads in these models as samples
are extended into the early 1990s, while this omitted variable bias is less of a problem
for an aggregate that adds bond and equity funds to M2. In addition, because the
yield curve was steep in the early 1990s, a wide spread between long-term interest
rates and the average rate on M2 deposits (which tend to have short-term maturities)
will be correlated with omitted data on declining transfer costs (and/or declining risk
aversion). As a result, omitted variable bias will likely result in a rise in the observed
sensitivity of M2 to long-term opportunity cost measures as samples are extended
into the early 1990s.
1
2
[
∆ ∂M 2 / ∂c
[
d
][c
∆ ∂M 2 / ∂c
4
s
d
]
/ M2 =
(1/ 9)α β [c ] [c ]
{α1/ 3 (c s )1/ 3 + β1/ 3 (c d )1/ 3}2
][c / M2] =
s
1/ 3
s 1/ 3
d 1/ 3
(1/ 9)α1/ 3 β1/ 3 [c s ]1/ 3 [c d ] 1/ 3
{α1/ 3 (c s )1/ 3 + β1/ 3 (c d )1/ 3 }2
M2 = (4/3) 2 /3 [γY + γY ]2/3
[(α/[E (rb ) – bvarrb – rd ]) 1/3
+ (β/[E (rb ) – bvarrb – rs ]) 1/3 ].
Rearranging equation 8 produces
(9)
Y 2 /3/M2 = (4/3) –2 /3 [γ (1 + )] –2 /3
{(α/[E (rb ) – bvarrb – rd ]) 1/3
+ (β/[E (rb ) – bvarrb – rs ]) 1/3 }–1,
which has several empirical implications about
velocity (Y/M ).
Most econometric models implicitly treat
interest rate spreads as having a constant effect on
velocity over time. Equation 9 implies that velocity may deviate from what these models predict
for three reasons:
1. Deviations of output from transactions
() will introduce noise into the relationship between money and output.
2. Declines in the costs of transferring funds
from nonmonetary assets to transactable
assets (β) and from nonmonetary assets
to nontransactions M2 accounts (α) will
raise the velocity of M2.2
3. An increase in household tolerance for
risk (that is, a decline in b) will lead to a
rise in the velocity of money.3
The opportunity cost of transactions deposits in this model is the risk-adjusted spread between
the expected return on securities (stocks and bonds) and the transactions deposit rate, while
the opportunity cost of small time deposits is the risk-adjusted spread between the expected
return on securities and the small time deposit rate.
Denoting the opportunity costs of transactions and small time accounts by c d and c s, respectively, the opportunity cost elasticities of M2 simplify to
1/ 3
3
(8)
In addition to these effects, another empirical
implication arises.
4. Because econometric models do not
have good time series measures of α, β,
and b, a decline in any one of these
parameters will (a) likely boost the
estimated sensitivity of M2 to opportunity cost spreads as samples are extended into the 1990s and (b) affect the
estimated sensitivity of M2 plus bond
and/or equity mutual funds to a smaller
extent because these expanded aggregates internalize most of the shifts between M2 and non-M2 that arise from
changes in these parameters. (See the
box entitled “Omitted Variable Bias.”)
−∆α ∆β
, and
+
α
β
∆α ∆β
.
+
α
β
Balanced technological change does not affect the transactions and nontransactions shares of
M2. Since the opportunity cost elasticities of transactions and nontransactions deposits are
constants, the constant shares imply that the opportunity cost elasticities of M2 are also
unchanged.
The same is true for estimates of the elasticity of transactions deposits with respect to the
opportunity cost of transactions deposits and of the elasticity of small time deposits with respect
to their opportunity cost.
4
The impact of financial churning, or volatility, falls under the first category. The second
implication covers technological advances that
lower α or β, such as declines in the costs of
using mutual funds, the spread of automatic teller
machines, improvements in services offered by
mutual funds, and greater ease in purchasing
Treasury securities. The third empirical implication reflects not only changes in risk aversion
stemming from demographic and preference
shifts, but also improvements in nonmonetary
assets that make it easier for households to
obtain a well-diversified portfolio and a greater
awareness of alternative investments that makes
households more willing to hold non-M2 assets.
In practice, the fourth implication appears as
omitted variable bias that leads to parameter
instability in conventional money-demand functions.
Evidence on this instability is presented in
the next section, partly as a means of showing
why monetary economists are concerned about
issues regarding financial technology, preferences,
and volatility. Then, the subsequent sections
review evidence on how technological changes,
shifts in preferences and demographics, and volatility in financial transactions have affected the
demand for money in ways not captured by
conventional models.
have found that adding bond and/or stock mutual
fund assets to M2 yields an aggregate that has
outperformed M2 in predicting either inflation
(for example, Becsi and Duca 1994, Duca 1994a,
and Koenig 1995b) or nominal GDP (for example, Darin and Hetzel 1994 and Duca 1994b)
in the 1990s.5 Furthermore, these studies find
that coefficients on the long-run relationships
between an M2-type aggregate and either prices
or nominal output change relatively less for the
expanded M2 aggregates as samples are extended into the 1990s. From a monetarist perspective, this is an important finding because if
velocity is stable in the long run, then monetary
aggregates should provide information about
medium- to long-run inflationary pressures.6
The second type of evidence is that as
samples are extended into the 1990s, the impact
of asset yields (especially long-term interest rates)
varies less in models of money (see Duca 1995
and Koenig 1995a), inflation (see Becsi and Duca
1994, Duca 1994a, and Koenig 1995b), and nominal output (see Duca 1994b) when an expanded
M2-type aggregate replaces M2.7 These findings
are consistent with the view that adding bond and
stock funds to M2 reduces the omitted variable
bias that arises from a lack of data on financial
technology and preferences.
The third kind of evidence is cross-section
data that confirm a recent shift away from certificates of deposit (CDs) toward bond and equity
fund assets (see Kennickell and Starr-McCluer
1994). In particular, during the period 1989–92,
when M2 growth was unusually weak, the share
of households having nonmoney (mainly bond
and equity) mutual fund assets rose from 7.1 to
11.2 percent, whereas the share owning CDs
(small and large time deposits) fell from 19.4 to
16.6 percent. Furthermore, over this period, the
median value of nonmoney mutual fund assets
rose from $11,200 to $18,000 among households
having such assets, while the median value of CDs
rose by a much smaller magnitude—from $12,600
to $13,500 —among households owning CDs.
While all three types of findings are consistent with the view that models using M2 suffer
from omitted variable bias, they do not provide
evidence on the actual sources of that bias. The
next three sections provide some evidence on
these sources.
Evidence suggestive of omitted variable bias
If substantial shifts in monetary technology
and preferences have occurred, then we can
observe two types of results from econometric
models that do not contain good time series
measures of transfer costs and risk adjustments to
nonmonetary asset returns. First, expanding M2
to include some of these nonmonetary assets
could yield an aggregate that would better predict
inflation and nominal output in the 1990s and
would have a more stable long-run relationship to
those variables in money models than would the
current definition of M2.4 For this to occur, the
advantage of internalizing time-varying substitution between M2 and such assets needs to
outweigh any extra volatility that arises because
the value of the added non-M2 assets fluctuates
(that is, most of these non-M2 assets have price
risk, unlike M2 components). If this condition
holds, then a second type of result arises: the
impact of asset returns in models of M2-like
aggregates, inflation, and nominal output should
vary less over time when a broader version of M2
replaces the current definition of M2 either as a
dependent or independent variable.
Three types of evidence are consistent with
these implications. First, econometric studies
FEDERAL RESERVE BANK OF DALLAS
Technology and shifts toward
nonmonetary assets
Since the early 1980s, the attractiveness of
nonmonetary assets has likely increased because
of two types of technological change: declining
costs of transferring funds from nonmonetary
5
ECONOMIC REVIEW FOURTH QUARTER 1995
assets to transactions deposits and the rising use
of financial services from nonasset products.
Lower asset transfer costs. As shown above,
a decrease in the cost of shifting funds from
savings deposits to transactions accounts (α)
and from nonmonetary assets to transactions
accounts (β) should reduce the transactions and
precautionary demands for money. There are
several indications that such costs have fallen.
With respect to mutual funds, Orphanides, Reid,
and Small (1994) cite evidence that load (commission) fees have fallen sharply over the past
two decades. Furthermore, many mutual funds
provide customers with a number of free transfers among funds in asset management accounts
(see Donoghue Organization 1987) that offer a
host of investments, including bonds, equities,
and commodities, and allow low- or no-cost
shifts among investments within mutual fund
families that typically include a checkable money
market fund. In addition, many banks now offer
mutual funds and have introduced integrated
customer management of their mutual fund and
bank deposit balances. Additionally, the Federal
Reserve has made it easier for households to
purchase Treasury securities directly, a change
that, coupled with interest rate movements, may
have spurred shifts from M2 into Treasury securities, as documented by Feinman and Porter
(1992).
More generally, the spread of better information technology is lowering transfer costs, with
respect to both domestic and foreign assets (see
the box entitled “Globalization”). In particular,
the rise of electronic banking (especially using
personal computers at home or in the office)
poses potentially large reductions in the pecuniary and convenience costs of making such
transfers. (For recent evidence, see Holland and
Cortese 1995 and Lewis 1995.) Unfortunately,
there is no continuous time series of data on
asset transfer costs. Nevertheless, the limited
evidence is consistent with the fact that most of
the unusual weakness in M2 during the 1990s
has been concentrated in small time deposits
(which compete with stocks and bonds) and
money market mutual funds (which experienced
outflows when stock and bond yields rose relative to short-term money market rates in the
early 1990s).
Financial services from nonassets. Since the
1960s, firms and households have increasingly
used new nonasset instruments and cash management techniques to reduce the average level
of liquid funds held to meet unexpected cash
outflows. In practice, these instruments enable
firms and households to better coordinate cash
inflow with cash outflow and to reduce check
usage by consolidating many purchases into
fewer check payments. Within the context of the
Milbourne model, these instruments can be interpreted as reducing the volatility of net cash flow
(γ) and thereby lowering the demand for money.
In the 1970s and 1980s, technological advances and high interest rates induced firms to
seek alternatives to using non-interest-bearing
demand deposits to meet their transactions
needs.8 Sophisticated cash management techniques enabled firms to better forecast cash
needs and to more readily tap nonmonetary
liquid assets to meet unexpected shortfalls in cash
flow. (For evidence, see Mahoney 1988 and
Porter, Simpson, and Mauskopf 1980, and for
more references, Judd and Scadding 1982.) In
particular, technological advances spurred many
firms to use wire or electronic transfers to minimize transactions balances (see Dotsey 1984 and
Flannery and Jaffee 1973).
Although there has been much research on
how off-balance-sheet innovations affect the
money balances of firms, their effects on household balances have been relatively ignored, even
though household transactions balances are
larger than those of firms. This lack of research
partly reflects that financial innovations spread
to households a bit later (in the 1980s and 1990s),
after enhancements to computer software whittled
down the economies of scale that had made
innovations more cost-effective for firms. By
providing off-balance-sheet liquidity, the rapid
spread of credit cards and credit lines may have
enabled households to shift their portfolios away
from liquid assets to other assets9 and may have
encouraged households to shift toward risky
assets by enabling them to tolerate more price
volatility among the assets they hold.
Using cross-section data from 1983, Duca
and Whitesell (1995) find that for every 10-percentage-point rise in the probability of owning a
credit card, checking accounts are 9 percent
smaller, while MMMF plus MMDA balances are
11 percent lower. Although their findings indicate that credit cards significantly affected transactions account levels, they found no statistically
significant effect on overall M2 account balances,
implying that credit cards primarily affected the
composition of M2 in the early 1980s. The impact
of credit cards on transactions balances may be
even larger today because the share of households owning credit cards is higher, credit cards
are more widely accepted, credit card purchases
are more quickly processed, and consumers are
now offered greater cash rebate/airline mile incentives to use credit cards.10
6
Globalization
Shifts between nonmonetary and monetary
assets also involve foreign assets. In terms of the
theoretical model, the costs of transferring from
foreign to M2 transactions assets (the β for foreign
assets) and the risk premium for holding risky
foreign assets (b ) have arguably fallen. Recent
studies generally conclude that financial markets
across countries have become increasingly integrated (see Obstfeld 1994, 1995 and Feldstein and
Bacchetta 1991).1
This has manifested itself during the 1990s
in at least three ways. First, global bond and equity
mutual fund assets have recently grown rapidly
(Figure A ), which may have depressed domestic
money holdings and funded overseas activity.2
Second, financial planners typically recommend
that household portfolios contain some foreign
Figure B
Change in U.S. Banks’ Net Liability
Position with Related Foreign Offices
Billions of dollars
25
20
15
10
5
0
–5
–10
’88
’89
’90
’91
’92
’93
’94
Figure A
International Bond and Equity
Mutual Fund Assets*
offices (Figure B )—to fund strong credit growth
amid weak M3 growth.3,4 However, because this
funding enables banks to avoid raising deposit
rates, it likely restrained M2 and M3 growth in ways
captured by the opportunity cost terms in money
models.
Billions of dollars
250
200
1
150
100
50
2
0
’84
’85
’86
’87
’88
’89
’90
’91
’92
’93
’94
* Household and institutional assets in mutual funds classified by the Investment Companies Institute as having
investment objectives falling under global bond fund,
international, or global equity.
SOURCE: Investment Companies Institute.
3
assets to improve diversification and to expand the
menu of investments having higher expected
yields. Third, an enhanced ability to shift funding
sources has enabled banks to pull in foreign funds
to fund domestic credit growth or use domestic
deposits to fund overseas credit growth. In 1993
and 1994, banks pulled in funds from overseas
offices—by increasing their net liabilities to foreign
4
Another important innovation is the spread
of automatic teller machines (ATMs), which reduce the need to carry precautionary currency
balances by enabling households to shift
nontransactions M2 deposits into cash or transactions accounts. In terms of the theoretical model,
ATMs plausibly lower α, the cost of transferring
FEDERAL RESERVE BANK OF DALLAS
Obstfeld (1994) finds that marginal rates of substitution
in consumption are converging across countries.
Feldstein and Bacchetta (1991) find a decline over time
in the positive correlation of domestic savings and
investment. Both studies find evidence consistent with
the view that capital is flowing across borders to areas
characterized by relatively higher credit demand.
While much, but not necessarily all, of this rise reflects
substitution between domestic bonds and equity and
foreign bonds and equity, some likely reflects shifts
between domestic transactions deposits and foreign
securities, consistent with a decline in transfer costs and
an apparent decline in the risk premium demanded by
U.S. residents to hold these foreign assets.
This is measured by the net extent to which commercial
banks in the United States are borrowing funds from
related foreign offices. The data plotted are from the
liability category, “net due to related foreign offices,” in
the Federal Reserve’s H.8 data release.
A related, earlier phenomenon was the rise of Eurodollars (offshore dollar-denominated bank deposits) in
the late 1970s and early 1980s (Tinsley, Garrett, and
Friar 1981), which prompted the inclusion of overnight
Eurodollars in M2 and of term Eurodollars in M3.
assets within M2, and should thereby lower
holdings of transactions deposits and total M2
deposits, with a larger effect on transactions
deposits in percentage terms.11 Using crosssection data from the 1984 and 1986 Surveys of
Currency and Transaction Account Usage, Daniels
and Murphy (1994a) find that a 100-percentage-
7
ECONOMIC REVIEW FOURTH QUARTER 1995
point rise in the probability of ATM use increased
the velocity of currency (the dollar volume of
transactions divided by currency) by 40 –45
percent for transactions account holders, while
Daniels and Murphy (1994b) estimate that a
5-percent rise in the proportion of ATM users
(from 41.7 to 43.8 percent) would boost average
transactions account balances by 4.5 percent.
Together, these studies imply that ATMs induced
households to shift from holding cash to holding
transactions account balances in the mid-1980s.
Unfortunately, Daniels and Murphy (1994a, 1994b)
do not estimate the effect of ATMs on currency
plus transactions balances, which corresponds to
transactable funds (D) in the Milbourne model.
Evidence shows that household payments
innovations affected the composition of M2 in
the early to mid-1980s. However, the costs of
shifting from nonmonetary to transactions assets
has fallen since then. Together, lower transfer
costs and greater use of nonmoney payments
media could now be lowering M2, in addition to
altering its composition.12 For example, many
mutual funds offer credit lines and cards with
asset management accounts.
ratio of income to transactions falls. In terms of
the Milbourne model, M2 holdings decline because of a permanent negative shock to that
reduces the demand for money at each combination of income, asset transfer costs, net cash
flow volatility, and opportunity cost spreads
(see equation 8).
While the post-1980 decline in the U.S.
savings rate may contradict the life-cycle theory,14
recent evidence supports its implications for
asset portfolios. With respect to M2, Duca and
Whitesell (1995) find, using cross-section data
from 1983, that M2 holdings —and in particular,
small time deposit and savings balances —are
higher for older age brackets after controlling
for other variables (for example, income and
wealth). Finally, Morgan (1994) finds that the
share of household assets held in the form of
stocks and bonds is positively correlated with the
population share of 35- to 54-year-olds.15
Changing preferences and financial sophistication. One factor that could be making monetary assets less attractive is households’ increased
awareness of investment opportunities in nonmonetary assets and an associated rise in their
willingness to tolerate risk in the assets they
control (that is, b is smaller in the theoretical
model presented earlier in this article).16 Aside
from the technological reasons for this trend
already mentioned, increased uncertainty in
labor markets, changing employment patterns,
and the liberalization of IRA/401K accounts have
resulted in more households having a hand in
managing their retirement assets.17 This, in turn,
has induced households to incur large, predominantly one-time costs to learn more about bond
and equity investments for retirement. In addition, because IRA/Keogh balances count toward
the minimum balance requirements for opening
asset management accounts with many mutual
funds, these retirement funds reduce the effective minimum balance requirement on non-IRA/
Keogh mutual fund assets. Consistent with this,
both IRA/Keogh and non-IRA/Keogh assets with
bond and equity mutual funds rose in the mid1980s, after IRA/Keogh tax laws were eased,
and in the early 1990s (see Duca 1995). Additionally, cross-section data indicate a general shift
in household portfolios toward bond and equity
mutual funds regardless of tax status (see
Kennickell and Starr-McCluer 1994).
These factors are consistent with a recent
study by Blanchard (1993), who found that the
extra return that investors demand from equities
over bonds (the “equity premium” of Mehra and
Prescott 1985) has been trending downward since
the 1940s and abruptly fell in the early 1980s. Five
The possible roles of demographics,
preferences, and learning
Consumer demand theory implies that
changes in attitudes toward risk can affect the
asset allocations of households. Some of these
changes can arise from shifting demographics
and economic factors that lead to increased
financial sophistication or greater tolerance for
investment risk.
Demographics. According to the life-cycle
theory of consumption, households save more in
their peak earning years before retirement. This
theory implies that as the baby-boom generation
reaches middle age, the overall savings rate and
the portfolio share of higher earning nontransactions assets should rise.
In terms of the Milbourne model, these
effects can be accounted for in two possible
ways. First, demographic trends may, by increasing the average need to provide for retirement,
plausibly raise the willingness of households to
invest in risky assets with higher expected longterm yields. In terms of the theoretical framework presented earlier in this article, a lower
average degree of risk aversion is reflected in a
smaller value of the parameter b. This, in turn,
raises the risk-adjusted opportunity cost of
money for a given spread between the return on
nonmonetary assets and money13 and thereby
reduces the demand for money. Alternatively,
as people reach their peak earning years, their
8
factors likely contributed to the decline in the
equity premium: (1) the waning effects of the
1929 stock market crash on risk aversion to stock
price movements; (2) investors’ realization, following the bond market debacle of the 1970s, that
bonds also pose price risk; (3) the rising ownership share of equities held by institutional investors, who are less risk averse and more long-term
oriented than households; (4) lower costs for
equity diversification, as evidenced by the proliferation of diversified, no-load equity funds; and
(5) declining risk aversion among individual investors as they accumulated wealth, gained experience in managing their IRA/Keogh assets, and
saw the stock market recover from temporary
price corrections in October 1987 and October
1989. As a result of a possible decline in risk
aversion, investors may have shifted away from
low-risk money assets toward nonmonetary
assets that pose higher risk. Nevertheless, because the econometric money results presented
earlier could arise for other reasons (for example, technological advances), it is difficult to
verify whether and to what extent a systematic
shift in risk preferences has noticeably affected
money holdings.
Figure 1
Estimated Effect of MBS Refinancings
On Demand Deposit Growth
(Seasonally Adjusted Annual Rate)
Percent
8
6
4
2
0
–2
–4
–6
–8
–10
’84
The impact of financial churning on money
holdings is more transparent when one recalls
that the quantity theory of money implies a
relationship between money and transactions,
rather than between money and output:
V = (P × T )/M = [P × Y × (1 + )]/M.
In practice, many analysts implicitly or explicitly
replace T with the level of production or consumption of goods and services and redefine
velocity accordingly. If the ratio of output to
total transactions is stable or predictable,18 then
this substitution does not result in any significant
errors in predicting near-term nominal GDP.
However, if a monetary aggregate is unusually
affected by volatility in non-output transactions,
then that aggregate may give a false signal about
nominal output. Two recent sources of such
volatility have been mortgage refinancings and
overseas use of currency.
Mortgage refinancings. In practice, volatility
in commercial financial transactions has not
affected the average monthly levels of monetary
aggregates much in the recent past. One major
reason is that economies of scale allow many
firms to use wire or electronic transfers to shift
funds from nonmonetary assets to settlement
funds without having to hold large money bal-
FEDERAL RESERVE BANK OF DALLAS
’86
’87
’88
’89
’90
’91
’92
’93
’94
ances for a noticeable period of time. While many
well-off households similarly manage their mutual fund balances, the way funds are transferred
when households prepay mortgages underlying
mortgage-backed securities (MBSs) has had
large effects on demand deposits, which constitute a large share of M1 and a smaller share of M2.
These prepayment effects arise because the
Government National Mortgage Association
effectively requires MBS servicers to place funds
from unscheduled repayments into demand deposit accounts until the fifteenth of the following
month before they make principal payments to
MBS holders. The Federal National Mortgage
Association (FNMA) requires that prepayments be
put into custodial accounts until the nineteenth of
the following month. While FNMA servicers are
not required to put such funds in demand deposit
accounts, many do. Because the MBS market was
relatively undeveloped until the early to mid1980s, these effects have only occurred during
the mortgage refinancing booms of the mid1980s and early 1990s. Duca (1990) estimates that
swings in MBS prepayments coupled with other,
less important effects accounted for one-third of
the demand deposit errors from a Federal Reserve
econometric model over 1986:1–88:2. Using his
methodology, these effects on demand deposits
were larger in the early 1990s (Figure 1), with
estimated effects ranging from adding 6 percentage points to the annualized growth rate in
fourth-quarter 1992 to subtracting nearly 9 percentage points in second-quarter 1994. Unless
practices change, waves of refinancing activity
will likely distort monthly growth patterns of
Volatility in financial transactions
(10)
’85
SOURCES: Federal Reserve Board; Federal National Mortgage
Association; Government National Mortgage
Association.
9
ECONOMIC REVIEW FOURTH QUARTER 1995
demand deposits and other transactions deposits
(see Anderson 1993).
Foreign use of U.S. currency. Fluctuations in
the share of currency that is held abroad also
distorts growth in narrow measures of money,
such as M1 and the monetary base (currency plus
reserves). According to reports, use of the dollar
has surged in countries suffering from high inflation and political uncertainty. If true, then much
of the recent movement in the currency component of U.S. money measures may reflect foreign,
rather than domestic, nominal economic activity.
holding of non-M2 financial assets. In tandem
with information advances, greater job mobility,
changing employment patterns, and tax incentives are likely to continue bolstering households’ role in managing their retirement assets.
This greater investment role may, in turn, continue to make households more willing to consider investment alternatives to conventionally
defined “money.”
Notes
Conclusion
Recent studies generally conclude that the
link between nominal output, interest rates, and
conventional definitions of broad money has
weakened or shifted. By reviewing the recent
literature in the context of a microtheoretic
model of money, this article attempts to shed light
on why these relationships have changed. Three
basic factors that may have caused this instability are identified: volatility in financial transactions, technological changes affecting expected
transfer costs, and shifts in preferences or demographics that have altered household risk tolerance. In general, while volatility in financial
transactions has had substantial effects on narrow
monetary aggregates (M1 or the monetary base),
it has not been a major source of instability for the
broader aggregates. Most of the recent instability
in M2’s link to nominal GDP does not stem from
temporary financial churning or excessive shortterm volatility but, rather, reflects an underlying
shift in longer term relationships.
By contrast, there is increasing evidence
that technological innovations have allowed
households to shift away from narrow money or
M2 assets toward other financial assets either by
reducing asset transfer costs or by allowing
households to obtain liquidity via credit lines or
electronic transfers. Changing preferences and
demographic factors may also be heightening
the extent to which other financial assets substitute for money, as manifested by an apparently
greater tolerance for risk-taking and a growing
share of households that invest their retirement
assets.
Changes in technology, and possibly preferences, may continue to alter the relationships
between monetary aggregates and nominal variables in coming years. The information revolution
will likely foster the spread of electronic financial
management, which will further lower asset
transfer costs, reduce the need to hold transactable assets in order to obtain liquidity, and
lower information barriers that discourage the
1
2
3
4
5
6
7
8
9
10
I thank Michelle Thomas for research assistance; Ken
Emery, Joe Haslag, and Evan Koenig for comments
and suggestions; and the late Stephen Goldfeld and
my many colleagues throughout the Federal Reserve
System for sharing their insights on money with me
over the years.
Waud’s (1975) model synthesizes Tobin’s (1958)
portfolio approach with the cash management insights
of Miller and Orr (1966). Milbourne’s (1986) model is
used in this article because it is relatively more transparent. Milbourne’s model is used rather than that of
Baumol (1952) and Tobin (1956) for two reasons. First,
the Milbourne framework can be used to analyze shifts
between nontransactions M2 deposits and non-M2
assets, whereas the Baumol–Tobin framework is a
model of transactions balances. Second, unlike the
Baumol–Tobin model, the Milbourne model allows for
uncertainty in cash flow that plausibly affects households’ precautionary demand for money.
This follows from the fact that ∂M2 /∂β and ∂M2 /∂α > 0.
This follows from the fact that ∂M2 /∂b > 0.
If innovations primarily lower β and thereby induce
shifts between savings deposits and non-M2 assets,
then Milbourne’s model implies that one should put
more emphasis on more narrowly defined money
measures that are not affected by such shifts. Nevertheless, even narrow money measures remain vulnerable to innovations, especially given demand shifts
that occurred in the early 1980s.
Orphanides, Reid, and Small (1994) come to a different conclusion, but their econometric models omit
information from the long-run relationship (cointegrating vector) between money and output, in contrast to
Duca’s model (1994b).
This was one of the main motivations for the development of the P* model of Hallman, Porter, and Small
(1991).
Feinman and Porter (1992) also find evidence that
M2’s sensitivity to long-term interest rates has risen
since the late 1980s.
The innovations induced by high interest rates are an
example of Lucas’s (1976) argument that behavior is
not invariant to policy (the Lucas Critique). For a
theoretical model of endogenous monetary innovation,
see Ireland (1995).
Many credit cards enable a household to consolidate
10
11
12
13
14
15
16
17
the settlement of many transactions into one monthly
payment that has an interest-free grace period. A
household can thus lower its average liquid deposit
balance by making one monthly transfer or by depositing a paycheck before a credit card bill is due.
See Whitesell (1992) for an analysis of how relative
costs of using cash, checks, and credit cards affect
the use of different payment media.
portable if employment at a particular firm ends.
Gustman and Steinmeier (1992) and Ippolito (1995)
estimate that half of the rise in the share of defined
contribution plans (401K and traditional defined contribution plans as a share of primary pension plans)
owes to employment shifts away from firms that
historically have favored defined benefit plans —
particularly unionized and larger firms. Ippolito (1995)
concludes that the other half of this rise stems from tax
law changes that made 401K plans more attractive
than pre-1980 defined contribution plans.
A decline in α reduces a household’s need to hold
transactions deposits. Since non-M2 assets have
higher pecuniary yields than M2 savings deposits, a
decline in α does not induce a rise in savings deposits
that offsets the decline in transactions balances.
Research on this issue is currently under way.
Recall that the opportunity cost of money is [E (rb ) –
bvarrb – rm ] for transactions accounts in M2 and [E (rb )
– bvarrb – rs ] for nontransactions accounts.
There is much controversy over whether savings
behavior supports the life-cycle and permanent
income hypotheses. Some, such as Carroll (1992) and
Carroll and Kimball (1995), argue that labor income
uncertainty limits how far ahead households plan,
implying that saving for retirement is much lower than
the certainty versions of these theories imply. Others,
such as Feldstein (1995a, 1995b, 1974), argue that
private pensions, Social Security, and college financial
aid programs discourage saving; by implication, the
depressing impact of social insurance programs on
savings may offset any boost from demographic
effects.
Other evidence contradicts Morgan’s hypothesis that
the aging of the baby boomers accounts for the
missing money of the early 1990s. First, the decline in
the population share of 35- to 54-year-olds during the
early 1970s was not accompanied by unusually strong
money growth but, rather, by the first case of the
missing money. In addition, aging effects alone cannot
account for why money models typically find that M2’s
sensitivity to long-term interest rates has risen since
the 1980s. Finally, the stock and bond market busts of
the 1970s may account for the low portfolio share of
these securities in that decade, while the higher
portfolio shares seen since the mid-1980s may reflect
other factors, such as the mid-1980s liberalization of
IRAs and Keoghs (see Duca 1995), stronger bond and
equity markets since the early 1980s, and a fall in the
risk premium on equities (see Blanchard 1993).
While Friedman (1995) points out that households are
typically more risk averse than traditional pension fund
managers in investing retirement assets, the experience of directing the investment of retirement assets
has likely made many people more tolerant of risk for
the investments they control.
Since the 1970s, there has been a shift away from defined benefit pension plans toward defined contribution
pension plans. One advantage of defined contribution
plans is that a greater share of the expected benefits is
FEDERAL RESERVE BANK OF DALLAS
18
For example, if the ratio predictably declines with time,
then one can include time trends in predicting velocity
(V ) and then back out a forecast of nominal output.
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13
ECONOMIC REVIEW FOURTH QUARTER 1995
In years to come, world financial markets
will recall December 20, 1994, the day Mexico
devalued its currency, as a landmark date in
financial history. The devaluation inadvertently
initiated what Michel Camdessus, managing
director of the International Monetary Fund, aptly
dubbed “the first financial crisis of the twentyfirst century.” Most analysts and economic advisors were surprised by not only the devaluation,
but also the speed with which its effects spilled
into other emerging economies. These effects
took the form of swift and massive capital outflows, as investors withdrew savings from those
countries in fear that they would devalue their
currencies as well.
The tequila effect, as the Mexican crisis
has come to be known in Latin America, has
eroded the living standards of millions of people
throughout the region.1 Also affected, although
to a lesser extent, are the countries and international organizations that quickly assisted Mexico
with an unusual financial package. The damaging effects, actual or potential, of the Mexican
crisis on so many people’s welfare have caused
the public, investors, and the press to question
how Mexico’s crisis happened, how it influenced other economies, and how to prevent
a similar crisis in the future. The response of
some analysts has been that the Mexican crisis
and its daunting spillover effects would have
been avoided had Mexico had a currency boardlike system similar to the one Argentina adopted
in 1991.
My goal in this article is to examine the
currency board proposition in light of current
economic theory and the experiences of Argentina and Mexico. In the first part of the article,
I describe the monetary policies of those two
countries and argue that Mexico was forced to
devalue its currency while Argentina was not
because Mexico managed its monetary policy
with much more discretion than did Argentina,
which managed monetary policy according to
strict rules.
The seemingly obvious conclusion of the
first part of the article is that all it takes to
prevent exchange rate crises such as Mexico’s is
to guarantee that rules will take precedence
over discretion. Currency boards, their advocates maintain, provide governments with the
adequate “technology” with which to handle
such a simple job.
In the second part of this article, however,
I argue that this optimistic view is too naive
because it overlooks the problem of time inconsistency,2 a bit of economics jargon for
policymakers’ tendency to find good reasons to
Argentina, Mexico,
And Currency
Boards: Another
Case of Rules
Versus Discretion
Carlos E. Zarazaga
Senior Economist and Executive Director
of the Center for Latin American Economics
Federal Reserve Bank of Dallas
F
ar more important than what
governments say — or even enact
into law —seems to be what governments do: actions speak louder than
words or laws. A country’s care for
its reputation plays a far more
important role than formal institutions in solving the time inconsistency
problem and in providing governments with the incentives to adhere to
policy rules despite the short-term
temptation to do otherwise.
14
repudiate plans they had promised not to abandon and policy rules they had vowed not to
break. Governments always justify those inconsistencies with the same basic excuse: the abandoned policy rule was the best course in the
conditions prevailing in the past but not for
present circumstances.3
Currency boards are a monetary policy
rule. As such they fail to resolve the time inconsistency problem because, despite claims to
the contrary, currency boards cannot provide
a quick and painless fix to the economic woes
of countries that, like Mexico and Argentina,
have long histories inconsistent with lowinflation targets. Quite to the contrary, implementation of rules in such countries is bound
to be costly because the credibility of each
country’s economic policies depends more on
the country’s track record in honoring past
commitments than on present institutional
arrangements.
In fact, as I argue in the third part of this
article, reputation is an important determinant of
which rules are best for a country. In general,
contingent policy rules or rules with (implicit or
explicit) escape clauses are superior to noncontingent rules such as currency boards. But
the recent experiences of Argentina and Mexico
may suggest that implementation of the more
flexible contingent rules is particularly difficult
in countries that have inappropriately used in
the past built-in escape clauses. By virtue of
their poor track records, such countries may be
limited to the use of noncontingent rules. Currency boards are one such rule, but certainly not
the only one, and policymakers should carefully
evaluate the merits and shortcomings of currency boards relative to other types of ironclad
rules before recommending currency boards as
the best rule for a country.
Whatever rule is chosen, countries that
have lacked monetary discipline in the past and
attempt to implement strict monetary policies
eventually may suffer severe economic hardships. When problems arise, ironclad rules such
as currency boards will be particularly susceptible to the time inconsistency problem. Countries will be able to overcome such problems
only if their people are convinced that the concrete costs of sticking to the policy rule today
will be outweighed by the potential gains that
will accrue when investors’ confidence is eventually regained. Unfortunately, this cost–benefit
analysis is subject to considerably more dispute
than currency board advocates sometimes recognize. Nonetheless, this article concludes on
the optimistic note that Argentina’s and Mexico’s
FEDERAL RESERVE BANK OF DALLAS
recent experiences may provide useful empirical
evidence to validate or refute claims about currency boards, principles of time inconsistency
literature, and theories about the superiority of
rules over discretion.
The monetary policies of Argentina
and Mexico
Currency boards: A devaluation-proof rule
for money base creation. A currency board is a
policy rule for monetary base creation that
guarantees that a country will not devalue under
any circumstance while following that rule.4
Under a currency board, monetary policy is run
according to a very simple rule: the monetary
authority issues money only against a designated reserve currency, such as the U.S. dollar
or German mark, at a fixed exchange rate. This
rule is formalized in the following equation:
(1)
x
= Stock of Reserve
Promised
Currency ,
Exchange Rate
where x is the level of monetary base that
satisfies the equality. In a country that runs its
monetary policy according to a currency board
rule, all policymakers need to do is print the
amount of money that satisfies x in equation 1.
This rule implies that if the stock of reserve
currency expands by 10 percent (say, due to a
capital inflow), then the monetary authority must
expand the monetary base by 10 percent. If, in
contrast, the stock of reserve currency shrinks
by 10 percent (say, due to a capital outflow),
then the monetary authority must contract the
monetary base by 10 percent. In other words, a
currency board mechanism for expanding and
contracting the monetary base ensures that the
proportion of monetary base to reserves remains
constant at the fixed exchange rate. To see this
more formally, define
(2)
Monetary Base
_______________________
Promised Exchange Rate
MB$FR = _______________________
Stock of Reserve Currency.
The left-hand term in this equation is the
MB$FR ratio. A currency board simply instructs
the monetary authorities to set that ratio equal to
1, so that
(3)
MB$FR = 1
becomes the currency board rule. The economic
interpretation of this rule is that the monetary
15
ECONOMIC REVIEW FOURTH QUARTER 1995
though many policy analysts refer to Argentina’s
current monetary regime as a currency board,
the policy has not been run as an orthodox
currency board rule. Even so, the policy so
closely resembles a pure currency board regime
that it serves as a useful example.
Figure 1 shows the evolution of the monetary base and foreign reserves in Argentina
during 1995. On January 1, 1995, the foreign
reserves were $15.7 billion, backing a monetary
base of 16.3 billion pesos. The MB$FR ratio was
very close to 1, the ratio stipulated by the currency board rule, so there was practically no
difference between a currency board and
Argentina’s monetary regime on January 1.
If Argentina’s policy were a textbook currency board, the two lines in Figure 1 would
overlap throughout the figure. The lines do not
overlap because, unlike an orthodox currency
board, Argentina’s convertibility law gives the
central bank some flexibility to act as lender of
last resort (Zarazaga 1995b). Argentina’s central
bank can issue money for that purpose up to the
level that would push the MB$FR ratio above
1.25. Stated differently, the convertibility law
does not require 100-percent backing of the
monetary base: only 80 percent of it must be
backed by foreign reserves (at the committed
1:1 exchange rate).
Had Argentina’s policy been a pure currency board, when the country’s foreign reserves shrank to about $10 billion in late March
1995, the monetary base would have shrunk
by 5.7 billion to 10.6 billion pesos. However,
Argentina’s monetary base declined only to
about 12.3 billion pesos. The MB$FR ratio peaked
at 1.23 on March 30, 1995.6 At that time,
Argentina’s central bank had $1 for every 1.23
pesos of bills and coins in the public’s wallets
and banks’ vaults (or, equivalently, $0.82 for
each peso of monetary base). Had the holders
of pesos wished to exchange all their cash—
the 12.3 billion pesos —for dollars, Argentina
would have been forced to devalue its currency
by about 23 percent.
Of course, this scenario overstates the risks
of a devaluation in Argentina in March 1995
because it would be rare for all individuals and
businesses simultaneously to want to rid themselves of the local currency. Some amount, even
if modest, of bills and coins will always be
needed to carry out transactions such as paying
taxes or buying a soda in vending machines.
Because some local currency will never be presented in exchange for dollars, the monetary
base can grow slightly beyond the currency
board limit.
Figure 1
Argentina: Monetary Base
And Foreign Reserves, 1995
Foreign reserves
(In billions of U.S. dollars)
17
16
15
14
Monetary base
13
12
11
Foreign reserves
10
9
January
February
March
April
May
June
SOURCE: Central bank of Argentina.
base is fully backed by the designated foreign
reserve currency.
To understand how a currency board works,
suppose that for some reason all the households
in a country suddenly decide to exchange all the
money they have in their country’s currency for
dollars. Under a currency board system, this
massive speculative attack against the local currency will not trigger a devaluation, as it did in
Mexico, because a monetary authority adhering
to a currency board rule never runs out of the
reserve currency and can eventually buy back
all the monetary base (that is, exchange it for
foreign currency) with its reserves at the promised exchange rate.
Unfortunately, currency board advocates
often fail to emphasize that the cost of successfully defending the parity between the reserve
and domestic currencies may be a severe financial crisis. Lessons about the virtues and shortcomings of a currency board, as well as the
events that led to Mexico’s peso devaluation,
can be drawn from a review of the recent economic experience of Argentina, a country that
has been following a quasi-currency board rule
very closely since 1991.
Argentina’s monetary policy and currency
boards. On April 1, 1991, Argentina’s congress
approved a convertibility law.5 This law obligates the central bank to issue domestic currency (the peso) almost exclusively against the
dollar value of foreign reserves at the fixed
exchange rate of 1:1—in other words, at the rate
of 1 peso for every $1 received by the central
bank. This standard is the basic rule for money
creation described in the previous section. Al-
16
The monetary authority can exploit this
fact to manage the monetary base and expand it
in moderate amounts, as Argentina’s monetary
authorities did, to act as lender of last resort.
Although such a moderate expansion to help
the financial system will not be backed by foreign reserves, the risk of a devaluation will be
reasonable if policymakers do not abuse their
leeway. Argentina’s 80-percent coverage of the
monetary base with foreign reserves, for instance, seems prudent.7
To summarize, Argentina’s quasi-currency
board rule has allowed its monetary authorities
a little more flexibility in conducting monetary
policy than an orthodox currency board would
have. Still, Argentina’s system imposes very clear
limits on discretionary expansions of the monetary base. Monetary authorities respecting similar limits to their discretion within a fixed
exchange rate regime will not be able to isolate
changes in foreign reserves from changes in the
monetary base for too long. Sooner or later,
sustained declines in foreign reserves will be
reflected in corresponding declines in the monetary base. This is why in Figure 1 the monetary
base and foreign reserves in Argentina move in
tandem, despite the flexibility built into the
country’s quasi-currency board regime.
Argentina’s quasi-currency board rule under
attack. When Argentina’s peso came under
speculative attack in first-quarter 1995, policymakers could defend the currency because they
stubbornly adhered to a policy rule that guaranteed that at least 80 percent of the monetary
base would always be covered by foreign reserves. But the price of this success was one of
the most severe banking panics in modern
Argentine history.
The performance of Argentina’s quasicurrency board during a financial crisis illustrates that currency boards can avert devaluations. But because of their very limited ability to
act as a lender of last resort, they introduce the
risk that a minor, Orange County-type liquidity
crisis 8 will become a devastating national financial panic almost overnight.
Argentina’s case study demonstrates that
currency boards have very little power to control financial crises when they occur in a
modern, independent country, rather than in
the colonies frequently cited as success stories
in the literature of currency board advocates.9
Argentina’s financial panic started with a
liquidity squeeze in Bank Extrader, a small
bank that held barely 0.2 percent of the total
deposits in Argentina’s financial system. Extrader
was heavily exposed in Mexican bonds and
FEDERAL RESERVE BANK OF DALLAS
securities. When the value of those assets fell
dramatically in the aftermath of the devaluation
of the Mexican peso on December 20, 1994, the
bank could no longer cover its short-term liabilities, particularly some time deposits that
came due. This shortage triggered a run against
the bank. Extrader, unable to honor its deposits,
was foreclosed on by the central bank on January 18, 1995.
The fear that other banks were similarly
exposed translated into a generalized banking
panic. Suddenly, Argentina’s financial system was
awash in the same indiscriminate chain reaction
that had transmitted the tequila effect throughout Latin American capital markets. Almost immediately, the run against the banks became a
run against the domestic currency. People feared
that Argentina would devalue as Mexico had
done shortly before. As depicted by the decline
in foreign reserves in Figure 1, much of the cash
withdrawn from Argentina’s financial system went
to purchase dollars that were sent abroad.
By the end of April 1995, Argentina’s financial system had lost 18 percent of the deposits it had before the Mexican peso devaluation.
As a measure of the severity of this contraction,
Argentina experienced in just three months the
same proportional contraction in deposits as the
United States did during the first two years of the
Great Depression. In the wake of Argentina’s
financial panic, many banks were forced to suspend the payment of deposits. Many investors—
foreign and domestic alike—have yet to recover
their savings. Argentina’s experience, therefore,
should dispel the notion that a currency board
would have prevented the financial meltdown
Mexico would have suffered without the U.S.–
International Monetary Fund aid package.
The complete interruption of the chain of
payments and shutdown of credit markets took
its toll on Argentina’s real economy. Secondquarter gross domestic product (GDP) in 1995
fell by about 5 percent from its second-quarter
1994 level, while the fall in third-quarter 1995
from third-quarter 1994 was 8 percent. These
figures have led many private forecasters to
conclude that Argentina’s 1995 GDP (adjusted
for inflation) will be 2.5 percent below that of
1994. Perhaps the most worrisome consequence
of the financial crisis was a jump in the country’s
unemployment rate, from 12.5 percent in October 1994 to an all-time high of 18.6 percent in
May 1995.
Numbers like Argentina’s make it easy to
understand why investors may fear countries
will abandon currency board-like rules. When
countries confront banking crises, such rules
17
ECONOMIC REVIEW FOURTH QUARTER 1995
provide little more than homeopathic therapy
while panics run their natural course.10 As time
inconsistency theory predicts, during times of
stress, investors grow skeptical about governments’ pledges to honor their commitments to
currency board-like rules. Investors conjecture
that rising unemployment and eroding political
support might force governments to abandon
the rule-bound currency board system and replace it with policies prone to devaluation—
what the currency board was designed to
prevent.11 That time inconsistency problem is
why investors questioned the continuity of
Argentina’s quasi-currency board rule and why
they withdrew their savings from the country.
This capital flight, in fact, helped generate the
financial crisis that continued the cycle of devaluation fears.
Contrary to the predictions of currency
board advocates, the formal legal arrangement
of a quasi-currency board did not protect Argentina from a speculative attack against its currency. Argentina’s monetary policy, as predicted,
prevented a devaluation, but the price was a
banking crisis far more severe than currency
board advocates had anticipated.
Mexico’s discretionary monetary policy. The
movement of Argentina’s monetary base and
foreign reserves displayed in Figure 1 contrasts
sharply with that of Mexico’s. Figure 2 shows
that Mexico’s monetary base remained fairly constant and even increased after October 1994,
despite a continuous decline in foreign reserves.
The difference between the two figures suggests
that Argentina was more conservative than
Mexico in tolerating deviations from the currency board rule. The MB$FR ratio never reached
the legal limit of 1.25 in Argentina but was 1.62
in Mexico on December 19, 1994, the day before
the devaluation.12 Undoubtedly, a devaluation is
much more likely in a country that backs less
than 80 percent of its monetary base with foreign reserves (as Mexico did in late 1994) than
in a country that backs 80 percent or more of its
monetary base with foreign reserves (as has
been the case in Argentina).
Interestingly enough, until October 1994,
Mexico had managed its monetary base according to a rule that far exceeded the rigor of the
currency board standard. Before fourth-quarter
1994, Mexico’s MB$FR ratio had been below 1
(that is, Mexico’s foreign reserves had exceeded
its monetary base). This observation suggests an
alternative interpretation of Mexico’s monetary
policy. Perhaps what differentiated Mexico’s experience from Argentina’s is not that Argentina
passed a law requiring a quasi-currency board
Figure 2
Mexico: Monetary Base
And Foreign Reserves, 1994
Foreign reserves
(In billions of U.S. dollars)
Monetary base
(In billions of new pesos)
60
60
50
Monetary base
50
40
40
30
30
20
20
Foreign reserves
10
10
0
0
Jan. Feb. Mar. Apr. May Jun. Jul. Aug. Sep. Oct. Nov. Dec.
SOURCE: Banco de México.
rule while Mexico did not but, rather, that sometime after October 1994 Mexico decided to repudiate its policy suddenly and almost without
warning.13
In any case, Mexico’s relatively high fourthquarter 1994 MB$FR ratio implies that Banco de
México was no longer in a position to exchange
Mexico’s entire monetary base for dollars at the
promised exchange rate, and that, subject to a
speculative attack, Mexico would eventually be
forced to devalue its currency by about 60 percent.14 Unfortunately, the fear of a speculative
attack became self-fulfilling and triggered a chain
of events that led to the December 20, 1994,
devaluation.
But why did the Mexican monetary authorities allow the monetary base to grow without
the backing of foreign reserves after October
1994? As Mexican monetary authorities later explained, a continuous drain of foreign reserves
had started in February 199415 and had exposed
the banking sector to the risk of a liquidity
crunch. Concerned abut a banking crisis, Mexican monetary authorities tried to preempt a
financial panic by acting as a lender of last
resort. Discount window loans to allegedly
troubled financial institutions expanded the
monetary base beyond the level of foreign reserves (Zarazaga 1995b), leaving Mexico vulnerable to speculative attack and devaluation.
On face value, the expansion of Mexico’s
monetary base through its central bank’s
discount window— despite declining foreign
reserves —may appear inconsistent with the
pegged exchange rate regime in place at the
time. The action, however, was not necessarily
18
inconsistent, provided the monetary authorities
had reasons to believe that the capital outflows
and consequent loss of foreign reserves were
only temporary and would reverse themselves
once the fears of political turmoil subsided,16
and that the minimum demand for local currency had increased as well.
Banco de México authorities have stated
that such reasons did indeed exist,17 even if
now, in hindsight, it may appear that the effects
of political uncertainty on Mexico’s creditworthiness were underestimated18 and the increase in demand for Mexican pesos was
overestimated.19
Undoubtedly, something went wrong.
Mexico most likely suffered the same problem
that has hit many other countries when their
currencies have been devalued after their
policymakers miscalculated the leeway they
had for expansions of the money base not
backed by foreign reserves. In the attempt to
fine-tune the economy, even the most skilled
policymakers may read the tea leaves incorrectly
from time to time. In Mexico’s case, the monetary authorities validated the use of the discount window—and, therefore, the increase of
the unbacked monetary supply—to a level
that, ex post, exceeded what the market was
willing to absorb.20
If the source of the problem is not necessarily unskilled policymakers but the discretion they enjoy in conducting monetary policy
(for example, to preempt bank runs), then the
obvious fix would be to take away policymakers’ discretion. This is the reasoning behind
many enthusiastic recommendations in favor
of currency boards and the focus of the next
section.
tent —in other words, governments will tend to
abandon them. Advocates of currency boards
have failed to show how such institutions can
overcome this problem. As mentioned earlier,
Argentina, despite its quasi-currency board, suffered a speculative attack driven by distrust in
the continuity of its monetary policy.
Argentina’s example further indicates that
legal institutions per se provide very little reassurance about a country’s future economic
policies. In fact, during Argentina’s financial crisis, Art. 17 of that country’s central bank charter
was modified by presidential decree to give
that institution more flexibility in its discount
window policies. That charter, approved by law
number 24,144 of September 23, 1992, had enacted the central bank independence. But the
presidential decree raised and justified the fears
that the whole central bank charter and, therefore, central bank independence, would be repudiated. Another indication of how ineffective
formal institutions and legal arrangements are
in limiting policymakers’ discretion comes
from German history. The Reichsbank, the central bank of the German Empire, was declared
legally independent on May 26, 1922, just three
months before the onset of the 1922–23 German
hyperinflation.21
Besides, neither Germany nor the United
States has an explicit or legislated rule for running monetary policy such as Argentina’s, yet
Germany’s or the United States’ credibility in
keeping inflation low and its currency stable far
exceeds Argentina’s because Germany and the
United States have strong track records.
Far more important than what governments
say—or even enact into law—seems to be what
governments do: actions speak louder than words
or laws. A country’s care for its reputation plays
a far more important role than its institutions in
solving the time inconsistency problem and in
providing governments with the incentives to
adhere to policy rules despite the short-term
temptation to do otherwise. This is the basic
insight of Barro and Gordon (1983) and the
literature that followed.22 The credibility of
policymakers and economic policies will be much
higher in countries with a long tradition of respecting policy rules than in countries with a
tradition of repudiating them.23
Given the role of reputation, new policy
rules will meet considerable skepticism in countries that have failed to demonstrate past discipline. Guided by a country’s history of repeatedly
broken commitments, economic agents will (justifiably) bet against policy continuity, whether
the government promises come in the form of
Can institutions eradicate
discretionary policies?
Since a currency board is nothing but a
rule for money creation, the debate about the
advantages, disadvantages, and desirability of
currency boards amounts to another rendition
of the long-standing rules-versus-discretion
debate. Currency board advocates maintain that
the Mexican crisis would have been avoided if a
currency board like Argentina’s had limited the
discretion of Mexico’s monetary authorities. Although this argument might ring true, it naively
attributes to formal rules and institutions more
power than they have in committing governments to keep their promises in the face of
adverse economic conditions.
The problem is that policy rules, however
institutionalized, are inherently time inconsis-
FEDERAL RESERVE BANK OF DALLAS
19
ECONOMIC REVIEW FOURTH QUARTER 1995
public statements or formal institutions such as
currency boards.24
Formal institutions or laws cannot remove
skepticism about governments’ ability to carry
out commitments in countries that have repeatedly failed to honor past promises. The
adoption of rules in such countries, however
implemented, sooner or later is likely to produce severe economic and social hardships while
the country persuades investors that it has
mended its ways and will no longer abandon its
commitments.
and theoretical issues involved remain largely
unresolved.29
But events in Mexico suggest that financial
markets participants did not view the monetary
policy actions at the end of 1994 as a temporary
and justifiable use of an escape clause. Rather,
the markets seem to have confused those policies with superficially similar ones that several
years earlier (in 1982 and 1987) had led to
devaluations accompanied or immediately followed by violations of elementary free market
rules, such as nationalization of banks, confiscation of deposits, open or disguised forms of
price and capital controls, and outright default
on government debt. As in the tale of the boy
who falsely cried wolf too often, Mexican
policymakers in 1994 were trapped by the bad
reputation of their predecessors.30
Perhaps one of the more important lessons
of the Mexican crisis of 1994 –95 is that the
invocation of escape clauses might be unwise in
countries that, in the eyes of investors, have
abused such outs in the past.31 For these countries, ironclad rules might well be the only hope
to restore investors’ confidence and, therefore,
future prosperity. But this essentially sound point
will be perhaps better served by the recognition that a currency board is just one type of
ironclad rule, not necessarily, and certainly not
in general, the best one.
Whichever ironclad rule proves best, it is
necessary to revisit the issue of how it will
overcome the time inconsistency problem.
More concretely, will societies accept the immediate costs of implementing a rule, particularly severe in countries with a poor reputation,
on the promise of the benefits that will accrue
in time?
Minimizing or dismissing the costs of a
particular ironclad rule in the zeal of promoting
its adoption (as has often been done) could
prove self-defeating because a society may too
easily become disenchanted and abandon the
rule at the first setback, before the rule has had
time to take hold and produce the desired results. To the contrary, the cause of rules would
be better served if scholars, decisionmakers, and
opinionmakers clearly explained to societies
the nature of the inevitable economic hardships
the rules will entail after years of inconsistent
monetary policy.
In this sense, Argentina’s decision to respect the quasi-currency board rule despite its
serious financial crisis is almost unprecedented. Perhaps Argentina’s authorities (and
Argentina’s people, who reelected the government in the middle of the crisis) were motivated
Are currency boards the best rule?
The failure to explain how currency boards
solve the time inconsistency problem is not the
only wrinkle in arguments that portray currency
boards as the instant recipe for restored credibility and prosperity. But setting aside the issue
of time inconsistency, there is the normative
question of which is the best rule. What the
literature has established is that optimal rules
are superior to discretion.25 A vast array of plausible policy rules and, in particular, of monetary
policy rules is available to policymakers, and
economists have yet to reach a consensus that
currency board rules are superior to any other
feasible rule.
Furthermore, many economists would
argue that contingent rules are superior to ironclad ones that are invariant to changing economic contingencies. Several studies, in fact,
show that rules with escape clauses are the best
course of action.26
In this spirit, Bordo and Kydland (1995)
argue that, despite appearing to be an ironclad
rule, the gold standard in reality had implicit
escape clauses. Bordo and Kydland point to
periods when England, the country that most
consistently adhered to the rule, temporarily
suspended convertibility of the pound into gold
(at a fixed exchange rate of £3.85 per ounce)
during wars and financial crises.27
Admittedly, the use of rules with escape
clauses opens a Pandora’s box because rules
with too many contingencies and escape clauses
can become indistinguishable from discretion.28
For example, did Mexico repudiate the fixed
exchange rate rule through its extensive lenderof-last-resort activity just before the devaluation?
Or, was Mexico simply exercising an escape
clause to avert a financial crisis in the face of
adverse and unforeseen political shocks, as
England did to quench the incipient banking
panics of 1847, 1857, and 1866? This will be the
subject of considerable debate for many years
to come, in part because several empirical
20
Conclusions
to stick to their guns by a conviction that the
alternative, to abandon the currency board, would
have been perceived, as in Mexico, not as the
use of an escape clause to control a banking
panic but as a return to the old ways of running
monetary policy. Such past policies were based
on almost unbounded discretion and led to
decades of impoverishing inflationary stagnation and to a traumatic hyperinflation during
1989–90.32
In any case, much of the difficulty policymakers face in choosing among different policy
rules arises because the theory of costs and
benefits of alternative policies is still well ahead
of the empirical evidence available to measure
them. For all their catastrophic dimensions, one
potentially positive outcome of recent events in
Mexico and Argentina might be to help close the
theory–evidence gap. After all, those experiences are as close as economists get to controlled experiments needed to measure the costs
and benefits of alternative policies: both are
Latin American countries with similar characteristics and past histories, and each responded
with a different policy to basically the same
speculative attack against its currency. Of course,
the task of identifying the effects of the different
policies followed by those countries so far will
not be as easy as the highly stylized, stark
identifying assumptions just mentioned might
suggest.
There are a number of other important
factors that now or in the future could affect the
economic outcomes of those two countries. But
in economics, as in any other social science, the
only feasible experiment is complex, sometimes
fuzzy historical evidence, and few economists
would argue that we have not learned anything
from examining the past. Just the opposite is
true, as few economists can resist the temptation of presenting data, which is information
from the past, to back up their arguments and
theories. It does not seem preposterous, therefore, to think that clever economists will be able
to design appropriate quantitative methods to
identify and measure cause–effect relationships
between the eventually different economic performances and the so far certainly different policy
responses of Argentina and Mexico. For that
reason, the recent experiences of those two
countries are already proving to be a popular
and fertile area of research, one that might
help assess the wisdom of Argentina’s decision
to stick to its quasi-currency board arrangement and, in any event, enrich and change the
terms of the rules-versus-discretion debate for
years to come.
FEDERAL RESERVE BANK OF DALLAS
This analysis of the monetary policies of
Argentina and Mexico has shown that, unlike
Mexico, Argentina prevented a devaluation of its
currency by following a quasi-currency board
rule. Based on this observation, many have recommended a currency board for Mexico as well.
This recommendation, however, is based on
the naive belief that the formal institution of a
currency board provides a commitment technology that ensures policymakers will conduct
monetary policy according to a very welldefined rule.
The truth is that currency boards and similar institutions cannot enforce a government’s
everlasting commitment to low inflation and
pegged or fixed exchange rate policies any
more than a wedding ring can ensure a spouse’s
commitment to an everlasting marriage. This
weakness is common to other institutions and
written laws as well, and its source is the same:
ironclad rules do not resolve the basic problem
of time inconsistency. This problem lies at the
heart of the lack of credibility that haunts
policymakers in countries that have frequently
broken their commitments in the past. This
lack of credibility explains why currency boards
are subject to speculative attacks that they can
resist without devaluing only at the cost of
very severe financial crises.
Therefore, depictions of currency boards —
or any other ironclad rule, for that matter— as
powerful devices that will magically restore investors’ confidence and, therefore, prosperity
almost overnight and without pain do not help.
On the contrary, this optimistic assessment may
have the perverse effect of providing policymakers with the incentive to abandon their commitments on the mistaken impression that later,
simply by institutionalizing a rule such as a
currency board, they can quickly and painlessly
restore lost credibility.
In truth, a government’s credibility is like
crystal: once broken, it is very difficult and
costly to restore. Rules would, perhaps, stand a
better chance of overcoming the time inconsistency problem if the governments and societies
of countries that abandoned past promises understood the true cost of regaining credibility.
The costs of following a sensible monetary rule
are the price to pay for the bad reputation that
stems from a past of broken trust and for the
future economic development that regaining credibility will eventually bring about.
Unfortunately, economic theory has made
little progress in predicting when and why
countries will finally abandon discretionary
21
ECONOMIC REVIEW FOURTH QUARTER 1995
policies and switch to rules, or, equivalently,
when countries will perceive that future benefits
of restored investor confidence outweigh the
present economic hardships of rebuilding reputations.
In any case, societies considering commitment to a rule should consider that noncontingent policy rules such as currency boards are, in
general, inferior to contingent rules. But because the distinction between pure discretion
and contingent rules may become blurred in
countries that have abused the flexibility provided by rules with escape clauses, such countries may have pushed themselves into an all or
nothing situation. Ironclad rules may be the only
rules previously deceived investors and financial
markets participants will interpret as rules in
such countries. But this is only conjecture that
so far, to our knowledge, has not been formally
proved. In this sense, the debate surrounding
the convenience and effectiveness of currency
boards is perhaps a red herring that distracts
from the real issues, which are how to determine the best policy rule for countries that have
frequently reneged on commitments and how to
protect those rules from the continuous assault
of the time inconsistency forces. Economists and
policymakers still have a lot of thinking to do on
both counts, especially after the recent economic experiences of Argentina and Mexico.
5
6
7
8
9
Notes
1
2
3
4
I would like to thank Ken Emery, David Gould, and
Owen Humpage for valuable comments on an earlier
version of this article. I am grateful as well to Stephen
Brown and Evan Koenig for insightful suggestions that
were extremely useful in presenting my arguments.
The editorial assistance of Rhonda Harris greatly
improved the clarity and quality of the exposition.
All remaining errors are mine.
For a more detailed discussion of the tequila effect,
see Zarazaga (1995a).
Unfortunately, with the notable exception of Schwartz
(1993), this insight has been lost in the currency
boards literature.
Although economists and social scientists have long
been aware of this problem, (see, for example, Simons
1936), it was not until 1977 that it was formalized and
brought to the forefront of the theory of economic
policy by Kydland and Prescott (1977). For an excellent summary, see Taylor (1985).
This article assumes the reader is familiar with the
definition of the main monetary aggregates and, in
particular, with the difference between primary expansion and secondary expansion of the money supply.
See Zarazaga (1995a) for a brief and pedagogical
exposition of these issues. For a more rigorous treat-
10
11
12
13
22
ment, see Hanke and Schuler (1994) and Humpage
and McIntire (1995).
Law number 23,928.
The stock of foreign reserves corresponds to the liquid
foreign reserves net of domestic government dollardenominated debt in the central bank’s portfolio.
The 2.3 billion pesos by which the monetary base
exceeded the stock of foreign reserves at the end of
March 1995 represented only about 1 percent of
Argentina’s GDP. It is unlikely that the demand for local
currency will ever fall below that proportion of GDP,
and, therefore, it was unlikely that in March 1995
Argentina’s central bank would have had to buy back
all the monetary base (12.3 billion pesos) with the $10
billion of reserves.
This reference is to the 1994 insolvency of a small
municipality in the United States that threatened to
send that country’s municipal bonds markets into a
tailspin because of fear that other municipalities would
default as well.
For example, Hanke and Schuler (1994, 86) assert that
“Failures by commercial banks have been minor in
[currency board] systems.” But the lessons that can
be extracted from the historical experiences they
reviewed are very limited because almost all such
experiences have taken place in British colonies
whose commercial banks were usually branches of
international financial institutions. Those financial
institutions had, as eloquently stated by Schwartz
(1993, 182–83), “the resources to support a troubled
local branch.…The London head offices of local
branches provided lender of last resort services, if
needed.” In contrast, foreign banks were among the
first to cut credit lines to their Argentine branches in
the aftermath of the devaluation of the Mexican peso.
It is important to emphasize that I do not claim that
currency boards create banking crises, but rather that
they have very limited ability to prevent them.
This perception would not be totally unjustified. After
all, as the next section explains, that is exactly what
happened in Mexico at the end of 1994.
According to Banco de México reports, on December
19, 1994, the stock of foreign reserves was $10.5
billion, while the monetary base was 59.6 billion new
pesos. The dollar value of this monetary base at the
exchange rate of 3.5 new pesos per dollar—that is, at
the approximate exchange rate promised on the eve of
the devaluation—implies a MB$FR ratio of 1.62.
MB$FR ratios of 1.62 on December 19, 1994, and 1.12
on November 30, 1994, suggest explosive behavior in
the intervening period. Indeed, in early December the
monetary base grew about 22 percent, while foreign
reserves fell around 16 percent. At least part of this
expansion, however, may have been justified in the
higher demand for currency typical of the month of
December, when consumers need unusual amounts
of cash to finance expenses related to Christmas.
14
15
16
17
18
19
20
In fact, the depreciation of the peso was in that order
of magnitude in the early phases of the floating
exchange regime adopted after December 22, 1994.
Although there is some debate about the underlying
consequences of those capital outflows, it is symptomatic that foreign reserves fell by 40 percent in the
twenty days immediately following a major political
disturbance: the assassination of presidential candidate Luis Donaldo Colosio in March 1994. In fact,
according to Calvo and Mendoza (1995), “Investors’
prospects on Mexico’s fundamentals suddenly
21
Cottarelli (1993, Appendix II) points out that it is
possible to identify countries—Belgium or Japan, for
instance—whose central banks are not legally independent yet act much more so than the central banks
of other countries that have theoretically independent
central banks with the authority of written law. Cottarelli
also discusses how the legal protection of the central
bank can be and has been circumvented in the latter
group of countries.
22
changed, in part because of the increasing complexity
of the ongoing political conflicts.” [Emphasis added.]
If Mexico’s policymakers were mistaken in this regard,
then they were in good company. As Calvo and
Mendoza (1995) write, “Most of the information available until the end of 1994, including the assessment of
international financial organizations, praised Mexico as
a country with full balance in monetary and fiscal
policies and set for strong future growth on the basis
of its far-reaching reforms— at about the same time the
crash occurred, Mexico was accepted as a member
of the OECD [Organization for Economic Cooperation
and Development].” [Emphasis added.]
See, for example, Mancera (1995) for the Banco de
México president’s account.
The inability to roll over the tesobonos debt (very shortterm government debt adjusted according to the exchange rate) played a major role in the events that led
to the crisis of December 1994. Interested readers
can consult the study by Calvo and Mendoza (1995)
and Cole and Kehoe (1995).
Had Mexican monetary authorities had the recent
econometric model of Kamin and Rogers (1995) and
used it to predict the demand for currency, they would
have forecast money demand growth below what they
actually observed, especially for the first and third
quarters of 1994. Had lower forecasts been used as a
target in setting domestic credit (discount window)
policies, the supply of monetary base would have
grown at a slower rate than it actually did. Calvo and
Mendoza (1995) use this finding to argue that monetary policy may have been too loose relative to the
fixed exchange rate target and may have helped create
the conditions for the speculative attack of late 1994.
One could blame the policymakers for having missed
several signs of the crisis to come. But many such
signals could have been dismissed ex ante on the
grounds that they reflected temporary factors containing very little information about more permanent economic imbalances. The exception, perhaps, is the
money demand estimates mentioned in note 19. It is
even possible to argue, as I do later, that Mexico was
following a fixed exchange rate rule with an implicit
escape clause, and that its policymakers merely exercised that escape clause in the face of extraordinary
political events.
23
See especially Lucas and Stokey (1983) and Chari
and Kehoe (1990).
This might explain why Canada, Belgium, and Italy
have been able to sustain levels of government debt
that, as percentages of GDP, are several times higher
than the corresponding levels for Argentina, Brazil,
and Mexico.
It seems implausible that Mexico could restore its
credibility with the simple announcement of a currency
board law similar to Argentina’s. Investors would
question whether Mexico would adhere to yet another
rule after abandoning its fixed exchange rate regime in
October 1994.
Examples of optimal rules are the Ramsey policies typically used as benchmarks of the analysis in the time
inconsistency literature (see, for example, Chari 1988).
Lucas and Stokey (1983), for example, construct
models in which the optimal (Ramsey) policy is to
abandon in the event of war the otherwise always
honored rule of repaying the government debt. As
Bordo and Kydland (1995) put it: “In an uncertain
world, the Ramsey plan generally would be a contingent plan or rule. Strictly speaking, in a realistic
environment the Ramsey plan would include many
contingencies, some of which may make little difference to society’s welfare.”
Bordo and Kydland identify these periods of suspension as 1797–1821 and 1914–25, which roughly
correspond with the Napoleonic wars and World War I,
respectively, and 1847, 1857, and 1866, which correspond to periods of banking panics.
Bordo and Kydland (1995) state the problem well:
“Drawbacks of including many contingencies, however, are lack of transparency and possible uncertainty
among the public regarding the will to obey the
original plan.”
Those who lean toward the second interpretation
may point out that the assassination of presidential
candidate Colosio qualified as a rare circumstance:
no former or current president or presidential candidate has been assassinated in Mexico in the past
fifty-six years.
Thus, investors seem to have reacted not so much to
fundamentals—that is, to economic policies—of the
present but to those of the past. The same seems to
be true about the causes of the bank panic that spread
the tequila effect to Argentina, since according to a
private report issued at the time, investors in that
FEDERAL RESERVE BANK OF DALLAS
24
25
26
27
28
29
30
23
ECONOMIC REVIEW FOURTH QUARTER 1995
country withdrew their money from the financial
institutions on the concern that “the government might
freeze bank deposits in order to stem a withdrawal of
funds from the country” (according to a June 1, 1995,
Bloomberg wire report) as it had done in 1990. The
conjecture that Argentina’s and Mexico’s track records
were catalysts of their financial crises could be of
particular interest to scholars and policymakers because it suggests that reputation (and thus, past fundamentals) may play a major role in the genesis of herd
behaviors like the one to which many analysts have
attributed, at least in part, the speculative attacks
against the currencies of Mexico and Argentina.
31
32
Cole, Harold L., and Timothy J. Kehoe (1995), “SelfFulfilling Debt Crisis,” unpublished manuscript, Federal
Reserve Bank of Minneapolis and University of Minnesota.
Cottarelli, Carlo (1993), “Limiting Central Bank Credit to
the Government: Theory and Practice,” Occasional Paper
110, International Monetary Fund.
Hanke, Steve H., and Kurt Schuler (1994), Currency
Boards for Developing Countries: A Handbook (San
Francisco: International Center for Economic Growth).
Humpage, Owen F., and Jean M. McIntire (1995), “An
Introduction to Currency Boards,” Federal Reserve Bank
of Cleveland Economic Review, Second Quarter, 2–11.
This is an informal restatement of Chari’s (1988) advice
that “policy recommendations that ignore the effect of
history on people’s expectations will yield inferior
outcomes” made in his insightful review of the extensions of the Barro–Gordon reputational framework to
the case of contingent rules.
Argentina’s people and policymakers also may have
been inspired by the example of their close neighbor,
Chile. That country’s rapid rate of growth over the past
twelve years (GDP per capita has grown at an annual
rate of almost 5 percent since 1983) is largely seen as
the reward for the very strict monetary policies with
which Chile responded in 1982 to a severe banking
crisis. That crisis resulted in a decline of 15 percent in
GDP and in unemployment rates in the same range as
those Argentina is experiencing now.
Kamin, Steven B., and John H. Rogers (1995), “Monetary
Policy in the End-Game to Exchange Rate Based Stabilization: The Case of Mexico,” unpublished manuscript,
Board of Governors of the Federal Reserve Board.
Kydland, Finn E., and Edward C. Prescott (1977), “Rules
Rather than Discretion: The Inconsistency of Optimal
Plans,” Journal of Political Economy 85 (June): 473–91.
Lucas, Robert E., Jr., and Nancy L. Stokey (1983),
“Optimal Fiscal and Monetary Policy in an Economy
Without Capital,” Journal of Monetary Economics 12
(July): 55–93.
References
Mancera, Miguel (1995), “Don’t Blame Monetary Policy,”
Wall Street Journal, January 31, A20.
Barro, Robert J., and David B. Gordon (1983), “Rules,
Discretion, and Reputation in a Model of Monetary
Policy,” Journal of Monetary Economics 12 (July):
101–21.
Schwartz, Anna J. (1993), “Currency Boards: Their Past,
Present, and Possible Future Role,” Carnegie –Rochester
Conference Series on Public Policy, 39 (December):
147–87.
Bordo, M. D., and Finn E. Kydland (1995), “The Gold
Standard as a Commitment Mechanism,” in T. Bayoumi,
B. Eichengreen, and M. Taylor (eds.), Modern Perspectives in the Gold Standard, (Cambridge: Cambridge
University Press).
Simons, Henry C. (1936), “Rules Versus Authorities in
Monetary Policy,” Journal of Political Economy 44
(February): 1– 30.
Calvo, Guillermo, and Enrique Mendoza (1995), “Reflection on Mexico’s Balance-of-Payment Crisis: A Chronicle
of a Death Foretold,” mimeo, Board of Governors of the
Federal Reserve System.
Taylor, Herb (1985), “Time Inconsistency: A Potential
Problem for Policymakers,” Federal Reserve Bank of
Philadelphia Business Review, March /April, 3 –12.
Zarazaga, Carlos E. (1995a), “Beyond the Border:
The Tequila Effect,” Southwest Economy, Federal
Reserve Bank of Dallas, Issue 2, 7.
Chari, V. V. (1988), “Time Consistency and Optimal Policy
Design,” Federal Reserve Bank of Minneapolis Quarterly
Review, Fall, 17– 31.
——— (1995b), “Can Currency Boards Prevent Devaluations and Financial Meltdowns?” Federal Reserve Bank
of Dallas Southwest Economy, Issue 4, 6 – 9.
———, and Patrick J. Kehoe (1990), “Sustainable Plans,”
Journal of Political Economy 98 (August): 783–802.
24
Should Bank
Reserves Earn
Interest?
The case for payments of interest on reserves applies not only to the 100% reserve
system, but equally to our present fractional
reserve system. Accordingly, even if reserves are not raised to 100%, Reserve Banks
should be required to pay interest on their
deposit liabilities.
—Milton Friedman
A Program for Monetary Stability
Scott Freeman
Professor
University of Texas at Austin
As the introductory quote indicates, Milton
Friedman (1959), among others, has advocated
paying interest on reserves.1 In the United States
and many other countries, banks and other financial intermediaries are required to hold a
fraction of their assets as fiat money—unbacked,
interest-free bills of the central bank. In the
absence of interest on these reserves, the average return to assets held by banks must lie
below the market rate of return. This implies
that banks must pay their depositors a return
below the market rate of interest, unnecessarily
discouraging the holding of bank deposits. Because such intervention into the business of
banking is so common, basic questions about
the desirability of such requirements may easily
be overlooked. For instance, by forcing banks to
hold unbacked assets paying no interest, might
the central bank be discouraging banking and
the accumulation of capital?
But where would the interest come from?
As with any government expenditure, interest
paid on reserves must (at least eventually) come
from taxes, raising two questions: Wouldn’t
wealth be reduced by the rise in taxes? Wouldn’t
taxation introduce its own economic distortions,
possibly worse than those that result from the
absence of interest?
Paying interest on reserves would increase
the demand for deposits and thus for reserves.
This, in turn, would raise the value of existing
reserves, increasing the wealth of those who
own bank deposits at the time that interest
payments are initiated. Bruce Smith (1991) shows
that this windfall gain to those holding deposits
at the time the policy is enacted comes at the
expense of future generations; that is, future
generations must pay the taxes to finance the
interest payments but do not receive all of the
resulting benefits. Thus, Smith shows that the
transfer of wealth created by the payment of
interest makes future generations worse off.
In this article, we propose a means of
eliminating this transfer. We begin by discussing
the role reserve requirements play in a simple
economy. People finance the next period’s consumption by holding deposits. The key feature
Joseph H. Haslag
Senior Economist
Federal Reserve Bank of Dallas
P
aying interest on reserves
would increase the demand for
deposits and thus for reserves.
This, in turn, would raise the
value of existing reserves,
increasing the wealth of those
who own bank deposits at
the time that interest
payments are initiated.
FEDERAL RESERVE BANK OF DALLAS
25
ECONOMIC REVIEW FOURTH QUARTER 1995
of the model is that reserve requirements force
banks to hold fiat money as fractional backing
for deposits. The merits of paying interest on
reserves will be clear if the government offsets
the wealth transfer identified by Smith.
Our idea for an offsetting transfer is adapted
from a policy proposed by Leonardo Auernheimer
(1974).2 When interest on reserves is initiated,
the central bank should expand the stock of
nominal reserves to keep the price level from
decreasing. If the central bank uses this increase
in the money stock to purchase interest-bearing
assets (an open market operation), the interest
generated by these assets can help pay for the
interest paid on reserves, lowering the tax burden on future generations. We argue that paying
interest on reserves, when accompanied by the
appropriate open market operation, can make
every future generation better off without hurting initial deposit holders.
We also take up the second of our nettlesome questions: Would taxation introduce its
own economic distortions? The taxes available
to government in the real world are generally ad
valorem taxes; the amount of tax collected is set
at some fraction of an economic variable, such
as income or sales. Ad valorem taxes artificially
discourage the taxed activity, just as the absence
of interest on reserves discourages deposits at
banks. We show that despite this tax-induced
distortion, we can make people unambiguously
better off by paying interest on reserves. This
improvement occurs even if the interest must
be funded by a tax used in the real world—
a distorting ad valorem tax on capital—if this
tax is accompanied by a price-stabilizing open
market purchase.
In sum, our questions about the costs of
paying interest on reserves are fairly straightforward to resolve. Both capital taxation and
open market operations are widely used realworld policy options. Therefore, there exists a
way to finance the payment of interest on reserves that will make the public unambiguously
better off.
nothing when old, but wishes to consume in
both periods of life. The problem facing these
people is the means of financing consumption in the second period of life. There is also
a generation that lives and consumes only in
the initial period, hereafter referred to as the
“initial old.”
In the first period of this model economy,
there is a fixed stock of M (divisible) pieces of
paper called fiat money. In addition to money,
there are also two forms of capital. The first form
is available to any individual in isolation. An
investment of kt goods in period t will produce
f (kt ) consumption goods in period t + 1. The
marginal product of capital, which we express
as f ′(k ), is positive but decreasing. The second
form of capital produces a constant x consumption goods (x > 1) in period t + 1 for each good
invested at t. This latter form of capital can be
made only in amounts greater than y so that no
individual alone has the resources to finance
capital. Both forms of capital produce consumption goods only once.
Note that the second form of capital is
illiquid in this economy because it cannot be
divided into small units. It is easy to see how an
intermediary can overcome this illiquidity by
simply pooling the deposits of many individuals
to an amount greater than y. We assume for
simplicity that the intermediation services are
costlessly and competitively provided by entities
referred to as “banks.” 3
In this economy, we assume that a reserve
requirement is imposed: for each good deposited, a bank must hold fiat money worth γ
goods but is free to invest the remaining 1 – γ
goods in the illiquid, or intermediated, capital
good.4 (We assume throughout this analysis
that the initial old hold positive quantities of
both unintermediated capital and deposits.) If
fiat money’s rate of return is less than that of
capital, banks will hold no more than the required balances of fiat money. Suppose, for
now, that banks do not hold any excess reserves. (We will verify shortly that this is a wise
decision.) If st denotes deposits per young person, then banks will hold fiat money balances
worth γNst goods. Those required reserves
represent the total demand for fiat money
measured in goods. The supply of fiat money
is M dollars or, when measured in goods, vt M,
where vt represents the goods that can be purchased by a single dollar. The goods value of
a dollar is simply the inverse of the dollar price
( pt ) of one good, or vt = 1/pt. Furthermore, the
gross real rate of return from holding fiat money
is the ratio of goods purchased by a single dollar
A model of reserve requirement banking
To address these questions, let us examine
a simple model adapted from the framework
shared by David Romer (1985), Thomas Sargent
and Neil Wallace (1985), Scott Freeman (1987),
and Smith (1991) in which financial intermediaries that mobilize capital are subject to a reserve
requirement.
In each period, starting from some initial
period 1, N people who live two periods are
born. Each produces y goods when young and
26
Figure 1
Determining Savings, Deposits, and Unintermediated Capital for a Given Reserve Requirement
R
Desired savings
f ′(k) = x(1 – γ) – γ
x(1 – γ) + γ
A
f ′(k)
Goods
Deposits
Unintermediated
capital
Total savings
subsequent generation suffers from this lower
rate of return on their deposits. Moreover, with
x > 1, equation 2 indicates that the bank best
serves its depositors by not holding reserves in
excess of those required.
People will invest in the asset paying the
better rate of return. This implies that the people
who hold both deposits and unintermediated
capital will invest in unintermediated capital
up to the point that its marginal rate of return
just equals the rate of return offered by intermediaries:
in period t + 1 to the goods purchased by a
single dollar in the current period, or vt +1/vt .
For the demand for fiat money to equal its
supply,
(1)
γNst = vt M.
Notice that when deposits, st , are constant over
time, the demand for fiat money is constant over
time. Therefore, when the stock of fiat money is
also constant over time, the value of a dollar and
the price level will both be constant over time. It
follows that the gross real rate of return of a
dollar, vt +1 /vt , equals 1.5
What, then, will be the rate of return offered by competitive banks? Assuming for simplicity that intermediation services are costlessly
provided by banks in a competitive market, then
banks will offer depositors the rate of return that
the banks can earn on the assets they hold. This
(gross, real) rate of return (call it R ) is
(2)
(3)
Because an increase in the reserve requirement lowers the return on intermediated capital,
people switch from deposits to unintermediated
capital. This switching occurs until the rate of
return on unintermediated capital falls to equal
the new lower rate of return on deposits.
Figure 1 illustrates the basic point made
in equation 3. The desired savings curve plots
the quantity of savings for next-period consumption at different rates of return. The rate of
return on the vertical axis is equal to the rate
offered by competitive banks and is determined
by the returns on intermediated capital and
reserves. The horizontal line emanating from
the value x (1 – γ) + γ on the vertical axis in
Figure 1 is the return on deposits. For a given
R = (1 – γ)x + γ
because for each good deposited, the bank can
invest (1 – γ) in capital paying the rate of return
x and purchase γ in fiat money paying the rate
of return 1. Notice in equation 2 that increasing
the reserve requirement lowers the rate of return
on deposits by forcing banks to hold more lowreturn fiat money per deposit. Clearly, every
FEDERAL RESERVE BANK OF DALLAS
f ′(k) = (1 – γ)x + γ.
27
ECONOMIC REVIEW FOURTH QUARTER 1995
Figure 2
The Effect of an Increase in the Reserve Requirement from γ to γ ′
R
Desired savings
x(1 – γ) + γ
x(1 – γ ′) + γ ′
f ′(k)
Goods
Deposits
Unintermediated
capital
Total savings
reserve requirements has on savings and each
form of capital.
There is, we should note, a group that
benefits from the imposition of a reserve requirement: the initial old. By assumption, this
group starts with a portfolio of assets that include fiat money. If reserve requirements were
removed, this fiat money would have no value.
Consequently, the value of the initial old’s portfolio would fall. Alternatively, increasing the
reserve requirement increases the demand for
fiat money, making each dollar more valuable
and raising the welfare of the initial old by
raising the value of fiat money (see equation 1).
In short, the reserve requirement transfers wealth
from all future generations to the initial old.
The central bank can increase the rate of
return on deposits if it increases the rate of
return on fiat money by, for example, paying
interest on required reserves. This will increase
the rate of return paid to depositors, but will it
make them better off? As we demonstrate in the
next section, the answer depends on how this
higher rate of return is financed.
level of savings, the distribution between intermediated and unintermediated capital depends
on the assumption that the return on unintermediated capital falls with each additional unit
of this form of capital. Figure 1 captures this
feature by representing the f ′(k) curve as a
downward sloping line. From equation 3, people
add units of unintermediated capital up to
the point at which the return offered by banks
equals the return on unintermediated capital.
This occurs at point A in Figure 1. The horizontal distance between the vertical axis and point
A measures how much unintermediated capital
people will choose. The difference between
desired savings and unintermediated capital—
the horizontal distance between total goods
saved and point A—measures the quantity of
deposits.
An additional implication of equation 3
seen in Figure 1 is that with reserve requirements, the output produced by one more unit of
unintermediated capital, f ′(k), is less than the
output from a unit of intermediated capital, x.6
Therefore, by encouraging people to switch
from intermediated capital to unintermediated
capital, a reserve requirement reduces output
for each good switched. More generally, higher
reserve requirements discourage total savings
because of the lower rates of return offered on
both unintermediated capital and deposits.
Figure 2 illustrates the effects an increase in
A case with interest payments on reserves
In this section, we consider how different
financing schemes affect the desirability of paying interest on reserves. Paying interest on reserves will be deemed desirable if at least one
group is made better off while no other group is
28
harmed. In the model outlined above, the groups
can be identified using the date at which the
policy is implemented as the reference point;
thus, the two groups that come to mind are
those already holding money when the policy is
implemented (the initial old) and the future
generations.
The central bank as an intermediary. Consider first a policy that would have the government pay the interest from interest-bearing assets
of the central bank. Suppose that instead of
leaving the initial stock of central bank money in
the hands of the initial old, the central bank
takes it and uses it to purchase (intermediated)
capital. This gives the central bank ownership of
a stock of capital. (We focus our attention here
on an equilibrium in which the stocks of reserves, central bank capital, and the value of
money are constant over time.) Formally, the
central bank’s balance sheet constraint is
(4)
which equals the gross rate of return on capital
regardless of the size of the reserve requirement.
For any positive reserve requirement, all future
generations are made better off by this plan to
pay interest on reserves because they are offered a higher rate of return on their deposits.
Would anyone oppose such a plan to pay
interest on reserves from central bank capital?
Yes, the initial old would. Notice that this financing scheme begins with the central bank
confiscating the initial old’s money balances without any compensation. Such a tax collection
scheme reduces the wealth holdings of the initial old, reducing their consumption.
The payment of interest on reserves from
central bank capital has the same welfare effects
as abandoning reserve requirements. In both
cases, future generations receive a better rate of
return (x) on their deposits, but the initial old
lose the value of their initial balances of fiat
money.
There are three differences between abandoning reserve requirements and confiscating
the initial old’s money balances. First, when
reserve requirements are simply abandoned, all
fiat money becomes worthless.8 Under central
bank intermediation, however, there is still a
demand for reserves, and the value of a dollar is
again determined by the equality of supply and
demand for reserves set forth in equation 1. As
we have shown, banks will hold zero excess
reserves, so that
K g = vM,
where K g is an interest-bearing asset that represents the value of capital held by the central
bank.7 The central bank will pay interest on its
liability, reserves (central bank money), using
the return on this capital net of its replacement
cost, xK g – K g = (x – 1)K g. If ρ denotes the
nominal net interest paid on a dollar of reserves,
then the interest paid on reserves equals ρvM,
implying that each period the central bank’s
budget requires
(8)
(5)
(x – 1)K g = ρvM.
Second, the model economy described
above specifies that intermediated capital always returns x units of the consumption good
for every one unit invested. It is not difficult to
imagine a situation in which returns are related
to the quality of the investment decisions made.
Under central bank intermediation, we entrust a
governmental body, the central bank, with investment decisions. The central bank may not
be motivated by maximization of profits. Consequently, if the central bank does not choose as
wisely as private banks, the return offered on
reserves may be below the market rate of return.
Of course, one way to remove the investment
decision from the purview of the central bank is
to open the discount window. Banks could borrow funds at the market rate of return and make
the investment decisions. Then the central bank’s
only responsibility would be to restrict its lending to sound banks.
Third, we have thus far assumed that intermediation services are costlessly provided. A
Because the central bank owns capital exactly
equal to the value of reserves (K g = vM ), the
central bank can offer interest on reserves equal
to the net return of capital:
(6)
ρ = (x – 1),
which implies that the gross rate of return on
reserves, 1 + ρ, is x. Because the central bank
backs its money with capital, reserves pay the
same rate of return as other interest-bearing
assets owned by private banks. Under this plan,
the central bank has become an intermediary
paying market interest rates to its depositors
(private banks). Therefore, depositors at private
banks will no longer care what fraction of their
deposits is required to go into reserves. The
gross rate of return on deposits is now
(7)
R = (1 – γ)x + γ (1 + ρ)
= (1 – γ)x + γx = x,
FEDERAL RESERVE BANK OF DALLAS
γNs = vM.
29
ECONOMIC REVIEW FOURTH QUARTER 1995
more realistic assumption recognizes that costs,
such as those of record-keeping, are associated
with creating private intermediary services. With
central bank intermediation, there is a second
level of record-keeping; people make deposits
at banks and then banks make deposits (hold
reserves) at the central bank. If it is costly to
keep records and otherwise manage deposits,
the total of these costs will be higher under this
two-level system of intermediation than under
the one-level setup.
Tax-financed interest on reserves. Suppose
that the central bank wants to finance interest on
reserves without hurting the initial old. It can do
so if each future generation is taxed to pay the
interest.9 Would the benefits of the increased
rate of return exceed the cost of the taxation?
Increasing the rate of return on deposits would
increase deposits and thus capital, as desired.
The increased deposits, however, also increase
the demand for reserves. Greater demand for
fiat money increases the value of the initial
reserves owned by the initial old. (Note from
equation 1, the equality of supply and demand
for reserves implies that v = γNs/M. Clearly, an
increase in s will increase v.) In effect, the taxes
paid by future generations go to pay interest on
reserves and to increase the wealth of the initial
old. Smith (1991) demonstrates that this transfer
of wealth from the future generations to the
initial generation lowers the welfare of the future generations despite the greater rate of return on deposits. To understand this result, note
that the taxes paid by people in the future
generations are exactly equal to the value of the
interest payments received on reserves. These
two changes to lifetime wealth, therefore, exactly cancel each other out. However, the policy
has a side effect: the reserves that the initial
generation owns and that subsequent generations need have been made more expensive.
This transfers wealth from subsequent generations to the initial old. Therefore, the central
bank cannot increase the welfare of the future
generations simply by financing interest on reserves through pay-as-you-go taxation.
Auernheimer (1974) suggests a way to finance the payment of interest on reserves without hurting or helping the initial old.10 The initial
old gain under the tax plan just described because of an increase in the value of their initial
money balances. The value of money can be
brought back to its initial level if the central
bank prints more money, such that the increased
demand for money is exactly matched by an
increased supply of money. How can a plan
featuring taxes and accommodating money sup-
ply increases help the future generations? Let the
central bank use the increase in the stock of its
money to buy capital. The central bank’s exchange of (intermediated) capital for fiat money
is an open market purchase. The additional
capital can then be used to help finance the
payment of interest on reserves, lessening the
tax burden of future generations. Freeman and
Haslag (forthcoming) show that this tax-financed
interest on reserves makes the future generations better off. (A formal proof is also presented
in the appendix.) The higher rate of return on
deposits encourages savings through banks at its
optimal level, without a transfer of wealth from
the future generations to the initial owners of
money. In short, the future generations pay
enough taxes to finance the interest payments
on reserves but do not pay for a transfer to the
initial old.
A case with distortionary taxes
The financing scheme outlined above is
based on a lump-sum tax. The desirability of
taxing to pay interest on reserves may no longer
hold if the tax, like many real-world taxes, itself
distorts individual incentives. An income tax, for
example, may well reduce incentives to work
and invest, therefore causing more economic
distortion than the absence of interest on reserves. To address this concern, we now examine the payment of interest on reserves financed
by a tax commonly used in the real world, a tax
on capital. We show that people are better off
with interest paid on reserves, even if it must be
financed by a tax that discourages the holding of
capital.
Consider, in particular, a tax applied against
the return from both types of capital; that is, the
payment of interest on reserves is to be financed
by a tax of α times the return to both intermediated and unintermediated capital. As with the
lump-sum case described above, we assume
that the government conducts an open market
purchase that keeps the price level constant.
Thus, the net interest on the government’s capital goods plus revenue from the capital tax is
equal to the government’s net interest on reserves.
The question is whether interest-bearing
required reserves are welfare-improving when
financed with a distortionary capital tax. Freeman and Haslag (forthcoming) and the appendix to this article show that the total net return to
the future generations is increased when the
government pays interest on required reserves,
even if the interest is financed by a tax on
capital.
30
The intuition behind this result is fairly
straightforward. If reserves pay no interest, a
reserve requirement directly distorts the return
to intermediated capital. In this way, the reserve
requirement is like a tax on the return to intermediated capital, while unintermediated capital
is not directly taxed. Paying the market rate of
interest on reserves means that deposits earn the
same return as unintermediated capital, ending
the discouragement of deposits resulting from
the lower return from required reserves. Taxing
both intermediated and unintermediated capital
at the same rate spreads the distortion equally,
and thus efficiently, across the two types of
capital. In short, people do not make investment
choices between the two forms of capital based
on after-tax returns. When taxes are applied
equally, both the pre- and after-tax returns are
equalized. The gain from the increased return
on deposits more than offsets the lower after-tax
return on unintermediated capital. Consequently,
future generations have a higher total return
than when the return of only one type of capital
is distorted.11
The payment of interest on reserves encourages people to marginally substitute intermediated capital for unintermediated capital. For
each extra unit of intermediated capital, x goods
are produced, while an extra unit of unintermediated capital produces f ′(k) goods. We have
seen that when intermediated capital is subject
to reserve requirements without interest, f ′(k) =
(1 – γ)x + γ = x – (x – 1)γ, which is less than x.
Therefore, when people switch one unit of savings from unintermediated capital to intermediated capital, more output is gained (x) from the
increase in intermediated capital than is lost
[ f ′(k)] from the drop in unintermediated capital.
Therefore, there is more overall output and
greater welfare when interest is paid on reserves. Output and welfare would be even greater
if the interest could be funded by lump-sum
taxes, but stuck as we are with distorting taxes,
the payment of interest on reserves is still an
improvement.
finance interest-bearing reserves will avoid some
of the pitfalls associated with either directly
taxing initial required reserves or the lump-sum
tax alone. When open market purchases accompany the payment of interest on reserves, members of the future generations are better off
while the initial old are unaffected. Clearly, this
makes society better off. We further show that
paying interest on reserves is strictly better than
not paying interest, even if the taxes are
distortionary. This last result underscores the
distortionary effect associated with reserve requirements. Spreading the distortion across both
types of capital—in the spirit of the Ramsey rule
of efficient taxation —raises welfare.
A key feature of the welfare improvement
is the accommodating open market purchase
suggested by Auernheimer. The payment of interest on reserves effects a transfer from future
generations to the initial old. This transfer can
be exactly offset by an open market purchase.
The assets thus purchased can then be used to
help finance the payment of interest. Such an
accommodation is not beyond the central bank’s
normal operations. Indeed, Haslag and Hein
(1995, 1989) provide evidence that the Federal
Reserve systematically accommodates changes
in reserve requirements with open market operations.
Overall, the main purpose of this article is
to demonstrate that paying interest on reserves
improves welfare in a broader class of model
economies than previously believed. We extend
the class of economies along two distinct lines.
For some time, people have recognized the
improvement that is possible in Friedman’s setting with infinitely lived people and lump-sum
taxes. Smith raises questions about the desirability of paying interest on reserves when the initial
(finite-lived) money holders benefit but are not
taxed. Our first extension shows that welfare
improvement is still possible in this economy if
a simple coordinated financing scheme is
adopted. The second extension shows that paying interest on reserves can improve people’s
welfare, even if the interest is funded through
distortionary taxes.
Conclusions
In this article, we demonstrate how alternative schemes to finance interest payments on
required reserves will affect people. We consider four different schemes: directly taxing
initial required reserves, a lump-sum tax on
future generations, and two financing schemes
that are accompanied by open market purchases —lump-sum taxes and capital taxes.
We show that using lump-sum taxes accommodated by an open market purchase to
FEDERAL RESERVE BANK OF DALLAS
Notes
1
2
31
George Tolley (1957) also argues that the central bank
should pay interest on reserves. Joshua Feinman
(1993) traces the historical evolution of reserve requirements in the U.S. banking system. Feinman also
notes that the Federal Reserve has explicitly supported
legislation authorizing the payment of interest on
reserves since the 1970s.
Auernheimer’s proposal is designed to offset changes
ECONOMIC REVIEW FOURTH QUARTER 1995
3
4
5
6
7
8
9
10
11
in the demand for money induced by inflation rate
changes. Also see Phillippe Bacchetta and Ramon
Caminal (forthcoming), who apply the idea to reserve
requirement changes.
Certainly there are many other services provided by
banks, but this one is simple to model and adequate to
illustrate the points of this article. Other services of
banks are implicitly included in x.
Bacchetta, Phillippe, and Ramon Caminal (forthcoming),
“A Note on Reserve Requirements and Public Finance,”
International Review of Economics and Finance.
Diamond, Peter A., and James A. Mirrlees (1971),
“Optimal Taxation and Public Production II: Tax Rules,”
American Economic Review 61 (June): 261–78.
Feinman, Joshua N. (1993), “Reserve Requirements:
History, Current Practice, and Potential Reform,” Federal
In the United States, the requirement for checkable
deposits at large banks is currently 10 percent, or
γ = 0.10.
More generally, if the economy is growing at the gross
rate n (that is, Nt = nNt –1) and the fiat money stock is
growing at the gross rate z (that is, Mt = zMt –1), the
gross rate of return on a dollar will be n /z.
From equation 3, f ′(k ) = x – (x – 1)γ < x.
The central bank could also buy bonds from private
banks, which would then use these funds to invest in
intermediated capital. This scheme is closer to actual
open market purchases but is equivalent in its effects
to the direct purchases of capital by the central bank.
This would not be true if there were an additional
demand for fiat money as currency (negotiable notes
passed from hand to hand). In most modern economies, the government retains a monopoly on the
issuance of currency by outlawing its issuance by
private banks backed by bank holdings of capital.
This is exactly equivalent to a reserve requirement
of 100 percent on currency.
This is the financing scheme associated with Friedman’s (1959) proposal and investigated by Smith
(1991).
Auernheimer (1974) describes just such a monetary
policy accommodation scheme in describing the
revenue-maximizing rate of inflation.
The idea that taxing all goods improves welfare is
discussed in Frank Ramsey’s (1927) rule for efficient
taxation. According to Ramsey, the government can
raise welfare by setting distortionary taxes such that
the percentage reduction in the quantity demanded of
each commodity is the same. In our setting, Ramsey’s
rule is implemented by taxing both types of capital
as opposed to taxing only one type. This result is
demonstrated by Peter Diamond and James Mirrlees
(1971) in a general setting. Diamond and Mirrlees
demonstrate that taxing an intermediate input is not
part of an optimal policy plan. In a monetary economy,
Kent Kimbrough (1989) shows that the Ramsey tax rule
applied to final goods improves welfare relative to a
case in which intermediate goods were taxed.
Reserve Bulletin, June, 569 – 89.
Freeman, Scott (1987), “Reserve Requirements and
Optimal Seignorage,” Journal of Monetary Economics 19
(March): 307–14.
———, and Joseph H. Haslag (forthcoming), “On the
Optimality of Interest-Bearing Reserves,” Economic
Theory.
Friedman, Milton (1959), A Program for Monetary Stability
(New York: Fordham University Press).
Haslag, Joseph H., and Scott E. Hein (1995), “Does It
Matter How Monetary Policy Is Implemented? Journal of
Monetary Economics 27 (May): 311–26.
———, and ——— (1989), “Reserve Requirements, the
Monetary Base, and Economic Activity,” Federal Reserve
Bank of Dallas Economic Review , March, 1–16.
Kimbrough, Kent (1989), “Optimal Taxation in a Monetary
Economy with Financial Intermediaries,” Journal of
Macroeconomics 11 (Fall): 493 – 511.
Ramsey, Frank P. (1927), “A Contribution to the Theory of
Taxation,” Economic Journal 37 (March): 47– 61.
Romer, David (1985), “Financial Intermediation, Reserve
Requirements, and Inside Money,” Journal of Monetary
Economics 16 (September): 175 – 94.
Sargent, Thomas J., and Neil Wallace (1985), “Interest on
Reserves,” Journal of Monetary Economics 15 (May):
279 – 90.
Smith, Bruce, D. (1991), “Interest on Reserves and
Sunspot Equilibria: Friedman’s Proposal Reconsidered,”
Review of Economic Studies 58 (January): 93 –105.
Tolley, George S. (1957), “Providing for the Growth of the
Money Supply,” Journal of Political Economy 65 (December): 477– 84.
References
Auernheimer, Leonardo (1974), “The Honest Government’s Guide to the Revenue from the Creation of
Money,” Journal of Political Economy 82 (May/June):
598 – 606.
32
Appendix
In this appendix, we show more formally that
paying interest on reserves will make people better
off, even if the interest is financed with a distortionary tax on capital. To do so, we must first calculate
the tax rate that would be needed to pay the market
rate of interest on reserves. We let S represent
total savings — deposits plus unintermediated
capital — per young person and use asterisks to indicate values of variables in the absence of interest
on reserves. The government must finance net
interest on reserves of (x – 1)γ (S – k ) from taxes
on the return from savings, x (S – k ) + f (k ), and
from the interest on the capital it acquires from
the open market purchase in the initial period,
(x – 1)γ [(S – k ) – (S * – k *)].
Altogether, this implies the government
budget constraint is
(A.1)
(A.3)
We can now use the government budget
constraint (equation A.2) to cancel several of the
tax terms with terms on the right-hand side of
equation A.3, leaving us with
(A.4)
(A.5)
x (k * – k ) > f ( k *) – f (k ).
We know that k * > k because unintermediated
capital is taxed when interest is paid on reserves.
Because f (.) is a concave function (capital has a
diminishing marginal product),
(x – 1)γ (S – k ) = x (S – k ) + f (k )
+ (x – 1)γ [(S – k ) – (S * – k *)],
(A.6)
f ′(k )(k * – k ) > f ( k *) – f (k ).
When interest is paid on reserves, we know that
the two forms of capital must offer the same
marginal rate of return; that is, f ′(k ) = x. It follows
that the inequality (equation A.5) is satisfied,
proving that future generations are better off
with interest paid on reserves, even if it must be
financed through a distorting capital tax.
(x – 1)γ (S * – k *) = x (S – k ) + f (k ).
Paying interest on reserves makes future
generations better off if for any given level of
savings, S = S *, the total return net of taxes is
greater when interest is paid on reserves:
FEDERAL RESERVE BANK OF DALLAS
–x k + f (k ) > –x k * + f (k *),
or
or
(A.2)
(1 – )x (S – k ) + (1 – )f (k )
> [x (1 – γ ) + γ ](S – k *) + f (k *).
33
ECONOMIC REVIEW FOURTH QUARTER 1995
@FedFRASER