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Monetary theory

productive resources. It neglects the rationing function of interest rates along

with other prices. To extend bank credit all across the board means giving
various lines of production more money with which to bid against each other
more intensely for limited resources. The result is higher resource prices, costs
and product prices. Money, made less scarce, loses purchasing power.
At increased prices, the real-bills doctrine allows a firm that will bring a
given physical quantity of goods to market to obtain a proportionately increased
loan in dollar terms. Rising prices call for an increase in the quantity of money,
falling prices for shrinkage of money. The real-bills doctrine ties the nominal
quantity of money to the nominal values of goods, not their physical quantities.
No physical quantity, whether of gold or anything else, defines the dollar. Its
purchasing power depends on the quantity of money interacting with the
demand for money, and the quantity of money under the real-bills doctrine
depends on the price level. Thus the quantity of money is anchored to a consequence of itself, which means not being anchored at all. The purchasing power
of the dollar is not anchored either. The real-bills doctrine, by itself, leaves the
money supply and price level indeterminate. In terms of Chapter 2, it lacks a
critical figure.12
Thornton (1802 [1978]) exposed the fallacy of the doctrine, yet it is
remarkably durable. In the United States it was one of the leading ideas
underlying the Federal Reserve Act of 1913, particularly in provisions for rediscounting of short-term commercial and industrial loans (as well as agricultural
loans). The doctrine was one of the ideas contributing to the German hyperinflation that climaxed in 1923 (see pages 2234 above).

NOTES
1. Dowd (1996, p. 430) presents some examples of how inflation can actually undermine the
original intent of a law.
2. Hicks (1977, pp. 11416) and Okun (1979, pp. 15) discuss these matters, including the role
of notions of equity in setting prices and especially wages.
3. Allais (1947) explicitly mentions land as well as money in his argument about unproductive
diversion of the willingness to save (see pages 5051 above). Fry (1988, p. 17) also recognizes
the point.
4. For eloquent remarks about the sidetracking of savings from capital formation into gold,
jewels, foreign money and foreign securities, luxury cars, furniture, real estate, and so forth;
about the appearance of easy gains; about the separation created between activities that are
privately and those that are socially most profitable; and about social tensions bred by inflation
conditions observed in Latin America see Costanzo (1961, pp. 13035).
5. Yeager (1976a) provides a fuller, partly mathematical, discussion of bootstrap inflation.
6. Several of the essays in Humphrey (1993) deal with the bullionist controversy.
7. He regarded money supply growth as accommodating rather than exogenous. For insight into
his thinking, see League of Nations (1946, pp. 1617, 31) and his address to the executive
committee of the Reichsbank on 25 August 1923, reprinted in Ringer (1969, pp. 936).

Inflation

241

8. The doctrine was so called because it held that money issues were sound if connected with
the banks discounting of real bills, that is, lending on bills of exchange associated with the
production or marketing of actual goods. For further discussion, see, besides Thorntons book,
Mints (1945), Humphrey (1982a) and this chapters Appendix.
9. Trevithick (1977, pp. 945), attributing the ideas summarized to J.R. Hicks and R.F. Kahn,
among others.
10. A growing literature has developed concerning the political business cycle. Snowdon and
Vane (1997b) provide a summary.
11. Fellner long insisted on points like these. See, for example, 1976, especially pp. 23, 1215,
11618 and 1978, pp. 112.
12. Humphrey (1982a) notes the similarity between the real-bills doctrine and the attempt by the
monetary authority to peg permanently the interest rate at too low a level. He argues (1983a)
that classical and neoclassical economists recognized that the authority could not permanently
peg the real rate of interest.

9. Money in an open economy

This chapter shows how monetary theory expounded without attention to the
outside world can be adapted to an open economy. It stresses the role of money
in balance-of-payments equilibrium, disequilibrium and adjustment. It contrasts
the processes determining a countrys money supply under fixed and floating
exchange rates. It illustrates the problems of compromise systems and reviews
experience accumulated and theoretical contributions made since floating
became widespread in 197173. Again the Wicksell Process plays a major role
in the analysis.

THE INTERNATIONAL GOLD STANDARD

Under a gold standard, a countrys monetary authority keeps the national
monetary unit and a definite quantity of gold equal in value on free markets. It
stands ready to buy (or coin) unlimited amounts of gold at a definite price and also
to sell unlimited amounts at the same or nearly the same price, as by redeeming
its paper money. An international gold standard exists among all countries that
tie their moneys to gold and allow its unrestricted import and export.
The international gold standard, which ended in 1914, limited exchange rate
fluctuations. Each government or monetary authority made its currency and
gold freely interconvertible at a fixed price. The United States would coin gold
into money and redeem money in gold at the rate of $20.671835 per fine troy
ounce. The British pound sterling contained 4.86656 times as much gold as
the dollar. When the dollar price of sterling on the foreign exchange market
rose above this mint par of $4.86656 by more than roughly two cents, arbitrageurs could make a profit. They would redeem dollars in gold, ship the gold
to England, have the gold recoined there into pounds sterling (or sell it to the
Bank of England at a corresponding price), thereby obtain sterling for dollars
more cheaply than at the exchange rate, and sell the sterling on the foreign
exchange market for more dollars than they started with. In so doing, the gold
arbitrageurs would check any further rise in the dollar rate on sterling. At the
opposite extreme, when the dollar price of sterling fell more than roughly two
cents below mint par, arbitrageurs could profitably redeem sterling in gold,
ship the gold to the United States and convert it into dollars, thereby obtain
242

Money in an open economy

243

more dollars for their sterling than corresponded to the exchange rate, and have
a profit in dollars after buying back their original amount of sterling on the
foreign exchange market. So doing, they would check any further fall in the
dollar rate on sterling.
The spread between the mint par and each of the two so-called gold points
on either side of it corresponded to the costs of crating and shipping and insuring
the gold, the interest lost on wealth tied up in gold in transit, and other costs of
carrying out the arbitrage. Since the interest loss and other costs of gold arbitrage
changed from time to time and since some of the costs were matters of rough
estimate anyway, the spread was not constant and precise. Still, the limits to
exchange rate fluctuation under the gold standard ordinarily stayed close to
mint par as in our example.
Each government (except in a few countries on a gold exchange standard)
ordinarily left exchange rate stabilizing operations to private gold arbitrageurs.
With minor exceptions, it restrained itself to maintaining two-way convertibility between its monetary unit and a fixed amount of gold.
When a gold standard currency had weakened almost to its so-called gold
export point, people would realize that it could not weaken much further and
that it would probably rise. Speculative or quasi-speculative capital movements
then came to the support of the currency and tended to keep gold exports from
actually becoming profitable. At the other extreme, outflows of speculative
capital from a country whose currency had almost reached its gold import
point would tend to keep inward gold arbitrage from becoming profitable. The
danger of distrust and destabilizing speculation was slighter under the gold
standard than under the compromise systems that followed because preserving
two-way convertibility between each national money unit and a fixed quantity
of gold was then seen as almost an overriding goal of financial policy.
The permanence of this policy depended in turn on a connection between a
countrys monetary gold stock and its stock of all kinds of money, including
banknotes and bank deposits. In a country losing gold because of excess imports
of goods, services and securities, the total money supply decreased. A country
gaining gold experienced monetary expansion. Governments had little scope to
manage money supplies to suit themselves, even if full employment and price
level stability had been their objectives. Money supplies, prices, employment,
production and incomes had to respond to the requirements of keeping foreign
transactions balanced at fixed exchange rates. Each country had to let deflation
and inflation at home keep generally in step with world-wide monetary
conditions (see pages 2524 below). Because countries gave up their monetary
independence in order to keep their exchange rates fixed, we say that they
adhered to the rules of the game.

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Monetary theory

MONEY AND THE BALANCE OF PAYMENTS

When exchange rates are fixed but a countrys currency is weakening under
the pressure of excess imports of goods, services and securities, the monetary
authority supports it by buying it with foreign exchange (broadly interpreted to
include gold) held in reserve for that purpose. In doing so the authority fills the
gap between the total value of imports of goods, services and securities and the
smaller value of total exports. This gap is the balance-of-payments deficit.1
Actually, the authority maintains as well as fills the gap, for if it were not
filled it could not exist. Unless it is financed, overimporting cannot occur.
Instead, the value of the countrys imports would necessarily shrink to the value
of its exports in some way or other, perhaps by depreciation of the home
currency or by controls designed to choke off demands for foreign exchange.
In keeping the exchange rate fixed, the authority can go on filling the gap only
as long as it has reserves left or is able to borrow more abroad.
An opposite imbalance, a surplus, requires the authority to absorb foreign
exchange and pay with home money to prevent its currency from strengthening. In doing so and thus financing and maintaining the countrys excess of
sales over purchases in foreign transactions, it faces no limit as definite as the
one in the opposite situation. It can create home currency to keep it from
strengthening, but it cannot of course create foreign exchange in the deficit case.
The authoritys sale or purchase of foreign exchange is similar in its monetary
consequences to its open-market sale or purchase of domestic securities, but
with one important difference. Although open-market operations are usually
undertaken at the authoritys discretion, foreign exchange sales and purchases
are practically automatic if the authority is committed to a fixed exchange rate.
Therefore, a payments deficit will shrink its base of high-powered money and
its money supply in turn. Conversely, a surplus will cause multiple expansion
of its money supply. The authority may try, however, to sterilize these results
by undertaking deliberate open-market operations with opposite monetary consequences. For example, it may try to match purchases of foreign exchange
with sales of domestic securities. Sterilization though would violate the rules
of the game for fixed rates.

DEMAND-DETERMINATION OF THE MONEY SUPPLY

UNDER FIXED RATES
According to the fundamental proposition of monetary theory, incomes and
prices adjust to make desired nominal cash balances equal in the aggregate to
the actual money supply. This proposition holds in a closed economy or an