260 Monetary theory

give up their defense of pegged rates as speculators enjoyed one-way options

on a mammoth scale. For example, on 1 March 1973 the Bundesbank was
compelled to purchase $2.7 billion, at that time the largest amount of foreign
exchange a central bank has ever had to acquire within a single day
(Bundesbank, 1973, p. 66). The following day it gave up support of the dollar
and floated its exchange rate.

THE UNIQUE POSITION OF THE UNITED STATES

Because of the dollars special international role as the dominant transactions,

intervention and reserve currency, the United States came close to retaining
even under the Bretton Woods system the domestic monetary independence
made possible by floating. Other countries pegged their currencies to the dollar,
while the dollar was nominally pegged to gold. In the United States high-
powered money and the domestically-held part of the money supply were not
usually affected by payments disequilibrium. For example, when the US ran a
payments deficit foreign monetary authorities acquired dollars. Typically they
chose to hold their dollar reserves not in currency and demand deposits but in
short-term US government securities. The actual money remained under US
ownership. Hence, the fundamental proposition of monetary theory held for
the United States even under pegged-but-adjustable exchange rates.

PURCHASING POWER PARITY

Supply and demand determine a freely floating exchange rate. The purchasing
power parity doctrine concerns the approximate level at which supply and
demand will balance. The doctrine notes that people value currencies for what
they will buy. If one Inland dollar buys as much goods and services as three
Outland pesos, a free exchange rate would hover in the range of three pesos
per dollar, 33 cents per peso. An actual rate that unmistakably undervalued the
peso, say 20 cents, would make Outland goods seem great bargains to Inlanders
and make Inland goods seem overpriced to Outlanders. Inland eagerness to buy
Outland goods and Outland reluctance to buy Inland goods would flood the
foreign exchange market with dollars seeking to buy scarce pesos. The
imbalance would eventually bid the rate back toward its purchasing power
parity. Corrective pressures would operate through changes in both the
quantities and the mix of goods traded.
Comparing two countries price levels to calculate a purchasing power parity
presupposes some one assortment of goods and services that can be priced in
 Money in an open economy 261

both countries and that accurately represents the types and relative quantities
of various goods and services produced and consumed in each. In fact, no one
assortment can typify the patterns of production and consumption in both of
two countries, so a direct comparison of purchasing powers is impractical or
dubious. If a calculation is nevertheless required, it is typically a makeshift.
The current parity exchange rate is estimated from changes in the purchasing
powers of the two currencies since some past base period when the actual rate
was supposedly in equilibrium. If the Inland price level has tripled over a certain
period of time while the Outland level has been multiplied by six if Outlanders
have suffered twice as much price inflation as Inlanders then the dollar should
be worth about twice as many pesos as before.
The convenience of using each countrys own price index, constructed in its
own way and representative of the local economy, is also a source of weakness.
The purchasing power parity doctrine is mainly concerned with the forces at
work determining an exchange rate at a given point in time, yet the calcula-
tions deal with price level changes over a span of time, during which many
sorts of changes may have robbed a price index of accuracy and even of clear
meaning. For many reasons, moreover, the base period actual exchange rate
used in the calculation may not have been an equilibrium rate. Tariffs and other
trade barriers may have become more or less severe since the base period.
All these difficulties concern makeshift calculations and do not impugn the
logic of the purchasing power parity doctrine itself. Fundamentally the doctrine
is a theory of monetary influences on exchange rates monetary influences
reflected in price levels. It is closely associated with the quantity theory of price
level determination. Meinich (1968) generalizes Patinkins quantity theory
(1956, 1965) to an open economy. Making simplifying assumptions similar to
Patinkins and working on a similar level of abstraction, Meinich shows, for
example, that doubling the supply of domestic money, given unchanged money
supplies abroad, would result in a doubled price level and a doubled home-
currency price of foreign exchange. Similarly, Patinkin (1989, pp. xxxixxlii)
generalizes his 1965 model of the neutrality of money to the small open
economy. He also shows how a doubling of the money supply results in a
doubling of the price level and price of foreign exchange with an unchanged rate
of interest.
Correctly understood, neither the quantity theory nor the purchasing power
parity doctrine denies that all sorts of influences besides money affect price
levels and exchange rates. Real factors affecting terms of trade and capital
movements, and even speculative capital movements, can of course affect
exchange rates. When these factors are strong, they can swamp and obscure
the influence of relatively small monetary changes reflected in price levels.
A major theme of this book is that one must go beyond the simple mechanics
of the quantity theory (or in this case purchasing power parity) in order to
262 Monetary theory

understand the processes of adjustment at work. When monetary expansion

thrusts initially excessive cash balances onto people, no reason exists to suppose
that they try to unload them onto nontraded goods first and that only later, in
response to changed price relations, they try to unload them onto traded goods
and foreign exchange. On the contrary, traded goods may be among the first
things onto which people try to unload excessive cash balances. When a
currency is losing value in consequence of monetary expansion, it does not lose
value at one stroke or at a uniform pace against all goods and services. Some
prices are stickier than others and an uncontrolled exchange rate is among the
least sticky of prices. It is sensitive and mobile in reflecting actual and antici-
pated changes in price levels and in their underlying monetary causes. The
phenomenon of exchange rates outrunning (or overshooting) their purchasing
power parities is illustrated particularly clearly in the classical hyperinflations.
Market participants do look ahead, taking account of whatever clues they have
to future relative purchasing powers. Demands for cash balances of a countrys
currency, for assets denominated in that currency, and for that currency on the
foreign exchange market respond to expectations of future monetary expansion
and to other speculative factors. (On anticipatory movements in exchange rates,
compare Mises, 1912 [1934] [1981], pp. 2436.)

VOLATILITY OF EXCHANGE RATES

Since 197173 floating rates have moved erratically. Over periods of hours,
months and perhaps even years, capital transactions have far overshadowed
trade in goods and services in determining exchange rates. As someone who
has always strongly favored floating exchange rates, Milton Friedman (1985)
admits that he did not anticipate the volatility in the foreign exchange markets
that weve had.9 Bilateral rates have fluctuated 10 and 20 percent over periods
of months and sometimes several percent from day to day or even within days.
Contrary to hopes pinned earlier on the development of market institutions and
the accumulation of experience, rate fluctuations appear not to have been getting
milder over time. How serious its consequences are is not clear. Volatility seems
not to have impaired the volume of international trade, or not enough for the
effect to be detectable beyond dispute (Aschheim, Bailey and Tavlas, 1987,
especially pp. 43341). Capital movements have flourished, perhaps exces-
sively in some sense.
Exchange rates in part have the character of asset prices, jumping around like
stock prices (if not that widely) as asset-holders seek to rearrange their
portfolios. Movements (overshooting) of exchange rates ahead of or in exag-
geration of or otherwise out of correspondence with the relative purchasing
 Money in an open economy 263

powers of the currencies involved is readily understandable (compare

Dornbusch, 1976). In contrast with the instant flexibility of free exchange
rates, the stickiness of many wages and prices comes into play. As Irving
Fisher said in a broader context (1922, p. 185): Just as an obstruction put
across one half of a stream causes an increase in the current in the other half,
so any deficiency in the movement of some prices must cause an excess in the
movement of others.
Another apparent cause of volatility is noise (compare Black, 1986). High-
technology communications and data-processing bring facts and figures and
rumors to the attention of traders more frequently and in more discrete bits than
in the past, causing frequent shifts in noise-oriented trading decisions. In the old
days, or so one may plausibly conjecture, news spread and its general inter-
pretation changed more gradually as otherwise discrete bits had time partially
to neutralize each other.
The current system is by no means one of free and general floating. It contains
elements of outright pegging and even floating rates are managed. Yeager
(1976b, Chapter 14) explains how official intervention can increase the volatility
of floating rates and provides some historical examples. While speculation itself
can be stabilizing, private speculation based on trying to guess or anticipate
what an authoritys activities and intentions are can be destabilizing. It can lead
to so-called bandwagon effects or herding behavior. The authoritys attempts
to smooth rate fluctuations may actually lead to outright pegging, with all of the
potentially disruptive consequences mentioned above.
Koppl and Yeager (1996) test the theory of big players and herding in
asset markets. A big player is someone who uses discretionary power to
influence the market while being immune from its discipline of profit and loss.
The authors analyze the behavior of the Russian ruble under two different
regimes in the late nineteenth century. One Russian finance minister was an
interventionist and big player. The other was a strict rule-follower and hence
not a big player (p. 371). Using rescaled-range analysis, which serves to detect
herd behavior, they find support that big players do encourage herding. Their
results may help account for the difficulty of explaining exchange rates in the
short to medium run (p. 379).10
Moreover, the special role of the dollar as worldwide reserve and interven-
tion currency, a role that all-around free floating would preclude, exposes the
dollar rate to changeable pressures beyond those directly associated with US
trade and capital flows. A system of managed floating is a compromise one
and may very well combine the worst rather than the best features of truly fixed
and fully free rates. It certainly lacks the automaticity of the adjustment
processes described above.
264 Monetary theory

MONETARY APPROACHES TO THE BALANCE OF

PAYMENTS AND EXCHANGE RATES

Throughout this book we have been using the money-supply-and-demand

approach or framework to explain our monetary theory. (Pages 28 above
explain the distinction between approach and theory.) Rabin and Yeager (1982)
speak of the weak version of the monetary approach to the balance of
payments (MABP) and the weak version of the monetary approach to
exchange rates (MAXR). Each weak version is an approach that uses the
money-supply-and-demand framework to develop propositions and theories
about the open economy. Each is a way of organizing discussion rather than a
causal theory.
The weak version of the MABP presupposes fixed exchange rates. Yeager
(1976b) and Mundell (1968) argue that the three approaches to balance-of-
payments analysis that used to dominate the literature monetary, elasticities,
and absorption reconcile with one another. Each of these approaches raises
questions and focuses attention on certain aspects of reality. Mundell (1968,
pp. 15051) summarizes:

It is not meaningful to question the validity of the three approaches. The terms can
be defined so that they are correct and assert identical propositions, even if capital
movements are included...The identity of the three approaches, when they are properly
interpreted, does not mean that each approach is not in itself useful. [Each approach]
provides additional checks on the logic of balance-of-payments policies.

On the other hand, the strong version of the MABP, associated with Harry
G. Johnson and his followers, is a theory that happens not to be generally valid.
It identifies a countrys balance-of-payments surplus with an excess demand for
money and a balance-of-payments deficit with an excess supply of money. It
denies the possibility that imposed surpluses and deficits can create monetary
disequilibrium. Rather, it views the balance of payments solely as an equili-
brating mechanism that helps remove an excess demand for or supply of
money. For example, this theory views the surplus that follows a devaluation
from equilibrium as a process that eliminates an excess demand for money.
Johnson (1972, p. 91; 1976, pp. 2734) states:

The effect of devaluation is transitory, working through the restoration of the publics
actual to its desired real balances via the impact of an excess demand for money in
producing a surplus...The balance-of-payments surplus will continue only until its
cumulative effect in increasing domestic money holdings satisfies the domestic
demand for money.