Frameworks for Monetary Stability
Chapter

9 In Search of a Monetary Anchor: Commodity Standards Re-examined

Editor(s):
Carlo Cottarelli, and Tomás Baliño
Published Date:
December 1994
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Author(s)
WARREN COATS

Without a return to liberal attitudes and self-restraints, a restored gold standard would not work well and would hardly endure. After all, the gold standard is simply a particular set of rules for policy regarding the monetary system; and these rules are no more inherently self-enforcing than any other set of monetary rules.1

For most of recorded history, man has simplified the process of trading by using one or a small number of commodities with convenient properties as the other half of each trade. Trade thus evolved from the exchange of goods and services into the purchase and sale of goods and services for “money.” For virtually all of this history, money was a commodity, such as gold or silver, or a direct claim on such a commodity. With periodic and well-noted exceptions, the value of most money over these many centuries was highly stable over long periods. For example, while the year-to-year value of money (gold) varied considerably under the gold standard in the United States, its value was essentially the same at the beginning of World War II as it had been at the beginning of the Civil War or as it had been at the beginning of the American Union 200 years earlier.2 The establishment of central banks and floating exchange rates (i.e., fiat or paper standards anchored by control of the money supply by central banks) brought an end to such long-run stability in the value of money. Since the beginning of World War II, the value of the U.S. dollar has fallen to about 12 percent of its previous value (i.e., prices have risen by a factor of more than 8). Many other countries have experienced dramatically worse inflations in recent decades.

With such a good record of price stability, it is difficult to understand why commodity standards have been replaced everywhere. The shift from a commodity (price) anchor to a money supply (quantity) anchor occurred because of several shortcomings of commodity standards. The gold standard, for example, suffered from gold’s fluctuating relative value and the costly need to maintain gold reserves in order to redeem money for gold. In addition, the desire by governments to spend more than they could finance with traditional tax and other sources of revenue (historically generally limited to war time) made financing by issuing money increasingly difficult to resist. It is also likely that the public’s anti-inflation resolve was weakened by the mistaken belief in the earlier days of the Keynesian revolution that a little bit of inflation could stimulate economic growth (e.g., that the Phillips Curve was stable in the long-run, as well as other perceptions perpetuated by the Keynesian paradigm).

Experience with discretionary monetary policy generally has not been good for inflation. This poor experience leads to the question of whether the shortcomings of commodity standards could not be diminished or eliminated. This paper explores and clarifies ideas associated with Black (1970), Hall (1982, 1983, and 1987), and Fama (1980)—known as BHF—Greenfield and Yeager (1983, 1986), and others for establishing monetary systems that avoid the shortcomings of traditional commodity standards, while preserving their virtues.3

BHF systems (named for Black, Hall, and Fama) establish a unit of account that is not a unit of money and tie the value of money4 to that of the unit of account rather than the other way around. In this respect, their systems are like traditional commodity standards. The essence of the traditional commodity standard, however, was the maintenance of the link of money’s value to the value of a specific commodity (the unit of account) by making money redeemable for a specific amount of the commodity. Redeemability ensured that the quantity of money was kept consistent with the demand for it at its independently determined value.

This traditional form of redeemability made it impractical to overcome the destabilizing effects of changes in the relative price of gold (or other single commodities used to define the unit of account) by broadening the number of commodities defining the unit of account.5 An important new insight, which overcomes this problem, is that a viable commodity standard does not require the redemption of money for the specific commodities defining the ultimate unit of account. It is sufficient that money be redeemable for an asset equal in current market value to the unit of account (commodity basket). “Indirect redemption” greatly simplifies and reduces the cost of operating such a system. This paper reviews these ideas and discusses a practical strategy for establishing stable money by giving the Fund’s special drawing right (SDR) a constant real value.

The paper is organized as follows. First, it very briefly discusses traditional commodity standards and their weaknesses. Next, it explains the role of arbitrage in controlling the quantity of money for both direct and indirect redemption of money, and then reviews Irving Fisher’s proposals for a unit of account with constant real value, contemporary examples of monetary systems based on independently defined units of account, and the proposals of Greenfield and Yeager (1983, 1986). The next section discusses the reasons that constant real value units of account have not been adopted in the past and suggests that giving the SDR a constant real value would make it more likely that a constant real value unit would be widely adopted. It then discusses some technical difficulties with the proposal. A final section summarizes the conclusions.

Traditional Commodity Standards

The Development of Commodity Money

The use of money shares something in common with the use of language, the telephone, or the facsimile machine—i.e., unless a lot of other people accept and use it also, it cannot be used for the purpose for which it was designed. The (gradual) replacement of barter trade with monetary trade, and the enjoyment of the enormous benefits that resulted from monetary trade, required general (or at least relatively widespread) agreement on the assets that would circulate as money. The establishment of monetary assets and conventions was necessarily a slow evolutionary process. It was quite natural that the first monies were widely demanded, relatively easily standardized, commodities with high values per weight, such as gold and other precious metals. It did not take an inordinate amount of faith to accept gold for goods offered in trade. In the natural effort of entrepreneurs to provide monetary services at lower cost, it was also a logical evolution of the commodity money system to accept paper bills promising to pay specific quantities of gold or other commodities. The acceptability of such paper money rested on the reputation of the issuer (usually monarchs and later banks)—i.e., on the confidence of the accepter in the promise of the issuer to redeem its note for a commodity on demand. The promise of governments to accept the notes of their central banks for taxes and other obligations to the state helps to establish the acceptability of fiat money.

By the nineteenth century, the mere acceptability of money tended to take second place to adopting monetary systems that insured the stability of the value of money and that gave a country’s money international acceptability. Systems based on the convertibility of currency notes for gold or other commodities proved very successful at maintaining relatively stable prices for very long periods of time. A gold standard, for example, required agreement on the amount of gold constituting one unit of money and the willingness of all issuers of money (notes and/or deposits) to redeem their issues for that agreed amount. Though prices were quoted in monetary units, the unit of account was an amount of gold, not (ultimately) an amount of money.6 The redeemability of money for gold insured that the value of a unit of money and a “unit” of gold (i.e., the money price of gold) were kept equal. This point is discussed more fully below. The requirement to redeem money for a fixed amount of gold applied to all institutions that issued money, whether private banks or government banks.

Gold standards had some very attractive features. The requirement to redeem bank money or government money for a fixed amount of gold limited the creation of money to the amount the public was willing to hold at the prevailing price of gold.7 This feature had two very powerful implications. First, the supply of money always adjusted as a result of automatic market mechanisms to the amount desired by the public.8 Second, the institutional arrangements and analytical and administrative skills required to operate such a monetary system were minimal. The monetary authorities had only to passively provide currency (or reserve account balances) when presented with gold, or gold when presented with currency. The supply of gold was endogenously (rather than politically) determined by the cost and other factors of its production in relation to its price. These features resulted in money’s value avoiding the extreme fluctuations that have been experienced with fiat money.

Gold standards had several shortcomings, however. They required inventories (reserves) of gold sufficient to honor potential redemptions, which was a costly requirement. Gold’s relatively inelastic supply (on a worldwide basis) meant that a more rapidly growing demand for money “backed” by gold could be met primarily only through “deflation”—i.e., by an increase in the price of gold relative to goods and services (though not relative to money). Gold’s value, and hence money’s value, was also sensitive to periodic gold discoveries or improvements in mining or refining technologies, which affected its supply and hence its relative price.9 Changes in non-monetary demand for gold could have the same effect.

The Demise of Commodity Standards

In retrospect, the shortcomings of the gold standard seem modest, if not trivial, compared with the damage to the world economy unleashed by what followed it. The full replacement of the disciplining mechanism of redemption for gold (or some other commodity) actually reflected, in my view, revolutionary changes in our views of how economies work and of our capacity to intervene for the better. The Keynesian revolution displaced price stability with (real) income stability as the primary objective of monetary policy and introduced an extreme elasticity pessimism into the thinking of most economists of the time, which justified and called for active aggregate demand management by governments in an effort to keep their economies off the rocks.10

It is illuminating to examine the arguments against commodity standards given exactly forty years ago by a young economist at the Fund who subsequently become its Director of Research.11 He gave the high cost of producing goods to store as reserves for the commodity-backed money less attention than he gave to the inability of commodity money to fulfill what was expected of a monetary system in the 1950s (i.e., income stabilization). Mr. Polak emphasized that the stabilization of the price of a commodity basket that would result from the government’s commitment to buy or sell the basket at a fixed price (with a spread) would have only a modest stabilizing effect on income. What he called the liquidity effect—i.e., the automatic adjustment in the supply of money to match the public’s demand—was virtually dismissed as of little interest. His short discussion of the “Effects on Liquidity” concluded that, “While it may be true that commodity currency would in the end reverse a depression in this way, it would obviously be absurd to rely on this effect of the system to bring a depression to an end” (Polak, 1954, p. 8).

This earlier period was not only characterized by the belief that a market economy’s adjustment mechanisms were very slow, but also by what might be called policy optimism. Economists tended to believe that they were, or soon would be, able to properly diagnose the problems and needs of the economy and therefore present the government with the appropriate policies. A very large literature developed in the late 1960s through the 1980s that explored the difficulties and pitfalls of actually doing so. The other element of policy optimism was the assumption that once the right policy was proposed, the government would implement it in a timely fashion. This assumption has been empirically falsified and the subsequent development of theories of government (or bureaucratic) behavior (public choice theory) explains why these naive assumptions were incorrect.

The experience of the last several decades, and refinements in monetary theory, have resulted in the view that the adjustment mechanisms of market economies are strong (prices flexible and elasticities high),12 and that governments tend to be motivated by short-run considerations and are in need of institutional arrangements that limit and discipline their actions. A large literature has documented the harm done by activist and interventionist macroeconomic policies. The optimism of the 1960s that the economy could be “fine tuned” is now seen as exaggerated and has been replaced with the view that governments should limit themselves to providing the general framework (rules of the game) for market activity. The long run, in which everyone agreed that money had no effect on real income, is now seen as arriving in a relatively short time. As a result, an increasing number of countries (with Fund support) have adopted price stability as the single (or at least the primary) objective of monetary policy. This shift in sentiment is reflected in the agreement to create a European Central Bank, which has been given the single objective of price stability.

The technically least demanding monetary policy, and the one that subjects governments to the most monetary discipline, is one that commits the monetary authorities to redeem their monetary liabilities for something else at a fixed price. The highly successful currency board adopted in Estonia in the summer of 1992, in which the money supply of Estonia is determined by its passive purchases or sales of deutsche mark at the price of 8 krooni per DM, is an example of such a system. Fixing the price of a currency to a commodity basket, with appropriate supporting policies, would be another. If the technical shortcomings of commodity standards could be overcome, they might once again be of serious interest in the new intellectual and political environment of the 1990s.

The New Commodity Standards

As already noted, a fixed money price of gold did not guarantee a constant real value for money because gold’s relative price could change for various reasons. This shortcoming could be reduced by adopting a unit of account based on a basket of many goods rather than just one, because some of the relative price changes of individual goods in the basket will be offsetting. A unit of account composed of many commodities was traditionally thought to be impractical, however, because of the transaction and storage costs involved in redeeming bank money for a basket of many goods. A more recent insight is that the self-regulating character of a commodity standard does not require redemption for the commodity itself. As discussed in more detail below, all that is required is that bank money be redeemable for a marketable asset having a current market value equivalent to that of the unit of account basket.13 Indirect redeemability makes possible a monetary system having the virtues of a commodity standard without its shortcomings.14 Indirect redeemability makes it possible to define a unit of account that has a virtually constant real value over all times, and hence to have money with constant purchasing power over all times.

Indirect redeemability separates the medium of exchange from the unit of account and introduces the concept of a medium of redemption. A medium of exchange is an asset that is widely accepted in trade and to settle financial obligations. Currency notes or transferable bank deposits are typical examples. A medium of account is the commodity defining the unit of account. A unit of account is a specific amount of the medium of account. For example, for the gold standard the medium of account is gold, while the unit of account might be one ounce or one pound of gold of specific purity. A unit of account is the unit in which the medium of exchange and other assets are denominated and in which other values and prices are expressed. Along with the medium of exchange and the medium (or media) of account, there is also a separate medium (or media) of redemption. Just because government fiat money (currency and commercial bank deposits with the central bank) currently serves all three of these purposes in most countries, it must not be concluded that it has always been or must always be so. In the monetary system discussed here, each of the three media will be different. The principal objective of this section is to establish that indirect redemption works—i.e., that it keeps the value of a unit of the medium of exchange satisfactorily close to the value of the unit of account while preserving the independence of the unit of account.

Indirect Redeemability

Consider an economy with paper money supplied solely by a central bank monopoly. These “outside” central bank currency notes may be used as reserves (base money) for a competitive banking system that supplies “inside” deposit money, or may be the only money with no private banks. The unit of account, a Valun (from “value unit”),15 is defined as a specific amount of a large number of goods and services (e.g., the consumer price index (CPI) basket). Money is denominated in Valuns and a one-Valun bill (currency note) is exchangeable at the central bank for one Valun’s worth of some other asset, such as treasury bills, that has a well-defined, market-determined value in terms of Valuns. One Valun is not the same thing as a one-Valun central bank note (i.e., money), but because of redeemability they will both have the same value.16

The mechanisms by which redemption maintains equality between the value of the unit of account and a unit of money can be discussed in terms of the quantity theory of money with causation reversed. Let the real demand for money (md) be given by the full employment level of income and the full employment rate of interest. The price level (P) in Valuns is given by the independently defined unit of account. As when prices of commodities are fixed by decree, the supply must conform to the amount demanded at the fixed price if nonmarket rationing is to be avoided. In the case of money with an independently determined price level, the demand for nominal money balances to which the nominal supply (M) must adjust is given by:

M = P.m.d

The right-hand side of the equation is totally predetermined, so that all adjustments take place in the left-hand side variable.17

What is the mechanism for adjusting the quantity of money to its predetermined nominal demand? Suppose that the central bank overissues paper notes. They will be exchanged by the public for things it would rather have. Some notes may be exchanged directly for the redemption asset by redeeming them at the central bank. Some will be exchanged for other goods and services. To this extent, prices of goods and services quoted in units of money (i.e., Valun bank notes) will rise. The money prices of the items making up one-Valun’s valuation basket would then add up to more than one Valun (that is, the one-Valun basket would cost more than a one-Valun bill). The difference between the market value of bank notes and their redemption value creates an arbitrage incentive to exchange (redeem) them for the redemption asset. The public’s preferences control the quantity of money in light of its independently determined value.

The mechanism can be brought out more clearly by describing its operational aspects. Let the central bank maintain reserves of treasury bills for redemption purposes.18 For simplicity assume that initially, i.e., before the overissue of currency, one treasury bill had a market value of one Valun.19 An overissue of α percent will raise the money price of all goods and services by α percent.20 As a result, the bank note value of the one-Valun valuation basket will be 1 + α. Assuming that the bank note price of one treasury bill remains one Valun, 1 + α treasury bills will have the same market value as the one-Valun basket. Therefore, the issuers of bank notes find that they must offer 1 + α treasury bills per one Valun bank note to honor their redemption obligation. A one-Valun central bank currency note, therefore, can be redeemed for 1 + α treasury bills. Because the treasury bill has a monetary value of one bank note in the market, redeeming one bank note and reselling the 1 + α treasury bills received in exchange results in a risk-free gain of α. People exploiting this arbitrage gain will reverse the overissue of notes, which will be redeemed as long as their nominal value (one Valun) remains below the market value of the valuation basket (1 + α Valuns). Arbitrage will make the overissue of redeemable notes unprofitable, α will never be greater than the transactions cost of going to the central bank and redeeming money at full value. Merchants and others can always accept money as if it is equal to its stated unit of account value both because arbitragers will insure that it is and because merchants themselves are always free to redeem that money for its full stated value.

It is a common misconception that money supplies are limited by the quantity of monetary gold (under a gold standard) or currency reserves (under the present fractional reserve banking system).21 However, an individual bank can always buy all the gold or currency it needs or wants. Money creation is limited by the unprofitability of buying gold or currency when unwanted money is redeemed.

The properties of such systems are well established and understood in the context of the small open economy with fixed exchange rates and freely mobile capital. Such economies cannot independently determine their money supplies, the demand for which is given by real factors affecting the real demand for money and the independently determined price level. The world price level and fixed exchange rate together fix the domestic price level in much the same way that the independently defined unit of account does in the above example.

Fisher’s Tabular Standard and More Recent Examples

Irving Fisher proposed a constant real value price standard over three quarters of a century ago. The plan, as he described it, involved “a combination of the tabular standard [indexing] with the principles of the gold-exchange standard” (Fisher, 1913, p. 337). While Fisher described several slightly different versions of this scheme, in essence the plan “is a convertible paper currency, the paper to be redeemable on demand—not in any required weight or coin of gold, but in a required purchasing power thereof. Under such a plan, the paper money would be redeemed by as much gold as would have the required purchasing power. Thus, the amount of gold obtainable for a paper dollar would vary inversely with its purchasing power per ounce as compared with commodities, the total purchasing power of the dollar being always the same. The fact that a paper dollar would always be redeemable in terms of purchasing power would theoretically keep the level of prices invariable. The supply of money in circulation would regulate itself automatically” (Fisher, 1913, p. 331). At an address to the American Economic Association in Boston, December 1912, Fisher summarized his scheme as follows:

Briefly stated, the plan is to introduce the multiple standard, in which the unit is a “composite ton” or “composite package” of many staple commodities, not of course by using such a package in any physical way but by employing instead its gold bullion equivalent. In essence it would simply vary the weight of gold in the dollar or rather behind the dollar. The aim is to compensate for losses in the purchasing power of each grain of gold by adding the necessary number of grains of gold to the dollar. . . . With the development of index numbers, … we now have at hand all the materials for scientifically standardizing the dollar and for realizing the long-coveted ideal of a “multiple standard” of value. In this way it is within the power of society, when it chooses, to create a standard monetary yardstick, a stable dollar (Fisher, 1913, pp. 494 and 502).

Fisher’s multiple or tabular standard was never adopted in the form he envisaged. However, independently defined units of account have been used in a variety of ways. Pegging an exchange rate and the general indexing of prices and monetary contracts are familiar examples of units of account that are not the medium of exchange. So are SDRs and the European Community’s European Currency Unit (ECU), each of which have values based on a fixed basket of currencies. In fact, those countries that peg the exchange rates of their currencies to the SDR or other currency baskets have adopted a loose form of Fisher’s multiple standard.

In addition to these more traditional examples, modern finance is providing an increasing number of interesting uses of independently defined units of account. One example is the use of mutual fund investments denominated in shares to make payments denominated in a currency. This is an example of share banking, which has very different risks than does traditional par value banking.

Par value banking refers to the traditional practice of recording bank deposits in units of the medium of exchange and transferring or redeeming them at par—i.e., for the same number of units of the medium of exchange. Because the value of a bank’s assets generally fluctuates in terms of the medium of exchange (except, of course, for “reserves,” which are the medium of exchange), the value of its assets will not always change to the same extent as its liabilities. This risk does not exist for share banking where accounts are recorded in units or shares of a portfolio of assets. In this case, the value of a bank’s assets always equals its liabilities. However, the value of its assets and hence its liabilities can fluctuate in terms of the medium of exchange. This potentially makes share bank deposits less attractive as a means of payment since payments are required in specific amounts of the medium of exchange. This problem has been overcome for money market mutual funds by allowing investors to transfer amounts denominated in the medium of exchange, as is done with par banking checks. When cleared, the amount of the check is converted into its equivalent value in units (shares) of the mutual fund and deducted from the depositor’s holdings in the fund.

Another example of an independently defined unit of account is provided by the ECU-denominated bank credits, bonds, and demand and time deposits created by commercial banks. In addition to these and other ECU-denominated assets, a large number of ECU-denominated payments are made daily despite the absence of any central bank or official agency supplying ECU-denominated reserve assets that could be used to settle ECU transfers between banks. To the extent that these payments do not net out between banks in the daily clearing administered by the Bank for International Settlements (BIS) on behalf of the ECU Clearing Association, ECU-denominated loans are extended or equivalent values of other assets are transferred. If one person pays another an amount of ECUs through their respective banks, the payor’s bank (to the extent that it is not the recipient of a reverse transfer through the bank clearinghouse) will either transfer the appropriate amounts of the twelve European currencies in the ECU valuation basket22 or the equivalent value of any one of them (or the U.S. dollar).23 All of these approaches are in fact used.24 The transfer of the agreed settlement asset (national currencies) uses established payment channels. This is an important example of indirect redeemability actually in use.

The private and unrestricted creation of a wide range of financial instruments denominated in ECUs (including credit cards, checking accounts, and traveler’s checks) is also a concrete example of the stability of an all “inside money” system. No central bank or other official agency supplies ECUs to the banking system. It has no “outside,” high-powered reserve asset.25 Banks freely supply whatever quantity of ECUs the public wants. It should be noted, however, that the value of the ECU (and the SDR) floats on the backs of existing national currencies and therefore could not (as presently defined) be a worldwide foundation of value capable of replacing all national currencies.

Guaranteeing Zero Inflation

If a constant real value price standard is adopted, can it be made more secure than previous price standards, all of which have been abandoned (not, however, without many years of good service)?

One of the most challenging objectives of any monetary arrangement is to insure adherence to the rules of the game, whatever they are. Governments are notoriously difficult to discipline. In the end, the governments that set the rules can change them. As long as governments retain control over the supply of money, this danger will exist for any standard adopted. The most that can be hoped for is strong public support for the rules, which makes them politically unattractive to change. Such support is most likely, in my view, if the rules are well understood, viewed as fair, produce generally desirable results, and involve the government (with its necessarily political nature) as little as possible. Rules that do not tempt governments to intervene in the money supply process are also more likely to endure.

Several conditions would be particularly helpful in protecting the rules of the game by making it less attractive or more costly to violate them. Chief among these is the right to contract in any mutually agreed unit (e.g., Valuns rather than Valun notes). Several other conditions would also be helpful: the prohibition of the government’s borrowing from its central bank; the general domestic and international convertibility of money; the right of residents to hold and deal in any monetary assets of their choice; and appropriate rules on the assets that must be held against currencies issued. Though clear rules of the game, as embodied in commodity standards, can be very helpful, ultimately the only safeguard of sound money is a vigilant public that values price stability.

A Proposed Strategy

Money with constant real value is clearly desirable.26 It has been argued above that money with constant real value is also feasible.27 The question immediately arises as to why countries have not adopted such a system. In the absence of constant real value money, why have individuals not adopted constant real value units of account more widely? This section briefly addresses these questions as a prelude to the paper’s central proposal, which is for the Fund to create a unit of account with constant real value—a real SDR.

Adopting a Better Unit of Account

The fact is that very few transactors have adopted units of account with a constant real value. The reason, I believe, is the fact that the convenience of using a single common unit of account is so great that even a relatively bad one already in use is better than using an uncommon unit. A corollary to this is that it is very costly to be the first to use a new unit of account—even a significantly superior one—because much of its benefit can be realized only when almost everyone else is also using it. “An established monetary standard spontaneously persists as a social convention because no trader by himself finds it advantageous to abandon it . . . . If the public are to choose intentionally between standards, they must do so in a setting of constitutional choice” (White, 1983, p. 294). In short, the unit of account is a public good.28

The failure to give sufficient weight to the costs of multiple units of account, in my view, is also the weakness in the suggestion made by Hayek (1978) over a decade ago to allow competition in supplying money as a way of putting market pressure on domestic monetary arrangements and policies. His approach requires only that countries allow their citizens to hold, use, and contract in monies and units of account other than their official national money and that such contracts be enforceable in the relevant courts.29 Hayek’s argument was that any national money whose behavior was considerably inferior to that of other monies would tend to be displaced by them, even in domestic use.30

Hayek (1978) did not clearly distinguish the unit of account from the medium of exchange aspects of his proposal. In fact, he seems to have implicitly assumed that money would be the unit of account.31 However, the implications of and prospects for competing media of payment are quite different than those for competing units of account. Most economies have had considerable experience with the competitive supply of money. For example, U.S. dollar-denominated means of payment include: Federal Reserve notes; coins; personal deposit claims on thousands of different banks, transferable by means of checks, debit cards and wire; bearer claims in the form of cashier’s checks and money orders, similarly drawn on thousands of banks and other institutions; many brands of traveler’s checks; and transferable shares in dozen of mutual funds. No serious transaction costs seem to result from the simultaneous use of many monies as long as they are all denominated in the same unit of account.

Diversity of units of account is more difficult. Much of the purpose of a unit of account is lost if it is not widely used. While the world has learned (at considerable cost) to live with competing units of account internationally (primarily in the form of national currencies), they are generally not in simultaneous use within a given geographical area except in border towns. The efficiency gains of a single standardized unit of account are so large that the behavior of its value must become quite unsatisfactory before it will be spontaneously and voluntarily abandoned.

The above considerations suggest that no country is likely to replace its current monetary arrangements with a constant real value standard unless its monetary system is in serious trouble.32 Residents of countries in the throes of monetary crisis can only turn spontaneously to already established alternative units. As a practical matter they cannot establish new units of their own. In short, a standard, as advocated by Black, Fama, and Hall, with a constant real value will not generally be adopted spontaneously and only well-established alternative units will be considered. The use of the U.S. dollar (or other units) for pricing and/or payment purposes in some Southern Cone countries with very high inflation proves that there is a cost threshold beyond which the established unit will be abandoned, but the alternative unit chosen spontaneously was the existing U.S. dollar rather than the conceptually possible but non-established constant real value unit. Longer-term contracts can also be indexed in order to maintain the real value of prices and other financial obligations stated in terms of money with decreasing purchasing power. However, indexing nominal values is more costly than directly maintaining the real value of nominal magnitudes on average, and it is difficult to make comprehensive. Indexing also suffers from lags in adjusting for monetary inflation. The widespread use of indexed contracts is common only in countries with very high and variable inflation rates (e.g., Argentina, Brazil, and Israel). CPI-indexed futures contracts, which are available in the United States (where inflation is very low), have not enjoyed much popularity. While governments could replace their existing official units with a constant real value unit, they must be prepared and able to forgo the revenue from money creation, and many are not.

How can the preference for stable prices be satisfied, when the choice of a superior unit is only feasible if everyone else chooses the same unit? One way out of this monetary “dilemma” would be to prepare the SDR for the role of an established, constant real value unit waiting in the wings to be adopted by countries (or individuals) with unstable monetary systems whenever they choose to do so. Its value is already independently defined on the basis of collective agreement, and it is already used to denominate a number of international obligations and financial instruments.33

The Special Drawing Right (SDR)

The SDR was created in the late 1960s by collective agreement of the member countries of the International Monetary Fund and generally replaced the several gold units that had been used in international treaties and agreements.34 The SDR is also used by the Fund to denominate all of its financial activities (e.g., loans to its members).

In addition to its official international standing, the attractiveness of the SDR as a unit of account and hence the willingness of institutions and other economic agents to use it for denominating obligations depends on the behavior of its value in terms of real goods and services.35 The present definition of the SDR’s value as a basket of the five major currencies has a number of attractions. As the inflation rates of the five currencies in the SDR valuation basket have generally been lower than the inflation rates of most other currencies, the SDR’s real value has been relatively stable. This definition has also made it easy for commercial banks to create private SDRs on demand without exchange risk to themselves by covering their SDR-denominated liabilities with assets reflecting the composition of currencies in the SDR valuation basket. However, the SDR’s purchasing power has been far from constant (since the adoption of the SDR valuation basket in 1974 its real value has fallen to about one third of its original value) and remains as uncertain as are the inflation rates of its component currencies. Perhaps in part for this reason, its adoption as a unit of account has been quite limited as has the demand for SDR-denominated instruments.

If the SDR had a more stable real value, I believe that it would be far more widely adopted internationally for denominating obligations. An SDR with a constant real value would provide the world with a unit of account very different from any other of international standing and would potentially have dramatic consequences for interest in and use of the unit.36 Providing a more stable contracting unit internationally would also tend to enlarge the extent of world trade and improve the efficiency of international resource allocation. More to the point of this paper, an SDR with a constant real value would be an established unit, which could be adopted easily by individuals and countries. The use of a “real” SDR might be of particular interest initially to individuals or countries whose monetary systems were performing badly.37 It might also exert competitive pressure on domestic monetary systems (following Hayek, 1978) to maintain more stable monetary values.

The United Nations Commission on International Trade Law, in its search for “a universal unit of constant value which would serve as a point of reference in international conventions for expressing amounts in monetary terms,” concluded that the most desired approach was to combine the use of the SDR with an index that would preserve over time the purchasing power of the resulting unit.38 For this purpose several Fund staff members proposed adjusting the amounts of currency in the SDR’s valuation basket in order to offset the effect of changes in the consumer (or some other broad-based) price indices of the five economies whose currencies are in the SDR’s valuation basket.39 An increase in one of the price indices (i.e., inflation) would result in an increase in the amount of that currency in the valuation basket by enough to preserve the command over goods and services that it contributes to the SDR.40 The resulting real SDR would have a higher currency value if its component currencies were inflating than would the current nominal SDR.

Another approach would be to base the SDR’s value on a representative basket of goods. In principle, this basket should be representative of the expenditures of the average world economic unit. As a practical matter, the basket would probably include a relatively small number of internationally traded goods whose price behavior was as representative as possible of the larger hypothetical basket and for which market prices were easily obtained.41

Any of these approaches could be adopted by the Fund’s membership under its existing Articles of Agreement. The method of valuation of the SDR is determined by a 70 percent majority of the Fund’s voting power. However, an 85 percent majority of the total voting power is required for a change in the principle of valuation or a fundamental change in the application of the principle in effect. A decision on the valuation of the SDR would require the consent both of countries that hold SDRs and have other assets denominated in SDRs, such as reserve tranche positions and loans to the Fund, and of countries that have obligations denominated in SDRs, such as outstanding credits from the Fund. It is therefore most unlikely that there would be a change affecting the valuation of the SDR that would be harmful to either creditors or debtors since countries standing to lose from such changes are in a position to block them. More to the point, it is very unlikely that, having adopted a real SDR, the Fund’s membership would be persuaded to abandon it or fundamentally modify it in response to the narrower interests of a few (or even a large number of) countries.

Technical Requirements

Establishing an SDR with more constant real value would require resolving a number of technical difficulties. These will depend on which approach is adopted. The currency basket approach is possible only so long as the national currencies in the valuation basket remain in use. Consequently, it could not be used if the SDR became the common world unit adopted by all countries for national as well as international purposes. This was recognized, for example, by the authors of “The All Saints’ Day Manifesto for European Monetary Community Union,”42 who in essence proposed a constant real value ECU by adjusting the national currency amounts in the ECU’s valuation basket so as to preserve their purchasing power. They recognized the need to abandon that approach once the ECU replaced national currencies within the European Community: “When the [ECU] has ultimately replaced national monies, its supply should be controlled according to a monetary rule that would continue to guarantee its purchasing power stability” (i.e., in their proposal the initial price rule would be replaced by a quantity rule). Consequently, the rest of the discussion in this paper focuses on the use of a commodity basket.

The purpose of the monetary system, and hence of the definition of the unit of account and the operation of the redemption obligation, is to stabilize the purchasing power of money as completely as possible. The value of money should be constant in both the short run and the long run, but especially in the long run. The redemption obligation must be capable of maintaining the money supply demanded with the implied purchasing power. The choice of commodities in the SDR’s valuation basket and the weights assigned to each, therefore, must meet the following criteria: (1) The value of the commodity basket should be highly correlated with the value of the basket of goods and services that ultimately are to be considered as stabilities (e.g., the CPI or GDP deflator). If the value of the valuation basket does not change, then the value of money in terms of the larger basket should not change either; (2) It must be possible to determine the value of the unit of account (i.e., the valuation commodity basket) unambiguously and frequently; and (3) The prices of the commodities in the valuation basket must be sensitive to market conditions and quick adjustment.

The choice of the redemption asset must meet the following criteria: (1) It must be in sufficient supply, or have such supply and demand elasticities that its relative price is not significantly affected by its monetary use; (2) Its price must be easily determined on a frequent basis; (3) Its price must be sensitive to market conditions and quick adjustment; and (4) Its demand should be very elastic.

Criterion (1) for the unit of account would be met best by putting everything into the valuation basket. For example, if the ultimate objective is to stabilize the CPI, the unit of account could be defined as the same basket as is used to compute the CPI. Such a basket, however, would violate criteria (2) and (3). The need for continuous valuation (to be discussed below) limits the items in the basket to commodities or currencies that are easily definable (e.g., a weight of gold of a particular fineness) and that trade in liquid secondary markets. Operation of the system would also be simplified by having only a relatively small number of representative commodities in the basket.43 By periodically adjusting the amounts in the basket to preserve the purchasing power of each, as suggested by Irving Fisher (1913), it is possible, of course, to maintain a constant real value with only one item in the basket just as well (and more easily) as with many. The advantage of having a number of items in the basket is the increased likelihood of relatively constant real value even in the short run (i.e., between adjustments in the basket).44 The conflicting criteria of simplicity and constancy of value suggest a compromise that involves a basket with relatively few items (say 20–50) and somewhat more frequent adjustments in their amounts (say monthly or quarterly). The frequency with which the amounts in the valuation basket are adjusted in order to correct any drift in the basket’s real value should be such as to avoid large discrete changes in the SDR’s value when adjustments are made.45

Value compensating adjustments in the amounts of the items in the basket would be a significant departure from the present method of adjusting the SDR or ECU valuation baskets in that the nominal (current market) value of the baskets would actually change on the days the new baskets come into effect.46 These modest changes would preserve the real value of longer-term contracts denominated in SDRs. Discrete changes in the value of the basket, however, could affect current goods prices and the value of tradable financial instruments near the time of the change, depending on the magnitude of the real change. If basket adjustments were relatively infrequent (e.g., annual), the direction and magnitude of the change in value of the basket could be fairly accurately anticipated and would be built into yields on financial instruments, but would require offsetting adjustments in goods prices at the time of each change. If adjustments were made monthly—e.g., when the previous month’s CPI became available, it is less likely that the change could be anticipated, but the magnitude of each change would likely be very small.

Criterion (2) is that the valuation basket must be capable of being valued continuously—i.e., that the current market prices of the items in the basket must be well defined and knowable. Criterion (3) is that the value of the basket must adjust quickly to market conditions. These criteria are necessary for the smooth functioning of the arbitrage mechanism that keeps the market value of units of money equal to the market value of the valuation basket.47 The arbitrage mechanism that controls the quantity of redeemable money could be unstable if the basket could not be revalued as market prices change or if the prices of its components were sticky. When the market value of the basket is greater than that of a unit of money, it will be profitable to redeem money until its market value rises to that of the basket. This can only happen if the basket’s market value is re-established as monetary redemption proceeds.

To demonstrate these points, consider the example of a daily valuation of the SDR basket based on yesterday’s closing commodity prices. Let the medium of exchange be dollar bank notes and the redemption asset be gold.48 Practical operations require these discrete adjustments in the value of the SDR basket and hence in the dollar redemption price of gold. In equilibrium, the initial condition in this example, one dollar equals one SDR equals one ounce of gold.

Assume an overissue of dollars yesterday that increased all prices proportionally (or at least the prices of gold and all of the commodities in the SDR valuation basket). If on this basis today’s SDR basket is valued at 1 + α dollars (i.e., dollar bank notes), yesterday’s closing market price of one ounce of gold of 1 + α dollars means that one ounce of gold continues to have the same value as one SDR today (based, as assumed above, on yesterday’s closing prices for all goods). This outcome is a simple result of the assumption that yesterday’s inflation did not change gold’s relative price. Today, therefore, it would seem that one dollar can purchase 1/(1 + α) ounces of gold in the market or one ounce of gold at the redemption center. If so, an arbitrage profit can be made by redeeming dollars for gold at the rate of one ounce of gold per dollar and selling the gold in the market for 1 + α dollars per ounce. The resulting redemptions will reverse the initial overissue. As redemptions proceed, the market price of gold (and everything else) will fall until the arbitrage profit opportunity is eliminated.

The preceding description of the adjustment process has overlooked the fact that purchasers of gold will not pay 1 + α dollars an ounce in the market when they also can buy it for one dollar an ounce at the redemption center. Hence gold’s price will remain stuck at one dollar an ounce. But a gold price of one dollar an ounce, when other prices have risen 1 + α percent, is a fall in the relative price of gold. At a lower relative price, more gold will be demanded and this demand will be met by redeeming dollars (which would partially reverse the initial overissue of notes). In light of this, today’s fixing of the SDR value and the redemption price of gold, based on yesterday’s market closing prices, will result in an SDR equal to 1 + α dollars and a gold redemption price of 1/(1 + α) dollars per ounce.49 This fall in gold’s redemption price immediately lowers today’s market price to the same level. As a result, the demand for gold is increased further and is satisfied by additional redemptions of dollars, thus further reducing the initial excess supply and lowering the general price level.

The failure of gold’s market price to rise, or indeed its tendency to fall, results from the assumption that it can be supplied without limit when redeeming notes. In fact, the gold reserves of money issuers will not be unlimited and will need to be replenished or maintained by buying the gold redeemed from the market, thus tending to increase its price along with general prices. This tendency for gold’s price to rise will lead to further redemptions in order to buy gold at the lowest possible price until the excess supply of money is fully reversed. The operation (buying gold on the market in order to redeem dollars with it) will tend to be unprofitable for money issuers (exactly to the extent that it is profitable for those redeeming dollars) and will exert strong pressure on them to reverse the overissue of money and to avoid overissues in the future. While this discussion highlights the importance of using a redemption asset with a high elasticity of demand, ultimately the process of redemption should not affect the relative market price of the redemption asset.

What if the prices of the commodities in the valuation basket are sticky? During the course of the day, the bank note issuer is committed to the redemption price based on yesterday’s closing market prices (any intra-day price adjustment will affect the value of the SDR basket, and hence gold, only tomorrow). If prices (being sticky) do not adjust appreciably during the day, the SDR basket will continue to be worth almost 1 + α dollars the next day as well. As one dollar buys 1 + α ounces of gold today, tomorrow note issuers must stand ready to redeem about 1 + 2α ounces of gold per dollar. On each succeeding day that the SDR rate remains above one dollar and gold’s relative price remains depressed, the redemption (and hence market) price of gold will ratchet downward. For this reason, it has been suggested that sticky prices could make the system dynamically unstable. Such instability, to the extent that it were actually a problem, could generally be avoided by the use of a sufficiently wide bid/ask spread between purchases and sales at the redemption window. A spread would be required in any event, as in the foreign exchange and other asset markets, to cover the cost of the window’s operations.

The use of a commodity (e.g., gold) as the redemption medium would seem to suffer from the problem that it becomes difficult for the market to determine its relative price when the issuers of bank notes are prepared to redeem them for an amount of the commodity equal in value to the SDR basket. Under these circumstances the redemption price of the commodity will set the market price, and the market will be supplied all it wants at that price. The issuers of bank notes cannot respond to the market’s excess demand for the commodity at its most recently posted redemption price by adjusting its price unless the market price of the redemption asset rises. This is exactly what happens as note issuers buy the commodity in the market in order to affect redemptions without unduly depleting their reserves of the commodity. Nonetheless, the operation exerts powerful market forces against the overissue of bank notes.

The use of financial assets as the redemption medium is free of this problem.50 The dollar price of a treasury bill depends only on its (dollar-denominated) interest return (and market interest rates). The purest form of the use of a financial asset as the redemption medium would be the use of bank notes themselves. The moment the dollar value of the SDR basket rose above one dollar, issuers would be required to redeem the basket’s value in bank notes for each bank note returned (e.g., one bank note could be redeemed for 1 + α bank notes). In this case redemption would not reduce the quantity of money directly but would exert powerful market pressure on issuers to do so by selling other assets for their bank notes. The potential for infinite arbitrage profits highlights the importance of revaluing the SDR frequently as market prices change in response to redemptions. Any stickiness in market price adjustments would necessitate bid/ask spreads at the redemptive window.

Conclusion

Defining a country’s unit of account so as to make its real value as constant as possible would have very important implications for efficiency and for the behavior of the monetary system. Much of the disruptive power of monetary shocks reflects the need for money’s value to adjust to its “exogenously” determined supply and the effect of that adjustment on values and expectations throughout the economy when money is the unit of account. The value of the unit of account should not be the slave of monetary policy.

Nonetheless, there is a considerable advantage to quoting prices in units of money and, hence, in denominating money in the independently defined unit of account. Money can be denominated in an independently defined unit as long as the supply of money adjusts to the nominal quantity demanded at the independently determined price level. If all money is redeemable for the unit of account, arbitrage will ensure that the supply of money equals its demand at that price. This proposition is well known from the gold-standard experience.

Like other single commodities, gold’s real value has not been constant. A unit of account based on a basket of many goods would have more stable real value. However, redeeming money for a large number of goods would be costly and impractical. Indirect redeemability will work just as well, however. As long as money is redeemable for assets equal in value to the unit of account, arbitrage will ensure that the supply of money equals its demand at the independently determined price level.

The nature of a unit of account requires its wide acceptance and use. It is therefore unlikely that even a superior unit will be accepted spontaneously in the current environment. Any country prepared to fix the exchange rate of its currency could do so to a unit of account with a constant real value. However, the adoption and spread of a unit with constant real value would be facilitated by its adoption by an established international organization, such as the Fund.

Defining the value of the SDR so as to preserve its real value to the maximum extent possible could achieve this objective, but would be worthwhile even if it did not. Such an adjustment in the SDR’s valuation would make a useful contribution to the efficiency of international trade, contracting, and payments. If the SDR could also be used for denominating domestic obligations, and if SDR-denominated assets could be used to settle them, the SDR could bring the benefits of more certain and more stable monetary value to all who wanted them. In addition, it could become an important competitive force for more stable domestic monetary policies and arrangements in countries that chose not to adopt it. Countries adopting the SDR (or pegging their currencies to it) would constitute a “zero inflation club.”

Given the lack of interest in the SDR outside the Fund, an equally promising, or perhaps even more promising, candidate for becoming a widely used unit with constant purchasing power is the ECU. The members of the European Union might find it politically easier to tie (i.e., peg) their respective currencies (the British ECU, the French ECU, etc.) to a real ECU than to the current currency basket. The resulting surrender of monetary control to the monetary union would be no greater than with any other firmly fixed exchange rate system. It seems more likely, however, that members could more easily find and sustain political support to fix the real value of their currencies than to fix them to the value of some other currency (or basket of currencies) or to surrender monetary control to a political organization (the European Central Bank).51

The relative attractiveness of a real ECU is strengthened by recent developments in Eastern Europe. The absorption of the German Democratic Republic into the Federal Republic of Germany and the unification of their two currencies increase the inflation risk of the German mark (the current anchor of the European Monetary System). In addition, the prospective membership of Eastern European countries in the EMS and therefore the eventual addition of their currencies to the ECU valuation basket is more likely to weaken than strengthen the stability of the ECU’s value. Monetary union based on the redeemability of national currencies for an ECU valuation basket with a constant real value would produce European currencies as uniform as the currency notes of the twelve Federal Reserve Districts of the U.S. Federal Reserve System.

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See Yeager(1984.p. 665).

This paper draws very heavily on the paper “In Search for a Monetary Anchor: A ‘New’ Monetary Standard,” published by the International Center for Economic Growth in San Francisco. The paper is a conceptual examination of commodity standards, not a historical examination of experience with such standards or of the considerable literature on the subject (see, for example, Keleher, 1991).

This paper uses “money” as synonymous with “media of exchange.”

Just as the medium of exchange refers to the asset (e.g., bank notes) used for making payments, “medium of account” refers to the commodity used as the unit of account (e.g., gold). The unit of account is a specific amount of the medium of account.

These very general statements skirt over more complex legal issues of contract law. Many of these issues have been discussed over the years by Sir Joseph Gold in his surveys of legal developments in SDRs, currencies, and gold.

“The economist Julius Landesberger likewise saw it as a grave defect of a system of purely fiduciary money that it could not work well ‘unless it were continuously possible to ascertain most reliably the need of the whole economy for means of circulation at all times and to regulate the monetary circulation correspondingly. To this, however, the resources of science are not adequate today.’ (Landesberger, 1892. p. 68).” as quoted in Yeager (1984. p. 653).

An increase in the demand for money was met by increased purchases of gold by the monetary authorities. Gold was presented for currency from domestic holdings of the public, from increases in the production of gold as a result of its increased monetary value, and from abroad. The international aspect of the gold standard and the ability of changes in monetary conditions in one country to elicit equilibrating capital (and hence ultimately gold) flows to or from abroad, were some of its more attractive features.

A commodity basket standard could greatly reduce the effects of relative price changes on the value of money, but would be very costly to operate as a result of the perceived need to maintain large reserves of all of the goods in the commodity basket for redemption purposes.

Elastlcity pessimism, generally combined with the assumption of very sticky wages and prices (at least in the downward direction), was the belief that the automatic equilibrating mechanisms of market economies (the price and resource allocation adjustments to changes in supply and demand conditions) worked so slowly that large government intervention was required to prevent depression and high unemployment. The experience with the Great Depression of the 1930s predisposed economists, political leaders, and the public to embrace the analysis and prescriptions of Keynesian economics that promptly followed. Virtually all Of the models used by macroeconomists in the 1950s and early 1960s ignored the price level (or explicitly assumed that it was fixed) so that all adjustments to exogenous events were in income and employment.

It is also likely that most economies have evolved in the direction of greater price sensitivity and responsiveness over the last 30 to 40 years.

This point is made by Stanley Fischer (1983).

For example, see Black (1970), Fama (1980), Hall (1982, 1983, 1987), and Greenfield and Yeager (1983, 1986).

Following Yeager(1989).

This discussion abstracts from the fact that secondary market prices contain a bid/ask spread, which reflects the cost of making and operating the market. The existence and appropriateness of a spread is well known from the gold standard experience, which in the case of gold tended to reflect transportation costs. The existence of bid and ask prices for the redemption asset means that the value of one Valun bank note may differ from the value of one Valun by an amount determined by the bid/ask spread of the redemption asset.

With a fiat standard, P would adjust in the equation to an exogenously given M.

Assume that a one-Valun currency note states: “Redeemable for an amount of treasury bills with a current market value equal to that of the basket of goods and services defined as one Valun.” This is not a traditional commodity standard because the redemption asset and the good or goods defining the unit of account are not the same. It would not serve the intended purposes of the scheme to simply redefine the unit of account as one treasury bill because a treasury bill’s price relative to the basket or to individual goods in the basket can change. The avoidance ot such relative price changes is. of course, the only reason for preferring a more complicated basket to a single good for defining the unit of account. More importantly the use of a bond as the unit of account and redemption asset would give rise to a circularity—namely, that bank notes could not simply be promises to pay bonds that were in turn simply claims to bank notes, etc., etc.

Though long-term contracts would legally be denominated in Valuns (the unit of account), it may be assumed that goods and services would be priced in units of money (valun bank notes).

When the conditions for monetary neutrality hold—e.g., absence of wealth effects.

This is obviously a misconception for individual banks (or money issuers), but it is a misconception for all banks collectively as well because not all gold or reserves would be in the banking system.

The number of currencies went from ten to twelve on September 21, 1989.

The values of the ECU in terms of the U.S. dollar and other currencies are circulated and published daily by the Commission of the European Communities. A dollar value may be computed at any time by applying the market exchange rates of the currencies in the ECU valuation basket in terms of the dollar and adding up the dollar equivalent of each currency

See Coats and others (1987). These details of the ECU Clearing House settlements changed after 1987. The current settlement rules are described in Folkerts-Landau and Garber (1991).

The “official” ECU used among EC central banks does not constitute such an asset as it is not and cannot be held by commercial banks.

This point is not defended here, but the reasons would include: (1) more efficient resource allocation because of the improved quality of price signals; (2) increased and more efficient investment as a result of the reduced risk of tong-term contracting; and (3) reduction or elimination of monetary business cycles as a result of elastic adjustment of money supply to (changes in) demand. The widespread use of such money (i.e., truly fixed exchange rates) would extend those benefits from national economies to the world economy. On the other hand, there could no longer be monetary policy in the sense of manipulations of the money supply to influence aggregate demands. I am persuaded by the evidence, however, that monetary policy has caused economic disturbances more often than it has prevented or moderated them. See, for example, Friedman and Schwartz (1963).

The notion of constant real value, however, is somewhat ambiguous. A unit of account can be defined unambiguously as so much gold of a specified purity or as a basket of specific amounts of commodities of particular qualities, but not as a basket of all goods and services, or even of all commodities, present and future. The economic world is characterized by ever-changing relative values between an ever-changing collection of goods and services. This does not mean that the value of a carefully chosen basket of representative commodities might not closely mirror the value on average of all goods and services. Nevertheless, it must be understood that a concretely defined unit of account cannot go beyond aggregating in some fashion the values of a discrete and specific set of things whose values concern us and cannot be defined so as to guarantee its real value in terms of an ever-changing list of all goods and services.

The arguments against the treatment of money as a public good given by White (1983, pp. 291–92) do not apply to the unit of account. An anonymous referee of Coats (1994) made the following insightful observation: “the unit of account is not a public good at the relevant margin. That is, the market gives us one without collective action, … and one is as many as we want. Improvement of the unit of account, or synchronized switching to a better unit of account, could be considered a public good.”

See Gold (various years).

A higher, and especially a less predictable, inflation rate in terms of a currency will make that currency an inferior unit of account. Such a currency will not necessarily be a less attractive means of payment or store of value if it earns a sufficiently attractive interest rate (something not currently feasible for cash). Exchange controls have generally been imposed by countries wishing to maintain below-market interest rates.

The same point was made by Yeager (1983).

In a period of a little more than one year, fourteen of the fifteen former Soviet republics replaced their currencies with new ones. This remarkable period of monetary history differed significantly from the monetary reforms of other countries with rapidly inflating currencies (e.g., in Latin America), in that new currencies were introduced in large measure to replace a “foreign” currency (i.e., the Russian ruble) with a national one. See Wolf (1994) and Coats (1994).

Examples of institutions or agreements that use the SDR are the Arab Monetary Fund, the International Telecommunications Union, the Common Fund for Commodities, and the International Center for Settlement of Investment Disputes.

Historically, the Fund’s members created the new asset in order to supplement existing reserve assets, not to introduce a new unit of account. The SDR’s value was defined to be the same amount of gold as defined one U.S. dollar at that time (1970). Its valuation was first based on a basket of currencies in 1974, following the widespread floating of the major reserve currencies.

This criterion is less important for the units denominating financial instruments because anticipated changes in the “real” value of such units (i.e., anticipated inflation in terms of such units) tend to be reflected (hence compensated for) in the interest rates paid on such instruments.

As Fund quotas are also denominated in SDRs, this would have the further advantage of maintaining the real value of the size of the Fund even when inflation erodes the values of the SDR basket currencies. Similarly the real value of allocated “official” SDRs would be preserved.

In addition to the usual list of high-inflation countries, the countries of Eastern Europe and the former Soviet Union come to mind.

United Nations, General Assembly Document ACN9/200, May 11, 1981.

Each currency component would simply be multiplied by its price Index.

One candidate is gold. However, in the IMF Survey article by Effros (1982), it is reported that “over the last decade the market price of gold appears to have been more volatile than the prices of most commodities.” In addition, the inclusion of gold in the valuation basket might raise questions about the restriction in the Fund’s Articles of Agreement (Article V, Section 12) against fixing the price of gold in the gold market. It is obvious, however, that fixing the gold content of money does not fix the relative price of gold in the gold market.

See Basevi and others (1975). The signatories of the Manifesto were Giorgio Basevi, Michele Fratianni. Herbert Giersch, Pieter Korteweg, David O’Mahony, Michael Parkin, Theo Peeters, Pascal Salin, and Niels Thygesen. Also see Fratianni and Peeters (1979) for proceed ings of conference held by the signatories.

The commodity indexes published by the Fund have 39 prices for 34 primary commodities. Hall (1982) argued in favor of a basket with only four commodities: ammonium nitrate, copper, aluminum, and plywood. Over a longer period all of these indexes have diverged considerably from the CPI. On the other hand, changes in these commodity prices have generally preceded changes in the CPI, suggesting that they reflect excess supply and demand for money more quickly than prices in general. This property makes the stabilization of the money price of a basket of such commodities a strong and ideal instrument for maintaining the appropriate supply of money with which to stabilize prices in general.

By definition, a change in the price of a commodity does not reflect the behavior of the overall price level when it is a relative price change for that commodity. Increasing the number of commodities in the basket should generally increase the probability that relative price changes will be offsetting.

The discontinuities in the value of the SDR that would occur when the valuation basket was adjusted could give rise to a discontinuity in interest rates. However, to the extent that the market correctly anticipates the magnitude of an adjustment, this information will be taken into account in market rates as the adjustment approaches, removing any interest rate discontinuity

The present rules require that a new basket have the same value as the old one on the last day the old one is in use.

The purpose of frequent valuation of the present SOR valuation basket is quite different. It is officially valued daily by the Fund and as needed (i.e., continuously) in private financial markets because most SDR obligations are settled in national currencies and because most SDRs are acquired or used in foreign exchange transactions. If the SDR was adopted as a national (or worldwide) unit of account, SDR obligations would be settled with SDR-denominated assets one for one. Its valuation basket would need to be valued only for purposes of the obligations to redeem SDR-denominated money.

To help keep the distinction clear between the unit of account (one SDR) and a unit of money, which is redeemable for an asset equal in value to one SOR, let us give the unit of money a different name, say one dollar. In equilibrium, then one dollar equals one SDR.

A dollar may be redeemed for an amount of gold equivalent in value to one SDR. One SDR has a value of 1 + α dollars and gold’s price is one dollar per ounce. Hence, one dollar may be redeemed for 1 + α ounces of gold, which implies a gold priceof 1/(1 + α) dollars per ounce.

The assumption here is that one financial asset, say treasury bills, is such a close substitute for any other financial asset that the elasticity of its demand is almost infinite, in which case any tendency for its relative price to fall will bring forth a very large increase in its demand.

Making the European Central Bank independent, with a price stability objective, is an important effort to minimize the political element of its policymaking.

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