Front Matter Page

European Department

Contents

• Summary

• I. Introduction

• II. FCDs and Money

• III. Demand and Supply of Foreign Money

• IV. FCDs and Monetary Policy Under Various Exchange Rate Regimes

  • 1. Floating exchange rates

  • 2. Fixed exchange rates with discreet changes

  • 3. Balance of payments targeting and real exchange rate rules

• V. Fiscal Implications of FCDs

• VI. Financial Programming and FCDs

• VII. Conclusion

• References

• Figures

  • 1. The real money stock and the rate of depreciation

  • 2. The real money stock and the rate of depreciation in the presence of FCDs

  • 3. The real exchange rate, the balance of payments, and the rate of depreciation in the presence of FCDs

Summary

This paper explores the macroeconomic policy implications of foreign currency deposits. A preference for the empirical definition of money implies that in principle it is not possible to decide on the appropriateness of the inclusion of foreign currency deposits in money before the necessary empirical work is carried out. In an inflationary environment, however, a measure of money which includes such deposits will probably satisfy the criterion of the empirical approach. Foreign currency deposits and foreign money in other forms may be held to protect the purchasing power of money holdings from inflation and to carry out transactions with foreigners, especially when there is foreign exchange risk or exchange restrictions.

With flexible exchange rates, the presence of foreign currency deposits, as money, increases the rate of change of prices and of the exchange rate in the face of any monetary disequilibrium. This is because the nominal money supply is endogenous when these deposits are present. When a normally fixed exchange rate system is in place, such deposits will diminish the effect of a devaluation On the real exchange rate and thus on the balance of payments, since the part of the money balances corresponding to these deposits is effectively indexed to the exchange rate. When a continuous depreciation of the currency (i.e., a real exchange rate rule) is followed in order to achieve a perpetual balance of payments surplus, the presence of these deposits implies that there is less of a trade-off between the rate of depreciation/inflation and the sustained balance of payments surplus/real exchange rate.

Larger amounts of these deposits, ceteris paribus, decrease the base over which the inflation tax can be levied, although the introduction of such deposits could raise government revenues. Although these deposits do not fundamentally alter the method of financial programming, they can affect certain aspects of it. If foreign and domestic currency deposits are perfect substitutes, programming should involve the projection of the demand of a broad monetary aggregate, which includes foreign currency deposits, and domestic credit expansion should be geared to cover the full projected growth in that broad aggregate (net of the revaluation effect of these deposits and the desired increase in net foreign assets). If, however, foreign and domestic currency deposits are imperfect substitutes, it would be necessary either to increase interest rates on domestic deposits or permit internal convertibility for the purpose of constituting foreign deposits. In case these options are not available, the programming exercise should involve the projection of the demand for only domestic money and should gear domestic credit growth to the projected growth of only that demand. In the presence of unanticipated movements in money demand or the real exchange rate, setting a ceiling on net domestic assets (excluding only the valuation effect of net foreign assets) would possibly call for unplanned contractions in domestic credit but would protect the program more than setting a ceiling on net domestic assets excluding the valuation effect of both net foreign assets and foreign currency deposits.