Swoboda 1973
Swoboda 1973
Swoboda 1973
The Suntory and Toyota International Centres for Economics and Related Disciplines
Monetary Policy under Fixed Exchange Rates: Effectiveness, the Speed of Adjustment and
Proper Use
Author(s): Alexander K. Swoboda
Source: Economica, New Series, Vol. 40, No. 158 (May, 1973), pp. 136-154
Published by: Wiley on behalf of The London School of Economics and Political Science and
The Suntory and Toyota International Centres for Economics and Related Disciplines
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[MAY
By ALEXANDER K. SWOBODA
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1973] MONETARY POLICY UNDER FIXED EXCHANGE RATES 137
'This assumption is not strictly necessary to the proof of the proposition stated
at the beginning of this section. If we assume that the system is stable and that
people learn, the full equilibrium to which the system eventually converges will
not be affected. However, some assumptions result in an unstable model.
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138 ECONOMICA [MAY
the economic system is stable; (2) that an increase in the money supply,
from equilibrium, tends to create a balance-of-payments deficit; and (3)
that the associated reserve loss tends to reduce the money supply.' For,
suppose that, starting from a position of full equilibrium in the economy,
the monetary authorities increase the domestic assets of the consoli-
dated banking system; for a given stock of foreign-exchange reserves
the money supply increases and a balance-of-payments deficit emerges
(by assumption 2); reserves fall and the money supply contracts (by
assumption 3); as long as the money supply has not returned to its
initial value there must be a balance-of-payments deficit and a further
contraction of the money stock; final equilibrium will occur when the
system has returned to its initial equilibrium position, as it will under
assumption 1. In the final equilibrium, the money supply is returned
to its initial level, as are all real variables and prices. Only the composi-
tion of the consolidated banking system's assets has changed, the
increase in domestic assets being matched by an equal decrease in
foreign reserves.2
Note that this conclusion has been reached independently of any
specific assumnptions as to the existence of capital movements, the
responsiveness of the latter to interest-rate changes, the ratio of traded
to non-traded goods, or the extent to which transitional changes take
the form of real output or price variations. These factors will affect the
path of adjustment (and their role in this context will be discussed in
the next section) but not the final equilibrium. That this should be so is
readily explained. Our assumptions imply that the money supply in an
open economy and under fixed exchange rates is an endogenous
variable in the "long run", that is, that, other things equal, there is
only one money stock compatible with payments equilibrium, and that
the monetary mechanism of adjustment works properly, i.e. that it will
ensure that the money stock converges to its equilibrium value. In an
important sense, our conclusion is nothing but the small-country
counterpart of the Ricardian "natural distribution of specie".
It may be useful to illustrate the above general proposition in the
specific context in which it was originally put by Mundell and amplified
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1973] MONETARY POLICY UNDER FIXED EXCHANGE RATES 139
x F
F3 A3___
B7L
/F2/ , X
do/' X
F1
0Y
FIGURE 1
I See Mundell [8], as reprinted in [10]; and Swoboda [13], from which Figure 1
is reproduced with minor changes. (References in square brackets are listed on
pp. 153-4.)
2 For the variable price case see, in particular, Mundell [9], also reprinted in [10].
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140 ECONOMICA [MAY
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1973] MONETARY POLICY UNDER FIXED EXCHANGE RATES 141
(1) Mw=M+M2=D,+D2+Rl+R2
D1+D2+R1+(Rw-R1)j D1+ D2+Rw,
where M refers to money supply, D to the domestic assets of the
consolidated banking system, R to foreign exchange reserves-, the sub-
subscripts 1, 2 and w refer to country 1, country 2 and the world,
PI ~~T
2 K'
K B
A c K'
T ~K
0 1
FIGURE 2
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142 ECONOMICA [MAY
(2) Pi Y1 = M1 V1;
(3) P2 Y2 =M2V2;
(4) P11P2= Q,
where V1 and V2 are income velocities of circulation, Y1 and Y2 are
real income levels, and Ql is a constant. Substituting from (2) and (3)
into (4) and carrying out log differentiation yields
Noting that Y1, Y2, V1 and V2 are assumed constant (we assumed unit
income elasticity of the demand for money), (5) yields: dlogM1=
d log M2; the increase in the world money supply is distributed propor-
tionately to existing money stocks, the latter being obviously related to
the size of countries (and exactly related if V1 = V2). For instance
suppose that, initially, the money stock of country 1 is $10 and that of
country 2 is $90. Now let country 1 increase the money supply by $1; in
the final equilibrium the money supply of country 1 will have increased
by $0'10, the other $0 90 spilling out to country 2 to increase the latter's
money stock. Money prices will have increased by only 1 per cent.,
even though the stock of money was initially increased by 10 per cent.
in country 1.
Much the same type of result can be obtained in a "Keynesian world"
where each country's economy is represented by the type of model
depicted in Figure 1 above. The bare bones of such a model are given in
Figure 3.1 Income levels replace prices on the abcissa and ordinate,
and the slope of the balance-of-payments equilibrium schedule TT is
equal to m1/m2, the ratio of marginal propensities to import. Assuming
1 A complete analysis of this model can be found in Swoboda and Dornbusch
[15].
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1973] MONETARY POLICY UNDER FIXED EXCHANGE RATES 143
that the income elasticity of the demand for imports is unity in both
countries and that the capital account is initially balanced, an increase
in the world money supply (whatever its origin) again shifts the KK
curve to K'K' and changes income levels in the two countries in the
same proportion. If we now assume that the income and the interest
elasticities of the demand for money are the same in the two countries,
the increase in the world money supply is again distributed among the
two countries in proportion to their income levels (and initial money
stocks) as the system moves from A to B. This result is independent of
the degree of capital mobility since, as Dornbusch and the present
writer have shown [15], the shift in KK is independent of the degree of
capital mobility and the equilibrium interest-rate differential is invariant
with respect to changes in the world money supply.'
Y2
K'
0 Y
FIGURE 3
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144 ECONOMICA [MAY
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1973] MONETARY POLICY UNDER FIXED EXCHANGE RATES 145
(6) M=mB=m(R+D*);
1 dM 1 (dR dD*)
(7) Mdt= 7dt+
Thus, keeping the money supply constant requires
'This statement is approximative rather than exact since the length of time
required to reach equilibrium after a temporary disturbance depends not only on
the speeds of adjustment in various markets but also on whether the approach to
equilibrium is direct or cyclical.
2 It may seem, at first, that treating points like B as quasi-equilibria violates
Walras' law. For how can there be a disequilibrium in the foreign-exchange
market when both the money and goods markets are in equilibrium? The answer
is that a flow excess supply of securities by the public matches their flow excess
demand for foreign exchange. The authorities prevent these disequilibria from
affecting the goods and money markets by absorbing the flow excess supply of
securities at the existing rate of interest through their neutralization operations
and by satisfying the excess private demand for foreign exchange at the existing
exchange rate through their exchange-stabilization operations.
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146 ECONOMICA [MAY
dR mE - (s +m)K1
(9) dt-sm) -) E (M-M*)<O,
where s and m are the marginal propensities to save and import,
respectively, E is domestic expenditure, L the demand for money, K net
capital imports, Y money income, i the rate of interest, M and M* are,
respectively, the actual and full-equilibrium stocks of money (M> M*),
and subscripted variables denote partial derivatives with respect to the
subscript.2 Obviously, the higher the interest responsiveness of capital
flows, Ki, the larger the payments disequilibrium created by a dis-
crepancy between the actual and full-equilibrium money stock. In the
limit, the payments disequilibrium tends to infinity as capital mobility
becomes perfect (Ki-*oo). This is the case where neutralization becomes
impossible and self-contradictory as it would require open-market
operations to be undertaken at an infinite rate; this is inconsistent with
positive and finite reserve stocks-a deficit country would rapidly lose
all its reserves, a surplus country accumulate the world's entire stock of
reserves. To summarize, the higher the degree of capital mobility the
less scope for the disequilibrium effects of monetary policy and the
larger the rate of neutralization operations required to maintain a given
quasi-equilibrium stock of money.3
Consider, next, the role of non-traded goods. To focus on the point at
issue, imagine that there are only three goods in the system; traded or
international goods, non-traded or domestic goods, and money.
Assume that the three goods are substitutes. Assume further that the
foreign-currency price-and hence the domestic-currency price at a
given exchange rate-of international goods is fixed or exogenously
determined. From equilibrium, let the monetary authorities increase
the money supply; the impact effect is to create an excess supply of
money and an excess demand for both domestic and international goods.
The excess demand for foreign goods is reflected in an excess demand for
foreign exchange, and the money supply will tend to decrease as the
authorities sell foreign exchange to stabilize the exchange rate. In the
end, full equilibrium will be re-established when the money supply has
returned to its original level, with international prices and domestic
prices unchanged. However, there will have been a transitory increase
1 Conceptually, it would be preferable to treat capital movements as resulting
from a stock-adjustment process. The flow approach could be considered as a
special short-run version of the stock-adjustment one, the interest sensitivity of
flows depending, in part, on the speed at which portfolios are adjusted.
2 For a derivation and further explanation see Swoboda [13].
3 If the stock-adjustment view of capital movements is adopted, the required
extent of neutralization policies becomes independent of the degree of capital
mobility in the long run; after the stock adjustment has been completed, the
neutralization rate depends only in the trade disequilibrium associated with the
quasi-equilibrium point B.
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1973] MONETARY POLICY UNDER FIXED EXCHANGE RATES 147
in domestic goods prices. The length of time it will take for the system to
return to equilibrium will depend partly on the size of the impact effect
on the excess demand for foreign exchange and hence on the balance of
payments and the rate of change of the money supply. To the extent
that part of the excess supply of money is absorbed by a rise in the
prices of domestic goods, the excess demand (per unit of time) for
international goods will be smaller than it otherwise would be (by
Walras' law). Therefore, other things equal, we would expect the
rapidity with which the system adjusts to a monetary disturbance to be
directly related to the ratio of traded to non-traded goods, even though
the final equilibrium is not.
The same type of reasoning can be applied to the analysis of the role of
non-traded goods in the transmission of "imported inflation". We will
show that, contrary to a belief sometimes expressed, the presence of
PD
0 P*~/
0 po1 p*
FIGURE 4
non-traded goods does not affect the full transmission of inflation in the
long run and in the absence of neutralization policies; it does, however,
affect the "length of the short run" and the rate at which neutralization
operations need to be carried out to maintain the domestic below the
international rate of inflation.
These points are illustrated in Figure 4, which is based on a diagram
used by Mundell to analyse the effects of devaluation (an issue with
which we are not concerned here).' The curve DD shows those combina-
tions of domestic-goods prices, PD, and international-goods prices, PI,
that equate the demand and supply of non-traded goods, II those
combinations of PI and PD that leave the excess demand for international
goods equal to zero, and MM those combinations of the two prices that
equate the demand for money with the existing stock. The three curves
are drawn on the assumption that the three goods are substitutes: in
' See Mundell [11], ch. 9.
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148 ECONOMICA [MAY
addition, assume that the real excess demand functions are homogen-
ous of degree zero in the two money prices and the nominal quantity of
money. Initial equilibrium is at Q. Suppose now that the price of
international goods rises in the rest of the world; the domestic-currency
price of international goods must rise in the same proportion, say from
P?' to P* if the rate of exchange is fixed and if goods arbitrage takes
place. Before the price of domestic goods changes, the impact effect of
the rise in foreign prices is to move the commodity prices to point R;
there is now an excess demand for money and domestic goods and an
excess supply of foreign goods. The price of domestic goods begins to
rise, and the country experiences a balance-of-payments surplus that
shifts the MM curve up and to the right pulling the DD and IH curves
in its wake. Final equilibrium is established at T; by the homogeneity
postulate the money prices and the money supply will all have increased
by PoP*/OPo.'
The movement to T, however, will tend to be slower with non-traded
goods present in the system. For, as domestic-goods prices rise, part of
the initial excess supply of money will be eliminated and the deficit per
unit of time be lower. Similarly, keeping the money supply at its initial
level involves a lower rate of sterilization operations when non-traded
goods are present. As foreign prices rise and the money supply is kept
constant, domestic goods prices rise until the market for domestic goods
is cleared, i.e. the system moves to point S. At S, the flow excess supply
of international goods is equal to the payments surplus and to the rate
of sterilization operations required to keep MM fixed. Define an
aggregate price index by P= aPD + (1- a)PI, where the quantity weights
are, respectively, the shares of domestic and international goods in
total expenditure. Sterilization policies keep the percentage increase in
P below the percentage increase in PI by preventing PD from rising in
the same proportion. The higher the share of non-traded goods in total
expenditure, the less P will increase for given increases in PI and lesser
increases in PD (such as those involved in moving to point S). The greater
the elasticity of substitution between traded and non-traded goods,
the closer the percentage increase in PD will be to that in P, (the closer
point S will lie to point T) and the less successful will a sterilization
policy be in moderating the rise in the price index p.2
I It may be interesting to note that Mundell shows that a devaluation of
P,P*IOPI- leads to a final equilibrium at T. Thus we,have shown that an x per
cent. devaluation is equivalent in its effects to an x per cent. "exogenous" increase
in foreign prices, a point that is consistent with a proposition developed by
Kuska [5] in an analysis of devaluation based on a Patinkin-type disaggregated
model. Kuska shows that an x per cent. devaluation is equivalent to a (lOOx/100-x)
per cent. increase in foreign money stocks. With due attention paid to the defini-
tion of percentage changes, the two propositions are equivalent.
2 In the discussion in the text capital movements were neglected. If we allow for
the existence of a bond market, the excess demand for money created by the
imported inflation at point Q would tend to result in a rise in the interest rate. As
the rate of interest would be higher when the system is at S than when it is in full
equilibrium, capital inflows will tend to take place and make the task of keeping the
domestic below the world rate of inflation more difficult.
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19731 MONETARY POLICY UNDER PIXED EXCHANGE RATES 149
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150 ECONOMICA [MAY
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1973] MONETARY POLICY UNDER FIXED EXCHANGE RATES 151
1 A case can also be made for the use of monetary policy to stabilize income and
prices when disturbances originate in finite shifts in the public's portfolio prefer-
ences.
2 See Mundell [7], reprinted in [10].
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152 ECONOMICA [MAY
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1973] MONETARY POLICY UNDER FIXED EXCHANGE RATES 153
of the policy mix may, or even is likely to, run counter to the dictates
of the welfare considerations imnplied by maximization -of a social
welfare function over time.' In the context of the policy-mix model, this
last consideration implies that a third instrument be found to make the
composition of the balance of payments consistent with the steady-
state one that maximizes world welfare over time.
REFERENCES
[1] Courchene, T. J., "The Price-Specie-Flow Mechanism and the Gold-
Exchange Standard: Some Exploratory Empiricism Relating to the
Endogeneity of Country Money Balances", in H. G. Johnson and A. K.
Swoboda (eds.), The Economics of Common Currencies, 1973.
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154 ECONOMICA [MAY
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