MMP BLOG #11: MODERN MONEY THEORY AND ALTERNATIVE EXCHANGE RATE REGIMES

L. RANDALL WRAY

Floating vs fixed exchange rate regimes. The previous blogs were quite general and apply to all countries that use a domestic currency. It does not matter whether these currencies are pegged to a foreign currency or to a precious metal, or whether they are freely floating—the principles are the same. In this blog we will examine the implications of exchange regimes for our analysis.

Let us deal with the case of governments that do not promise to convert their currencies on demand into precious metals or anything else. When a $5 note is presented to the US Treasury, it can be used to pay taxes or it can be exchanged for five $1 notes (or for some combination of notes and coins to total $5)—but the US government will not convert it to anything else.
Further, the US government does not promise to maintain the exchange rate of US Dollars at any particular level. We can designate the US Dollar as an example of a sovereign currency that is nonconvertible, and we can say that the US operates with a floating exchange rate. Examples of such currencies include the US Dollar, the Australian Dollar, the Canadian Dollar, the UK Pound, the Japanese Yen, the Turkish Lira, the Mexican Peso, the Argentinean Peso, and so on.
In the following sections we will distinguish between these sovereign nonconvertible floating currencies and currencies that are convertible at fixed exchange rates.
The gold standard and fixed exchange rates. A century ago, many nations operated with a gold standard in which the country not only promised to redeem its currency for gold, but also promised to make this redemption at a fixed exchange rate.
An example of a fixed exchange rate is a promise to convert thirty-five US Dollars to one ounce of gold. For many years, this was indeed the official US exchange rate. Other nations also adopted fixed exchange rates, pegging the value of their currency either to gold or, after WWII, to the US Dollar.
For example, the official exchange rate for the UK Pound was $2.80 US. In other words, the government of the UK would provide $2.80 (US currency) for each UK Pound presented for conversion. With an international fixed exchange rate system, each currency will be fixed in value relative to all other currencies in the system.

In order to make good on its promises to convert its currency at fixed exchange rates, the UK had to keep a reserve of foreign currencies (and/or gold). If a lot of UK Pounds were presented for conversion, the UK’s reserves of foreign currency could be depleted rapidly.
There were a number of actions that could be taken by the UK government to avoid running out of foreign currency reserves, but none of them was very pleasant. We will save most of the details for a later discussion. The choice mostly boiled down to three types of actions: a) depreciate the Pound; b) borrow foreign currency reserves; or c) deflate the economy.
In the first case, the government changes the conversion ratio to, say, $1.40 (US currency) per UK Pound. In this manner it effectively doubles its reserve because it only has to provide half as much foreign currency in exchange for the Pound. Unfortunately, such a move by the UK government could reduce confidence in the UK government and in its currency, which could actually increase the demands for redemption of Pounds.
In the second case, the government borrows foreign currencies to meet demanded conversions. This requires willing lenders, and puts the UK into debt on which interest has to be paid. For example, it could borrow US Dollars but then it would be committed to paying interest in Dollars—a currency it cannot issue.
Finally, the government can try to deflate, or slow, the economy. There are a number of policies that can be used to slow an economy—but the idea behind them is that slower economic growth in the UK will reduce imports of goods and services relative to exports. This will allow the UK to run a surplus budget on its foreign account, accumulating foreign currency reserves.
The advantage is that the UK obtains foreign currency without going into debt. The disadvantage, however, is that domestic economic growth is lower, which usually results in lower employment and higher unemployment.
Note that a deflation of the economy can work in conjunction with a currency depreciation to create a net export surplus. This is because a currency depreciation makes domestic output cheap for foreigners (they deliver less of their own currency per UK Pound) while foreign output is more expensive for British residents (it takes more Pounds to buy something denominated in a foreign currency).
Hence, the UK might use a combination of all three policies to meet the demand for conversions while increasing its holding of Dollars and other foreign currencies.
Floating exchange rates. However, since the early 1970s, the US, as well as most developed nations, has operated on a floating exchange rate system, in which the government does not promise to convert the dollar.
Of course, it is easy to convert the US dollar or any other major currency at private banks and at kiosks in international airports. Currency exchanges do these conversions at the current exchange rate set in international markets (less fees charged for the transactions). These exchange rates change day-by-day, or even minute-by-minute, fluctuating to match demand (from those trying to obtain dollars) and supply (from those offering dollars for other currencies).
The determination of exchange rates in a floating exchange rate system is exceedingly complex. The international value of the dollar might be influenced by such factors as the demand for US assets, the US trade balance, US interest rates relative to those in the rest of the world, US inflation, and US growth relative to that in the rest of the world. So many factors are involved that no model has yet been developed that can reliably predict movements of exchange rates.
What is important for our analysis, however, is that on a floating exchange rate, a government does not need to fear that it will run out of foreign currency reserves (or gold reserves) for the simple reason that it does not convert its domestic currency to foreign currency at a fixed exchange rate. Indeed, the government does not have to promise to make any conversions at all.
In practice, governments operating with floating exchange rates do hold foreign currency reserves, and they do offer currency exchange services for the convenience of their financial institutions. However, the conversions are done at current market exchange rates, rather than to keep the exchange rate from moving.
Governments can also intervene into currency exchange markets to try to nudge the exchange rate in the desired direction. They also will use macroeconomic policy (including monetary and fiscal policy) in an attempt to affect exchange rates. Sometimes this works, and sometimes it does not.
The point is that on a floating exchange rate, attempts to influence exchange rates are discretionary.  By contrast, with a fixed exchange rate, government must use policy to try to keep the exchange rate from moving. The floating exchange rate ensures that the government has greater freedom to pursue other goals—such as maintenance of full employment, sufficient economic growth, and price stability.
As we continue this discussion in coming weeks, we will argue that a floating currency provides more policy space—the ability to use domestic fiscal and monetary policy to achieve policy goals. By contrast, a fixed exchange rate reduces policy space. That does not necessarily mean that a government with a fixed exchange rate cannot pursue domestic policy. It depends. One important factor will be whether it can accumulate sufficient foreign currency (or gold) to defend its currency.
Next week, however, we will take a brief diversion to examine so-called commodity money. The fixed exchange rate based on a gold standard has been a reality in relatively recent times. And during much of the past two millennia, governments issued coins with silver and gold content. Many equate these with “commodity money”—a monetary system supposedly based on precious metal, indeed, one in which money derives value from embodied gold or silver.
We will come to a surprising conclusion, however. Even coins made of gold and silver are really IOUs stamped on metal. They are not examples of commodity money. They are sovereign currencies.
I can already hear the teeth of our resident Austrian gold bugs rattling so hard their fillings threaten to shake loose.

18 Responses to MMP BLOG #11: MODERN MONEY THEORY AND ALTERNATIVE EXCHANGE RATE REGIMES

  1. 1. I see Ramanan bring the IMF currency convertibility article up all the time. What are the implications of this, and how does it affect our analysis?2. For future posts perhaps, are there other pros and cons to floating and fixed exchange rage regimes other than policy space? For example, the floating regime gives more policy space, but what are the potential cons that come along with it and vice versa? Does it also depend on the 'economic status' of the sovereign country?Thanks!

  2. From post #1 – "Finally, we will explore the nature of money. We will see that money cannot be a commodity, rather, it must be an IOU."Why must money be an IOU?

  3. "so hard their fillings threaten to shake loose."Gold fillings obviously…

  4. I've been wondering whether there ever can be such a thing as a free-floating exchange rate given the power of speculative attacks in the world.As you point out the defence of the rate has to be discretionary, but when under sustained speculative attack the real effect of cost push inflation surely can become so great that a country is forced to act.At which point you become essentially a fixed rate currency for a while. Or a candidate for regime change.Assuming a lack of consensus, are there any policy defences that a country can take on its own against the speculators? Or is it the case that MMT's recommendations can only really work initially in those countries with currency areas so large they are difficult to move significantly speculatively?

  5. "…in which the government does not promise to convert the dollar.""Indeed, the government does not have to promise to make any conversions at all."That is inconsistent with Article VIII, Section 4 of the IMF Articles of Agreement.

  6. "The choice mostly boiled down to three types of actions: a) depreciate the Pound; b) borrow foreign currency reserves; or c) deflate the economy. "- In a fixed exchange rate. If the country does not do a or b, then c is the de facto choice.

  7. Commodity money… I suppose citizens/consumers could be stocked with scales & whatever other types of instruments needed to certify the purity of the metal…LOL.. Then would need to follow the price of the metal by the minute to calculate what we would actually be paying for the goods/services. The instant a sovereign state assigns value to the metal then it is no longer a commodity.

  8. Anonymous,Money never worked the way everyone says it works. This from Warren Moslers's site:http://moslereconomics.com/mandatory-readings/what-is-money/

  9. How does a government accumulate foreign exchange reserves via trade? Does the government itself need to sell goods directly to another country, or does the private sector do that? Does a government actually hold physical currency or have foreign money in an account? If there is a transaction between the private sectors of two countries, does the country that has a trade surplus accumulate foreign reserves?

  10. @ RamananEvery religious belief system in this world quotes their text (G.O.D.'s word no less) as an authority for their prejudices and principles.Whilst doing exactly whatever it is they want to do, changing the rules accordingly (re-interpreting or editing the text).It's what people do that matters, not what they say.When humans decide it is best to look after everybody on the planet, then the ideologies will reflect that. Even the legal system in the end is just a series of plastic concepts, as is every political system. The IMF article you quote will one day just be used for toilet paper (recycled)! What do you want? When Ramanan rescued Sita, he didn't have to abide by the social mores of the time and banish her.Cheers …jrbarch

  11. jrbarch,Irked .. heh ?Yes, break the rules! Make a manifesto. "The IMF article you quote will one day just be used for toilet paper (recycled)! What do you want? "Just wanted to point out. Nothing else. Its an article of *agreement*. Doesn't mean you go around claimining xyz. Please note, members of the IMF have to make their current account convertible and its fully implemented, so lets not go in the direction that its all imaginary etc.

  12. Dear Ramanan (lol)No, not irked, nor counter revolutionary; but definitely imaginative !Not all of the kids on the block are going to play by the same rules; and they will change imho!The only LAW that matters in the long run are the ones that can't be written down: everything else is up for revision (human nature). So, in that sense imaginary is absolutely correct!! And *agreements* have after-lives and secondary utility.Ergo, there is naught in the entire universe that stands still, or is not subject to change. I don't think the IMF Articles are that holy are they? Otoh I've heard some IMF 'legal' practices are quite inhumane …I used 'toilet paper' in the sense of 'toilet training'; too much of which leads to anal retention and its cerebral antipode – conceptual rigor mortis! Am not accusing you of such: just trying to point out that not everything need be set in concrete. Lots of that on planet earth hey! People use concepts to bind more than liberate. Hammer each other rather than lift and educate.I hope you don't work for the IMF. :-DCheers …jrbarch

  13. "Governments can also intervene into currency exchange markets to try to nudge the exchange rate in the desired direction. They also will use macroeconomic policy (including monetary and fiscal policy) in an attempt to affect exchange rates. Sometimes this works, and sometimes it does not."Maybe some more detail on this might be instructive. Specifics of how they do these things etc.@RamananI'm looking forward to Randy engaging with your point about the IMF article.My guess is — and I'm not lawyer, so maybe I'm reading this wrong — but it appears to me that Section 4 includes a fairly substantial clause [note that it is in (a) that the obligation to convert currency exists]:"(b) The obligation in (a) above shall not apply when:(i) the convertibility of the balances has been restricted consistently with Section 2 of this Article or Article VI, Section 3;"That seems to me to say that part (a) of Section 4 does not apply when convertibility has been restricted which, if I understand correctly, is precisely the definition of a floating exchange-rate.

  14. I'm curious how the MMT prescription would have worked in Russia during the 90s. I remember they went from a fixed exchange rate to a floating rate, then defaulted on debt. Is there any recommended reading/case study on that from an MMT/functional finance perspective? I'd even be interested in a non-MMT perspective if the narrative had the mechanical details correct.

  15. Patriot,There is some discussion here of Russia by Warren Mosler (who was deeply involved at the time). I know he wrote more on this, but can't find it. I'm sure he would answer any questions you might have if you emailed him. http://www.epicoalition.org/docs/flawed_logic.htmBest,Scott Fullwiler

  16. "Even coins made of gold and silver are really IOUs stamped on metal. They are not examples of commodity money. They are sovereign currencies."That made me go find a comment I put here nearly a year ago:http://neweconomicperspectives.blogspot.com/2010/10/fiscal-sustainability-teach-in-and.html"I am a bit familiar with Professor Wray's paper (or maybe part of his book) countering the argument that "money" evolved from bartering and the "natural" selection of a particularly useful commodity, but rather, money was invented by Sovereigns for their own purposes. (I rather like that Willem Buiter used the phrase "fiat commodity money" to illustrate that most anything could be picked out as the index value, if that's what you really want to do.)"Which brought me back to:http://blogs.ft.com/maverecon/2009/11/gold-a-six-thousand-year-old-bubble/#axzz1VIQB8l9A"Gold – a six thousand year-old bubble" ….I don't know if this means I am making progress or going in circles.

  17. Thanks Scott. Will check it out.

  18. Scott,I read over it and although helpful, still does not shed light on why the Russians defaulted. Perhaps we'll never know until someone comes forward with the equivalent of the Gorbachaev papers, but for Yeltsin.http://www.spiegel.de/international/europe/0,1518,779277-4,00.html