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The question of reserve holdings is closely related to the optimum

Chapter 7 currency-area issue. If two countries form a currency area the domain
of risk-sharing is extended as Arthur Laffer has emphasized. A
UNCOMMON ARGUMENTS FOR COMMON harvest failure, strikes or war in one of the countries causes a loss of
CURRENCIES real income, but the use of a common currency (or foreign exchange
reserves) allows the country to run down its currency holdings and
ROBERT A. MUNDELL cushion the impact of the loss, drawing on the resources of the other
University of Waterloo country until the cost of adjustment has been efficiently spread over
the future. If, on the other hand, the two countries use separate
monies with flexible rates the whole loss (with a qualification) bas to
I THE CASE FOR A COMMON MONEY be borne alone; the common currency cannot serve as shock absorber
for the nation as a whole except (this is the qualification) insofar as
When a commodity is used as money for a long time its monetary the dumping of inconvertible currencies on (black or white) foreign
characteristic takes on a life of its own, independent of metallic con- ~arkets attrac ts a ~peculative capital inftowinfavour of the deprecia-
tent. At that stage it can be replaced by token money through one of , ting currency. 1 W1th the closely connected exchange markets in the
the various techniques of debasement or devaluation or replacement West and diversified money holdings one could always rely to some
by paper or ink money and the pure metal originally embodied in the exte~t on stabilizing speculation, at a low enough currency price, to
coin itself can be turned to productive use. The resource saving is provtde extra resources to provide some cushion for the other
'seigniorage'. country.
There may be costs associated with doing away with the metaolli<t Be that as it may, most local monies are not money on a world
content. If the management of a state is unintelligent or in th•e g••ipof scale, and a country cannot rely on external markets to act as an
factions, it may inftate the currency and reduce the value e.ffic!ent shock absorber in case of national calamities. Money is
monetary apparatus as a guide to rational calculation. The ro]>la<:e,; hqutd to a country or person only when the demand is elastic and it is
ment of metallic money by paper money or ink money or highly unlikely that most of the hundred-odd currencies in the world
money may inflict a loss on the state because ofee:~x~t;•::rn~~a;l;~~';;~:~; C:Ould be used as eme~gency reserves even in a world where enough
tions. If we consider two different countries, one\\· time had lapsed to bnng foreign exchange markets into being. The
acceptable gold as money, and the other with inconvertible argument is especially valid for the smaller lesser-known national
money, the state with the gold is better off since, other th'ing:seq currencies, and it is one reason why central banks (or governments)
the gold can be spent abroad- used as an emergency reserve hold reserves and maintain iixed exchange rates. A purpose of re-
rest of the world is on a gold standard and the state in question serves is to maintain confidence in the ability of a central bank to
not make up too large a share of the world (as measured defend its rate. Except for surplus contingency reserves and working
Inconvertible national paper is not a reserve for the state as balances, reserves are for display, not use. A fixed exchange rate
except insofar as it can be marketed abroad, even th<JU!lh system is a device for automatic cushioning of shocks without
reserve for a typical individual within the state. What is a destroying the image of the international moneyness of the national
for the individual may not be a hard asset for a single coontzy( money in the public mind.
The larger the fraction of money that is 'backed up' The foregoing argument has been made explicit by Arthur Laffer 2
nationally acceptable money the greater the reserve on handfor
tingencies. An extreme case is that where the country uses : Random ra!cl"alls in an area will lead to rising and falling waterlevels in any
1 tl\o lakes, but 1f the lakes are connected by canals the average intensity of the
money as its circulating medium.
fluctuations decreases.
1 A country could !JO!d more than 100 per cent reserves, as it 2 'Two Arguments for Fixed Exch!lrl!le Rates', Chapter 1 in this volume.
marginal social utility of reserves exceeds the marginal private utmty;

and it has long been implicit in the arguments for fixed exchange rates population of each island would be without food, so eventually each
of Robert Triffin and some central bankers. The argument is import- island would be without population.
I, ant enough to model. One can see the symbiosis of the populations of the two islands.
L- When food can be shipped from one island to the next an arrange·
ment can be made by means of which half of Capricorn's crop
II CURRENCY AND MERCANTIL!Sl>l maturing in the autumn can be shipped to Cancer in exchange for
half of Cancer's crop shipped in the spring. In this situation each part
Consider a world of two islands, one south of the equator, Capricorn, of the world's population wiii work half a year and spend the rest of
and one north of the equator, Cancer. Both islands can produce the year in leisure, while the world food production will be evenly
a single crop of perishable food each year, but Capricorn's crop distributed and consumed throughout the year. The population of
ripens in the autumn and Cancer's crop ripens in the spring. Food in each of the islands is dependent for its survival on the population of
each island can be stored for up to six months, after which it is unfit the other.
for human consumption. Let us suppose that the population of the We want to explore now the nature of the credit instruments or
world is equally distributed, initially, between the two islands. financial arrangements by means of which the exchange necessary for
Under these circumstances one can ask: How should world society survival takes place. One arrangement is state trading, but let us put
be arranged? Let us suppose first that there is no barrier to the that aside for now and concentrate on arrangements compatible with
movement of people or food from one island to the other. Then the free market. Let us suppose that both Cancer and Capricorn re-
solutions present themselves at once. One solution is for the ____, > spectively produce one hundred units of food in the spring and
world population to spend six months in Cancer and six months . autumn. In the spring Cancer ships half its crop to Capricorn, but
Capricorn. When the Cancer crop ripens in the spring the · what does it receive in exchange? It must receive an evidence of
take the food with them to Capricorn and consume it during Capricorn's debt, a claim to part of Capricorn's wheat crop maturing
period they are producing the crop in Capricorn. By the in the autumn. Who produces the claims?
Cancer crop is exhausted but the Capricorn crop matures and Suppose that in the previous autumn when Capricorn's crop was
brought with the population to the northern island to maturing, the government of Capricorn issued money to Capricorn's
Cancer's crop. The other solution is for the people to stay where citizens in exchange for half of Capricorn's crop, where the money
are and engage in trade with food being exported by Cancer received was interpreted by Capricornians as an equivalent claim to
summer, and by Capricorn in the winter. Whethe>ec,;th~~is~~;;~~~o;~, food in the spring. To make good on the claim the CapriCorn central
the yearly migration will dominate wi!I depend on t bank has to acquire a claim on half of Cancer's spring crop. Now jf in
or externalities, primarily transport costs and taste patterns. the autumn the Cancer bank issues claims to Cancer spring wheat to
grain shipping is cheap, trade will emerge whereas if popullati< the Capricorn bank in exchange for current autumn wheat, the
move, the migration solutions will prevail. Externalities arrangement can be completed when the Capricorn bank delivers the
climate will play a part. For example, I am told that many autumn wheat to the Cancer bank (in return for Cancer notes), and
British go to Spain and the south of France to bring in the the Cancer bank sells the wheat to Cancerians to redeem previously
enjoy the sun, just as the ducks migrate southwards every issued Cancer notes.
But generally speaking, the human race tends to be rather Our interest is not primarily in how the arrangement gets started
and prefers to trade rather than migrate. but in the nature of the rotating equilibrium. Every spring the Bank
Let us now suppose instead that the world population of Cancer will be engaging in open market purchases of wheat from
equally between the two islands and that there is no mc>bil'ity Cancerians, increasing the Cancer money supply by an equal amount,
them; transport costs are infinite. If there were and the country as a whole will be running a balance-of-payments
shipping of food the populations would die out. For h•'"""~ surplus equal to the sales of wheat to Capricorn. The Bank of Cancer

will thus be acquiring Capricorn notes and issuing to Cancerians element of uncertainty into the system. Each country depends on the
Cancer notes. Meanwhile, the Bank of Capricorn will be running a other but the producer of the current crop calls the tune in the short
balance~of~payments de.ficit and engaging in open market sales of run even though, in the situation under analysis, the ability to exploit
food, reducing its indebtedness to Capricornians while increasing its this opportunity is limited by international symbiosis in the long run.
indebtedness to the Bank of Cancer. The process is reversed in the Forward exchange transactions are of no help either because they
autumn. lack credibility when major disruptions occur. In the case under con-
I This arrangement would function satisfactorily in a world of cer~ sideration there would be strong incentive for the two countries to
tainty in which crops were known in advance and no defaults were establish in advance a set of rules or laws- a monetary order- for
made on the redeemability of currencies. But in a world of uncer~ the sharing of the gains and losses of fluctuations in the harvest.
tainty it would be subject to speculation about the convertibility of A common money performs the sharing function very effectively.
foreign currencies. Suppose, for example, Cancer's spring crop was Suppose that the two countries agree to the creation of a common
below average; Capricorn would hold Cancer's currency but the currency. Before the spring harvest Capricorn puts into a world
complete conversion of these liabilities at par into food would mean bank 50 units of the claims it holds on Cancer's spring crop, and gets
that the whole burden of adjustment to the crop failure was borne by in exchange 50 units of world money. When the spring crop emerges
Cancerians. For example, if the spring crop were normally 100 units, the Capricornians use their world money to buy 50 units of Cancer
equally divided between the two islands, Capricorn would present 50 money from the Bank of Cancer (which has agreed to accept world
units of Cancer's currency and get an equivalent in food; but if in money) with which they buy half the spring crop; and then the
one year the crop produced only 70 units of food, the complete Cancerians exchange their 50 units of Cancer money for 50 units of
redeemability of Cancer's notes would leave Cancerians with only world money. The balance sheet of the world bank will then involve
20 units. assets amounting to 50 units of the money of each country and total
Such a situation would not be viable. Devaluation of Cancer's .. liabilities of IOO units of world money. Producers in Capricorn will
currency would be the usual defence against having to pay out half· be using 50 units between the spring and autumn harvest to pay the
the crop, depriving residents of the bulk of their produce. At expenses of production of the autumn crop, while consumers in
extreme they could declare the currency worthless. Tllis Cancer will be holding 50 units to buy half the Capricorn crop
would leave Capricornians without food and they would in the autumn. The process will be exactly reversed in the winter
tion not in Cancer's interest; the result would be .Olnc•ed'<m ,ge.mci~o/ months.
in the short run and suicide in the long run. For without the At this point there will not appear to have been a gain to the sys~

;-- the following autumn. Consequently both altruism and 1

cornians the Cancerians would die next spring and the C a;;;~~;::: tern as a whole by the amalgamation of the two monies. But the gain
appears when the variability of the crops is taken into account. For
would dictate only a partial devaluation so that ihe burden of the example, suppose again that the spring crop in Cancer is below the
could be shared. average, let us say at 70 units. Then Capricorn consumers hold 50
An analogous situation occurs if there is a bumper crop. · units of the world money as do Cancer producers. As long as com~
Cancerians have to pay 50 units to the Capricornians and are petition prevails and there are no delays in the transmission of goods
with the remainder, which is more than 50 units. Of course or information the 100 units of world money will exchange for the 70
tion of the currency is possible, this being one way of giving units of food irrespective of who holds the money; this is because
part of the surplus. In the short run this appears to be an competition and freedom of arbitrage assure the single price. The
gift, but in the long run it has the beneficial effect price of a unit of food thus rises to 100/70 for both Capricornians and
convention of 'sharing' the good as well as the bad. Cancerians and the burden of the harvest fluctuation is met equally
The important point to recognize, however, is that when by the two islands. The common currency assures an automatic and
different currencies the threat of devaluation i~tro<im,.sanad·ditii?! equal sharing of the risk of the fluctuations.
to u2 *. For both upward and downward fluctuations iixed exchange
rates. increase the galn or decrease the loss. It is always better to
It is possible to illustrate formally the gains from sharing the risk of fluctuate between F and Ethan between C and D. The gains from a
fluctuations. Let qr in Figure 7.1 be potential consumption in period common currency system arise from the opportunity it allows a
t and q . be potential consumption in period t+l, the line BB' country to redistribute through time the burden of random fluctua-
repres~ting the opportunity line of the country. For simplicity the tions. The use of a common currency of a currency union by one
slope is taken to be -1 and the choice is made to divide income member implies involuntary lending on the part of the remaining
equally between the two periods as indicated by the choice of the members. The 'borrowing' member gains, but do other members lose
point F.

qt+l ~-------------=~8
s' l


'' f
A Gt
Figure 7.2

Figure 7.1 less? To prove that gains and losses for a single country are cushioned
by the use of reserves is not the same as demonstrating world gain
since the costs may be borne completely by the partner country.
Now let us suppose income is subject to fluctuation, o•oillafuJtl
To complete t11e proof let us assume two time periods, t and t+ 1,
a pendulum from C to D and back again. Then utility
between u1 and u2 • When reserve changes are possible,,, ~:::~
and two countries. A and B. Suppose the countries are alike in tastes
and resources, and also symmetrical in the two periods. In Figure
under fixed exchange rates for example, or under a c;
7.2 the average income is distributed at the consumption point P on
rency, inter-temporal autarky is not necessary. Instead of
u , utility need only fall to u 1*; instead of rising to u2 , utiii'tlyc<ii the contract curve AB.

Now consider rhythmic disturbances affecting both countries shocks. The balance of these two opposing forces produces an
equal to HJ and LK in total amplitude: Strikes or harvests or wars equilibrium level of reserves that is optimal. We seek practical
with third parties create a dispersion lowering or raising consump- criteria of the characteristics of the optimum.
tion potential in country A by HP or PJ in period Cr+I and LP and Let us use as the index of reserve adequacy the number of months'
PK in period C,. Now if the :fluctuations in income in country A imports reserves will buy. The proposition suggested below is that the
required fluctuations in consumption there also, the consumption unadjusted optimal reserve index is equal to twelve times the recipro-
pattern would recurrently involve points like the vortices H, K, J cal of the income velocity of money.
and L, which are suboptimal. Given random fluctuations, points Consider a population randomly distributed over a transactions
anywhere in the square RSTU are possible. The possibility of efficient domain using a single currency. Every economic entity- person,
reserve cushioning restores Pareto optimality, and when random firm, institution- in it wili settle on, by experience, a given average
:fluctuations in both countries and time periods are allowed for, the level of money holdings suitable for its needs. The desired level of
zone of contract shrinks to the square QMNO. The risk from income reserves will be positively related to the level of transactions and
fluctuations is, therefore, unambiguously reduced, the saving being negatively to the opportunity cost of holding the reserves. These
the dotted zone of excess suboptimal positions. I shall refer to this ratios vary between individuals and countries and will change over
time due to long-run trends as financial innovations change optimal
contribution as Laffer's proposition.
The dotted area in Figure 7.2 indicates the welfare cost arising liquidity holdings, or make changes in the definition of money assets
from the loss of the automatic credit facility provided by the fixed needed to satisfy liquidity requirements. Nevertheless, the liquidity
ratios as measured by the ratio of cash balances to income, expendi-
exchange rate system. 1
ture or transactions do provide an adequate benchmark to judge the
adequacy of individual liquidity holdings as a first approximation.
IV CURRENCY UNIONS AND SWAPS Let n be global population and s the number of people inn com-
In between the extremes of zero (or negative) reserves and reserves of prising a currency area. Required external reserves R needed by s is
100 per cent or more, we lack guidelines to govern a country's obviously a function of nand s:
serve policy. What is the optimal level of reserves?
Zero reserves and floating exchange rates are suboptimal
of the externalities associated with the currency prices. It But what is the explicit form of the function?
for no national cushion against shocks and forces upon An answer can be found by relating the required reServes to the
the need to bold excessively large -socially non-optimal- number of transactions, T. Let c be the money needed per transac-
offoreign money. At the other extreme, however, a 100 or mu"' P''"' tion so that
cent reserve system will be suboptimal except in countries where M=cT.
state's need for emergency reserves exceeds the needs of
The opportunity cost of higher reserves has to be balanced We need then to know how transactions vary with the size of the
the benefits the reserves provide in cushioning the system population.
We assume each transactor engages randomly in transactions with
1 Some of its broader implications are beyond the scope this
other members inside or outside the currency area. Let o be the value

of d north so~t~h,jro~1"f;"~'~'~~"~"~"~w~o~u;ld:~tr~y~j'"£~~~~]~~~l~l~i
currency areas as a hedge against risk and
and in a politically
spring and autumn
of transactions per person with each other person. Then the average
number of transactions for each person is e(n-1) where n is the
at a mercantilism model; · one power of the number of transactors. The total world value of purchases or sales
becomes imperialistic. Attention should be drawn the is then
elusions are the opposite of those of Viner's Customs Unirm Issue, in wbioh,,fr<
world welfare criterion, union between rivals is best.

and the reserves needed for the world as a whole are and the reserve saving is
M= cen(n-1).
R•+I -R. = c,c; [(n-s-1)(s+ 1)-s(n-s)]
Now we ask again, how can we determine the saving of external = n-2s-1.
reserves, R, needed by a currency area composed of .s members of the
population n? The new reserve ratio is
The total money needed by the s-membered currency area is R.h (n-s-l)(s+l) n-s-1
s lls+I = -M-,-+-1 = ce ce(s+l)(n-1) = --=n-cl.-
M, =- M = c es(n-1).
n compared to the original ratio of
But we need to know what fraction of this is accounted for by the
need to finance external transactions. External transactions are
tt= n-1·
as(n-s), counting only purchases, so we find that the needed external
reserves of the s-membered currency area is The reserve ratio falls as the size of the area increases.
R, = ces(n-s). Now we have to ask what are the costs and benefits of adding
another member to the area. He brings his own reserves to the area
The reserve saving is therefore but adds his own purchases from non.members, but decreases the
M.-Rs= ccs(n-1)-ces(n-s) external purchases of the other members. Before entering the mone~
~y union he would hold reserves of c,c;(n-1) which he could bring
= css 2 -ces mto the central reserve pot, 1 while his own external transactions
= ces(s-1). would add n-s-1 to the external transactions of the area, and
decrease those of other members by s, leaving a residual ofn-2s-1,
If the monetary authorities of a newly formed s-membered currency: th: figure noted abo~e. Clearly it is always beneficial, from the stand-
area replaced an international currency, it would collect cBS(n-1) Ci :> pomt of reserves savmg to add another member to the area.
international currency from members, giving an equal amount of __ _
newly-created domestic money in exchange. But 100 per cent re-. ::'
serves behind the domestic money would now be unnecessary be:~:.: VA PARADOX
cause s(s-1) of the transactions are internal to the currency Now a most intriguing paradox arises. If we start off With a world
The appropriate reserve ratio is evidently only currency there will be a tendency for it to break down into currency
R., ces(n-s) areas as countries try to exploit the gains from reserve saving. When
-= =-- two members of a common currency system pool their reserves they
M, ces(n-1) n-1
no longer need as many reserves jointly as they needed singly. But any
which is clearly less than unity for s> l. We can now ask: Wllat!S tne,, two transactors can achieve this gain. There seems to be no limit to
gain from an internationalization of reserves that oom•o tmm ''"'l,tt the process since it is always profitable to add extra members to the
a new member to the currency area? For a given s we have union. The optimum currency area is the world but a world currency
external reserves of cBS(n-1). The shift of an outside co,unl,ryinto area is unsustainable!
area reduces external transactions of the inside members by If this argument were complete we would expect to find persistent
adds external transactions of the new member of ,c;(n-s). throbs of integrative and disintegrative forces making themselves felt
level of required reserves is therefore
exterm~:J rese.rves may be h~ld in the form of the currency of the original
R•+l = ce(n-s-1)(s+1) eurre~cy area, m W~!C~ cas~ th~ .&tu.n would have to be discounted by the extent
to Wh!ch the rcduct1on m a hab1hty !S worth less than a gain in new reserves.

in the world economy. There would be tendencies for gold, silver, currency areas, rands so that r+s =nand choose units so that
currency standards to rise and fall recurrently. These forces can be llC = 1.
observed historically, but the time period over which they operate is Then
very long. There must be other forces at work that impart more M, ~ '(n-1); M, ~ r(n-1)
intermediate--run stability to the economic system. One of them is R.=sr; R, = rs.
transactions costs which ultimately determine the number of ranks in
the currency hierarchy. But our interest is in factors other than If a member now shifts from r to s the new levels are
transactions costs. M,.,~(H1)(N-1); M,_, ~ (r-1)(n-1)
Let us consider more explicitly the functional forms for R~+ 1 = (s+1)(r-1); R,_, ~cr-1)(H1).

R~R(,,n) The change in the needed level of reserves of the initial s-membered
bloc is
considered above, The required reserves are precisely
R.+ 1 -Rs= r-s-1.
R$ = ces(n-s)
If the mobile member brings with him n-1 of reserves the extra
which reaches a maximum when liquidity of the bloc is
-=cen-2c8S=0 n-1-(r-s-1) = 2s
a, or twice the initial membership. However the loss of net liquidity of
i.e. when
the initially r-membered bloc is given by the change in the level of
s=±n. reserves needed,
As a currency area becomes larger it needs larger absolute external _ R,._ 1 -R,.=r-s-1
reserves until it becomes more than half the world, after which it,;:: :
minus the loss of reserves taken by the mobile member. If the latter is
needs fewer reserves. This is a fundamental though perhaps ·
again taken to be his total money supply, n-1, the releasing bloc
result. After a certain point the shift of countries to a currency
reduces the absolute need for reserves on the part of existing
r-s-1-(n-1) = -2s
bers. To carry the argument close to its apotheosis, a currency
of all countries except Andorra would need rather few reserves. of liquidity. Competition for the affections of the mobile member will
It is this same principle that underlies the relation between . then exert countervailing forces to prevent the split-up of the mem-
usefulness of the IMF quotas and their size configuration. bership. The nature of the competition would take the form of
Consider now a single-currency world. There are obvious exchange guarantees, higher interest rates, or banking services but is
from breaking it down. Pairs of countries can always make re,ery~ not within the scope of consideration here. Swaps would proliferate
saving bargains to their mutual advantage. But the gains to capitalize on the reserve saving when the transaction costs for
currency union proceed. An extra country always helps (by creating a common currency are too high. All such agreements are
saving criteria alone) by putting into the common pot mc>reex inflationary.
reserves (though an adjustment has to be made for liabilities it There are different stages of currency unions that correspond to
of the fanning centre) than is needed to 'finance' the different types of gain associated with monetary union. There are,
transactions of the enlarged area. However, there are first of all, three types of gain accruing to the public authorities of
checking expansion, One is the splitting up of too large a any two or more countries pooling reserves. These are based on the
other is a coalition curtailing excessive aggrandizement. Let insurance principle, the internalization principle and the inventory
sider the latter problem. Let the world be divided, initially, principle. The insurance principle arises from risk pooling, as we

discussed in Section I, and can be exploited by a reserve pool; the by the system as a whole and by individual countries within the
second principle arises from the reserve saving due to the internaliza~ system? We have shown the advantages of using international
tion through credit of what was formerly external trade and can be reserves as a shock absorber in the system and the advantages of a
achieved through swap arrangements (or a reserve pool); the third common currency, On the other hand 100 per cent reserves as under
principle sterns from the economies of scale associated with spreading a common currency system is clearly excessive. In between zero
overhead costs of transactions further- the gains in this case can be reserves and I 00 ·per cent reserves we should be able to establish
achieved by merging financial managements. a liquidity index that represents the number of months' imports a
There are also economies experienced through the improvement in currency area holds in the form of reserves. Define
the asset used as money by the joining populations, and there are,
similarly, three principles through which these gains are experienced: Reserves ( ) Number of months' imports
intermediation, information and innovation. By the creation of a (J = Imports per year x 12 =held in reserves
common currency in place of two separate national currencies, an equals the liquidity index.
element of risk is reduced to the extent where the moneyness of each
We want to find criteria for establishing in practical terms a
currency is increased. There are, second, economies of information.
numerical value for this index. In the preceding analysis we were able
The single currency performs as a medium of information (a quota·
to establish that the ratio of external money to internal money
tion, unit of account, etc.) just as well or better than the two cur· should be
rencies did before (after an initial fixed cost of adjustment) but it
Reserves n-s
reduces one price quotation needed, yielding an information saving. =!l=-
Money n-1
Finally, there is the innovational aspect of the new currency, which
is superior to the two old currencies partly due to its greater size, on the assumption that there is no 'localization' of transactions. We
hence stability, insofar as the adjustment burden has to be borne in can, however, relate the openness coefficient (n-s)/(n-1) to the
inverse proportion to the size of the monetary domain. . import/income ratio. For an s~membered currency area purchases
Table 7.1 summarizes the nature of the principle involved and the·.··· from outside the area (imports) are es(n-s) while total transactions
gains to which they lead or have led in some actual cases. are es(n-1). The ratio of internal to external purchases is therefore
equivalent to the ratio of imports to income so that
Table 7.1
Principle Instrument Example 11-1
Insurance Reserve pooling Sterling Area pool
Internalization Clearing or swaps ill'U We then find that the reserve ratio should be equal to the import
Inventory Joint management Belgium-Luxembourg . · income
Reserves Income Imports Money
Intermediation Fixed exchange rates U.S.A.-Panama (R) x (Y) ~ (I) X (M) .
Information Policy ccrordination CCC
Innovation Common currency Puerto Rico-U.S.A. It follows then that
a~ 12M/Y ~ 12/V
VI A LIQUIDITY INDEX where Vis the income velocity of money. Vis an increasing function
of the rate of interest.
Let us now use the results obtained to make progress towards The liquidity standard is not a magic constant of social nature any
one of the fundamental problems of the international monetary . more than the gravitational coefficient is a constant of physical
tern. What determines the quantity of international reserves nature. It could in principle be affected by political and economic

variables. It has even been argued that it is not possible to have a penditure and improve the balance of payments, leading to an
measure of reserve adequacy because the latter depends on the increased supply of money and reserves; this demand-induced change
vicissitudes of speculation, the state of the world and the whims of in reserves will generally be associated with high interest rates. On the
the central banker. other hand, an increased supply of reserves and money will lead to
There is, of course, a sense in which this judgement is correct but increased expenditure and income; this supply-induced change in
it is not a sense in which science can be of much help to political reserves will generally be associated (temporarily) with low interest
economics. The purpose of science is to simplify, not complicate. rates.
Reality is too complicated to talk about and the best science can do is In the world economy it is necessary to keep several propositions
to provide rough guidelines for policy. Only a naive person would separate. As world trade grows it can be assumed that the demand
apply this standard measure to an individual country uncritically. It for reserves increases; in this sense the demand for reserves is a func-
would make no more sense than applying the Newtonian formula for tion of trade, On the other hand, world trade is itself a function of the
the time it takes an object to fall to the earth without allowing for supply of world reserves (via domestic monetary policies). The prob~
differences in barometric pressure, wind, etc. Certain countries antici- lem of disentangling supply and demand for reserves is therefore a
pating bad harvests, strikes, wars or new rivals may need more than serious one. If world reserves are easy to measure (e.g. gold stocks)
this amount, while others protected by credit worthiness can get by there are no grave problems of identification provided stable supply-
on less. of~gold functions can be assumed. But if the supply of world reserves
Nevertheless the standard measure does provide a bench mark is itself a function of the demand for them, as is certainly suggested
against which other considerations can be brought to bear. The ratio by the current proliferation of swaps, the problem of identification
of reserves to the money supply should correspond to the openness looms large again unless we have explicit theories of swap creation.
propensity of the economy. In the United States, for example, the The analysis of Section III of this paper has shown how swap ar-
reserves should be that fraction of the money supply that imports --.. rangements and the creation of a required central bank are substitutes
represent in aggregate e:~,:penditure. With the import ratio at 4 per :·- · for one another, and leads to a general theory of swaps.
cent, and the non-interest-yielding money stock at $200 billion, free The dynamic implications of the very simple system I have de~
U.S. gold reserves should be $8 billion. The behaviour of reserve ___ veloped is that world trade, as measured, say, by imports, will
centres is likely to be unique since they have automatic overdraft ·::. expand or contract depending on whether the actual liquidity posi~
faculties. Other countries can easily calculate these indexes · tion of the world economy exceeds or falls short of the liquidity
themselves. standard along the lines suggested by the following equation:
For the world as a whole the velocity of money is about four, so
index suggests a level of reserves equal to about three mcmtns~i
dJ ~ p(R:c -I)
dt a
At the current level of world imports, $280 billion, this where Pis a speed of adjustment. Such a guide is suggestive, rather
reserves of $70 billion. This makes no allowance for than rigorous, but could easily be extended to take into account
the world environment which has probably increased second-order effects.
liquidity by as much as inflation has altered its form. We may conclude this analysis by showing how the study of the
It is a common error, in interpreting monetary phen<>mem>,:l optimum reserve ratio has a bearing on the problem of the optimal
confuse cause and effect. With a fixed exchange system the speed of adjustment. In addition to the above adjustment equation
supply in an open economy is a dependent variable, ewiOjlenot> for an individual country we have the balance-of~payments identity
determined by the need of each dependent economy to p~::~~
balance of payments. Thus an increased income level will p dR
increase in demand for money and reserves, which will
dt ~ X(t)-1.

We want to find the slowest adjustment speed, p, that is compatible

with adjustment without fluctuations, taking exports as constant. Chapter 8
By differentiation and substitution we get
dt2 +Pdt+;;:I=O
which is stable. It will oscillate in approaching equilibrium, however, ALEXANDER K. SWOBODA
unless Graduate Institute of International Studies
P> 4/cr ~ 4/3 per month
if we use our guide that a = 3 months. This means that if imports are
above or below normal they should be run down or built up at a rate
Simultaneous achievement of internal and external balance by the
which would correct the discrepancy within three weeks.
world's- or a currency area's- economies constitutes a major prob-
lem for economic policy. This problem must be solved if international
economic disintegration is to be avoided. It is particularly acute when
increasing economic integration is pursued under a regime of fixed
exchange rates -as it would be under a scheme of regional monetary
Indeed, the optimum currency-area question was originally raised
in this context: the benefits of having a single currency are balanced
against the internal adjustment costs attendant on the restoration
of external balance in the face of a change in the terms of trade.
The optimum domain of the currency area then spans that area over
which the tenus-of-trade change can be effected under fixed exchange
rates without bringing about (too large) deviations from internal
balance; this may, for instance, be the domain over which factors of
production are mobile. 1 In the context of this paper and of particular
instances of monetary union, it is probably more useful to cast the
analysis in tenns of ~·iable rather than optimum currency areas. The
optimum currency area may be smaller or larger than the viable
currency area, viability being characterized by the possibility of re-
conciling (at least within tolerable margins) internal and external
balances under fixed exchange rates for a given group of countries or
International co-ordination of economic policies has been pro-
posed, both in general and in the particular context of monetary
"' I am indebted to Harry G. Johnson for his comments on a first draft of this
See Robert A. Mundell, 'A Theory of Optimum Currency Areas', American
Economic Review, Vol. LI, No.4 (September 1961) pp. 657-65.