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«Elke Muchlinski1 Explicit or implicit Monetary Coordination – Considering Historical And Future Aspects© Key words: currencies, central banks, ...»

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Diskussionsbeiträge des

Fachbereichs Wirtschaftswissenschaft

der Freien Universität Berlin

VOLKSWIRTSCHAFTLICHE REIHE

Nr. 2002/5

Elke Muchlinski1

Explicit or implicit Monetary Coordination – Considering

Historical And Future Aspects©

Key words: currencies, central banks, international monetary coordination

JEL Classification Numbers: E 42, E 58, F 33, F 41

ISBN-3-935058-35-7

1 Dr. Elke Muchlinski, Freie Universität Berlin, Department of Economics, Boltzmannstrasse 20, Germany 14195 Berlin: elke.muchlinski@fu-berlin.de http://www.fu-berlin.de/wiwiss/institute/wirtschaftspolitik-geschichte/muchlinski Explicit or implicit monetary coordination? Dr. Elke Muchlinski 2002 2 Abstract This paper introduces a theoretical approach to defining the old and new configuration of currency tripolarity as an important framework for monetary coordination. The theoretical approach encompasses three dimensions: (i) the designation of unequal, but dominant currencies, which (ii) is itself determined by the international functions of money and (iii) the monetary coordination expected from central bank policy and exchange rate management. The paper is limited to special remarks regarding these three dimensions, set against certain the historical background. It reviews literature emphasizing that economic interdependencies are no longer identified merely as restrictions on domestic macropolicy, in contrast to the view held in the preceding decades.

Introduction The paper introduces a theoretical approach to a configuration of tripolarity focusing on unequal structures of three dominant currencies and its implications. It implies a hierarchy of currencies. Each currency can be defined by the international functions of money. The introduced tripolar configuration of currencies goes beyond a normative claim. It avoids assertations such as, that in the long run the world will be divided into a bipolar or tripolar international monetary system. The approach tries rather to capture the hierarchical structure of currencies taking into consideration old and new configurations of tripolarity. The old configuration consists of the U.S.dollar, d-mark and yen. The new configuration consists of U.S.dollar, euro and yen. The important element of the new configation is that the d-mark was replaced by a non-national currency, the euro issued Explicit or implicit monetary coordination? Dr. Elke Muchlinski 2002 3 by a non-national central bank. A comparison of the hierarchical structure of both configurations leads to very different results.

Much empirical evidence on these dominant, but unequal, currencies has been provided, e.g. by McCauley (1999), the European Central Bank (ECB), the Bank of International Settlements (BIS), and the International Monetary Fund (IMF). Other authors have, however, investigated a model of a multipolar world in order to explain how and why distinct vehicle currencies have emerged, e.g Kenen (1983) and Krugman (1984).2 Canzeroni (1982) has provided a pioniering model. The motivation for introducing a theoretical approach results from debates over a tripolarity versus a bipolarity of currencies or currency blocs in order to discuss the implications of a tripolar configuration for the international monetary system.

The literature on the international monetary system and exchange rate coordination is extensive. Contributions to these topics have been provided by, e.g., Bergsten (1999), Fratianni eta al (1998), McCauley (1999), Mundell (2000) and Salvadore (1998). Mundell (2000) raises the point that "today, the dollar, the euro, and yen have established three islands of monetary stability, which is a great improvement over the 1970s and 1980s" (2000, 339).

It is worth noting that a positive theory of monetary coordination does not exist.

The topic of international monetary coordination therefore has become a field of research for many different theoretical approaches (Weber 1996), including game theory Hartman (1998) investigates a three country model from the viewpoint of transaction costs theory, focusing on the financial market from the viewpoint of microstructure analysis.

Explicit or implicit monetary coordination? Dr. Elke Muchlinski 2002 4 (Canzeroni/Henderson 1991), international money, exchange rates and monetary system (Eichengreen 1998, Fratianni et al 1998, Frankel 1999, McKinnon 1993), central bank policy (Blinder 1998), and international macroeconomics (Kenen 1994, Mundell 1995, Salvadore 1998b). Not to mention that this reference to the literature is not complete.

The new literature on monetary coordination left behind the idea of an optimizing approach, which dominated the early 1970s and 1980s (Bryant 1995; Ghos/Masson 1994; Goldstein 1994). Economic interdependencies are not to be identified as restrictions to domestic macropolicy as they were throughout the past decades.

The paper is structured as follows: Part I introduces a theoretical outline of a tripolar configuration as a composite of different dimensions. Part II applies the configuration of tripolarity to the contemporary world, comparing an old and new configuration in a brief historical reconsideration. Part III surveys some basic features of exchange rate theories, referring to proposals for improvements in the international monetary system. And finally, Part IV provides some conclusions.





A terminological approach to tripolarity A theoretical outline of the configuration of tripolarity is a composition that encompasses three dimensions: (i) The designation of three dominant currencies regarding the functions of international money; (ii) the non-neutrality of money; and (iii) a managed exchange rate system, i.e., monetary coordination.

This theoretical outline follows an approach to economic theory introduced as representative realism. Whom or what does representative realism represent? It states a Explicit or implicit monetary coordination? Dr. Elke Muchlinski 2002 5 non-correspondence between reality and observations because the distinction between theoretical notions and notions that are "pure" observations is useless.3 Representative realism focuses on a comparison of theories or models. It emphasizes that models are the primary and not the final step in analyzing economic problems. Therefore, models must have a link to the contemporary world, i.e., the perceivable world.

I now want to refer to the first dimension of the theoretical outline that has already been described in the literature. It deals with the function of money in particular (Kenen 1983, Krugman 1984). As for the functions of money in general, international money is defined as a medium of exchange, a unit of account, and a store of value for both private and official preferences. Money as an international medium is defined by its function as a settlement of international payments, as a denomination of price and as a liquid asset for international transactions. Private agents use the U.S.dollar as a unit of account. Finally, the U.S.dollar serves as a store of value for banking activities. Official agents, i.e., central banks, intervene with the U.S.dollar. They use this currency as a unit of account in order to peg currencies to it. Regarding the third function of international money, the preference of central banks to hold – for instance – the U.S.dollar as a store of value, i. e., as a reserve currency in their portfolios, has been significant since 1971.

Nevertheless, there have been remarkable changes in currency compositions (Dal Bosco 1998).

Considering the function of money, the U.S.dollar meets the criteria of international money for both private and official agents (Issing 1998, McCauley 1997). As a Explicit or implicit monetary coordination? Dr. Elke Muchlinski 2002 6 medium of exchange, private and official agents use the U.S.dollar as a vehicle currency. Three criteria in particular characterize a vehicle currency: (a) economic performance; (b) degree of integration in the financial market; and (c) expected inflation rate. Each criterion is important in itself; but to judge a vehicle currency does not simply mean adding (a) + (b) + (c) equally. More important, the last criterion, the expectated inflation rate, leads to the phenomenon of the liquidity premium of a currency and hence to the credibility of a central bank.

The hypothesis of non-neutrality of money

–  –  –

The non-neutrality of money is a second component part of the theoretical outline. The hypothesis of the neutrality of money was originally advocated by Friedman in 1968. Robert E. Lucas and The New Classical Macroeconomics (NCM) treated this proposition with more radicalism and rigor in so far as they additionally implemented the hypothesis of rational expectations (RE). The premise of this paper is that the abandonment of the hypothesis of neutrality of money and hence of international money seems to be required for thinking about monetary coordination, because monetary coordination is a function of central bank policy and finance authorities which do not The theory-laden approach to economic theory introduces Viskovatoff (1994), and Muchlinski (1998c).

Explicit or implicit monetary coordination? Dr. Elke Muchlinski 2002 7 decide on the basis of rigid rules, but rather according to various models. A mechanistic use of models or a robotic application of a single model is not compatible with monetary decision making under uncertainty (Vickers 1998).

These hypotheses – the hypotheses of neutrality and RE – opened up never ending controversies within the community of science. The Lucas critique, a famous result of these paradigmatical debates, has been guiding the macroeconomic discussions up to now (Mishkin 1995). McCallum résuméd, "it should be remembered that Lucas's critique itself was not new, but merely a (brilliantly persuasive) application of Marschak's (1953) fundamental insight that policy analysis requires a structural (as opposed to reducedform) model" (1999, 181). To be brief on that point: The hypothesis of the neutrality of money implies that money does not matter. While stressing the non-importance of money, Friedman and Lucasians demanded rigid rules for money supply (Hahn 1982, 45-6).

One conclusion of this viewpoint is that only unanticipated money-system changes have real effects. Sargent objected to the interpretation given by some authors of a triad consisting of the hypotheses of rational expectations, neutrality of money, and policy ineffectiveness in Lucas's work, because papers on equilibrium models are concerned with different monetary and fiscal policy arrangements (1996, 543). Without going into much details, I would like to emphasize that different models on different monetary or fiscal policies should not be confused with their implicit unique premise determined by the view of the NCM.

International monetary coordination cannot be based on rigid rules and premises which – for the sake of simplicitiy – are not linked to the contemporary world. The application of RE can be misleading for two main reasons: First, it implies a convergence Explicit or implicit monetary coordination? Dr. Elke Muchlinski 2002 8 of the 'true model' which is perceived and acknowledged by economic agents and which determines their expectations. Systematic mistakes by agents are excluded by premise.

Pesaran manifested that the assumption, economic agents learn from their mistakes is hardly indisputably, rather "the issue of whether the learning process converges to the rational expectations equilibrium is an open one. Generally speaking, the learning problem has been studied in the literature using two types of framework: the rational (or Bayesian) learning model, and the boundedly rational learning model" (Pesaran 1996, 31). Beyond this, the substitution of the premise 'true model' with the premise, agents "are committed to some plausible learning rule" as stated by some authors, has not been avoiding the core problem of this model (Pesaran 1996, 32). The RE is addressed to a special model of rational expectations building, it does not contain any link to contemporary world. This model is to be distinguished from the model of a rational use of information (Simon 1992).4 Second, this method of defining a premise for the "sake of simplicity" shall provide a stable environment and consistent modeling. Considering the market euphemism emphasized in this view, one has to ask why the idea of price as a market clearing function should be eliminated by the implementation of a unique ('true') model? What function, then, should a price have?5 To conclude this consideration so far, it is hardly acceptable to work with the RE and reject the premise of the neutrality of money.

Theoretical refinements and applications of rationality reviews Runde/Anand (1997).

For greater investigations:Hoover (1997, 1991), Muchlinski (1999), Schotter (1996). New evidence on the unacceptability of RE has been presented by Ball/Croushore (1998) Explicit or implicit monetary coordination? Dr. Elke Muchlinski 2002 9 Because the premise of the neutrality of money implies a certain conclusion, i.e., the result that an anticipated monetary system change does not provide real effects in the economy, it is quite clear that both are connected in a certain theoretical way of thinking.



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