Opinions expressedil'lthe/ nomic Review do not necessarily reflect the vie management of the Federal Reserve BankofSan Francisco, or of the Board of Governors the Feder~1 Reserve System.
The FedetaIReserve Bank ofSari Fraricisco's Economic Review is published quarterly by the Bank's Research and Public Information Department under the supervision of John L. Scadding, SeniorVice Presidentand Director of Research. The publication is edited by Gregory 1. Tong, with the assistance of Karen Rusk (editorial) and William Rosenthal (graphics). For free 2 Ramon Moreno· The traditional critique of the "real bills" doctrine argues that the price level may be unstable in a monetary regime without a central bank and a market-determined money supply. Hong Kong's experience sug gests this problem may not arise in a small open economy. In our century, it is generally assumed that mone proposed that the money supply and inflation could tary control exerted by central banks is necessary to successfully be controlled by the market, without prevent excessive money creation and to achieve central bank control ofthe monetary base, as long as price stability. More recently, in the 1970s, this banks limited their credit to "satisfy the needs of assumption is evident in policymakers' concern that trade". financial innovations have eroded monetary con The real bills doctrine was severely criticized on trols. In particular, the proliferation of market the beliefthat it could lead to instability in the price created substitutes for money not directly under the level. However, a number of leading economists control of monetary authorities has led Phillip such as Fama (1980) and Sargent and Wallace Cagan (1979) to argue for regulatory reform: (1982, 1983) have recently argued in favor of re gimes where the money supply is market-deter New financial developments may make the mined. past degree of monetary control increasingly In this respect, Hong Kong provides an interest more difficult to maintain. Yet pursuit of ing example ofan economy where there is no central national policies to restrain inflation and sta bank, and where, to the extent possible, central bilize economic activity appears impossible banking functions are minimized. Thus, it provides without effective monetary controls. The a unique opportunity for ascertaining whether a creation ofa regulatory environment in which market-determined money supply is consistent with the erosion of monetary controls is kept to a overall macroeconomic stability, particularly sta minimum is particularly important in the bility in the price level. present period of rampant inflation. Section I reviews the real bills doctrine and dis cusses how it may be feasible in a small open While this statement reflects the mainstream view economy even if it may lead to price instability in a today, it has not always been obvious that the closed economy. The discussion identifies certain government, rather than the market, should deter testable features that distinguish a stable monetary mine the money supply. A market-determined regime from an unstable one. These features form money supply is traditionally associated with the the basis for an empirical test on the stability of long discredited "real bills" doctrine. This doctrine Hong Kong's monetary system in a later section. Section II discusses three key features of Hong * Economist, Federal Reserve Bank of San Fran Kong's monetary sector typically believed to influ cisco. Thanks to Mark Thomas for excellent ence money creation and monetary control: (I) the research assistance. note issuance mechanism under fixed and floating 17 exchange rates, (2) the interest-setting agreement of Q!tiy may be consistent with price level stability the Hong Kong Association of Banks, and (3) li tlnder either fixed or floating exchange rates, and quidity ratios. Section HI reviews Hong Kong's that monetary authorities under such conditions macroeconomic performance and includes an may relax their control over monetary aggregates. empirical test ofthe stability ofHong Kong's mone Furthermore, such a prescription may be most tary system under floating exchange rates as well as appropriate under a fixed exchange rate regime a discussion of exchange rate sta15ility. since,underfloating rates, Hong Kong was unable The paper concludes that allowing the market to to counteract destabilizing speculation against the determine the money supply in a small open econ- value of its currency. I. The Real Bills Doctrine and the Price Level The Closed Economy bills doctrine, as well as the presentation adopted For over two centuries, there was a widespread here, do not restrict loan supply to short-term com belief that price stability could be achieved as long mercial paper. as banks extended only short-term self-liquidating The previous discussion also suggests two possi loans for business needs. Known as the "real bills ble models of the real bills doctrine. In one model, doctrine" , this viewpoint was once so influential it the real loan demand is defined in such a manner was a premise underlying the creation of the Federal that borrowers are assumed always to repay their Reserve Systeml . loans. In such a case, lenders could seek to accom While John Law first proposed the real bills modate any real loan demand by borrowers3 , and doctrine in 1705, the classic statement on this the real money supply thus passively accommodates subject was provided by Adam Smith (1776). Smith real money demand. Most presentations of the real suggested that an appropriate rule for money crea bills doctrine4 implicitly make this assumption, tion is for each bank to "discount(s) to a merchant a which is equivalent to a monetary regime where a real bill ofexchange drawn by a real creditor upon a central bank targets interest rates. real debtor, and which as soon as it is due, is really The real bills doctrine may also be modelled by paid by that debtor." In other words, Smith advo assuming that banks limit loan supply according to cated that banks only finance short-term commer their perception of default risk. Real loan supply at cial paper arising from real transactions in goods any given interest rate therefore will not necessarily and services. coincide with real loan demand because banks may The original version of the real bills doctrine ration credit rather than passively accommodate real appears to have emphasized short-term commercial credit demand. The result would be a loan and paper linked to real economic activity to ensure that money supply function that is upward sloping (over banks indeed financed only those loans that would a certain range) in relation to the rate of interest. A be repaid. By so doing, the doctrine also limited the money supply function that is upward sloping in quantity of those loans. However, it may not be relation to interest rates also results if one assumes necessary to restrict loans to certain types of that .bank operations are characterized by rising activities2 and to short maturities to guarantee marginal costs. This is the supply function postu repayment. Instead, banks may be allowed to lated by Patinkin (1965). As shown in the appendix, finance any type of activity as long as they can the macroeconomic equilibrium of a real bills re correctly assess credit risk. This last criterion will gime depends significantly on the loan and money still •satisfy the essential requirements of the real supply process assumed. bills doctrine: that loans respond to the requirements Most ofits early proponents believed that the real ofthe market, that they be selected in such a manner bills doctrine would suffice to prevent an overissu that they will be repaid, and that the volume ofloans anceof notes and to maintain a stable price level be limited. Thus, modem interpretations of the real because, under the doctrine, real loan supply would 18 be limited by real loan demand in the economy. 5 rates,banks may determine the volume ofloans and (Alternatively, loan supply may be limited by the deposits created on the condition that their liabilities perceived capacity to repay). Loan supply would in be fully convertible to gold at a fixed rate. This tum limit money creation, since banks concerned condition is sufficient to guarantee that banks will aboutthevalueoftheir monetary liabilities would have to limit the amount of money they create seek to ensure that these are not excessive in relation according to the availability ofgold in the domestic to the loan assets backing them. The flaw in this economy. 9 reasoning is that ifthe nominal value of bank assets In an open economy, convertibility to gold rises with inflation, then banks may also increase implies that the external sector will regulate the the nominal value of their liabilities, and. create supply ofmoney and the price level. The adjustment more money, without penalty. process in such cases is traditionally described by Critics of the real bills doctrine have emphasized the classical price specie flow mechanism. An that while the market limits real loan supply and excess supply of money would tend to raise domes real money creation, this does not mean that the tic prices and reduce international competitiveness. market will successfully limit nominal money sup This, in tum, would tend to produce a gold outflow ply or the price level. The mistake of the original that would eliminate the excess supply of money exponents ofthe real bills doctrine was to confuse an and lower domestic prices until a trade balance is equilibrium in real terms with an equilibrium in restored. nominal terms. The appendix shows that in a closed In a modem economy, a system analogous to a economy, an endogenous or market-determined gold standard would be one that requires convert money supply may be inconsistent with price level ibility with some internationally traded asset at a stability. 6 fixed exchange rate (such as sterling or the U.S. Another fault of the real bills doctrine, first found dollar) and one in which capital mobility, as well as by Henry Thornton (1802), is the possibility of trade flows, govern the adjustment process. An accelerating inflation under a real bills regime. excess supply of money in this case would tend to Anticipating Wicksell by almost 100 years, Thorn lower domestic interest rates and thereby create an ton argued that if interest rates were pegged below incipient capital outflow. In the process ofaccom the equilibrium there would be a persistent excess modating this capital outflow, the banking sector demand for loans. Under the first model of the real would supply foreign assets in exchange for its bills doctrine described above, the nominal increase monetary liabilities at a fixed exchange rate. 10 This in loan supply to accommodate this excess demand would preserve the fixed exchange rate while elim would result in an increase in money supply and inating the excess money supply and preventing any prices. The increase in priceswould reduce real loan instability in the price level. and money supply below equilibrium, and lead, in Under both the classical gold standard and a tum, to a further increase in nominal loan demand modem economy with fixed exchange rates, a mar and nominal money. This would set off a process of ket-determined money supply is well-defined and continued expansion of loans, money and prices. 7 self-limiting. Variations in the supply ofthe interna Notwithstanding these shortcomings, economists in tionally traded asset would, however, induce fluc recent years seeking to address the implications of tuations in the domestic price level of a modem unregulated banking have attempted to rehabilitate economy such as Hong Kong's because the domes the real bills doctrine. 8 tic rate of inflation depends on the rate ofgrowth of the internationally traded asset. The Open Economy As shown in the appendix, the money supply may Smith's analysis avoided traditional objections to also be self-limiting under flexible exchange rates if the real bills doctrine as the regime he described was two key assumptions hold: domestic output is not a small open economy following a. gold standard. fully insulated from the external sector, and the real Under this system, which closely resembles Hong loan supply - and therefore the real quantity of Kong's monetary regime under fixed exchange money supplied by profit-maximizing banks - is 19 positively related to interest rates. Capital mobility A market-determined money supply under float pegs the domestic interestrate to the world rate. This ing rates may lead to price level instability if either determines the real money supply. Atthe same time, ofthe two key assumptions made above do not hold. interaction with the external sector determines an Ifflexible exchange rates fully insulate the domestic exchange rate and a price level consistent with econorny, the external sector will not stabilize the money market and goods market equilibrium. Since domestic price level. Price instability is also possi the price level is stabilized by the external sector, ble ifbanks passively accommodate money demand bank decisions affecting real loan supply in effect rather than limit money supply at any given interest determine nominal loan supply and nominal money rate. balances. The reason this prescription does not work Aside from stability in money and prices, policy in a closed economy is that a closed economy has no makers may be concerned with other implications of external sector to regulate the price level. an exchange rate regime. For example, in a small Comparative statics exercises show that, at the open economy with a high degree ofcapital mobili exchange rate and price level consistent with equi ty, there may be sudden shifts in the demand for librium, an excess supply of money would result in domestic assets. Under fixed exchange rates, these an equilibrating reduction in loans and money financial sector shocks can be offset by appropriate because banks would find that real loan supply variations in domestic money supply. Under flexible exceeds real loan demand at the prevailing rate of exchange rates, these shocks are reflected in varia interest. In contrast, when prices are above equi tions in the value of the currency. For a small librium, the contractionary effects on the trade economy where trade represents a large proportion balance and aggregate demand would result in equi of gross national product, informational advantages librating price reductions. This contrasts sharply may favor a fixed exchange rate regime. Further with the unstable Thornton/Wicksell scenario where more, persistent fluctuations in the value of the money creation leads to price increases, and price currency may lead to destabilizing speculation. As increases lead to further money creation. The dis we shall see, the last consideration, in particular, tinction is the basis for later empirical tests on the appears to have influenced the choice of an stability of Hong Kong's monetary regime. exchange rate regime in Hong Kong. II. Money and Monetary Control A first step towards understanding the process of Note Issuance and Currency Backing money creation in Hong Kong is to recognize that In a typical central banking regime, the monetary government intervention in Hong Kong is generally authorities control the creation of base money, believed to be ineffective and harmful to growth. II defined as currency and reserves l 3, by limiting its This non-interventionist philosophy manifests itself availability to private banks. Given the supply of in a conservative fiscal posture that is justified as a base money, a money multiplier (a function of the means of controlling money creation. Hong Kong's banks' desired holdings of reserves in relation to government believes that "the public sector's totald~posits and the public's desired ratio of cur impact on the growth of the money supply should, rency to d~posit holdings) will then determine the on the average, be neutral". 12 total money supply. In a real bills regime, each bank This philosophy is also apparent in the govern can either issue its own currency or, on its own ment's reliance on the market to determine the initiative, present some asset it holds to the govern money supply. The market works within a frame ment in exchange for currency. In contrast to a work of three institutional restrictions thought to regime with a central bank, where the availability of influence money creation: the mechanics of note currency is controlled by the monetary authority, the issuance, the interest rate setting agreement of the amount of currency in a real bills regime is deter Hong Kong Association of Banks, and required mined by the market, as is the total money supply. 14 liquidity ratios. In this section, we review the Hong Kong's monetary system operates exactly implications of these restrictions for price stability. 20 like a real bills regime. Two note-issuing banks foreign currency deposits for domestic currency credit the account of a government Exchange Fund notes and the ratio of vault cash and currency to and receive the equivalent amount in Hong Kong deposits. This multiplier is illustrated in the box. dollar certificates of indebtedness against which The fixed.exchange rate regime implemented in HongKongdoHarnotesm 21 22 23 An immediate effect ofthe 1972 revision was that omy may guarantee that real money demand equals domestic monetary issuance by banks need not have real money supply even as the nominal money any relationship to the exchange rate set by the supply, prices and exchange rates are indeterminate government. When a government pegs the exchange or unstable. rate,it will find itself unable to enforce the pegged rate unless that rate was consistent with the market Interest-Setting in Hong Kong equilibrium rate. Independent money creation by Since 1964, banks in Hong Kong have restricted banks could neutralize any effort by the government the interest rates they pay on deposits with matu to fix the exchange rates. This was the sequence of ritiesof less than twelve months to a level deter events in Hong Kong between July 1972 and mined by the Hong Kong Association of Banks November 1974. The government attempted to peg (HKAB) or its predecessor, the Exchange Banks' the currency to the U.S. dollar only to abandon the Association. This restriction was designed to pre effort because of the limited impact of its interven vent the destabilizing interest rate competition tion. In effect, Hong Kong went into a floating rate experienced during banking crises in the early regime by default because it had adopted an institu 1960s, and was formalized in legislation in 1981 tional arrangement inconsistent with a fixed that established the HKAB and empowered it to exchange rate. As we shall show later, this institu require banks to observe the interest rates it estab tional arrangement would have implications for the lished. While this agreement was originally estab feasibility of stabilizing exchange rates in response lished for prudential reasons, subsequent discus to shocks. sions of its function have focused on the Abandoning the requirement that currency issu implications for price stability and monetary con ance be backed by foreign assets also removed the trol. self-regulating mechanism that limits the monetary Jao (1984) and Fry (1985) assert that the HKAB base under fixed exchange rates. As discussed ear set interest rates consistently below the equilibrium lier (and shown formally in the appendix), in a small determined by the world market. Given our earlier open economy such as Hong Kong's, where flexible discussion ofWicksell and Thornton, it would seem exchange rates do not fully insulate the domestic that such a policy could create the potential for economy, interaction with the external sector may hyperinflation on the assumption that banks would nevertheless guarantee price level stability as long set the loan rate as well as the deposit rate below the as banks limit the loan and money supply at any market equilibrium. Competition in the loan market given interest rate. could prevent this from happening. FurthernlOre, If these conditions do not hold, money, prices, given that the loan rate was in fact set below the and exchange rates in Hong Kong could be indeter market equilibrium, the Thornton/Wicksell view minate or unstable. This view is held by a number of also assumes that banks continually seek to accom observers of the Hong Kong scene. For example, in modate an excess demand for loans. This may not the December 1983 issue of the Asian Monetary occur if profit-maximizing banks respond to an Monitor, John Greenwood remarked: ex<;ess demand for loans by rationing credit rather ... Hong Kong's monetary arrangements than continually raising the nominal loan and (under floating exchange rates) constituted an money supply. indeterminate, metastable equilibrium sys There are also indications that the ability of the tem. This meant that for any given level of HKAB to influence interest rates was limited, par money supply and prices in Hong Kong, the ticularly as the 1970s progressed, and that it proba exchange rate would adjust to that price level; bly had to adjust its interest rates to reflect market alternatively, given any level of the exchange conditions. One reason it may have been forced to rate, money supply and domestic prices would raise rates is that the profitability of Hong Kong's adjust to that exchange rate. IS financial system depends on attracting depositors Greenwood's reasoning is analogous to the tradi who have access to the Euromarket. Hong Kong tional criticism of the real bills doctrine. The econ- banks must therefore pay internationally competi tive rates. By affecting the cost of funds in a 24 competitive lending environment, the external sec 1982-83 episode in which uncertainty about the tor would tend to bring overall Hong Kong interest future government of Hong Kong caused the value rates into line with the world market.equilibrium, ofits currency to plummet, a rise in the rate paid on and thereby limit the ability of the HKAB to set Hong Kong dollar deposits could have dampened deposit rates that were excessively out ofequi th~drop in. the value of the currency. Instead, the librium. HKAB was reportedly reluctant to raise interest Another factor that may have limited the ability of rates, .and the government was reluctant to insist. 16 the HKAB to determine interest rates was the rapid Liquidity Ratios growthofDeposit Taking Companies (DTCs) inthe 1970s. DTCs were financial intermediaries that, up Aside. from the mechanics of note issuance and to 1976, had avo.ided banking restrictions by limit the int~rest rate. agreement, the liquid assets ratio ing their business to deposits with maturities in requirement is typically cited as a potential means excess ofthree months. As DTCs were not subject to for limiting the money supply in Hong Kong. Also the interest rate agreement, they undoubtedly made established for prudential, rather than mac it increasingly difficult for the Hong Kong Associa roeconomic, reasons, this institutional restriction tion of Banks to fix the interest rate. The frequency requires that the ratio of liquid asset holdings with which interest rates were revised suggests that (mostly vault cash and foreign assets, given the the DTCs were influential. The HKAB revised its limited amount of marketable government deposit rates only once, in 1976 when the Deposit securities) of banks to deposits exceed twenty-five Taking Ordinance was passed. This ordinance percent. allowed DTC deposits of any maturity but imposed In Hong Kong, this requirement is often believed other restrictions on their operation. In 1980, to restrict money creation in a manner analogous to however, just before major additional restrictions reserve requirements. However, the analogy is were imposed on DTCs, the HKAB revised its invalid since the market, and not the government, deposit rates 13 times. Thus, while concern about determines the creation of liquid assets by the their inflationary impact was typically associated acquisition of foreign currency deposits or the with DTCs, DTCs probably helped ensure that mechanism of note issuance described previously. market considerations prevailed in determining Thus, the liquid assets ratio has not functioned as a interest rates in Hong Kong. The impact of the reserve requirement in the sense of requiring banks HKAB interest-setting agreement may therefore to hold liabilities of the government monetary have been limited to some distortion of the term authority, the supply of which is determined by structure of interest rates, and, as in other countries policymakers. In particular, base money creation by where restrictions of this kind are imposed, may banks could nuIIi:ry any effects ofliquid assets ratio have reduced the availability of savings. requirements. In any case, the government has The government could use the interest-setting altered the liquid assets requirements very infre powers ofthe HKAB as an instrument for monetary quently. control to the extent that the HKAB was not limited It may also be noted that the liquid assets ratio by competition to adjusting interest rates passively was not binding on banks, which typically held in response to market conditions. Variations in the liquid assets significantly above the required level. interest rate could induce desired changes in real For example, between 1972 and 1984, the year-end money demand or supply, and affect prices and liquidity ratio ofbanks averaged well in excess of40 exchange rates. However, this approach would not percent. Up to the early 1980s, deposit-taking com always work, as the criteria used by the HKAB in panies, which were close competitors of banks, ass~ts setting interest rates need not be based on mac were not subject to liquid ratio requirements. roeconomic considerations. The weakness of liquidity ratios as instruments Furthermore, the government appears to have for monetary policy under floating rates is illus been unable to use the interest rate agreement to trated by the effort ofthe government to use them to achieve certain macroeconomic objectives on cer control money creation at the end of the 1970s. In tain critical occasions. For example, during the February 1979, the government imposed a 100 25 percent liquid assets requirement on deposits of the money and price level depends on the process gov Exchange Fund. As a result, note-issuing banks had erning note issuance, including the pegged to hold either currency or foreign exchange assets exchaJ1ge rate arrangement, and that other institu against these deposits. tional r~strictions, such as the interest-setting agree If the constraint were binding, it would tend to mentof theHKABor liquid assets ratio require contract the money multiplier, as the banks' vault ments, are of limited importance. cash to deposit ratio would have to rise. However, it Unlike most modern economies, base money would not necessarily limit the creation of base creation in Hong Kong results from the initiative of money. As the Hong Kong dollar depreciated, a two private note-issuing banks whose decisions are fixed amount of foreign assets used to serve the based. on market considerations. The institutional liquidity requirement could support an increasing restrictions on note issuance guarantee that money amount of domestic currency creation. That is, the creation is self-limiting under fixed exchange rates. effectiveness of this policy as a means for controll The stability of Hong Kong's monetary system ing the money supply was diluted because the gov under floating exchange rates is less obvious. Lead ernment did not set a price for the Hong Kong dollar ing observers believe that the monetary process may in relation to its foreign currency liquid assets have been unstable, and theory is ambiguous on this cover. 17 point. A closer look at the empirical evidence is Our brief review of Hong Kong's monetary re therefore indicated. gime suggests that the stability of Hong Kong's m. Hong Kong's Macroeconomic Performance Macroeconomic Indicators One feature of a regime where the money supply If Hong Kong's monetary system had adverse is market-determined is that movements in the effects on its economy, it is not apparent in the money supply tend to be procyclical. For example, performance of the real sector. Real gross domestic Ml dropped 5 percent in 1974 and may have con product (GDP) growth averaged 8.0 percent tributed to the rise in the unemployment rate to 9.1 between 1966-1972 when exchange rates were percent in 1975. However, the cost of a procyclical fixed, and 8.5 percent between 1974-1983 when the monetary adjustment was offset by a drop in the Hong Kong dollar was floating. In fact, as shown in inflation rate from 16 percent in 1974 to 1.6 percent Table I, Hong Kong's economic growth has been the year after. among the highest in the world since the early Furthermore, flexible real wages have undoubt 1960s. edly been a major stabilizing influence and reduced This remarkable growth is partly attributable to a the need for countercyclical monetary policy. For competitive labor market that has resulted in a high example, although annual real GDP growth slowed degree of real wage flexibility. Between 1974 and during the world recessions of 1975 and 1982 (to 1982, real wage growth averaged only 1.9 percent, 2.2 and 2.9 percent, respectively), Hong Kong has and it fell sharply during certain years. For example, not experienced a GDP decline in at least twenty real wages fell 12 percent following the first interna years. While the costs to the real sector of Hong tional oil price shock in 1974, and 11 percent during Kong's market-determined monetary regime are not the severe world recession of 1975. evident, it is also necessary to investigate whether Unemployment data, available on a yearly basis the stability of prices and exchange rates was only since 1975, suggest a satisfactory economic affected. performance. The unemployment rate averaged 4.4 As shown in Table 2, Hong Kong's inflation rate percent between 1975 and 1983 notwithstanding averaged 4.7 percent in the period 1966-1972 when periodic surges in the labor force caused by immi fixed exchange rates applied. During the period gration, such as the Y2 million immigrants from the when Hong Kong's currency floated, the average Chinese mainland between 1978 and 1981. inflation rate almost doubled to 9.3 percent, but it 26 27 remained below that offive ofthe other six develop national product or inflation. In Hong Kong, the ing countries in the table. Furthermore, it was not problem is complicated by two additional consid much higher than the inflation rate of the U. S. (8.5 erations. First, until 1981, money supply data did percent) or Japan (7.8 percent). not distinguish between the Hong Kong dollar and Aghevli and Khan (1980) surveyed some of the foreign currency. Second, Hong Kong does not countries included in Table 2 (Brazil, Colombia, separate Eurocurrency operations from domestic Dominican Republic and Thailand) and found that financial transactions. As a result, there may be fiscal deficits in those countries lead to destabilizing large movements in the reported money supply that monetary accommodation and inflation. Given the are unrelated to domestic economic activity and that inflationary experience of countries such as Brazil would have no inflationary implications. and Colombia, it would seem that fiscal deficits The measurement error in Hong Kong's monetary represent a greater problem for monetary policy statistics implies that reliable estimates of the effect than does a market-determined money supply. money may have on prices are not possible. IS Thus, While Hong Kong's inflationary performance was while preliminary tests suggest that money has a clearly satisfactory when compared to other econo very weak influence on prices in Hong Kong - a mies during the floating exchange rate period, such result that is consistent with our description of a casual observation does not rule out the possibility stable monetary regime in an open economy - this that the regime was unstable. After all, the rate of result is still open to question. inflation was much higher during the period of The measurement error in Hong Kong's monetary floating rates, and other factors, such as Hong statistics do not preclude estimates of the impact of Kong's rapid growth, may have disguised the effects prices on money cr~ation. Inflation leading to ofan unstable monetary regime. A more formal test money creation is a necessary condition for mone is therefore desirable. tary instability when the money supply is market determined, and we will focus on it here. Further An Empirical Test more, as the share of Eurocurrency transactions is Earlier, we noted that in stable monetary regimes, much larger for Hong Kong's M2 and M3, tests will disturbances to money and prices tend to correct be limited to the effect of prices on MI. One themselves. In unstable monetary regimes, technique for ascertaining whether prices "cause" however, they do not, so an increase in the money money creation is the test of Granger causality. supply leads to an increase in the price level, and an Prices are said to "Granger cause" money if past increase in the price level leads to a further increase values of prices improve the forecast of the current in the money supply. money supply. If the hypothesis that Hong Kong's monetary There are a number of ways to implement the regime under floating rates was unstable were cor Granger test l9, and two different methods were rect, money creation should induce inflation and attempted here. The first method involved filtering price increases should have led to further money the monthly series of money and prices for the creation after 1972. The Hong Kong government's period of floating exchange rates to remove trend conservative fiscal stance permits us to rule out and seasonality and to approximate white noise. government deficits as the source of any monetary Then the cross-correlation of de-trended and de accommodation that may be found, and allows us to seasonalized money with prices was estimated for focus exclusively on whether the operation of the prices lagged backwards and forwards 30 months. A private market leads to instability. positive cross-correlation between past prices and Before proceeding with an empirical test, it is current money supply would indicate that "innova appropriate to remark on certain peculiarities of tions" in prices lead to "innovations" in money, and Hong Kong's statistics. In modem economies, it has would be consistent with the view that prices become increasingly difficult to determine which "Granger-cause" money. This procedure is dis monetary aggregate is most related to nominal gross cussed in Pierce and Haugh (1977). 28 Table 3 reports the results ofth!efirst t!eSt. For the pastvalues as wen as past prices lagged 1 to 12 p!eriod January 1973-0ctober 1983, the data failed months: to .reject •at .a 10.percent significance kvel·.th!e hypothesis that the cross-correlation •at 29.lags is 12 12 zero. .The •• hypothesis of. zero cross-correlation Mt A + .2: Bt-jMt- j + .2: Ct- j Pt- j J=1 J=1 would be rejected at 17.lags because tbe cross correlation betw!een Past prices and current money exceeds two standard!errors for prices lagged eleven If past prices have significant coefficients, then montbs (witbiacorrelation.coefficientofO.21) and they .canbesaid to "Granger callse" money. Evi thirteen months (coefficient - 0.23). As the filter dence of GrangercausaIity is a necessaryblltnot ing proceduredidnotJldly su.cceed in "whitening" sufficient condition for. instability.in money •afid the series, these· coefficients probably reflect an prices. Two starting periods were chosen in the annual seasonal factor. "Causality" of prices to second test: (1) January 1973 was some six months money therefore cannot be inferred, and even if it after domestic currency assets were permitted as a could be, the alternating signs ofthe coefficients are basis for note issuance. We have argued that tbis is ambiguous. inconsistent with fixed exchange rates and could One difficulty with the above procedure is that the lead to monetary instability. (2) November 1974 was pre-whitening process may remove any evidence of when Hong Kong abandoned the effort to peg its a relationship between prices and money. As a currency to the U.S. dollar. After that month, we result, an alternative test of Granger causality is can be certain that any systematic effort to back reported below. Furthermore, although it was earlier domestic currency issuance with foreign assets at a argued that the imposition of a 100 percent liquid fixed price was abandoned. assets ratio requirement on Exchange Fund deposits The results are shown in Table 4. As can be seen, in February 1979 had certain flaws, it may neverthe no significant relationship, in the Granger sense, less have affected the link between prices and could be established between past prices and current money. Subsequent estimation does not extend money supply. The results therefore suggest that beyond this date. Hong Kong's monetary regime was stable even The second test of Granger causality involved during the period of floating rates. regressing the logarithm ofmoney supply on its own 29 Exchange Rate Stability ment of the HKAB also appears to have been quite While Hong Kong's monetary regime under float limited. ing exchange rates appeared to be stable (in prices), Neither the market mechanism nor the weak the inability ofthe government to enforce a currency instruments available to the government was suffi peg under floating exchange rates could prove cient to' control the speculation against the Hong costly. Kong dollar, so the government halted the Hong This is illustrated by the 1982-83 fall in the value Kong dollar's precipitous drop by reforming the of the Hong Kong dollar caused by uncertainty terms of note issuance. On October IS, 1983, it about the future of Hong Kong. This uncertainty announced that it would peg the value of the Hong provoked a general shift out of Hong Kong dollar Kong dollar at 7.8 Hong Kong dollars per U.S. denominated assets into foreign currency assets, dollar and once more require the note-issuing banks and resulted in a drop in the trade-weighted value of to deposit foreign currency assets with the the Hong Kong dollar of27 percent over 15 months. Exchange Fund to back note issuance. Furthermore, it is quite possible that the crisis put The immediate result of this policy was that any the exchange market on a speculative path, on further efforts to shift away from the Hong Kong which expectations about further declines in the dollar would contract the domestic money supply to Hong Kong dollar created further pressure on the the point where the supply of Hong Kong money currency and thus tended to be self-fulfilling. In July was brought down to the level demanded. Further 1982, when the Hong Kong dollar began its sharp more, it would restore confidence in the Hong Kong decline, the annualized rate ofdepreciation was 7.7 currency, which now had foreign asset backing at a percent. By September 1983 - the last month of fixed price. The peg to a strengthening U.S. dollar the crisis - the Hong Kong dollar was depreciating was immediately effective and' has been suc at a 65 percent annual rate. The government was cessfully maintained, with the result that the Hong therefore compelled to take steps to break this Kong dollar has appreciated significantly on a trade accelerating erosion in the value of the currency. 20 weighted basis since1983 - reversing the trend of While the Exchange Fund could (and possibly the preceding five years. did) intervene during the 1982-83 crisis by selling This last episode highlights the risk of a market its foreign assets in exchange for Hong Kong dollar determined money supply under floating rates. In notes, note-issuing banks could fully offset this the absence of discretionary instruments for mone intervention by simply printing more notes to tary control, the requirement that note issuance be acquire foreign currency assets. 21 As pointed out backed by an internationally traded asset at a fixed previously, the ability of the government to influ price appears to be necessary to offset shocks that ence interest rates through the interest-setting agree- prompt speculative attacks against the currency. 30 IV. Conclusion Our inability to find results consistent with mone raise interest rates to stabilize exchange rates in tary instability in Hong.Kollg is somewhat surpris 1982-83 .. Instead, the governmenthad to impose a ing given the traditional critique of the real bills fixed exchange rate regime that would accomplish doctrine. The result expected from a real bills re the necessary results. gime did not occur for one of two reasons. First, Our· findings are therefore consistent with the Hong Kong's monetary regime. may actually not view that a market-determined money supply in a have satisfied the real bills doctrine. This would be Small open economY need not .be associated with the case ifnote-issuing banks did not base theirIoan price level instability or indeterminacy. Theysug decisions only on lllarket considerations but cared gest that monetary authorities under circumstances about the price level and behaved as if they were a similar to those in .Hong Kong could successfully modern central bank. Second, proponents of the relax their direct control over monetary aggregates. real bills doctrine may have been correct in arguing Casual observation suggests that certain features of it would ... not result in price indeterminacy or Hong Kong's economy, such as a conservative fiscal instability. posture and real wage flexibility, may help this The idea that the private note-issuing banks, monetary regime work. particularly Hongkong and Shanghai Bank, acted However, the exchange rate regime and the like a central bank is appealing. As the major bank institutional arrangements underlying it also are in Hong Kong, Hongkong and Shanghai Bank pre important to Hong Kong's monetary regime. Under sumably could be affected by macroeconomic con the monetary system in force during the period of siderations such as price stability. However, deci floating exchange rates, Hong Kong had essentially sions based consistently on public policy no instruments to prevent destabilizing speculation considerations could pose insurmountable prob against the Hong Kong dollar. It did not control lems for a bank accountable to its stockholders. interest rates or the monetary base, and could not There is no evidence, for example, that the rely on the market to stabilize the value of the Hongkong and Shanghai Bank voluntarily con· currency. Only through the current pegged regime tracted note issuance, or that the HKAB sought to do these problems appear to have been solved. 22 31 ApPENDIX Formal Treatment of Regimes withAn Er'ldogenous Money Supply In the case of a classical closed economy, a where the signs under the arguments correspond to regime with an endogenous money supply may be those of the partial derivatives and charllcterized as follows (see Plltinkin 1965, Sargent 1979): rF world rate of interest y, YF domestic and foreign output, respec G(y,r) = 0 Goods market (A. 1.1) tively (M/P) = m (r,y) Money market (A.l.2) A domestic absorption B net exports Given output (y), equation A.I.l can determine the interest rate (r). Equation A.l.2 can determine Equation A.I.3 applies because exchange rates combinations of money (M) and prices (P) that affect aggregate supply in an open economy. A satisfy money market equilibrium. HQwever, since depreciation will raise consumer prices and reduce money supply is endogenous, both nominal money labor supply while not affecting labor demand. and the absolute price level are indeterminate. Under fixed exchange rates, equation A.l.4 can Loosely speaking, the number of equations is not determine the combinations of output and home sufficient to determine the number of unknowns. prices consistent with equilibrium in the goods Somewhat less familiar is the applicability of market. Equation A.I.3 determines y with fixed these conclusions to an open economy with flexible exchange rates, and, given the foreign interest rate prices. This may be illustrated in the simplest possi and the home price, it is possible to determine ble manner by modifying equations A.l.l - A.l.2 nominal money supply in equation A.l .5 . to incorporate the effects of the external sector in a While loan supply is still determined by loan small open economy. demand, as was the case in the closed economy The price level in an open economy depends on described by equations A.I.I - A.I.2, the problem both domestic and foreign prices adjusted for the ofprice level indeterminacy does not arise here. The exchange rate, that is, reason is that an increase in loans, and therefore of M, will result in an offsetting money supply con traction to maintain the fixed exchange rate. The fixed exchange rate guarantees a determinate quan where PH represents the price of goods produced at tity of money. Adam Smith was aware of this result home, E is the domestic currency price of foreign and, while he subscribed to the real bills doctrine exchange, and the foreign price is set equal to one. and a market-determined money supply, he also We may begin by assuming perfect capital mobi would have required banks to ensure that their lity as such a case is the easiest to illustrate. Under monetary liabilities were fully convertible with gold fixed exchange rates, the domestic interest rate at a fixed price. equals the foreign rate ofinterest, and equilibrium is Consider now the case of flexible exchange rates given by with an endogenous money supply. The reader may verify that equations A.I.3 to A.I.5 cannot deter y = y(E) Aggregate Supply (A. 1.3) mine the nominal levels ofM, P or E. This problem is compounded by the fact that even output is now G[y, A(y, rF), B(y, YF' PH/E)] = 0 Goods Market + - + + - + (A. 1.4) indeterminate. Once more, we may loosely say that there are too many unknowns given the number of (M/P) = m(rF' y) Money Market - + (A.I.5) equations. Reducing one plausible unknown does 32 not solve the problem. For simplicity, assume ini Except for Patinkin(1965), most of the literature tially that domestic output is fixed, and insulated uses A.I.5 rather than A.I.6 to model the real bills from the external sector so equation A.I.3 does not doctrine. However, A.I.5 is not necessarily consis apply. Then the reader may verify that equations tent with profit-maximization, and more appropri A.1.4 and A. L5 can determine the optimal real ately describes the behavior of a central bank peg money balances but not the nominal quantities M ging the interest rate rather than the behavior of and P, orE. private banks. The above provides a formal interpretation of a A well-defined level of money, prices, and prevalent view that Hong Kong's monetary regime exchange rates occurs because we have assumed in under flexible exchange rates was indeterminate. It equation A.I.3 that the domestic economy is not also appears to be the rationale for the view of the fully insulated from the external sector even under Asian Monetary Monitor, quoted in the text. floating rates. If we assumed instead that exchange Equation A.I.5, and equation A.I.2, assume that rates did not influence the level ofoutput at all, and real money supply passively adjusts to accommo that output is fixed, we would once more have a date real money demand. This is the standard way of situation where equation A. 1.4 determines the ratio modeling how a real bills regime operates in an PHfE, and equation A.I.6, the ratio MfP. However, economy with a central bank. It is also an appropri neither the level of M nor P can be determined. ate way of modeling a market-determined money Another problem is that if interest rates were supply under fixed exchange rates, as it is consistent determined abroad, there would be no reason to with the view that banks exploit any arbitrage suppose that the money supply given by equation opportunities arising from deviations from the fixed A.I.6 is consistent with the money demand of rate set by the Exchange Fund. equation A.I.5. Hong Kong, however, has no central bank to take However, it is implausible to assume that the the initiative in adjusting money supply, and equa external sector does not influence domestic activity tion A.I.5 does not appear to portray accurately the in a small open economy like Hong Kong's. Thus, it behavior ofprofit-maximizing banks under a closed is likely that Hong Kong's nominal money and price economy or in an open economy with flexible level were well-defined even under floating rates. exchange rates. In particular, under flexible We may now examine how similar results can be exchange rates, A.I.5 suggests that the real money obtained if we relax the strong assumption that supply always will be set by banks to equal the real domestic and foreign assets are perfect substitutes. money demand. At any given interest rate, however, A more elaborate framework will also permit us to it is more likely that private banks will only be analyze the implications of the interest-setting willing to supply a limited amount ofcredit based on agreement ofthe Hong Kong Association ofBanks. considerations of cost or default risk. Thus, they Following Tobin and de Macedo (1980), we used would follow the rule: a modified IS-LM approach in which all asset mar kets satisfy flow as well as stock equilibrium. Ifwe MlP = S(r) (A. 1.6) assume that the government maintains fiscal bal + ance, there are four markets: the market for private domestic bonds or commercial paper, the market for Substituting S(r) for MfP into A.I.5, it can be seen foreign bonds, the money market, and the goods that, under floating rates, the behavior of profit market. By Walras's law, equilibrium in the first maximizing banks ensures an equilibrium. In par three guarantees equilibrium in the fourth. Thus, we ticular, A.I.5 and A.I.6 determine the level of may characterize the overall equilibrium by: output and, through A.I.3, the exchange rate that would be consistent with equilibrium. Equation A.I.4 then determines the prices ofhome goods and y = y(E) Aggregate supply (A.I.3) therefore the price level. This will suffice to deter mine the nominal money supply. 33 AH(rH, rp, E, y, a) qH(rH)K 1 = to determine the absolute price level P, and the + ± + + nominal money supply M in equation A.l.6. Thus, I(r , y) Domestic Bond Market (A.I.7) h ina small open economy with flexible exchange rates and imperfect capital mobility, the price level, AF(rH' rp, E, y, a) EF- I = + ± + nominal money supply, and exchange rates are HE/PH' y) Foreign bond market (A.l.8) determinate. + m(rH' rp, y) = M/P Money market (A.I.9) ± + where ImpUc:ations of the Interest-Setting Agreement rH domestic interest rate The HKAB sets the interest rates it pays on a asset preference shift parameter in deposits, and this rate-setting may affect the corre volving the relative desirability of sponding loan rate. If we assume that the interest domestic and foreign bonds setting agreement of the HKAB were effective in determining domestic interest rates, there would be qh the market valuation of a domestic no indeterminacy ifbanks passively supplied money bond according to this interest rate (that is, we could K_ 1 the pre-existing capital (or private ignore equation A.l.6). This arrangement is equiv domestick bond) stock of foreign alent to a central bank with an interest rate target. bonds In fact, given such a money supply rule, a fixed F _ 1 the pre-existing stock offoreign bonds interest rate would be required to obtain a well A(.) asset demand defined nominal equilibrium in money, prices, and exchange rates. Furthermore, this money supply 1(.) investment rule would permit the use ofinterest rates as a policy TO trade balance tool. m(.) money demand Consider the 1982-1983 attack on the Hong Kong dollar which may be described as an effort to shift from domestic to foreign bonds (a persistent decline in thea parameter in equations A.I.7 and A.I.8). Comparative statics analysis reveals that the shift The arguments ofthe demand functions and their would lead to an exchange rate depreciation. signs are generally familiar. The exchange rates Although not explicitly modeled here, if the enter to represent capital gains or losses from hold depreciation in tum leads to further efforts to shift ing assets denominated in different currencies. If away from the Hong Kong dollar, we would have an Hong Kong were a net creditor, the net holding of unstable process. In contrast, an increase in interest foreign assets would be positive and capital gains rates by the HKAB would create an offsetting ten obtained from holding assets during a depreciation dency towards exchange rate appreciation that may would be reflected in a rise in a demand for all restore stability. assets. The reverse applies if Hong Kong were a net If we more realistically assume that the money debtor. supply function of profit-maximizing banks is The domestic interest rate, rH' and output can be upward sloping with respect to interest rates (equa determined by substituting S(r) from A.l.6 into tion A.l.6) when exchange rates are floating, the equation A.!.9 and using equation A.!.7. The money market equilibrium could not be guaranteed corresponding nominal exchange rate follows from unless the Hong Kong Association of Banks sets rH A.l.3, while equation A.l.8 can then determine the in such a way as to ensure that money supply equals price of home goods. This is sufficient information money demand. This is not a trivial calculation, and 34 the HKAB may set interest rates to create a per approaches - do not fully capture the role and sistent excess demand for or excess supply of motivation of banks in creating money in an open money. economy. For example, it would be desirable to In the text of this article, we have noted that price reconcile A.1.5, which we assumed applies under instability may then result in line with Thornton and fixed exchange rates, with A.l.6, assumed to deter Wicksell's reasoning. Thornton and Wicksell , mine money creation under floating rates. Both however, appear to have been describing a regime reflect efforts to exploit profit opportunities under consistent with A.I.5 rather than A.I.6. Ifequation different exchange rate regimes. A.l.6 applies, banks may ration credit rather than Furthennore, in light of the discussion of the create money given an excess demand for loans, and money multiplier in the text, it would be desirable to it is not obvious that price instability will neces spell out explicitly what detennines the proportion sarily follow. Furthennore, the relative weakness of of foreign currency deposits banks will convert for the HKAB in a small open economy would favor note issuance under fixed exchange rates. Such price stability. Note, however, that the inability of exercises would clarify the process by which a the HKAB to detennine interest rates in this regime market-determined money supply in an open econ would mean that there are no policy instruments omy achieves stability, given the profit-maximizing available to offset an attack on the value ofthe Hong behavior of banks. In the meantime, the examples Kong dollar, as occurred in 1982-83. used serve to illustrate the feasibility of stable, One limitation ofthe discussion in this Appendix market-detennined monetary regimes. is that the models used - modifications of standard FOOTNOTES 1. Oneofthe purposes olthe Federal Reserve Act of 1913, loosely to refer to either indeterminacy or instability. Patin according to its introduction, is "to furnish an elastic cur kin (1965) observed that indeterminacy arises because a rency, (and) to afford means of rediscounting commercial change in prices does not affect the excess demand for paper". In line with this, Section 13 of the Act states that goods in the economy. In particular, because the money Federal Reserve Banks "may discount notes, drafts and supply is market-determined under a real bills regime, the bills of exchange arising out of actual commercial transac equilibrium in the money market applies independently of tions; that is, notes, drafts and bills of exchange issued or the equilibrium in the goods market. This would not be the drawn for agricultural, industrial or commercial pur case if the money supply were determined by a central poses ..." Note the similarity of this concept to Adam bank that sought to limit the nominal quantity of money. Smith's definition of the real bills doctrine, quoted in the 7. The dynamic instability of a real bills regime has been next paragraph of the text of this article. succinctly described in a recent paper by Thomas 2. For example, the Federal Reserve Act sought to enforce Humphrey (1982), who showed that it may be associated application of the real bills doctrine according to this with hyperinflation, hyperdeflation or an indeterminate narrow concept by forbidding the discount of "notes, price level. drafts or bills covering merely investments or issued or 8. For example, Fama (1980) solves the problem of price drawn for the purpose of carrying or trading in stocks stability by suggesting that the chosen numeraire be one bonds or other investment securities, except bonds and with a value that does not depend on the volume of notes of the government of the United States". deposits outstanding in the financial sector. Sargent and 3. Whether banks would succeed in accommodating real Wallace (1982) suggest that a real bills regime has certain loan demand would depend on the real savings resources welfare properties that make it in some sense superior to a available in the economy. If at a given interest rate, the real regime with "quantity theory" restrictions consistent with savings resources are less than the demand for loans, the price level stability. While not endorsing the real bills effort to accommodate loans may lead to the price doctrine, McCallum (1984) shows conditions under which instability described by Thornton and Wicksell, and dis it may be consistent with price level stability. cussed later in the text. 9. The description of the operation of the gold standard in 4. Sargent (1979) and McCallum (1984). an open economy is attributed to Hume. However, Laidler 5. This view was not necessarily shared by Adam Smith, (1981) observes that Hume had little to say about the however. See Laidler (1981) and the discussion of the operation of the financial sector under a gold standard. It open economy under fixed exchange rates which follows. was Adam Smith who first pointed out that full convertibility of the monetary liabilities of banks with gold was required 6. As shown in the Appendix, the problem is that the level to prevent note overissuance. He also recognized that any of nominal money balances and the price level become excess supply of money would"spill over" into the external indeterminate. As this concept is less familiar than that of sector. instability, in the text the term "instability" will be used 35 10. The equilibrium of this system is described in the 18. Technically, the measurement error in the money simplest terms in the Appendix, using the flexible price series implies that when used as an explanatory variable version of the Mundell-Fleming model. for prices, it is correlated with the error term. This "errors in 11. This is a traditional government viewpoint, according variables" problem implies that the estimated coefficient to a former Financial Secretary. See Philip Haddon-Cave on money would be inconsistent. (1984). 19. Sims (1972) and Haugh and Pierce (1977). 12. Philip Haddon-Cave (1984). As a result of this fiscal 20. The exchange rate drop was precipitated bya crash in conservatism, Hong Kong had no marketable government the real estate market that reduced the loan collateral of debt outstanding in 1982. banks and consequently their net worth. Beers, Sargent 13. Wallace (1983) argues that reserve requirements and Wallace (1983) present the intriguing hypothesis that would also be necessary to ensure that banks hold the the governmentmay have allowed the exchange rate to currency liabilities of the government. However, if hand-to depreciate to reduce the Hong Kong dollar deposit lia hand currency were legal tender and the circulation of bilities of banksand thus to improve their balance sheets. foreign notes forbidden, as it is in Hong Kong, these Ketkar and Sweet (1984) discuss the balance sheet struc conditions may suffice to create a demand for the legal ture under which a depreciation will actually benefit banks, tender. For a related discussion, see Keeley and Furlong's and suggest there is an optimal rate of depreciation (or paper in this issue of the Economic Review, and Fama appreciation) depending on the particular balance sheet (1983). structure of banks. As a general point, it should also be 14. This of course does not preclude a central bank from noted that, to benefit from a depreciation, the foreign following a policy that accommodates the market demand assets of banks should exceed their foreign liabilities. In for money by targetting exchange rates or interest rates. this way, their wealth increases from capital gains induced However, it is still the central bank rather than the private by a depreciation (see discussion of the Tobin-de Macedo sector that retains the initiative for money creation in this model in the Appendix). case. Although it is not clear that the balance sheet structure of 15. Using a different framework, Beers, Sargent and Wal banks in Hong Kong would have benefited from a lace have argued that the exchange rate was indetermi depreciation in 1982-1983, the Beers, Sargent and Wal nate in Hong Kong during the period of floating rates. lace argument highlights the potential use of exchange Exchange rates could also be indeterminate under floating rate policy to satisfy certain objectives in the financial rates if Hong Kong money and foreign money were perfect sector. This novel point raises many interesting questions substitutes, as shown by Kareken and Wallace (1981) in for policy, but our discussion suggests that during the the context of an overlapping generations model. Maxwell period of floating rates, the Hong Kong government simply Fry (1985) has also arqued that Hong Kong's monetary did not have the instruments to conduct a deliberate regime in the floating rate period was unstable. Our gen exchange rate policy of the sort described by Beers, eral description of Hong Kong's monetary system under Sargent and Wallace. fixed and floating rates is closer to that of the Asian 21. In fact, note-issuing banks could speculate against Monetary Monitor. the value of the currency by increasing the rate of note 16. Asian Monetary Monitor, Vol. 7, NO.6. issuance to purchase foreign assets. The data on currency creation during 1982-1983 suggest that this did not hap 17. A similar problem applied to the objective of the pen at the time of the attack on the Hong Kong dollar, but in Exchange Fund of maintaining full foreign asset backing of principle, this could be a destabilizing sour~e of note note issuance. Under floating exchange rates, it is not issuance. clear what "full backing" means, since a fixed amount of foreign assets may "back" an increasing quantity of note 22. This is nollo say that a fixed exchange rate regime has issuance as the currency depreciates. Thus, the "backing" no disadvantages. It is not obvious that pegging to a would not limit note issuance under floating rates, and, as strongly appreciating currency such as the U.S. dollar was argued in the text, would not be effective in pegging the the best course. Furthermore, Hong Kong's money crea exchange rate because note issuance would not be limited tion and domestic inflation rate are particularly vulnerable by the availability of foreign exchange assets. to external disturbances under this regime. In contrast, under fixed exchange rates, the Hong Kong dollar is fully backed in the sense that at the rate set by the government, the Exchange Fund always has enough for eign currency assets to redeem on demand any quantity of Hong Kong dollar notes in circulation. The fact that Hong Kong dollar note issuance is limited by foreign asset availability at the fixed rate ensures that the currency peg is enforceable. 36 REFERENCES Aghevli, B.B. and Khan M.S. "Government Deficits and the Kareken, John and Neil Wallace. "On the Indeterminacy of Inflationary Process in Developing Countries" in War Equilibrium Exchange Rates," Quarterly Journal of ren L. Coats and Deena R. Khatkhate, eds. Money and Economics, Vol. 96, No.2, May, 1981. 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