A Model of Currency Substitution in Exchange Rate Determination, 1973-78 ARTURO BRILLEMBOURG and SUSAN M. SCHADLER * д т THE OUTSET of the current floating exchange rate regime, jfTi expectations were widespread that the new system would allow countries a high degree of policy independence yet reduce strains on the free international movement of goods, services, and capital. Even long-standing critics of exchange rate flexibility seemed unable to oppose meaningfully the advent of flexible exchange rates in the face of the severe strains of reserve changes and international payments imbalances. Domestic financial pol- icies and economic performance in the major industrial countries had diverged to such an extent that fixed relationships among currencies were obviously unfeasible. After several years' experience with floating exchange rates, however, it is far from clear that exchange rate flexibility enhances the ability of coun- tries to pursue their own chosen policies without contributing to severe disruptions in the international monetary system. In fact, as experience with the regime grows, a number of the fun- damental tenets of flexible exchange rate advocates are being called into question. The long-standing case for floating exchange rates has centered principally around the argument that exchange rate flexibility allows individual countries to choose financial policies indepen- dently while removing the burden of intervention on those coun- * Mr. Brillembourg, economist in the Special Studies Division of the Research Department, is a graduate of Harvard University and of the University of Chicago. Ms. Schadler, economist in the Special Studies Division of the Research Department, holds degrees from Mount Holyoke College and the London School of Economics and Political Science. 513 ©International Monetary Fund. Not for Redistribution 514 ARTURO BRILLEMBOURG and SUSAN M. SCHADLER tries whose policies deviate from the average. This argument has been summarized forcefully by Professor Harry G. Johnson: The adoption of flexible exchange rates would have the great advan- tage of freeing governments to use their instruments of domestic policy for the pursuit of domestic objectives, while, at the same time, removing pressures to intervene in international trade and payments for balance- of-payments reasons. Both of these advantages are important in contem- porary circumstances. On the one hand, a great rift exists between nations like the United Kingdom and the United States, which are anxious to maintain high levels of employment and are prepared to pay a price for it in terms of domestic inflation, and other nations, notably the West German Federal Republic, which are strongly averse to inflation. Under the present fixed exchange-rate system, these nations are pitched against each other in a battle over the rate of inflation that is to prevail in the world economy, since the fixed rate system diffuses that rate of inflation to all the countries involved in it. Flexible rates would allow each country to pursue the mixture of unemployment and price trend objectives it prefers, consistent with international equilibrium, equilibrium being secured by appreciation of the currencies of "price-stability" countries relative to the currencies of "full-employment" countries. l The essential point made by flexible exchange rate advocates, and reflected in the above passage, is that exchange rates that are allowed to adjust freely to market forces provide an adjust- ment mechanism that insulates each economy from external influences that would, under fixed exchange rates, dominate its own policy decisions. Under flexible exchange rates, it is assumed that each domestic monetary authority controls the supply of an independent currency that is not a substitute for others. Each monetary authority can set a particular money growth rate for its currency, and excess demands for each cur- rency will be eliminated by exchange rate and price level changes, with purchasing power parity (PPP) establishing the equilibrium relationship between the two. This process is in obvious contrast to a fixed rate system, which can be understood most easily in the context of a stylized model with one world money and one price level for goods in terms of money. In this case, differences among countries' excess demands for money are eliminated through the balance of payments, which changes the physical distribution of world money among countries. There is, then, only one rate of inflation, and that is determined by the world excess demand for money. [ Johnson (1973), p. 209. ©International Monetary Fund. Not for Redistribution CURRENCY SUBSTITUTION IN EXCHANGE RATE DETERMINATION 515 This simple view of the distinction between fixed and flexible exchange rates leaves out a critical aspect of the differences between them. In the case of a fixed exchange rate regime, the concept of the world demand for money is clear. Yet, just as in the case of the world price level under fixed exchange rates, prices or exchange rates under a flexible exchange rate system are determined by the world excess demand for each particular currency. Thus, the fundamental distinction between the mon- etary approach to the balance of payments and the monetary approach to exchange rates lies in the fact that the former should be concerned with national demands for a world currency while the latter should be concerned with the world demand for a national currency. This distinction between national and global demands for a currency takes on startling importance when the concept of the world demand for national currencies is examined more closely. Residents of any country may want to hold a variety of currencies in their portfolios, both to facilitate transactions in different cur- rencies and to earn the rate of appreciation of a particular cur- rency vis-ä-vis others. As any one currency becomes less attrac- tive as a store of value or medium of exchange, it is reasonable for portfolio holders to replace it with other stronger currencies. In addition, as the decline in the real value of a currency makes the losses involved in holding it larger, its role as a medium of exchange is likely to be taken over by stronger currencies. In the extreme case when currencies are highly substitutable and expectations of the continuing depreciation of a currency are held with certainty, the relative attractiveness of a strong cur- rency will eliminate demand for a weak currency, and the exchange rate between the two will cease to exist. 2 The lesson of this admittedly stylized conclusion is that, when currencies are substitutes, monetary authorities face similar types of constraints under flexible rates and under fixed rates. Under fixed exchange rates and unimpeded trade in capital and goods, excessive domestic credit creation results in a balance of payments deficit that eventually leads to a reversal of the expansionary policy. When exchange rates are permitted to change, monetary authorities may have more flexibility in the 2 In a simple theoretical model of the demand for two currencies, Girton and Roper (1976) develop the implications of different degrees of currency sub- stitution for the stability of the system and for policy independence. ©International Monetary Fund. Not for Redistribution 516 ARTURO BRILLEMBOURG and SUSAN M. SCHADLER short run. In the long run, however, a continuing attempt to expand the money supply faster than demand for it grows will steadily erode demand and increase the rate of depreciation of the currency as money holders attempt to switch into other cur- rencies. Thus, even with flexible exchange rates, there are limits to the policies available to monetary authorities. In the long run, excessively expansionary policies must be reversed or capital and trade restrictions will have to be imposed. 3 In the short run, when an expansionary monetary policy is unlikely to drive a currency out of existence, a more complex relationship occurs among the different currencies which is, per- haps, equally limiting to the pursuit of an independent monetary policy. In particular, while the substitution between strong and weak currencies will still be important, complementarity or sub- stitutability with respect to third currencies may be equally influential. In this case, an expansionary monetary policy may not only weaken a country's own currency but also weaken those currencies that have in the past tended to follow the weakening currency and strengthen those that have tended to diverge from it. In modeling third-currency effects, the importance of uncer- tainty and its consequences on exchange rate determination should be emphasized. Indeed, uncertainty plays a central role in the development of an asset view of exchange rate determi- nation, as it is the uncertainty of asset returns that induces a wealth holder to invest in a variety of assets with different expected returns. In particular, a wealth holder will hold cash as well as bonds even though the former has a lower expected rate of return because it has the offsetting advantage of being less risky. This principle of risk diversification can be extended in a more general model that includes various currencies as well as bonds and other financial instruments among the available assets. By aggregating across individual portfolios and assuming that domestic capital markets are well integrated in international capital markets, one can postulate a market portfolio that includes a number of national currencies. As in the case of an individual, the market holds a variety of currencies in order to 3 Kareken and Wallace (1978) in fact argue that insofar as currencies are intrinsically useless they are necessarily perfect substitutes. They argue that perfect substitutability among currencies, while not always evident, implicitly requires that countries choose between the options of harmonizing financial policies and imposing prohibitive controls on capital and trade flows. ©International Monetary Fund. Not for Redistribution CURRENCY SUBSTITUTION IN EXCHANGE RATE DETERMINATION 517 diversify risk so that the prices of currencies will reflect their expected rates of return as well as their expected covariances.