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 <copies ofthis and otherFederal Reserve. publications, write or phone the Public InfofIllation Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco, California 94120. Phone (415) 974-3234. 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.