The long-run effects of alternative monetary policies under two-tier exchange rates

Economics

Letters

32 (1990)

163

163-167

North-Holland

THE LONG-RUN EFFECTS EXCHANGE RATES Ching-Chong

OF ALTERNATIVE

POLICIES

UNDER

TWO-TIER

LA1

Academia Sinicn Nanknng, Tarpei 1 IS29 Taiwan National Central Uniuersrty, Chung-Lt,

Wen-Ya

MONETARY

Taiwan

CHANG

Fu-Jew Catholic Unuxrsity,

Received

20 March

Accepted

11 July 1989

This paper

1989

first develops

examine

the long-run

powerful

or powerless

or ‘outside’

Taipei, Tarwan

a portfolio

impact

balance

of alternative

to affect the economy,

model of a small open economy money crucially

creation

under two-tier

rules. It is found

depending

exchange

that a monetary

rates, and uses it to

expansion

upon whether the money stock is increased

may be either through

‘inside’

money creation.

1. Introduction Recently, many developing countries have instituted the two-tier exchange regime in which current account transactions are conducted at an exchange rate different from that of capital account transactions. As usual, the commercial exchange rate, which is pegged by the authorities, is used for all current account transactions, while the financial exchange rate, which is free to fluctuate and to be determined by market forces, is used for all capital account transactions. By so doing, it is hoped that the regime will shield the economy from speculative capital movements and the current account will be immune from the volatility of the exchange rate. In view of the existing literature dealing with the two-tier exchange regime, Aizenman (1985) Gardner (1985) and Lai and Chu (1986) conclude that in the long run an expansion in the money stock will definitely have a zero effect on the financial exchange rate and a complete offsetting effect on the official reserves. In contrast, Cumby (1984) finds that a monetary expansion will have a non-zero long-run effect on the financial exchange rate and a partial offsetting effect on the official reserves. ’ This paper attempts to set up a portfolio balance model, and uses it to synthesize these two conflicting results. Specifically, we show that the fundamental element determining these two contrasting conclusions is, on the one hand, as Aizenman (1985) Gardner (1985) and Lai and Chu (1986) have assumed, that the money stock is increased through ‘outside’ money creation, and on the ’ The interactions

between domestic

have already been extensively

credit expansion

and the change of official reserves in the context

discussed in the past decade.

See, for example,

(1974).

0165-1765/90/$3.50

0 1990,

Elsevier Science Publishers

B.V. (North-Holland)

Argy and Porter (1974).

of fixed exchange

rates

and Kouri and Porter

C.-C. Lai. W.-Y. Chang / Long-run

164

effectsof alternative

monetary

pohcies

other hand, as Cumby has assumed, that the money supply is increased through ‘inside’ money creation. ’ The rest of the paper is arranged as follows. The structure of the model is outlined in section 2. The long-run property under a regime of outside money creation is discussed in section 3, while section 4 examines the long-run effect of inside money creation. Finally, the main findings are summarized in section 5.

2. The theoretical

framework

The framework we shall set out can be viewed as a modification of the Kouri (1976) portfolio balance model, but it possesses its own special features. More specifically, we consider an economy in which: (i) there are two types of goods: traded and non-traded goods; (ii) the residents hold their wealth in the form of domestic money, domestic bonds, and foreign bonds, and they view these assets as imperfect substitutes; (iii) there are two foreign exchange markets, one for current account transactions and the other for capital account transactions, with the commercial exchange rate in the former market being fixed and the financial exchange rate in the latter market being freely flexible. In accordance with the above descriptions of the economy, the model can be described by the following

set of equations: p=xp*,

(1)

D”(p,/p,

W/p)=S”(p,/p)

L(r,

xr*/e+rr,

J(r,

xr*/e+

~(r,

for

D;
Di>O,

S,“>O,

(2)

W/p)=M/p

for

Lt
Lz~O,O
(3)

7r, w/p)=BP/p

for

J,>O,

J,
(4

W/p)=eF/p

for

K, ~0,

xr*/e+vr,

xd=[S(p,/p)-D(p,/p,

W/p)]p+xr*F

Kz>O,O
S,
(5) D,>O,

Dl>O,

(6)

W=M+BP+eF,

(7)

M=B”+C+xR,

(8)

B=BP+Bm,

(9)

where p = domestic currency prices of traded goods, x = commercial exchange rate (defined as the home currency price of foreign currency), p * = foreign currency prices of traded goods, D” = demand for non-traded goods, S” = supply of non-traded goods, p,, = home currency prices of non-traded goods, W = private nominal wealth denominated in home currency, L = real demand for domestic money r = home interest rate, r * = foreign interest rate, e = financial exchange rate (defined as the home currency price of foreign currency), T = expected rate of depreciation of the financial exchange rate, M = nominal money supply, J = real demand for domestic bonds, BP = domestic bonds held ’ Cumby (1984) takes another viewpoint to analyze the effect of open market operation, and finds that the crucial factor for determining the long-run impact of monetary policy is whether domestic bonds held by the public are regarded as net wealth or not. For a detailed discussion on this topic, see Obstfeld (1982).

165

C. -C. Lm, W. - Y. Chong / Lang-run effects of alternative monetary policies

by the public, K = real demand for foreign bonds, F = nominal stocks of foreign bonds denominated in foreign currency, R = foreign exchange reserves denominated in foreign currency, S = supply of traded goods, D = demand for traded goods, C = the sum of currency in circulation and bank borrowing from the Federal Reserve, B = supply of domestic bonds, B” = domestic bonds held by the central bank, and an overdot indicates the rate of change with respect to time. Equation (1) states that the prices of traded goods are the same in the home country and the world economy as they are subject to perfect arbitrage. Equation (2) is the equilibrium condition for the non-traded goods market. The equilibrium condition for home money, domestic bonds, and foreign bonds is specified respectively, in eqs. (3)-(5). The demands for these three assets are functions of the return on holding domestic bonds (r), the return on holding foreign bonds (x~*/e + r), ’ and the private real wealth (W/p). Equation (6) states that official reserves will change over time as a result of current account imbalance, which is the sum of the trace balance and the service balance. Equation (7) defines that the nominal wealth of domestic residents is the sum of the stock of the three assets they hold. Obviously, it follows from eqs. (3) (4) (5), and (7) that L, + J, + K, = 0, L, + J, + K, = 0, and L, + J3 + K, = 1. The money supply is defined by eqs. (8), which specifies that the money supply can be altered through open market operations, issuing the currency, or purchasing foreign reserves. 4 Finally, eq. (9) describes that the stock of domestic bonds can be held either by the domestic residents or by the central bank. Before proceeding the discussion of alternative money creation rules, two points should be addressed. First, since the purpose of this paper is to clarify the long-run effect of an expansion in money supply on the financial exchange rate in the context of the two-tier regime, this paper only concerns the stationary property of the economy. Second, since the financial exchange rate adjusts freely to clear the financial foreign exchange market, the stock of foreign bonds, F, remains intact at all times.

3. Outside money creation Following Gurley and Shaw (1960), outside money creation is defined as the monetary authorities increasing the domestic money stock without compensating purchases of domestic bonds. As a result, outside money creation is characterized by dC > 0 and dB” = dBP = 0. In the long run, a = R = 0. Substituting eqs. (l), (7) (8), and (9) into (2), (3), (4), and (6), we have ’ D;-S,”

0

FD;

0

L,

FL, - r *L,

0

J,

FJ3 - r *J,

0

- FD,

S, -D,

-D,“(dC+dB”+dBP) =

(1 - L,)(dC -J,(dC+ D,(dC+

+ dB’“) - L, dBP dBm) + (1 -Lx)

dB”

+ dBP)

dBP

1 ’

(10

3 Flood (1978) and Gardner (1985) offer a detailed derivation. 4 For a similar explanation, see Thornton (1984) for a closed economy, and Marston (1985) for an open economy. ’ Due to the wealth definition, in eq. (10) we do not explicitly deal with the equilibrium condition for the foreign bonds.

C-C. Lai, W.-Y. Chang / Long-run effects ofnlternatioe monetary policies

166

where the ‘ - ’ on the top of the endogenous variables indicates Moreover, without loss of generality, it is assumed that initially paper. It follows from eq. (10) with dB” = dBr = 0 that

a&w=

their stationary equilibrium values. x = e = pn = p * = 1 throughout this

-1,

(11)

aiyac= ap,/ac= ar/ac= 0.

(12)

Equations (11) and (12) indicate that, irrespective of the asset substitutability, outside money creation is totally ineffective to affect the economy, that is, it will lead to an offsetting reduction in the foreign reserves and have zero effect on the financial exchange rate and other macro variables. Following an initial rise in C, the demand for both non-traded goods and traded goods will increase since the stock of M (and hence IV) has risen. Given fixed p, one might argue that j, should rise to meet the increased demand for non-traded goods. Unfortunately, the increased j, will further lower S and raise D, and hence will contradict the stationary condition for the current account, which requires the difference between S and D to be held constant. Consequently, the only way for sustaining equilibrium in the non-traded goods market and in the current account is that nominal wealth turns back to its initial level and the price of non-traded goods stays put. Moreover, in view of both domestic bonds and foreign bonds markets, both ? and Z should remain intact due to the fact that the nominal wealth, the stock of private domestic bonds, and the stock of foreign bonds are unchanged. Equipped with this information, upon the shock of increased C, the fixed level of nominal wealth is maintained through an equal decumulation of the official reserves. This is the reason why Aizenman (1985), Gardner (1985) and Lai and Chu (1986) conclude that outside money creation is impotent under a two-tier regime. 6

4. Inside money creation We now turn to examine the effect of inside money creation, which is defined as the monetary authorities conducting a monetary expansion through buying domestic bonds. Consequently, inside money creation is characterized by dC = 0 and d Bm = -d BP > 0. Solving eq. (10) with dC = 0 and dB” = -dBP yields

ap,/aBm

=

0,

(13)

aF/aBm= -(F +'*K*)/[J,P+r*(J2L,-J,L,)](0,

(14)

a%/aBm=FK,/[J,F+r*(J2L,-J,L,)]

~0,

(15)

aZ/i3Bm=

>O.

(16)

-K,/[JIF+r*(J,L,-J,L,)]

With the similar reasoning to a regime of outside money creation, when we are faced with an inside monetary expansion, in order to ensure the equilibrium conditions for the non-traded goods and for the current account, the private nominal wealth and the price of non-traded goods should be kept at their initial levels. As is evident, an open market operation will lead to an excess supply in the 6 This conclusion

is true in Aizenman

(1958) where the central

bank does not hold foreign

interest-bearing

assets.

167

C.-C. L.ai, W.-Y. Chang / Lang-run effects of alternative monetary pohcies

money market

and an excess demand

in the domestic

bonds market

since the supply of money has

increased and the supply of private domestic bonds has lowered. In order to maintain all asset markets in equilibrium, the long-run level of the financial exchange rate should rise and the long-run level of the interest rate should fall. ’ In response to a depreciation of the financial exchange rate, the official reserves are required to fall so as to maintain a given level of nominal wealth. Therefore, under a regime of inside money creation, the fixed level of the nominal wealth is maintained through altering the composition of long-run values of the financial exchange rate and the official reserves. As inside money creation is effective in from the viewpoint of policy implication, a consequence, influencing the domestic economy in the context of the two-tier sharp contrast with the operation of outside money creation.

exchange

regime,

which

runs in

5. Concluding remarks Based on a standard portfolio balance model, this paper examines the steady-state efficacy of alternative monetary policies in a world of two-tier exchange rates and imperfect asset substitutability. It is shown that the fundamental source ultimately determining conflicting results in the existing literature of the two-tier regime is what kind of money creation rule the monetary authorities adopt. When the central bank conducts outside money creation, the domestic economy will be unaffected in the long run, that is, the stationary financial exchange rate and other macro variables remain intact and the stationary official reserves exhaust with the same amount as the increased money stock. If the monetary expansion is brought about by an open market purchase of domestic bonds, the steady state of the economy will be disturbed, that is, the long-run financial exchange rate depreciates and the long-run official reserves decline, which only partially offsets the initial monetary expansion.

References Aizenman, J., 1985, Adjustment to monetary policy and devaluation under two-tier and fixed exchange rate regimes, Journal of Development Economics 18, 153-169. Argy, V. and P.J.K. Kouri, 1974, Sterilization policies and the volatility in international reserves, in: R.Z. Aliber, ed., National monitary policies and the international financial system (University of Chicago Press, Chicago, IL) 209-230. Cumby, R.E., 1984, Monetary policy under dual exchange rates, Journal of International Money and Finance 3, 195-208. Flood, R.P., 1978, Exchange rate expectations in dual exchange markets, Journal of International Economics 8, 65-77. Gardner, G.W., 1985, Money, price, and the current account in a dual exchange rate regime, Journal of International Economics 18, 321-338. Gurley, J. and E. Shaw, 1960, Money in a theory of finance (Brookings, Washington, DC). Kouri, P.J.K., 1976, The exchange rate and the balance of payments in the short run and the long run: A monetary approach, Scandinavian Journal of Economics 78, 280-304. Kouri, P.J.K. and M.G. Porter, 1974, International capital flows and portfolio equilibrium, Journal of Political Economy 82, 443-467. Lai, C.C. and Y.P. Chu, 1986, Adjustment dynamics under dual exchange rates, Journal of International Economic Integration 1, 183-193. Marston, R.C., 1985, Stabilization policies in open economies, in: R.W. Jones and P.B. Kenen, eds., Handbook of International Economics, Vol. II (Elsevier Science Publishers, Amsterdam, Netherlands) 859-916. Obstfeld, M., 1982, The capitalization of income streams and the effects of open-market policy under fixed exchange rates, Journal of Monetary Economics 9, 87-98. Thornton, D.L., 1984, The government budget constraint with endogenous money, Journal of Macroeconomics 6, 57-67. ’ In order to ensure all asset markets in equilibrium, either 7 has to fall or 2 has to rise, or both occur, to maintain the monetary equilibrium; either i or 2 or both have to decline to maintain the domestic bonds market equilibrium; f and 2 should move oppositely to maintain the foreign bonds market equilibrium. Thus the unique combination to keep all asset markets in equilibrium is i has to fall and 5 has to rise.