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Managing a common currency.
Political and cultural preferences
Tal Sadeh
During the 19908 the global process of financial and economic integration accelerated
with the deregulation of money and equity markets and the liberalization of capital
flows. This process made fixed exchange rates increasingly hard to maintain, and
forced many governments to either float their currencies or adopt a foreign cUlTency
th
or a currency board l , Although the prevalent phenomenon at the end of the 20 centlllY can still be summarized as "one country, one currency", the launching of the single European currency (the euro) and the increase in the number of currency boards2
pose a challenge to the basic political science perception, that a cUlTency is an important manifestation of collective identity. sovereignty and a means to rule 3 .
While political scientists are puzzled by cunency unions. economists on the contrary are puzzled by the insistence of nations on monetary autonomy. given the inefficiency of currency proliferation. The challenge for economists is to find when it
would be efficient for a country to retain its currency. and under what conditions
would efficiency mandate a common currency or a fixed exchange rate?
The major economic theOlY that tries to explain the conditions for efficient currency unions is the theory of optimal currency areas (OCA), which balances the costs
and benefits of fixing the exchange rate between any two currencies. Since exchange
rate volatility and CUlTency exchange costs are assumed to be a trade barrier. fixing
the exchange rates or forming a single currency among trade partners is beneficial.
However, as long as labor markets are not globally integrated, prices not perfectly
flexible. and social and political realities diverge around the world. differences will
persist among countries in the macroeconomic environment and in government policies. Preventing unemploYment or inflation within each country in the face of asymmetric external macroeconomic or political shocks could require exchange nite adjustments.
2
3
Lawrence 1. BROZ I Jeffry A. FRIEDEN, The Political Economy of International Monetary
Relations, in: Annual Review of Political Science, 4, 1, 2001, pp. 317-343. Barry EICHENGREEN,
International Monetary Arrangements for the 21st CentUlY, Washington DC; Brookings Institution
1994.
In 2000 eleven European states were sharing the Euro. 14 African states adhered to the franc zone,
six Caribbean countries shared a common currency, and seven countries had unilaterally adopted
the US doUar. Eight other countries were committed to currency boards.
Charles A. E. GOODHART, The Two Concepts of Money: Implications for the Analysis of Optimal
Currency Areas, in: European Journal of Political Economy, 14, 3, 1998, pp. 407·432. Eric
HELLEINER, National Currencies and National Identities, in: American Behavioral Scientist, 41,
10,1998,pp.1437-1451.
TalSadeh
Managing a common currency
In other words, the microeconomic benefit of a currency union comes at a macro~
economic cost. Therefore, according to classic OCA theory, the conditions under
which a cun-ency union is efficient include: sufficient labor and capital mobility
among the members; flexible wages and prices; similar responsiveness of trade to exchange rate changes; and concentration of the member's production in similar indus-
nipulation could not have long-term real effects, giving up one's currency entails no
~a~roec?nomi~ ~osts. On the other hand, a currency link could be useful in making
dlsmflatlOn poliCies more credible in a weak currency country by tying its currency to
a strong one 7 . However, this argument is relevant only for a transition period, and
only for the weak currency. Does a currency union lose its cause once stabilization is
achieved? If so, its credibility would paradoxically decline as stabilization progresses.
And why would the authorities of a strong currency choose to link with a weak currency in the first place? Is the euro really all about disinflation?
Indeed, the process of European monetalY integration seemed to defy the theory
of OCA, which was used by economists to suggest that the Economic and Monetaty
Union (EMU) in Europe is either not desirable or not possible8 . Furthermore, it often
seems that politicians ignore the theory of OCA when deciding on currency unions.
The establishment of the EMU is not the only example. Cohen used six historical examples to show that OCA theory fails to either explain or predict currency unions9
This calls for adjustments in the OCA theorylO. There must be other benefits to a cur-
132
tries. Cunency union efficiency can also be supported by similar tax structures and
similar inflation rates among the members 4.
However, scholars discovered that the effect of exchange rate volatility on trade is
either slim, or velY hard to pl'Ove empirically5. Academic interest in OCA theory
faded in the 1970s as international trade continued to flourish in spite of the breakdown of the system of fixed exchange rates. Most of the risk associated with exchange
rate volatility could be hedged in money markets, at least among the major cun-eocies.
There was no obvious need for governments to step in as insurers.
In the 1980s, new approaches to the OCA theory were developed and further criteria were added. These new approaches concentrated on the effectiveness of monetalY policy under rational expectations, on the credibility and consistency problem of
an inflationary government, and on floating exchange rates' ability to adjust external
disequilibrium6. The argument was that since monetary policy and exchange rate ma4
5
6
See Giuseppe BERTOLA, Factor Flexibility, Uncertainty and Exchange Rate Regimes, in: Marcello
DE CECCO I Alberto GIOVfANNINI (eds.), A European Central Bank? Perspectives on Monetary
Unification After Ten Years of the EMS, Cambridge: Cambridge University Press 1989. William
H. BRANSON, Factor Flexibility, Uncertainty and Exchange Rate Regimes: Discussion, in:
Marcello DE CECCO I Alberto GIOVIANNINI (eds.), A European Central Bank? Perspectives on
Monetary Unification After Ten Years of the EMS, Cambridge: Cambridge University Press 1989,
pp. 119~121. Daniel GRas, A Reconsideration of the Optimum Currency Area Approach - The
Role of Ex tema I Shocks and Labor Mobility, Center for European Policy Studies Working Paper,
No. 101, Brussels 1996. Paul MASSON I Mark TAYLOR (eds.), Policy Issues in the Operation of
Currency Areas, Cambridge: Cambridge University Press 1993. Ronald MCKINNON, Opt!mum
Currency Areas, in: The American Economic Review, 53, 4. 1963. pp. 717v725. Jack MELlTZ,
Brussels on a Single Money, in: Open Economies Review, 2, 1991, pp. 323-336. Robert
MUNDELL International Trade and Factor Mobility, in: American Economic Review, 57, 3,1957,
pp. 321-3'35. Robert MUNDELL, A Theory of Optimum Currency Areas, in: The Am:rican
Economic Review, 51. 4,1961, pp. 657-665. George S. TAVLAS, The "New" Theory ofOphmum
Cunency Areas, in: The World Economy, 16,6, 1993, pp. 663 v685.
See Hali J. EDISON I Michael MELVIN, The Determinants and Implications of the Choice of an
Exchange Rate System, in: William S. HARAF I Thomas D. WILLETT (eds.), Monetary Policy for a
Volatile Global Economy, Washington: The AEI Press, 1990, pp. 1-44. Jeffrey A. FRAN~L,
Monetary Regime Choice for a Semi-Open Economy, in: Sebastian EDWARDS (ed.), Ca~ttal
Controls Exchange Rates and Monetary Policy in the World Economy, New York: Cambndge
Universi~y Press 1995, pp. 35-69. Andrew ROSE, One Money, One Market: Estimating the Effects
of Common Currencies on Trade, in: Economic Policy. 15,30,2000, pp. 7-46. For a more robust
support of the relationship between cunency unions and trade see Jeffrey A. FRANKEL I ~Ildrew
K. ROSE, An Estimate of the Effect of Common Currencies on Trade and Income, 10: The
Quarterly Journal of Economics, 117,2,2002, pp. 437-66.
See Michele FRATIANNI I Jiirgen VON HAGEN, Asymmetries and realignments in the EMS, in:
Paul DE GRAUWE I Lucas PAPADEMOS (eds.), The European Monetray System in the 1990s,
London: Longman 1990, pp. 86-1l6. Michele FRATIANNI I JUrgen VON HAGEN, The European
Monetary System and European Monetary Union, Boulder: Westview Press 1992. Daniel GRas I
Niels THYGESEN, European Monetary Integration, 2nd edition, Essex: Longman 1998. Paul R.
133
KRUGMAN, Has the adjustment process worked?, Washington, DC: Institute for International
Economics 1991. Lorenzo Bini SMAGHI I Stefano MfCOSS1, Managing Exchange Markets in the
EMS with Free Capital, Paper presented at the conference on the European Monetary System in
the 1?90~, ~thens 1989. TAVLAS, New Theory. Jiirgen VON HAGEN, Monetary Policy
CoordmatlOn 111 the European Monetary System. Sonderforschungsbereich 303 Discussion Paper,
No. 8-159, 1990.
.
7
Francesco GIAVAZZI I Alberto GIOVANNINI, Limiting Exchange Rate Flexibility: The European
Monetary System, Cambridge: MIT Press 1989.' Francesco GfAVAZZI I Marco PAGANO The
Advantage of Tying One's Hands: EMS Discipline and Central Bank Credibility, in: Eur~pean
Economic Review, 32, 5,1988, pp. 1055-1082.
8
See Matthew B. CANZONERI I·Carol Ann ROGERS, Is the European Community an Optimal
Currency Area? Optimal Taxation Versus the Cost of Multiple Cun-encies, in: The American
Economic Review, 80, 3, 1990, pp. 419-433. Barry EICHENGREEN I Jeffry FRIEDEN I 1tlrgen VON
HAGEN (eds.), Monetary and Fiscal Policy in an Integrated Europe, New York: Springer 1995.
Paul R. KRUGMAN, Currencies and Crises, Cambridge: The MIT Press 1992. MASSON ITA YLOR
Policy Issues. Alfred STEfNflERR (ed.), 30 Years of European Monetary Integration From th~
Werner Plan to EMU, London: Longman 1994.
9 Benjamin J. COHEN, Beyond EMU; The Problem of Sustainability, in: BalTY EICHENGREEN I
Jeffi:y. FRIEDEN (eds.), The Political Economy of European Monetary Unification, Boulder:
Westvlew Press 1994, pp. 149-165. Some economists argue that OCA theory is a nonnative rather
than a ~ositive. theory. However, a theory that is often ignored by policymakers evidently misses
somethmg. It lS unreasonable to assume that politicians are irrational or that they can forever
ignore economic efficiency arguments.
10 As the EMU bandwagon moved on, undetell'ed by foreign exchange tUl'moil and economic antiEMU ar~uments, more generous judgments of EMU were made. Especially, some scholars argued
~hat busmess c?,cJes tend to get endogenously synchronized in a currency union, if enough intramdustry trade IS generated among the members. See Michael J. ARTIS I W. ZHANG, International
Business CY,cJes a?d the ERM: Is There a European Business Cycle?, Center for Economic Policy
Research DISCUSSIOn Pap~r, No. 1191, London, 1995. Paul DE GRAUWE I Yunus Aksoy, Are
Central European Countnes Part of the European Optimum Currency Areas?, in: Paul DE
GRAUWE I V.ladimir LAVRA (eds.), Inclusion of Central European Countries in the European
Monetmy Umon, Boston: Kluwer 1999, pp. 13~36. Jeffrey A. FRANKEL / Andrew K. ROSE The
Endogeneity of the Optimum Currency Area Criteria, in; Economic Journal, 108, 449, 1998, pp.
Managing a common cmrency
Tal Sadeh
134
relley union and perhaps other costs, which the OCA theory in its current form oyer-
looks.
In order to understand the difficulties of the OCA theory and to theorize about
currency unions and the international financial order, a better understanding of money
in general is required. Money is a public good that provides a variety of services for
society. OCA theory relates only to some of these services, but neglects others.
This chapter argues that every society has collective preferences regarding the different services that money provides, While several of the services that money provides
can simultaneously be enjoyed, each one of them has a different weight in the utility
function of each society, just as individuals have sets of preferences regarding the
consumption of different goods and services in general. Thus, some of the services
that money provides may be more important than other services for different societies
in different times. Any cost-benefit analysis of currency areas must take these preferences into account. The following discussion here aims to stimulate debate and suggest a research agenda.
This chapter discusses the major economic services that money provides, and the
way the relative importance of these services was historically influenced by social,
political and cultural variables l1 . In addition, we analyze economic theories and the
assumptions that underline them in order to show how emphasizing a certain service
that money provides predetermines a theory's conclusions and its policy implications,
whether explicitly or implicitly.
1. Money as a medium of account
1.1. Valuation and ghost money
In an economy based on individual ownership, production and consumption are almost always organized by using money. The exchange of goods is impossible without
prices. Therefore, money is needed as a medium of account, as a standard against
which prices are quoted so the value of different goods can be compared. According
to Hall, a "monetary system is a social agreement upon the interpretation of the numbers merchants write on goods and upon the ways for conveying purchasing power"12.
Quoting prices and values can be done in terms of physical units or in terms of some
135
The price level's volatility is affected by the choice ofa medium ofaccount 13 . A
commodity chosen to serve as a medium of account has a set of relative prices versus
other goods, and the fluctuations in these prices would lead to fluctuations in the general price level. Therefore, the fluctuations in the general price level would be smaller,
the greater the share of the chosen commodity in the consumption bundle. In this
sense paper money is the best medium of account, as long as the monetary authorities
avoid sharp fluctuations in its supply.
Which fiduciary numeraire would best-serve price stability and an efficient allocation of resources? Although a law can force people to hold a governmental paper
money, it is more efficient to make money attractive to its holders by according it a
stable purchasing power. This, in turn, could be done by not only paying interest to
the holders, but also by indexing money to the price levej14.
However, an abstract non-physically existent medium of account is possible too,
and in fact, most of the payments in a developed economy take place without the
physical use of notes and coins. Abstract mediums of account (ghost money) are especially common under conditions of excessive price instability. In such circumstances,
the service that money provides as a medium of account is being hampered if it remains attached to the currency in circulation, and, therefore, may be spontaneously
separated from the medium of exchange.
The service that money provides as a medium of account is known since ancient
times. Fictitious monetary units were used for evaluation and measurements in primitive societies in spite of having no physical existence 15 . Mediaeval European ghost
moneys developed because of the monetary authorities' inability to preserve a fixed
parity between the different denominations of a given currency, and the poor variety
of different denominations l6 .
For example, the English pound was for most of its histOIY just a weighting unit of
silver, not a coin or a note. The low real value of the penny (11240 of a pound according to the Carolingian standard inherited from Charlemagne's days) made it uncomfOliable for accounting, and the pound was preferred. Accounting was at issue and not
transaction costs, as most payments were cleared at the time with goods l7 . Later on,
the real penny's value deteriorated, but the population preserved the ghost penny's
parity at 11240 of a pound of silver.
A similar development occurred with the florin and its denominations. This goldbased cUlTency was struck in Florence from 1252 and eventually replaced the Ca1'o-
governmental (fiduciary) standard of value.
11
12
1009" I025. However, the criteria for the development of sufficient intra-industry trade are not yet
developed.
Admittedly, analyzing the functions of money is not the domain of economists alone. See for
example Bruce G. CARRUTHERS I Wendy NELSON, Money, Meaning, Morality, in: American
Behavioral Scientist, 41,10,1998, pp. 1384-1408. However, non"economic functions of money
are not treated in this paper.
Robert E. HALL, Optimal Fiduciary Monetary Systems, in: 10umal of Monetary Economics, 12, I,
13
14
15
16
1983, p. 33.
17
Jilrg NlEHANS, The Theory of Money, London: The Johns Hopkins University Press 1978 pp.
122-3.
'
HAL~, Fidu~iary Sys.tem.s, See for example the interest bearing notes issued by provincial
govewment III Argentma III 2002 (Patacones).
Paul EJNZIG, Primitive Money - In Its Ethnological, Historical and Economic Aspects London'
'
.
Eyre & Spottiswoode 1966, p. 17.
Carlo M. CIPOLLA, Money, Prices, and Civilization in the Mediterranean World _ Fifth to
Seventeen.th Century, Princeton: .Princeton University Press 1956, pp. 38·51. For example a lack
of the eqUivalents of a 50"cent com, a 25~cent coin, a I O"cent coin, etc.
CIPOLLA, Money and Civilization.
137
Tal Sadeh
Managing a common currency
ling ian standard in Western Europe 18 , From time to time a new physical denomination
of the florin was issued in the wake of a monetary reform to catch up with the ghost
denomination, but inflationary pressures continued to break the ghost from the physi-
gold and silver, rather than gold alone. While this standard reduced price volatility to
a certain extent, it was vulnerable to speculation on the gold-silver exchange rate,
which was fixed in the basket. Thus, bimetallic standards worked better when applied
over large areas and included the major financial centers. This feature of the bimetallic standard was the main reason for the establishment of the Latin Monetary Union
(LMU)24.
In summmy, the service that money provides as a medium of account is essential
for economic activity. It becomes more important when national unity or social integration are at stake
136
cal cun"ency.
These historical examples of ghost money serve to show how the service that
money provides as a medium of account can be more important than the service it
provides as a medium of exchange.
1.2. Mediums of account and the nation state
Before the appearance of the nation state, a few mediums of account often served in
one economy. For example, three different standards were used in the Roman Empire
in the age of Augustus Caesar l9 , Gold was used for imperial payments and taxes. International trade (both within the empire and between it and the rest of the world) relied on a silver standard and local traders and poor people used copper.
Similarly; in Mesopotamia grain was the medium of account among the poor,
while silver was used for large transactions and international trade 2o . Silver was inconvenient for small transactions because even as much as eight grams of it constituted a month's pay for labor and the measurement technologically was not sufficiently accurate to allow for smaller denominations. Grain was inconvenient for large
transactions because of handling difficulties and because its value was fluctuating
with the seasons and the weather. For this reason the interest rate on grain was around
35 percent, while on silver it was 20 percent.
When nation states started to appear, greater emphasis was put on acquiring a single and stable medium of account. A common medium of account is like a common
language21 . The adoption of separate mediums of account by different sectors of society poses a challenge to the formation of a nation 22 . In fact, social or national integration was sometimes the purpose of monetary reforms that adopted a common medium
of account. And social division as a result of separate mediums of account was often
easier to overcome by a switch from commodity money to paper money23. In other
words, the service that money provides as a medium of account can become more important when social or national integration is at stake.
The concem for the stability of the price level encouraged some European governments in the 19 th century to adopt a bimetallic standard rather than a monometallic
one. Under the bimetallic standard, goods were valued against a basket consisting of
Robert S. LOPEZ, Back to Gold, 1252, in: Robert S. LOPEZ (ed.), The Shape of Medieval Monetary
History, London: Variorum Reprints 19561l986, pp. 219·240.
19 Elgin Earl GROSECLOSE, Money and Man - A Survey of Monetary Experience, New York:
Frederick Ungar 1961, p. 33.
20 Marvin A. POWELL, Money in Mesopotamia, in: Joumal of the Economic and Social History of
the Orient, 39, 3, 1996, pp. 228-9.
21 Charles A. E. GOODHART, The Political Economy of Monetary Union, in: Peter B. KENEN (ed.),
Understanding Interdependence - The Macroeconomics of the Open Economy, Princeton:
Princeton University Press 1995, pp. 473-4.
22 HELLETNER, National Currencies.
23 See next section for the distinction between commodity and paper money.
2. Money as a medium of exchange
2.1. The coincidence of wants and transaction costs
A classic view in economics is that in order to interact economically, individuals need
a medium of exchange. Without a medium of exchange, trade depends on the existence of a "double coincidence of wants," two individuals with perfectly complementing needs. The greater the variety of goods and professions, the harder it becomes to
find such a perfect trade partner. In other words, while in primitive societies baIter
was not nece~sarily so inconvenient, sophisticated economies are much more dependent on a medIUm of exchange for their functioning25 . The logic of this argument can
also be rever~ed. In other words, it is possible to say that in order to achieve a high
level of sophl~tication and specialization in production and consumption, a society
needs the effiCiency that money introduces to trade 26 .
However, in the ancient world the use of money and the level of material development were not perfectly related. In some societies, religious objections, an absence
of private ownership, or the existence of a planned economy hindered the development of money. Sometimes the development of money paralleled social, rather than
material development. Barter, and eventually money, did not appear until family ties
weakened and individualism became stronger27 . Thus, the more individualized a society becomes, the more money is viewed as a medium of exchange.
Even on economic grounds barter is not always inefficient. Transaction costs that
are additive over the goods exchanged, such as transportation, storage, and inspection,
should be distinguished from transaction costs that are not additive, such as the search
18
24
25
26
27
Establisl~e~ in ~865 this monetary union consisted of France, Switzerland, Belgium, and Italy.
~reece JOJ.ned Jl1 1869. A~ the turn of the centUl"Y this regime weakened, and was formally
dissolved III 1927. See Wlm F. V. VANTHOOR, European Monetary Union Since 1848 - A
Political and Historical Analysis, Cheltenham: Edward Elgar 1996.
ETNZIG, Primitive Money, p, 24. POWELL, Money in Mesopotamia, pp. 225-6.
Jilrg NrEHANs, Money in a Static Theory of Optimal Payment Arrangements, in: Journal of
Money, Credit and Banking, 1,4, 1969, pp. 706-726. mrg NIEHANS, Money and Barter in General
Equilibrium with Transactions Costs, in: American Economic Review, 61, 5, 1971, pp. 773-783.
EINZIG, Primitive Money, pp. 340-364.
139
Tal Sadeh
Managing a common currency
for the right trade partner28 . Money saves on non~additive costs, but increases the additive costs by breaking one transaction into a few. If the additive costs are dominant,
the full monetization of the economy might not be efficient. Thus, the importance of
the service that money provides as a medium of exchange depends on individualistic
patterns of economic activity, on the balance between additive and non-additive transaction costs, and on the extent of specialization within the economy.
spontaneous. It is issued and held with varying degrees of compulsion by law. Thus,
the adoption of commodity money is more likely, the weaker are the law and the govemment's control of its territory and subjects.
138
2.2. Commodity and paper money
For some economists, money is a spontaneous creation of the market, its value derived
out of its utility to individuals 29 . Indeed, over the years and cultures, human societies
have adopted many forms of mediums of exchange, often spontaneotlsly30, A token
serving as a medium of exchange must 'be easy to handle and carry, divisible and
common to the population so as to lower identification costs 31 . However, identification problems have always required some non-spontaneous intervention32 • Difficulties
in metal quality verification in ancient times caused the use of precious metal bars to
resemble barter trade more than a monetary payment33 . Thus, the mints started to
guaranty metal quality and stamp the bars. Since bullion can be clipped without damaging its stamped part, the guarantee is better, the greater the surface of the bullion
covered by the stamp 34. This is probably how the stamp evolved over the years to become a coin.
A form of money more developed than commodity money is fiat, or paper tnoney,
first known to have appeared in China at AD 650 35 A paper cun-ency (whether made
of paper or of other materials) is characterized by having no practical use other than
being money. The advantages of paper money as a medium of exchange are the ease
of identification, its anonymity, and the efficiency in transfer. Its disadvantages are its
dependence on the stability and credibility of the issuer. Paper money cannot be fully
28
29
30
31
32
33
34
35
Robert A. JONES, The Origin and Development of Media of Exchange, in: Journal of Political
Economy, 84,4,1976, pp. 757-775.
See Annen A. ALCHrAN, Why Money?, in: Journal of Money, Credit and Banking, 9,1,1977, pp.
133-140. Karl BRUNNER I Allan H. MELTZER, The Uses of Money: Money the Theory of an
Exchange Economy, in: American Economic Review, 61, 5, 1971, pp. 784-805. GOODHART,
Implications for OCA's, p. 1. Charles A. E. GOODHART, Two Concepts of Money, and the Future
of Europe, in: Mario I. BLEJER I Jacob A. FRENKEL I Leonardo LEIDERMAN I Assaf RAZIN (eds.),
Optimum Currency Areas - New Analytical and Policy Developments, Washington DC:
International Monetary Fund 1997, p. 89. Nobuhiro KIYOTAKT I Randall WRIGHT, On Money as a
Medium of Exchange, in: Journal of Political Economy, 97, 4,1989, pp. 927-954.
EINZIG, Primitive Money.
GOODHART, Future of Europe, p. 90. JONES, Media of Exchange, pp. 775.
GOODHART, Implications for OCAs.
POWELL, Money in Mesopotamia, p. 227.
GOODHART, Implications for OCAs, pp. 411f., 417. GOODHART, Future of Europe, p. 90. Jack
MELlTZ, Primitive and Modem Money: An InterdisciplinalY Approach, Reading: Addison-Wesley
Publishing Company 1974.
Martin SHUBIK, Fiat Money, in: John EATWELL I Murray MILGATE I Peter NEWMAN (eds.), The
New Palgrave: A Dictionary of Economic Theory and Doctrine, 2, New York: Macmillan 1987, p.
316.
2.3. Outside and inside money
In addition to paper and commodity moneys, mediums of exchange may also be divided into outside and inside money. Outside money consists of what is popularly referred to as "cash", that is the legal tenders in circulation and all other liabilities of the
monet31Y authorities. Inside money consists of private liabilities, which are commitments for a payment in the legal tenders at some time (credit). While inside money involves a default risk of varying degrees, outside money (usually government money)
is socially most acceptable. Thus, it is possible to conceive of a pyramid of money issuers, each Witll a different level of credibility and social acceptability. The degree of
social acceptability of a note is reflected in the interest rate it pays. Since legal tenders
are perfectly acceptable, they pay no nominal interest at all. In fact, as the following
discussion shows, if the benefits of money are great enough, it is the holders of
money, rather than its issuers, which are willing to pay for it.
It is theoretically possible, of course, to envision a regime where goods would be
exchanged for credit only. In this pme credit economy there is only inside money and
no outside money36. Indeed, most of the money in modern economies is inside money,
which is convenient for big or institutionalized transactions or among people who
know each other. Inside money is more responsive than outside money to the liquidity
needs of the economy37. However, in some cases the costs of operating credit (such as
evaluating credit risk, and keeping record) are greater than the inconvenience of currency. In those cases, cash would be prefened over credit. Proponents' of outside
money also contend that the supply of inside money can be extremely volatile, and
nee9s regulation. Furthermore, the higher risk of credit associated with inside money
makes it even more of a fiat than outside paper money. Money is money only as long
as one believes it to be money. In a sophisticated economy much of the wealth is
merely perceived to be as such. This is because wealth is' often held in the form of
electronic signals in computers, and its existence depends on private people and institutions to be good on their commitments. Stock-exchange wealth is even more dependent on being perceived as such. A sudden collapse of the belief in money can be
materially devastating. Therefore, the creation and maintenance of inside money systems are highly sensitive and depend not only on material needs, but also on social
stability and norms.
To conclude, the use of outside money is more pervasive the greater the share of
small or anonymous transactions, the greater economic uncertainty is, and the weaker
trust among people is.
36
37
Knut WICKSELL, Lectures on Political Economy, London: Routledge, 190711946.
Robert G. K1NG, On the Economics of Private Money, in: Journal of Monetary Economics, 12, I,
1983, pp. 127-158. Thomas J. SARGENT I Neil WALLACE, The Real-Bills Doctrine versus the
Quantity Theory: A Reconstruction, in: Joumal of Political Economy, 90, 6, 1982, pp. 1212- 1236.
2.4. Policy implications
This sub-section surveys four major models in which macroeconomic policy implications are based on the medium of exchange approach to money. The first is the Quantity Theory of Money (QTM), which at the beginning of the 20th century was the out-
side-money proponents' major macroeconomic theory. An important treatment of
money as a medium of exchange was Irving Fisher's interpretation of the QTM and its
famous formulation 38 :
Y*P~M'V
where Y represents the volume of transactions in the economy, P represents the general price level, M - the nominal money amount and V - the velocity of money. Since
Fisher assumed that money was circulating rather than held, and that velocity was
constant, this equation represented mostly the service that money provides as a medium of exchange39 . A constant velocity meant according to Fisher that the money
quantity follows the volume of transactions since aiding the transactions is sole purpose of money. Friedman followed on this transaction approach in the 1950s and
1960s and made it the basis for his contention about the neutrality of money 40.
A related and interesting treatment of the service that money provides as a medium of exchange in order to propose a macroeconomic policy was Friedman's optimum quantity of money approach4l. This quantity is reached when the marginal benefits from money equal the marginal cost of it. Since the real production costs of paper
money are negligible, real balances should be provided to the point of saturation,
where their marginal benefit is zero too. In order to cause individuals to hold the optimal quantity of money. argued Friedman, the nominal interest rate on assets (which
is the individual's alternative cost to holding money) should be driven to zero. At that
point the real interest rate is the rate of price deflation 42 ,
, Another important group of medium of exchange models adopts the cash in advance (CIA) approach, also often referred to as the Clower approach43. This approach
assumes that money buys goods, goods buy money, but goods do not buy goods. In
other words cash has to be obtained prior to any transaction. This may be due to legal
requirements (coercion) or to uncertainty on the part of the individuals regarding the
38
39
40
41
42
43
Managing a common currency
Tal Sadeh
140
Irving FISHER, The Purchasing Power of Money, New York: Macmillan 192211971, second
revised edition.
Irving FISHER, Money, Prices, Credit, and Banking, in: American Economic Review, 9, 2,1919,
pp. 407·9. D. FOLEY, Money in Economic Activity, in: John EATWELL / Murray MILGATE / Peter
NEWMAN (eds.), The New Palgrave: A Dictionary of Economic Theory and Doctrine, 3, New
York: Macmillan 1987, p. 523.
On the neutrality debate see Section 7.
Milton FRIEDMAN, The Optimum Quantity of Money and Other Essays, Chicago: Aldine 1969.
For references to critics of this approach and its pre-Friedman origins, see Peter HOWITT,
Optimum Quantity of Money, in: John EATWELL / Murray MILGATE / Peter NEWMAN (eds.), The
New Palgrave: A Dictionary of Economic Theory and Doctrine. Vol. 3, New York: Macmillan,
1987, pp. 744-5.
Robert CLOWER, A Reconsideration of the Microeconomic Foundations of Monetary Theory, in:
Western Economic Journal, 6,1967, pp. 1-8.
141
timing and volume of the transactions. Examples of uncertainty-related CIA analysis
are discussed below.
A good example of coercion CIA model is Sargent's version of Lucas' Tree
mode144 . The model assumes that a market for risk-free interest-bearing private debt
exists and that a govemment forbids individuals from consuming their own tree's fruit
and forces them to first acquire cash and then use it to trade goods. Based on this general framework Sargent argued that money is neutral and that exchange rates are determined by the money quantities in the different countries 45 .
A fourth group of medium of exchange models is based on the Bewley-Townsend
Tumpike framework 46 . The main feature of these models is the lack ofa private loans
market because every two individuals meet only once in their lifetime (hence, the
"Turnpike"). If individuals differ in their periodical non-storable endowments, but
share the same preferences. and live an equal, multi-temporal, and finite life (a complete overlap of individual lives), then under complete ceItainty, the desire to smooth
the consumption time path calls for the introduction of money. In the absence of a private loans market, individuals depend on govemment paper money. Thus. the govemment's role is to smooth the individuals' consumption time paths.
All of these models show how emphasizing the service that money provides as a
medium of exchange in the assumptions of the model, leads to the conclusions that
money is neutral, and that its issuance should follow the volume of economic activity
rather than try to control it.
3. Money as a store of value
3.1. The interchangeability of the store of value and the medium of exchange
For money to serve as a store of value. it should be socially acceptable that a certain
object can be exchanged for goods at any point in the future. But why would this be
socially acceptable? Some writers deem money to have originated as an object of social value. Even in modem societies cultural, national and sentimental as well as religious causes, can accord social acceptability and value to an object before it truly be-
44
45
46
Thomas J. SARGENT, Dynamic Macroeconomic Theory. Cambridge: Harvard University Press
1987, pp. 156-62. The basic assumptions of Lucas Tree model are: (1) The sole income that the
individuals receive is a fixed dividend that trees yield. (2) There is no labor, no production
function, and no markets for factors of production (although trees can be traded). (3) There is
perfect certainty. See Robert E. LUCAS, Equilibrium in a Pure Currency Economy, in: Economic
Inquiry, 18,2, 1980. pp. 203-220. Robert E. LUCAS, Interest Rates and Currency Prices in a TwoCountry World, in: Journal of Monetary Economics, 10.3, 1982, pp. 335-360.
SARGENT, Dynamic Theory, pp. 182-190. Other examples of coercion CIA models that conclud
that money is neutral are Thomas. F. COOLEY / Gary D. HANSEN, The Inflation Tax in a Real
Business Cycle Model. in: American Economic Review, 79.4,1989, pp. 733-748. David ROMER,
A Simple General Equilibrium Version of the Baumol-Tobin Model, in: Quarterly Journal of
Economics, 101,4, 1986, pp. 663-686.
SARGENT, Dynamic Theory, pp. 200·226.
142
Managing a common currency
Tal Sadeh
comes money in the economic sense47 , In some ancient societies, gold was first used
as an ornament, then for storing value, henceforth as a medium of exchange, and only
lastly as a medium of account48 . In the Carolingian kingdom, the curre~cy served
mostly as a store of value and as a medium of account, but rarely as a medIUm of exchange49 ,
The services that money provides-as a medium of exchange and as a stor~ of value
are often two sides of the same coin. If selling and buying are not conducted mstantly,
then one is forced to hold money for an intermediate period. For tha~ period, he?f she
is forced to use money as a store of value. Similarly, value cannot be stored wIthout
exchange. In the act of saving, goods are exchanged for money. At some pomt m the
future the savings will be spent by exchanging the money back i~to goods. Thus, losing its ability to store value, a currency cannot serve as a medium of exchange el.
ther5o .
However outside money is rarely modeled and viewed as a store of value, whIle
inside money'is usually regarded as the provider of this service, but i~ not viewed as a
good medium of exchange. Treating outside money merely as a medIUm of exchange
and inside money merely as a store of value is n.ot inevitabl.e. :Why would market
agents not accept private bonds as a medium of exchang~? If ms~de money were not
socially acceptable as a medium of exchange, why would It be SOCIally acceptable as a
store of value? After all, when money is held as a store of value, Its holder IS even
more exposed to the risk of default by its issuer than when it circulates as a medium of
exchange.
Similarly, outside money could serve as a store of value. It can be argued t~at outside money is inferior to other assets as a store of value because it rarely pays mterest,
and in fact it canies an effective-negative yield equaling the price inflation. However,
the interes~ rate that inside money pays is supposed to compensate its holder for the
default risk and should not be interpreted as a net cost of holding outside money. Outside money could be a safer store of value than inside money.
Money is more of a medium of exchange and less of a store of value when the
cun'enc), is inconvertible. For example, from the Great Depression to 1958 the curren47 See Joseph BOLING, Building a National Currency: Japan 1868 ~ 1899, in: International Bank
Note Society Journal, 27, 1, 1988, pp. 5-13. EINZIG, Primitive Money, pp. 368-376. R?bert
FRIEDBERG, Paper Money of the US, Chicago: Follett Publishing Co. 1962. HELLEINER, NatIOnal
Currencies. Virginia H. HEWITT, Beauty and the Banknote: Images ?~ wome~ on .Paper Money,
London: The British Museum Press 1994. Christina MCGINLEY, Commg NatlOnahty: Woman as
Spectacle on Nineteenth-Century American Currency, in: American Transcendental Quarterly, 7,
3, 1993, pp. 247-269. M'LlTZ, Primitive and Modem Money, pp. 39-42. Cullen MURP~Y, ~
License to Print Money, in: The Atlantic, 269, 6, 1992, pp. 26-28. John PORTEOUS, Cams 1t1
History, London: Weidenfeld and Nicolson 1969, pp. 230-231. Guy SWA~SoN,.A~e~ts ofCuiture
and Nationalism: The Confederate Treasury and Confederate Currency, m: Vlrgmla H. HEWITT
(ed.), The Banker's Art: Studies in Paper Money, London: The British Museum Pre.ss 19~5.
Tuuka TALVIO, Something Characteristic afOUl' Land: Eliel Saarinen as a Banknote Designer, m:
HEWITT, The Banker's Art.
48 EINZIG, Primitive Money, p. 368.
49 GOODHART, Implications for OCAs, pp. 428-9.
50 Charles RIST, History of Monetary and Credit Theory from John Law to the Present Day. London:
Allen and Unwin 1940.
143
cies of Western Europe were usually inconvertible. The European Payments Union
was established in 1950 in order to allow for free international trade without returning
to full convertibility5l. The attempt to restore the British pound's convertibility failed
in 1947, because of the political aspects of this measure. All of these policies reflected
in effect the inferiority of the service that money provides as a store of value compared with its other services.
4. Theories
0/a store o/value
A good example for the interchangeability of the services that money provides as a
medium of exchange and as a· store of value is the Cambridge Real Balances approach. This approach developed out of the QTM and famously reformulated the
quantity equation 3s 52
Y*P*k~
M.
k being the inverse of the velocity of money. This approach tended to view money
more as a store of value, and less as a medium of exchange. In other words money
was perceived as being held, rather than constantly circulating.
The services that money provides as a store of value and as a medium of exchange
are also hard to separate in Samuelson's Overlapping Generations (OG) modeI'3. According to this model, paper money is an intergenerational medium of exchange. The
young, endowed with goods, trade them for money with the old, which are not endowed with goods, but cany money from their days of youth. The OG model shows
how money, through the service it provides as a store of value, allows Pareto Optimwn wherever goods are non-storable, intergenerational tlust exists and the economy
is eternal 54. No monetary policy is required for the operation of the economy.
Cagan developed another model, which essentially viewed money as a store of
value 55 . Assuming fixed real variables (including production and the real interest
rate), his demand for money is a function of the public's adaptive expectations for inflation. The higher the expected rate of inflation the lower the amount of money that
the individuals would demand56 .
GRaS I THYGESEN, European Monetary Integration.
Milton FRIEDMAN, A Theoretical Framework for Monetary Analysis, in: Robert J. GORDON (ed.),
Milton Friedman's Monetary Framework ~ A Debate with His Critics, Chicago: The University of
Chicago Press 1974, pp. 1-62.
53 Paul A. SAMUELSON, An Exact Consumption Loan Model of Interest with or without the Social
Contrivance of Money, in: Joumal of Political Economy, 66, 6, 1958, pp. 467-482.
54 A final generation does not need money, and if there is a final generation then via a chain reaction
no other generation would accept money either.
55 Phillip CAGAN, The Monetary Dynamics of Hyper infiat ion, in: Milton FRIEDMAN (ed.), Studies in
the Quantity Theory of Money, Chicago: University of Chicago Press 1956, pp. 25-117.
56 The significance of this model to issues of seigniorage is discussed below.
51
52
145
Tal Sadeh
Managing a common currency
Patinkin developed an inter-temporal model of a consumer that receives an endowment every period, but also transfers each period's savings to the next periodS?, In
each period his real wealth (the real value of the nominal balances he holds) and the
real value of his endowment determine his demand for goods. Changes in the nominal
Others have taken the CIA approach described earliers9 For example, Blanchard
and Fischer presented a CIA model with a precautionary demand for money60. Individuals have to decide how much money to hold during their two-period life when
their consumption's time path is unceltain. Outside money is striped out of the service
it provides as a store of value by assuming that interest-bearing bonds are available.
Thus, individuals forgo the interest for the sake of the liquidity services that outside
money provides, Therefore, the higher inflation or the nominal interest rate is, the
lower the demand for outside money iS61 .
Keynes too argued that the demand for money is affected by states of mind such
as insecurity and distrust. It was precaution against the uncertainty of transactions that
motivated people to hold money62. Patinkin believed the Money in the Utility Function (MITUF) models to better capture the nature of money than either the OG or the
CIA approaches63 . By providing liquidity services, he asserted, money is no different
than any other good included in the consumer's utility. In contrast, the OG models essentially treat money as a store of value, an unimportant service in an economy with
interest bearing assets. The CIA approach supposedly emphasizes the service that
money provides as a precautionary device too, but it is at fault according to Patinkin
because it artificially compels the individual to use money and implies a constant velocity. The MITUF approach is better because it introduces a cost to money, and allows the individual to make his choice and arrive at an optimal solution. On the other
hand, both CIA and MITUF models fail to account for the dependency of money upon
the governmental maintenance of law, order, and regulation 64 .
However, uncertainty and the precautionalY motive are not typical only of consumers, Producers must operate in the same conditions. Therefore. money can be seen
as a factor of production, its optimal inventory the firms must determine. According to
the inventOlY approach, it is possible to derive the demand for money from the minimization of a cost function 65 . The cost function takes into account the alternative loss
144
quantity of money and in prices affect the consumer's real wealth and demand. This
approach tended to support the contention that money is neutral.
In summary, while the services that money provides as a medium of exchange and
as a store of value are to a great extent interchangeable, they are not identical. The
major difference between these two services that money provides is that a medium of
exchange has no time dimension; a store of value does. Thus, the demand for a medium of exchange is not sensitive to inflation and interest rates. If the demand for
money is sensitive to these variables it is serving as a store of value or a precautionary
device. A policy of inconvertibility is designed to enable money to serve as a medium
of exchange, while limiting its ability to serve as a store of value. Such a policy reflects a low emphasis on the later service. On the other hand. policies aiming at low
inflation and high interest rates reflect a strong emphasis on the service that money
provides as a store of value.
5. Money as a precautionary device
Since in reality infonnation about the timing of transactions is partial and uncertainty
is prevalent. money can be held for precaution. When the population feels insecure regarding the availability of means of payments, it prefers to keep an ample supply of
money at hand. Money in this case provides liquidity services. For example, if there is
a doubt regarding the credibility of the banking system, individuals would want to
hold more outside money relative to the volume of expected transactions. There would
be a switch from inside money to outside money. Thus, institutions and rules that
regulate banking and allow for a lender of last resort are designed to reduce the resort
to the liquidity services of money, and to enhance the use of inside money. This was
why the Federal Reserve System was established in the US in 1913.
If money is a good that provides an insurance against transaction uncertainty, individuals may be willing to pay for holding it. Thus, an old tradition has been to introduce money into the individual's utility function. Patinkin traced this tradition back to
Walras, but also developed it himself'8.
57
58
nd
Don PATINKIN, Money, Interest, and prices - An Integration of Monetary and Value Theory, 2
edition, New York: Harper and Row 1965, pp. 13-33.
PATINKIN, MIP (1965), pp. 78-161, 541-80. Other prominent scholarly work that belong to this
tradition includes contributions by Miguel SIDRAUSKI, Rational Choice and Patterns of Growth in
a Monetary Economy, in: The American Economic Review, 57, 2, 1967, pp. 534-544. SARGENT,
Dynamic Theory.
59
See Steven M. GOLDMAN, Flexibility and the Demand for Money, in: Journal of Economic
Theory, 9, 2, 1974, pp. 203-22. Meir KOHN, In Defence of the Finance Constraint, in: Economio
Inquiry, 19,2,1981, pp. 177-95. Paul KRUGMAN 1 Torsten PERSSON 1 Lars SVENSSON, Inflation,
Interest Rates and Welfare, in: Quarterly Journal of Economics, 100, 3, 1985, pp. 677-96. Lars E.
O. SVENSSON, Money and Asset Prices in a Cash-ill-Advance Ecqnomy, in: Journal of Political
Economy, 93, 5, 1985, pp. 919-44.
60 Olivier Jean BLANCHARD 1 Stanley FISCHER, Lectures on Macroeconomics, London: The MIT
Press 1989, pp. 167-8.
61 Douglas DIAMOND 1 Philip PYBVIG, Bank Runs, Deposit Insurance and Liquidity, in: Journal of
Political Economy, 91, 3, 1983, pp. 401-19.
62 Paul DAVIDSON, A Keynesian View of Friedman's Theoretical Framework for Monetary Analysis,
in: GORDON, Milton Friedman's Monetary Framework, p. 98; John Maynard KEYNES, The
General Theory of Employment Interest and Money, London: Macmillan 1936/1967, pp. 170- J 72.
63 Don PATlNKIN, Money, Interest, and Prices - An Integration of Monetary and Value Theory, 2nd
edition, abridged, London: The MIT Press 1989, pp. xxvi-xxxiv.
64 GOODHART, Implications for OCAs, p. 418.
65 The inventory approach was developed by William J. BAUMOL, The Transactions Demand for
Cash, in: Quarterly Journal of Economics, 67, 4, 1952, pp. 545-56. James TOBIN, The Interest
Elasticity of the Transactions Demand for Cash, in: Review of Economics and Statistics, 38, 3,
1956, pp. 241-7. PATINKIN MIP (1965), pp. 146-161.
147
Tal Sadeh
Managing a common cun-ency
of interest on money holdings on the one hand, and the risk of running out of money
on the other66
In summary, the liquidity services of money are more important in times of economic and political uncertainty. If liquidity services are important, velocity is not stable. Institutions and rules that regulate banking and allow for a lender resort of last re-
Seigniorage revenues, the product of the rate of nominal outside money growth
and real balances, are to be distinguished from inflation tax revenues, the product of
the rate of inflation and real balances68 . The government's inflation tax revenues are
its revenues from the individuals' current income, while its seigniorage revenues are
the sum ofits revenues from the individuals' cu~rent and future income.
Examples of debasement include ancient Japan, where the surface of coins had
sometimes a higher gold content then the interior of the coins69 . Debasements were
frequent in the Roman Empire for 230 years starting during Caligula's reign (37 AD),
and ending in Diocletian's currency reform7o . Debasements were also intensively used
in the Ottoman Empire in the late 16 th century and early 17th century, and during the
reign of Mahmud II between 1809 and 1839. During the Hundred Years' war French
debasement revenues amounted at some point to as much as eight times the other
taxes' revenue7l . Seigniorage revenues were also significantly used in Germany during the Thirty Years' war and in England during Henry the Eighth's time and in the
1i h century 72.
Examples for revenue motivated paper money manipulation include the l860s
American civil war and 20th centUlY inter-war Genuany73. On the other hand, seigniorage revenues were difficult to extract in 19(h <ientury Europe because it was common for foreign currencies to circulate together with the domestic currency. Neveliheless, whenever the inflation tax was in need, governments temporarily printed inconvertible paper money and forced it on their citizens74 .
146
sort are designed to reduce the resort to the liquidity services of money, and to enhance the use of inside money.
So far, the discussion dealt with what is often refel1'ed to as the classical services
that money provides. These are the services that serve people as individuals. Some
scholars argue that money originated spontaneously because of the demand on the patt
of individuals for these services. However, governments were there ever since human
society existed, and a world without them is impossible. Indeed, some contend that it
was the government rather than individuals that invented money in the first place.
6. Money as a taxing device
6.1. Taxing methods
A government can use its currency to extract resources from its subjects by either buying goods from individuals in return for notes that the government arbitrarily prints or
reducing the quality of the standard commodity money (debasement). Medieval debasements took place by either reducing the currency's pure metal content, by increasing the number of coins struck from one unit of standard weight, or by increasing the
nominal value of each coin67 .
To use the QTM's fonnulation, any expansion in the money supply (M) results in
a combination of a rise in prices (P) and production (Y), and a decline in velocity (V).
The specific combination of adjustments is an issue over which economists have been
historically divided, and which is discussed in the next section. While nominal balances increase as the individuals sell goods to the government, if the price inflation
matches the monetary expansion then the real balances are left unchanged. In other
words, the individuals are in effect giving goods to the government in exchange for
thin air. Thus, they are taxed.
However, if the monetary expansion is also adjusted for by a temporary increase
in production then growth initially partially compensates the individuals for this tax
and the full burden of the tax is only felt later, when production returns to its longterm level. In other words, the individuals pay inflation tax in installments. Alternatively, if velocity declines (because the individuals want cash to store value or as a
precaution), then the erosion in the -purchasing power of the individuals would take
place whenever velocity returns to its initial level.
66 Merton H. MILLER / Daniel ORR, A Model of the Demand for Money by Firms, in: Quarterly
Joumal of Economics, 80, 3,1966, pp. 413-435. Daniel ORR, Cash Management and the Demand
for Money, New York: Praeger 1970.
67 Nathan SUSSMAN, Debasements, Royal Revenues and Inflation in France During the Hundred
Years War, 1415-1422, in: The Journal of Economic History, 53,1, 1993, pp. 44-70.
6.2. Coercion and credibility
If money is a public good, then government control of the money supply is often required. In commodity-money systems the government ensured the credibility of the
stamping authority, which would othelwise be tempted to spend its credibility and
manipulate the metal composition of the coins. The government could also protect
mints from theft and violence75 . The same logic of preventing abuse goes for paper
68
69
70
71
72
73
74
75
BLANCHARD/FISCHER, Lectures on Macroeconomics, p. 198.
GOODHART, Implications for OCAs, pp. 427-428.
Arthur Robert BURNS, Money and Monetary Policy in Early Times, London: K. Paul, Trench,
TlUbner and Co., 1927/1965, p. 411. Kenan T. ERIM 1 Joyce REYNOLDS I Michael CRAWFORD,
Diocletian's Cunency Reform; A New Inscription, in: The Journal of Roman Studies, 61, 1971,
pp. 175-6.
SUSSMAN, Debasements.
Robert MUNDELL, Updating the Agenda for Monetary Union, in: Mario I. BLEJER 1 Jacob A.
FRENKEL I Leonardo LEIDERMAN 1 Assaf RAZIN (eds.), Optimum Currency Areas - New
Analytical and Policy Developments, Washington DC: Intemational Monetary Fund 1997, p. 39.
Barry EICHENGREEN, Elusive Stability - Essays in the HistOlY of International Finance, 19191939, Cambridge: Cambridge University Press 1990. Milton FRIEDMAN 1 Anna JACOBSONSCHWARTZ, A Monetary History of the United States 1867 - 1960, Princeton: Princeton
University Press 1963.
VANTHOOR, EMU Since 1848, pp. 6-7.
GOODHART, Implications for OCAs, pp. 428-9. George MACDONALD, The Evolution of Coinage,
Chicago: Obol International 1916/1980.
149
Tal Sadeh
Managing a common currency
money issued by banks. Sometimes the government is the only organization able to
supply a store of value (such as in Turnpike models).
However, some scholars argue that governments invented money for taxation76 ,
Governments definitely invented central banks77 . Depending on the popular legiti,
macy of the use of money as a taxing device a certain amount of coercion would be
required to prevent a competition among governments over credibility and ensure the
the other hand, conventional tax evaders may find it much harder to evade inflation
tax. Sometimes the government actively pursues a re-distribution policy using the inflation tax, by transferring the money it prints to preferred sectors.
However, coercion has its limits of effectiveness too, and excessive inflation tax
that is deemed as illegitimate by individuals can lead to the creation of spontaneous
mediums of account, mediums of exchange and stores of value. Therefore, governments levy inflation tax only when they deem it to be of utmost necessity. In times of
peace, governments are willing to give up using money for taxation, in order to earn
credibility82. Thus, credibility is not a value in itself. Credibility is intended by the
government to be spent later, when the need arises.
Credibility is almost always being spent in times of revolution or war. The value
of a currency sometimes fluctuates according to the expectations of the government's
survival. Domestic political instability as well as bad news from the war front might
mean more inflation tax to finance the struggle for survival. Even in a well functioning democratic political system, the specter of loosing the next upcoming elections
could enhance inflationary tendencies within the government83 .
Thus, the service that money provides as a taxing device is more important in
times of political emergency. For this reason currency unions are generally difficult to
sustain when money is used as a taxing device.
148
desired seigniorage revenues. Thus, the government's monopoly over the issuance of
money emanates directly from its monopoly over the use offorce78 ,
In order to coerce people into holding its currency, the government can become a
dominant provider of a store of value by depressing the private financial sector, outlawing foreign currency holdings or otherwise controlling international capital flows.
Alternatively, the government can force people to hold its currency by compelling
them to pay taxes in that currency79. The government also uses its own money to pay
for goods purchased from the population and to pay the salaries of its employees.
Therefore, the larger the weight of the government in the economy, the harder it
would be for the popUlation to escape using its currency. However, coercion and distortion come with every tax, thus the inflation tax can be seen as just one fiscal tool
among many, all of which should be applied so as to equate their marginal costs to society80.
Since different sectors may be differently exposed to inflation, the government
can manipulate money to change the income distribution in society. Whoever has access to a foreign currency (or other inflation-resistant assets) can easily escape the inflation tax. Tax brackets and tax exemptions not only re-distribute income directly,
but also combine with inflation to create dynamic income distribution effects 81 . On
76
77
GOODHART, Implications for OCAs, p. 415.
1. Lawrence BROZ, The Origins of Central Banking: Solutions to the Free-Rider Problem, in:
International Organization, 52, 2, 1998, p. 231.
GOODHART, Implications for OCAs, p. 416.
Nigel DODD, The Sociology of Money - Economics, Reason & Contemporary Society,
Cambridge: Polity Press 1994, pp. 29-30.
80 See Michael J. ARTIS, One Market, One Money: An :r;:valuation of the Potential Benefits and Costs
of Forming an Economic and Monetary Union, in: Open Economies Review, 2, 1991, p. 319.
CANZONERI/RoGERS, Is the EC an OCA? Paul DE GRAUWE, The Economics of Monetary
Integration, 2nd revised edition, Oxford: Oxford University Press 1994, pp. 26-29. Stanley
FISCHER, Seigniorage and the Case ofa National Money, in: Journal of Political Economy, 90, 2,
1982, pp. 295-307. Vittorio GRILLI, Seigniorage in Europe, in: Marcello DE CECCO I Alberto
GIOVANNINl (eds.), A European Central Bank? Perspectives on Monetary Unification After Ten
Years of the EMS, Cambridge: Cambridge University Press 1989, pp. 53-79. TAVLAS, New
Theory, p. 673.
.
81 See Henry AARON, Inflation and the Income Tax, in: The American Economic Review, 66, 2,
1976, pp. 193-99. Assa BIRATl / Alex CUKlERMAN, The Redistributive Effects of Inflation and of
the Introduction of a Real Tax System in the U.S. Bond Market, in: Journal of Public Economics,
12, I, 1979, pp. 125~139. Michael R. DARBY, The Financial and Tax Effects of Monetary Policy
on Interest Rates, in: Economic Inquiry, 8, 2, 1975, pp. 266-76. Nicolaus T. TIDEMAN / Donald P.
TUCKER, The Tax Treatment of Business Profits under Inflationary Conditions, in: Henry J.
AARON (ed.), Inflation and the Income Tax, Washington DC: The Brookings Institution 1976, pp.
33-74.
78
79
6.3. Models of seigniorage revenues
Seigniorage revenue models generally assume a fixed output or endowment and explore the relationship among money (M), prices (P) and velocity (V). (The relationship between money and production (Y) is a separate and contentious issue, discussed
in the next section.) Cagan's model serves as the basis for many attempts to model
seigniorage revenues 84 . For example, Blanchard and Fischer showed that this model
can feature two points of equilibrium85 : Slow-adjusting expectations and inelastic demand for money would lead to a low-inflation steady state. The other equilibrium features high inflation, is unstable and could lead to hyperinflation.
Flood and Garber's empirical findings on the German hyperinflation of the 1920s
tend to support Cagan's model 86 . However, the replacement of the adaptive expectations with rational ones tends to make the inflationary process more prone to hyperinflation 87 . Miller and Zhang used a version of Cagan's model to analyze the recent
seigniorage revenues in the Former Soviet Union (FSU) republics 88 . Assuming ra82
83
84
85
86
87
88
David GLASNER, Free Banking and Monetary Reform, Cambridge: Cambridge University Press
1989, pp. 29-39.
GOODHART, Future of Europe, p. 91.
CAGAN, Dynamics of Hyperinflation.
BLANCHARD / FISCHER, Lectures in Macroeconomics, pp. 199~20 1.
Robert P. FLOOD / Peter M. GARBER, Market Fundamentals Versus Price-Level Bubbles: The First
Tests, in: Journal of Political Economy, 88, 4,1980, pp. 745-70.
In fact, rational expectations allow for hyperinflationary bubbles through a process of self~
fulfilling prophecies, even under a constant money supply. See PATINKIN, MIP (1989), p. xxxvi.
Marcus MILLER / Lei ZHANG, Hyperinflation and Stabilization: Cagan Revisited, in: The
Economic Journal, 107,441, 1997, pp. 441-454.
150
Tal Sadeh
Managing a common currency
tional expectations they found that if the population believes the public deficits to be
temporary, even if large and volatile, then in the short term the inflation rate can exceed its long-term steady state rate without hyperinflation and a cUlTency collapse.
However, scholarly work on inflation tax is not confined to Cagan '8 framework.
For example, Sargent modeled seigniorage revenues with a MITUF version of Lucas'
Tree model 89 , Seigniorage revenues in this model are possible with zero inflation because of the intrinsic utility of money. In terms of the QTM's formulation the increase
in M is followed by a decline in V rather than an increase in P. In other words the
public switches from inside to outside money without inflation90 . In addition, in this
tity of money to that end. In other words, it was perceived that money can Serve as a
macroeconomic policy tool. However, a great debate persisted between, broadly, the
Monetarist tradition and the Keynesian tradition regarding how money should be manipulated. This debate focused on the money neutrality question, and as is shown,
emanated from the different emphasis put on the different services that money provides.
If the nominal quantity of money does not influence real variables such as national income, employment, savings and investment, as the Monetarist tradition has it,
then money is said to be neutral. Monetary policy according to the Monetarist tJadition may only be used to stabilize the economy. On the other hand if money is not
neutral, as the Keynesian tradition claims, the government can manipulate its quantity
to further output and jobs.
model inflation is not fueled by inflationaty expectations because of the complete certainty regal'ding the flow of government debt. Thus, in Sargent's model seigniorage
revenues resemble a swap: The individuals sell goods to the government in return for
cash they need for precaution, and are assured to indirectly get their goods back in return for cash in the future91 .
Sargent also used a version of the OG model with inhibitions to the operation of a
private loans market to show how inflation tax under full certainty affects consumption and saving decisions92. Like in Cagan's model, two long-term points of equilibrium exist in this OG-Turnpike framework. However, in this case it is the higher rate
of inflation, which is stable and not the lower one and no hyperinflation can exist.
All of these models emphasize the dependency of inflation tax on either surprise
(manipulating the expectations of the public), necessity (MITUF, OO-Turnpike) or
compulsion (CIA). The harder it is to surprise or compel the public to hold the government's currency and the more liberal the economy is, the harder it would be for the
government to levy the inflation tax. Inflation tax under uncertainty and rational expectations is prone to hyperinflation. Under adaptive expectations, seigniorage revenues are cheaper in terms of inflation, but credibility is harder to earn. On the other
hand, certainty on the part of the individuals reduces the risk of hyperinflation and
turns inflation tax into something closer to a regular tax or a loan. In such cases seigniorage revenues are possible if the public regards money mostly as a precautionary
device or as a store of value.
7. Money as a Macroeconomic Tool
For most of the 20th century, there was a consensus that an economy should have a
monetary policy of some sort. Governments were held responsible for the material
well being of the entire society, and were expected to manipulate or control the quan89
90
SARGENT, Dynamic Theory, pp. 145-148.
This perhaps is the process taking place in Japan in recent years, although monetary policy there is
not revenue motivated.
91 The combination of complete certainty with MITUF though is self-contradictory since the utility
of holding to money is the precaution it provides against uncertainty.
92 SARGENT, Dynamic Theory, pp. 275-85. See also Stanley FISCHER, The Economy of Israel, in
Karl BRUNNER / Allan H. Meltzer (eds.), Monetary and Fiscal Policies and Their Applications,
Amsterdam: NOlih-Holland, 1984, pp. 7-52.
151
7.1. The Monetarist tradition
Patinkin and Steiger traced scholarly reckoning of a relationship between money and
h
th
prices to the 1i and 18 centuries 93 . All of the early writers viewed money as reflecting economic activity, rather than as generating it, and in that sense could be regarded
as belonging to the Monetarist tradition94 .
At the beginning of the 20 th centmy the Monetarist tradition centered mostly on
the QTM in its various forms. According to Fisher the velocity of money is constant
and the demand for real balances is stable over time. Since the money supply is exogenous, and the supply of goods and services depends only on technology and the
available factors of production, an injection of nominal money creates an excess of
money. The agents' attempts to get rid of this excess cause it to be cleared through a
rise in prices95 . Fisher admitted that in the shott run money was not neutral because of
what he termed "the dance of the Dollar": Price inflation would precede the adjustment in the nominal interest rate and erode the real interest rate. Thus, real activity
would temporarily be enhanced.
The Cambridge approach agreed with Fisher that money has no real effects, but
not because velocity was constant. Rather, an increase in the demand for money
would be accompanied by a decline in the demand for goods (the act of saving), hence
a decline in prices, and therefore, an increase in real balances and a decline in velocity 96.
93
Patinkin, MIP (1965), pp. 527-664. Don Patinkin / Otto Steiger, In Search of the "Veil of Money"
and the "Neutrality of Money": A Note on the Origin of Tenns, Scandinavian Journal of
Economics, 91,1,1989, pp. 131-146.
94 Foley, Economic Activity, pp. 520-522.
95 Friedman, Theoretical Framework. Milton Friedman, Quantity Theory of Money, in: John
Eatwell, Murray Milgate I Peter Newman (eds.), The New Palgrave: A Dictionary of Economic
Theory and Doctrine, 4, New York: Macmillan, 1987, pp. 3-20.
96 Don Patinkin, Neutrality of Money, in: John Eatwell, Murray Milgate / Peter Newman (eds.), The
New Palgrave: A Dictionary of Economic Theory and Doctrine, 3, New York: Macmillan, 1987,
p. 641.
152
153
Tal Sadeh
Managing a Common cUlTency
In the 1930s and 1940s, the political atmosphere in most industrialized countries
was in favor of active government manipulation of the quantity of money and distrust
rithmic version of the QTM, with a constant velocityl03. The Lucas model coneluded
that monetaIY policy could be effective in creating jobs only as much as it surprises
the public, and that in the long term money is neutral lo4 .
towards the market. The Monetarist tradition seemed irrelevant to the new reality.
Nevertheless, prominent quantity theorists of the Chicago School, such as Mints,
Pigou, Simons, Knight and Samuelson advocated controlling the money quantity as a
means to achieving price stability 97.
From the mid-1950s to the mid-1970s, the Monetarist tradition resurrected in the
form of Monetarism, which viewed nominal production and inflation to depend on the
money supply98. Friedman, Brunner and Meltzer rejected the prevailing view at the
time that inflationary policies result in lower unemployment99 . They argued that the
unemployment-inflation tradeoff existed only as long as individuals were taken by
surprise by inflationary shocks. In the long term the Non Accelerating Inflation Rate
of Unemployment (NAIRU) prevailed. Friedman as well as Brunner and Meltzer contended that an active monetary policy tends to exacerbate rather than smooth economic fluctuations. Thus, it is better to follow a declared constant" monetary growth
rate 100. Friedman also advised policy makers to aim at zero inflation in the long term,
and not to try to affect interest rates or exchange rates lOI •
The followers of the Monetarist tradition during the 1970s and 1980s relied on
more consistent general equilibrium models, but frequently assumed a fixed endowment, which predetermined that money is neutrall 02 . In Lucas' influential islands
model the aggregate supply of goods depended on the unexpected part of the rise in
the general price level, while the aggregate demand function for goods was a loga97 Lloyd W. Mints, Monetary Policy for a Competitive Society, New York: McGraw-Hill, 1950.
A. C. Pigou, The Classical Stationary State, Economic Journal, Yol. 53,212,1943, pp. 343-51. Henry
Simons, Rules versus Authorities in Monetary Policy, Journal of Political Economy, Vol. 44, I,
1936, pp. 1·30.
98 Phillip Cagan, Monetarism, in: John Eatwell, Murray Milgate / Peter Newman (eds.), The New
Palgrave: A Dictionary of Economic Theory and Doctrine, Vol. 3, New York: Macmillan, 1987,
pp.492.
99 Milton FRIEDMAN, The Quantity Theory of Money - A Restatement, in: Milton FRIEDMAN (ed.),
Studies in Quantity Theory of Money, Chicago: Chicago University Press, 1956, pp. 3-21. Milton
FRIEDMAN, The Role of Monetary Policy, The American Economic Review, Yol. 58, 1, 1968, pp.
1-17. Milton FRIEDMAN, The Counter-Revolution in Monetary Theory, London: The Institute of
Economic Affairs, 1970. FRIEDMAN, Theoretical Framework. BRUNNER / MELTZER, Uses of
Money. Karl BRUNNER / Allan H. MELTZER, Money, Debt, and Economic Activity, Joumal of
Political Economy, Vol. 80, 5,1972, pp. 951~77. Karl BRUNNER I Allan H. MELTZER, Friedman's
Monet8lY Theory, in: GORDON, Milton Friedman's Monetary Framework, pp. 63-76.
100 Robert J. BARRa, Rational Expectations and the Role of Monetary Policy, in: Journal of Monetary
Economics, Vol. 2,1,1976, pp. 1~32.
101 Milton FRIEDMAN, Monetary Policy: Theory and Practice, in: Eugenia FROEDGE TOMA I Mark
TOMA (eds.), Central Bankers, Bureaucratic Incentives, and Monet8lY Policy, Dordrecht: Martinus
NijhoffPublishers 1986, pp. 14-15. For empirical support for Monetarism's arguments see Phillip
CAGAN, Determinants and Effects of Changes in the Stock of Money 1875 - 1960, New York:
National Bureau of Economic Research 1965. CAGAN, Monetarism, p. 493. FRIEDMAN /
SCHWARTZ, Monetary History.
102 See Sanford GROSSMAN / Laurence WEISS, A Transaction-Based Model of the Monetary
Transmission Mechanism, in: American Economic Review, Vol. 73, 5, 1983, pp. 871-880.
SARGENT, Dynamic Theory. SlDRAUSKI, Rational Choice.
7.2. The Keynesian tradition
The Great Depression in the 1930s shattered the beliefs of many supporters of the
QTM and was interpreted by many as proof of the ineffectiveness of the monetary
policy even in the short tel"m. This motivated Keynes to develop a new macroeconomic paradigm. Contrary to the QTM's approach, Keynes' contended that in a world
of uncertainty money is a precautionary device 105 . Interest rates do affect velocity because of the confusing effect of inflationary expectations on the real interest rates l06 .
In addition, Keynes argued that although a correlation between money, prices and
output is indeed observed, the causal relationship may be reversed: People may first
wish to buy more goods. and only then do they demand more money107. Money, con
eluded Keynes, is neutral only when prices and wages are completely flexible l08 .
The Neo-Keynesian school, which consisted of different interpreters of Keynes in
the 19408, assumed wage and price stickiness and concluded that both monetary and
fiscal policies could be used to manage the demand for goods and affect output and
employment l09 . Neo-Keynesian demand-side analysis centered on the IS-LM model,
where the interest rate affects output by determining the money demand and balancing
investments and savings I 10. Money is neutral only as long as the goods' market is in
full employment. In the Mundell-Fleming model (the open economy version of the ISLM model), the interest rate also affects the balance of payments and the nonneutrality of money was limited to a situation of less than full employment and floating exchange rates]!l.
Patinkin summarized the conditions for the non-neutrality of money under full
employment ll2 : (1) Inflexible prices and wages. (2) Confusion on the PaIt of individuals of real and nominal values. (3) A re-distribution effect of inflation on real income if individuals have different propensities to save, and (4) open market operations
R
103 Robert E. LUCAS, Some Intemational Evidence on Output-Inflation Tradeoffs, in: American
Economic Review, Vol. 58, 3, 1973, pp. 326-334.
104 Stanley FISCHER, New Classical Macroeconomics, in: John EATWELL I Munay MILGATE / Peter
NEWMAN (eds.), The New Palgrave: A Dictionary of Economic Theory and Doctrine, Vol. 3, New
York: Macmillan 1987, pp. 647-651.
105 DAVIDSON, Keynesian View. KEYNES, General Theory, pp. 238-239.
106 KEYNES, General Theory, pp. 142-143.
107 John Maynard KEYNES, A Treatise on Money, London: Macmillan 1930, p. 3.
108 KEYNES, General Theory, p. 191.
109 James TOBIN, Friedman's Theoretical Framework, in: GORDON, Milton Friedman's Monetary
Framework, pp. 77-89.
110 J. R. HICKS, Mr. Keynes and the "Classics"; A Suggested Interpretation, in: Econometrica, 5,
1937, pp. 147-159.
111 Rudiger DORNBUSCH I Stanley FISCHER, Macro Economics, Singapore: McGraw-Hill 1987.
112 PATlNKlN, MIP (1965), pp. 274·294.
154
Tal Sadeh
Managing a common currency
on the part of the government when market agents regard bonds at least partially as
net wealth.
Tobin concluded that money is not neutral in the long term because inflation induces a portfolio switch from cash balances to physical capital\ 13. Thus, the Tobin Effect is based on viewing money as a store of value, However, when Levhari and Patinkin relaxed Tobin's assumption that saving is a constant proportion to real disposable income, and made the savings-income ratio dependent upon the expected rates of
return, they concluded that higher inflation reduces the incentive to save, leading to
less capitaP!4.
Howitt and Patinkin suggested that negative non-neutrality (a negative effect of a
monetary expansion on output) can stem from the effects of inflation on learning and
technological progress!!5. On the other hand, Stadler argued that if research and development activity is enhanced in the short term by a monetary expansion, its flUits
would materialize in the long tetID 116.
In the 1970s the Disequilibrium approach was developed as Neo-Keynesianism's
dynamic and modem version. It emphasized price rigidity and output constraints, and
featured both anticipated and unanticipated monetary shocks as the causes of fluctuations in output l17 , This approach focused on market imperfections, claiming that coordination problems among groups of workers 118 as well as monopolistic competition 1l9, price updating costsl20 and taxation l21 cause price rigidities.
8. Conclusions
113 James TOBIN, Money and Economic Growth, in: Econometrica, Vol. 33, 4,1965, pp. 671-684.
114 David LEVHARI / Don PATINKJN, The Role of Money in a Simple Growth Model, in: American
Economic Review, Vol. 58, 4,1968, pp. 713-753.
115 Peter HOWITT, Money and Growth Revisited, in: Bairn BARKAI I Stanley FISCHER I Nissan
LIVIATAN (eds.), Monetary Theory and Thought - Essays in Honour of Don Patinkin, London:
Macmillan 1993, pp. 260 w283. PATINKIN, MIP (1989), p. xlix.
116 George STADLER, Real Versus Monetary Business Cycle Theory and the Statistical Characteristics
of Output Fluctuations, in: Economic Letters, 22, 1986, pp. 51 w54.
117 See surveys by Allan DRAzEN, Recent Developments in Macroeconomic Disequilibrium Theory,
in: Econometrica, Vol. 48, 2, 1980, pp. 283-306. Jean-Pascal BENASSY, Disequilibrium Analysis,
in: John EATWELL I Murray MILGATEI Peter NEWMAN (eds.), The New Palgrave: A Dictionary of
Economic Theory and Doctrine, Vol. 1, New York: Macmillan 1987, pp. 858-863. Stanley
FISCHER, Recent Developments in Macroeconomics, in: Economic Joumal, 98, 391, 1988, pp.
294·339.
118 James TOBIN, Price Flexibility and the Stability of Full-Employment Equilibrium, in: Haim
BARKAII FISCHER I LIVIATAN, Monetary Theory, p. 62.
119 Olivier Jean BLANCHARD I Nobu KIYOTAKI, Monopolistic Competition and the Effects of
Aggregate Demand, in: American Economic Review, 77, 4, 1987, pp. 647-666.
120 BLANCHARD I FISCHER, Lectures in Macroeconomics, pp. 382-399.
121 BIRATI I CUKIERMAN, Redistributive Effects. Martin FELDSTEIN, Inflation, Capital Taxation, and
Monetary Policy, in: Robert E. HALL (ed.), Inflation: Causes and Effects, Chicago: University of
Chicago Press, 1982, pp. 153-167.
155
Money is a public good that provides a variety of services. It can serve simultaneously
as a medium of account, a medium of exchange, a store of value, a precautionary device, a factor of production, a taxing device, a macroeconomic policy tool, and performs many other non-economic functions. However, the relative importance of these
different services that money provides may vary with time and among different societies.
Emphasizing social and national cohesion would stimulate a quest for a good me·
dium of account. Societies where economic activity is family or tribal-based do not
emphasize the service that money provides as a medium of exchange in the way that
individualized societies do. If varying transaction costs are higher than fixed transaction costs, barter may be prefened and a medium of exchange may not be adopted.
Under a weak government commodity money may be more stable than paper money.
Trust among people, uncertainty and the size of transactions, all detelmine the extent
to which cash is preferred over credit. Societies that suffer from great unceltainty may
treat money more as a precautionary device. Money provides taxing services in times
of national crisis, such as in Getmany of the 1920s or Russia of the 1990s, or when
undemocratic governments are about to lose power, such as in Latin America of the
1970s.
The decline of the Monetarist tradition from the 1930s to the 1950s is inseparable
from the decline of domestic and international liberalism in general at that period.
Similarly, the flourishing of the Monetarist tradition from the late 1960s on reflects
the reemergence of liberalism and a renewed focus on the individual in society. Trusting private financial institutions could cause individuals to reject the need for any
monetary policy at all. All of these preferences regarding the different services that
money can provide imply different monetary policies and institutions.
Thus, if money is merely a medium of exchange then the proper monetary policy
is to dtive the nominal interest rate to zero. Models that view money primarily as a
medium of exchange usually tend to support the neutrality thesis. This is because the
quantity of money in these models is adjusted to the volume of transactions in the
economy or the level of income. The prescribed monetary policy is passive, and supplies money in a close relation with the volume of production.
Treating money mostly as a store of value justifies policies of zero price inflation,
or even price deflation and leads to a conclusion that money is neutral. Institutions
and rules that regulate banking and allow for a lender of last reSQ1t are designed to reduce the resort to the liquidity services of money, and to enhance the use of inside
money. Models that consistently relate to money as a precautionary device usually
conclude that money is not neutral. Should people pay for holding outside money, or
rather be paid? If money is a medium of exchange then according to Friedman it
should carry no interest at all. As a medium of account it should pay interest and as a
precautionary device it should be paid for.
Emphasizing the service that money provides as a taxing device would lead governments to impose restrictions on capital flows, depress the domestic financial market and dominate it. Printing money also works better the bigger the government is
relative to the economy. Since sUlprise improves the effectiveness of monetary financ-
156
TalSadeh
iog, deterioration in government transparency and deliberate policies of deception can
be expected as well. However, deception is less required when the public holds money
mostly to store value or for precaution.
The Monetarist tradition, which contends that money is neutral, prescribes a separation of the monetary authorities from the elected politicians. It is based on a longtenn view and on assumptions of rational expectations or even perfect foresight on the
part of individuals.
On the other hand, assuming or modeling price and wage rigidities or inhibitions
to the operation of a financial market leads to the conclusion that money is nonneutral. This is typical of scholars belonging to the Keynesian tradition. This tradition
supports close coordination between the government and the monetary authorities.
Price staggering, price updating costs, monopolistic competition and taxation can all
slow or distOli price adjustments.
OCA theory views money as a two-functional social device. It essentially weighs
the service that money provides as a medium of change against the service it provides
as a macroeconomic policy tool. The other servi(::es that money provides are generally
neglected by this theory. In addition, the OCA theOlY does not discriminate among its
criteria and applies all of them equally in any given case. However. different potential
members of a currency union may care more about different services that money provides and therefore, expect different monetary policies and institutions.
Different national preferences regarding the services that money provides influence the monetary policies and institutions advocated. It follows that in order to share
a common currency and to formulate common monetalY policies the preferences of
the member states with regard to the services that money provides have to converge.
The political economy of monetary unification.
The Swedish euro referendum of 2003
Lars Jonung
1. Introduction}
On Sunday September 14th 2003. voters in Sweden went to the polls to answer the
question: "Do you think that Sweden should introduce the euro as its official currency?"2 Three options existed: "Yes", "No" and a blank ballot. The voters decided
whether to maintain the domestic currency, the krona, which was introduced as the official currency unit in 1873. when Sweden adopted the gold standard, or to replace it
with the eura. the currency of twelve of the then fifteen member states of the European Union, that came into physical existence in Januaty 2002.
The Swedish referendum dealt with a clear-cut choice involving both the currency
and. the exchange rate regime - a choice different from that facing the voters in any
previous referendum in Europe. The No-option implied that Sweden should maintain
its domestic currency based on a floating exchange rate combined with inflation targeting by the Riksbank, the Swedish central bank. The Riksbank, which gained independence from the executive authority in the 1990s. announced, at its own initiative.
in Januaty 1993, a policy regime of inflation targeting. The Bank set a target ofa two
percent annual rate of inflation within a band of plus/minus one percentage point to be
valid from January 1995. The Yes-altemative implied that Sweden would be a member of the Eurosystem by replacing the krona with the euro, at the earliest in 20052006. The policy of the European Central Bank (ECB) would replace the national inflation targeting by the Riksbank.
Other countries have held referendums on the Maastricht Treaty and on membership in the EU. However, in these cases the adoption of the new currency, the euro,
was one of a larger set of issues on which the voters had to decide upon. The Danish
euro referendum in September 2000 is an exception. In Denmark the choice was between adopting the euro or maintaining the fixed exchange rate between the euro and
the Danish krone within ERM 2. From a monetaty policy point of view, the Danish
referendum did not represent much of a real choice. Although the Danish No-vote
meant that the domestic currency unit was maintained, Denmark still behaves after the
2
This chapter is a slightly revised version of a paper published in the Cato Joumal, vol. 24, 1-2,
Spring/Summer 2004. The usual disclaimer applies. The views and opiuions expressed here are
those of the author. They do not represent the views ofDG ECFIN, Brussels.
This translation is taken from the press release of the Government on December 12,2002, officially announcing the referendum to take place on 14th of September 2003.