(This policy bulletin is extracted from FMF monograph Money, central banking and monetary policy in the global financial arena, published by the FMF in 2001.)
Money and exchange-rate regimes
No modern economy functions well without a stable standard of value.
One job of money is to provide a standard of value, or unit of account. Money defines a unit of account – a dollar, a euro, a peso, a yen, a pound, depending on the economy in which you are interested. Division of labour, specialisation, markets, and trade all rely upon a unit of account that makes disparate commodities and assets comparable in the minds of different people.
Benefits of stable money
The economic efficiency that comes from a stable monetary unit of account is one of the pieces of a Hayekian infrastructure that a market economy requires. That is, a market economy requires a foundation of enforceable property rights, generally-accepted accounting principles, sound financial institutions, and a stable currency.
Where public contracts are not honoured and private contracts are not enforced, markets are impaired. Where title to property is not certain, normal banking is not possible. Where financial statements are not reliable, investment opportunities are obscured. Where the purchasing power of money is not stable, resources are wasted in gathering information or in producing and consuming the wrong things.
Changes in the money prices of goods and assets convey information. If an economy’s monetary unit is known to be a stable standard of value, then changes in money prices will accurately reflect changes in the relative values of goods and assets. That is, price fluctuations signal changes in the demand for and supply of goods and assets. Resource utilisation then shifts toward more valued uses and away from those less valued.
However, if changes in money prices are contaminated by the changing purchasing power of money, false signals are sent to businesses and households. Bad decisions are made, and resources are misallocated. Standards of living fail to rise at the potential rate. Nominal interest rates respond to shifting expectations about the future purchasing power of money. Changes in real interest rates are obscured. Again, resources are misallocated. Saving and investment decisions are affected, and growth is impaired.
Neither inflation nor deflation enhances economic performance. Unanticipated inflations and deflations induce redistributions of wealth – especially between debtors and creditors – but they leave the average standard of living lower. According to a former Governor of the Federal Reserve, “a place that tolerates inflation is a place where no one tells the truth”. He meant, of course, that true changes in the relative values of things cannot be observed from stated prices when the purchasing power of money is not stable.
The standard of value is stable – money is sound, the quality of money is high – when people can make decisions in the confident expectation that all observed changes in money prices are changes inrelativeprices, and all observed changes in interest rates are changes inrealrates.
While it is now generally accepted that accelerations and decelerations of inflation do not enhance economic performance, the same is also true of administered devaluations and revaluations of the external value of a currency. If a stable domestic standard of value is optimal, then, as Mises said, “It is impossible to take seriously the arguments advanced in favour of devaluation”. A government’s decision to alter the exchange rate of a currency that had been fixed involves the breaking of promises. Losses are imposed on someone.
This Monograph can be downloaded here.
AUTHOR Jerry L Jordan. This Policy Bulletin may be republished without prior consent but with acknowledgement to the author. As always the views expressed in this Monograph are those of the author's and are not necessarily shared by the members, directors or staff of the Foundation.
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