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 or a currency board l , Although the prevalent phenomenon at the end of the 20th 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 rule3.

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.

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.

2 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.

3 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.

132 TalSadeh

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 indus­tries. Cunency union efficiency can also be supported by similar tax structures and similar inflation rates among the members4.

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 ma-

4

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. 663v685. 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.

Managing a common currency 133

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 one7. 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-

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.

134 Tal Sadeh

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 sug­

gest 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 governmental (fiduciary) standard of value.

1 009" I 025. However, the criteria for the development of sufficient intra-industry trade are not yet developed.

11 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.

12 Robert E. HALL, Optimal Fiduciary Monetary Systems, in: 10umal of Monetary Economics, 12, I, 1983, p. 33.

Managing a common cmrency 135

The price level's volatility is affected by the choice ofa medium ofaccount13. 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 existence15. 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-

13 Jilrg NlEHANS, The Theory of Money, London: The Johns Hopkins University Press 1978 pp. 122-3. '

14 HAL~, Fidu~iary Sys.tem.s, See for example the interest bearing notes issued by provincial govewment III Argentma III 2002 (Patacones).

15 Paul EJNZIG, Primitive Money - In Its Ethnological, Historical and Economic Aspects London' Eyre & Spottiswoode 1966, p. 17. ' .

16 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.

17 CIPOLLA, Money and Civilization.

136 Tal Sadeh

ling ian standard in Western Europe18, 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 physi­cal 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 Caesarl9, 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 trade2o. 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 nation22. 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 19th century to adopt a bimetallic standard rather than a monometallic one. Under the bimetallic standard, goods were valued against a basket consisting of

18 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.

Managing a common currency 137

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

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 trade26.

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

24 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.

25 ETNZIG, Primitive Money, p, 24. POWELL, Money in Mesopotamia, pp. 225-6. 26 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.

27 EINZIG, Primitive Money, pp. 340-364.

138 Tal Sadeh

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.

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 individuals29 . 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 costs31 . 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 stamp34. 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 65035 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 Robert A. JONES, The Origin and Development of Media of Exchange, in: Journal of Political Economy, 84,4,1976, pp. 757-775.

29 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.

30 EINZIG, Primitive Money. 31 GOODHART, Future of Europe, p. 90. JONES, Media of Exchange, pp. 775. 32 GOODHART, Implications for OCAs. 33 POWELL, Money in Mesopotamia, p. 227. 34 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.

35 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.

Managing a common currency 139

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.

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 Knut WICKSELL, Lectures on Political Economy, London: Routledge, 190711946. 37 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.

140 Tal Sadeh

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 out­side-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 formulation38:

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 deflation42,

, 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 Irving FISHER, The Purchasing Power of Money, New York: Macmillan 192211971, second revised edition.

39 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.

40 On the neutrality debate see Section 7. 41 Milton FRIEDMAN, The Optimum Quantity of Money and Other Essays, Chicago: Aldine 1969. 42 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.

43 Robert CLOWER, A Reconsideration of the Microeconomic Foundations of Monetary Theory, in: Western Economic Journal, 6,1967, pp. 1-8.

Managing a common currency 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 countries45 .

A fourth group of medium of exchange models is based on the Bewley-Townsend Tumpike framework46. 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 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.

45 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.

46 SARGENT, Dynamic Theory, pp. 200·226.

142 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 ex­

change49 , 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 out­

side 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 curren-

47 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.

Managing a common currency 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 3s52

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 value55. 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.

51 GRaS I THYGESEN, European Monetary Integration. 52 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 in fiat 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.

144 Tal Sadeh

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 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 Don PATINKIN, Money, Interest, and prices - An Integration of Monetary and Value Theory, 2nd

edition, New York: Harper and Row 1965, pp. 13-33. 58 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.

Managing a common currency 145

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 regulation64 .

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 function65 . The cost function takes into account the alternative loss

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.

146 Tal Sadeh

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 re­sort 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.

Managing a common cun-ency 147

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 16th 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 1 i h century72.

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.

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 BLANCHARD/FISCHER, Lectures on Macroeconomics, p. 198. 69 GOODHART, Implications for OCAs, pp. 427-428. 70 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.

71 SUSSMAN, Debasements. 72 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.

73 Barry EICHENGREEN, Elusive Stability - Essays in the HistOlY of International Finance, 1919-1939, Cambridge: Cambridge University Press 1990. Milton FRIEDMAN 1 Anna JACOBSON­SCHWARTZ, A Monetary History of the United States 1867 - 1960, Princeton: Princeton University Press 1963.

74 VANTHOOR, EMU Since 1848, pp. 6-7. 75 GOODHART, Implications for OCAs, pp. 428-9. George MACDONALD, The Evolution of Coinage,

Chicago: Obol International 1916/1980.

148 Tal Sadeh

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 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 effects81 . On

76 GOODHART, Implications for OCAs, p. 415. 77 1. Lawrence BROZ, The Origins of Central Banking: Solutions to the Free-Rider Problem, in:

International Organization, 52, 2, 1998, p. 231. 78 GOODHART, Implications for OCAs, p. 416. 79 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.

Managing a common currency 149

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.

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 revenues84. 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 model86. However, the replacement of the adaptive expecta­tions with rational ones tends to make the inflationary process more prone to hyperin­flation87. Miller and Zhang used a version of Cagan's model to analyze the recent seigniorage revenues in the Former Soviet Union (FSU) republics88. Assuming ra-

82 David GLASNER, Free Banking and Monetary Reform, Cambridge: Cambridge University Press 1989, pp. 29-39.

83 GOODHART, Future of Europe, p. 91. 84 CAGAN, Dynamics of Hyperinflation. 85 BLANCHARD / FISCHER, Lectures in Macroeconomics, pp. 199~20 1 . 86 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. 87 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. 88 Marcus MILLER / Lei ZHANG, Hyperinflation and Stabilization: Cagan Revisited, in: The

Economic Journal, 107,441, 1997, pp. 441-454.

150 Tal Sadeh

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 model89, 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 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 quan-

89 SARGENT, Dynamic Theory, pp. 145-148. 90 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.

Managing a common currency 151

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.

7.1. The Monetarist tradition

Patinkin and Steiger traced scholarly reckoning of a relationship between money and prices to the 1 i h and 18th centuries93 . 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 20th 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 veloc­ity96.

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 Tal Sadeh

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 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 stability97.

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 loga-

97 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.

Managing a Common cUlTency 153

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.

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 device105. 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, conR

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 employmentl09. 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 employmentll2 : (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

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

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 outputl17 , This approach focused on market imperfections, claiming that co­ordination problems among groups of workers118 as well as monopolistic competi­tion1l9, price updating costsl20 and taxation l21 cause price rigidities.

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. 260w283. 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.

Managing a common currency 155

8. Conclusions

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 2005-2006. 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

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.

2 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.