Money , Inflation , and Output Under Fiat and Commodity Standards

This study examines the behavior of money, inflation, and output under fiat and commodity standards to better understand how changes in monetary policy affect economic activity. Using long-term historical data for 15 countries, the study finds that the growth rates of various monetary aggregates are more highly correlated with inflation and with each other under fiat standards than under commodity standards. Money growth, inflation, and output growth are also higher under fiat standards. In contrast, the study does not find that money growth is more highly correlated with output growth under one type of standard than under the other. This study was originally published in the Journal of Political Economy (December 1997, vol. 105, no. 6, pp. 1308–21). It is reprinted in the Federal Reserve Bank of Minneapolis Quarterly Review with the permission of the University of Chicago Press. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. Recently, Lucas (1996, p. 661) argued that the question of how “changes in the conduct of monetary policy can influence inflation, employment, and productio n . has not been given anything like a fully satisfactory answer. ” A shift in monetary standards from commodity to fiat by a country would seem to be one type of experiment that could provide some empirical evidence to help answer this question. Such shifts in monetary standards occurred beginning in the1880sandcontinued through the1930s.Duringthatperiod,mostcountrieschangedtheirmonetarystandards: they permanently left a commodity standard (either gold or silver) and went to a fiat standard. Under commodity standards, governments minted coins and issued paper currency that represented promises to specified amounts of specie. After the change in standards, governments issued fiat money: token coins and paper currency that carried no promise of either present or future convertibility into gold, silver, or anything else of intrinsic value. The purpose of this study is to examine whether the relationshipsbetweenmoneyand inflationandbetweenmoney and output differ between economies operating under a commodity standard and economies operating under a fiat standard. The basis for our study is long-term historical money, price, and output data for 15 countries that have operated under both types of monetary standards. Using these data, we establish several facts about the differences in the relationships between money and inflation and between money and output when economies operate under a commodity standard and when they operate under a fiat standard. We find that under fiat standards, the growth rates of various monetary aggregates are more highly correlated with inflation and with each other than they are under commodity standards. We also find that money growth and inflation are higher. In contrast, we do not find that money growth is more highly correlated with output growth under one standard than under the other. However, we do find that under fiat standards, output growth is higher. A study of relationships between money, inflation, and output is not, in itself, original. (See, for example, Cagan 1956, Friedman and Schwartz 1963, Schwartz 1973, Sargent 1982, Smith 1985, Barro 1987, Dwyer and Hafer 1988, and McCandless and Weber 1995.) What sets our study apart is that we document differences in the behavior of these variables under the two monetary standards over a long period in a large sample of countries. Previous studies that use a long period, such as Friedman and Schwartz 1963, have typically examined only a single country and have failed to distinguish between periods with different monetary standards. Others that use a large number of countries, such as Barro 1987, Dwyer and Hafer 1988, and McCandless and Weber 1995, have typically examined only a short period over which a single monetary standard prevailed. The study by Backus and Kehoe (1992) utilizes data on 10 countries over a period roughly comparable to that used here. However, that study focuses on whether the cyclical behavior of money, inflation, and output is the same across countries. The study does not consider how the behavior of these variables differs across monetary standards. We focus on differences in the relationships between money and inflation and between money and output under the two monetary standards. When a difference is found, as is the case with the correlation between money and inflation, one might be tempted to conclude that the change in monetary standards caused the difference. Such an inference is not necessarily correct. Some other factor could have caused both the change in the monetary standard and the change in the money/inflation relationship. Before one can determine what caused an observed change in economic relationships under fiat and commodity standards, a model of monetary standard determination is needed that can confront the facts documented in this study. In other words, to establish causality, one needs a theory that both explains why governments decide to adopt a particular monetary standard and predicts the observed changes in the relationships between money, inflation, and output. In the first section below, we take care of some preliminary issues concerning how we obtain our results. Specifically, we define commodity and fiat standards, discuss the various measures of money we use, and describe the data. In the next two sections, we present our findings about money/inflation relationships and money/output relationships. Then, at the end, we summarize these findings nd present some suggestions for future research. Preliminaries Since our investigation is directed at uncovering differences in the relationships between money, inflation, and output under two monetary standards (commodity and fiat), we first carefully define what we mean by a monetary standard.Making this definition rigorous proves useful in classifying the periods we consider. By amonetary standard, we mean the objects that serve as the unit of account and that back the objects that circulate as generally accepted means of payment (that is, the objects that back the objects that are money). Under a commodity standard, the unit of account is a fixed amount of the commodity. Government currency consists of coins made of the commodity and notes redeemable in the commodity; private monies, such as bank notes, are also redeemable in the commodity. Under a fi t standard,the unit of account is some abstract value, such as a dollar, pound, or peso. Government currency consists of irredeemable token coins and notes (fiat money), and private monies are redeemable in fiat money. Identifying the monetary standard under which a country is operating is not always straightforward. The standard is unambiguous when people expect it to be permanent. Identification is less clear with temporary fiat standards, which are often the result of a need to finance a war. Bordo and Kydland (1993) argue that such standards are, in fact, commodity standards because people believe that there is a positive probability that the money will be convertible in the future. Bordo and Kydland argue that the gold standard should be thought of as a rule permitting such temporary suspensions. For this study, we adopt the Bordo-Kydland definition of the gold standard and consider those temporary fiat standards that are followed by a return to a commodity standard as being part of a commodity standard. Assessing the relationships between money, inflation, andoutputunderdifferentmonetarystandards requiresempirical counterparts to the concept of money. We use an eclectic approach. Following conventional studies of money and inflation, we use a broad measure of money (M2) that encompasses most objects that circulate as media of exchange or can quickly be converted into such objects. Because some theories of money suggest that broad measures of money may fail to reveal important relationships between money and inflation, we also employ narrower measures of money. 1 These theories imply that money should be divided into two mutually exclusive categories: objects that represent a convertibility promise by, or claim on, the issuer and objects that represent no convertibility promise or claim. For convenience, we refer to the nonconvertible, unclaimable objects as primary moneyand the convertible, claimable objects as secondary money. 2 Gold and silver coins (specie) that used to circulate in the United States and Federal Reserve notes that circulate today are examples of primary money: the issuers of this money do not promise to convert it into anything of value. Bank notes that used to circulate in the United States and bank deposits that circulate today are examples of secondary money: the issuers of this money promise to convert it into something else, usually on demand. We measure the quantity of primary money by the total monetary assets that remain after the balance sheets of all agents in the economy (the nonbank public, the banks, the central bank, and the government) are consolidated. In netting out assets and liabilities, we consider objects that conventionally appear on the balance sheet of central banks and governments as liabilities only when they actually represent convertibility promises on the part of the issuer. 3 Undera commoditystandard, thequantity ofprimarymoney is the total specie held by all agents in the economy. Under a fiat standard, the quantity of primary money is the monetary base, the quantity of fiat money plus specie that is held by the bank and nonbank public. To measure the quantity of secondary money, we add all the assets held by the nonbank public that are used as media of exchange and subtract the quantity of primary money. We take the assets that circulate as media of exchange to include those types included in the conventionally used monetary aggregate M2. Hence, our