Currency Substitution and Instability in the World Dollar Standard: Comment

Myron Ross correctly points out in his comment that U.S. price inflation is better predicted by the American money supply (MlUS) than by the broader ten-country world money supply (MlW) over the whole statistical time-series from 1960 to 1980 provided in McKinnon's 1982 article. Specifically, he showed that American price inflation is more highly correlated with MlUS lagged one or two years than with MlW similarly lagged. However, McKinnon's present-tense assertion that "In general, growth in the world money supply is a better predictor of American price inflation than is American money growth" applies only to the weak dollar standard of the 1970's and early 1980's-as his preceding discussion intended, but failed to indicate clearly. Only in this later period of volatile exchange rates and price-level instability in the United States do alternative hard currencies (such as the yen and deutsche mark) become competitive as international stores of value and units of account. Hence, international currency substitution-associated with the ebb and flow of speculation against or for the dollar-significantly destabilized the demand for MlUs in the 1970's and 1980's. And only in this later period might one expect the sum of these internationally substitutable monies, Ml, to predict world, and perhaps even American, price inflation better than does Mlus. In contrast, during the strong dollar standard of the 1950's and 1960's, the dollar was unchallenged as international money. Exchange rates were (by and large) convincingly fixed: speculation for or against the dollar was incapable of substantially altering U.S. interest rates or of directly affecting the demand for MlUS. Because cyclical international influences did not then destabilize the demand for dollars, MlUS was by itself a fairly efficient predictor of American prices. Thus Ross's statistical results for the period 1960 to 1980 show somewhat greater predictive strength in Mlus, compared to Ml', because the 1960's data outweigh the dissimilar data of the 1970's. Let us instead partition the sample of IMF data around the year 1970, whence began the transition from fixed to fluctuating exchange rates and the maturation of alternative monetary systems in Europe and Japan. After applying similar statistical correlation procedures to those used by Ross, we show a striking structural shift in the world's monetary system: the explanatory power of Mlw increases sharply as that of MlUS declines moderately (Tan, 1982). For the early period of 1960 to 1970, Table 1 shows simple correlation coefficients between annual percentage changes in money supplies and changes in American and world wholesale price indices. The MlUs provides a good explanation of U.S. prices and of world prices one to two years hence, whereas the broader definition of Mlw (in which MlUs enters with a 50 percent weight) does surprisingly poorly, being insignificantly correlated with American or world prices. Apparently, money growth in industrial countries other than the United States was not then an independent source of worldwide inflationary pressure during the strong dollar standard. Table 2 shows the same simple correlations between percentage changes in prices and money for the weak dollar standard of * Stanford University. Please note that a typographical error giving the last word in the original title as "Market" appeared on the cover of the June 1982 issue of this Review. The title was correct in the table of contents and on the article.