The basic relationship between money and prices is often described in terms of the "quantity theory of money." In the long run, according to this proposition, the price level moves proportionately to the money supply. As a result, the rate of inflation depends on the rate of money growth. Though this proposition holds precisely only under restrictive conditions, it identifies in a more general sense an essential link between money and prices. It is therefore useful in understanding the way changes in the nature of money might affect the determination of the price level.
Under commodity money systems, money is often
privately produced, and the price level of non-money goods in terms of the
commodity money depends on the supply of commodity money relative to the
supplies of the non-money commodities. In a sense, there is no absolute price
level of goods in such an economy, only a set of relative prices. However, the
relative prices of non-money goods in terms of the commodity money become, in
effect, a measure of money prices, as we would think of that term today. The
supply of commodity money, in turn, depends on technology and--particularly in
the case of precious metals--on the pace of discovery. Prices of non-money
goods in terms of the commodity money need not be constant, but there is no
opportunity for discretionary monetary policy.
As states came at times to monopolize the issue of
commodity money, such as gold or silver coins, they often were tempted to
debase the currency by reducing the proportion of silver or gold in the coins
in an attempt to realize "seignorage" or revenue from issuing money.
Debasement of the currency typically resulted in inflation--a rise in the price
of non-money goods in proportion to the debased currency, which, in effect,
maintained the underlying relationship between the commodity, gold or silver,
and the price of other goods. These are the first experiences with significant
inflation induced by government's manipulation of money.
The next evolutionary step was representative paper
money. As long as the relationship between the commodity money and the amount
of paper money backed by the commodity money is stable, inflation will be
determined by the available supply of commodity money. But the beginning of
modern banking, by breaking the strict link between the commodity money and the
money supply, added an element of flexibility to the money supply and further
opened up the possibility for inflation.
During the international gold standard period,
currency issue and coin production were linked to and convertible into gold, so
that a country's total domestic money supply was tied to the domestic supply of
gold. This situation did not guarantee a stable price level, but it did remove
the risk of government-induced inflation. The result--and an indeed an
important motivation--was to constrain and, in principle, eliminate the
government's discretion regarding the supply of money. The gold standard, in
effect, put in place a rule that governed monetary policy.
If a country ran a trade deficit that exceeded private
capital inflows, it would, in principle, finance the difference by shipping
gold to other countries. Doing so reduced the money supply--and hence income
and prices--in the country with the balance of payments deficit and increased
the money supplies, incomes, and prices in the countries with balance of
payments surpluses. As a result, the system had a built-in tendency to move the
deficit and surplus countries toward balance. In fact, drains on a country's
gold or foreign exchange reserves were typically countered by an increase in
central bank's discount rate. The effect on income and prices was, in this
case, not due directly to changes in the gold supply, but to the changes in
interest rates that were implemented to limit the drain on gold.
However, principle and practice differed under the
gold standard. Richard Cooper (1992) summarizes the contrast in the following
terms: "The idealized gold standard . . . conveys a sense of automaticity
and stability--a self-correcting mechanism with minimum human intervention,
which ensures rough stability of prices and balance in international payments.
. . .The actual gold standard could hardly have been further from this
representation."
Cooper notes that economic growth during the late
nineteenth century was respectable, but variability in income growth was
substantially greater under the gold standard than during the period after
World War II.
But the gold standard was predominantly about price stability, so here we might
give special weight to evidence pertaining to that characteristic. Cooper notes
that short-run variations in wholesale prices were greater during the pre-war
gold standard than during the period from 1949 to 1979. In assessing economic
performance under the gold standard, one must also look at possible trends in
prices. Here the story is more complicated. If one compares 1877 and 1913, for example,
the price level is essentially unchanged. But the period covers a sharp and
extended decline in the price level followed by an equally sharp and persistent
increase. Prices from 1873 to 1896, for example, decreased 53 percent; this
decrease was followed by an increase of 56 percent from 1896 to 1913. These
swings can be explained, in large measure, by fluctuations in gold production
driven by discoveries of new deposits.
In the early post-World War II period, nations sought
an alternative to the international gold standard to govern exchange rates and
international economic relations. At a conference at Bretton Woods, New
Hampshire, in 1944, participating governments agreed to maintain a fixed
exchange rate system--more precisely, an adjustable peg. Exchange rates were
mostly stable but could be altered in discrete amounts, under prescribed
circumstances--allowing deviation from a fully rules-based system to one with
more discretion. In practice, the system was implemented by the commitment of
the United States to maintain a fixed relation between its currency and gold
and other countries' agreement to fix their exchange rates relative to the
dollar, at rates agreed to at the conference.
Fixed exchange rate systems provide a degree of
constraint on domestic monetary policies. Under such a system, imbalances in
payments were settled by flows of acceptable assets, typically gold or dollars.
Most countries, given limits on their international reserves, had to follow
policies consistent with supporting their fixed exchange rates--though, as
noted above, they had the option of changing the exchange rate. The United
States, however, was in a unique position because it could print more of the
assets--dollars--acceptable for settling payment imbalances. As long as the
United States was prepared to convert dollars into gold, at a fixed exchange
rate for official purposes, other countries seemed willing to hold dollars. As
dollars grew relative to the U.S. gold supply, the sustainability of this
system came into question. When the United States broke the link to gold in
1971, other major countries no longer were willing to accept dollars at the
fixed exchange rate. The adjustable peg system broke down, and the world ended
up, de facto, in a regime of floating exchange rates, with exchange rates
determined by supply and demand in the foreign exchange market.
Most countries were operating under fiat money systems
by this time. The combination of fiat money systems and floating exchange rates
removed the earlier constraints on domestic monetary policies for other
countries and made price stability and other dimensions of domestic economic
performance dependent on the conduct of their domestic monetary policies.
Central banks had to learn how to exercise that discretion in support of the
objectives usually dictated by their legislatures, almost always including
price stability and, in the case of the United States, price stability and full
employment.
There have been disappointments as well as successes
with monetary policy around the world. Over time, the number of independent
central banks has increased significantly, and independence no doubt enhances
the ability of central banks to achieve price stability. There has also been an
advance in our understanding of how to conduct monetary policy to achieve
stable rates of inflation, at least on average over a period of years, and
perhaps also to contribute, at the same time, to smoothing output and
employment growth. Over the last ten to fifteen years, coinciding with both an
increased emphasis on the price stability objective and the advances in our
understanding about the conduct of policy, inflation performance has been very
good.
However, some countries today continue to impose
constraints on discretionary monetary policy through fixed exchange rate
regimes, tying their inflation rates to inflation in the country to which their
exchange rate is pegged. This system does not eliminate the influence of
discretion, but it makes inflation in one country dependent on the discretionary
monetary policy in some other country. A currency board and dollarization are
tighter versions of a fixed exchange rate regime--that is, fixed exchange rate
systems from which it is progressively more costly to exit.
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