H. Robert Heller
To what extent did the recent increase in international reserves help to precipitate the world-wide monetary expansion that was an important cause of world-wide inflation in the early 1970s? To consider international monetary factors from this angle should not imply that they were exclusively responsible for global inflationary forces. Other factors played important roles: autonomous supply changes, some of them triggered by bad harvests or declining fish catches; the exercise of newly found monopoly power on behalf of producers; and increasing aggregate demand due to population and real income increases. Furthermore, it should be recognized that the monetary changes that will be analyzed here were often the result of fiscal policy actions.
There does, however, appear to exist a link between changes in international reserves and changes in world prices. Changes in global international reserves have both a direct and an indirect impact on the world money supply, and these changes in the world money supply in turn influence the world-wide rate of inflation.
Three basic factors determine the changes in a nation’s money supply: changes in the international component of the monetary base, that is, international reserves; changes in the domestic monetary base components; and changes in the monetary base multiplier. The acquisition of new international reserves will have a direct impact on a ration’s money supply by expanding the monetary base. An increase in the international reserves held may also have an indirect impact on the money supply if the monetary authorities feel that the increase in international liquidity has eased their reserve constraint so that more expansionary domestic monetary policies may be pursued. These increases in the monetary aggregates will in turn have an impact on national inflation rates. The channels through which such monetary changes are translated into price changes are many and varied, and have been the subject of extensive discussion.
The world monetary expansion of the early 1970s triggered a sharp increase in the demand for internationally traded commodities, because the rise in international reserves had eliminated or substantially reduced the foreign exchange constraint in many countries. Consequently, the global trade sector became the leading sector in the recent inflation. The sudden rise in the prices of internationally traded goods was a significant factor in making the recent inflation a truly world-wide phenomenon.
Why reserves expanded
Between 1950 and 1969, international reserves grew at an average annual rate of 2.7 per cent (Table 1). From the beginning of 1970 to the end of 1972, they increased from SDR 78 billion to SDR 146 billion; of this, increases in foreign exchange reserves accounted for SDR 67 billion—almost the entire addition to reserves during that period.
|Amount in billions of||Annual growth rate|
(In per cent)
|End of period||U.S. dollars||SDRs||U.S. dollars||SDRs|
Since SDR 59 billion of this increase can be identified as a growth of U. S. dollar reserves, it has been argued that an excessive monetary expansion in the United States was the main cause of the increase in world liquidity and the ensuing world-wide inflation. However, there is not much convincing evidence to support this notion. In fact, during 1970–72, the increase in the money supply of the United States was more moderate than in any other industrial country.
Instead, a shift by U. S. and foreign private entities out of dollars and into other currencies led to an excessive expansion of global liquidity in the early 1970s. Between the end of 1965 and 1969, private foreign entities had increased their liquid assets in the United States from $11.5 billion to $28.2 billion. But as the inflation rate in the United States accelerated somewhat during the late 1960s, the real returns on these financial assets fell. In addition, the growing volume of U. S. liquid foreign liabilities resulted in a questioning of the future external stability of the dollar and, in particular, the convertibility of the dollar into gold. Consequently, foreign private entities—in particular, foreign commercial banks—shifted out of dollars and into other currencies. Between the end of 1969 and the end of 1971, U. S. liquid liabilities to private foreigners decreased from $28.2 billion to $15.1 billion.
There is also reason to believe that U. S. corporations and individuals correctly anticipated the dollar devaluations of 1971 and 1973 and moved substantial funds into currencies that were likely to appreciate. For instance, U. S. commercial banks more than doubled their foreign assets from $6.5 billion at the end of 1969 to $13.6 billion at the end of 1972, while their foreign liabilities actually decreased from $32.5 billion to $26.0 billion during the same period.
The Euro-currency market
At the same time the size of the Euro-currency market continued to grow. The U. S. dollar component of the Euro-currency market, however, decreased from 81.3 per cent of total liabilities in December 1969 to 72.4 per cent by December 1971. The net dollar positions of the Euro-currency banks decreased from $1.43 billion to $0.75 billion over the same period, while their net positions in other Euro-currencies increased from $0.06 billion to $1.65 billion. It stands to reason that this shift in the currency composition of the Euro-market was indicative of the expected exchange rate movements.
The Euro-currency market might also have played a role in international reserve expansion in the early 1970s. If central banks in the rest of the world place their funds in the Euro-currency market, an additional multiple deposit expansion may result, which is unregulated and outside the traditional scope of monetary policy.
It appears, then, that the expansion in the volume of international reserves held by foreign central banks in the early 1970s was not due to an excessive monetary expansion in the United States but to a decrease in the private demand for dollars.
As some private households, banks, and firms shifted their assets from dollars to other currencies, they forced central banks in the rest of the world to purchase these dollars at the agreed-on parity of their own currency. These central banks, in return, issued their own currency or other central bank liabilities to the depositors of dollars and added the dollars to their foreign exchange reserves. This process led to a multiple expansion of the global money supply, as the amount of high-powered central bank money increased.
Because reserves are a component of the monetary base, one might expect that the relationship between reserve changes and changes in the monetary aggregate is direct and instantaneous. However, changes in international reserves are only one factor determining the changes in a nation’s money supply. Central banks have the option of offsetting the changes in the external component of base money by changing the domestic elements of the monetary base. Changes in reserve requirements, discount policies, and other monetary instruments may also be used to neutralize the effects of autonomous changes in the external component of the monetary base. Furthermore, it takes time for the impact of a change in a monetary base component—such as a change in international reserves—to be fully reflected in changes in the monetary aggregates. The money multiplier does not operate instantaneously. It is dependent on the interaction between many decisionmaking units, and a considerable amount of time may pass until final portfolio equilibrium is attained by all relevant units.
Investigations covering the 126 Fund member countries for the period 1951–74 indicates a significant lagged relationship between percentage changes in the value of global reserves and the growth rate of the world money supply (see H. Robert Heller, “International Reserves and World-Wide Inflation,” Staff Papers, March 1976). Estimates using both annual and quarterly data indicate an average lag of approximately one year in this relationship between global reserves and money. The results show that changes in international reserves can explain slightly more than half the variation in the world money stock actually observed.
Effect of reserve changes on prices
The second link in the chain connecting reserve changes to price changes is the relationship between changes in the monetary aggregates and changes in the price level. That this relationship exists on a national basis has been well established in economic investigations covering a wide variety of countries. Our data permit us to test this relationship for the first time on a global basis. Data limitations made it necessary to restrict ourselves to tests of the simple hypothesis that there is a direct relationship between the percentage changes in the global money supply and the rate of global inflation. Through regression techniques we estimated the lag structure and determined an average lag of approximately one and a half years in the relationship between money and prices.
It may well be that velocity changes account for part of this lagged price response to changes in the monetary aggregates. As the world money supply increases, the velocity of circulation may well decrease at first. Therefore, the impact of the monetary changes on the price variable will be experienced only after the velocity of circulation has returned to its normal value.
It is tempting to add the mean lag of one year established in the relationship between reserves and money and the mean lag of approximately one and a half years in the relationship between money and consumer prices, and to conclude that a lag of approximately two and a half years might be expected between reserve changes and world price changes. Direct estimates of the length of the lag between reserve and price changes indicate an average lag of three to four years in this relationship, emphasizing the variability of the lagged response.
The direction of causation
On the basis that an increase in the global price level will increase the demand for nominal reserves as countries want to restore the real value of their international reserve holdings, it can be argued that reserve changes do not cause price changes but vice versa. To test the validity of this alternative hypothesis we estimated an equation that incorporated percentage changes in international reserves both as leading and lagging variables. It was found that only the coefficient for reserve changes leading price changes by two periods is statistically significant. On the other hand, none of the reserve coefficients lagging behind the price changes are significantly different from zero. It is also noteworthy that the sum of the regression coefficients with reserve changes leading the price change is equal to 1.08, indicating that an increase in international reserves by 1 percentage point will eventually be reflected in a price change of slightly more than 1 per cent. In contrast, the sum of the coefficients for reserve changes lagging behind price changes is equal to 0.01, as one might expect if reserves are not influenced by the monetary aggregates. On the basis of this evidence we may conclude that reserve changes do indeed cause price changes rather than the other way around.
Effects on structure of world inflation
International reserves have often acted as a constraint on economic expansion. However, in the years 1970 to 1972 each of the industrial and more developed countries registered an increase in international reserves (with the sole exceptions of the United States and South Africa). Even among the less developed nations only a few experienced reserve losses, with most countries making substantial reserve gains. The industrial countries as a group increased their international reserves by 92 per cent, and the less developed countries increased theirs by 106 per cent during the first three years of the 1970s.
These substantial reserve gains had a particular influence on commercial policy. Between 1970 and 1972, out of a total of 111 countries, the number of nations having restrictions on current account transactions decreased from 73 to 58. Other countries substantially reduced their import restrictions. The response by importers was not surprising: in the years 1970 to 1972 imports increased by an average annual rate of 12 per cent in real terms. The plentiful supplies of international reserves fueled this world-wide import boom. However, it is clear that this rate of real increase was not sustainable at constant prices. The index of world import prices almost doubled, from 100 to 195 in the 1970–74 period, with most of the increase coming in the last two years of this period.
A further factor contributing to the inflation in the prices of traded goods was that many international prices are quoted in dollars. Given the declining value of the dollar itself, many commodity prices looked very attractive indeed to foreign buyers, and therefore the demand for commodities increased.
The sharp increases in international reserves during the years 1970–72 consequently had an effect on the structure of world prices, and here the relationship between prices of traded and nontraded commodities is particularly interesting. As there is no adequate price index of nontraded goods, the world-wide consumer price index can be used as an indicator of general price developments, while the world export and import price indices are indicative of price developments in the traded goods sector.
Since World War II, prices of internationally traded goods have shown a marked stability and have generally exercised a restraining influence on domestic price developments. Only minor changes in world trade prices occurred between 1950 and 1969. It is one of the hallmarks of the recent world-wide inflation that this historical tendency has been reversed. Table 2 shows that increases in consumer prices exceeded price increases in traded commodities during the 1950s and 1960s, while in the years since 1972 the rate of price change of traded goods was greater than the changes in the consumer price index.
|Year||Consumer prices||Export prices||Import prices|
In virtually all earlier inflationary episodes, an excessive expansion of the domestic component of the monetary base was responsible for the creation of inflationary pressures, but during the recent inflation the high rate of expansion of the international reserve component of the monetary base played a decisive role.
A systematic relationship
Under fixed exchange rates there is then a systematic relationship between changes in world-wide international reserves and the rate of world-wide inflation. Changes in the world money supply serve as the crucial link in this relationship.
The evidence examined shows that changes in global international reserves have a significant impact on the aggregate world money supply and that there is an average lag of about one year in this relationship. There also exists a relationship between changes in the world money stock and changes in world prices. The evidence indicates a mean lag of approximately one and a half years in this relationship.
Estimates relating changes in global international reserves directly to changes in world consumer prices found a significant lagged relationship between these two crucial variables. The mean length of the lag was determined to be three to four years. All these lags are averages of distributed lag relationships. The standard errors vary between one half and three years, which indicate that there is considerable variability in the estimated lag structure.
It was also found that the sharp increase in international reserves that helped to trigger the world-wide inflation of the early 1970s had an effect on the structure of the recent inflation. The increase in international means of payments in the hands of individual countries led to a world trade boom that resulted in a significant increase in the prices of internationally traded commodities. In contrast to the experience after World War II, the international sector represented an intensifying rather than mitigating inflationary influence since 1972.
While an increase in the U. S. dollar component of international reserves was the proximate cause of their increase in the early 1970s, there is little evidence that a more excessive monetary expansion in the United States than in other countries was responsible for this. Instead, a private shift from dollars into other currencies resulted in an expansion of the volume of foreign exchange reserves in the form of U. S. dollars.
The expansion in international reserves played a crucial role in the recent worldwide inflation. The large increases in the world monetary aggregates created the framework for translating what might have been sectoral price increases into a world-wide inflationary surge. Had the same real changes taken place within a framework of monetary restraint, the outcome would probably have been different.
It should also be noted that the conceptual framework of this analysis and the empirical data base pertain to the period of largely fixed exchange rates. Under such a fixed exchange rate system monetary impulses are transmitted between countries and it is difficult for any individual nation to isolate itself from foreign monetary developments. We might expect that the introduction of widespread floating will result in a greater independence of countries to pursue appropriate anti-inflationary policies and that countries willing to take the appropriate policy actions might insulate themselves more successfully from international inflationary pressures than was possible under the fixed rate system.
Although the volume of international reserves in existence has no direct effect on price levels, the changes in national monetary aggregates that accompany changes in international reserves do have a significant lagged impact on national and international price developments—unless national monetary authorities take appropriate actions to neutralize these induced monetary changes. An alternative would be a better control over international liquidity creation, so that the aggregate volume of international reserves may be expanded to avoid excess demand and inflation as well as economic stagnation and deflation in the world.