Commentary. * In International Inflation: Four Commentaries, pp Chicago: Federal Reserve Bank of Chicago, 1974.

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1 Commentary. * In International Inflation: Four Commentaries, pp Chicago: Federal Reserve Bank of Chicago, Unaccustomed as I am to being between central bankers with one on the right and two on my left it s a pleasure to be here with these gentlemen. I might start by departing for a moment from what I am going to say to add a footnote to this very fascinating presentation by Mr. Freeman. One of our Canadian students has done an interesting study comparing what happens to Canadian income with what happens to the U. S. money supply and comparing what happens to Canadian income with what happens to the Canadian money supply. And it turns out that, on average, Canadian income is more responsive to the U.S. money supply than it is to the Canadian money supply. This greater responsiveness is more marked during the period of fixed exchange rates, as you would expect. I m not absolutely sure, I don t remember the results in detail, so I don t guarantee this, but it s my impression that the same response also holds for the period of floating exchange rates, but less precisely. It s an interesting statistical footnote to the extent that the Canadian economy has linked itself with the U. S. economy, although the floating exchange rate would have enabled it to separate. Brimmer: Excuse me. I m curious, did he offer an explanation? Friedman: Oh yes. I don t think the explanation is very difficult, given what Mr. Freeman said. If I were asked to relate the income in Illinois either to the money supply in Illinois or to the money supply in the United States, I would not be surprised to find a closer relationship with the money supply in the United States. If Canada is the thirteenth Federal Reserve District, in fact although not in name, why, then it s not surprising that the money supply in the whole area is more closely related to income within Canada than is the money supply within Canada. Brimmer: Well, I suspected that, but it s better to have you say it than me. 1

2 Friedman: See the great virtues of academic freedom. I want to make two sets of comments with respect to the problem of international inflation we are dealing with. The first is the difficulty people always have in adjusting themselves to new sets of circumstances. I believe that in discussing the problems of international inflation, the discussion has not sufficiently adjusted itself to the drastic change in the system of exchange rate determination that has occurred. Almost all discussions proceed as if we were still in the Bretton Woods world. We are not. We are in a world of dirty floats which may be worse than clean floats but to my mind, is far better than a world with dirty fixed rates. In a world of dirty floats the effect of inflation in one country on another country is quite different than it is in a world with fixed exchange rates. Let me illustrate that by going back to the episode which Governor Brimmer commented on; namely, the recent experience of the United States. We have heard over and over again that inflation in the United States, somehow or other, was increased or exacerbated or produced by the international rise in prices of raw materials and other things. Now, that is a statement of mixed validity, and it has to be examined very carefully. We have to distinguish sharply two different elements. In the first place, in the course of the past year or so, the U.S. balance-of-payments deficit has been reduced. Now, regardless of what happened in the rest of the world, regardless of how that reduction was brought about whether it was brought about by devaluation, by allowing exchange rates to decline, by import controls, by export subsidies the reduction in the balance-of-payments deficit, per se, was inflationary in the sense that it meant we were getting fewer goods back relative to the goods we were sending out. It meant that for a given total aggregate money demand, we had a smaller volume of goods to set against. Now leave that aside, and let s suppose there had been no change in the balance-ofpayments deficit. What would the effect of the world inflation have been? As it happens, under the circumstances of the last year, world inflation would have been deflationary in the United States, not inflationary. Why? Because it so happened that world inflation was 2

3 concentrated in goods we export rather than in goods we import. World inflation was in raw materials and foods, and it produced a very sharp improvement in our terms of trade. This improvement in our terms of trade meant that we got more imports for a given volume of exports. To put it differently, the reduction in the U.S. deficit was much less inflationary than it might have been because of the accidental character of world inflation. Now we hear people say and this ties in with Miss Arak s paper 1 the devaluation of the U.S. dollar contributed to U.S. inflation. That s nonsense. It was U.S. inflation that produced the devaluation. Suppose the United States had followed a much tighter monetary policy, suppose the United States had had a smaller rate of inflation at home but had improved its balance-of-payments deficit by the same amount; then the depreciation would have been less than it was. The fact of the matter is, the dollar depreciated as much as it did because of U.S. inflation not the other way around. You see what I mean by cultural lag of a fixed exchange rate system? Under the Bretton Woods system, the statement that depreciation forced us to inflate would have been exactly right. That s what Miss Arak s paper demonstrates. On the other hand, with floating exchange rates the correct and important relationship is the other way around from our inflation to the exchange rate, not from the exchange rate to our inflation. Now I come to a second point I want to talk about, which is quite a different point, but not unrelated. It has to do with the effect on world inflation of the end of the two-tier system for gold. Now why do I say it s related? One of the questions that Mr. Sweeney 2 brought up this morning had to do with the question of the monetarist versus the Keynesian view of liquidity. Another question brought up this morning asked, why is it that in the last couple of years, since we have had floating exchange rates, we have had a coordination of worldwide rates of inflation, and why has there been a rapid rise in inflation? The question raised is, why is it that, if anything, inflation rates seem to be more alike in different countries of the world since we have had free exchange rates than before we had them? Well, I submit that that s an optical illusion. The end of fixed rates may have been a factor contributing to an acceleration 3

4 of worldwide inflation. But if you look at the rates of inflation, they are at least as divergent as the rates of inflation were before. Only before, some of them were inflation, some were deflation. The range was different. Why should the end of a fixed rate system, as a transition matter, have been an inflationary factor? As you know, I m in favor of the end of the fixed rate system. I think the floating rate system is fine. But as economists, we have to analyze what the consequences of the floating rate system are. One of its consequences has been to reduce the demand for liquidity for central bank reserves. If you have a truly floating rate system, you don t need any reserves at all. And one of the effects of shifting from a pegged rate system to a floating system was to reduce the demand for international reserves. Well now, it has always been incredible to me how inconsistent people are in their domestic and international monetary theory. How people who know perfectly well that doubling everybody s nominal cash balances will, in time, simply double the price level can believe that something different applies in international affairs has always baffled me. If central banks become more liquid, sooner or later they are going to take advantage of that. Therefore, the shift to a floating rate system has had the effect, once and for all, of increasing central bank reserves relative to desired reserves, and in that sense has been a source of worldwide inflation. It wasn t a coordinated international inflation. But, in fact, in a great many countries you had the same force at work. That brings me to the end of the two-tier system for gold. The two-tier system was a mistake. It never should have been introduced in the first place. I applaud its ending, but let s recognize its effect. The effect of ending the two-tier system is that $40 billion of frozen reserves have become $100 billion of liquid reserves. I don t guarantee my numbers, but the gold that central banks listed on their balance sheets was not an available reserve. It was a frozen reserve. The Common Market countries discovered this a year or two ago when Italy was asked to settle up its snake deficit in gold. Italy said no siree; why should we turn over gold worth $100 an ounce on the marketplace at 4

5 an official price of $38 or $40 an ounce whatever it was then. So that $40 billion of gold valued at former prices held by the central banks of the world was a frozen element of their reserves. Today it s an unfrozen element. It s valued at $100 billion roughly, and the central banks are free to sell it or convert it into other things. It would be incredible if the effect of that were not inflationary. The long-run effect of the present reserve situation is that, sloshing around in the world, you have an amount of reserves which is inevitably going to produce a worldwide inflation over the next ten or 15 years. I m not saying the reaction is immediate, any more than it is for individuals. I don t know what the lags are, they may be long; they may be variable. But the ultimate effect is very clear unless something is done to immobilize or eliminate those reserve balances. I don t know if anything can be done or should be done, but I think in considering international inflation we should be aware of that fact. Well those are the two points I wanted to make, both of which have to do with the notion that we should adjust our analysis of the world situation to the changes that have taken place in the arrangements. Notes * From a panel discussion including Andrew Brimmer, George Freeman, Helmut Schesinger, and Milton Friedman at the Federal Reserve Bank of Chicago, 3-4 December Marcelle Arak, The Effects of Currency Depreciation on the Price Level: Estimates for the United States. Paper delivered at the meeting of the Federal Reserve System Committee on International Research and Analysis, Chicago, December 3,

6 2 Richard Sweeney, International Transmission of Inflation: A Survey of Mechanisms and Issues. Paper delivered at the meeting of the Federal Reserve System Committee on International Research and Analysis, Chicago, December 3,