UNCOMMON ARGUMENTS FOR COMMON CURRENCIES 115
The question of reserve holdings is closely related to the optimum
Chapter 7
UNCOMMON ARGUMENTS FOR COMMON
CURRENCIES
ROBERT A. MUNDELL
University of Waterloo
I THE CASE FOR A COMMON MONEY
When a commodity is used as money for a long time its monetary
characteristic takes on a life of its own, independent of metallic con-
tent. At that stage it can be replaced by token money through one of ,
the various techniques of debasement or devaluation or replacement
by paper or ink money and the pure metal originally embodied in the
coin itself can be turned to productive use. The resource saving is
'seigniorage'.
There may be costs associated with doing away with the metaolli<t
content. If the management of a state is unintelligent or in th•e g••ipof
factions, it may inftate the currency and reduce the value
monetary apparatus as a guide to rational calculation. The ro]>la<:e,;
ment of metallic money by paper money or ink money or
money may inflict a loss on the state because ofee:~x~t;•::rn~~a;l;~~';;~:~;
tions. If we consider two different countries, one\\·
acceptable gold as money, and the other with inconvertible
money, the state with the gold is better off since, other th'ing:seq
the gold can be spent abroad- used as an emergency reserve
rest of the world is on a gold standard and the state in question
not make up too large a share of the world (as measured
Inconvertible national paper is not a reserve for the state as
except insofar as it can be marketed abroad, even th<JU!lh
reserve for a typical individual within the state. What is a
for the individual may not be a hard asset for a single coontzy(
The larger the fraction of money that is 'backed up'
nationally acceptable money the greater the reserve on handfor
tingencies. An extreme case is that where the country uses
1 tl\o lakes, but 1f the lakes are connected by canals the average intensity of the
money as its circulating medium.
1 A country could !JO!d more than 100 per cent reserves, as it
marginal social utility of reserves exceeds the marginal private utmty;
currency-area issue. If two countries form a currency area the domain
of risk-sharing is extended as Arthur Laffer has emphasized. A
harvest failure, strikes or war in one of the countries causes a loss of
real income, but the use of a common currency (or foreign exchange
reserves) allows the country to run down its currency holdings and
cushion the impact of the loss, drawing on the resources of the other
country until the cost of adjustment has been efficiently spread over
the future. If, on the other hand, the two countries use separate
monies with flexible rates the whole loss (with a qualification) bas to
be borne alone; the common currency cannot serve as shock absorber
for the nation as a whole except (this is the qualification) insofar as
the dumping of inconvertible currencies on (black or white) foreign
~arkets attrac ts a ~peculative capital inftowinfavour of the deprecia-
ting currency. 1 W1th the closely connected exchange markets in the
West and diversified money holdings one could always rely to some
exte~t on stabilizing speculation, at a low enough currency price, to
provtde extra resources to provide some cushion for the other
country.
Be that as it may, most local monies are not money on a world
scale, and a country cannot rely on external markets to act as an
e.ffic!ent shock absorber in case of national calamities. Money is
hqutd to a country or person only when the demand is elastic and it is
highly unlikely that most of the hundred-odd currencies in the world
C:Ould be used as eme~gency reserves even in a world where enough
time had lapsed to bnng foreign exchange markets into being. The
argument is especially valid for the smaller lesser-known national
currencies, and it is one reason why central banks (or governments)
hold reserves and maintain iixed exchange rates. A purpose of re-
serves is to maintain confidence in the ability of a central bank to
defend its rate. Except for surplus contingency reserves and working
balances, reserves are for display, not use. A fixed exchange rate
system is a device for automatic cushioning of shocks without
destroying the image of the international moneyness of the national
money in the public mind.
The foregoing argument has been made explicit by Arthur Laffer 2
: Random ra!cl"alls in an area will lead to rising and falling waterlevels in any
fluctuations decreases.
2 'Two Arguments for Fixed Exch!lrl!le Rates', Chapter 1 in this volume.
 116 THE ECONOMICS OF COMMON CURRENCIES
and it has long been implicit in the arguments for fixed exchange rates
of Robert Triffin and some central bankers. The argument is import-
I, ant enough to model.
L-
II CURRENCY AND MERCANTIL!Sl>l
Consider a world of two islands, one south of the equator, Capricorn,
and one north of the equator, Cancer. Both islands can produce
a single crop of perishable food each year, but Capricorn's crop
ripens in the autumn and Cancer's crop ripens in the spring. Food in
each island can be stored for up to six months, after which it is unfit
for human consumption. Let us suppose that the population of the
world is equally distributed, initially, between the two islands.
Under these circumstances one can ask: How should world society
be arranged? Let us suppose first that there is no barrier to the
movement of people or food from one island to the other. Then
solutions present themselves at once. One solution is for the ____, >
world population to spend six months in Cancer and six months .
Capricorn. When the Cancer crop ripens in the spring the · what does it receive in exchange? It must receive an evidence of
take the food with them to Capricorn and consume it during
period they are producing the crop in Capricorn. By the
Cancer crop is exhausted but the Capricorn crop matures and
brought with the population to the northern island to
Cancer's crop. The other solution is for the people to stay where
are and engage in trade with food being exported by Cancer
summer, and by Capricorn in the winter. Whethe>ec,;th~~is~~;;~~~o;~,
the yearly migration will dominate wi!I depend on t
or externalities, primarily transport costs and taste patterns.
grain shipping is cheap, trade will emerge whereas if popullati<
move, the migration solutions will prevail. Externalities
climate will play a part. For example, I am told that many
British go to Spain and the south of France to bring in the
enjoy the sun, just as the ducks migrate southwards every
But generally speaking, the human race tends to be rather
and prefers to trade rather than migrate.
Let us now suppose instead that the world population
equally between the two islands and that there is no mc>bil'ity
them; transport costs are infinite. If there were
shipping of food the populations would die out. For h•'"""~
UNCOMMON ARGUMENTS FOR CoMMON CURRENCIES 117
population of each island would be without food, so eventually each
island would be without population.
One can see the symbiosis of the populations of the two islands.
When food can be shipped from one island to the next an arrange·
ment can be made by means of which half of Capricorn's crop
maturing in the autumn can be shipped to Cancer in exchange for
half of Cancer's crop shipped in the spring. In this situation each part
of the world's population wiii work half a year and spend the rest of
the year in leisure, while the world food production will be evenly
distributed and consumed throughout the year. The population of
each of the islands is dependent for its survival on the population of
the other.
We want to explore now the nature of the credit instruments or
financial arrangements by means of which the exchange necessary for
survival takes place. One arrangement is state trading, but let us put
that aside for now and concentrate on arrangements compatible with
the free market. Let us suppose that both Cancer and Capricorn re-
spectively produce one hundred units of food in the spring and
autumn. In the spring Cancer ships half its crop to Capricorn, but
Capricorn's debt, a claim to part of Capricorn's wheat crop maturing
in the autumn. Who produces the claims?
Suppose that in the previous autumn when Capricorn's crop was
maturing, the government of Capricorn issued money to Capricorn's
citizens in exchange for half of Capricorn's crop, where the money
received was interpreted by Capricornians as an equivalent claim to
food in the spring. To make good on the claim the CapriCorn central
bank has to acquire a claim on half of Cancer's spring crop. Now jf in
the autumn the Cancer bank issues claims to Cancer spring wheat to
the Capricorn bank in exchange for current autumn wheat, the
arrangement can be completed when the Capricorn bank delivers the
autumn wheat to the Cancer bank (in return for Cancer notes), and
the Cancer bank sells the wheat to Cancerians to redeem previously
issued Cancer notes.
Our interest is not primarily in how the arrangement gets started
but in the nature of the rotating equilibrium. Every spring the Bank
of Cancer will be engaging in open market purchases of wheat from
Cancerians, increasing the Cancer money supply by an equal amount,
and the country as a whole will be running a balance-of-payments
surplus equal to the sales of wheat to Capricorn. The Bank of Cancer
 118 THE ECONOMICS OF COMMON CURRENCIES
will thus be acquiring Capricorn notes and issuing to Cancerians
Cancer notes. Meanwhile, the Bank of Capricorn will be running a
balance~of~payments de.ficit and engaging in open market sales of
food, reducing its indebtedness to Capricornians while increasing its
indebtedness to the Bank of Cancer. The process is reversed in the
autumn.
I This arrangement would function satisfactorily in a world of cer~
tainty in which crops were known in advance and no defaults were
made on the redeemability of currencies. But in a world of uncer~
tainty it would be subject to speculation about the convertibility of
foreign currencies. Suppose, for example, Cancer's spring crop was
below average; Capricorn would hold Cancer's currency but the
complete conversion of these liabilities at par into food would mean
that the whole burden of adjustment to the crop failure was borne by
Cancerians. For example, if the spring crop were normally 100 units,
equally divided between the two islands, Capricorn would present 50
units of Cancer's currency and get an equivalent in food; but if in
one year the crop produced only 70 units of food, the complete
redeemability of Cancer's notes would leave Cancerians with only
20 units.
Such a situation would not be viable. Devaluation of Cancer's ..
currency would be the usual defence against having to pay out half·
the crop, depriving residents of the bulk of their produce. At
extreme they could declare the currency worthless. Tllis
would leave Capricornians without food and they would
tion not in Cancer's interest; the result would be .Olnc•ed'<m ,ge.mci~o/
in the short run and suicide in the long run. For without the
;-- the following autumn. Consequently both altruism and 1
cornians the Cancerians would die next spring and the C a;;;~~;:::
would dictate only a partial devaluation so that ihe burden of the
could be shared.
An analogous situation occurs if there is a bumper crop. ·
Cancerians have to pay 50 units to the Capricornians and are
with the remainder, which is more than 50 units. Of course
tion of the currency is possible, this being one way of giving
part of the surplus. In the short run this appears to be an
gift, but in the long run it has the beneficial effect
convention of 'sharing' the good as well as the bad.
The important point to recognize, however, is that when
different currencies the threat of devaluation i~tro<im,.sanad·ditii?!
UNCOMMON ARGUMENTS FOR COMMON CURRENCIES 119
element of uncertainty into the system. Each country depends on the
other but the producer of the current crop calls the tune in the short
run even though, in the situation under analysis, the ability to exploit
this opportunity is limited by international symbiosis in the long run.
Forward exchange transactions are of no help either because they
lack credibility when major disruptions occur. In the case under con-
sideration there would be strong incentive for the two countries to
establish in advance a set of rules or laws- a monetary order- for
the sharing of the gains and losses of fluctuations in the harvest.
A common money performs the sharing function very effectively.
Suppose that the two countries agree to the creation of a common
currency. Before the spring harvest Capricorn puts into a world
bank 50 units of the claims it holds on Cancer's spring crop, and gets
in exchange 50 units of world money. When the spring crop emerges
the Capricornians use their world money to buy 50 units of Cancer
money from the Bank of Cancer (which has agreed to accept world
money) with which they buy half the spring crop; and then the
Cancerians exchange their 50 units of Cancer money for 50 units of
world money. The balance sheet of the world bank will then involve
assets amounting to 50 units of the money of each country and total
liabilities of IOO units of world money. Producers in Capricorn will
be using 50 units between the spring and autumn harvest to pay the
expenses of production of the autumn crop, while consumers in
Cancer will be holding 50 units to buy half the Capricorn crop
in the autumn. The process will be exactly reversed in the winter
months.
At this point there will not appear to have been a gain to the sys~
tern as a whole by the amalgamation of the two monies. But the gain
appears when the variability of the crops is taken into account. For
example, suppose again that the spring crop in Cancer is below the
average, let us say at 70 units. Then Capricorn consumers hold 50
units of the world money as do Cancer producers. As long as com~
petition prevails and there are no delays in the transmission of goods
or information the 100 units of world money will exchange for the 70
units of food irrespective of who holds the money; this is because
competition and freedom of arbitrage assure the single price. The
price of a unit of food thus rises to 100/70 for both Capricornians and
Cancerians and the burden of the harvest fluctuation is met equally
by the two islands. The common currency assures an automatic and
equal sharing of the risk of the fluctuations.

THE EcONOMICS OF COMMON CURRENCIES
120
III THE GEOMETRY OF THE RISK ARGUMENT
It is possible to illustrate formally the gains from sharing the risk of
fluctuations. Let qr in Figure 7.1 be potential consumption in period
t and q . be potential consumption in period t+l, the line BB'
1
repres~ting the opportunity line of the country. For simplicity the
slope is taken to be -1 and the choice is made to divide income
equally between the two periods as indicated by the choice of the
point F.
UNCOMMON ARGUMENTS FOR COMMON CURRENCIES 121
to u2 *. For both upward and downward fluctuations iixed exchange
rates. increase the galn or decrease the loss. It is always better to
fluctuate between F and Ethan between C and D. The gains from a
common currency system arise from the opportunity it allows a
country to redistribute through time the burden of random fluctua-
tions. The use of a common currency of a currency union by one
member implies involuntary lending on the part of the remaining
members. The 'borrowing' member gains, but do other members lose

qt+l ~-------------=~8
s' l
qt+l

'
'

'' f
A Gt
Figure 7.2

Figure 7.1 less? To prove that gains and losses for a single country are cushioned
by the use of reserves is not the same as demonstrating world gain
since the costs may be borne completely by the partner country.
Now let us suppose income is subject to fluctuation, o•oillafuJtl
To complete t11e proof let us assume two time periods, t and t+ 1,
a pendulum from C to D and back again. Then utility
between u1 and u2 • When reserve changes are possible,,, ~:::~
0
and two countries. A and B. Suppose the countries are alike in tastes
and resources, and also symmetrical in the two periods. In Figure
under fixed exchange rates for example, or under a c;
7.2 the average income is distributed at the consumption point P on
rency, inter-temporal autarky is not necessary. Instead of
u , utility need only fall to u 1*; instead of rising to u2 , utiii'tlyc<ii the contract curve AB.
1

122 THE ECONOMICS OF COMMON CURRENCIES
Now consider rhythmic disturbances affecting both countries
equal to HJ and LK in total amplitude: Strikes or harvests or wars
with third parties create a dispersion lowering or raising consump-
tion potential in country A by HP or PJ in period Cr+I and LP and
PK in period C,. Now if the :fluctuations in income in country A
required fluctuations in consumption there also, the consumption
pattern would recurrently involve points like the vortices H, K, J
and L, which are suboptimal. Given random fluctuations, points
anywhere in the square RSTU are possible. The possibility of efficient
reserve cushioning restores Pareto optimality, and when random
:fluctuations in both countries and time periods are allowed for, the
zone of contract shrinks to the square QMNO. The risk from income
fluctuations is, therefore, unambiguously reduced, the saving being
the dotted zone of excess suboptimal positions. I shall refer to this
contribution as Laffer's proposition.
The dotted area in Figure 7.2 indicates the welfare cost arising
from the loss of the automatic credit facility provided by the fixed
exchange rate system. 1
IV CURRENCY UNIONS AND SWAPS
In between the extremes of zero (or negative) reserves and reserves of
100 per cent or more, we lack guidelines to govern a country's
serve policy. What is the optimal level of reserves?
Zero reserves and floating exchange rates are suboptimal
of the externalities associated with the currency prices. It
for no national cushion against shocks and forces upon
the need to bold excessively large -socially non-optimal-
offoreign money. At the other extreme, however, a 100 or mu"' P''"'
cent reserve system will be suboptimal except in countries where
state's need for emergency reserves exceeds the needs of
The opportunity cost of higher reserves has to be balanced
the benefits the reserves provide in cushioning the system
1 Some of its broader implications are beyond the scope this
worl
of d north so~t~h,jro~1"f;"~'~'~~"~"~"~w~o~u;ld:~tr~y~j'"£~~~~]~~~l~l~i
currency areas as a hedge against risk and
marketofarmngements
and in a politically
spring and autumn
the
and
at a mercantilism model; · one power of the
becomes imperialistic. Attention should be drawn the
elusions are the opposite of those of Viner's Customs Unirm Issue, in wbioh,,fr<
world welfare criterion, union between rivals is best.
UNCOMMON ARGUMENTS FOR COMMON CURRENCIES 123
shocks. The balance of these two opposing forces produces an
equilibrium level of reserves that is optimal. We seek practical
criteria of the characteristics of the optimum.
Let us use as the index of reserve adequacy the number of months'
imports reserves will buy. The proposition suggested below is that the
unadjusted optimal reserve index is equal to twelve times the recipro-
cal of the income velocity of money.
Consider a population randomly distributed over a transactions
domain using a single currency. Every economic entity- person,
firm, institution- in it wili settle on, by experience, a given average
level of money holdings suitable for its needs. The desired level of
reserves will be positively related to the level of transactions and
negatively to the opportunity cost of holding the reserves. These
ratios vary between individuals and countries and will change over
time due to long-run trends as financial innovations change optimal
liquidity holdings, or make changes in the definition of money assets
needed to satisfy liquidity requirements. Nevertheless, the liquidity
ratios as measured by the ratio of cash balances to income, expendi-
ture or transactions do provide an adequate benchmark to judge the
adequacy of individual liquidity holdings as a first approximation.
Let n be global population and s the number of people inn com-
prising a currency area. Required external reserves R needed by s is
obviously a function of nand s:
But what is the explicit form of the function?
An answer can be found by relating the required reServes to the
number of transactions, T. Let c be the money needed per transac-
tion so that
M=cT.
We need then to know how transactions vary with the size of the
population.
We assume each transactor engages randomly in transactions with
other members inside or outside the currency area. Let o be the value
of transactions per person with each other person. Then the average
number of transactions for each person is e(n-1) where n is the
number of transactors. The total world value of purchases or sales
is then
 124 THE ECONOMICS OF COMMON CURRENCIES
and the reserves needed for the world as a whole are
M= cen(n-1).
Now we ask again, how can we determine the saving of external
reserves, R, needed by a currency area composed of .s members of the
population n?
The total money needed by the s-membered currency area is
s lls+I
M, =- M = c es(n-1).
n compared to the original ratio of
But we need to know what fraction of this is accounted for by the
need to finance external transactions. External transactions are
as(n-s), counting only purchases, so we find that the needed external
reserves of the s-membered currency area is
R, = ces(n-s).
The reserve saving is therefore
M.-Rs= ccs(n-1)-ces(n-s)
= css 2 -ces
= ces(s-1).
If the monetary authorities of a newly formed s-membered currency:
area replaced an international currency, it would collect cBS(n-1) Ci :>
international currency from members, giving an equal amount of __ _
newly-created domestic money in exchange. But 100 per cent re-. ::'
serves behind the domestic money would now be unnecessary be:~:.:
cause s(s-1) of the transactions are internal to the currency
The appropriate reserve ratio is evidently only
R., ces(n-s)
-= =--
M, ces(n-1) n-1
which is clearly less than unity for s> l. We can now ask: Wllat!S tne,,
gain from an internationalization of reserves that oom•o tmm ''"'l,tt
a new member to the currency area? For a given s we have
external reserves of cBS(n-1). The shift of an outside co,unl,ryinto
area reduces external transactions of the inside members by
adds external transactions of the new member of ,c;(n-s).
level of required reserves is therefore
R•+l = ce(n-s-1)(s+1)
UNCOMMON ARGUMENTS FOR COMMON CURRENCIES 125
and the reserve saving is
R•+I -R. = c,c; [(n-s-1)(s+ 1)-s(n-s)]
= n-2s-1.
The new reserve ratio is
R.h (n-s-l)(s+l) n-s-1
= -M-,-+-1 = ce ce(s+l)(n-1) = --=n-cl.-
n-s
tt= n-1·
The reserve ratio falls as the size of the area increases.
Now we have to ask what are the costs and benefits of adding
another member to the area. He brings his own reserves to the area
but adds his own purchases from non.members, but decreases the
external purchases of the other members. Before entering the mone~
~y union he would hold reserves of c,c;(n-1) which he could bring
mto the central reserve pot, 1 while his own external transactions
would add n-s-1 to the external transactions of the area, and
decrease those of other members by s, leaving a residual ofn-2s-1,
th: figure noted abo~e. Clearly it is always beneficial, from the stand-
pomt of reserves savmg to add another member to the area.
VA PARADOX
Now a most intriguing paradox arises. If we start off With a world
currency there will be a tendency for it to break down into currency
areas as countries try to exploit the gains from reserve saving. When
two members of a common currency system pool their reserves they
no longer need as many reserves jointly as they needed singly. But any
two transactors can achieve this gain. There seems to be no limit to
the process since it is always profitable to add extra members to the
union. The optimum currency area is the world but a world currency
area is unsustainable!
If this argument were complete we would expect to find persistent
throbs of integrative and disintegrative forces making themselves felt
exterm~:J rese.rves may be h~ld in the form of the currency of the original
1
His
eurre~cy area, m W~!C~ cas~ th~ .&tu.n would have to be discounted by the extent
to Wh!ch the rcduct1on m a hab1hty !S worth less than a gain in new reserves.
126 THE ECONOMICS OF COMMON CURRENCIES
in the world economy. There would be tendencies for gold, silver,
currency standards to rise and fall recurrently. These forces can be
observed historically, but the time period over which they operate is
very long. There must be other forces at work that impart more
intermediate--run stability to the economic system. One of them is
transactions costs which ultimately determine the number of ranks in
the currency hierarchy. But our interest is in factors other than
transactions costs.
Let us consider more explicitly the functional forms for
R~R(,,n)
considered above, The required reserves are precisely
R$ = ces(n-s)
which reaches a maximum when
oR,
-=cen-2c8S=0
a,
i.e. when
s=±n.
As a currency area becomes larger it needs larger absolute external _
reserves until it becomes more than half the world, after which it,;:: :
needs fewer reserves. This is a fundamental though perhaps ·
result. After a certain point the shift of countries to a currency
reduces the absolute need for reserves on the part of existing
bers. To carry the argument close to its apotheosis, a currency
of all countries except Andorra would need rather few reserves.
It is this same principle that underlies the relation between .
usefulness of the IMF quotas and their size configuration.
Consider now a single-currency world. There are obvious
from breaking it down. Pairs of countries can always make re,ery~
saving bargains to their mutual advantage. But the gains
currency union proceed. An extra country always helps (by
saving criteria alone) by putting into the common pot mc>reex
reserves (though an adjustment has to be made for liabilities it
of the fanning centre) than is needed to 'finance' the
transactions of the enlarged area. However, there are
checking expansion, One is the splitting up of too large a
other is a coalition curtailing excessive aggrandizement. Let
sider the latter problem. Let the world be divided, initially,
UNCOMMON ARGUMENTS FOR COMMON CURRENCIES 127
currency areas, rands so that r+s =nand choose units so that
llC = 1.
Then
M, ~ '(n-1); M, ~ r(n-1)
R.=sr; R, = rs.
If a member now shifts from r to s the new levels are
M,.,~(H1)(N-1); M,_, ~ (r-1)(n-1)
R~+ 1 = (s+1)(r-1); R,_, ~cr-1)(H1).
The change in the needed level of reserves of the initial s-membered
bloc is
R.+ 1 -Rs= r-s-1.
If the mobile member brings with him n-1 of reserves the extra
liquidity of the bloc is
n-1-(r-s-1) = 2s
or twice the initial membership. However the loss of net liquidity of
the initially r-membered bloc is given by the change in the level of
reserves needed,
R,._ 1 -R,.=r-s-1
minus the loss of reserves taken by the mobile member. If the latter is
again taken to be his total money supply, n-1, the releasing bloc
gains
r-s-1-(n-1) = -2s
of liquidity. Competition for the affections of the mobile member will
then exert countervailing forces to prevent the split-up of the mem-
bership. The nature of the competition would take the form of
exchange guarantees, higher interest rates, or banking services but is
not within the scope of consideration here. Swaps would proliferate
to capitalize on the reserve saving when the transaction costs for
creating a common currency are too high. All such agreements are
inflationary.
There are different stages of currency unions that correspond to
different types of gain associated with monetary union. There are,
first of all, three types of gain accruing to the public authorities of
any two or more countries pooling reserves. These are based on the
insurance principle, the internalization principle and the inventory
principle. The insurance principle arises from risk pooling, as we
128 THE ECONOMICS OF COMMON CURRENCIES
discussed in Section I, and can be exploited by a reserve pool; the
second principle arises from the reserve saving due to the internaliza~
tion through credit of what was formerly external trade and can be
achieved through swap arrangements (or a reserve pool); the third
principle sterns from the economies of scale associated with spreading
overhead costs of transactions further- the gains in this case can be
achieved by merging financial managements.
There are also economies experienced through the improvement in
the asset used as money by the joining populations, and there are,
similarly, three principles through which these gains are experienced:
intermediation, information and innovation. By the creation of a
common currency in place of two separate national currencies, an
element of risk is reduced to the extent where the moneyness of each
currency is increased. There are, second, economies of information.
The single currency performs as a medium of information (a quota·
tion, unit of account, etc.) just as well or better than the two cur·
rencies did before (after an initial fixed cost of adjustment) but it
reduces one price quotation needed, yielding an information saving.
Finally, there is the innovational aspect of the new currency, which
is superior to the two old currencies partly due to its greater size,
hence stability, insofar as the adjustment burden has to be borne in
inverse proportion to the size of the monetary domain.
Table 7.1 summarizes the nature of the principle involved and the·.···
gains to which they lead or have led in some actual cases.
Table 7.1
Principle Instrument Example
Insurance Reserve pooling Sterling Area pool
Internalization Clearing or swaps ill'U
.•.
Inventory Joint management Belgium-Luxembourg . ·
Intermediation Fixed exchange rates U.S.A.-Panama
Information Policy ccrordination CCC
Innovation Common currency Puerto Rico-U.S.A.
VI A LIQUIDITY INDEX
Let us now use the results obtained to make progress towards
one of the fundamental problems of the international monetary .
tern. What determines the quantity of international reserves
UNCOMMON ARGUMENTS FOR COMMON CURRENCIES 129
by the system as a whole and by individual countries within the
system? We have shown the advantages of using international
reserves as a shock absorber in the system and the advantages of a
common currency, On the other hand 100 per cent reserves as under
a common currency system is clearly excessive. In between zero
reserves and I 00 ·per cent reserves we should be able to establish
a liquidity index that represents the number of months' imports a
currency area holds in the form of reserves. Define
Reserves ( ) Number of months' imports
(J = Imports per year x 12 =held in reserves
equals the liquidity index.
We want to find criteria for establishing in practical terms a
numerical value for this index. In the preceding analysis we were able
to establish that the ratio of external money to internal money
should be
Reserves n-s
=!l=-
Money n-1
on the assumption that there is no 'localization' of transactions. We
can, however, relate the openness coefficient (n-s)/(n-1) to the
. import/income ratio. For an s~membered currency area purchases
from outside the area (imports) are es(n-s) while total transactions
are es(n-1). The ratio of internal to external purchases is therefore
equivalent to the ratio of imports to income so that
n-'
m=--.
11-1
We then find that the reserve ratio should be equal to the import
income
Reserves Income Imports Money
(R) x (Y) ~ (I) X (M) .
It follows then that
a~ 12M/Y ~ 12/V
where Vis the income velocity of money. Vis an increasing function
of the rate of interest.
The liquidity standard is not a magic constant of social nature any
more than the gravitational coefficient is a constant of physical
nature. It could in principle be affected by political and economic
130 THE ECONOMICS OF COMMON CURRENCIES
variables. It has even been argued that it is not possible to have a
measure of reserve adequacy because the latter depends on the
vicissitudes of speculation, the state of the world and the whims of
the central banker.
There is, of course, a sense in which this judgement is correct but
it is not a sense in which science can be of much help to political
economics. The purpose of science is to simplify, not complicate.
Reality is too complicated to talk about and the best science can do is
to provide rough guidelines for policy. Only a naive person would
apply this standard measure to an individual country uncritically. It
would make no more sense than applying the Newtonian formula for
the time it takes an object to fall to the earth without allowing for
differences in barometric pressure, wind, etc. Certain countries antici-
pating bad harvests, strikes, wars or new rivals may need more than
this amount, while others protected by credit worthiness can get by
on less.
Nevertheless the standard measure does provide a bench mark
against which other considerations can be brought to bear. The ratio
of reserves to the money supply should correspond to the openness
propensity of the economy. In the United States, for example, the
reserves should be that fraction of the money supply that imports --..
represent in aggregate e:~,:penditure. With the import ratio at 4 per :·- ·
cent, and the non-interest-yielding money stock at $200 billion, free
U.S. gold reserves should be $8 billion. The behaviour of reserve ___
centres is likely to be unique since they have automatic overdraft ·::.
faculties. Other countries can easily calculate these indexes
themselves.
For the world as a whole the velocity of money is about four, so
index suggests a level of reserves equal to about three mcmtns~i
imports.
At the current level of world imports, $280 billion, this
reserves of $70 billion. This makes no allowance for
the world environment which has probably increased
liquidity by as much as inflation has altered its form.
It is a common error, in interpreting monetary phen<>mem>,:l
confuse cause and effect. With a fixed exchange system the
supply in an open economy is a dependent variable, ewiOjlenot>
determined by the need of each dependent economy to p~::~~
balance of payments. Thus an increased income level will p
increase in demand for money and reserves, which will
UNCOMMON ARGUMENTS FOR COMMON CURRENCIES 131
penditure and improve the balance of payments, leading to an
increased supply of money and reserves; this demand-induced change
in reserves will generally be associated with high interest rates. On the
other hand, an increased supply of reserves and money will lead to
increased expenditure and income; this supply-induced change in
reserves will generally be associated (temporarily) with low interest
rates.
In the world economy it is necessary to keep several propositions
separate. As world trade grows it can be assumed that the demand
for reserves increases; in this sense the demand for reserves is a func-
tion of trade, On the other hand, world trade is itself a function of the
supply of world reserves (via domestic monetary policies). The prob~
lem of disentangling supply and demand for reserves is therefore a
serious one. If world reserves are easy to measure (e.g. gold stocks)
there are no grave problems of identification provided stable supply-
of~gold functions can be assumed. But if the supply of world reserves
is itself a function of the demand for them, as is certainly suggested
by the current proliferation of swaps, the problem of identification
looms large again unless we have explicit theories of swap creation.
The analysis of Section III of this paper has shown how swap ar-
rangements and the creation of a required central bank are substitutes
for one another, and leads to a general theory of swaps.
The dynamic implications of the very simple system I have de~
veloped is that world trade, as measured, say, by imports, will
expand or contract depending on whether the actual liquidity posi~
· tion of the world economy exceeds or falls short of the liquidity
standard along the lines suggested by the following equation:
dJ ~ p(R:c -I)
dt a
where Pis a speed of adjustment. Such a guide is suggestive, rather
than rigorous, but could easily be extended to take into account
second-order effects.
We may conclude this analysis by showing how the study of the
optimum reserve ratio has a bearing on the problem of the optimal
speed of adjustment. In addition to the above adjustment equation
for an individual country we have the balance-of~payments identity
dR
dt ~ X(t)-1.
132 THE ECONOMICS OF COMMON CURRENCIES

We want to find the slowest adjustment speed, p, that is compatible

with adjustment without fluctuations, taking exports as constant. Chapter 8
By differentiation and substitution we get
POLICY CONFLICT, INCONSISTENT GOALS,
d' I dl p AND THE CO-ORDINATION OF ECONOMIC
dt2 +Pdt+;;:I=O
POLICIES'
which is stable. It will oscillate in approaching equilibrium, however, ALEXANDER K. SWOBODA
unless Graduate Institute of International Studies
P> 4/cr ~ 4/3 per month
if we use our guide that a = 3 months. This means that if imports are
above or below normal they should be run down or built up at a rate
Simultaneous achievement of internal and external balance by the
which would correct the discrepancy within three weeks.
world's- or a currency area's- economies constitutes a major prob-
lem for economic policy. This problem must be solved if international
economic disintegration is to be avoided. It is particularly acute when
increasing economic integration is pursued under a regime of fixed
exchange rates -as it would be under a scheme of regional monetary
integration.
Indeed, the optimum currency-area question was originally raised
in this context: the benefits of having a single currency are balanced
against the internal adjustment costs attendant on the restoration
of external balance in the face of a change in the terms of trade.
The optimum domain of the currency area then spans that area over
which the tenus-of-trade change can be effected under fixed exchange
rates without bringing about (too large) deviations from internal
balance; this may, for instance, be the domain over which factors of
production are mobile. 1 In the context of this paper and of particular
instances of monetary union, it is probably more useful to cast the
analysis in tenns of ~·iable rather than optimum currency areas. The
optimum currency area may be smaller or larger than the viable
currency area, viability being characterized by the possibility of re-
conciling (at least within tolerable margins) internal and external
balances under fixed exchange rates for a given group of countries or
regions.
International co-ordination of economic policies has been pro-
posed, both in general and in the particular context of monetary
"' I am indebted to Harry G. Johnson for his comments on a first draft of this
paper.
1
See Robert A. Mundell, 'A Theory of Optimum Currency Areas', American
Economic Review, Vol. LI, No.4 (September 1961) pp. 657-65.