The Monetary Approach to Official Reserves and the Foreign Exchange Rate in France, 1962-74: Some Structural Estimates
Any test of the monetary approach centered on the period of fixed exchange rates would now be predominantly of historical interest. At the time of this study, however, experience with flexible exchangc rates was still too short to permit concentr.ating econometric analysis exclusively on this more recent system. Caught in this net, we have attempted an analysis of official reserves and the foreign exchange rate in lIr;unce covering both fixed and flexible exchange rates, that is, thirty-nine quarters of tixed rates, 1962.11971.3, and thirteen quartcrs of flexible rates, 1971.4-1974.4. cost is the presence of errors in our simultaneous equation estimates of the exchange rate during the period of fixed rates. But the benefit is an econometric analysis founded on fifty-two observations, and yet covering three years of flexible rates. Since the errors in the estimates of the exchange rate under fixed rates are quite moderate, the cost would seem to be worth the benefit. most important characteristic of our work is the use of a detailed structural model of bank credit and money in testing the monetary approach. early tests of this approach simplified the structure of the monetary to the utmost and considered the domestic source component of the reserve base (or the total base minus official foreign reserves) and the money multiplier as exogenous.' But there is really no logical basis for these restrictive assumptions. monetary approach states that the demand and supply of money in a small country together determine 1) money, and 2) official reserves or the foreign exchange rate or the attainable combinations of the two, depending upon fixed, floating, or managed exchange rates. Nothing but a correct specification of the conditions for monetary equilibrium can provide a basis for testing this proposition. We also deviate from the tendency in the literature on the monetary approach to suppose that any convenient measure of money will do. Based on this attitude, there have been many tests of the monetary approach using simply the reserve base as the measure of money, even though this aggregate, consisting of currency plus an arbitrary fraction of deposits, is inappropriate in analyzing the monetary behavior of firms and households.2 In justifying this measure in a well-known econometric work, Pentti Kouri and Michael Porter nmerely say: The essential features of the model [would not be] substantially changed by incorporating a more complete banking system (p. 448). But not only does this fail to meet the criticism, it also neglects the fact that the monetary approach can give rise to conflicting estimates of changes in official reserves and the exchange rate depending on the money measure.3 There is no way of assessing the seriousness of this last objection without testing. In this work we shall examine the extent to which varying and tenable money measures in France yield convergent results. In spite of these deviations from the literature, we may be said to adhere to a strict
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