ARTICLE IN PRESS

Journal of Monetary Economics 50 (2003) 13331350

A model of the Federal Reserve Act under the international gold standard system$
Hiroshi Fujiki*
Institute for Monetary and Economic Studies, Bank of Japan, 2-1-1, Hongoku-cho, Nihonbashi, Chuo-ku, Tokyo 103-8660, Japan Received 24 November 1997; received in revised form 16 October 2001; accepted 11 September 2002

Abstract Freeman (Am. Econom. Rev. 86 (1996a) 1126) shows that an elastic money supply enhances the efciency of monetary equilibrium by clearing default-free debts at par value in the domestic credit market. This research adds a foreign exchange market to Freemans model and extends his analysis into a two-country model, in which the arrival rates of agents are not equal between the two countries. In this model, an elastic money supply in the foreign exchange market to clear the exchange of at monies at gold standard parity, accompanied by an elastic money supply in the domestic credit market, could improve the efciency of monetary equilibrium. r 2003 Elsevier B.V. All rights reserved.
JEL classication: E58 Keywords: Central Bank; Clearinghouse; Foreign exchange market

The author would like to especially thank an anonymous referee and Robert King for their extremely insightful comments on earlier versions of this paper. The author also thanks Edward Green, Akihiro Matsui, Ruilin Zhou, and seminar participants at the Federal Reserve Bank of Minneapolis for their useful comments on earlier versions of this paper. William Roberds and Scott Freeman suggested to me a complementary work by Hernandez (2002), that shows under different assumptions on agents consumption and production, similar environment studied in this paper could result in no trade in the foreign exchange market. This work is based on research conducted when the author was a Visiting Scholar at the Federal Reserve Bank of Minneapolis and an Associate Professor at the Kyoto Institute for Economic Research, Kyoto University. The author would like to thank the Federal Reserve Bank of Minneapolis for their hospitality. However, the opinions expressed in this paper are those of the author, and do not necessarily represent those of the Bank of Japan or Institute for Monetary and Economic Studies. *Corresponding author. Tel.: +81-3-3277-1514; fax: +81-3-3510-1265. E-mail address: hiroshi.fujiki@boj.or.jp (H. Fujiki). 0304-3932/$ - see front matter r 2003 Elsevier B.V. All rights reserved. doi:10.1016/S0304-3932(03)00080-1

ARTICLE IN PRESS
1334 H. Fujiki / Journal of Monetary Economics 50 (2003) 13331350

1. Introduction The Federal Reserve Act of 1913 established a nationwide settlement system with a lender of last resort, aimed at preventing seasonal uctuations in interest rates by supplying money elastically in accordance with the Real Bills Doctrine. Freeman (1996a, b) demonstrates why such a central bank operation is desirable in general equilibrium monetary models. He considers an economy where agents are spatially separated, and thus, private debt incurred between two parties can only be redeemed with at currency at a central clearing area. Suppose that the departure rate of creditors from the central clearing area is higher than the arrival rate of debtors. In this case, the amount of currency available at the central clearing area is less than the par value of debt, and late-departing creditors can buy the risk-free assets of earlydeparting creditors at discounted prices in exchange for at money. The resulting equilibrium will be liquidity-constrained. Suppose a central bank issues additional at money to purchase the IOUs of early-departing creditors, and receives at money from the debtors at the central clearing area. Then, the IOUs of earlydeparting creditors can be cleared at par value, and the money stock remains constant as long as this central bank takes the money received from the debtors in the second-hand debt market out of circulation. Such a central bank intervention leads to an optimal allocation of resources. By this reasoning, Freeman shows that an elastic money supply to smooth the seasonal uctuations in the nominal interest rate in the short run, and a constant money supply in the long run, are consistent and desirable policies. As West (1974) argues, like the Real Bills Doctrine, the international gold standard system was an important foundation for the Federal Reserve Act of 1913. Therefore, this paper extends Freemans model into a two-country model under gold a standard, and seeks additional policy implications. The analysis in this paper shows that an elastic money supply in both the domestic debt market and the foreign exchange market arranged by the central bank a la Freeman is required to enhance the efciency of monetary equilibrium. More specically, consider the two-country model of Freeman (1996a), in which old creditors are subject to taste shocks. They want to consume young foreign debtors goods in their second stage of life with a small probability. Suppose that old creditors know their preference for foreign goods only after their debt is settled in their domestic central clearing area. Due to the country-specic cash-in-advance constraint, old domestic creditors must pay foreign currency to obtain goods from young foreign debtors. Imagine the turnpike of Townsend (1980) that connects the central clearing areas of two countries. Old creditors with taste shocks travel this turnpike, and they meet old creditors coming from the other country at a trading post. They exchange their at money for the at money of the other country. Suppose that the arrival rates of old creditors with taste shocks to the trading post are not equal between two countries. For example, if one country is inhabited by many bankers (or late-departing creditors), only a small fraction of old creditors come to the foreign exchange market in the early stages of the market transaction. Then, the currency of a country with a large banking sector might be in short supply, compared with the gold standard parity. In such a

ARTICLE IN PRESS
H. Fujiki / Journal of Monetary Economics 50 (2003) 13331350 1335

situation, the at money of the other country, though its value is backed by gold, might be exchanged at a discount. This could happen despite the central bank intervention to clear all domestic debt at per value. Central bank intervention in the foreign exchange market could offset the deviation of the foreign exchange rate from the gold standard parity. Such an operation is incentive compatible for the central bank in the country with the large banking sector under the gold standard. This central bank can obtain foreign notes at a low price in the foreign exchange market from the early-departing old creditors. Moreover, it faces the chance of selling its domestic currency at a premium price in the foreign exchange market to the latedeparting old creditors. After these operations, the domestic money supply increases temporarily by the amount of foreign exchange intervention. This central bank recognizes the risk of a currency attack, and hence it takes the extra at money from the foreign exchange intervention out of circulation. Does any private arrangement, as Green (1997) and Gorton and Mullineaux (1987) suggest, work as a substitute for central banks in a two-country setup? Private clearinghouses can do the same job as the central bank under the gold standard system with full redemption, because this institutional setup brings the total money supply back to a constant level by the end of the period. Other institutional setups might lead to equilibria subject to ination or deation. The organization of this paper is as follows. Section 2 discusses the details of a two-country model with a liquidity constraint. Section 3 analyses a stationary equilibrium. Section 4 discusses policy implications, and Section 5 concludes the paper.

2. A two-country model with a liquidity constraint Imagine a two-country overlapping-generations model as put forth by Freeman (1996a). There are two types of agents, called creditors and debtors, in each country. For the purpose of illustration, let the domestic country be Mexico and the foreign country be the United States. In both countries, creditors and debtors scatter and live in small villages. Their populations are normalized to one, and their lifetimes are two periods. Between Mexico and the U.S., there is a river called the Rio Grande. Agents cannot swim, thus they rst climb up the central hills in each country and then go through the tunnels connecting the two central hills to go to the other country. Hereafter, lowercase letters represent Mexican variables and uppercase letters stand for U.S. variables. Mexican and American creditors and debtors are endowed with goods % specic to their villages in their rst period of life, in the amounts y; x; Y and X % % % respectively. Creditors consume in both periods of their lives, while debtors only consume in the rst period. Both debtors and creditors in each country travel during their lifetimes as summarized in Figs. 1 and 2. The details of their consumption, borrowing and debt settlements, which are summarized in Table 1, will be explained in the following sections.

ARTICLE IN PRESS
1336 H. Fujiki / Journal of Monetary Economics 50 (2003) 13331350
Mexico Debtor Village (4) Central Hill (1) (3) (3) (1) Debtor Village (4)

(2) Creditor Village River Rio Grande Debtor Village (4)

(2) Creditor Village

Debtor Village (4)

(1) (3) Central Hill (2) Creditor Village (3)

(1)

U.S.

(2) Creditor Village

Fig. 1. Pattern of travels when young. (1) Young debtor visits creditors village; (2) young debtor meets a young creditor and obtains creditors goods in exchange for IOU; (3) young debtor goes back to his village; (4) young debtor meets an old creditor and obtains at money in exchange for goods (travels made by old creditors are explained in Fig. 2); Note: Thick solid lines show travel made by young Mexican debtors, and thick dotted lines show travel made by U.S. debtors.

2.1. Travel by debtors Mexican debtors born at time t have a common, additively separable, continuous, and continuously differentiable utility function u udxt udyt : The function is strictly increasing and concave in each argument with indifference curves that do not cross the axes. The argument dxt is consumption from the debtors own endowment, and dyt stands for consumption of a Mexican creditors endowment. The thick solid arrows labeled as (1) in the top panel of Fig. 1 show that after consuming dxt ; a young Mexican debtor visits a young Mexican creditors village. The young Mexican debtor consumes dyt of the creditors good, whose nominal price is pyt at time t: Since this young Mexican debtor does not have money, he goes into debt with a promise to pay ht dyt pyt pesos at time t 1: Afterwards, the young Mexican debtor comes back to his village (see the thick solid arrows labeled as (3) in the top panel of Fig. 1). He sells x dxt of this endowment at the market price pxt to an old Mexican creditor %

ARTICLE IN PRESS
H. Fujiki / Journal of Monetary Economics 50 (2003) 13331350
Mexico Debtor Village Debtor Village

1337

(7) Central Hill (3) (2) (1) (1) (6) Creditor Village River Rio Grande Debtor Village (6) (4) (7) (1) (3) (2) (1) Creditor Village U.S. Debtor Village (5) Currency exchange Tunnel (4) Creditor Village

Central Hill Creditor Village

Fig. 2. Pattern of travels when old. (1) Debtors and creditors visit the central hill, however, the arrival rate of debtors is less than one. Some old creditors identify themselves to be early departing; (2) debts are repaid with domestic at money, and old debtors die after debt settlement. After debt settlement, some old creditors identify their taste shock; (3) old creditors without a taste shock scatter to the debtor village, obtain young debtors goods in exchange for at money; (4) old creditors subject to a taste shock visit the tunnel; (5) in the middle of the tunnel, old creditors with a taste shock exchange their at money; (6) old creditors with a taste shock travel to the central hill of the other country with the at money issued in the other country; (7) old creditors with a taste shock scatter to the debtor village in the other country. Note: The thick solid line shows travel made by old Mexican debtors; thin solid lines show travel made by Mexican creditors. The thick dotted line shows travel made by old American debtors, and thin dotted lines show travel made by the U.S. old creditors.

or an old American creditor born at time t 1 who is visiting his village, in exchange for mt pesos. He will use at money to repay his debt at time t 1: The Mexican debtor born at time t chooses ht to maximize udxt udyt subject to ht =pyt dyt ; ht mt ; and x ht =pxt dxt : The rst-order condition is Eq. (1), %     ht pxt ht ux x uy ; 1 % pxt pyt pyt where ux and uy are the derivatives of utility function u: At time t 1; old Mexican debtors born at time t climb up the Mexican central hill to repay their debt in pesos (see the thick solid arrow labeled as (1) in the upper panel of Fig. 2). However, only

ARTICLE IN PRESS
1338 H. Fujiki / Journal of Monetary Economics 50 (2003) 13331350 Table 1 Steps of trading under liquidity constraint in Mexico Step 1 2 3 4 5 6 7 Young Young Mexican debtors visit domestic neighboring creditors village. Old All old Mexican creditors and l early-bird Mexican debtors visit central hill. 1 a old Mexican creditors identify that they are early-departing creditors. Debt settlement at the central hill begins. 1 a old Mexican early-departing creditors leave central hill. 1 a1 g old Mexican early departing creditors identify their taste shock. 1 ag old Mexican early-departing creditors travel to Mexican debtor island with peso. 1 a1 g old Mexican early-departing creditors arrive at the tunnel and meet U.S. early-departing old debtors, and foreign exchange market opens. 1 a1 g old Mexican early-departing creditors obtain dollar, and continue their travel to the U.S. debtor island via the U.S. central hill. 1 l old Mexican debtors arrive at the Mexican central hill. Debt settlement at the central hill begins. Remaining a old Mexican creditors leave the central hill with peso. a1 g old Mexican late-departing creditors identify their taste shock. ag old Mexican late-departing creditors travel to Mexican debtor island with peso. 1 a1 g old Mexican late-departing creditors arrive at the tunnel and meet U.S. old debtors, and foreign exchange market opens. 1 a1 g old Mexican late-departing creditors obtain dollar, and continue their travel to the U.S. debtor island via the U.S. central hill.

9 10 11 12 13 14

15

16 17

Young Mexican debtors come back from the neighboring young creditors village. Young Mexican debtors obtain pesos from old Mexican creditors and old American creditors in exchange for their endowment.

All old Mexican creditors and the U.S. creditors with taste shock arrive at Mexican debtor village.

fraction l of old Mexican debtors (hereafter called early-bird debtors) arrive at the Mexican central hill before the arrival of old Mexican creditors. Old Mexican debtors die after their debt settlement. Suppose that the trips made by American debtors are mirror images of those of Mexican debtors, as illustrated by the thick dotted arrows in the bottom panel of Figs. 1 and 2. Their rst-order conditions are obtained by replacing the lower case variables in Eq. (1) with upper case variables.

ARTICLE IN PRESS
H. Fujiki / Journal of Monetary Economics 50 (2003) 13331350 1339

2.2. Travel made by creditors and the setup of debt settlement Mexican creditors born at time t consume cyt units of their endowment at time t: They exchange the remainders of their endowments for the loan certicates issued by young Mexican debtors born at time t; who promise to pay lt pesos at time t 1: The Mexican creditors budget constraints at time t are ypyt cyt pyt lt ; and lt depends % on their consumption patterns to be known at time t 1; as summarized in Table 1. At time t 1; all old Mexican creditors visit the central hill to receive pesos from the old Mexican debtors (see the thin solid arrows labeled (1) in the upper panel of Fig. 2). Upon arrival at the Mexican central hill and just before their debt settlement, old Mexican creditors realize their taste regarding the timing of debt settlement. With probability 1 a; they are early-departing creditors, who can wait for the arrival of the early-bird debtors to the central hill only. With probability a; they are late-departing creditors, who can wait for the arrival of all old debtors. Therefore, at the central hill, the debt settlement between all creditors and early-bird debtors occurs rst, and then the remaining debts are cleared after the departure of earlydeparting old creditors and the arrival of the rest of the old debtors. Specically, fraction 1 l of the old Mexican debtors nd that their debt is traded in the secondhand debt market, and the other creditors wait to receive their payment from them. If the number of early-departing creditors exceeds the number of early-bird debtors, the clearing of debt on the central hill is problematic. Although earlydeparting creditors will offer to sell their debt to late-departing creditors, the total amount of liquidity, llt ; becomes the upper bound for the nominal value of debt in the secondary debt market. Let the discount rate be rt1 and let qt be the par value of nominal debt purchased by late-departing Mexican creditors. Then, the nominal value of debt purchased by late-departing creditors, rt1 qt ; is less than or equal to the value available to creditors obtained from early-bird debtors, llt : Hence, latedeparting Mexican creditors face a domestic liquidity constraint, llt Xrt1 qt : 2.3. Travel made by debtors after debt settlement Old Mexican creditors face another taste shock after the debt settlement, immediately before the departure from the central hill. With probability g; they scatter to young Mexican debtors villages randomly, as shown by the thin solid arrow labeled (3) in the upper panel of Fig. 2. If they depart early, their budget constraint at time t 1 is cxt1 pxt1 rt1 1 llt llt ; where B indicates * variables for early-departing creditors. If they depart late, their budget constraint # is cxt1 pxt1 1 rt1 qt lt ; where 4 indicates variables for late-departing creditors, and they also face the liquidity constraint llt Xrt1 qt : With probability 1 g; old Mexican creditors nd that they want to consume young American debtors goods. Their travels will be discussed in the next two paragraphs. Travels made by American creditors born at time t and their debt settlement at the U.S. central hill are mirror images of the travels and debt settlement at the Mexican central hill (Fig. 2, lower panel). Let A; L; X and Q stand for the population of the U.S. late-departing creditors, the population of the U.S. early-bird debtors, the U.S.

ARTICLE IN PRESS
1340 H. Fujiki / Journal of Monetary Economics 50 (2003) 13331350

discount rate, and the per value of nominal debt at the U.S. secondary debt market. After the debt settlement, at the U.S. central hill, with probability G; old creditors scatter to the U.S. debtors village. Early-departing old creditors face the budget * constraint CXt1 PXt1 Xt1 1 LLt LLt : The budget constraint for late# departing old creditors is CXt1 PXt1 1 Xt1 Qt Lt and they also face the liquidity constraint LLt XXt1 Qt : With probability 1 G; old American creditors wish to consume young Mexican debtors goods, and their travels will be explained immediately below. In this model, the foreign exchange market works as follows. First, old Mexican creditors and old American creditors who have been subjected to a taste shock visit the tunnel connecting the two countries (arrows labeled (4) in Fig. 2). Then, they exchange pesos and dollars in the middle of the tunnel (point (5) in Fig. 2). Assume that the guardians in the tunnel are honest and can live without any consumption. The guardians receive pesos from the old Mexican creditors, and give them dollars because, by law, Mexicans are forced to use dollars for all transaction in the U.S. Suppose that the guardians in the tunnel force agents to go in one direction through the tunnel without stopping, for security reasons. The tunnel is similar to the turnpike of Townsend (1980) with only one trading post. Therefore, it is not possible for early- and late-departing old creditors to trade their currencies with each other. Under those assumptions, the number of dollars that early-departing Mexican creditors with a taste shock can obtain is determined by the number of dollars obtained from early-departing old American creditors with a taste shock. Earlydeparting old creditors with a taste shock face the nominal peso/dollar exchange rate et1 in the middle of the tunnel at time t 1: * 1 g1 art1 1 llt llt et1 1 G1 AXt1 1 LLt LLt : * 2

Late-departing old creditors with a taste shock face the nominal peso/dollar # exchange rate et1 in the middle of the tunnel at time t 1: # 1 ga1 rt1 qt lt et1 1 GA1 Xt1 Qt Lt : 3

After obtaining dollars, old Mexican creditors with a taste shock go to the U.S. central hill (see the thin solid arrow labeled (6) in the lower panel of Fig. 2). Then they scatter randomly to the U.S. young debtors village (see the thin solid arrow labeled (7) in the lower panel of Fig. 2). Old American creditors with a taste shock go to the Mexican central hill, and then scatter randomly to the young Mexican debtors village. In summary, suppose Mexican creditors born at time t have the expected utility function vcyt g1 av*xt1 gav#xt1 1 g1 av*Xt1 1 gav#Xt1 :1 c c c c
The continuous and continuously differentiable utility function v is strictly increasing and concave in each argument with indifference curves that do not cross the axes. Suppose that young American creditors # * born at time t have the expected utility function V VCYt G1 AVCXt1 GAV CXt1 # * 1 G1 AV Cxt1 1 GAV Cxt1 : Function V has the same properties as v has.
1

ARTICLE IN PRESS
H. Fujiki / Journal of Monetary Economics 50 (2003) 13331350 1341

Using the budget constraint and liquidity constraint at time t and t 1 yields the following optimization problem for the young Mexican debtors with respect to lt at time t:     lt r 1 llt llt Max v y g1 av t1 % lt pyt pxt1   1 rt1 llt =rt1 lt gav pxt1   r 1 llt llt 1 g1 av t1 PXt1 et1 *   1 rt1 llt =rt1 lt 1 gav : 4 # PXt1 et1 Therefore, the rst-order condition of this problem becomes the following Eq. (5):     pyt lt 0 0 rt1 1 llt llt g1 av rt1 1 l l v y % pyt pxt1 pxt1   pyt 0 1 rt1 llt =rt1 lt gav 1 l l=rt1 pxt1 pxt1   0 rt1 1 llt llt 1 g1 av rt1 1 l l PXt1 et1 * pyt pxt1 PXt1 et1 pxt1 *   0 1 rt1 llt =rt1 lt 1 gav 1 l l=rt1 # PXt1 et1 pyt pxt1 ; 5 #t1 pxt1 PXt1 e where primes indicate rst derivatives.

3. Stationary equilibrium This section examines a stationary equilibrium. The market clearing conditions in the goods markets are Eqs. (6) through (9): # * x dxt g1 a*xt ga#x 1 G1 ACxt 1 GACxt ; c c 6 % y cyt dyt ; % # * % X Dxt G1 ACXt GACXt 1 g1 a*Xt 1 ga#Xt ; c c and % Y CYt DYt : 9 % The currency markets clearing conditions are m mt ht in Mexico and M % % are money supplies exogenously determined by Mt Ht in the U.S., where m and M % 7 8

ARTICLE IN PRESS
1342 H. Fujiki / Journal of Monetary Economics 50 (2003) 13331350

the central bank in each country based on their gold reserve. The equilibrium conditions in the loan markets are lt ht in Mexico and Lt Ht in the U.S. The liquidity constraints and the equilibrium of secondary debt markets will yield llt rt1 qt and aqt 1 a1 llt in Mexico and LLt Xt1 Qt and AQt 1 A1 LLt in the U.S. One can solve Eqs. (1) through (3), (5), (6) through (9), equilibrium conditions in the currency market, loan market, and second-hand debt market simultaneously. In particular, consider a stationary equilibrium, at which h ht lt l; pxt pxt1 px ; pyt py ; rt1 r; H Ht Lt L; PXt PXt1 PX ; PYt PY ; and Xt1 X are satised. Assume that 1 a l > 0 and 1 A L > 0 throughout the following analysis, which makes the equilibrium discount rates less than one. Then, the equilibrium conditions of the second-hand debt market lead to r a=1 al=1 lo1 and X A=1 AL=1 Lo1: Those results simplify the budget constraints for old Mexican and U.S. creditors without a taste shock to * # cx1 l=1 al=px ; cxt1 1 l=al=px ; CXt1 L=1 AL=PX and * # Xt1 1 L=AL=PX : Let ls l=px ; hs h=px ; py =px ps ; Ls L=Px ; C Hs H=Px ; and Py =Px Ps : Solving Eqs. (10) through (13)   1 hs ux x hs uy ; 10 % ps ps       ls l 1l ls ps g1 lv0 l s ps glv0 v0 y % 1a a ps   l px px ls ps 1 glv0 1 a PX e PX e * *   1 l px px ls ps ; 1 g1 lv0 11 # # a PX e PX e   1 HS % UY U X X HS ; 12 PS PS       L L 0 0 1L % S GLV 0 LS PS G1 LV LS PS V Y 1A A PS   L PX e PX e * * Ls 1 GLV 0 PS 1A px px   # # 1 L PX e PX e Ls 1 G1 LV 0 PS ; 13 A px px with hs ls and Hs Ls yields six equilibrium values: ps ; Ps ; hs ; ls ; Hs ; and Ls : Note that Eqs. (10) and (11), and similarly Eqs. (12) and (13), correspond to the stationary solution proposed by Freeman (1996b) when g G 1: The third and fourth terms on the right-hand sides of Eqs. (11) and (13) show that the terms of trade measured by goods x and X affect the utility of creditors, since we generalize Freemans model into a two-country model. The terms of trade are determined in the foreign exchange market. Using the budget constriants for old-departing creditors,

ARTICLE IN PRESS
H. Fujiki / Journal of Monetary Economics 50 (2003) 13331350 1343

Eqs. (2) and (3) become px L1 GLS ; PX e * l1 gls px 1 L1 GLS : # PX e 1 l1 gls 14

15

Substituting Eqs. (14) and (15) into Eqs. (11) and (13), we solve Eqs. (10) through (13) for hs ls ; Hs L ; ps and P ; with the superscript stars indicating the s s equilibrium values under a liquidity constraint. A numerical verication of the existence of solutions for Eqs. (10) through (13) is possible if utility functions display constant relative risk aversion. For example, let us suppose that utility functions are as follows: vz uz z1s =1 s and V Z UZ Z 1S =1 S: In this case, Eqs. (10) and (12) provide us two monotone functions, hs ps and Hs Ps :2 Application of the implicit function theorem to Eqs. (11), (14) and (15) implies that ls is increasing in ps and increasing (decreasing) in Hs if so1 s > 1: Similarly, Eqs. (13)(15) imply that Ls is increasing in Ps and increasing (decreasing) in ls if So1 S > 1: Let us suppose that s S 0:9; x 1; y 10; g 0:9; l 0:2; a 0:2; m 10; % % % % % % X 10; Y 100; G 0:95; L 0:4; A 0:4; and M 100: Then, h ls s L 5:570675; p 0:129782; and P 0:127019: Using the 0:556477; Hs s s s budget constraints of debtors, we obtain the nominal price level p m=hs % x M=H 17:95; because nominal price levels are adjusted where % 17:97 and PX s young debtors exchange their goods for money delivered by the old creditors.3 Using the budget constraints for creditors at time t 1 yields Eq. (16): cx * al 1 a1 l r o1; #x c * C AL X X o1: # 1 A1 L CX 16

Eq. (16) says that the consumption of domestic goods made by early-departing old creditors is less than that of late-departing creditors by a factor of the nominal interest rate. * # # x # Substituting the results that cX cx px =PX e ; cX cx p =PX e ; Cx * * * # # * P e =p ; and C C P e =p into Eqs. (14) and (15) leads to Eqs. (17) CX X * x x X X# x and (18)   * cX C 1 A * a a . A X X # # A 1a 1a 1A cX C X L a ; 17 1L 1a
Note that dhs=dps uy 1 s=uxx =p2 uyy : Thus, if so1; hs ps is decreasing in ps ; and if s > 1; it s is increasing in ps : One can also show that hs ps fx explnps =s ps g=f1 explnps =s ps g: 3 These solutions were obtained using the solve command in the Mathcad 2000 Professional version. The numerical examples in Table 2 use those parameter values for the sake of exposition.
2

ARTICLE IN PRESS
1344 H. Fujiki / Journal of Monetary Economics 50 (2003) 13331350

   * C cx 1 a * A A a x r # # a 1A 1A 1a C cx x l A : 1l 1A 18

A high value of a means that large fractions of creditors do not need to be repaid immediately and thus are ready to purchase second-hand debt. Hence, a=1 a represents the size of the banking sector. The parameter l stands for the fraction of debt that will be redeemed with at money that arrives early enough to trade with early-departing old creditors. Thus l approximates the rapidity of monetary transfers, or the availability of funds given the size of the banking sector. High values of both a and l mean that the discount rate in the second-hand debt market is relatively close to one. Thus, Eqs. (17) and (18) indicate that the ratio of consumption of foreign goods by early-departing creditors and that by latedeparting creditors is proportional to the foreign discount rate, adjusted by the relative size of the domestic banking sector to the foreign banking sector.

4. Policy implications 4.1. Benchmark efcient allocation Consider a benchmark stationary state allocation, where a social planner maximizes the weighted average utilities of two citizens, given the world resource constraint. This social planner maximizes Eq. (19), where the ys are weights for Mexican and American citizens subject to Eqs. (6) through (9): y1 fudx udy g y2 fvcy g1 av*x gav#x 1 g1 av*X c c c 1 gav#X g c y3 fUDX UDY g # * y4 fV CY G1 AV CX GAV CX # * 1 G1 AV Cx 1 GAV Cx g: 19

The optimal solution satises three properties. First, consumption by creditors with b # # # #X * and without a taste shock is equal: cx cx cb ; cX cX cb ; CX CX CX and * x * # * x Cx C b ; where superscript b stands for the benchmark solution. Second, C x creditors marginal rates of substitution between creditors goods and debtors b b goods, and those of debtors, are equal: v0 cb =v0 cb u0 dy =u0 dx and y x 0 b 0 b 0 b 0 b V CY =V CX U DY =U DX : Third, Mexican and American creditors marginal rates of substitution between Mexican goods and American goods are equal; b b v0 cb =v0 cb V 0 CX =V 0 Cx : The third condition means that the real exchange X x rate between American and Mexican goods, the terms of trade, must be equalized independent of the timing of arrival at the tunnel.

ARTICLE IN PRESS
H. Fujiki / Journal of Monetary Economics 50 (2003) 13331350 1345

4.2. The role of central bank discounting To analyze the characteristics of a stationary monetary equilibrium, assume that aoA and loL: That is, the discount rate in the U.S. second-hand debt market is relatively close to one. Using Eqs. (16) through (18), aoA means that fa=1 ag= fA=1 Ago1; hence cX ocX : With loL; lA=1 A1 loAL=1 A1 L * # * # o1; and therefore Cx oCx : Consider a central banks intervention into the domestic credit market which temporarily supplies money for the repayment of all loans at par. For example, in the domestic credit market for the early-departing creditors at the central hill, the Mexican % (or, American) central bank can supply 1 a lm 1 A LM in the U.S.) % units of at money by purchasing IOUs at par value. Then, these central banks sell the IOUs to late-arriving debtors in exchange for at money, and discard the amount % of money equal to 1 a lm 1 A LM in the U.S.). Let us consider % equilibrium under those operations, and assign superscript to equilibrium values. First, since these operations are carried out given p and PS ; it is obvious that s ps p and P P : The nominal price level remains constant, i.e., p s S S x % m=hs p and PX M=HS P : This is because the total amount of money in % x X circulation, which is redistributed to young debtors, is constant. Nonetheless, by # * # clearing all debt at par value, we establish c cx and CX C : Rows 2 and 3 *x X in Table 2 show that the expected utility of creditors will increase if a central bank intervenes, compared with the liquidity constrained stationary equilibrium discussed in Section 3 in row 1 under the benchmark parameter values. Note that a central bank intervention in one of the domestic credit markets changes the terms of trade through Eqs. (14) and (15), and thus the utility level of creditors in the other country. Second, If g G 1; this equilibrium corresponds to the equilibrium found by Freeman (1996a). The concavity of utility functions leads to the conclusion that this # equilibrium coincides with the benchmark optimal solutions c cx cb and *x x C C b : # * CX X X Third, if g and G are not equal to one, r X 1 and Eq. (17) leads to =# o* =# 1 A=1 aa=Ao1 because aoA: Therefore, central cX cX cX cX * banks interventions in their domestic second-hand markets are generally not # enough to establish efciency. However, by establishing c cx and making *x =# close to one relative to c =# ; the average utility of Mexican creditors cX cX * * X cX improves compared with the liquidity constrained stationary equilibrium. # * # *x In the U.S., the central bank intervention establishes C C ; while c cx X X # * =C 1 a=1 AA=a > 1: Since the stationary equilibrium means Cx x # * under liquidity constraints results in C oCX ; consumption by the U.S. creditors X with a taste shock changes in favor of early-departing creditors. To see why, remember that the central banks interventions into the second-hand debt market lead to r X 1: Therefore, Eqs. (17) and (18) imply that the ratio of consumption of foreign goods by early-departing creditors and late-departing creditors is proportional to the relative size of the domestic banking sector. In other words, a relatively large American banking sector means that the nominal exchange rate faced by early-departing American creditors appreciates compared with the

ARTICLE IN PRESS
1346 H. Fujiki / Journal of Monetary Economics 50 (2003) 13331350 Table 2 Numerical examples Parameter US creditors utility 27.444601 27.526826 27.456952 27.539178 27.54093 27.543865 27.539434 27.545691 Mexican creditors utility 21.452713 21.477105 22.07927 22.103662 22.094304 22.112893 22.119607 22.106796 U.S. domestic credit market Mexican domestic credit market 0 0 1 a lm 1 a lm 0:91 a lm 1 a lm 1 a lm 1 a lm Foreign exchange intervention by U.S. 0 0 0 0 0 1 GA aM 1:51 GA aM 0:51 GA aM

Benchmark 1 2 3 4 5 6 7 8 a 0:3 9 10

0 1 A LM 0 1 A LM 0:91 A LM 1 A LM 1 A LM 1 A LM

27.542875 27.542815

22.111221 22.105997

1 A LM 0:91 A LM

1 a lm 0:91 a lm

0 0

Note: The parameters and functional forms of utility functions for benchmark stationary solutions are: vz uz z1s =1 s; VZ UZ Z1S =1 S; s S 0:9; x 1; y 10; g 0:9; l 0:2; % % % % % a 0:2; m 10; X 10; Y 100; G 0:95; L 0:4; A 0:4; and M 100: %

nominal exchange rate for late-departing American creditors. Since the domestic price levels are unchanged, the terms of trade have a one-to-one relationship with movements in the nominal exchange rate, and thus with the amount of cash brought to the tunnel at each time of settlement. The U.S. central banks intervention in the U.S. credit market allows the U.S. creditors to bring more money than the Mexicans to the foreign exchange market for late-departing creditors. Hence, the terms of trade for the U.S. late-departing creditors get worse if both central banks intervene. Numerical examples in rows 4 and 5 of Table 2 show that the expected utility of the U.S. creditors is higher if both central banks supply 10% less than the amount of at money needed to clear the domestic second hand debt at par. This is because marginal benet of making domestic consumption of the U.S. creditors more uniform is smaller than the adverse effect of making the foreign goods consumption of the U.S. creditors uneven in this case. Of course, the benet and cost of domestic intervention depend on the relative size of the banking sector. For example, consider another stationary equilibrium where a 0:3; rather than 0.2. In this case, a situation analogous to that illustrated in rows 4 and 5 will increase the average utility of the U.S. creditors as can be seen in rows 9 and 10 of Table 2. 4.3. Monetary policy based on the Real Bills Doctrine and Rules of the Game Consider a nominal exchange rate where there is no liquidity constraint. Then, the % equilibrium exchange rate must be eF 1 gm=1 GM: Exchange rate eF is the % fair price of foreign exchange based on gold standard parity. The formula for eF means that smaller values of g correspond with greater demand for U.S. goods by

ARTICLE IN PRESS
H. Fujiki / Journal of Monetary Economics 50 (2003) 13331350 1347

Mexicans, and hence a depreciation of the peso relative to the dollar.4 This section will show that U.S. central bank intervention in the foreign exchange market improves the ex-ante expected utility of creditors compared with the equilibrium analyzed in the previous section. Given the Mexican central banks intervention in the Mexican second-hand debt markets, early-departing old Mexican creditors bring 1 g1 am pesos to the % foreign exchange market. On the other hand, early-departing old American creditors % bring 1 G1 AM dollars to the foreign exchange market. Suppose that the U.S. central bank supplies T dollars in the foreign exchange market for early-departing creditors. Then, the nominal exchange rate will be e 1 g1 am=1 * % % GA aM T; and the U.S. central bank obtains e T pesos for their reserve, * where superscript indicates a state of equilibrium under the interventions in both the domestic credit market and the foreign exchange market. In the foreign exchange % market for late-departing old creditors, 1 gam pesos and 1 GAM dollars will % be delivered. The U.S. central bank sells e T pesos, and the nominal exchange rate * % # for late-departing creditors will satisfy e 1 gm e T=1 GAM: The % * U.S. central bank rst issues T dollars and then takes e T=# dollars out * e of circulation once the foreign exchange markets closed. The U.S. price level % % will be determined by 1 e =# T M=X D P ; rather than by * e x x % X Dx P : % M= x Such an operation made by the U.S. central bank is either inationary or % deationary, but consider the case where T 1 GA aM: Then, e * 1 gm=1 GM eF ; and P 1 e =# T M=X D % % % # e * e % xt x % % M=X Dx P : Therefore, in this special case, given the value of cx cx and * # x # # * * CX C ; this intervention supports cX cX and Cx C : * # X x In this equilibrium, given the price levels in each country, the U.S. intervention equates the nominal exchange rate for early-departing creditors and late-departing creditors (or, the terms of trade since the price levels are constant). The operation cures an over-valued peso-dollar exchange rate in favor of early-departing American creditors with a taste shock, adjusting it towards eF : Since the consumption of agents without a taste shock remains constant, this operation allocates the foreign goods consumption of agents with a taste shock equally. Given the strictly concave utility function, this equilibrium Pareto dominates the equilibrium with domestic intervention alone. See the numerical example in row 6 of Table 2. However, the intervention made by the U.S. central bank cannot support the benchmark optimal allocation of resources shown in Section 4.1, because the country specic cash-in-advance constraint still requires that cX =*x * c =P e C =C ; while the optimal solution requires v0 cb =v0 cb * * px * X x X X x b b V 0 CX =V 0 Cx the terms of trade. Both conditions are compatible only in a special case, for example, if both vz V z lnz and g G hold.
Matsuyama et al. (1993) use a two country random matching model to obtain the result that the currency of a larger country emerges as the international currency because it gives people better chances of acquiring their consumption goods. In our model, different country size does not alter the condition which central bank should intervene in the foreign exchange market as long as aoA:
4

ARTICLE IN PRESS
1348 H. Fujiki / Journal of Monetary Economics 50 (2003) 13331350

4.4. Institutions to prevent ination and deation Does the U.S. central bank have an incentive to intervene unilaterally to achieve a fair exchange rate? Suppose the U.S. central bank temporarily issues more than % 1 GA aM dollars. Then, the total amount of dollars in circulation in the U.S. will increase. This is because Mexican creditors with a taste shock bring larger amounts dollars into the U.S. than the U.S. creditors with a taste shock brought into the tunnel, thus P > Px will hold. Note that the total money balance of old x % American creditors without a taste shock is still GM; and therefore, their consumption will decrease. Moreover, given the Mexican price level and the consumption of Mexican creditors, this operation distributes the consumption of Mexican debtors goods by old American creditors with a taste shock unevenly compared with the case with equilibrium exchange rate eF : Hence, by issuing more % than 1 GA aM dollars, the utility of American creditors will decrease. Therefore, such an operation would not be supported by the U.S. citizens (see row 7 % of Table 2 for a numerical example in which T 1:51 GA aM: % Consider the case in which the U.S. central bank issues less than 1 GA aM dollars. Then, the total amount of dollars in circulation will decrease, and P oPx x will hold. The old U.S. creditors without a taste shock welcome deation, since their nominal money balance remains constant, while this operation squeezes the consumption of Mexican creditors with a taste shock. However, the departure of the nominal exchange rate from the fair rate reduces the utility of American creditors with a taste shock. Nonetheless, the overall average utility of American creditors can rise at the sacrice of Mexican creditors with a taste shock and the U.S. creditors with a taste shock, provided that the population of U.S. creditors without a taste shocks is large enough. For example, this is true if the U.S. central bank chooses % * # T 0:51 GA aM; e 0:228571; e 0:157143; and the expected utility of American creditors is 27.545691 as can be seen in row 8 of Table 2. % # Similarly, if T 1 GA aM; then e e 0:2 and the expected utility of * American creditors is 27.543865 (Table 2, row 6). Suppose two countries central banks are under the gold standard and they are committed to domestic and external price stability. Then they are not subject to the temptation of ination and deation, because pressure from speculative attacks would be a sufcient deterrent. For example, honest guardians in the tunnel can play the role of speculators, and make the exchange rate fair as long as they can issue the perfect substitute for the U.S. dollar. Regarding the risk of ination, observe that the U.S. citizens would not welcome aggressive intervention beyond an inux of % 1 GA aM dollars. Hence, the U.S. central bank is unlikely to pursue such an inationary policy. Indeed, the Bank of England under the gold standard is rarely subject to the temptation of creating ination. Most periods of ination are related to war nances, which require the temporary suspension of the gold standard system (see Barro, 1987; Brown, 1990 for examples). Regarding the temptation of deation, remember that deation caused by the U.S. central bank would be harmful to the Mexican creditors with a taste shock. Therefore, the Mexican government might wish to reduce consumption by U.S. creditors with a taste shock to retaliate against

ARTICLE IN PRESS
H. Fujiki / Journal of Monetary Economics 50 (2003) 13331350 1349

the selsh behavior of the U.S. central bank. Moreover, the U.S. deation policy would redistribute the consumption patterns of the U.S. creditors with a taste shock unevenly. Thus, such a policy is not consistent with the U.S. banks original policy intention to treat all creditors equally at the domestic second-hand debt settlement. Suppose that two countries do not operate under the gold standard. To achieve domestic and external stability, it is useful for the U.S. and Mexican central banks to target domestic price stability, or to control for the overall amount of banknotes as Freeman (1996b) proposed. Suppose that there is no central bank in Mexico or the United States. However, a Mexican private clearinghouse can issue a perfect substitute for the peso and an American clearinghouse is allowed to issue clearinghouse certicates, which are perfect substitutes for the U.S. dollar. The use of clearinghouse loan certicates during the 19th century banking crisis in the U.S. effectively stopped the nancial panic. Such episodes show that private institutions can work as lenders of last resort (see Timberlake, 1978). Green (1997) stressed that both an independent central bank and a clearinghouse can achieve an optimum allocation of resources by supplying enough money to clear all the debts at par value. In the model presented above, two clearinghouses can perform the same welfare-improving operation by clearing all domestic debt at par, provided that the American clearinghouse intervenes in the foreign exchange market, and both clearinghouses commit to domestic price stability. Such commitments are credible through the threat of full redemption and speculative attacks under the gold standard as in Freeman (1996b). However, the price stability mandate is not incentive compatible with the old U.S. creditors without a taste shock because they like deation once they know their preference shock. Thus, the governance of the clearinghouse must balance the interests of different agents.

5. Conclusion This paper presents a two-country version of the model by Freeman (1996b). The model demonstrates that in order to enhance the efciency of equilibrium in the face of liquidity shortage, central banks under the gold standard must supply at money elastically both in the domestic credit market and in the foreign exchange market. Such operations by the central banks are consistent with the rules of the game of gold standard summarized by McKinnon (1993). Those operations are also in line with the spirit of the 1913 Federal Reserve Act, whose external policy goal is based on the international gold standard, and whose domestic policy is based on the Real Bills Doctrine.

References
Barro, R., 1987. Government spending, interest rates, prices, and budget decits in the United Kingdom, 17011918. Journal of Monetary Economics 20, 221247.

ARTICLE IN PRESS
1350 H. Fujiki / Journal of Monetary Economics 50 (2003) 13331350 Brown, C.E., 1990. Episodes in the public debt history of the United States. In: Dornbusch, R., Draghi, M. (Eds.), Public Debt Management: Theory and History. Cambridge University Press, Cambridge. Freeman, S., 1996a. The payments system, liquidity, and rediscounting. American Economic Review 86, 11261138. Freeman, S., 1996b. Clearinghouse banks and banknote over-issue. Journal of Monetary Economics 38, 101115. Green, E.J., 1997. Money and debt in the structure of payments. Monetary and economic studies, Bank of Japan 15 (1), 6387. Gorton, G., Mullineaux, D.J., 1987. The joint production of condence: endogenous regulation and nineteenth century commercial-bank clearinghouses. Journal of Money, Credit and Banking 19, 457468. Hernandez, P.L., 2002. Disruptions of liquidity, international nancial crises and monetary integration. Ph.D. Dissertation, University of Texas. Matsuyama, K., Kiyotaki, N., Matsui, A., 1993. Towards a theory of international currency. Review of Economic Studies 60, 283307. McKinnon, R., 1993. The rules of the game: international money in historical perspective. Journal of Economic Literature 31, 144. Timberlake, R.H., 1978. The Origins of Central Banking in the United States. Harvard University Press, Cambridge, Massachusetts and London. Townsend, R., 1980. Models of money with spatially separated agents. In: Kareken, J.H., Wallace, N. (Eds.), Models of Monetary Economics. The Federal Reserve Bank of Minneapolis, Minneapolis, Minnesota, pp. 265304. West, R.C., 1974. Banking Reform and the Federal Reserve, 18631923. Cornell University Press, Ithaca.