Academic journal article Journal of Money, Credit & Banking

Institutions of Foreign Exchange Settlement in a Two-Country Model

Academic journal article Journal of Money, Credit & Banking

Institutions of Foreign Exchange Settlement in a Two-Country Model

Article excerpt

FUJIKI (2003) demonstrates the possibility of efficiency gains in monetary equilibrium from the combination of an elastic money supply in the foreign exchange market, to clear the exchange of fiat monies at gold standard parity, and an elastic money supply in the domestic credit market. This paper employs the Fujiki (2003) model to analyze three other institutional designs that seem to achieve the same improvement in efficiency: (1) a private arrangement based on a payment versus payment settlement standard supported by central banks' free intraday credit, (2) a financial institution that provides a negotiable certificate of deposit, and (3) a currency union.

Since the model here is an extension of the Freeman (1996) model, this paper begins by reviewing Freeman's model. Freeman considers an economy where agents are spatially separated, and private debt incurred between two parties can only be redeemed with fiat currency in 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 early-departing creditors at discounted prices in exchange for fiat money. A central bank can issue additional fiat money to purchase the IOUs of early-departing creditors and can receive fiat money from the debtors in the central clearing area. Then the IOUs of early-departing 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. Freeman (1996) shows that such a central bank intervention leads to an optimal allocation of resources.

Fujiki (2003) considers a two-country version of the Freeman model under a gold standard and assumes that old domestic creditors 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. However, 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 fiat money for the fiat money of the other country. Suppose that the rates at which old creditors with taste shocks arrive at the trading post are not equal. For example, if one country is inhabited by many bankers (or late-departing creditors), only a small fraction of old creditors comes 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 situation, the fiat money of the other country, though its value is backed by gold, might be exchanged at a discount. This could happen even though the central banks intervene to clear all domestic debt at par value.

Fujiki (2003) shows that a central bank intervention in the foreign exchange market can prevent the market exchange rate departing from the gold standard parity and can improve the ex ante expected utility of agents. However, such an operation could increase the overall average utility of one country's creditors at the expense of the other country's creditors with a taste shock. To avoid the need for such an operation, it was shown that the central bank should be subject to a gold standard or price level target.

This paper considers three other institutional mechanisms that seem to replicate the welfare improvement suggested by Fujiki (2003). The first is a foreign exchange market that ensures that a final transfer of one currency occurs if and only if a final transfer of the other currency or currencies takes place (i. …

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