Academic journal article Atlantic Economic Journal

Modeling the Currency Issue

Academic journal article Atlantic Economic Journal

Modeling the Currency Issue

Article excerpt

Introduction

Economists devote considerable energy to the preparation and testing of theoretical models which frequently show great analytical elegance, and their work is generally of use in explaining and predicting economic trends. From this, it derives its value. In some cases, however, published models are not useful forecasting tools and only make an insubstantial contribution to the understanding of economic events. A recent example is the paper by Barry [1994] in which he described the D-Metric framework for analyzing the sequence of currency denominations in circulation. It is perhaps noteworthy that, despite its weaknesses, this paper was published by the Reserve Bank of New Zealand, the publications of which are well regarded by academic economists. This critique of Barry's article has two functions. It points out the failings of his approach and presents an alternative discussion of the characteristics of the notes and coins in circulation.

D-Metric Flaws

In the D-Metric model [Payne and Morgan, 1981],(1) the independent variable of overriding importance in determining the most efficient sequence of values of notes and coins in use is the amount of the average day's pay (D) for the country in question. In order to achieve an optimal system, it is necessary, according to the D-Metric approach, that the minimum coin denomination has a value of about D/5000, that the maximum note denomination has a value of about 5D, and that the note-coin boundary (between the highest-value coin and the lowest-value note) is between D/20 and D/50.

Maintaining an adequate supply of notes and coins in circulation is a significant role of central banks. Therefore, analysis of the chosen structure is of interest. However, the D-Metric approach suffers from seven weaknesses to which Barry does not refer.

Flaw 1

Since the sequence of note and coin denominations is an administrative decision, it is not clear that a theoretical model of this type is appropriate. Central banks can, of course, decide to issue any combination of denominations. The private sector is usually given a very limited choice and will be obliged to use all but the least acceptable forms of cash provided. It does not follow that a structure leads to maximum efficiency or even that it is more efficient than other structures merely because it is widespread. Identifying similarities between currency structures of different countries is an interesting exercise but is not likely to lead to a workable forecasting device. The authorities in a particular country are not constrained to follow the practice of other countries and there may be very good reasons. for not doing so.

Many countries have reduced their monetary autonomy by fixing the value of their currency in terms of another currency (or group of currencies). An extreme case of this, where the sequence of note and coin denominations matched those of another state, is the Irish Republic. Until the inception of the European Monetary System in 1979 when the United Kingdom (U.K.), unlike the Irish Republic, declined to join the exchange rate mechanism [Mushin, 1986], the Irish pound had a rigidly fixed exchange rate with the British pound and each of the two banking systems cleared the other's checks as if denominated in its own currency [Mushin, 1980]. These very close financial links meant that every policy decision of monetary importance in the U.K. coincided with an identical change in the Irish Republic. These included the currency reforms of 1949 (devaluation), 1967 (devaluation), 1971 (decimalization), and 1972 (floating exchange rate). It was convenient that the sequence of currency denominations was the same in both countries [Mushin, 1997]. However, this exception does not demonstrate the relevance of the D-Metric approach, even in this case.

It is difficult to support Barry's assertion that the D-Metric model is a "coherent rationale" from which reliable predictions may be constructed. …

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