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A Return to the Convertibility Principle? Monetary And Fiscal Regimes in Historical Perspective

  • Bordo, Michael D.

    ()

    (Department of Economics)

  • Jonung, Lars

    ()

    (European Commisson)

What is the long-run relationship between monetary and fiscal policies? This paper provides an answer by examining a large set of data covering major economies during the past 115 years. The evidence suggests the existence of a close interaction between the monetary regime, that is the behaviour of the central bank/monetary authorities, and the fiscal regime, that is the tax and spending behaviour of governments as reflected in the evolution of budget deficits and public debt. In the past, a monetary regime based on the commitment to convertibility of the domestic currency into specie, the 'convertibility principle', was the prevailing pattern in the world economy. According to this principle, the fiscal regime is subordinated to the monetary regime. The monetary regime places binding constraints on fiscal policies. The major exception to this pattern occurred during major wars and their immediate aftermath when fiscal demands determined monetary policy. Since the mid 1960s and especially after the breakdown of the Bretton Woods system in the period 1971-73, monetary policy has abandoned the 'convertibility principle' and in many countries has been geared towards domestic stabilization goals, especially that of full employment. This led to a build-up of inflationary pressures in the 1970s which has been largely rolled back since the early 1980s. In the same period bond-financed fiscal policy has been used as a stabilization policy tool, when many countries accumulated debt to income ratios sufficient to threaten monetary stability. These results suggest a prediction for the future. If fiscal balance is restored in most major economies, monetary regimes based on either an internal commitment such as the goal of price stability or low inflation or an external commitment to peg to a foreign currency will prevail.

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Paper provided by Stockholm School of Economics in its series SSE/EFI Working Paper Series in Economics and Finance with number 415.

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Length: 66 pages
Date of creation: 06 Dec 2000
Date of revision:
Handle: RePEc:hhs:hastef:0415
Note: Forthcoming in Axel Leijonhufvud, ed., Monetary Theory as a Basis for Monetary Policy, MacMillan.
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  1. Michael D. Bordo & Lars Jonung, 1996. "Monetary Regimes, Inflation And Monetary Reform: An Essay in Honor of Axel Leijonhufvud," Departmental Working Papers 199407, Rutgers University, Department of Economics.
  2. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
  3. Michael D. Bordo, 1993. "The Bretton Woods International Monetary System: A Historical Overview," NBER Chapters, in: A Retrospective on the Bretton Woods System: Lessons for International Monetary Reform, pages 3-108 National Bureau of Economic Research, Inc.
  4. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
  5. Jonung, Lars, 1979. "Knut wicksell's norm of price stabilization and Swedish monetary policy in the 1930's," Journal of Monetary Economics, Elsevier, vol. 5(4), pages 459-496, October.
  6. Cooley, Thomas F & Ohanian, Lee E, 1997. "Postwar British Economic Growth and the Legacy of Keynes," Journal of Political Economy, University of Chicago Press, vol. 105(3), pages 439-72, June.
  7. Ronald I. McKinnon, 1988. "An International Gold Standard without Gold," Cato Journal, Cato Journal, Cato Institute, vol. 8(2), pages 351-392, Fall.
  8. Atish R. Ghosh & Anne-Marie Gulde & Jonathan D. Ostry & Holger C. Wolf, 1997. "Does the Nominal Exchange Rate Regime Matter?," NBER Working Papers 5874, National Bureau of Economic Research, Inc.
  9. Alogoskoufis, George S & Smith, Ron, 1991. "The Phillips Curve, the Persistence of Inflation, and the Lucas Critique: Evidence from Exchange-Rate Regimes," American Economic Review, American Economic Association, vol. 81(5), pages 1254-75, December.
  10. Herschel I. Grossman, 1988. "The Political Economy of War Debts and Inflation," NBER Working Papers 2743, National Bureau of Economic Research, Inc.
  11. Michael D. Bordo & Eugene N. White, 1991. "British and French Finance During the Napoleonic Wars," NBER Working Papers 3517, National Bureau of Economic Research, Inc.
  12. Bennett T. McCallum, 1997. "Issues in the Design of Monetary Policy Rules," NBER Working Papers 6016, National Bureau of Economic Research, Inc.
  13. Alberto Alesina & Roberto Perotti, 1994. "The Political Economy of Budget Deficits," NBER Working Papers 4637, National Bureau of Economic Research, Inc.
  14. Barro, Robert J., 1979. "On the Determination of the Public Debt," Scholarly Articles 3451400, Harvard University Department of Economics.
  15. Michael D. Bordo, 1984. "The Gold Standard: The Traditional Approach," NBER Chapters, in: A Retrospective on the Classical Gold Standard, 1821-1931, pages 23-120 National Bureau of Economic Research, Inc.
  16. Bordo, Michael D. & Rockoff, Hugh, 1996. "The Gold Standard as a “Good Housekeeping Seal of Approval”," The Journal of Economic History, Cambridge University Press, vol. 56(02), pages 389-428, June.
  17. Eichengreen, Barry, 1992. "Three Perspectives on the Bretton Woods System," Department of Economics, Working Paper Series qt8rg1h520, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  18. Michael Bordo, 1993. "The Gold Standard, Bretton Woods and other Monetary Regimes: An Historical Appraisal," NBER Working Papers 4310, National Bureau of Economic Research, Inc.
  19. Abramovitz, Moses, 1986. "Catching Up, Forging Ahead, and Falling Behind," The Journal of Economic History, Cambridge University Press, vol. 46(02), pages 385-406, June.
  20. Sargent, Thomas J & Velde, Francois R, 1995. "Macroeconomic Features of the French Revolution," Journal of Political Economy, University of Chicago Press, vol. 103(3), pages 474-518, June.
  21. repec:cup:cbooks:9780521562584 is not listed on IDEAS
  22. Bordo, Michael D. & Schwartz, Anna J., 1999. "Monetary policy regimes and economic performance: The historical record," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 3, pages 149-234 Elsevier.
  23. Alberto Alesina & Roberto Perotti, 1995. "The Political Economy of Budget Deficits," IMF Staff Papers, Palgrave Macmillan, vol. 42(1), pages 1-31, March.
  24. Alberto Giovannini, 1993. "Bretton Woods and Its Precursors: Rules versus Discretion in the History of International Monetary Regimes," NBER Chapters, in: A Retrospective on the Bretton Woods System: Lessons for International Monetary Reform, pages 109-154 National Bureau of Economic Research, Inc.
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