The three evaluation criteria
Adjustment = how BoP disequilibria are corrected: quickly and at low cost
Liquidity = reserve assets available to settle TEMPORARY disequilibria
Confidence = belief the mechanism works and reserves keep their absolute and relative values
Any question asking you to evaluate a system, past or present. Take the three in order and give a verdict on each.
- Adjustment
- The process criterion. Fails when correction is slow or bought with unemployment and inflation
- Liquidity
- The stock criterion. Fails when reserves are too small for a nation to avoid deflating
- Confidence
- The belief criterion. Fails when reserve assets are doubted or a devaluation is expected
Measuring the three criteria
Adjustment cost = deficit / MPM (income given up; ratio is 1/MPM)
Policy cut = (deficit / MPM) / k (autonomous spending to cut)
Import cover = reserves / monthly imports
Years financed = reserves / annual deficit
Backing ratio = convertible asset / foreign-held claims
Whenever a question hands you figures and asks how well a nation or a system is placed. State the formula used.
- 1/MPM
- Units of income destroyed per unit of deficit closed. 6.67 at MPM = 0.15, 20 at MPM = 0.05
- import cover
- Months of imports payable from reserves. Three months is the usual minimum benchmark
- backing ratio
- Share of foreign claims that could actually be converted. Falls mechanically as claims grow
The two classifications
By exchange rate mechanism: fixed | flexible | hybrid (managed float, adjustable peg,
crawling peg, currency board, dollarisation)
By reserve asset: gold standard | gold-exchange standard | fiat standard
Describing any historical or present regime. Give one answer on each axis; the axes are independent.
- gold standard 1880-1914
- Fixed rates, gold reserves
- Bretton Woods 1947-1971
- Adjustable peg, gold-exchange standard
- today
- Managed float, fiat standard