InCognito

Being intimately familiar with the gold standard in both its historical and theoretical forms, I noted in the comment that having a fixed reserve ratio without a fixed-exchange rate for gold itself may actually make for a good monetary policy rule. As the price of gold rises, the bank will sell its gold. When the price falls, the bank will purchase more gold. There is a problem though. Employing only gold as a reserve commodity adds noise as the price of a single commodity is unlikely to reflect underlying market conditions. I suggest this can be amended by broadening the basket of commodities.

The functioning of a commodity reserve currency is straight forward (Hayek 1943; Graham 1944). Hayek and Graham suggested that base money be fully backed by a basket of commodities and that authorities peg the price of the basket, selling the basket when the price rose above the target price and purchasing it when its price moved below that price. I suggest some slight deviations from this formulation. Under a regime with fractional reserves, the monetary authority agrees to back a particular fraction of its notes with a basket of a broad array of commodities. When the price of these commodities rise, the central bank must automatically sell its holdings of this basket until the ratio returns to its statutory level. If the value of the basket falls, the central bank will purchase shares of this basket to maintain the statutory reserve ratio. As prices are procyclical during the business cycle, this policy automatically acts as a stabilizing force in the economy, as it stabilizes prices and provides liquidity when money is dear. This rule is convenient because, once the basket of commodities and operating structure are chosen, it is simple to execute. That the base money stock is responsive to changes in prices means that this rule promotes a money stock that is adaptive to changing market conditions. That is, it tends to facilitate changes in demand for money. Furthermore, since not all base money must be backed by the basket, expansion and contraction will also target credit markets and, therefore, regulate them according to market conditions as reflected by the value of the basket of commodities.

* I'm still working out the details, so I would be more than happy to read your critiques in the comments.

** The above is taken from an amendment to "Wither Gold". The new draft is up online!

Late: The 20% reserve requirement for the Swiss National Bank is a minimum, not a fixed reserve ratio.