Multiple currencies: Benefits of Multiple Currencies
Central banks today issue fiatmoney, or money that is intrinsically worthless and is not backed by an asset or a commodity at the central bank. Fiat money has value because people anticipate that others will agree to exchange goods and services for the money. It is generally well understood that issuance of fiatmoney suffers from a time inconsistency problem, in which the government chooses to change its policy from that promised earlier, often after other actors have made decisions or investments based on the previously announced policy. Themonetary authority, or the government that controls it, has an incentive to issue toomuchmoney because the cost of producing an extra unit of money is lower than the value of the money.
Businesses and consumers can choose to trade in another currency, one that they expect will retain its value. This gives them some protection from the inflation tax, a term that refers to the erosion of purchasing power. For this reason, one would expect multiple currencies to circulate in countries that have suffered from high inflation. Further, one would expect that the foreign currency that circulates is issued by a central bank with a reputation for maintaining the value of its currency.
Over the last 20 years, the Federal Reserve’s record of keeping inflation low in the United States has been much better than that of a number of developing countries. Moreover, the institutional setting in which the Federal Reserve operates suggests that the U.S. dollar is unlikely to suffer from high inflation in the future. This is also true of other currencies, such as the euro. Hence, it is not surprising that the dollar or the euro often circulate in other countries.
The circulation of multiple currencies can also help discipline a monetary authority because it reduces the incentives to set high inflation. The easier it is for businesses and consumers to trade with another currency, the more constrained the monetary authority is. In some extreme cases, the local currency can disappear entirely and be replaced by a foreign currency. Because multiple currencies can serve to discipline a monetary authority, they can also be used as a commitment device in a country where institutions make it difficult for the monetary authority to commit to low inflation. This means that the impetus for multiple currencies may come from a government, rather than consumers and businesses. In such a case, the government aims to signal that it wants the monetary authority to refrain from implementing high inflation.