Discussion of Institutions of Foreign Exchange Settlement in a Two-Country Model

1. Discussion of Institutions of Foreign Exchange Settlement in a Two-Country Model David C. Mills, Jr. Board of Governors of the Federal Reserve System david.c.mills@frb.gov Disclaimer: Views of author not necessarily views of Federal Reserve Board or System

2. Freeman (AER 1996) • Formulates role for central bank lending • Key ingredients • Money used to purchase goods and repay debt • Liquidity problem rationalizes central bank discount window

3. Fujiki (JME 2003) • Adds foreign exchange market with liquidity need • Old creditors with taste shock must exchange currencies • Only subsets (of different measure) from each country arrive early to foreign exchange market • Different exchange rates contingent on arrival to foreign exchange market

4. Fujiki (JME 2003) • Solution: • One of central banks provides liquidity for early foreign exchange • Liquidity provision restricted by gold standard at optimal exchange rate

5. Today’s Paper • Implicitly asks if such a policy is essential • Answer: no • Private payment-versus-payment system with central bank liquidity provision • Private Eurodollar accounts • Currency union only under special case

6. Essentiality • Definition of essential payment mechanism • Why essentiality test is important • Approach to modeling payments systems: focus on fundamentals

7. Essentiality: A Definition • Achieves desirable outcomes that cannot be achieved by any other payment mechanism • Example of desirable outcomes: public policy objectives • Fed: safety, efficiency, accessibility • Desirable outcomes strike right balance • Today’s paper • Focus on efficiency

8. Why an Essentiality Test? • Strong case must be made for central bank involvement • Careful evaluation of private sector solutions • Example: Monetary Control Act of 1980 • Federal Reserve must compete with private sector in provision of payment services • Must review whether provision of some services are essential

9. Why an Essentiality Test? • Determines degree of involvement • Catalyst • Regulation and oversight • Direct provision of payment services • Weigh adequacy of tools that favor less involvement with those that favor more

10. Essentiality Test in Today’s Paper • Equivalent • Central bank liquidity provision under a gold standard • Private payment-versus-payment system with central bank liquidity • Private Eurodollar accounts • Question: How robust is this equivalence?

11. Modeling Payments: Fundamentals • Policy-maker criticism: models seem highly stylized • Risk that conclusions not taken seriously • Solution: focus on relevant fundamentals

12. Lessons from Monetary Theory • Some necessary conditions for money to be essential as means of payment • Imperfect memory about trading histories • Imperfect commitment to (enforcement of) future actions • Recast language of islands, hills and tunnels into language of information, commitment and enforcement • Example: Mills (RED 2004) • Recast Freeman (AER 1996) • Assumptions about enforcement can raise doubts about essentiality of payment mechanism with need for liquidity

13. Conjecture about Today’s Paper • Strong assumptions about commitment of guardians are driving results • Example: Eurodollar accounts • Commitment to negotiable CDs • Commitment to gold standard • Commitment to cooperate • Central bank liquidity provision under gold standard seems to require less commitment

14. Conclusion • Essentiality test is important line of research in theoretical models of payments • Explicit assumptions regarding fundamentals (such as information, commitment, enforcement) add to economist understanding and aid policy-makers