A Fixed Reserve Ratio Commodity Standard - More on Operating Procedures

Yesterday I laid out the basics of a fixed reserve ratio commodity reserve standard. The basic idea is that the central bank hold a broad basket of commodities. It does not attempt to stabilize the price of the basket. Instead, it buys or sells the basket as the reserve ratio deviates from its target, and only does so until the official reserve ratio has been reestablished.

I did not fully lay out the nature of central bank non-commodity reserves. Expansion in this system would not only occur through the purchase of the commodity basket. The central bank would also purchase securities. The rate of purchase of these securities would be equal to the rate of purchase of the commodity basket. If the central bank need to increase it dollar value of commodity holdings by 10%, it would also increase by 10% it holding of treasuries. This should have two effects. First, the price of the bundle will not be determined by the central bank. Under this policy, the change in the price of the bundle cues action by the central bank. Central bank purchases of the commodity should make price movement  more shallow, but it will not eliminate price volatility altogether. This is a nice advantage as a change in prices is a force that pulls speculators into the market, and thus, information provided by speculators will not be lost or greatly distorted. Second, the central bank will also purchase or sell securities at the same rate that it alters holdings of the commodity basket. When it purchases these securities, it should do so from a large number of investment firms and from a variety of types of securities so as to minimize distortions in the market. When interest rates rise, the value of these holdings will increase, so the central bank will buy more commodities and securities. When interest rates fall, the opposite will occur. So we can see that holdings of commodities will make the base money stock responsive to changes in prices. Holdings of securities will make the base also help stabilize the interest rate. However, it would by no means determine the interest rate. That would be left up to the market process to decide. This proposal moderates prices and interest rates.

The final piece left to complete this sketch of policy is to determine the ratio of commodities that comprise central bank reserves. It may make sense to let commodities make up the same proportion of central bank reserves as they do for the proportion of total consumption they represent. The proportion of reserves that the commodities comprise should definitely be no greater than that proportion.