Monday, September 23, 2013

Ghost Money: Chile's Unidad de Fomento

Santiago skyline

This post continues on the topic of the separation of the medium-of-exchange function of money from the unit-of-account function. My previous post discussed how the medieval monetary order was characterized by both a medley of circulating coins and one universal £/s/d unit of account. This post introduces a modern example of medium-unit divergence: the Chilean peso and Chile's Unidad de Fomento. I'll explain how the Chilean system works and end off by asking some questions about the macroeconomic implications of this separation, specifically what happens at the zero lower bound.

Like most modern currencies, the peso is issued by the nation's central bank; the Banco Central de Chile. Local banks offer peso-denominated chequing and savings accounts. Chileans use these pesos as the nation's medium-of-exchange. They pay their bills with pesos, settle rent with it, and buy food with it.

The differences between Chile's monetary system and those of other nations only emerges when we begin look at the unit in which goods are priced. Most nations have one unit-of-account, but Chile has two. While many Chilean prices are expressed in terms of the peso, or P, a broad range of prices are expressed in an entirely different unit, the Unidad de Fomento, or UF. Real estate, rent, mortgages, car loans, long term gov securities, taxes, pension payments, and alimony are all priced using UF. As examples, this real estate website sets prices in UF terms, and this car rental business levies insurance in UFs. On the other hand, wages, consumer good prices, and stock prices are expressed in peso terms.

So what is the UF? The UF was introduced in 1967 by the Chilean government, though it only came into wide use as a unit-of-account in the 1980s. There are no UF coins or notes circulating in the Chilean economy. Rather, the Unidad de Fomento exists as a purely abstract, or indexed, unit-of-account, totally divorced from any media-of-exchange. Goods and services quoted in terms of the UF can only be purchased with an entirely different medium — pesos.

The UF is defined as the amount of currency units, or pesos, necessary for Chileans to buy a representative basket of consumer goods. The amount of pesos in one UF, or the peso-to-UF exchange rate, is calculated daily, and is published on the Banco Central's website. The daily value is interpolated from the previous month's consumer price index, or the Indice de Precios al Consumidor (IPC). If you go to this website, you can see the current peso-to-UF rate and how it has been adjusted over the last week.

This all sounds quite odd, so let's use an example to get a better idea for how the system functions. When a Chilean seller prices something in UF, they are indicating that they expect to receive a fixed quantity of CPI basket-equivalents as payment. For instance, say that a landlord advertises an apartment in downtown Santiago at a monthly rate of 10 UF. A potential renter, curious about the price, checks the UF-to-peso exchange rate at the central bank's website. He sees that today's rate stands at 23,000. Using a cellphone app (in real life, the rate will probably not be a convenient round number), he multiplies 10 UF x 23,000 P/UF to arrive at the current monthly rate in pesos, or 230,000P (this is about US$450). Deciding that the price is good, the renter signs a lease and starts to pay UF-denominated rent each month in pesos.

Say that the Banco Central adopts an easy money policy and six months later the Chilean peso's purchasing power has fallen by around 10%. Rent is still priced at 10 UF. But now the peso content of the UF has risen —after all, it takes about 10% more pesos to buy the same consumer basket. The computed rate on the central bank's website is now 25,000 P/UF. The monthly amount in pesos that the renter must make out to the landlord now comes out to 250,000P (10UF x 25,000 P/UF), up from 23,000. However, while the rent payment is nominally higher, the payment's UF value is constant. In other words, the transaction represents the exact same quantity of CPI baskets as six months before.

It works the same way when the with a tight money policy. Imagine a 10% peso deflation. The UF sticker price stays constant while the conversion rate to pesos on the central bank's website falls by 10%. Rent is nominally lower in peso terms but in terms of representative consumer baskets it has stayed constant.

The UF/P system is similar in many ways to a partially dollarized economy in which the US dollar has been adopted as the unit in which to price long term contracts while the local currency is used to price current goods and services. What makes Chile different from partially dollarized economies is that the dollar tends to circulate along with the local currency as a medium-of-exchange. Thus there are two different units-of-account corresponding to two different media-of-exchange. Chile's UF, on the other hand, is a purely abstract unit with no corresponding medium of its own.

Irving Fisher was skeptical of medium-unit divergence and declared so in his 1913 paper The Compensated Dollar:
Not only would the multiple standard necessitate much laborious calculation in translating from the medium of exchange into the standard of deferred payments, and back again but, if, as has been suggested, the employment of a multiple standard were at first optional, the result would be that many business men whose prosperity depended on a narrow margin between their expenses and receipts would be injured rather than benefited by having one side of their accounts predominantly in the actual dollar and the other in the ideal unit.
Fisher went on to propose his compensated dollar scheme, which was essentially a combined unit-of-account/medium-of-exchange dollar. The real purchasing power of the compensated dollar would stay constant over time, much like the UF/peso combination, but without the necessity of imposing the laborious calculations involved in medium-unit divergence. That Chileans did choose to adopt a somewhat laborious mechanism that involves conversion from/to pesos to/from the ideal UF demonstrates the degree to which they were willing to free themselves of the burdens imposed by the 1970s inflation of the peso. According to Shiller, the practice of publishing the UF-to-peso rate on a daily basis—which began in 1977— may have also encouraged UF adoption. Prior to then, the UF had only been calculated monthly.

While the idea of separating the unit from the medium is not a common one, when it does arise it tends to have been inspired by the desire to avoid the deleterious effects of inflation. Widespread use of the UF, as pointed out earlier, came about as a response to 500%+ peso inflation of the 1970s. Robert Shiller, the most vocal modern advocate of unit/medium separation, is also motivated by the inflation side of the equation. Shiller believes that because people tend to succumb to money illusion when dealing with inflationary episodes, the adoption of indexed units-of-account may be the most palatable way to reduce the problem.

Just as interesting, however, is the idea of separating the unit-of-account and medium-of-exchange to help cope with deflationary episodes and the zero-lower bound problem

First, let's set up a hypothetical scenario without the UF and a combined peso unit-of-account and medium of exchange. Say the Chilean economy suddenly collapses. Pessimistic Chileans expect to earn a negative return on projects and investments. Peso cash provides a superior return in this environment since it pays 0%—hardly great, but 0% is better than -x%! Peso prices need to fall dramatically in order to restore equilibrium. Put differently, the value of the peso needs to rise to a level at which it is expected to decline at the same rate as all other projects and investments. Yet peso-denominated sticker prices are rigid, preventing the necessary adjustment. What should be a short period of sharp adjustment turns into a long painful period of high unemployment and idle resources.

Now let's assume that all prices are expressed in UF while actual transactions are conducted in pesos. The same shock hits the Chilean economy. Once again the negative yield on projects and investments is overwhelmed by the 0% yield on peso cash. Peso prices need to fall dramatically in order to equilibrate the peso's return with all other yields. As before, sticker prices are rigid.

Here's the difference between our first and second scenarios. In a world with an ideal unit-of-account and no related medium-of-exchange, it really doesn't matter that prices can't adjust. This is because prices are no longer expressed in terms of 0%-yielding peso cash. Rather, they are expressed in terms of UF. Because the UF lacks a physical counterpart, there are no equivalent UF instruments that might also hit the zero-lower bound. The peso's outsized 0% return relative to all other negative yielding assets, which before was the root of the problem, will be quickly equilibrated as the peso-to-UF exchange rate published on the central bank's website jumps higher.

So a shock to an economy in which a combined medium-of-exchange and unit-of-account prevails can quickly become a tragedy. The 0% nature of the former interferes with the stickiness of the latter. But when the medium-of-exchange is divorced from the unit-of-account, the 0% nature of the former will quickly be resolved since stickiness is now in terms of an ideal unit, and not in terms of pesos.

Medium/unit separation, it would seem, could be yet another foolproof way of escaping deflation and the zero-lower bound.

1. Robert Shiller, Indexed Units of Account: Theory and Assessment of Historical Experience, 1997. [RePEc]
2. Robert Shiller, Designing Indexed Units of Account, 1998. [RePEc]
3. Robert Hall, Controlling the Price Level, 2002. [RePEc]
4. Stephen Davies, National money of account, with a second national money or local monies as means of payment: a way of finessing the zero interest rate bound, 2004


  1. JP, you mention "unit-of-exchange" exactly once in your next to last paragraph. Did you mean to write "unit-of-account" here instead?

  2. JP you're an idea factory for new monetary policy regimes! So are you suggesting we create a new mandatory price unit, say the UF, AND the government defines UF:$ at will (perhaps monthly). Perhaps the UF is determined by industrial capacity or unemployment. In some sense, is this like price controls?

    1. It's a potential fix among 1001 fixes. There are more politically palatable ways to get the same effect such as Sumner's NGPD futures scheme or Miles Kimball's floating rate between cash and central bank deposits.

      I'm sure the UF could be defined in all sorts of ways other than CPI baskets. Shiller suggested nominal income, for instance. And no, I don't think that unit/medium separation is like price controls. It doesn't interfere with the normal functioning of the allocative mechanism.

  3. 1. Makes you wonder why the Peso is used ever used as the unit of account. There must be fairly significant costs to using the UF if it hasn't been universally adopted.

    2. "Robert Shiller, the most vocal modern advocate of unit/medium separation"

    This is the same Shiller of the Case-Shiller housing price index fame? Who knew.

    3. JP, you never fail to astound me with your ability to dig up wacky historical examples that are highly illustrative of what are usually very abstract debates. Thanks.

    1. 1. I think you're right. For small retail transactions the nuisance factor involved in making UF conversions probably overwhelms the positives, so retailers stick to the peso unit.

      2. Like you, I was very surprised to find that Shiller has done work in monetary econ, and very high quality too. He's a man of many talents. Nobel prize one day?

      3. Thank you, sir. I enjoy bringing these ideas to life -- a good example always helps me understand things better.

  4. I'm assuming the UF was adopted as a measure to help the economy cope with hyperinflation, given it was adopted just a few years before Pinochet... Or was it adopted right before the hyperinflation problems? It seems this scheme might give the central bank a great deal of wiggle room because there is less backlash from inflation, introducing a whole host of public choice problems.

    1. According to Shiller, it was implemented in the 1960s, but never really adopted by the population until the early 1980s, after the hyperinflation had subsided.

      You make a good point about wiggle room. The UF allows the central bank to continue to earn seigniorage profits during a hyperinflation since the public will continue to demand a stock of pesos for transactions. Something like defacto partial dollarization would allow less wiggle room since the USD threatens to displace the peso not only as a unit-of-account but also a medium of exchange. Central banks prefer to have more of their media in circulation since that increases seigniorage.

  5. Another fine post, JP. It seems to me that central banks have two jobs, which tend to get blurred together: defining a unit of account, and issuing base money. They can be un-blurred if the bank adopts an explicit, well defined (level) target. The target defines the unit of account, not the banking actions (changing the quantity of money or interest rate) of the central bank.

    1. Thanks Max.

      Makes sense to me. Mind you, if actions taken by the central bank contradict the target, then the target will no longer define the unit of account. Say the Reserve Bank of Zimbabwe announces a 3% inflation target, but creates 10,000% instead, prices in terms of the unit of account will rise by 10,000%, not by 3%. The target will have ceased to define the unit.

  6. Bitcoin is actually a great example of this as well. Even though the price is highly volatile, there have been no bitcoin "depressions" or "hyperinflations" because the dollar is often used as a unit of account while bitcoin is simply the medium of exchange.

  7. Shouldn't the debt-deflation/balance sheet recession people also support greater indexation of long-term debt? It would keep the real value of debts from increasing due to unexpected slowdowns in inflation (like we've had post 2007).


    I thought this was a good write-up by Shiller too:

  8. Does the base wage of the average chilean fluctuate with this exchange? If not does this then have a negative impact on the average wage earner,as illustrated in your rent example?

  9. I would second this question. I don't believe wages are denominated in UF's. Therefore, by denominating certain expenses in UF's, would this not simply pass along inflation risk to the end consumer while removing it from the seller? Apologies in advance for the layman's question

  10. The base wage typically does not fluctuate and the risk is passed along to the end consumers. The UF ends up being a protectionist barrier to keep money with large institutions and the rich who own UF while the poor are stuck paying in pesos.

  11. Thank you for the very best explanation of the convoluted UF system of account.