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Monetary equilibrium, the goal of monetary policy

The goal of monetary policy is monetary equilibrium. This is true for any monetary arrangement that claims to serve a general interest among the population rather than to simply divert wealth to the ruler and his cronies.

Monetary equilibrium is a situation where the supply of money equals the demand, given a particular constellation of prices. The supply of money includes both the monetary base and various forms of credit. In monetary equilibrium, the monetary system is doing the most it can to facilitate beneficial trades. An excess supply of money induces people to make some trades that market participants will later judge not to have been beneficial. A deficient supply of money hinders people from making some beneficial trades.

Under free banking (so the argument goes), the profit motive guides banks toward monetary equilibrium. The way it has done so in historical cases of free banking is through the clearing system. The clearing system is where the supply and demand for credit meet. If a bank, or other credit-issuing institution, has issued a greater supply of credit than people are willing to hold, it experiences losses of reserves. Losses of reserves lead to monetary losses, because liquidating assets may involve selling them at a loss. On the other hand, if a bank or other credit-issuing institution is issuing less credit than people are willing to hold, it is missing an opportunity to make a profit. Other banks, if sufficiently alert, will seek to fill the gap and capture the profits for themselves.

Profit cannot guide central banks toward monetary equilibrium in the same way. By design, central banks have no direct competition. The result is that when a central bank issues an excess supply of the monetary base, under a rigid exchange rate it does not lose reserves as quickly as free banks would, because it loses reserves only from transactions connected with foreign trade, not also with those connected with domestic transactions as free banks would. Under a floating exchange rate the central bank is not subject to the competition in terms of quality that free banks would presumably offer. (Here one must be a bit speculative because as far as I know there has never been a historical free banking system where each bank’s issue constituted a distinct floating currency.)

When a central bank issues a deficient supply of the monetary base, the field is not open to rivals who have the incentive to fill the gap because it will earn them profits.

Because central banks cannot rely on profit to guide them toward monetary equilibrium, they need to find other indicators. Economists have devoted much thought to what indicators central banks should use, but have rarely acknowledged that what they are doing is devising substitutes for profit and loss signals. Moreover, there is not much work in the area that capably bridges theory and practice. The best book I know is Manuel Johnson and Robert Keleher’s Monetary Policy, a Market Price Approach (2001; $125 new, so try looking for it used), which explicitly uses the idea of monetary equilibrium as a guide.

It is widely understood that central banks can make large monopoly profits by issuing a grossly excessive supply of the monetary base and inducing high inflation. That is the rationale for pegged exchange rates, inflation targeting, and other ideas for restraining central banks’ discretionary powers. What is not so widely understood is the other side of monopoly: central banks have less incentive than free banks to avoid a deficient supply of money that leads to deflation. Unlike free banks, they do not lose market share or suffer the threat of absorption by rivals if they issue too little. They receive political criticism, but often can successfully deflect it because monetary policy is a technical subject.

ADDENDUM: Scott Sumner (see  this post on his blog for his worldview) and several other economists advocate that central banks, at least in large economies, should target nominal gross domestic product and use a market in nominal GDP futures to guide how they achieve the target. Among the other economists are some who have been influenced by the idea of free banking, including Bill Woolsey, David Glasner, and David Beckworth. George Selgin and Steve Hanke also think nominal GDP targeting would get central banks closer to monetary equilibrium than the policies they have actually followed. So, for thinking about how guide central bank activity without the profit and loss signals that competition would generate, this is a well developed idea, even though it has not yet been elaborated at book length. Compared to inflation targeting, currently the standard practice for many central banks, nominal GDP targeting implies lower inflation rates or even deflation during periods of fast growth, and higher rates during periods of slow growth or recession.


  1. Economists have devoted much thought to what indicators central banks should use, but have rarely acknowledged that what they are doing is devising substitutes for profit and loss signals.

    This of course is "market socialism" and as Mises made clear, not matter how hard they try, it is impossible for central planners to engage in economic calculation.

    All the more reason to close down the central banks around the world…

    1. Given that dissolution of the central bank is not a realistic prospect, what is the alternative? Inflation or gdp targeting might not be the ideal, but will they serve as a second best? Will they at least serve as a kind of restraint on the capricious whims of central planners?

      Or do we just let the Federal Reserve operate willy nilly until such a time as we can institute ideologically pure free banking? I for one would vote to use the imperfect restraints in the meantime.

  2. The abstract ideal of a perfectly competitive market is indispensable when analysing and judging the properties of real markets, for friends and enemies of the free market both. It is how friends conceptualise the effects of government intervention, and it is how enemies define what it means for a market to fail. It is the underlying conceptual framework that everyone shares, to some extent or other, and it is the mutually understood background of almost all explanatory theories in economics.

    But when it comes to money and monetary policy, none of this is true. Everyone is groping in the dark, and different schools of thought are mutually incomprehensible. It's crazy.

  3. Imagine if economists had to explain how sugar tariffs effect the market for sugar, but they were forbidden from mentioning or suggesting how the world might be different if there were no tariffs. It seems to me this the position that most economists are in when it comes to money, except that nobody is forbidding from doing anything.

  4. I can't help myself.
    The condition of monetary equilibrium is when an average of 2.5 people are at the ATM machines during the typical business hour. This simple result comes from a model of commerce as a finite distribution network that has to maintain inventory along the chain.

  5. " The goal of monetary policy is monetary equilibrium."

    That point seems lost on many, hence the usual framing of monetary policy in terms of “stimulus” or as “propping up” something. This makes monetary policy sound like another lever to be used in Keynesian economic. Of course free banking is preferable to central banking but if you don’t have free banking, then it falls to the central bank to manage the demand/supply relationship. All of which leads me to my first question (and a half) which is:

    1) Has anyone tried to derive an explicit central banking rule from the money supply behaviour of banks in a free banking model, i.e., whereby the central banking rule would mimic the free banking result? If not, why not?

    2) It has always seemed to me that there was an assumption implicit in an NGDP targeting rule that EMH (or something like it) held. In other words, any impact of excess money supply on asset prices is an indirect effect of, e.g., output prices rising faster than input prices (maybe, but what about commodity prices – they seem to move very quickly) or lower interest rates (Scott Sumner presumably would object to any equation of lower interest rates with easy money). The asset price increases are thus “rational” in that they are based on expected cash flows and present values. The implication is that asset bubbles could be avoided by properly targeting nominal income and that there would be no need for monetary targets also to take explicit account of what may be happening to the prices of existing assets.

    The assumption thus is that there is no direct liquidity effect on the prices of existing assets that derives from individuals spending excess money balances on existing assets as well as on units of current output. If I recall correctly, however, Vernon Smith found in trading experiments that even once traders fully understood that excess liquidity caused price bubbles, the bubbles still occurred, they were just smaller and popped earlier. One can view that as a departure from EMH or alternatively, that the presence of monetary disequilibrium itself becomes a “fundamental” valuation factor, at least in the short/medium term. There also seems to be a firm belief among at least some financial market practitioners that, in effect, people spend excess money balances on existing assets (see “The Liquidity Theory of Asset Prices” by Gordon Pepper and Michael Oliver; I also recall reading something similar by Tim Congdon). My intuition is that EMH (or something like it – defined in the normal sense of asset values reflecting expected cash flows from operations) doesn’t hold during monetary disequilibrium.

    The whole issue as to whether to target asset prices in addition to prices of the components of GDP (or, alternatively, growth/level of NGDP) thus seems to really be a debate about the demand for money and what people do with excess money balances. Another way to frame the discussion would be to ask “what terms do we put on the right hand side of the equation of exchange”?

    Which leads me (finally – sorry!) to my second question:

    Has anyone attempted to broaden the discussion of monetary equilibrium, and derivation of a single monetary rule, to a transactions-based version of the equation of exchange (MV=PT) rather than a nominal income version (MV=PY)? It would allow one to incorporate the possibility that people spend excess money balances on existing assets, as well as making explicit any assumptions about the relationship between asset prices and input/output prices (EMH/no EMH/whatever).

    1. Oops. Meant also to say that this was an excellent post, particularly this point:

      " What is not so widely understood is the other side of monopoly: central banks have less incentive than free banks to avoid a deficient supply of money that leads to deflation. Unlike free banks, they do not lose market share or suffer the threat of absorption by rivals if they issue too little. They receive political criticism, but often can successfully deflect it because monetary policy is a technical subject."

    2. I guess I'll have to do what RickdiMare did below and reply to my own comment but is it not the case that what we have been going through at the moment is some sort of monetary disequilibrium? And that it is expressing itself through asset prices, i.e., not simply components of current GDP?

  6. Scott Sumner states:
    "Scott Lawton found a new article by Earl Thompson and noticed some important similarities to my view. As you will see, there are good reasons why we would have similar views. In the last paragraph there is a link to a paper modestly subtitled 'The Perfect Monetary System.' Amazingly, he might be right."

    Earl A. Thompson states:
    "However, there IS a financial system–one with a labor standard and free banking–that would, at least theoretically, simultaneously prevent all macroeconomic ills REGARDLESS of the kinds of shocks that hit our economy and without ANY reliance whatsoever on discretionary policy intervention." Earl A. Thompson, "Free Banking and Labor Standard–The Perfect Monetary System" (1982). (Emphasis is that of Mr. Thompson.)

    Isn't this quite simply and "amazingly" what the framers of the U.S. Constitution understood by limiting Congress' money-creation power to metallic coin in Article 1, Section 8? The labor involved in the mining, smelting, distributing, etc. of coinage (ANY metallic coinage) ties the money-creation (and distribution) process, in a meaningful way, to human labor.

    However, the addition of zeros to paper, or the extra keystrokes needed to add zeros to electronic notes, has absolutely no meaningful relationship to human labor. Of course, this doesn't mean we should physically carry only metallic coinage to engage in commerce, but it does suggest that there needs to be some legal way of informing all parties to a transaction that coinage has been demanded.

    (But otherwise, the economic language contained in the above linked articles provided by Kurt is pretty much a foreign language to me.)

    1. It's bad when one replies to one's own post, but there's another Constitutional issue regarding the Legal Tender Cases (1871-1874) that I think the group should know about, or at least consider, when thinking about changes to the existing central bank system, or when thinking about replacing the central bank system with a free banking system.

      That is, the Legal Tender Cases require Congress to keep its notes redeemable for current U.S. coin, and this restriction would apply to prospective free banks. Temporary suspension of payment in specie is Constitutional during extraordinary events, such as the Civil War, and maybe even the Cold War, i.e., unforeseen events that require either a change in the coin's metal type or a change in the "weights and measures" that define "dollar." But permanent note-irredeemabilty is clearly unconstitutional in my view (unless we voluntarily choose and/or tacitly consent to their use).

      This is because the power for Congress to issue non-coin money is based on the Article 1, Section 8 power "to borrow money," i.e. the Borrowing Clause. In other words, Congress cannot issue non-coin money that simply "borrows" (indefinitely and permanently); it must "borrow MONEY," and as I've stated before, the only money authorized by the Constitution is metallic coin under the Coining Clause, which is also an Article 1, Section 8 power. Everything other form of "money" is not really money that can discharge debts in the eyes of the Constitution, but rather debt-based fiduciary media that can be regulated under the Commerce Clause.

  7. I have a question that has been bugging me in thinking about fractionally backed bank notes in a free banking system. What incentive does the money user have in using notes instead of base money? If the notes don't offer interest, then the only advantage I can see is that paper is lighter and easier to carry than metal. That doesn't seem like such a big advantage as to drive out all base money from circulation. Fractionally backed deposits usually offer interest to entice depositors, but notes didn't, right?

    1. Eitan, I don't understand your question, but I'd like to say I find it truly mind-boggling, and almost beyond comprehension, how much economic injustice occurs simply because "paper is lighter and easier to carry than metal."

    2. A century ago, silver was the main precious metal used in retail transactions. Gold and gold coins were so much more valuable that they were not nearly as often used. U.S. silver dollar coins weigh about an ounce apiece. Try carrying around a pound or two of coins whenever you go shopping and you will see why people used notes. Notes typically did not pay interest.

  8. Nominal gross domestic product targeting is an intriguing idea as a "second best" option. Can anyone elaborate (or speculate) on what this would have meant in terms of Fed policy over the past decade (since the dot com bust) ? I assume that Free Bankers would want the target to be a constant NGDP ? (I followed some of the links above and most of those economists talked about a 5% NGDP target, and appeared in some cases to think that inflation would be a good thing "to stop people hoarding money").

  9. "Monetary Equilibrium" is a rather unclear concept.

    As for "monetary policty" – even Milton Friedman eventually came to the conculsion that there should not be one. Or, rather, that governments should not try and expand the money supply in order to keep the "price level" stable (rather than allowing prices to gradually fall over time as better ways of doing things were discovered and developed).

    On "balancing the supply and demand for money" this is done by interest rates. Not government or central bank set interest rates (there should be no such interventions), but by the interest rates that borrowers offer savings (either directly – or via honest banks and other straight third parties).

    If people wish to borrow more money than is available – then they must be prepared to pay higher interest rates (and, an often overlooked factor, satisfy lenders that they will be able to PAY THE MONEY BACK) and then people will save more (consume less) so that more money is avaiable to be lent.

    As to the reference to the word "credit".

    All borrowing must be from real savings (although such savings need not be local ones), if a credit bubble is created (rather than borrowing being from real savings) then a boom/bust cycle will be created.

    Sometimes I despair of people getting so obsessed with complexities and technical jargon that they miss basic common sense.

  10. People are supposed to know that the "monetary base" (notes and coins) is not the same thing as "broad money" ("M3" or other measures of bank credit).

    Yet why is one measure of money bigger than the other?

    Surely if banks just "put people's savings to work" then "M3" would be no bigger than "MB"? What would happen is that the banks would take in money (savings) and then lend out most of it (borrowings) – increase in the money supply ZERO.

    But that is NOT what happens – the measures of "broad money" get wildly out of line with the monetary base (the notes and coins) now why is that?

    Surely the reason must be that the banks (backed by the Federal Reserve and so on) are NOT just "putting people's savings to work" they create a credit bubble – which leads to (which is) a boom/bust.

    That is your "monetary disequlilibrum" or whatever other fancypants language people want to use.

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