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Monetary theory and monetary policy in one sentence each

Scott Sumner recently issued a paper called "A Market-Driven Nominal GDP Targeting Regime." In it he comments that

it is not clear that the preceding five economists [Milton Friedman, Bennett McCallum, Robert Mundell, Robert Hall, and Michael Woodford] would even agree on what is meant by the term “monetary policy.” Friedman and McCallum might argue that monetary policy is all about control of the quantity of money, however defined. Mundell and Hall might argue that monetary policy determines the price of money (in terms of foreign exchange, or gold, or a basket of commodities.) Woodford might see monetary policy in terms of changes in the rental cost of money (i.e., short-term interest rates). The quantity, price, and rental-cost approaches to policy have all been around for hundreds of years. And both the short-run sticky-price and long-run classical frameworks go back at least to David Hume. These differences of opinion will not be resolved anytime soon.

Here is my proposed solution: Monetary theory is about how the nominal supply of money adjusts to the real demand for money. Monetary policy is about the best way for the adjustment to happen.

Briefly, there is a demand to hold a certain amount of purchasing power as money, both in the narrow sense of the monetary base and in the broader sense of various credit aggregates. The demand is clearly not purely nominal. When currency redenominations happen and 1 new peso is made equal to 1,000 old pesos, people who kept 100,000 old pesos in their wallets will rarely try to keep 100,000 new pesos in their wallets. The demand for money is in a certain sense "fuzzier" than demand for many other goods, though, because of money's function as a store of value. If somebody were to give me a ton of apples, I would try to get rid of them immediately. I have all the apples I need right now and I don't need a ton rotting on my hands. If, however, somebody were to give me the equivalent value in money, which let us assume is $800, I might hold onto part or all of it for quite a while before spending it.

The nominal supply of money can adjust to the real demand for money through price, quantity, or quality. A frozen monetary base is an example of price adjustment: the monetary base does not change and the purchasing power of each unit adjusts. A gold standard is an example of quantity adjustment: the purchasing power of each unit is fairly stable and the quantity of units in existence adjusts. A change in exchange controls is an example of quality adjustment: tightening exchange controls when the real demand for money falls makes each unit of money less useful, reducing the quality-adjusted supply.

I think that the five economists Sumner mentions, and many others as well, would agree with my suggestion that they are trying to figure out the best way for the nominal supply of money to adjust to the real demand. Where they differ is in their proposed solutions: freezing the monetary base? Adopting a gold standard? Targeting short-term interest rates? Manipulating exchange controls? Targeting nominal GDP? One of the many other policies imaginable? Proponents of free banking would argue that discussions about "the best" policy imply a degree of knowledge that we do not in fact have, and that the pressing need is to let competing approaches work themselves out in the market so that we can discover what is best.

  • Benjamin Cole

    A frozen monetary base is an example of price
    adjustment: the monetary base does not change and the purchasing power of each
    unit adjusts. A gold standard is an example of quantity adjustment: the
    purchasing power of each unit is fairly stable and the quantity of units in
    existence adjusts. — Kurt Shuler.

    This sentence stumped me.

    I would think in a gold standard,the quantity of units is fixed. My guess is that with a gold standard—and a fixed number of units circulating—you have to get continual deflation to accommodate economic growth.

    That, I fear, is the Achilles Heel of the gold standard. The chronic deflation would suppress real estate investment and some types of business borrowing. Maybe eventually, the sticky wage problem could be overcome, but that is another concern.

    I suppose one could arge that as gold becomes more valuable, more people would open up their deposit boxes and spend the yellow metal. But one could also argue that if gold is becoming more valuable, people will hoard it, as a great investment.

    Fiat money strikes me as a sound solution. You can increase the supply every year to accommodate economic grwoth, and build in mild inflation and an economic lubricant.

    Oddly enough, despite fears of "easy" money, the problem has been that central banks have developed hoary traditions and cultures of moonetary ascetism, and have been too tight in recent years.

    Would a gold standard fix that? I don't know, but I fear not.

    • Benjamin,

      The gold standard is NOT a "fixed number of units circulating". It is a fix price between gold and a money with rules that regulate its supply to be consistent with its gold price.

      There seems to be an issue about the important role of money as a store of value. In an exchange between me and Mike Sproul last week (here under my Hard Anchor for the Dollar blog) he argues that money can be only a unit of account with nothing having that value used for payments that has to be held between transactions. I don't really understand that, but he seems to think so.

      • Mike Sproul

        Warren:

        "money can be only a unit of account with nothing having that value used for payments that has to be held between transactions. I don't really understand that, but he seems to think so."

        I don't understand that either. In the simplest case of paper dollars that are backed by and convertible into 1 oz. of silver, the value of the dollar will be 1 oz regardless of its store of value function, regardless of money demand and money supply, regardless of velocity of circulation, etc. The trick of the backing theory is to recognize that convertibility can take many forms. Dollar bills can, for example, be convertible into silver, tax payments, loan payments, bonds, real estate, etc. If one of those forms of convertibility is suspended (usually silver convertibility), while the other forms of convertibility remain, then the dollar is still convertible, still backed by 1 oz. worth of assets, and therefore still worth 1 oz. The trouble with monetarists is that they think that 'inconvertible into silver'='unbacked'.

        • Mike,

          As I explain in some detail in my Hard Anchor for the Dollar note, it doesn't matter much what the dollar is redeemable (convertible) for as long as it establishes a link between its supply and its official value (e.g. price of silver). The link is provided by arbitrage. This, of course, is a monetarist perspective where prices are determined by supply and demand.

          • Mike Sproul

            Warren:

            I don't follow this:

            "as long as it establishes a link between its supply and its official value "

            As long as a banknote is convertible into something worth 1 oz of silver, and as long as the issuer of that bank note has enough assets to redeem all of its notes for 1 oz each, then the value of those notes must be 1 oz., regardless of the supply of and demand for those notes.

          • Mike,

            One last note as we have been round this circle several times. You say that as long as a banknote is convertible into something worth 1 oz of silver… This is what I have called indirect convertibility and I agree. But the real issue is under what circumstances would anyone redeem the bank note. You said "arbitrage" and I agree. But what are the details. If the market value of the banknotes differ from the official value of 1 oz of silver then there is an arbitrage opportunity to redeem them or buy more at the official price depending on whether the market price is above or below the official one. What is the consequent of that. It changes the supply of banknotes in the market until the price difference (arbitrage opportunity) is eliminated. That is the monetarist explanation summarized in my sentence you quoted and said you did't follow. What is your explanation for how redemption possibility keeps market and official price the same?

          • Mike Sproul

            Warren:
            If a bank holds 99 oz worth of assets and has issued $100 of notes, and if the official price is $1=1 oz., then notes return to the bank and the supply of notes in the market FALLS as the value of each note FALLS. By the time $98 of notes has been redeemed, the bank has just 1 oz of assets backing $2 of notes that are still in private hands, so each note is worth 0.5 oz. After the 99th note is redeemed, the bank has no assets left and the 1 note remaining in private hands is worthless. This is the opposite of what the quantity theory says. The quantity theory would say that as the notes reflux to the bank, the supply of banknotes in the market FALLS, and their value will RISE.

    • Kurt Schuler

      Elaborating on Warren Coats's reply, there is a difference between a frozen monetary base and a slowly growing monetary base. Gold has a slowly growing supply. As you point out, there are also nonmonetary uses of gold, which gives the stock of monetary gold more flexibility than one might think just from looking at the overall growth rate of the supply of gold. In light of the record of fiat currency, I am less optimistic than you that it is a sound solution, though I will watch with interest what happens with Bitcoin and its ilk.

  • Another criticism of free banking has just appeared on the Cobden site by Detlev Schlichter: 7,000 words – if you’ve got time. He also tends to use a thousand words where one will do, though this particular article doesn’t contain too much hot air: a welcomed change. See:

    http://www.cobdencentre.org/2013/08/money-demand-and-banking/

    • Kurt Schuler

      Thanks. I see that you also have a comment there.