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Nick, I like this post a lot. One thing I would bring up is how much does social/legal conventions contribute to the unique status of money. In your Zimbabwe example, the government was able to issue as much currency as it wished because it was illegal to not take payment in the Zimbabwean currency the use of other currencies was also outlawed. If that government could not force people to accept currency then it is hard to imagine that money supplied would be determined just by money supplied in that case. Of course in most countries money is accepted as money simply by convention with no legal justification.

Countries also seem able to impose some degree of financial repression if they so wish which allow them to supply a greater amount of bonds at any given interest rate than they would otherwise. A good example is war bonds during WWII. It would seem that bonds then can take on some of the economic characteristics of money.

You've done a lot of posts about why money has these weird properties that it does which I really enjoy but I feel are under discussed in general. It's not something that you can put into a model but it definitely affects how variables behave in a model. The liquidity trap model incorporates the idea that bonds can act wholly like money but I don't know of any models where money does not have all the usual properties of money (I don't know if you can really even it call it money then) or bonds sort of act like money like cases of mild financial repression (Japan?).

Maybe I missed it in there somewhere but is the answer yes or no?

Bank notes are just bonds. That's why they both show up on the liability side of the government's balance sheet. Notes bear lower interest than other bonds, but for that matter, 1 year bonds bear lower interest than 10 year bonds.

This means that it's not right to say that governments can always get people to accept more notes but not more bonds. If I have some wheat to sell, and Zimbabwe wants to buy it, then I'd accept either Zim notes or Zim bonds. They'd have to pay me a lot of either one, but I'd accept them both, and they'd both get entered the same on the liability side of Zimbabwe's balance sheet.

OK, after wracking my brain I think I'm seeing something of the model you prefer. Essentially, equation 1 holds, but only because the price level is constantly adjusting to insure that the real money stock intersects money demand at a fixed Rm.

If the price level adjusts slowly, a decrease in nominal money stock M will produce an excess demand for money. For conventional goods, excess demand is associated with queues, black markets, and reductions in quality. A queue in the market for money would essentially be unemployment and a general glut, right?

But what would be the implication of an increase in the stock M? You seem to be saying that (unlike conventional goods markets) it's not possible to produce an excess supply of money. The central bank could increase the money supply without bound, and the quantity demanded would never fall below the quantity supplied at Rm (unless sufficiently high inflation causes people to abandon one medium of exchange for another, in which case we would expect a discontinuous change).

These two paragraphs only seem to go together if there is always an excess demand in the market for money. But it seems like the whole point of the post is that the price level does 'clear the market' for money in some sense (whereas Rb clears the market for bonds). For the same reason, I'm unclear what the implications would be if there were a change in Rm.

I guess I'm a bit unclear whether your model has a market for money with a stable equilibrium, or if it's fundamentally a disequilibrium model.

Mike Sproul, you said "Bank notes are just bonds."

Bonds have a coupon, a face value, and a date of maturity. I'm comfortable with your case that money has a coupon of zero. But when does a bank note reach maturity? Is it a very short term (instantaneous) bond, or a very long term (infinite-time-to-maturity) bond? And how would you calculate it's face value? What sort of payment could you receive when a bank note matures other than more bank notes?

And good luck using those Zim bonds at a food cart to buy your lunch. You could try to make the case that the difference in liquidity between bonds and notes is trivial for macro purposes, but the difference exists.

Are IOR paying reserves bonds or money?

Norman:

1. Take away the coupon and it's still a bond.
2. Bank notes have a face value. They say "One Dollar", or something to that effect.
3. If a bond's date of maturity is uncertain, it's still a bond. Bank notes might promise 1 oz of silver any time, or after 30 days, 30 years, or at some unspecified time when the issuing bank decides to shut down.
4. The payment received at a bank note's maturity could take many forms. It could be silver, or the note issuer might sell some of its used furniture for its own notes, then retire the notes. In that case the note is redeemed for furniture. Or the note might be redeemed for one of the note-issuer's government bonds, which are in turn used to pay a tax owed to the government. In that case the notes are redeemed for tax obligations.
5. I'd have a hard time buying lunch with either Zim notes or Zim bonds. If you try to define money by its relatively high liquidity, you'll soon be confronted with a whole spectrum of things with varying degrees of moneyness, and you'll realize that defining money is an exercise in drawing lines where nature didn't put any.

Joseph: thanks!

"One thing I would bring up is how much does social/legal conventions contribute to the unique status of money."

Social convention always matters a lot in which particular good people will use as money. Whether I am willing to accept some good in exchange for the goods I sell depends a lot on whether I think others in turn will accept it from me. Just like we tend to speak the language of those around us. And the law can sometimes reinforce those social conventions.

Presumably people in Zimbabwe would have abandoned the Zim dollar for an alternative a lot quicker otherwise.

Jerry: it's a "why?" question, so won't have a yes/no answer.

Mike: OK. Notes are like a zero coupon perpetuity, that are used as media of exchange. If you like, some bonds are, and some bonds aren't, used as media of exchange. The ones that are used as media of exchange we call "money", and the others we call "bonds".

Norman: I'm wracking my brain too. I think you are seeing it about as clearly as I'm seeing it.

"A queue in the market for money would essentially be unemployment and a general glut, right?"

Yes. Because there is no (one) "market for money". The "market for money" is every single market in the whole economy, because money is bought and sold in every market.

"But what would be the implication of an increase in the stock M?"

You can always get any individual to *accept* more money even if no individual wishes to *hold* more money. Because each individual believes, correctly, that he can always pass it on to some other individual.

I think I'm missing why the supply of bonds affects the price level in a way different from (say) the supply of bananas.

All goods are priced in terms of money so if the quantity of money changes then (other things being equal) the price of all goods changes.

If the supply of bananas changes then the money prices of bananas will changes and all other prices (I suppose) will adjust slightly as well.

How do bonds differ from bananas ? When the supply of bananas increases their prices falls. When the supply of bonds rises their price might rise (because the govt has to pay more interest to attract buyers). But that seems a minor difference. Bonds are also used to fund govt deficits and I suppose that could affect the price level, but that would be a secondary effects.


"ones that are used as media of exchange we call "money", and the others we call "bonds"."

But that makes at least the first two equations irrelevant, since the value of bonds is determined by the value of the assets and promises backing them, and not by the supply and demand of bonds.

Nick,

"Suppose we considered a government that did not issue money and could only issue bonds. A local or provincial or Eurozone national government, for example. So we can delete M, Rm, and equation 1 from the model. How many degrees of freedom would such a government have? It would have one degree of freedom. It could choose the deficit, or it could choose Rb, but it cannot choose both."

You are forgetting about time (unless you are dealing with all single period bonds). A government can choose both the deficit and Rb by adjusting the term structure of the bonds that it sells. A government can reverse the bond auction process by stipulating the interest rate that it will pay and asking that all bidders submit the duration that they will accept for the bond.

Ron:

"why the supply of bonds affects the price level in a way different from (say) the supply of bananas."

Because bonds are the liability of their issuer, while bananas are nobody's liability. A firm or government that issues $100 worth of bonds will sell them for $100 worth of other stuff. The bonds increase the issuer's liabilities by $100, while the other stuff increases the issuer's assets by $100, so the issuer's assets move in step with liabilities and the value of the bonds is unaffected. Not so for bananas.

I dont see where the second degree of freedom comes from. Even if the government sets Rm = 0, the "real" Rm isnt 0, it equals the societal costs of seignorage. If the economy works as we would usually expect then real Rm = Rb in the Long run. If the government sets a higher Rm then 0, then all it is doing is undercutting its seignorage profits, which is kind of pointless. So all I see is one degree of freedom, which is financing the deficit. There is only an assymetry to me if we think that financing through seignorage has different short run effects (or even long run in a very weird economy) than financing through debt.
Am I missing something obvious here?

Nick

"Now let's take the opposite extreme case. Suppose we consider a government that never issues bonds and that finances its deficit only by issuing money. So we can delete B, Rb, and equation 2 from the model. How many degrees of freedom would such a government have? I say it would have two degrees of freedom. It can choose the deficit, and it can choose Rm."

In this case (assuming the time period for Rm interest payments is instantaneous), there is no difference between the direct expenditures that help create the deficit and the interest payments prescribed by Rm. There are not two degrees of freedom because the Rm interest payments and the government expenditures above income are realized in the same time period.

Suppose for example that you received $100 in deficit spending from the federal government and $100 in Rm interest payments in the same envelope. Could you tell which was which?

Mike: "...the value of bonds is determined by the value of the assets and promises backing them, and not by the supply and demand of bonds."

I would say that's a false dichotomy. The demand price (what people are willing to pay for bonds) is a function of the assets and promises backing them.

Alex1: no, you aren't missing anything obvious. But in the case of money, the change in inflation (and hence real Rm) comes as an *eventual consequence* of the government's choice of M. In the case of bonds, the government must promise Rb *before it can even sell* the bonds.

Nick,

"But in the case of money, the change in inflation (and hence real Rm) comes as an *eventual consequence* of the government's choice of M."

How then does a government have two degrees of freedom here? It can choose the deficit but must wait for the *eventual consequence* to figure out the Rm?

With bonds, a government could set the Rb and the deficit and request bids on the duration of bonds it wants to sell.

Nick:

The supply price is also a function of assets and promises. If R=5% and a bond reliably promises $105 in 1 year, then the supply curve (and the demand curve) today will both be horizontal at $100. If the bond sold for $101, people would supply infinite amounts of bonds, while if P=$99, nobody would supply any bonds. (This implies, by the way, that supply and demand don't determine bond prices in the way that they determine banana prices. Bananas are produced using scarce resources and they are consumed. Not so for bonds.)

MIke

"Because bonds are the liability of their issuer, while bananas are nobody's liability"

Well, if you buy bonds you defer spending into the future, and if you sell bonds you get to spend extra now. But these 2 things cancel out and total spending will be the same (unless , I suppose, the bond buyer would have hoarded the money otherwise?) . It may be that the bond issuer will buy different goods than the bond buyer would have done , . but that still seems like a secondary issue to me.

If there is anything here that MMTers have not already worked out, can someone tell me what it is? For example take Nick’s sentence, “A government that can only finance a deficit by selling bonds must persuade people to buy its bonds by offering a sufficiently high rate of interest…” . Well that point is covered in Warren Mosler’s “Soft Currency” article. See:

http://www.gate.net/~mosler/frame001.htm

And if Warren can explain the point, as he does, by way of an analogy with an ultra-simple economy consisting of just one household, I have to ask why Simon Wren-Lewis has such difficulty with the idea.

Ralph,

“A government that can only finance a deficit by selling bonds must persuade people to buy its bonds by offering a sufficiently high rate of interest…”

A bank borrowing short and lending long would require an interest spread between what it borrows at short term (set by the Fed) and what it lends at long term to remain profitable and in business. An individual deciding whether to consume now or lend and consume later may be conscious of the inflation adjusted component on the interest rate he / she is receiving on the government bond.

If the federal reserve sets short term interest rates at 3%, the federal government must sell long term bonds at an interest rate above 3% to get the banking system to buy them.

Mosler seems to forget that banks operate as for profit businesses.


Ralph: my sense when writing this was that MMTers would agree with my main point.

But could you point to the place in that article by Warren where you think he explains it more simply?

Mike: a demand curve for bonds may be perfectly elastic, if those bonds are perfect substitutes for other bonds, and if the supplier is small enough relative to the total bond market. But the government is typically a large supplier of bonds, and will face a downward-sloping demand curve (or upward-sloping, if we put Rb on the vertical axis). My equation 2 implicitly assumes the government is a large supplier, otherwise 2 would collapse into a degenerate Rb = H(stuff that excludes B/P).

The concept of fiat money can be illuminated by a simple model: Assume a world of a parent and several children. One day the parent announces that the children may earn business cards by completing various household chores. At this point the children won't care a bit about accumulating their parent's business cards because the cards are virtually worthless. But when the parent also announces that any child who wants to eat and live in the house must pay the parent, say, 200 business cards each month, the cards are instantly given value and chores begin to get done. Value has been given to the business cards by requiring them to be used to fulfill a tax obligation. Taxes function to create the demand for federal expenditures of fiat money, not to raise revenue per se. In fact, a tax will create a demand for at LEAST that amount of federal spending. A balanced budget is, from inception, the MINIMUM that can be spent, without a continuous deflation. The children will likely desire to earn a few more cards than they need for the immediate tax bill, so the parent can expect to run a deficit as a matter of course.

To illustrate the nature of federal debt under a fiat monetary system, the model of family currency can be taken a step further. Suppose the parent offers to pay overnight interest on the outstanding business cards (payable in more business cards). The children might want to hold on to some cards to use among themselves for convenience. Extra cards not needed overnight for inter-sibling transactions would probably be deposited with the parent. That is, the parent would have borrowed back some of the business cards from the children. The business card deposits are the national debt that the parent owes.

The reason for the borrowing is to support a minimum overnight lending rate by giving the holders of the business cards a place to earn interest. The parent might decide to pay (support) a high rate of interest to encourage saving. Conversely, a low rate may discourage saving. In any case, the amount of cards lent to the parent each night will generally equal the number of cards the parent has spent, but not taxed - the parent's deficit. Notice that the parent is not borrowing to fund expenditures, and that offering to pay interest (funding the deficit) does not reduce the wealth (measured by the number of cards) of each child.

Frank: OK, that might be the bit that Ralph has in mind.

I don't think warren's business card metaphor works. I explain why in this sequence of comments on JP's Moneyness blog.

Nick,

"Suppose Warren Mosler were issuing new business cards all the time, so that the stock of business cards were growing faster than the number of people in the room. Suppose furthermore Warren promised (like the Bank of Canada) that he would always issue enough business cards so you could always buy one 2% cheaper if you just waited a year. Would they still be valuable?"

If you lived for an infinite amount of time they would not be valuable (just wait until Mosler and his bouncer keel over from a stroke or heart attack). With a finite lifespan, yes they still have value.

Nick,

I had in mind this passage of Mosler’s: “The parent might decide to pay (support) a high rate of interest to encourage saving. Conversely, a low rate may discourage saving.” I.e. if the interest rate rises, the private sector will hold more government debt, all else equal.

Frank,

Commercial banks are not of huge relevance here since in the US they hold only about 2% of government debt (and 10% in the UK). I.e. it’s the private sector as a whole that holds the debt. So I agree with your point about banks being profit motivated, but it needs broadening into something like: “the private sector is profit motivated”. But I suggest Mosler takes account of that. I.e. he says, as mentioned just above, that if “debt holding” becomes more profitable, the private sector will hold more debt.

Ralph,

"Commercial banks are not of huge relevance here since in the US they hold only about 2% of government debt.."

But they are a significant presence in the bond auction process - the place where interest rates on the federal debt are initially set. And so a bank (primary dealer) submitting bids on government debt will not bid the interest rate on new issuance of debt below its own short term cost of funding even if the bank has no plans to retain the bonds for very long.

Ralph: Ah. But that bit of Warren you quoted is fairly standard. Almost any macroeconomist would say something similar. I thought you maybe had something else in mind.

Frank:

Your business cards have value because they are convertible into food and shelter, and backed by the parents' assets. When most people talk about fiat money, they are thinking that bits of paper have value because they are demanded (for liquidity) and limited in supply. By that definition, business cards are not fiat money. They are backed and convertible, just like a privately-issued bank note that lets its holder claim 1/35 oz of gold.

It's a little unclear to me what you are assuming is the same and what you are varying as between your two scenarios, particularly with regard to the rates. It looks like you are saying that the only difference between the two cases is that in the first dM =0 and in the second dB=0. Then, in both cases, the government can set both the deficit and Rm, and we see what happens to Rb and P.

Or are you saying that in the first case the government fixes Rm and lets Rb float, and in the second case fixes Rb and lets Rm float?

Alternatively, looking at your closing sentences are you saying that the money issuing government can issue more money any time it likes whilst keeping both Rm and Rb constant, but that the bond issuing government has to let either Rb or Rm vary if it wants to issue more bonds? Or are you in fact saying that Rb must vary in both cases (if Rm is fixed) - just that it goes down in one case, up in the other?

Nick: Yep it's unclear. I'm still trying to make it clear. Let me have another try:

"Alternatively, looking at your closing sentences are you saying that the money issuing government can issue more money any time it likes whilst keeping ... Rm ... constant, but that the bond issuing government has to let ... Rb ... vary if it wants to issue more bonds?"

Yes. (The dots are where I have edited out your words. Because I want to consider the two extreme cases, where the government issues only money, or issues only bonds.)

" But in the case of money, the change in inflation (and hence real Rm) comes as an *eventual consequence* of the government's choice of M. In the case of bonds, the government must promise Rb *before it can even sell* the bonds."

Hmm, but People theoritcally could immediately demand Rm = Rb, if they have perfect Information and rational expectations. So to me it seems that the assymetry stems from the fact that we assume People are very good at pricing bonds but not good at predicting Inflation (which I think is true at any rate). But, in that sense, if we said that for some reason people were bad at pricing bonds but good at predicting inflation, couldn't the assymetry run the other way (after all, Greece did get a lot of debt at a comparatively at a probably too low rate for several years, the costs of which are only felt now...)?

Alex1,

"Hmm, but People theoritcally could immediately demand Rm = Rb, if they have perfect Information and rational expectations."

But with a bond, one person is able to save (defer consumption) while another is able to spend and so net consumption is unchanged (neglecting the influence of the central bank). And so the Rb that is offered is self fulfilling. When a government only issues money, it will struggle to maintain a real money rate (Rm) because there is nothing preventing the recipient of the Rm interest payment from turning around and spending it in the same period.

Nick

Thank you for your reply, but by dotting out part of my question, it sort of ducks it. I'm also only thinking of the extreme cases.

It looks to me as if you are assuming that Rm is fixed in both cases. We know that Rb then has to float if new bonds are issued. The question is what happens to Rb if new money is issued?

In the money issuance scenario, I would expect Rb also to float, but down rather than up. After all, new money will lead to a relative fall in the real supply of bonds.

In your bond only scenario, you assume (it appears) that Rm is fixed and Rb floats. A true parallel for the money only scenario would be to assume Rb is fixed and Rm floats. (This is clearly an unusual and impractical way of conducting policy, and maybe that's the point.) In that instance, you would expect greater deficits to lead to an increase in Rm, so the two cases are really the same and it all comes down to the magnitude of the parameters.

However if, for both cases, you assume Rm is fixed (which is more realistically how policy is conducted), then Rb will rise on bond issuance and fall on money issuance. If overall demand for assets is a positive function of rates, this will mean that money issuance will have a greater impact on prices than bond issuance.

Nick: OK. Let me try this.

Let's assume that Rm is fixed at 0%, for simplicity (the only government money is currency, which cannot pay interest).

Start with both 1 and 2 holding.

Assume the demand for bonds is a positive function of Rb, and the demand for money is a negative function of Rb. (Standard assumptions).

In order to be able to sell more bonds, the government must *first* increase Rb, otherwise people will refuse to buy them, and so the government will be unable to sell them.

If the government sells more money, Rb will decrease *as a consequence* of selling more money (or else P will rise as a consequence of selling more money). But the government does not *first* have to reduce Rb (or increase Rm) in order to persuade people to buy more money. It just goes out and buys some goods, and people will *accept* that money in exchange for goods even if they don't want to *hold* more money.

In an extreme case, imagine that Rb is fixed by law (as well as Rm being fixed). The government will be unable to sell more bonds, but it can still sell more money by buying goods.

What's the difference between money and bonds?

1. People will *accept* more money even if nobody wants to *hold* more money, because everyone knows they can pass it on to someone else. That's not true for bonds. Money circulates in a way that bonds don't.

2. In a monetary exchange economy (as opposed to a barter economy): Money is bought and sold for every other good. Bonds are only bought and sold for money.

Great. Thanks for clarifying. That is a much better explanation.

I don't think it's worth going into this too much, but I think it is worth noting that you have a dis-equilibrium in both instances of your extreme case of a fixed Rb.

On the one hand, as you say, the government would be unable to find buyers for additional bonds at that rate. However, in the other case, you would have investors wanting to buy bonds (with their excess money) but being unable to find sellers.

Nick: Yep. But a disequilibrium in the market for bonds is very different from a disequilibrium in the "market" for money. Because bonds have just one market, where bonds are traded for money. But money has every market in the whole economy (ignoring barter), because every good is traded for money. (Which is why Walras' Law doesn't work.)

Actually, I think both disequalibria are in the bond market - in one case supply exceeds demand and in the other demand exceeds supply. After all, it's the bond price, we're preventing from clearing the market.

"But with a bond, one person is able to save (defer consumption) while another is able to spend and so net consumption is unchanged (neglecting the influence of the central bank). And so the Rb that is offered is self fulfilling. When a government only issues money, it will struggle to maintain a real money rate (Rm) because there is nothing preventing the recipient of the Rm interest payment from turning around and spending it in the same period."

But, if you assume perfect rationality govt Money printing leaves consumption equally unchanged, because the rational actor will say "I realize youre just printing Money, so when you come to spend this deficit Money I will give you less goods in Exchange, thus enforcing Rb anyway". Ist as if the government printed bonds, just instead of having to repay P(1+Rb) in a years time, instead it only gets P/(1+Rb) goods now, which, with the perfect market assumptions should make no difference. Of course thats wildly unrealistic, but still it seems to me that the hot potatoe is an insufficient condition to cause an assymetry. Meanwhile, if for some reason the rational actor is really bad at pricing bonds, thus causing him to errounesly only demand P(1+(Rb - x)) in a year, it does seem to me that the assymetry could run the other way round, because the govt would earn a seignorage (or spread if you like, assuming ist a good Investor) from printing bonds.

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