The return of Monetarism

As interest rates approach zero, and central banks look at "unorthodox" monetary policies, the Neo-Wicksellian perspective on monetary policy has switched to a blank screen. We are witnessing the return of Monetarism.

That's the main reason why economists find it hard to think about unorthodox monetary policies. The dominant Neo-Wicksellian paradigm which fills our heads can say nothing about them. We are forced to return to older, half-forgotten ways of thinking. There is perhaps a "Dark Age" in thinking about monetary policy, just as much as in thinking about fiscal policy.

The dominant paradigm for monetary policy over the last decade has been the Neo-Wicksellian perspective: monetary policy is the central bank setting a short-term nominal rate of interest. The current short-term rate of interest, and expected future short-term rates of interest (solved for in a model-consistent or "rational" way), determine current demand for output (on an IS curve). Demand for output is assumed to determine current actual output, since firms are monopolistically competitive. Current output, plus expected future inflation (again solved for in a model-consistent way), determines inflation via a Phillips Curve equation.

In short, the canonical Neo-Wicksellian model is an ISLM model (plus a BP curve for an open economy), plus a Phillips curve, plus rational expectations, plus as much microfoundations as the New-Keynesian modellers can handle. Except: the LM curve is not really an LM curve; it's a monetary policy reaction function, in which the central bank sets the interest rate as a function of various indicators. It's certainly a model of a monetary exchange economy (as opposed to barter), but money itself appears nowhere in the model.

You can always add money to the model, if you like, by adding a money demand function. But it doesn't do anything. The quantity of money would be demand-determined, by whatever amount people want to hold at the rates of interest, prices, and incomes determined by the rest of the model. Money is a fifth wheel: an epiphenomenon. You could delete it from the model without anything else changing.

The standard model of monetary policy, in other words, says absolutely nothing about money. 'M' does not appear in the model. As David Laidler wrote, it's like "Hamlet without the ghost". "Quantitative easing" cannot be understood using a model where M, the quantity of money, does not appear.

And when I talk about "the standard model of monetary policy" I mean both the computer models that central banks use in setting monetary policy, and the models in the heads of monetary economists when they teach or research monetary policy. The canonical Neo-Wicksellian graduate textbook, Michael Woodford's "Interest and Prices", is a model of a cashless economy. Our heads can't handle quantitative easing, because the quantity in question is no longer in our heads.

The only way of thinking about unorthodox monetary policies, in the dominant Neo-Wicsellian paradigm, is in terms of the central bank creating expected inflation. This would reduce real interest rates (with nominal rates stuck at zero), and would increase consumption and investment demand. But this is useless advice, because there is no actual mechanism whereby the central bank can create expected inflation. It can only push on the useless lever of interest rates, which is already stuck at zero.

So we need to revert to an older, earlier way of thinking. Monetary policy is about changing the stock of money. The objective of monetary policy, in a recession, is to create an excess supply of money. People accept money in exchange for whatever they sell to the central bank, because money by definition is a medium of exchange. But they don't want to hold all that money. Or rather, the objective of the central bank is to buy so much stuff that people don't want to hold the money they temporarily accept in exchange. An excess supply of money is a hot potato, passing from hand to hand. It does not disappear when it is spent. It spills over into other markets, creating an excess demand for goods and assets in those other markets, increasing quantities and prices in those other markets. And it goes on increasing quantities and prices until quantities and prices increase enough that people do want to hold the extra stock of money.

That's classic Monetarism. That's what I learned from David Laidler. That's what I hear when I read Scott Sumner too.

I will return to this theme. But right now I need to do a little university administration for Carleton.

Comments

[brendon]

The two monetary policy books I have on my shelf are Woodford's and Carl Walsh's - not a whole lot of discussion of money supply in either - Walsh does have an excellent, though brief, discussion of how to get out of a liquidity trap that I pinched for a post on my blog.

[brendon]

excellent post by the way.

I'm curious what your view is on what it would take for inflation expectations to become unanchored given an established inflation targeting regime and if so, how successful do you think the Bank will be in generating inflation expectations through the purchase of imperfect money substitutes such as long-term bonds?

[pointbite]

"And it goes on increasing quantities and prices until quantities and prices increase enough that people do want to hold the extra stock of money."

I didn't understand this line. Can you further elaborate on how inflation (what you described sounds almost like hyperinflation) causes people to hold currency?

[Patrick]

Hey Nick:

http://krugman.blogs.nytimes.com/2009/03/03/hey-who-you-callin-neo-wicksellian-wonkish/

[JKH]

Nick,

Doesn’t quantitative easing include the case whereby the central bank increases the quantity of money as a necessary part of credit or qualitative easing? (Like the Fed is doing now?)

This reflects a flight from risky assets to risk free assets, more or less.

So the holders of the new money hold it more for its value as asset class than its value in purchasing goods and services.

So wouldn’t this part of quantitative easing be ineffective for purposes of providing a stimulus like effect? (As opposed to funding a government deficit?).

[Patrick]

Hope we figure out how to stimulate the economy somehow, be it fiscal and/or monetary policy. New data from the AB gov't on major construction projects is ... interesting. The approx. 20% annualized decline continues:

http://www.albertacanada.com/statpub/1120.html

February: $261735.9 x 10^6
December: $270727.3 x 10^6
November: $279300.0 x 10^6
October: $286527.2 x 10^6

AB was way over heated, so we probably had some room to cool down without doing too much harm, but the economic motor of AB is big capex. If that continues to fall off a cliff, employment will surely follow.

[Adam Purzitsky]

This is so wrong it's scary that a professional economist can't see it. Money is NOT a hot potato if there's no interest cost to holding it. Put another way, the whole arguement is only true when something like a cash-in-advance constraint is binding. In a liquidity trap the whole problem is that this constraint doesn't bind and CONSTRAINTS THAT DON'T BIND DON'T CHANGE BEHAVIOUR. To change behaviour you need a price signal, in the undergraduate IS-LM model changes in M change the interest rate and that is your price signal, no change in prices means no change in behaviour. I implore you to read Krugman on the subject (http://web.mit.edu/krugman/www/japtrap.html).

[reason]

Nick you are correct, the central bank should print money and give it to people.-)

(P.S. The problem is how to distribute it, and I REALLY think that is the best solution, but that is not I think what you are saying.)

[reason]

Nick Krugman has responded to you on his blog.

[Jim Sentance]

If the Banks are truly moving to classic Monetarism, should we be on the lookout for helicopters in the sky?

[Nick Rowe]

Well, it was great to see Paul Krugman's response!

In answer to his title question: ("Hey, who you callin' Neo-Wicksellian?" I expect the best short answer is "Nearly all of us, sort of".

It's hard to disagree with him too much, because he half agrees with me, and I sort of half agree with him on the remainder. In particular, he accepts my basic point that you can't analyse quantitative easing - the effect of changes in M - in a model which does not have M as a variable. (Sort of obvious really, once it's stated). And he links to a model of his which does contain M, and is not Neo-Wicksellian.

Adam: I had read that Paul Krugman link before. It doesn't really settle the argument. Here's the problem, and it's the exact same problem I have with your counter-argument:

We can model money using a cash-in-advance constraint: M>=P.c (That's M is greater than or equal to nominal consumption expenditure.) But there is one big problem with doing so, and it's a problem that has been well-understood right from the early days of modeling money with a cash-in-advance constraint. You have a stock on the left hand side of the equation, and a flow on the right hand side. The units are not the same. That the constraint can ever bind (or even make mathematical sense) is an artefact of modeling the economy in discrete time, rather than continuous time.

And this is not just a prissy math/technical point. Even in hyperinflations, people still use money as a medium of exchange (barter happens a little but is still rare). Real money balances (M/P) fall very low relative to nominal expenditures. The velocity of circulation gets very big, if you like. So if a cash-in-advance constraint is ever binding, it is binding in hyperinflations. But then the cash-in -advance constraint would not be binding outside of hyperinflations. Which would mean that monetary policy (an open market operation of money for short-term bonds) would be impotent outside of a hyperinflation. Which is false. So that's a reductio ad absurdam of the CIA argument that monetary policy is useless in a liquidity trap.

There is no distinction between "circulating money" and "idle hoards". (The $100 cash sitting in my wallet right now is an idle hoard, since I am not right now spending it.)

And to change behaviour you don't (necessarily) need a price signal to change behaviour. Changes in wealth (money is net wealth), changes in expectations, changes in quantities, can also change behaviour. Whether changes in the quantity M, or expected future M, can change behaviour is what is at issue.

"This is so wrong it's scary that a professional economist can't see it." I don't think so. Even if wrong, it is not obviously wrong, and certainly not wrong for the reasons you state. What is scary is when we think we understand things better than we do.

Brendon: I think expectations of inflation may already have become unanchored, unfortunately. From indexed bond spreads, from the BoC survey, and from anecdotal evidence. How to create expected inflation? I'm going to duck/postpone that question.

pointbite: Distinguish between the price level and the rate of inflation. An increase in the price level would make us want to hold more money (we want to hold a certain real value of money in our wallets, not a certain number of bits of paper). An increase in the (expected) rate of inflation would make us want to hold less money, because it is depreciating.

JKH: quantitative and qualitative easing can mean a lot of things. I'm going to duck your question. In the current context, I use the words very loosely, to refer to anything the central bank can do once nominal interest rates on short bonds hit zero.

[David Pearson]

Nick,

It seems to me that your response to Adam overlooks one point. Clearly changes in wealth change behavior, and hyperinflation causes a change in wealth. The question is, what does the function look like? Will any perceived fear of loss of wealth cause velocity to rise? And, if so, is the function non-linear (quite shallow at low levels of inflation, spiking thereafter)?

You and others seem to argue that a little inflation expectation will goose velocity. You don't want too much -- no need to risk hyperinflation -- and a little is enough. Scott Sumner, Andy Harless and some of your writings have implied this assumption.

I think Krugman would argue that if you have a little inflation now and take it back later, such that the long term inflation expectation is unchanged, then there should be little impact on the perceived risk of losing wealth. The come-back to that is price-level targeting, where you make the wealth loss permanent. Except, the idea of price-level targeting is that wealth will change by a pre-determined, quantifiable amount. It has no tail risk (none that you're willing to recognize, anyway).

So you want to present economic actors with a choice: With a high degree of certainty, lose a small amount of pre-determined wealth by hoarding cash; or, risk losing a large amount of wealth by buying real assets. What good is this choice? Do you really think it will influence behavior?

Krugman has it right. The Fed must act in a "reckless" or "irresponsible" fashion to raise the tail risk of holding cash balances and create a more symmetric risk trade-off between cash and real assets. The problem, of course, is that he's a Keynesian, and he thinks inflation risk is negligible under a large output gap.

The reality is that there is no free policy lunch. To fight deflation, risk hyperinflation. That's not to say hyperinflation is the outcome, only that its a possible outcome. It didn't result the Great Depression (in 1936) or in Japan, but there are countless examples where it did result.

[Adam Purzitsky]

Ok, first of all sorry about the first sentence. It was really more a reflection of frustration with other stuff I'm reading then what you said. However, I disagree with your response as regards to the effectiveness of increasing the money supply.

The cash-in-advance model was not really central to the argument (this was supposed to be indicated by the "something like" comment). As far as I understand it, the issue is that people will try to satisfy their euler equations for consumption. If we are on a consumption path where future consumption is expected (or feared) to be low enough that a negative real rate of interest is needed to support it then there are only two possibilities. Either we get a negative real rate or current consumption falls. This just an example of the usual thing that if prices don't adjust then quantities do. The only way to get people to perceive a negative real rate is expected inflation and just expanding the money supply today won't get you that. In this case, without the expected inflation, people hold on to the money not as medium of exchange but as a store of value. The real point though is that money holdings have nothing to do with anything, people won't consume today because they are trying to satisfy a consumption euler equation with a non-negative real rate of interest and no amount of money holdings will change that.

My initial focus on money holdings was a response to your "hot potato" comment which is where I think you're wrong. Actually though, your response brings us closer to agreement I think. Changes in expected inflation are what's needed but please bear in mind that an increase in expected inflation (that is, a negative real rate) is a price signal. Moreover, changing expectations was not mentioned in your original post and the manner in which it works has nothing to do with creating an excess supply of money.

[jp]

Krugman said in his reply to Nick that: "What comes down to is this: once you’ve pushed the short-term interest rate down to zero, money becomes a perfect substitute for short-term debt."

But how can they ever be perfect substitutes when money acts as a medium of exchange (and a financial asset) while bonds are only financial assets?

[Adam Purzitsky]

Correction: changing inflation expectations was mentioned in your original post but only in the context of dismissing it as a policy tool. In this context I guess I should be more precise and say that the manner in which it works has nothing to do with an excess supply of money today. Krugman's point is that the central bank needs to commit irreversibly to an excess and growing supply of money for a long time. I see no reason why the fed can't commit to a target of 6% inflation for say 8 years. If the commitment is believed then it should goose demand and at the same time, if the target is exceeded they can tighten as much as they need to avoid a hyperinflation.

[Adam Purzitsky]

jp, in the liquidity trap money is being held both as a transactions medium and a store of value. In normal times you would try as much as possible to hold money for transactions and bonds as a store of value because bonds pay interest. The interest cost to holding money is what makes it a hot potato. If the short rate of interest is zero then money serves the store of value function just as well as short-term debt (which doesn't have any other use in the portfolio) and so they are perfect substitutes.

[pointbite]

Nike:
"An increase in the price level would make us want to hold more money "

By money do you mean something of value other than dollars? Otherwise it still doesn't make sense to me. I don't see a material difference between prices rising and dollars depreciating. Perhaps you are using the terms in some cryptic way I don't understand, but it seems to me that should the price level measured in dollars rise, the last thing I want is more dollars, I want the thing with a rising price.

David Pearson:
"To fight deflation, risk hyperinflation. "

This brings me back to Russian roulette. Is there any evidence such a policy has ever worked anywhere on the planet? What scares me is how scared everyone is of deflation. We had an enormous credit bubble, deflation is exactly what we need. It won't be pretty, but the only thing worse than a depression is a hyper-inflationary depression. Deflation kills debtors, so what, declare bankruptcy. The financial sector is bloated, most of these people add no value to the world. How can swapping pieces of paper back and forth create wealth? Financiers shouldn't be richer than the people they're financing. As big as the financial sector got during the boom, that's how small it has to get during the bust. That's my story and I'm sticking to it!

[pointbite]

Adam, I don't even think changing expected inflation will cut it. Nobody is taking into consideration the possibility that we are entering a new savings paradigm. I hate to be a broken record, but baby-boomers got burned and now they're shifting focus to their broken retirement dreams. Echo-boomers saw their parents get burned and are determined not to make the same mistakes. Everyone who avoided the stock market will have their beliefs re-enforced, everyone who lost a fortune in the stock market is losing confidence and given most baby-boomers' position as net-sellers over the next few decades regardless of performance (retirees) they are unlikely to jump back into the market in any significant way, even if they could afford it.

If you manage to create the conditions for expected inflation at a time like this (no confidence, crashing stock market, companies going bankrupt all around you) you could be more likely to create demand for other forms of money instead of consumption.

You are basically making the case for gold.

[Nick Rowe]

Hi Jim! Welcome aboard! I will be sure to recommend one helicopter flies over PEI!

David: I sort of agree with a lot of what you say. Remember one thing though: people are already holding real assets, and cash, so on the margin they must be indifferent between the two. The risks balance. We don't need (or want) real assets to dominate cash in total. We only need to shift that balance at the margin. And once we start to shift it, and confidence starts to return (or fear diminishes a little), all the normal positive feedback forces will help us out.

Adam:
1st paragraph: understood. Yep, I feel like that sometimes too!

2nd paragraph: this is really the guts of the issue. And where I am in two minds. The Neo-Wicksellian part of me says "yes, you are right, and the only way out is to create expected inflation". And the monetarist part of me says "No, you are wrong. That Euler equation is exactly what happens when you start with the Neo-Wicksellian assumption that a monetary exchange economy can be modeled as if it were a frictionless Walrasian barter economy, with a nominal price level and central bank (somehow) setting nominal interest rates tacked on as an afterthought". Sorry. That's as good an answer as I can give at the moment. I know it's not adequate.

3rd paragraph (and next comment): We sort of agree. Expected future monetary policy matters more than today's, and the question is: how to link the two, so we can do something today that affects expectations of the future. But on the excess supply of money we might disagree. Here I'm channeling both monetarism and the 1970's "disequilibrium macro" approach (you know, Barro/Grossman, Malinvaud, Benassy, Leijonhufvud, etc., or whatever you want to call that brief flowering). In a monetary exchange economy, in disequilibrium, there exist as many definitions of "excess supply of money" as there are markets. With n different goods, including money and all financial assets, there are n-1 markets, and n-1 definitions of "excess supply of money" (and n-1 variants of Walras' Law too). Thinking about it this way, there is not one "money market" (which is just a weird slang name for the market in short-term bonds); there are n-1 money markets. And we want to create an excess supply of money in all of them (right now).

jp: what Adam said. The puzzle is: when money can do something that bonds can't, why should they have the same rate of return? Adam's answer (and most people's answer) is that it must mean that people don't value that extra thing that money can do, *at the margin*. And once the marginal value drops to zero, it can never diminish further, and become negative, so they become perfect substitutes past a certain point.

pointbite. This is where natural languages get difficult. Compare two countries. Identical, and with the same rate of inflation, except that A has a higher level of prices than B. People in A will want to hold more money. Now compare two other countries, C and D, identical, and with the same price level right now, but C has a higher expected rate of inflation than D. People in C will want to hold less money.

[pointbite]

Nick, now I understand your point. But I still don't like it! How do you get to a higher price level without inflation? How does it switch from depreciation-causing-less-demand-for-money to higher-price-level-causing-more-demand-for-money? That logic seems broken, it was just mentioned in passing in your post. You're using discrete and continuous time on your other discussion, so I'll use it here too -- If you jump in a time warp from stable prices and income at a lower level to stable prices and income at a higher level (or country 1 to country 2 like your analogy) you may be correct, but transitioning from one price level to another doesn't happen in a vacuum, you need inflation to get there. Unless I'm missing something.

[Nick Rowe]

pointbite: no, you are not missing anything. But there's the price level today, and the expected rate of inflation between today and tomorrow. And they are different.

[pointbite]

Nick, I understand the distinction, but what is the magical price level at which behavior changes and inflation suddenly stops? This line, "until quantities and prices increase enough that people do want to hold the extra stock of money" still makes no sense to me.

Are you assuming that once velocity of money picks up, monetary policy will be effective in reducing inflation? If we go with Krugman's assumption that only reckless amounts of new money will change behavior on the upside, what kind of reckless policy would be required to tame velocity on the downside?

Russian roulette...

[Nick Rowe]

pointbite: It's hard for me to explain, without drawing a lot of curves. If expected inflation does pick up, and the economy recovers, then monetary policy becomes effective again. That's not the current issue. Admittedly, if actual inflation overshot the target (if we overdid it), then it's tricky managing the transition to lower inflation. But we've done it before.

[pointbite]

Nick, thank you for being patient and answering the questions. I will probably simply disagree with you about this. The previous tamed inflations were caused (I believe) by too much money, the inflation you describe in this post would be caused by too much velocity (prices won't rise no matter how many dollars you print until people change behavior). The former is monetary, the latter is mostly psychological. This is the point of dispute I have with almost every economist, everybody is convinced they can reverse behavior with their policy tools, I have my doubts. I think if we pursue this money-printing policy it's more likely to end in hyper-inflation. I'm not looking at equations, I'm just looking at people. That's why I think my perspective is a little different.

As we witnessed in the fall of 2008, consumers tend to shift behavior very quickly. As Nassim Talib says, the world doesn't move in a small steps, it jumps from one extreme to another. The bottom really fell out of the economy in a matter of weeks. The ability of people to change behavior in sudden and dramatic waves in a short period of time is much greater than the ability of any government or central bank to react. Admittedly that's my bias, but that has also been the history of these attempts, according to my research anyway. When behavior changes, all those dollars will suddenly flood a market that has adjusted supply for lower demand and prices will rocket to the moon long before production can be ramped up. Once is gets started, people panic and it only gets worse. If you have a counter-example I would be happy to learn about it. Where has such an un-orthodox intervention ever lead to anything other than hyper-inflation?

[Patrick]

pointbite, you can't have it both ways. Either monetary expansion 'works', or it doesn't. It's faulty reasoning to claim that it only applies so long as it supports your hyper-inflation conclusion.

[westslope]

Good blog post, good discussion. I look forward to more.

[pointbite]

I can have it both ways and it's not faulty reasoning. Prices rise for different reasons thus ending the rises require different prescriptions. There is little difference in your equations between $10 spent and $5 spent twice in the same time frame, inflation-wise, both will have the same effect on prices, but the policy required to reverse inflation is completely different. In one case you have too much money, so reduce the supply, no brainer. In the other, people have lost confidence in the currency and couldn't care less where you set interest rates or how many bonds you buy. Then what?

When people want to save, should you fight that tendency by printing like crazy, obviously, at some point psychology will change and people will spend. But when they do, it will be at a time the supply of goods is constrained (after years of recession) and the supply of money fueling demand is enormous (because it was hoarded for so long despite the money printing). The analogy I like to use is a giant tower of cash falling over a few pieces of cheese. When inflation is caused by psychology, it's a different animal.

[pointbite]

* how many bonds you (try to) sell, not buy.

[jp]

Nick and Adam, thanks for your responses. My very last quick question... hoping it makes sense.

Nick said: "When money can do something that bonds can't, why should they have the same rate of return? Adam's answer (and most people's answer) is that it must mean that people don't value that extra thing that money can do, *at the margin*. And once the marginal value drops to zero, it can never diminish further, and become negative, so they become perfect substitutes past a certain point."

Wondering why we measure the marginal value of money's medium of exchange feature only against bonds? Why not against the other things money can buy including things like houses, cars, cigarettes, and art? Isn't it a stretch to say that because money's marginal value as a medium of exchange versus one of the millions of things it can buy is zero (that case being bonds), money itself has zero value as a medium of exchange?

[reason]

Pointbyte
lets remember we are talking about debt deflation. So that the reason for wanting people to expect inflation is to cut down on bankrupcies (by pushing up asset prices and making people feel less broke). You keep making an argument that is relevant to normal times. Circumstances matter. It is always a problem with these hypothetical arguments that that gets forgotten. Our model is an any point only a local linear approximation.

[Adam]

jp, actually (see below) the point is not that the marginal value of money as a medium of exchange is zero. The point is that the marginal value of money as a medium of exchange is less than the marginal value of money as a store of wealth. Thus, on the margin you are only holding the money as a store of wealth instead of spending it as medium of exchange. And at zero interest rates money and bonds are perfect substitutes in the role that money is playing. More detail below which also explains why I disagree with Nick's claim that creating an excess supply of money will increase aggregate demand.

First of all, just because the marginal value of money is low doesn't mean its average value is low. The first dollar you got was spent on a good that you value, that dollar had a high value as a medium of exchange. Same for the second dollar and so on... each of those dollars had a positive marginal value as a medium of exchange but the more you have the less is that marginal value. This is the same as the usual declining marginal utility story. Each dollar could also be exchanged for a bond that has a positive marginal value as a store of wealth. The money also had some positive marginal value as a store of wealth but the bond's marginal value in this role is (in normal times) higher because it pays interest. So you stop spending on goods when you reach the point where the marginal value of MONEY as a medium of exchange is less than the marginal value of the BOND as a store of wealth, at this point you start exchanging your money for bonds instead of goods.

But what if the real rate of interest on bonds is zero? Do you ever reach a point where the marginal product of money as a medium of exchange is zero? NO. That is not the arguement, if the real rate of interest is greater than or equal to zero, but the nominal rate on bonds is zero, then you would just keep on trying to spend the money on real goods (consumption or investment goods). That is what Nick is arguing (I think) when he speaks of creating an excess supply of money.

However, if the real interest rate that would support your consumption path is negative then eventually the marginal value of money as a transactions medium falls below the marginal value of MONEY as a store of wealth. So you stop spending money on goods and start keeping it as a store of wealth. The main point is that even the zero interest rate can seem like a good return when the real rate is negative. The marginal transactions value of money is not zero but it is less than its own marginal value as a store of wealth! So now the money you have and bonds are both being used as a store of wealth and with zero nominal interest rates they are perfect substitutes IN THIS ROLE.

[Adam]

reason, agreed. I would even point out that these loans were all made with the expectation that inflation would stay positive so lenders inferred a lower real rate when assesing credit quality. A massive deflation ends up bankrupting borrowers who, in the absence of the deflation, are perfectly good credits. In this case the lack of inflation causes far more distortion than does a high inflation if we happen to overshoot the target.

[Nick Rowe]

Adam on jp: That is not the answer I expected you to give, Adam.

Here's the (orthodox) answer I expected you to give: Holding bonds gives you a store of wealth. Holding money gives you a store of wealth plus a medium of exchange. (Money gives you two benefits, added together; bonds give you only one.) But bonds (normally) pay (nominal) interest, while money gives zero nominal interest. So the marginal value of holding an extra $ for one year equals the rate of interest on bonds, in equilibrium. But as you hold more and more money, the marginal benefit of holding an extra $ of the medium of exchange diminishes to zero, so the marginal benefit of money is just as a store of wealth, and is exactly the same as bonds, at a zero rate of interest. Past that point they become perfect substitutes, since they are identical in every other respect, (and you put no marginal value on the one respect where they differ).

Similarly, owning a refrigerator is a store of wealth, but also useful as a store of beer. As I accumulate more and more refrigerators, their marginal benefit as a store of beer diminishes to zero, and an extra refrigerator becomes merely a store of wealth.

Continuing with the orthodox story: there is the portfolio allocation decision (whether to hold wealth as money or as bonds); and there is the consumption/savings decision (whether to hold more wealth for future consumption or consume more today). The first decision is where we compare the marginal benefit of a medium of exchange to the nominal rate of interest. The second decision is where we compare the real interest rate with the (declining) marginal utility of current consumption.

That's what I take to be the orthodox (Keynesian) perspective.

And one problem with the orthodox perspective is that it implicitly assumes you can hold negative quantities of bonds, and pay the same (currently zero) nominal rate of interest. But nominal interest rates on consumer loans are not currently zero. So an increased supply of money could affect that (non-zero) nominal rate of interest on consumer loans, and spillover directly into consumption demand.

In other words (returning to an earlier favourite theme of mine), the representative agent model is highly misleading, because the representative agent (must) hold positive quantities of bonds (since government bonds exist and are held by someone) but not every agent does hold bonds.

[pointbite]

Reason and Adam, yes I understand prices are falling and bankruptcies are rising, but my point is that our major challenge today is not the supply of money, it's the velocity of money. People are afraid and desperate to reconstitute their lost savings. You can't change behavior with a printing press. If you fight someone determined to save, the result will not necessarily be a return to normal consumption, instead people will look for alternate forms of savings.

The economy will bottom when the economy will bottom, and the more expansionary the monetary policy on the way down, the more shocking the inflation will be on the way up. As sudden as velocity collapsed, it can return. But when it returns, it will have the force of many more paper dollars that have been hoarded in the interim as a result of the stimulus packages and failed expansionary policies.

So my argument is about step 2, I admit, after the economy hits a bottom, the upside inflation will be like a tsunami (or a "tower of cash falling on a few pieces of cheese") and just as orthodox monetary policy failed to end psychological deflation, orthodox monetary policy will fail to end psychological inflation. Especially given the fact when prices begin to rise again politicians are likely to claim victory and take credit for economic recovery. The fact oil prices hit 147 then collapsed will cause complacency next time around, they will declare it another bubble as it passes 100, 125, 150, 175, 200... Uh oh, it's not stopping. By the time they recognize it's a problem, it will be too late.

We don't want to repeat the mistakes of previous years, always solving today's problem and ignoring the future... Nick said, "we have done it before". I disagree. You have never stopped an inflation caused by a general lack of confidence in the currency by regular people. There is precedence for hyper-inflation in American history, it has destroyed their previous currencies, look it up. These policies could have implications that will take generations to reverse.

Anyhow, that's my warning. And the fact everyone keeps dismissing me is the reason I'm happy to hold my gold for a few more years. Once you all agree, that's when I'll sell, so keep me posted ;)

[jp]

Thanks both of you for your responses. That's alot to digest but I am getting there. Pretty interesting.

Adam, when you wrote: "So you stop spending on goods when you reach the point where the marginal value of MONEY as a medium of exchange is less than the marginal value of the BOND as a store of wealth, at this point you start exchanging your money for bonds instead of goods" did you mean MONEY instead of BOND?

I know I said no more questions, but... given the two decisions in the orthodox story that Nick mentioned (portfolio allocation and investment/savings) in which of these does one get the chance to compare the marginal benefit of the medium of exchange (keeping cash in your wallet) to the rate of return on a consumption good, say a chocolate bar?

That's my last.

[Adam]

jp, no I meant bonds. The point there is that in normal times, when the interest rate on bonds is greater than zero, you never use money as a store of wealth. You could use money to store wealth but you don't want to because bonds are better for this function (because you get interest). In the liquidity trap case, you do use money as a store of wealth because it's now no worse than bonds.

I'll get try to get back to the second question a bit later.

[Adam]

jp, to continue. The story I told was a story of the consumption/investment decision. The first dollar had a high marginal value for its transactions service exactly because the first dollar of consumption yields the highest marginal utility. The declining marginal value of money spent on consumption was just a way to express the declining marginal utility of consumption. The marginal utility of consumption falling below the marginal utility of a dollar of savings is exactly the same as the marginal value of a dollar for transactiions services falling below the marginal value of a bond as a store of wealth. The point at which this happens depends on the interest rate.

So, to answer your question more directly. The value of the money in your wallet is exactly the value of what you buy with it, in this story you never leave money just sitting in your wallet and not being spent. If it's in your wallet you intend to spend it, otherwise you use it to buy a bond.

[reason]

pointbite
that is why it is important to spread the money first at the bottom - to those who need every penny they can get. Then you can be certain it will be spent. But there are other effects - a promise of loose(r) money should push the exchange rate down. Improving the solvency of a wide band of people will eventually encourage them to start spending. The promise that something will be done, will make people feel safer in their jobs.

[reason]

And pointbite,
I thought the main cause of hyperinflation was an unwillingness to tax. I would increase marginal taxes on the rich as part of the package. As the economy recovers so will finances (and then you start issuing bonds). I'm talking about special policies for special times.

[pointbite]

reason, my comment yesterday in the "(Im)perfect financial markets and quantitative easing" post is an adequate response to your point of view. Needless to say I don't agree with you.

[jp]

Adam, thanks for your response. So to recap, the marginal utility of money as a means of exchange is set via the consumption/investment decision and the marginal utility of money as an asset in the portfolio allocation decision. You are of the mind that the marginal utility of the latter is higher than the former.