The optimum size of the central bank?

In 1969, Milton Friedman wrote an essay on "The Optimum Quantity of Money".  Another way of framing this question is to ask: what is the optimum long run growth rate in the money supply, or the optimum long run inflation rate?

I want to suggest a different way of framing this same question: what is the optimum size of the central bank?

In the long run, the size of the central bank is negatively related to the rate of inflation.

If you want deflation, do you really want the central bank to get bigger? In the limit, if you want big enough deflation, do you really want the central bank to own everything? Are you a communist?

Suppose we had a very high long run growth rate in the stock of money supplied by the central bank, and a very high inflation rate. Since central bank currency does not pay interest, the desired velocity of circulation would be very high. People would want to get rid of their money very quickly, because it is depreciating rapidly. Nominal rates of return on other assets would be very high, and the nominal rate of return on money is zero, so the opportunity cost of holding money would be very high. So the stock of money held would be very small as a percentage of the total assets of the economy.

A simple picture of the central bank is a balance sheet with currency on the liability side, and an equal amount of assets on the other side. With high inflation, the central bank would be very small, relative to the size of the economy.

That was long run analysis. In the short run, the demand for money can fluctuate, and unless the central bank adjusts the supply of money to accommodate those fluctuations in demand, the result will be monetary disequilibrium with short run booms and recessions. So the central bank should expand and contract in the short run to accommodate those fluctuations in the demand for money. When it expands and contracts, both the liability and asset sides of its balance sheet will expand and contract. When it increases the supply of money it buys more assets; and when it decreases the supply of money it sells assets.

So in a world of high inflation, we will see a small central bank, relative to the size of the economy. The size of the central bank will fluctuate. In percentage terms those fluctuations may be large, but relative to the size of the economy they will be small.

As we reduce the long run money growth rate, and reduce the long run inflation rate, the cost of holding central bank money will fall, and the stock of central bank money held will increase as a percentage of the size of the economy. The central bank will get bigger. It will hold a larger percentage of the total assets of the economy. And even if the fluctuations in the demand for money stay the same size, percentage-wise, those fluctuations will be a bigger percentage of the total assets in the economy.

What happens as we push this process to the limit, and keep on reducing the long run inflation rate, down to zero, and then into deflation? The central bank keeps on getting bigger and bigger, and owns a larger and larger share of the total assets in the economy. It buys all the short-term government bonds, then all the long-term government bonds, then all the commercial bonds, then all the shares, then all the land, then all the houses....Because as the rate of inflation falls, falls to zero, and keeps on falling into negative territory, people will want to hold more and more of their wealth in the form of central bank money. And unless the central bank satisfies that demand, by selling them money and buying their other assets, the result will be an excess demand for money and recession.

Where does it end? Do we ever hit some absolute liquidity trap where people want to hold money rather than any other asset? Well, not really. Because the central bank has to keep on buying assets that people do not want to hold because they want to hold money instead.

It doesn't end in a liquidity trap. It ends when the central bank runs out of things to buy, because it already owns everything, right down to your house, furniture, and toothbrush, which it rents back to you. It ends in communism.

Those who wish for deflation should think through what it means.

If you don't want the central bank to get bigger permanently, you had better let it get bigger temporarily, so it can satisfy the temporary excess demand for money and prevent inflation falling into deflation.

Comments

[marris]

Nick,

I understand every point of your analysis except one. Why should an a high growth rate in the money supply necessarily boost velocity? That is, I think a large part of the analysis is tied to the "central bank buying stuff" model. If instead, the bank changed its money injection process to just increase notional values, then there should not be an increase in this velocity, right? The CB says that if your bank balance is 10 today it is 11 tomorrow. Or if you hold a bill with 10 and creation timestamp of today, it's notional value is 11 tomorrow. In this "even inflation" world, people don't rush out to spend their money, right? They expect prices to increase in lock step with their cash balances.

It seems that velocity increase implies that people are trying to outfit each other. Like "I'm going to scoop up that widget before you realize that it's price should be higher." And why do I think it should be higher? Because I think money supply quantity is increasing while you don't?

I think this even inflation model tells us that long-run "bank buying stuff" model would only lead to the bank buying everything if people did not have good information about what everyone else and the bank is doing. If I really wanted CB notes, won't I charge the CB higher prices to meet this demand? And wouldn't other people raise their prices to the CB in a similar way? They don't want to be the sucker who sold his real widget to the CB for 10 while his neighbors held out for a price of 11. If things are really going to play out with the CB buying everything, we know the CB will eventually come around offering 11.

[Nick Rowe]

marris: A permanent change in the *level* of the money supply (the stock of money) will cause a permanent change in the *level* of prices. A permanent change in the *growth rate* of the money supply will cause a permanent change in the growth rate of prices (aka the rate of inflation).

If there's higher inflation, your money is losing value quickly, so you want to spend it quickly, soon after receiving it.

In terms of MV=PY. Suppose we start out with M, V, P, and Y all constant. Then M starts growing at 10%, holding Y constant. If V were constant, P would also start growing at 10%. But if P is growing at 10%, V will rise to a new higher level. So P will have to grow even faster than 10% temporarily, to compensate for the rise in V.

The faster M is growing, the bigger is V, and the smaller is the ratio M/PY. That ratio, M/PY, is a rough measure of the size of the central bank relative to the size of the economy.

[Becky Hargrove]

This post made a lot of sense to me, as I have been one of those who wished for more deflation in housing...there does not seem to be real solutions for housing as it currently exists or banks would not need to be destroying them. However, even though the United States has not experienced true hyperinflation, the prices have been rising in such a way over the years that they have actually overwhelmed people. Now, when the average citizen hears that it will take a trillion dollars to take care of X, the immediate reaction is 'no way'. But a trillion dollars does not mean what it once did, not even close. Perhaps the large numbers tend to freeze up people on economic action as much as anything. At such a point in time, sometimes nations make headway by simply changing up the numbers, i.e. calling a trillion dollars something a lot smaller. That one action could ultimately change the size of a central bank.

[Ian Lippert]

This is probably a dumb question but doesn't the central bank create inflation when it buys up assets, ie prints money to buy assets. I think I am missing something and this post sounds interesting.

[anon]

In your scenario, the central bank gets bigger because it's paying a high real return on its liabilities (currency). It's not clear how these returns would be funded in the long run. In practice, the government might have to give more and more funding to the central bank as its assets side shrinks due to negative yield.

I suspect that Japan is having very similar problems right now: the monetary authority is targeting zero inflation (i.e. a zero real return on currency), so Japanese folks hold too much currency (and near-currency such as govt bonds) and too little of other assets.

In practice, a central bank can avoid this problem by charging negative interest on reserves and monitoring the amount of physical currency. If currency is excessive, charge a fee on new issuance and pay out a subsidy when currency is converted to bank reserves. It's not perfect but it largely solves the problem.

[W. Peden]

Of course, most deflationists don't want a central bank anyway.

I'm still not QUITE sure I get the long run/short run distinction here. Does "long run growth rate" refer to the growth of deposits, while the central bank is purchasing assets using base money? Does this mean that there can be a long-run inverse correlation between base money and deposits?

[Andy Harless]

This is awesome.

It never occurred to me that maximizing the real quantity of money could just as reasonably be described as maximizing the size of the central bank. I imagine it never occurred to Milton Friedman either. Maybe Von Mises was right to call him and his colleagues a bunch of socialists.

[Nick Rowe]

Thanks Andy!

It had never occurred to me either, until just recently. But it's obvious once you think of it (if you've already read Friedman). My guess is you didn't need to read anything below the fold on this post. Yep, I don't think Milton Friedman was a commie, but I wonder what Lenin would have said? What's that thing Keynes said that Lenin said, about inflation being the surest way to eliminate capitalism? Maybe he was 180 degrees off!

Becky: "At such a point in time, sometimes nations make headway by simply changing up the numbers, i.e. calling a trillion dollars something a lot smaller. That one action could ultimately change the size of a central bank."

Not really. It's the the size of the central bank as a ratio of the size of the economy, both measured in the same units, that matters. If you change the units, the ratio stays the same. But if you have higher inflation, people want to hold less money as a ratio of their dollar income, so the size of the central bank gets smaller as a ratio of the dollar size of the economy.

Ian: there's the short run and the long run. It takes time for higher money growth to translate into higher inflation and increased velocity. If you increase the growth rate of the money supply permanently, in the short run the money supply will increase faster than nominal income, so M/PY will rise. But in the long run higher inflation means V will rise as people want to hold less money as a ratio of their nominal income (they want to spend it more quickly, so M/PY will fall. The short run and long run effects go in different directions. That's standard Milton Friedman.

anon: Assume we are below the seigniorage revenue-maximising rate of inflation. (Seems reasonable, for most countries). As we reduce the inflation rate, the central bank's profits will fall. But profits can never go to zero (I'm ignoring printing and admin costs) as long as the central bank does not buy assets that pay a lower real return than currency. Only in the limit, I think, does the central bank's profits approach zero. The central bank becomes one giant mutual fund, and currency is shares in that mutual fund.

(Speaking of which, where's Mike Sproul?)

"In practice, a central bank can avoid this problem by charging negative interest on reserves and monitoring the amount of physical currency. If currency is excessive, charge a fee on new issuance and pay out a subsidy when currency is converted to bank reserves. It's not perfect but it largely solves the problem."

I need to think about that. Wouldn't currency disappear, or be rationed??

W.Peden: see my reply to Ian above, on long run vs short run.

"Of course, most deflationists don't want a central bank anyway."

Yep, and then we get into the question of whether money is a natural monopoly. Because I want to use the same money that everyone I trade with uses.

[Jacques René Giguère]

Nick: Inflation does not ruin an economy. An economy is destroyed, few goods are available, inflation ensues.
As usual, Lenin was wrong ( in good company with all the right wing types who envy his methods...

[Mike Sproul]

Nick:

It's easy for the central bank to pay interest on currency. Just redeem each old paper dollar for (1+R) paper dollars at the end of the year. Then people will hold indefinitely large stocks of paper currency, and you don't get those velocity effects you mentioned

[Scott Sumner]

Mike, In that case doesn't the interest rate on currency approach infinity as the date approaches December 31st, 11:59PM?

[Scott Sumner]

Nick Intriguing post. I'm probably way off base, but I'll throw this out anyway. Suppose the real yield on T-bills is 2%, and the Fed promises to do 10% deflation (on average) for a million years. Doesn't the price level immediately fall very sharply, and then from that point forward is expected to fall at 2% per year, for a million years? At that rate cash and T-bills become perfect substitutes, and the demand for cash only rises to about 10% or 20% of GDP (as in Japan.) Where did I go off course?

I realize that sticky prices make things more complicated, but I believe the Fisher effect applies primarily to flexible prices. In any case, your model should apply to a flexible price world.

[Nick Rowe]

Jacques Rene: inflation can in principle arise from supply shocks, but all the really big long-lasting inflations seem to come from the monetary side. And since (solvent) central banks can always offset a supply shock if they choose to, from a policy perspective we can always say it's too much money, even if that is understood as relative to the goods the economy can produce.

Mike: There's going to be some weird saw-tooth pattern to the demand for money if you did that. And a weird saw-tooth pattern to the price level too, if prices are flexible. If prices are sticky, you will get a weird saw-tooth pattern in other asset prices.

Scott: OK. Let me run with the assumption of perfectly flexible prices. It's simpler. If the central bank merely promises 10% deflation on average, over a million years, what you say is right. Suppose instead it promises 10% deflation each and every year from now on. The real demand for money jumps up, as everyone wants to sell almost every asset they own to get a guaranteed 10% return from holding money. To prevent an initial massive fall in the price level, the Fed would have to satisfy that increased demand for money, and print money like crazy, and buy up everything in the whole economy. We would probably be left owning our toothbrushes and underwear, since we wouldn't want to rent them even if the opportunity cost of owning them were 10% per year. But not much else.

[edeast]

A permanent change in the *level* of the money supply (the stock of money) will cause a permanent change in the *level* of prices.

Can you work through a MV=PY shock to level of M. ala shadow banking etc. Balance sheets of broadmoney collateral hit, reduce size of M/PY, short run, increase it long run?

[Nick Rowe]

edeast: It might not be the same for the "money" created by shadow banks. The currency created by the central bank pays no interest, so when inflation rises and nominal interest rates on other assets rise, the opportunity cost of holding currency rises, and velocity falls. But for a money that pays interest, if that interest rate rises with inflation, there won't be this effect.

[K]

Nick: "The optimum size of the central bank?"

Zero. Just like the amount of central bank money used by banks in Canada. There is nothing good about zero-interest bearing money, and nobody should want to hold any of it. If it wasn't for our grossly inefficient settlement system for real economic agents (write a check, wait a few days...) nobody would hold money. Why would anybody not prefer T-Bills???

I think ISLM really messes people up thinking that because nominal rates impact inflation/growth when there is non-interest bearing money, then somehow non-interest bearing money performs some sort of critical role in economic control. But it doesn't. Take Krugman's baby-sitting economy. There is no nominal/real distinction because the money is denominated in baby sitting hours. But it's cool because it's apparently sufficiently complex to support macro disequilibrium in practice. But there is no reason a central bank could not control that economy by controlling the *real* rate of interest (so long as they could set negative rates). And could they do that without directly actually interfering with the supply of money? Of course they can. They already do it all the time in our current interbank market with only the threat of financial penalties on anyone who is caught long or short credit (money) if credit is trading away from the policy rate.

If there was a central settlement mechanism for liquid capital assets and those assets settled instantaneously, 24 hours a day, and everyone had an account at the central bank, and electronic money could also be transferred instantaneously, then *nobody* would ever hold *any* money *at all*. They would only create it for the brief instant in which they exchange it for some consumption good or other capital asset, and the receiver would then immediately convert it into some other capital asset. If, furthermore, there was no paper money, then we could have negative rates too, and there'd be no liquidity trap either.

[edeast]

Right collapse in private moneys would show up in increased money demand.

Can not figure out you/sumner million year deflation.
Why can't the fed overpay for a good rather than buy everything, to stem the price level collapse?

follow up, is the ZLB preventing overpaying for loans,

[edeast]

... implying, 'fiscal' overpayment. etc
Leading to MMT, my freaking brain has run in circles for too long.

[Rob]

I'm not sure I agree with the conclusions.

Suppose the CB announces that it will set the NGDP target at -1% next year and increase by an additional -1% each year forever (-1%,-2% -3% etc). At first this may increase demand for money both as holding cash now leads to increased purchasing power over time and because businesses confidence may be affected by the policy change. The CB would initially have to buy assets to increase the money supply to maintain AD as Nick suggests.

However eventually if expectations were set appropriately wouldn't the economy adjust so that price spreads on investments would give a yield equal to the natural rate of interest adjusted for the current rate of deflation ? This would mean that there would be no special reason for cash holding to be high (as there would be better uses of the money investing in business and this would be controlled by the IR) so given the NGDP target I would expect the CB to increasingly sell assets to reduce the money supply.

Of course a smart communist in charge of the CB could still find plenty of other ways to cause uncertainty and cause AD to fall so maybe I'm being pedantic.

[Mike Sproul]

Scott and Nick:

Paying interest on paper money is just like paying interest on reserves. The money and interest exist as pieces of paper in one case and bookkeeping entries in the other, and there's no reason you'd get infinite inflation or sawtooths in either case. On quantity theory principles, inflation is avoided because the interest induces people to hold ever-increasing amounts of money rather than spending it. On backing theory principles inflation is avoided because every new dollar issued is matched by a new dollar's worth of assets acquired by the central bank.

Old time paper bills of exchange bore interest, and there have probably been lots of other cases that I don't know about. I'm not sure why you guys both think it would lead to crazy results.

[Scott Sumner]

Mike, No it's not the same. Reserves earn interest continuously, cash only once a year in your proposal.

Nick, I'll take that. As long as I'm right up to a million years, I'll concede that even longer Fed commitments that are credible will do the crazy things you predict.

Of course if I wanted to be annoying I would have asked for a billion years, but I'm not that greedy.

[Mike Sproul]

Scott: Say the central bank issues $100 in paper and $100 in reserves, and holds bonds worth 200 oz of silver. Each dollar starts the year worth 1 oz. At year-end, the central bank gets 20 oz interest on its bonds. Each holder of $1 in reserves gets his account credited for $.10 , and each holder of a paper dollar gets a paper note worth $.10. Now there are a total of $220 (paper+reserves) laying claim to central bank assets worth 220 oz. Each dollar is still worth 1 oz. Each dollar (paper or reserves) would rise in value over the year in anticipation of that end-of-year payment, effectively earning continuous interest in either case, though the value of the dollar drops suddenly at year-end, only to rise gradually over the next year. It's not hard in either case to smooth out this drop-off.

Nick: Is that what you meant by a sawtooth pattern?

[edeast]

scratch my comment,
buying assets not fiscal, but seems to be still political, after buying up all the gov bonds. great post, my brain is relieved.

[edeast]

wait a sec, wouldn't you expect a sovereign gov to keep issuing bonds to the fed, while they buy up all the assets?

different for the ecb.

[Min]

"Suppose we had a very high long run growth rate in the stock of money supplied by the central bank, and a very high inflation rate. Since central bank currency does not pay interest, the desired velocity of circulation would be very high. People would want to get rid of their money very quickly, because it is depreciating rapidly. Nominal rates of return on other assets would be very high, and the nominal rate of return on money is zero, so the opportunity cost of holding money would be very high. So the stock of money held would be very small as a percentage of the total assets of the economy."

Errr, where are the negative feedback mechanisms?

[Too Much Fed]

I probably won't say this right the first time but...

"In the limit, if you want big enough deflation, do you really want the central bank to own everything?"

What if the central bank owned nothing?

And, "A simple picture of the central bank is a balance sheet with currency on the liability side, and an equal amount of assets on the other side."

What about currency as a liability and no assets on the other side of its balance sheet?

[Craig Burley]

Curse you Nick! Making me actually think and all that! (Great post...)

[Too Much Fed]

The post talks about the central bank and currency and then talks about the central bank and the supply of money. I believe you need to add demand deposits to your model and probably central bank reserves too.

[Too Much Fed]

"It buys all the short-term government bonds, then all the long-term government bonds, then all the commercial bonds, ..."

What happens if these bonds start defaulting?

[John Becker]

Nick,

I followed you over from Sumner's blog because I wanted to continue our discussion of deflation. I think deflation is an important subject. There are a couple points I wanted to make about this post that tie in to our previous discussion.

1. There is no possibility of a "hyperdeflation." The reason is really simple: it is possible to spend every paycheck immediately and have no cash balance but it is not possible to save every paycheck and have no expenditures simply because people need to buy food and usually shelter to survive. In other words, there is a basic ceiling on how high the demand for money can go. History and basic reasoning show that there is no such floor on how low the demand for money can go. The fact that New Keynesian analysis misses this point shows their hysterical fear of deflation.

2. There is no possible way for the central bank to accurately, and swiftly react to changes in the demand for money. This is because there is simply no scientific way of measuring the demand for money. Similarly there is no way of measuring the "price" or purchasing power of money.

3. The optimal size of a central bank is zero. They shouldn't exist. Their monopoly on currency and interest rates convulses the entire economic system. History agrees with this theory as the worst economic disasters (depressions, hyperinflations, lost decades, etc) have occurred under the vigilant watch of central banks.

[Nick Rowe]

Mike: "Nick: Is that what you meant by a sawtooth pattern?"

Yes, I think so.

edeast: "wait a sec, wouldn't you expect a sovereign gov to keep issuing bonds to the fed, while they buy up all the assets?"

You could think about it either way. Either your way, or mine, where the central bank buys up all the assets. Mine is simpler, but it really doesn't make any difference, as far as I can see, since the government owns the central bank. What's monetary policy and what's fiscal policy? Shrugs.

Min: this is very standard long run money/macro. Assume the demand for money (the stock people want to hold) is proportional to the price level, and negatively related to the rate of inflation. Md=P.L(-Pdot/P). Where L(.) is some function, and Pdot/P is the inflation rate. In equilibrium, the demand for money equals the supply. So we get: (M/P)=L(-Pdot/P). A differential equation. You can either think of the central bank as choosing the time path of M, or the time path of P. It's simplest to just think of the central bank as choosing the inflation rate Pdot/P.

[Anon]

"this is standard long run money/macro"

Which is why it probably misses the mark by nearly 180 degs

[Nick Rowe]

Back soon.

[jean]

I am quite happy to see someone framing this question that way.
However, I think you should also have mentioned that high-inflation countries often use financial repression, which enables these countries to maintain a big central bank (or a big public banking sector), and thus a significant seignoriage.

[Nick Rowe]

Craig: Thanks! Sometimes it's good to think about old questions in a new way. And to push questions to the limit, to see what happens. I can't think of liquidity traps in the same way now. I can't think of the distinction between monetary and fiscal policy in the same way now.

TMF: suppose we introduce commercial banks into the picture. OK. As the rate of inflation falls, and the central bank expands, it crowds out the commercial banks. Central bank money crowds out commercial bank money, and central bank's assets crowds out commercial bank assets.

John:

1. For the purposes of this post, I would say the ceiling on money demand is when we want to hold all our assets in the form of money. I think you are looking at another margin: how much assets do we want to hold vs how much consumption we want to do now.

2. How best in practice for the central bank to estimate and respond to short run fluctuations in the demand for money is not obvious. Inflation targeting may come close. NGDP targeting may come closer. Sure, it's hard to get it right. But you can't just say the central bank should "do nothing". What does "do nothing" mean?

3. Money seems to be a natural monopoly. We all want to use the same money that everyone around us uses. Could we really have a competitive market in money, if those monies were genuinely different (i.e. not with fixed exchange rates between them)? If the government is providing a service, and making a profit, and competitive services can exist but stay small (e.g. hippy monies like LETS), the government seems to be meeting the test of the market.

Anon: that was a useless comment. Some anonymous person on the internet thinks standard money/macro is wrong. OK. And in other news...

jean: Hmmm. Fair point. I expect I am asking the normative question, and my guess is that that sort of financial repression is not optimal?

[Min]

Nick Rowe: "Money seems to be a natural monopoly. We all want to use the same money that everyone around us uses."

Hmmm. I remember reading a while back (sorry, I don't remember where) that in the U. S. just before the creation of the Federal Reserve system in 1913, there were 50,000 (!) different currencies circulating in the U. S. I suppose that that included private bank notes and things like store coupons, as well as Spanish dollars and other gov't currencies. I cannot vouch for the accuracy of that figure, but even if it is an exaggeration, that does not sound like a monopoly. (It sounds like a mess! ;))

[Determinant]

It depends on what you view currency as. A bank note is a bill of exchange, worth say $10 of government bonds drawn on the Fed (today) or $10 of whatever drawn on the issuing bank back in the day, usually better rated bank notes, less frequently gold or silver which had separate Gold and Silver Certificates.

Canada was the same way until 1937. Bank notes were drawn on chartered banks.

[Jon]

This just as well makes a case against a fiat standard as it does for inflation.

Your scenario can never happen under a gold standard. If you can demand conversion into one asset, you can readily bankrupt the cb that has bought all assets unless gold is the only asset.

This is why the gold standard was considered a core safeguard of liberty. So nice to bring this up but you can find this story elsewhere...

[Min]

Nick Rowe: "The faster M is growing, the bigger is V, and the smaller is the ratio M/PY. That ratio, M/PY, is a rough measure of the size of the central bank relative to the size of the economy."

And M/PY = 1/V. Then can't we rephrase your question as, What is the optimal velocity of money? :)

[Nick Rowe]

Jon: but under the gold standard, banks, including the banks that became central banks in the modern sense, did not have 100% gold reserves. They suspended convertibility in the event of a run.

Min: "Then can't we rephrase your question as, What is the optimal velocity of money? :)"

We could. There are several different ways to frame this same question. "What is the optimal nominal rate of interest?" is another. 0% is the standard answer, following Milton Friedman's argument.

[Mike Sproul]

Nick:
"there were 50,000 (!) different currencies circulating in the U. S."

I've always heard a figure closer to 5,000. But keep in mind that there were something like 5000 towns in the US, so a bank would set up in a small town, issue its own notes that circulated almost exclusively within that town, and were used by people who rarely traveled or traded further than 20 miles from home. I don't think it was quite the chaos that a lot of textbooks claim.

[Min]

Mike Sproul:

"Nick:
"there were 50,000 (!) different currencies circulating in the U. S."

"I've always heard a figure closer to 5,000. But keep in mind that there were something like 5000 towns in the US, so a bank would set up in a small town, issue its own notes that circulated almost exclusively within that town"

That was me, not Nick, and I cannot vouch for the number, that's just what I read somewhere. The 5000 figure sounds more reasonable. :) But bank notes could travel pretty far. A merchant might take a note on a bank that he had never heard of that might be counterfeit, but take it at 25% of its face value. And get rid of it as quickly as he could. Talk about a hot potato! ;)

[Min]

Nick Rowe: "There are several different ways to frame this same question. "What is the optimal nominal rate of interest?" is another. 0% is the standard answer, following Milton Friedman's argument."

0% nominal interest. That's where the Central Bank owns half of everything? ;)

[Jon]

Nick the point about not having 100 percent reserves is my point. Under a gold standard it's just not possible for a bank to corner all assets so long as gold isn't the only asset.

Regarding convertibility and suspension, I don't think we need to rehash the boullon debates. It was done all three ways--you have in mind the Scottish approach.

Could the Fed suspend gold convertibility during the 20s and 30s? Not by itself...

[Ralph Musgrave]

I’m amazed that no one has mentioned the Pigou effect so far. Pigou pointed out that as the real value of peoples’ stock of money rises given falling prices, the more they will tend to spend their bloated stocks of money on consumer goods, which boosts demand and brings the fall in prices to a halt. In fact it ideally leads back to full employment.

[Nick]

Nick,

QE is not the final line in the sand. There's still the helicopter. Friedman first coined the term in 1969.

What if the Fed simply prints and gives money away? If money is given away, instead of exchanged for assets -- ultimately including toothbrushes and underwear -- doesn't the 'deflation leads to communism' argument evaportate?

Moreover, the mere prospect that sometime in the future money might be given away should serve to reign in the need for an ever expanding central bank.

Nick Ricc
Kyoto, Japan

[Min]

Ralph Musgrave: "Pigou pointed out that as the real value of peoples’ stock of money rises given falling prices, the more they will tend to spend their bloated stocks of money on consumer goods, which boosts demand and brings the fall in prices to a halt."

Ah! A negative feedback mechanism.

Thanks, Ralph. :)

[Min]

Becky Hargrove: "However, even though the United States has not experienced true hyperinflation, the prices have been rising in such a way over the years that they have actually overwhelmed people."

I think that this statement highlights different ways in which the term, "inflation", is used. Most people use inflation to refer to the things like the rise in the consumer price index. But it is also used, as in this post, as the rate of change of prices in general, **which includes wages**. People are being overwhelmed when their incomes have not risen to match the rise in their expenses. The problem is not so much inflation as increasing inequality. (The average income in the U. S. has risen more than the median income for the past 30 years because the increases are being siphoned up to the top. On paper we have had increasing prosperity, but the average American has not shared much in that increase.)

[John Becker]

Nick,

When I say the central bank should do nothing, I really mean that they should close their doors, fire their employees, and dynamite the building. The second best thing they could do is cease all open market operations and only provide loans as a last resort to banks with liquidity and not capital constraints. Furthermore, these loans should come at a market rate based on the likelihood that the bank will survive to pay them back.

As far as money goes, I'd be in favor of a classical 19th century gold standard or the competing currencies idea put forward by Hayek. There are huge transaction costs to not having the same money throughout a fiscal area and, for that reason, one money will tend to predominate. If every bank could issue their currency, people would establish their preference for one very rapidly. The competition would force that currency to remain sound.

During the 19th century, there were many different types of banknotes in circulation, but these were not different types of money because all the banknotes represented claims on gold. There was only one true money and that was gold.

[Darius]

Nick: "Money seems to be a natural monopoly."

Uh-oh. Money also "seems" to be an ordinary good, yet it isn't, really. And it's certainly not a consumable good. Can a non-ordinary, non-consumable good be a natural monopoly? Also is money considered rival, or isn't it, and do macro people and micro people agree about whether it's rival?

Consider that in exactly the same sense that you're using here, language is a natural monopoly. You want to speak the same language that everyone around you speaks, right? So (getting up on my hobby horse here) what's the difference between language and money? It can't be that money has a central issuing authority, because money doesn't necessarily have that (plus consider the Académie française). It can't be that money is backed by a commodity because that isn't always true either. Money doesn't have to be backed by real wealth at all - it can be backed by the expectation of real wealth, or coercion, or mere social ephemera like trust.

Let's suppose that media of exchange are "sticky" and "contagious" in the same way that language is sticky and contagious, and not in the way that other natural monopolies are sticky and contagious (barriers to entry, economies of scale, transport friction, dedicated infrastructure). Is any kind of "sticky" and "contagious" enough to meet our definition of natural monopoly, or does it have to be an ordinary good as well? Does it have to be a commodity? Does it have to be consumable?

[*] I think it's okay to say non-ordinary instead of Giffen here, because the Giffen stuff doesn't apply. Giffen specifies that consumption goes up with price, but I'm not willing to stipulate that money is consumable (though I might be willing to stipulate that it's an inferior good to reputation ;-)

[Min]

John Becker: "During the 19th century, there were many different types of banknotes in circulation, but these were not different types of money because all the banknotes represented claims on gold. There was only one true money and that was gold."

People did not like that, though. At one point a bank in New Jersey issued some $600,000 in loans backed by 7 bits of a Spanish dollar (that's $0.875) in the vault! In addition, the loss of money when the U. S. went off of a dual gold-silver standard to a gold standard in 1873 contributed to the Long Depression. That is why Bryan's "Cross of Gold" speech remained popular for years. The gold standard also contributed to the Great Depression. When major economies went off of the gold standard, their economies rebounded. (That was not the only reason, OC.) The gold standard is oppressive.

[Scott Sumner]

Mike, If currency rises in value over the course of the year, what good is it as currency? I thought the whole point of currency was that its nominal price is fixed, otherwise it's not very convenient. And even if the nominal value did rise over the course of the year, the interest rate on currency would still approach infinity as the date approached December 31st.

[Determinant]

Nick,

When I say the central bank should do nothing, I really mean that they should close their doors, fire their employees, and dynamite the building. The second best thing they could do is cease all open market operations and only provide loans as a last resort to banks with liquidity and not capital constraints. Furthermore, these loans should come at a market rate based on the likelihood that the bank will survive to pay them back.

As far as money goes, I'd be in favor of a classical 19th century gold standard or the competing currencies idea put forward by Hayek. There are huge transaction costs to not having the same money throughout a fiscal area and, for that reason, one money will tend to predominate. If every bank could issue their currency, people would establish their preference for one very rapidly. The competition would force that currency to remain sound.

During the 19th century, there were many different types of banknotes in circulation, but these were not different types of money because all the banknotes represented claims on gold. There was only one true money and that was gold.

Nonsense.

Canada was one of the last countries to set up a central bank. We only did it in 1935. Before then there were Dominion Notes for $1 and bank notes drawn on chartered banks for everything else. Yes, the Canadian dollar was defined in gold but most transactions were conducted in chartered bank notes.

By 1930 there were 10 note-issuing banks.

This nicely competitive system did not save us from the Great Depression when then, as now, Canadian banks remained solvent by the Canadian economy still got squeezed by collapsing terms of trade. Canada went off the gold standard in 1933.

Actually Canadian experience goes against the Gold Standard or any fixed exchange standard. Any standard like that has to be defended and if it can't be defended with infinite resources it will ultimately collapse. That's why we let the Canadian Dollar float in 1950 in order to balance our trade accounts with the UK and the US. We always had large import/export flows for a country our size and the 1950's were fine even with a floating currency. We eschewed Bretton Woods mostly. We went on a US dollar peg from 1962 to 1970 per Bretton Woods and then floated again thereafter.

[Mike Sproul]

Scott:

I don't see how you arrive at infinite interest rates. I'm thinking of a world where a holder of $10 in paper can present them to the central bank on Dec 31 and get back $11. At the start of the year each dollar is worth 1 oz of silver. The dollar grows in value until it is worth 1.10 oz on dec 31, then the $1 interest is paid, and each dollar suddenly drops to 1 oz. It's just like a stock that pays dividends in stock, and you don't get infinite inflation in that case.

I agree about the convenience of a stable currency unit, but the fact is that old bills of exchange did grow in value over the year, thus effectively bearing interest even as they were used as money.

Besided, we presently use dollars that lose 3% of their value every year. I think I could deal with dollars that grew in value by 3%/year.

[Nick Rowe]

Darius: "Consider that in exactly the same sense that you're using here, language is a natural monopoly." "Let's suppose that media of exchange are "sticky" and "contagious" in the same way that language is sticky and contagious,..."

I fully agree. I use that exact metaphor myself, sometimes. The only difference is that language is not a good, that somebody produces and prices. Microsoft Word is a better analogy in that respect.

Jon: I'm trying to think though what would happen if people used 100% reserve backed notes in the gold standard, and the equilibrium growth rate of the economy were high enough, relative to gold production and industrial demand for gold, that gold was appreciating at (say) 10% relative to the CPI. Who would want to hold any assets other than gold? Could that be an equilibrium?

Ralph: John and I above, in comments, were in effect talking about the Pigou effect.

Nick Ricc: But if helicopter money were big enough, you couldn't have deflation.

[Determinant]

Jon: I'm trying to think though what would happen if people used 100% reserve backed notes in the gold standard, and the equilibrium growth rate of the economy were high enough, relative to gold production and industrial demand for gold, that gold was appreciating at (say) 10% relative to the CPI. Who would want to hold any assets other than gold? Could that be an equilibrium?

In short, no. The economy would run into the constraint of the gold production rate. At that point there would be a choice: either suspend or modify the 100% gold backing standard, reduce the growth rate of the economy or accept deflation.

The latter choice is intellectually comfortable but entirely unrealistic. The economy can produce more goods and more real wealth but cannot because of an artificial money constraint. It's nonsense and inhumane and that's why most countries if faced with that choice modified their gold standard.

Deflation will mean a reduction in real growth anyway due to contracts which extend back through time. Deflation will mean default on nominal contracts.

[Too Much Fed]

Nick Ricc said: "What if the Fed simply prints and gives money away? If money is given away, instead of exchanged for assets -- ultimately including toothbrushes and underwear -- doesn't the 'deflation leads to communism' argument evaportate?

Moreover, the mere prospect that sometime in the future money might be given away should serve to reign in the need for an ever expanding central bank.

Nick Ricc
Kyoto, Japan"

Let's change that money to medium of exchange. Can "should serve to reign in the need for an ever expanding central bank." be changed to "should serve to reign in the need for an ever expanding central bank on the asset side."?

This seems to come down to what should a central bank have as assets, "nothing", treasury debt, any type of debt, any type of asset.

[Too Much Fed]

Optimum size of the central bank:

IMO, liability side: the correct amount of medium of exchange

asset side: "nothing" (used loosely)

[J.V. Dubois]

This is very funny, because I had recently exact copy of this discussion but for fiscal policy. If you have a government that promises budget surplus from now on forever, you also end in communism. That is a world run by Sovereign Funds who invest the money produced by surpluses and which own everything there is to be owned. It was very funny to watch that cognitive dissonance on the face of the "no deficit" believers trying to think it out in real time. In the end, the dogma prevails.

[Nick Rowe]

JV: Yep. That's doubly funny, because I once did a paper with Vivek Dehejia (no downloadable version on the net) trying to figure out the optimum long run debt/GDP ratio if you assumed uncertainty and a deadweight cost of taxation function that gave you a Laffer curve. We "proved" that the government should run surpluses until the debt/GDP ratio went so negative that the government didn't need any taxes at all. It could pay for all its spending from the interest on its negative debt.

[grandiosity]

I dunno. I distrust Friedman, because his arguments were based on such a partial analysis - and most especially, given his soapbox and his position as spokesperson for anti-government, he was intent on proving the non-existence of a liquidity trap.

If you have an argument that leads to an infinitely great central bank in a liquidity trap, then you have a problem: we ARE in a liquidity trap.

[Nick Rowe]

grandiosity. The funny thing is that Friedman never actually proposed monetary policy that would match with what he wrote in this paper. Even though this paper remains (roughly) undisputed as theoretically correct, while most/all other of Friedman's writings have been disputed heavily. His actual proposals for monetary policy did not call for deflation at all.

"If you have an argument that leads to an infinitely great central bank in a liquidity trap, then you have a problem: we ARE in a liquidity trap."

But that's exactly my point. If we stay in a "liquidity trap", because we have deflation (or at least the fear of deflation) we are going to have a very big central bank, relative to the size of the economy. Either the central bank grows to match the size of the economy at something roughly like "full employment", or else the economy shrinks to match the size of the central bank.

[Sergei]

There is one asset which central banks can not buy by definition. That is deposits at commercial banks. Central banks can choose a regulation to penalize such deposits but this decision is independent from the decision about the balance sheet size.

[Too Much Fed]

"It ends when the central bank runs out of things to buy, because it already owns everything, right down to your house, furniture, and toothbrush, which it rents back to you. It ends in communism."

J.V. Dubois said: "If you have a government that promises budget surplus from now on forever, you also end in communism."

What is it called when the very few rich people continuously run surpluses (very high real earnings and real earnings growth) so they own all the "currency" and assets and want to rent them back to everyone else?

It seems to me that the problem is excess savers.

[Min]

Nick Rowe: "But that's exactly my point. If we stay in a "liquidity trap", because we have deflation (or at least the fear of deflation) we are going to have a very big central bank, relative to the size of the economy. Either the central bank grows to match the size of the economy at something roughly like "full employment", or else the economy shrinks to match the size of the central bank."

Sorry to be the perennial skeptic, Nick, but that seems to me to be a false dichotomy. Perhaps there are some assumptions that need to be relaxed. :)

During the Long Depression in the U. S., banks, but not the central bank, because the U. S. did not have one, became larger, through usury and foreclosures. But that dynamic seems rather different from the one with a central bank. Can we say that deflation tends to make banks -- central or not -- larger relative to the economy?

[jean]

Of course, financial repression is not optimal. In some way, the use of financial repression prove your point: to collect revenue from seignoriage, a state needs to use financial repression, otherwise it reaches rapidly the Laffer point where the balance sheet of the central bank shrinks too much to collect more revenue.