Another weird monetary world

Imagine you lived in a world where the central bank issued two types of money: paper money; and electronic money. If you want to pay for something with the paper money, you have to physically transfer it. If you want to pay for something with the electronic money, you just need to tell the central bank to transfer it for you, perhaps by setting up an automatic system (just like how I pay for my car insurance now).

The two monies have a pegged exchange rate of one. The central bank swaps paper money for electronic money at par, on demand.

Anyone can use the paper money, but only a very select group of customers are allowed to use the central bank's electronic money.

The paper money always pays 0% interest nominal. The electronic money can pay whatever nominal interest rate the central bank chooses to pay.

The nominal interest rate on paper money is always 0%, but that does not mean the real interest rate on paper money is always 0%.

The strategic objective of the central bank is to try to ensure that the real interest rate on the paper money does not vary over time. It targets a fixed real interest rate on paper money.

The central bank adjusts the nominal interest rate on electronic money to try to hit that target real interest rate on paper money.

The central bank has a theory about the relationship between the nominal interest rate on electronic money and the real interest rate on paper money.

According to that theory: if the central bank wants to lower the real interest rate on paper money (because it thinks there's a danger the real interest rate on paper money will rise above target unless it does something) it needs to lower the nominal interest rate on electronic money. The central bank calls this the "short run" part of its theory.

But, according to that same theory: if the central bank's target for the real interest rate on paper money were lower, the nominal interest rate on electronic money would need to be higher. The central bank calls this the "long run" part of its theory.

Very few people understand the central bank's theory. Even some very good monetary economists don't get the short run part, and think that if the central bank wants to lower the real interest rate on paper money, all it needs to do is raise the nominal interest rate on electronic money.

Just in case you haven't figured it out yet: this is not an imaginary world. It's the real world. But it definitely is weird. Only a finance theorist could have dreamed up a world this weird.

 

Comments

[Nick Rowe]

Jeff: "There's no magic allowed!"

OK. The central bank sells something. But does it matter much if it sells land, or houses, or Tbills? I could buy land from the central bank, and earn rents, or buy houses from the central bank, and earn rents. Or buy Tbills, and earn interest.

"Except that the demand for money is satiated at both values of the quantity, before and after your OMO."

Suppose all prices are sticky, except the price of farmland is perfectly flexible. So people can always buy and sell farmland for money. The market for farmland always clears. So people are always indifferent, at the margin, between holding money and holding farmland. When the central bank sells farmland, to reduce the supply of money, the price of farmland drops, to clear the farmland market. It does not affect the rest of my story. Would we say that the drop in the price of farmland is what caused the recession? Or would we say that the excess demand for money caused the recession and also caused the drop in the price of farmland?

Now substitute "bonds" for "farmland".

[Jeff]

Nick,

That was Pigou's argument. His flaw (and yours) is that the demand for money can in reality be satiated. How do we know that? Because the price of the asset swap between reserves and t-bills went to zero. Pigou assumed that the elasticity of demand was always finite, but we know that is wrong because the price is zero and hasn't changed over the last five, or so, doublings of the money supply in the US. So nobody is going to be trying to "rebuild their monetary balances" if the Fed halves the quantity. As far as I can tell, nobody is going to do anything.

[Jeff]

Oops. That last comment was a reply to your 10:01 comment.

[Jeff]

"Or would we say that the excess demand for money caused the recession and also caused the drop in the price of farmland?"

We would say that swapping t-bills for money isn't going to help, because people are indifferent between t-bills and money as the t-bill-relative demand for money has been satiated. So if the central bank has been distorting the price of farmland, they need to stop it. And whether they sell farmland for money or they sell it for t-bills will make no difference whatsoever. Money has nothing to do with it.

[Nick Rowe]

Jeff: @10.18. Pigou's argument with the "Pigou effect" was a bit different. He was saying, that *even if* the demand for money was perfectly elastic wrt the interest rate on bonds (the liquidity trap), a fall in the price level would increase real wealth (because outside money is net wealth) which would increase consumption demand.

I gotta go now, but I address the "liquidity trap" argument in this post

Plus, the central bank can also use commitments about the future quantity of money.

[Jeff]

"He was saying, that *even if* the demand for money was perfectly elastic wrt the interest rate on bonds"

No, he was saying pretty well exactly what you were saying. From page 348 of Pigou's "The Classical Stationary State" (The Economic Journal, Vol. 53, No. 212, Dec., 1943):

"r = g(T/x) where T/x is always positive and the functional form g is such that d(g(T/x))/d(T/x) is negative and g(T/x) is positive for all possible value of T/x; whence it follows that, as T/x increases towards infinity, g(T/x) falls asymptotically towards, but never reaches 0. "

T is the real balance and x is the real level of income.

[Nick Rowe]

Jeff: read a bit further along, where (IIRC) Pigou talks about the price level, real balances, wealth, and consumption demand. Because the bit you have quoted is about the "Keynes effect" (increasing M/P reduces r which increases C and I, provided we are not in a liquidity trap).

[D. Tohmatsu]

What impacts AD is marginal changes in the volume of financial assets exchanged by the non-banking sector for real goods and services. Money is used as an intermediate medium to facilitate the exchange. Marginal changes to the volume of financial assets exchanged for goods and services can be independent of changes to both nominal and real rates, but marginal changes in Base less ER correlates pretty well (with some adjustment). However, you can't conclude causality. If the banking sector marginally increases net purchases of financial assets from the non-banking sector (e.g. makes loans to the non-banking sector), the quantity of money has to increase. Yin and Yang.

Nick is wrong to assume causality when only correlation exists and Jeff is wrong to think it's necessarily and always correlated to changes in r.

BTW - It would be nice if you would both acknowledge that Tbill-reserve swaps do absolutely nothing.

[Jeff]

D.T.: "It would be nice if you would both acknowledge that Tbill-reserve swaps do absolutely nothing."

But, that's what I've been saying! Given that they have the same yield and demand for that particular asset swap is currently infinitely elastic, your statement is clearly true. Of course, it isn't always true, if liquidity preference is not satiated.

Nick,

"read a bit further along"

It's the same assumption right to the end. The general conclusion of the paper is formed in paragraph 11 on page 350, with the statement: "our knowledge of the form of function g, as set out paragraph 9, assures us that r, while it falls towards zero as T/x rises towards infinity, can never fall to zero. Thus the "some circumstances" in which it seemed, according to paragraph 7 [Keynes/Hansen], that the classicals' full-employment stationary state was impossible, have been found to be such as cannot, in fact, occur"

The current conditions have proven Pigou's assumption (and yours at 10:01) to be incorrect.

My points at 10:18 and 10:31 stand.

[Too Much Fed]

Tom Brown, Jeff, and anyone else, this should be fairly simple. Use a gold standard with no banks.

http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/10/medium-of-account-vs-medium-of-exchange/comments/page/1/#comments

“[Update: just to clarify terminology: in my model, gold is the medium of account; and (say) an ounce of gold is the unit of account.]”

Agreed.

And, “Here is a simple model, where one good (gold) serves as medium of account, and another good (silver) serves as medium of exchange.”

Agreed, except change silver to currency and assume 100% backing.

Now make gold and currency have a 1 to 1 fixed convertibility. There is now a dual MOA with one MOE.

Have there be $1,000 ounces of gold. That means there could be $1,000 in currency circulating with 1,000 ounces at the central bank.

Now allow gold to be MOE also. Everyone uses gold as MOE. The $1,000 in currency goes back to the central bank. There is 1,000 ounces in gold circulating. Now make 50% of each MOA/MOE. $500 in currency circulates, and 500 ounces of gold circulates. In all three cases, it is 1,000 total.

I’m pretty sure Scott Sumner would agree with me until here.

Now drop the gold standard. Add commercial banks. Replace demand deposits for gold. Demand deposits and currency are both MOA/MOE.

[D. Tohmatsu]

Jeff,
Sorry, had not seen some of your more recent comments when I posted. BTW - Don't think it has anything to do with the liquidity preference. I think it's just a function of the counter-party. Unless there is an ultimate counter-party (or an expectation of one in the future) outside of the banking system, the swap will be ineffective as a policy action. OMP which merely increase reserves have no impact.

[Too Much Fed]

Nick's post said: “Imagine that the central bank issues paper currency, which people use as a medium of exchange. Every other good is bought and sold for paper currency. The central bank pays interest on that paper currency (ignore the practical difficulties), and can vary that rate of interest, and chooses to vary that rate of interest to try to keep inflation on target (maybe by following a Taylor Rule). Now suppose, to reduce the risk of muggers, instead of physically transferring the paper currency to the seller of goods, you send an email to the central bank telling it to transfer currency from your "safety deposit box" to the seller's "safety deposit box". Now make that paper currency an electronic currency which is transferred between electronic safety deposit boxes (which makes no theoretical difference). Now allow people to have negative balances in their electronic currency accounts.
It's still money. Do we now have the New Keynesian model?”

This is one reason I asked about commercial banks. The email does not go to the central bank. It would go to the commercial bank. Also, 1 to 1 convertibility needs to be guaranteed.

Deposit currency at the commercial bank. The currency goes in the bank’s “safety deposit box”. (Commercial bank) demand deposits go in the buyer’s “safety deposit box”. The bank then sends the currency to the central bank. The bank gets central bank reserves put in its “safety deposit box” at the central bank.

Now the seller accepts demand deposits in exchange for a good. The seller banks at a different bank. The seller will make sure demand deposits at his bank and the buyer’s bank can be exchanged 1 to 1. The seller’s bank says OK because of the fed clearing the demand deposits. The exchange of goods and demand deposits happens.

Overall, it is as if the demand deposits “moved” from the buyer’s bank to the seller’s bank. The central bank reserves just ensure 1 to 1 convertibility (clear the payment). The demand deposits are 1 to 1 convertible to currency making them MOA. They also are MOE.

Demand deposits and currency are both MOA and MOE.

[Jeff]

Nick,

Thanks for the debate. It clarified my thoughts about quite a few things, in particularly Pigou's contribution, but lots of other things too. I do wish we could have taken the discussion to a more final conclusion, as all too often, it seems that no permanent progress in the public debate is ever really made in this medium. Anyways, looking forward to future posts, perhaps on some of the issues we've discussed in this thread.

Best,
Jeff

[Nick Rowe]

Thanks Jeff. I learned from it too. Sorry for not continuing. Sometimes I just get burned out, and need a mental health break. And sometimes, final conclusions (or the slow asymptotic approach towards them) just take time, for thought.

I have done some other posts on liquidity traps (which is where our discussion broke off), but didn't have the mental energy to go through it all again at the moment. (The search box top right will probably find some of them, if you are interested, but maybe favour the later ones over the earlier ones, since my views have developed a bit over time.)

I very much hope you will stick around and comment in future.

[Too Much Fed]

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