Euro MOA+MOE plus Drachma MOE

Suppose your country (call it "Greece") is in recession, because there is an excess demand for money (call it "Euros"). And suppose that the Euro is both Medium of Account (prices are quoted in Euros) and Medium of Exchange (all other goods are bought and sold for Euros).

Now suppose your government introduces a new currency (call it "Drachmas"). It introduces the new currency by paying pensions via helicopter. But the Drachmas do not displace the Euros. The Euro remains as medium of account. Prices are sticky in terms of Euros, but the exchange rate between Drachmas and Euros is perfectly flexible, so prices are perfectly flexible in terms of Drachmas. Both Euros and Drachmas are used as media of exchange.

What happens? Does the introduction of the Drachma make the recession less severe?

I say it does make the recession less severe.

There are two ways to explain why it makes the recession less severe:

1. Unless the Drachma has an exchange rate of zero, the introduction of the Drachma, in addition to the existing stock of Euros, increases the total real value of the stock of media of exchange, and so lessens the excess demand for the media of exchange, and so reduce the severity of the recession. And if at least some people are willing to use at least some Drachmas as a medium of exchange, there will be some demand to hold Drachmas, and so the exchange rate of the Drachma will not be zero.

2. If at least some people are willing to use at least some Drachmas as a Medium of exchange, that means that Drachmas are an (imperfect) substitute for Euros. The introduction of a new good will reduce the demand for any existing good that is a substitute for the new good. So the introduction of the Drachma reduces the excess demand for the Euro, and so lessens the recession.

But in order to get this point, you have to understand the essentially monetary nature of recessions. They aren't caused by real interest rates being wrong, or real exchange rates being wrong, or real wages being wrong. Those are all just symptoms, or side effects. The underlying cause of the recession is the reduction in the volume of trade caused by an excess demand for the one good that is demanded or supplied whenever any other good is traded.

If you want a model, use my "Tiny money/macro model for microeconomists", and ask what would happen if we started out in recession, so there was too little trade in apples and carrots, and then introduce an endowment of a fourth good, dates, that was a substitute for the bananas that are used as a medium of exchange. Even if the prices of apples and carrots stayed exactly the same in terms of bananas, and the price of dates were perfectly flexible, the volume of trade in apples and carrots would increase.

This is in part a response to JP Koning's good post. He may be right about the Euro remaining the medium of account, but it is the excess demand for the media of exchange that causes recessions.

Comments

[H Brown]

Doesn't the depreciation of the drachma worsen the external debt problem, since the debts are denominated in euros? If you can't service a debt of 170 per cent of GDP, how do you service a debt of, say, 340 per cent of GDP? Of course, you could reduce the debt, either through agreement with your creditors or unilaterally. But if you're going to allow debt reduction, you don't need to depreciate - there is surely a level of debt at which Greece would not only begin to recover, but prosper, inside the euro. Conversely, even a massive depreciation won't solve Greece's debt problem. This is not to argue that the euro is an OCZ. Clearly, it isn't. But it seems to me that heart of the current problem isn't the exchange regime, but the shear quantity of external debt.

[Roger Sparks]

We can only pin Greece's recession on "excess demand for the media of exchange" if we ignore the possibility of Greek (as a national company) mismanagement.

The Greek nation can be compared to a company. One government runs a nation just like one management runs a company. Management creates the operating rules, including the distribution of rewards, for both nations and companies.

Now if a company pays out more than it receives for year after year, then it is no surprise when the company can no longer borrow to continue meeting payroll and cash responsibilities. We have no hesitation in blaming management for mismanaging the company.

We should not hesitate to blame the management of a national government if they consistently borrow to meet everyday expenses.

[bill woolsey]

Where is Sumner's comment?

Good one Nick. Central to a key issue among Market Monetarists, right?

I think you are right.

But I would, right?

[Nick Rowe]

Thanks Bill! Yep, I figured you would be on-side. (But notice a question that I carefully ducked: the introduction of the Drachma lessens the recession; but does an increase in the nominal quantity of the drachma further lessen the recession? Not if it's done under QT assumptions.)

H Brown: it doesn't affect the external debt problem. Incomes and debts are measured in Euros. But if the introduction of the Drachma lessens the recession, then real income will increase, so it is easier to service the same amount of debt.

Roger: Greece has supply-side problems, just like a mismanaged company. But the demand-side (monetary) problems of a nation are very different to a company.

[Max]

"The introduction of a new good will reduce the demand for any existing good that is a substitute for the new good. So the introduction of the Drachma reduces the excess demand for the Euro, and so lessens the recession."

What prevents the supply of euros from decreasing? If drachma holdings increase but euro holdings decrease by the same (real) amount, you are back where you started.

[Lord]

Introduction by paying in the new currency certainly forces the recipients to use it, just as payment of wages in it will force workers to use it, and acceptance of it for payment of taxes will define the exchange rate, but altering the rate would be seen as cuts and wouldn't be effective against goods.

[Nick Rowe]

Max: good question. That depends. Suppose it does cause the Euros to exit Greece. All of them. Then the government must increase the supply of drachmas to compensate. But it will depend on the degree of substitutibility between Euros and Drachmas.

Lord: it doesn't *force* them to use it. If I hand out bits of paper to my students, it doesn't force them to use them as media of exchange. And if you hand out more bits of paper every year than you demand back in taxes, the bits of paper might be a free good. There's always enough just laying on the sidewalk, so you pick a few up to pay taxes, and drop them back down when the government pays pensions, but the stock on the sidewalk increases forever.

[Avon Barksdale]

"...but it is the excess demand for the media of exchange that causes recessions."

Well, I guess that Stockholm will be calling soon, Nick. You know what causes recessions and the simple things we need to do to stop them.

You see, Nick, it's statements like the one you made in your post that makes all the other sciences look down on economics. That's unfortunate because there is really great economics. You will never find a physicists working at the coalface of a poorly understood phenomenon tell us that, "Oh, it's just this simple thing here, what's all the fuss about?" Scientists are a careful lot, constantly trying to find ways in which they are wrong, constantly doubting their own ideas. In the end, they want to be wrong, because then there is something to work on and new phenomena to understand. But we have to be extra careful to ensure that we really understand.

To give you an example of how easy it is to fool yourself. In astronomy for a long time a pair of green emission lines from nebular gas defied explanation. Astronomers could not match the emission structure with any known element. Was this a case of the discovery of a new element in the periodic table? After all, Helium was discovered this way in the atmosphere of the sun, so did these astronomers find another new element? Well, it would be easy to say YES, YES, YES!!! But they didn't. They carefully thought of all the ways in which they could be wrong. After thinking about problem, they realized that they were seeing a "forbidden" transition resulting from a quantum mechanical metastable state in doubly ionized oxygen. It's impossible to observe the transition in the lab, you need a huge collection of super-rarefied gas and the only place we can get a gas like that is in a nebula. In the end, there was no new "nebulium" element, it was just oxygen. See how hard it is to know things in the physical sciences? It's even hard to know things in economics. Nick, it's really, really, hard to know things.

It's the responsibility of scientists to doubt their own ideas. In fact, all good scientists are their own worse critics. When the great physicist Wolfgang Pauli received a letter from Werner Heisenberg in which Heisenberg claimed that he had developed a unified theory of particle physics, Pauli responded with a blank piece of paper with the subtitle: "This is to show the world that I can paint like Titian. Only technical details are missing."

I'm sorry, but the simple statement that excess demand for the medium of exchange is the CAUSE of recessions is unbecoming of a scientist.

[Roger Sparks]

"But the demand-side (monetary) problems of a nation are very different to a company."

Yes, I certainly agree with this quote, unless the nation has agreed to be part of a larger monetary unit. Part of the euro agreement was to limit the money supply expansion to the expansion rate of the monetary unit as a whole. Failure of the Greek government management to respect that limit seems to be the root of most of the Greek current problems.

At this juncture, the Greek government seems to be nearly broke. If we assume that the Greek government has no remaining euros, what would it use to back a new drachma? I do not think taxes could back it because taxes were inadequate to back the euro commitments of the Greek government.

I think one valid question is "How would the Greek government establish creditable valuation to a new drachma?".

[Nick Rowe]

Avon: Other macroeconomists will disagree with me, and will recognise it as a hypothesis. I have done lots of (too many?) other posts explaining why I think that. This post is not one of them.

One example: http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/12/more-greek-barter-evidence-for-monetary-disequilibrium.html

[Avon Barksdale]

Nick,

No, your statements are musings - even less developed then Heisenberg's “unified theory”. You have no real model, no real mathematical structure, and no facts that you can explain beyond the phenomenon that you're studying. There is nothing that in your ideas that if a fact came out the other way that you couldn't accommodate it. That's not science, that's bad story telling.

Approach economics like a science. Stop with arguing by prose, “goes like this, or like that” – your methods would have taken the astronomy data at face value and declared nebulium a new element. Write down a serious – not toy – but serious model. Work out the details. Explain more than just the facts you used. Do science for crying out loud!

[Nick Rowe]

Avon: suppose I learned that barter were procyclical. That would be a problem.

[JKH]

“It introduces the new currency by paying pensions via helicopter.”

Suppose instead it introduced it with cross currency QE – an exchange of drachmas for Euro denominated bonds of some sort.

How would the effect on recession compare?

[Avon Barksdale]

"..suppose I learned that barter were procyclical. That would be a problem."

Nick, that's a fact. Fine, how many other ways are there to accommodate it and what else would I predict? This does not mean that excess demand for the media of exchange CAUSED the recession. You might be looking at an inappropriate government response to a recession that happened for other reasons.

It's not easy to know stuff, Nick. Organize the facts, write down a careful model. Just because we see the equity premium puzzle, it does not mean that people are irrationally risk averse in the stock market. Carefully constructed time varying risk premium models not only accommodate the fact but at the same time the explain "excess" volatility. The models explain more than one fact. It goes on.

If we want economics to be taken as a serious science - and I think we should - then economists need to approach their discipline like a SCIENCE. If we don't understand a phenomenon, just say, "We really don't know. We have approximate beliefs, but we don't know. Honestly, we really don't know what CAUSES recessions." You will not see scientists make up some malarkey about some phenomenon - she'll just we don't really understand it.

[Max]

Nick, I though you might mention capital controls. Because if euros are free to leave Greece, then excess euros in Greece (due to partial drachma adoption) should reflux to the ECB.

[Declan]

Since I was critical on the last post, I should be consistent and offer praise here, Nick. My understanding is that we've seen the dynamic you mention in play numerous times throughout history as people turn to alternative local currency systems when faced with a shortage of the medium of exchange.

Max raises an interesting question, but I think if you are Greece in this situation, you *want* all the Euros out (maybe not all at once, of course). You're not back where you started because you started with a currency you can't print and ended with one you can. Given the shortage of Euros in Europe, the Europeans would benefit from getting their Euros back from Greece as well, I suppose, although I haven't really thought that through.

[am]

What about good money drives out bad. Or is that not relevant or even true.
What would salaries be paid in: euros or drachmas.

[Nick Edmonds]

It's useful to consider an alternative scenario here, where drachma is introduced, but the public declines to use it as MOE. Instead, recipients of drachma pensions sell their drachma for euro and then continue to use euro as the only MOE. There is the question of why anyone would buy drachma at all (and I think this applies to your scenario as well), but we can borrow from the chartalists and say that, as long as the government is taxing in drachma, there will be at least some demand.

The question then is does it make any difference if drachma are not used as MOE, but merely as a store of value. Why would someone spend more when they can use drachma as MOE, than when they have to change it for euro first? And if your answer is that they may be unable to sell their drachma for euro, because no-one wants the other side of that trade, doesn't that raise the question of why anyone would accept drachma as MOE?

[JP Koning]

Like Bill I'm wondering what Sumner will say. Incidentally, the ideas we're batting around we're at the core of the first big market monetarist "internecine" battles back in 2012:

http://www.themoneyillusion.com/?p=17412
http://uneasymoney.com/2012/11/25/its-the-endogeneity-redacted/
http://www.themoneyillusion.com/?p=17368
http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/10/medium-of-account-vs-medium-of-exchange.html

"But notice a question that I carefully ducked: the introduction of the Drachma lessens the recession; but does an increase in the nominal quantity of the drachma further lessen the recession? Not if it's done under QT assumptions."

What did you mean by this? Why not take your argument all the way and say that a new drachma could cause a boom?

Second question is this: up until the bank closure, Greece had a functioning banking system. Wouldn't banks, who's job is to manufacture liquidity, have solved the excess demand for media of exchange (a Greek bank deposit is as good as a paper euro), thus saving Greece from recession? Were they simply not making enough of the stuff? Your argument makes a lot of sense to me post-June 25, 2015, when the banking system was shut down. But Greece had been in a recession long before then.

[djb]

It's not just that

Greece will be able to pay its own people in drachmas that they don't have to borrow or pay for

this is a redistribution

And so a fiscal intervention

[Nick Rowe]

JKH: I think there would be a quantitative difference. For a given amount of new money, helicopter money normally increases AD more than OMO. But qualitatively the same effect. (But I don't think your scenario is as realistic, because the Drachma would tend to be introduced by a government that was unable to borrow to finance its spending.)

Avon: there are economics survey papers, and applied econometrics papers, and formal model-building papers, which do that sort of thing. And then there are speculative off-the-cuff blog posts like this one. If *all* economics were like this blog post, or if *no* economics were like this blog post, economics would be worse than it is.

Max: yep. But I'm still trying to get my head around the simple case where the stock of Euros stays fixed.

Declan: thanks. Yep, JP was comparing to Bitcoin, and I was thinking also about things like LETS. Both should lessen recession, if I'm right. But LETS tend to have a sort of fixed exchange rate?

am: Gresham's Law is relevant, but it assumes the bad money does not trade at a discount when used as a MOE. If stores accepted either X Euros or the same X Drachmas for the same good, people would likely pay Drachmas and hoard Euros, just like in Gresham's Law. But that violates my own assumption that Euros are MOA and Drachmas have a flexible exchange rate against the Euro.

Nick E: in your alternative scenario (which I agree should be considered), then "Drachmas" are really bonds, rather than currency. In the Warren Mosler Business Card model (Warren hands out his business cards at a meeting, but won't let anyone leave the room unless they hand over a card) his cards would have zero value if the government collects fewer cards in taxes than it hands out in pensions.

It is not obvious to me whether Drachmas would in fact be used as an MOE. Again, there's a network externality/ multiple equilibrium issue here. If some other people use them as MOE, then I have an incentive to use them as an MOE too. It needs some big player to get the ball rolling. And here, I think, is the grain of truth in the Chartalist theory. The government is a big player. If it hands Drachmas out in pensions, and accepts Drachmas (or only Drachmas) in taxes, that might be enough to get the MOE ball rolling.

[Jeff]

@Avon. Lord knows I've disagreed elsewhere with Nick, but wouldn't a more generous reading of Nick on this particular point ("cause" of recessions) make more sense? (Maybe there is some history of which I am unawares tho...)

Isn't the vicious-cycle nature of recessions agreed at least? If so, Nick's wording could be just shorthand for "here's where I have concluded is the (only? only useful?) place in the cycle to focus policy"? Yes it may be blinkered as to other ways to initiate or interrupt the cycle. (Or is maybe shorthand for "all other ways have 'unacceptable' (to me) ramifications".) And thus subject to being blindsided by an effective "other way".

I agree that it is "unscientific", similarly to Romer's criticism of Lucas. But taken in context (his own blog, not a published paper, and subject to immediate counter-comment, as here), I can't see it as so egregious as you make it out. (Again, I could be completely wrong due to my own historical ignorance; both correct me if so (or ignore); thanks.)

[Nick Rowe]

djb: we normally think of helicopter money as both monetary and fiscal policy. But you are right that I'm emphasising the monetary aspect, because I'm giving a "monetarist" analysis (in the very broad sense of that word, that includes some "keynesians" who see that monetary exchange is essential to understanding recessions).

[JP Koning]

Whoops, I think I ended up in the spam folder. Too many links.

[Nick Rowe]

JP: rescued you from spam, thus training TypePad!

On my obscure "QT" comment. Start with an equilibrium where X Drachmas are in circulation, and the exchange rate is S Drachmas per Euro. Now do a one-time helicopter drop to double the stock of Drachmas in circulation. According to Quantity-Theoretic reasoning, X doubles and so S doubles, with no real effects, because the real stock of Drachmas (measured in Euros) X/S stays the same. (But this assumes that the whole expected future time-path of X(t) also doubles.)

Commercial banks are beta banks, not alpha banks. It would be the same if the government offered to exchange Drachmas for Euros at par, and keep the exchange rate fixed. No takers.

Yep, we are back into the Market Monetarist internecine war!

[am]

Why I asked about salaries and pensions being paid in drachmas was that on intro of the new currency at say 1:1 against the euro nothing changes. A pension of 500 new buys 500 euro worth of goods. But, assuming, as the currency depreciates a pension at the end of the next month will only buy 250 euros worth, then the gov needs to pay out a new pension at 1000 new to get the previous value of euros. This goes on and on until the currency no longer depreciates. New salary and pension rates vary every month with the chaos not to say anger that results.
However if that is what it is worth then that is what will happen.
A big problem parallel to that is the government need of euros. It can corner the market for euros.
The scenario is really no different to colonies after independence: currencies collapsed, hyper inflation resulted and salaries were not increased so poverty abounded. Your difference allows both the euro and new as moe with the euro as moa. It may make a difference as you suggest.

[dlr]

I think you are contradicting your own argument about the primacy of the MOE over the MOA. In both (1) and (2) you are assuming that by issue an MOE substitute, you can change the demand for the MOE/MOA and affect the price of the MOA, i.e. the only way the MOE will matter is if it affects demand for the MOA. But this may not work. What if marginal demand for the exchange value of euros is satiated in Greece? Leave the current bank run aside for the moment. Greece is at the ZLB give or take, and there is no liquidity penalty for holding euros relative to, say, Bunds. The marginal liquidity value of an additional euro might well be zero. The value might be identical to the value of a marginal Bund.

Printing Drachmas would do nothing, then to change the demand for Euros, even if they did act as partial MOE substitutes, as long as Drachmas weren't considered close substitutes as vehicles for safe savings. And if they didn't change the demand for Euros, they wouldn't change Euro-based prices, and sticky prices would still be too high relative to flexible prices. Those sticky-MOA-priced assets would still be unemployed. I am reading your post to be about the recession and not just the recent bank run, which has created new marginal MOE demand dynamics.

[Nick Rowe]

am: if the stock of Euros falls by the same (real) amount that the stock of Drachmas rises, then yes, it won't work. But that's not what I have in mind.

dlr. Let's assume the price of goods in terms of the MOA stays exactly the same. Take my tiny money/macro model for microeconomists. Start in recession, where the prices of apples and carrots in terms of bananas is too high, so we have a recession. Hold prices fixed, and increase the endowment of bananas. You get increased trade in apples and carrots. Now instead provide an endowment of dates, that are a substitute for bananas. You get the same effect, qualitatively. This is especially obvious if U=log(A) + log(B+D) +log(C), so bananas and dates are perfect substitutes, but it should hold if B and D are imperfect substitutes too.

[dlr]

Start in recession, where the prices of apples and carrots in terms of bananas is too high, so we have a recession. Hold prices fixed, and increase the endowment of bananas. You get increased trade in apples and carrots. Now instead provide an endowment of dates, that are a substitute for bananas. You get the same effect, qualitatively.

It really seems like you are doing the same thing again. The question you are begging is whether dates are, in fact, substitutes for bananas. Let's say people demand B for two reasons. One, they use them as home decor on their tables. Two, they eat them. Now assume there is no marginal demand for fruit decor, it is fully satiated. The value of the marginal banana is entirely determined by its food value. Introduce dates. Are dates substitutes at the margin? That depends. Maybe people have good taste and are aware that dates are repugnant as food, and they only value dates as decor. Then dates are not substitutes in that they do not affect the marginal demand for bananas at all. Bananas can disappear entirely as decor without any change in the marginal demand for bananas and thus no increased trade in apples and carrots.

[Nick Rowe]

dlr: "The question you are begging is whether dates are, in fact, substitutes for bananas."

I am assuming, or rather asserting, that there is an excess demand for the medium of exchange. That seems very plausible to me. There are Greek workers and firms who would like to sell labour and goods for Euros, but cannot at existing wages and prices. And if hypothetically those individual workers and firms *were* counterfactually able to sell extra labour and goods for Euros, they would then turn around and spend (most of) those Euros buying goods and labour. Which would mean there is an excess demand for Euros qua medium of exchange.

And I am assuming (though this is certainly a debatable assumption) that the newly-introduced Drachmas would in fact circulate as a medium of exchange, just like Euros do. And if two different goods are both being used for the same function (medium of exchange) it seems reasonable to assume they would be substitutes (though we can imagine a world where they are complements, like if you buy right shoes with Euros and left shoes with Drachmas).

[dlr]

That seems very plausible to me. There are Greek workers and firms who would like to sell labour and goods for Euros, but cannot at existing wages and prices. And if hypothetically those individual workers and firms *were* counterfactually able to sell extra labour and goods for Euros, they would then turn around and spend (most of) those Euros buying goods and labour. Which would mean there is an excess demand for Euros qua medium of exchange.

Okay, I think your entire argument for MOE over MOA rests entirely on your assertion that this assumption that there is marginal demand for euros as an MOE is plausible. But surely you can agree that at some point the demand for MOE is satiated, e.g. the past few years in the US. In that case, adding an MOE-only substitute would do nothing to prices, and thus would do nothing to alleviate nominal frictions. And moving prices, i.e. moving the value of the MOA, is what alleviates nominal frictions. Whether increasing the supply of the MOE can do that is entirely dependent on the marginal demand for the MOE feature of the MOA. If it is zero, and at some point it most definitely hits zero, then it is irrelevant. I don't really know why you think it is very high in pre-bank run Greece at the ZLB. This goes back to why people like Delong started talking about an excess demand for money+bonds. Because once the marginal MOE demand is zero, the substitute is more safe savings (or more usefully a decline in the expected risk adjusted return from holding the MOA), not more MOE.

[Squeeky Wheel]

dlr: I don't think the US is a good example b/c MOA == MOE. For example, I would be happy to take all your US MOE - my marginal demand is not satiated. I don't think you'd give it to me b/c your marginal (-delta) demand is non-zero. I think the rest of your post essentially says that the above situation is b/c MOE = MOA. I think that your argument is that it's difficult to have a MOE with non-zero value if it has no MOA feature.

To try to be more concrete: Given a) Greece airdrops drachma into the country every month to pay pensions, b) Greece accepts drachma for taxes, but taxes are denominated in euros at a free-market exchange rate. Greece declares drachma to be a MOE but not MOA. What with the exchange rate be? I would guess non-zero but rapidly falling towards zero as the supply of drachma increases. Like you, I don't see how Greece can introduce a pure MOE (counter-example: bitcoin)

Option 2: a) Greece airdrops drachma, b) Greece accepts drachma for taxes at some defined (peg, crawl, band, or some other function) exchange rate. Now drachma have at least some MOA feature and should have some demand for that.

[Roger Sparks]

When you assert "that there is an excess demand for the medium of exchange", you are making a 'perspective' argument. A perspective argument is one based from an under-laying reference point.

Here is an illustration using a dime (A dime is a 10 cent American coin.)

A dime has been dropped on the sidewalk in an American city. A rich man walks by, notices the dime but does not stop to pick it up. He reasons that it is not worth his time and and effort to pick up a dime. This would be a case of lack of demand for the medium of exchange.

A dime is still on the street. A less wealthy person (or perhaps a more enterprising person) walks by and notices the dime. He reaches down and retrieves the coin. This would be a case of normal demand for the medium of exchange. A reasonable amount of work is exchanged for something of value.

Another dime is on a different street. Two poor people pass by simultaneously. Both notice the dime and reach for it. An argument breaks out over who should own the dime. This is a case of excess demand for the medium of exchange.

Now notice that in the each case, a determination has been made that the actions of the finder are to be judged against a standard. Each of the three finders has also made a judgement, each different but each rational from the finders perspective. It is the observer who is making the perspective based analysis, thus categorizing each of the finders.

[Nick Rowe]

dlr: " But surely you can agree that at some point the demand for MOE is satiated, e.g. the past few years in the US."

No. I totally disagree. I can almost hear you silently talking about "the money market"! ;-)

If the price of peanuts is perfectly flexible, there can never be an excess demand for the MOE in the market for peanuts. The price of peanuts would instantly fall if there were. We ca't just look at the peanut market, or the bond market, to tell if there's an excess demand for the MOE.

[dlr]

Nick: If the price of peanuts is perfectly flexible, there can never be an excess demand for the MOE in the market for peanuts. The price of peanuts would instantly fall if there were. We ca't just look at the peanut market, or the bond market, to tell if there's an excess demand for the MOE.

I am not saying that. I am saying that the nominal interest rate normally represents the marginal liquidity value of the medium of exchange; i.e. the marginal demand for the MOE. That is true even though the money/bond market is perfectly flexible. When it is zero, it is totally unclear whether there is marginal demand for the liquidity feature of money. Here's the question (and this also responds to Squeaky, above). It is not whether someone would have like one of my marginal dollars. It is whether spending would have been affect had stocks and bonds been added as additional MOE. I say probably not, and yes, even considered all the neck arching T-bills-as-hypothecation-collateral arguments. I say our wallets have been full, so to speak, and the marginal shortage has been safe savings. That may also be true in pre-bank run Greece.

[Nathanael]

"The underlying cause of the recession is the reduction in the volume of trade caused by an excess demand for the one good that is demanded or supplied whenever any other good is traded."

This is basically right. I thought it might help to explain it better than Nick explained it.

Almost all "recessions" are "general gluts" where there is an excess demand for money so everything else is glutted.

Exception: 1970s oil-shock recession. In that case, there was an excess demand for OIL, not for money. Because oil was a keystone product in the economy, with no short-term substitutes, you can get the same effect.

You can also get the same effect with an 'excess demand' for food -- aka a crop failure / food shortage. Also a product which (as a whole) has no substitutes.

So there are non-monetary recessions. They're caused by a shortage in a 'keystone' product which is used by nearly everything in the economy, like food or oil -- a product which is non-substitutable in the short term. (Money is also non-substitutable in the short term. It's hard to switch your medium of exchange!)

This tells you what the key feature of a recession is -- shortage of a good which is non-substitutable in the short term.... usually medium-of-exchange money, but it COULD be something else. Something irreplaceable.

Oil wasn't a medium of exchange, but excess, unsatisfiable demand for oil led to a recession.

Nick, feel free to use my terminology.

[Nathanael]

If I define a recession as a decline in productive activity (manufacturing, agriculture, service, etc.) -- and I consider money a factor of production because it is used in arranging the supply chain -- then I can say what I just said before as:

"A shortage of a non-substitutable good which is a factor of production, causes a decline in productive activity".

When I put it this way, it sounds obvious.

[Tom Brown]

@Nick, interesting post. I gather from the comments above that Scott Sumner may not agree with you on this one.

@Avon, perhaps you can demonstrate what you'd like to see Nick do by demonstrating to us a macro model/framework that makes a set of falsifiable predictions (if A then we'll see B. If C then we'll see D. etc), about possible future states of a set of macro economies. These should be predictions that anybody can check to see if your model is false. The more predictions the better since we'll never be able to check if your model is true: we can only check if it's false over and over. I'd love to see how your model compares with the NY Fed DSGE model for example, if you have a model, or if you know of one.

[Avon Barksdale]

"And then there are speculative off-the-cuff blog posts like this one."

Nick, again, this is why science looks down on economics. You won't find medical researchers running a blog that says, "Oh, Crohn's disease is caused by eating too much sugar - see it was easy to understand along." or something else equally speculative and silly. We don't know what causes Crohn's disease and we don't know what causes recessions. It is not helpful to the public for university professors to make outlandish claims - which could never get published in a serious econ journal - and which trivializes how hard it is to know things.

Treating economics like a speculation club undermines serious science.

[Lord]

JP's argument was there would be no interest in adopting it as no one would be forced to accept it and no one would choose it, but paying pensions and wages in it would force acceptance. Force is relative, they could emigrate, find other work in other countries, or curl up and die, but those are hardly serious choices. No one would be forced to accept it in payment but if no one did it would be worthless. Acceptance for taxes would establish a value. It wouldn't fall to zero immediately once all taxes were paid as taxes will be paid every year, but once it begins to fall, pensions and wages paid in them become unstuck and to a lesser extent goods produced with them. Imported goods and to a lesser extent exported goods would rise in terms of it as it depreciates. Eventually MOE becomes MOA as it increasingly becomes the only money circulating. The government wouldn't have any euros to pay any debt but that wouldn't be that much different from now. It would help though the transition would be inconvenient and messy.

[Jim Rootham]

Avon, ask a physicist to explain exactly what is going on in a turbulent system and watch them turn white. There is lots of silly speculation going on in all sciences, it's what make progress possible. Economics has the problem of doing it in public. Also, there are indeed issues of physics and math envy in economics, but blogs like this are not inherently part of that problem.

To the particular point, the models that say depressions are a monetary problem, notably the Keynesian ones, have a good track record on predicting events recently. The others, not so much.

[Avon Barksdale]

"...notably the Keynesian ones, have a good track record on predicting events recently."

OK, that's hilarious!

[Jim Rootham]

Counter examples please.

[Tom Brown]

@Jim Rootham, re: example: check out my comment to Avon above.

[Jim Rootham]

I am of Nate Silver's opinion of complex models of complex phenomenon. Not a good idea, at least if you want to make real predictions. Until you can capture all of the complexity, simple, general, and more approximate models work better.

Upon reflection I decided that it would be better for me to move first on the model/history presentation front.

Krugman's simple IS-LM model of the American economy said that the behaviour of the Fed at the zero lower bound would not generate galloping inflation, and it hasn't. So we have one good example of Keynesianism working out.

[Avon Barksdale]

"IS-LM model of the American economy said that the behaviour... "

No grad school in econ has taught IS-LM since the 70s. Seriously, IS-LM is just utter nonsense - it's like phrenology. You will not get published in any top tier journal writing IS-LM models.

[Avon Barksdale]

Tom,

It's not about me writing down a better DSGE model - it's about being honest. We don't know the cause of recessions. There are all kinds of conditional models, and econ is pretty good at that - if A then B. But predicting that A will occur unconditionally, well that's just super hard. If you have an unconditional model - and it works - start a hedge fund.

[Nick Edmonds]

Avon Barksdale: "Seriously, IS-LM is just utter nonsense.."

Most economic models are to some extent nonsense. The problem with IS-LM is that, without micro-foundations, its incomplete. At least DSGE is complete nonsense. (Apologies to Bernard Woolley)

[Nick Rowe]

dlr: suppose we used cows as money. An increased demand for milk (plus sticky prices) would cause a recession, because people would stop spending their cows because they didn't want to lose the milk. If the government helicoptered in some dry cows (that gave no milk) that would cure the recession. Dry cows would trade at a discount, but people would spend them.

Avon: a New Keynesian DSGE model *is* (can be expressed as) an ISLM model. The consumption-euler equation gives you the IS curve; the central bank's reaction function gives you the LM curve.

[john]

Nick, if the greek debt is denominated in euros then wouldn't the greek state have to pay interest on that debt (and repay the debt eventually) in euros?

Doesn't that imply that the greek state would REALLY prefer taxes beeing payed in euros instead of new drachmas? Or, alternatively, wouldn't the greek state need to swap its tax drachmas into euros?

If that's the case, and everybody knows that, won't everybody be hoarding euros in order to lend at the state on the date it needs to make a repayment?

Wouldn't that effectively at some point a) make the euro scarce and b) make the euro extremely costly in terms of new drachmas?

With all that going on, wouldn't there be a tension between the moa and the moe that would probably lead to a breakdown of the dichotomy?

thanks!

[dlr]

suppose we used cows as money. An increased demand for milk (plus sticky prices) would cause a recession, because people would stop spending their cows because they didn't want to lose the milk. If the government helicoptered in some dry cows (that gave no milk) that would cure the recession. Dry cows would trade at a discount, but people would spend them.

This again assumes the conclusion that there is an excess demand for cows-to-trade in the first place. What happens when enough dry cows fall and there is no marginal demand for dry cows at all but the demand for milk is still rising? Won't there still be downward pressure on the price level amid nominal rigidity?

You are adding an unnecessary wrinkle with this story, because the helicoptered dry cows are also, by definition, marginal wealth And there is always a demand for marginal wealth. This is why the cow/drachma analogy doesn't work: There is no such thing as a completely "dry drachma," since milk in this story = safe savings, and for the drachma to have any MOE use it must have *some* safe savings feature. That's why I asked you to imagine the government successfully announcing that existing shares of stock would heretofore be used as an additional MOE (but not MOA). Otherwise you are conflating the issues. Helicoptered drachma with no marginal MOE demand might work anyway as fiscal stimulus, but that is different than saying you are relieving excess demand for the MOE.

Do you at least agree that you can imagine a world where the cow government successfully converts (jawbones) all existing shares of stock into an additional MOE (but prices are still quoted in cows and cow/stock prices are flexible as usual), people are fully satiated in liquidity, but a spike in milk demand causes a very familiar recession (more sellers than buyers, because, of course, sticky prices are too high relative to the price of cows -- not because of a lack of MOE)? Doesn't this tell you that Drachmas-as-MOE might have limitations as a cure just as more base money very quickly became irrelevant in the US in 2009?

[Avon Barksdale]

Nick,

You know better, New Keynesian models have nothing to do with traditional Keynesian models.

[W. Peden]

It seems like a leap from "ISLM model" to "traditional Keynesian model".

[Nick Rowe]

Avon: you know better than to use the patronising "you know better" style of argument. Are you accusing me of lying? Actually, New Keynesian models do have a lot to do with ISLM. Some economists don't see this, but I do.

[Nick Rowe]

john: "Nick, if the greek debt is denominated in euros then wouldn't the greek state have to pay interest on that debt (and repay the debt eventually) in euros?"

Yes.

"Doesn't that imply that the greek state would REALLY prefer taxes beeing payed in euros instead of new drachmas?"

No. As long as they have the same value, at the current exchange rate, the state won't care.

"If that's the case, and everybody knows that, won't everybody be hoarding euros in order to lend at the state on the date it needs to make a repayment?"

No more than they currently are hoarding Euros to pay taxes.

[W. Peden]

Nick Rowe,

As you put it once, New Keynesianism is a conspiracy to convince central bankers to make the RBC/Walrasian/loanable funds theories seem true.

[Nick Rowe]

dlr: maybe this old post explains my argument better.

[dlr]

Nick, I remember that post, and I don't agree. It has some similarities to your even earlier rent-control argument. It misses the MOE vs MOA issue, in my view. In that post, you seem to assume that Barter only means "no medium of exchange," and so conclude that MOE is the key. But that is not what barter means. Barter means no medium of exchange AND no medium of account. This is required because at the barter limit where every item is fully liquid, it makes no sense to have an MOA. Direct ratio exchanges in barter trumps an MOA. So you eliminate both the MOA and MOE, but somehow conclude that this shows the MOE is what's important. Imagine an impossible world where all items were liquid, yet the law oddly required all transactions to be priced on each side with respect to the market price of a single MOA. Say, Gold. People can trade bananas directly for haircuts, but they cannot just negotiate ratios directly, they must simply look up the gold-price of haircuts and the gold-price of bananas and offer these ratios. In that case, you still get a recession if the gold price is too high, because although bananas and haircuts can be exchanged directly, they cannot be exchanged directly at the right price. People will not trade despite being flush with media of exchange. Obviously that world isn't going to exist at the barter limit (or maybe you don't want to call that "barter"); I am just making a point that your paradox of hoarding post doesn't accurately address the MOE/MOA distinction.

Antiques in that post, like rent control in other posts, are a red herring. Antiques and rents are not the medium of account. In that sense, you are right that the demand for those things or for Government Bonds, which also are neither the MOA nor MOE, is not the proximate cause of a nominal recession. But this is not in any way an effective MOE vs. MOA case. Those things are neither.

I keep meeting you on your own metaphorical terms (bananas, cows, antiques), but you won't answer my question above. Imagine a world in which the Greek government successfully convinces people that some set of existing stock shares, say all shares that trade on the ASE, will immediately become additional media of exchange. People can now pay wages and buy coffee with shares. Every shop will have a Bloomberg terminal showing the updated Euro-value of every ASE stock. In other words, the Euro is still the MOA but now we have way more MOE. Do you agree that it is possible for people to become 100% sated in MOE, yet still have a typical recession if an increase demand for Euros purely as a store of safe savings puts downward pressure on sticky (Euro!) prices, leaving them too high?

[Jim Rootham]

I just realized there is an error in the grounding of the peripheral argument. We need to distinguish between science and engineering. The standard for doing something in (normal) science is: does this remove a possible falsification? The standard for engineering is: Does it work and is it useful? Medicine is not science, it's human biological engineering.

On the Greece question, we need engineering, not science. I don't think DSGE models are good engineering, at least not until they get specific about the time limits they are accurate for.

The analogy is to weather models, modelers know they are are not accurate past about 4-5 days, but that is still useful, and knowing that makes it more useful, not less.

[Avon Barksdale]

"Are you accusing me of lying? "

No, I am accusing you of exaggeration. That also goes for your claim that excess demand for the MOE is the cause of recessions. It's like you don't care how hard it is to be right.

More to the point, I became aware of this blog when you wrote a post about Garth Turner in which you said, "Because I was never that good at variances and covariances and CAPM and stuff." That's just awful - that you were never good at variances and covariances and stuff. Really, a professor of economics who can't be bothered to understand how basic stats works? And you believe you are in a position to tell us what the cause of recessions are? You believe that even with having very shaky math skills you can entangle New Keynesian models and tells us how to reinterpret everything through the old static ISLM language?

I give this blog a hard time because the public believes the things you write and if a professor says so, it must be right. But this is such a disservice. It is so important to work through the details. It's fine to show the public a thumbnail sketch of a complicated model, but it's incumbent on the author to understand the model at the professional level first.

[Tom Brown]

@Jim, regarding DSGE, what would you change about the NY Fed DSGE model forecast in my comment above? It shows the error bars growing with time. Doesn't that amount to a "time limit" like you say?

Also I think there is a distinction between engineering and science (as you point out), but engineers, medical doctors, medical researchers and even car mechanics do regularly use the scientific method and thus engage in science (i.e. hypothesis formation and testing).

Also it's difficult to engage in effective engineering (or medicine) until some basic scientific research has been accomplished. Perhaps economists recommending policy today are like a Medieval physician to the king: they are turned to in a time of acute need, but even if they want to do the best job possible, and they personally are on the right track (epistemologically speaking), they're still left with limited (unsavory) options due to lack of advancement in basic science: leeches, cupping, the theory of the four humors and some knowledge of "medicinal" herbs. Or maybe that's a terrible analogy. Looking in from the outside, it's hard for me to tell.

[Jim Rootham]

@Avon Economic systems have non linear feedback loops, AKA they are chaotic (or complex, I understand the terminology has changed). Such systems do not have linear error behaviour. Conceivably high order polynomial, more likely exponential or worse. The uncertainties in the Fed graphs seem to me to be much too linear and small.

I could see a counter argument that says historically economies are sort of linear except for occasional large discontinuities. AKA tail risk, in that case you want to mark the timeline at a point where you calculate that the cumulative tail risk has reached a significant probability.

Yes science provides tools, but we have to evaluate them in engineering terms, whether or not a particular tool is taught in grad school is completely irrelevant.

An example from the mathematical (as opposed to the natural) sciences. Information theory has generated lots of good tools and theorems, but nobody does research in it any more. It's done.

[nivedita]

@dlr, not following your gold example. Why wouldn't bananas be exchanged for haircuts if they were both too expensive in terms of gold, but can be directly traded for each other?

[Mike Sax]

Nick I wonder what you make of this post by Cullen Roche.

http://www.pragcap.com/hyperinflationary-lessons-for-greece

He claims that leaving the euro was the preferred solution for Greece in 2011 but now doing it has a real risk of hyperinflation. Do you think bringing back the drachma would run this risk?

[dlr]

not following your gold example. Why wouldn't bananas be exchanged for haircuts if they were both too expensive in terms of gold, but can be directly traded for each other?

nivdeita,

Because in the (absurd and thought-experiment-only) world of "barter" with an MOA, people are not really trading haircuts for bananas. The "buy" side of the transaction is acquiring an MOE -- that just happens to be in the form of haircut-vouchers or bananas or whatever the buyer chooses, because almost everything is an MOE in this world. Let's say the buyer wants a haircut and happens to use bananas as their MOE and the seller just wants to sell a haircut. They aren't negotiating the quantities in this story, all they know is that they are acquiring or spending $10 worth of something. But the whole point of the rising value of the MOA is that the buyer no longer wants to pay $10 for that haircut, they want to pay less. They are "forced" to use the $10 MOA price as their accounting coordination system by assumption -- they have no idea how many bananas/shares of Intel/golf balls they should want to trade for a haircut, so they still think they want to keep the "$10" and don't buy the haircut* If you say this is not really barter, I agree. The point is not that this is a reasonable world or a good definition of barter. The point is just to illustrate that when Nick thinks he is isolating the MOE by assuming barter, he is actually eliminating both the MOE and MOA. So showing that a recession wouldn't happen under barter doesn't show that hoarding the MOE is any more proximate a cause of recessions than saving in the MOA (which of course are the same thing in most economies today).

*A side point is that to the extent nominal rigidity exists, there is surely a continuum of stickiness among stuff that would make the Calvo fairy blush. So even if you wanted to try to assume that haircut buyers would somehow make allowances for knowing that they might be paying less than $10 by paying in bananas, there would be still be large frictions as they would have no way of knowing how sticky/flexible every asset in their portfolio was relative to the stickiness of haircuts, and the sticky reference prices would still result in non-trading. The is the accounting/computing information that is crucial to the unit of account function of what we currently call "money." The minute people can decide to trade the "right" number of bananas for the "right" number of haircuts irrespective of the reference price of $, they have eliminated both the MOE and MOA.

[Nick Rowe]

dlr: "Imagine a world in which the Greek government successfully convinces people that some set of existing stock shares, say all shares that trade on the ASE, will immediately become additional media of exchange. People can now pay wages and buy coffee with shares. Every shop will have a Bloomberg terminal showing the updated Euro-value of every ASE stock. In other words, the Euro is still the MOA but now we have way more MOE."

If you take an asset (shares in your example) that is currently just willingly held (neither in excess demand nor excess supply) and magically (but that's OK, because this is a thought-experiment) convert it into an MOE, you increase the supply of MOE but you also increase the demand for MOE by exactly the same amount. So you do not reduce the excess demand for the MOE.

But that's not what the Greek government is doing in my example. It's not turning an existing good into an MOE. That would only work if that good were already in excess supply (like converting Greek labour into an MOE). It is increasing the supply (from zero) of a good that is (by assumption) an MOE.

"Imagine an impossible world where all items were liquid, yet the law oddly required all transactions to be priced on each side with respect to the market price of a single MOA. Say, Gold. People can trade bananas directly for haircuts, but they cannot just negotiate ratios directly, they must simply look up the gold-price of haircuts and the gold-price of bananas and offer these ratios."

That was exactly the world I was imagining.

"In that case, you still get a recession if the gold price is too high, because although bananas and haircuts can be exchanged directly, they cannot be exchanged directly at the right price."

Start with all prices at market-clearing equilibrium. Now double all prices in terms of gold (the MOA). If gold is the MOE, we get a fall in trade of bananas and haircuts, with an excess supply of both goods. It's a recession. But if we allow barter, then direct trade in bananas and haircuts can continue exactly as before, at the same relative price as before, so there is no recession, only an excess demand for gold.

My tiny macro model for microeconomists makes this clear, I thought.

[Nick Rowe]

Jim: in this case it's much worse than that. Take a simple linear version of (say) the NK DSGE model. Any competent math/physics grad can solve the equations. And if they are foolishly arrogant (and some are, but not all are) they think that means they understand the model. But they don't have a clue what's going on. If you ask them whether this is a model of a monetary exchange or barter economy, they won't know where to begin. Or they think that it's totally different from the ISLM model, because the equations look different (in fact it's just a limiting case of ISLM, with a perfectly elastic money supply function, and a coefficient of one on expected future income). Or you show them the Fisher equation, which shows a positive equilibrium relationship between inflation and nominal interest rates. And they think it means that if the central bank raises nominal interest rates it causes inflation to increase.

[Declan 2]

Nick,

Don't both your arguments 1 and 2 depend on the assumption that there is a fixed stock of Euros? Which is certainly not true within Greece, and not even in the Eurozone as a whole.

Like if a small country on the gold standard started issuing paper money - there is a bit of seignorage revenue but other than that it I think it does basically nothing? Or in your tiny model, if the bananas can be produced at constant cost instead of there being a fixed endowment, I don't think adding dates would do anything either.

[Jim Rootham]

All math depends on the premises. All models depend on some connection to the real world. I was assuming the modellers had that sorted out.

I thought the point of DSGE models was to be microfounded, any linear model is certainly not that.

It seems obvious to me that the central bank raising rates would increase inflation as a first order effect, it just gets swamped by higher order effects. If you show people linear equations and say this is how the economy works that's impossible to see.

And (off topic, so ignore, or pick up elsewhere) how do economists deal with corrupt institutions like the current stock markets(see Michael Lewis, "Flash Boys", or Arnuk and Saluzzi "Broken Markets"?

[Oliver]

john: "Nick, if the greek debt is denominated in euros then wouldn't the greek state have to pay interest on that debt (and repay the debt eventually) in euros?"

Nick: Yes.

John: "Doesn't that imply that the greek state would REALLY prefer taxes beeing payed in euros instead of new drachmas?"

Nick: No. As long as they have the same value, at the current exchange rate, the state won't care.

I don't think that's right. The Greek state has to repay its debts in Euros, not in Drachmas worth as much as the Euro debt. Euroland would not accept them. So, even if they managed to command an increasing real amount of Drachmas in tax payments, even if they managed to produce a veritably domestic boom, they would still have to borrow the Euros with which to pay back their Euro debts. Which of course is self-defeating.

The only way that a new MOE can work is if it leads to a substantial increase in exports that are paid for in Euros. They have to earn the Euros in Euroland / from Eurolanders, not at home. I don't see that happening one way or another because there just isn't enough stuff that Greece can export for them to dig themselves out of the hole they're in. There's only so many olives Euroland will eat and only so many Greek holidays they are willing to buy, especially since the rest of southern Europe is in recession too.

Or maybe I misunderstood your comment.

If you take an asset (shares in your example) that is currently just willingly held (neither in excess demand nor excess supply) and magically (but that's OK, because this is a thought-experiment) convert it into an MOE, you increase the supply of MOE but you also increase the demand for MOE by exactly the same amount. So you do not reduce the excess demand for the MOE.
Yet this seems to be at the core of conventional monetary policy. Confused, I is.

[jonathan]

The thought experiment I considered is that the Greek government announces a Drachma-Euro exchange rate, and then converts bank accounts to Drachma at this exchange rate.

The problem would be a self-fulfilling "run" on the new currency. Then we would expect runaway inflation (because the Euro is the unit of account), and the erosion of the value of savings. So part of the problem would be a sort of reverse Pigou effect, in which inflation erodes the value of savings (i.e. the store of value definition of money).

The obvious solution would be an exchange rate peg, but at a level that implies a substantial real devaluation. But for this to be credible, the Greek CB would need access to a lot of Euros, together with a discount lending rate to banks.

This is a very (politically) risky strategy for whoever is supplying the Euros to Greece, but if you pull it off credibly, and got the original exchange rate / interest rate right, then Greece wouldn't actually need to use the Euros.

[JP Koning]

Nick says to dlr: "...but you also increase the demand for MOE by exactly the same amount."

I don't follow. Why does the demand increase?

[Nick Rowe]

JP: consider an economy where each individual produces one variety of fruit, and wants to consume all varieties of fruit. And there is a stock of gold that is used as a MOA and MOE. And a stock of silver that is used as jewelry. And suppose that the price of fruit is stuck too high (relative to the stock of gold), so there is an excess supply of fruit, too little trade in fruit, and a recession. But the price of silver is perfectly flexible, so the silver market clears.

Now suppose that someone invents a way to test the purity of silver easily, so that silver can be used as a MOE too. So the stock (supply) of MOE increases from gold to gold+silver. But if the existing stock of silver were already willingly held (because of the jewelry demand) at the existing price of silver, we have to add that jewelry demand to the demand for gold+silver, so the quantity of MOE=gold+silver demanded will exceed the original demand for MOE=gold, by the same amount that the supply has increased. Nobody has any extra incentive to get rid of gold+silver.

On the other hand, people would now want to switch out of gold into silver, and so the price of silver will rise, so you might argue that the real stock of MOE = (Qg/Pf + Qs.Ps/Pf) (where Pf is the gold price of fruit, and Ps is the gold price of silver) will increase, which creates an excess supply of MOE, which increases the volume of trade in fruit.

I think that's right (though it's not very clear).

[dlr]

If you take an asset (shares in your example) that is currently just willingly held (neither in excess demand nor excess supply) and magically (but that's OK, because this is a thought-experiment) convert it into an MOE, you increase the supply of MOE but you also increase the demand for MOE by exactly the same amount. So you do not reduce the excess demand for the MOE.

The demand for the MOE means the demand to hold someone for use in exchange. Are you really arguing that if stocks suddenly became an additional MOE, that wouldn't affect the supply/demand (i.e. relieve excess demand for) existing MOE, i.e. the demand to hold a certain amount of cash/deposits purely to use in exchange? That's like arguing that cameras in phones won't affect the supply/demand of existing cameras because the demand for cameras will automatically increase to offset the new supply.

Start with all prices at market-clearing equilibrium. Now double all prices in terms of gold (the MOA). If gold is the MOE, we get a fall in trade of bananas and haircuts, with an excess supply of both goods. It's a recession. But if we allow barter, then direct trade in bananas and haircuts can continue exactly as before, at the same relative price as before, so there is no recession, only an excess demand for gold.

My tiny macro model for microeconomists makes this clear, I thought.

I don't think this is right. Please see my reply to nivedita, above. If you are forcing people to conduct trade that at the same relative price as before, you are assuming a strange, stale MOA. But this (1) wouldn't work, because relative prices move and if they are sticky are surely not sticky to the same degree and (2) doesn't reflect what an MOA really means. If I am a buyer of haircuts and I know the MOA has gained value, I suddenly don't want to pay $10 for a haircut. That's all I know. I don't know how many bananas to trade for a haircut and even if I do know the barber has no clue. Pure barter would allow this but again that eliminates the MOA as well. The idea that I would simply assume that even though $10 I paid for the haircut is the "wrong price" any of my MOEs would probably be the "right price" really misses the point of what it means to have unit of account in the first place. Should I know not to pay with stock, oil, wheat or milk because those prices will me more flexible relative to haircuts and so I will making a mistake?

[dlr]

Now suppose that someone invents a way to test the purity of silver easily, so that silver can be used as a MOE too. So the stock (supply) of MOE increases from gold to gold+silver. But if the existing stock of silver were already willingly held (because of the jewelry demand) at the existing price of silver, we have to add that jewelry demand to the demand for gold+silver, so the quantity of MOE=gold+silver demanded will exceed the original demand for MOE=gold, by the same amount that the supply has increased. Nobody has any extra incentive to get rid of gold+silver.

On the other hand, people would now want to switch out of gold into silver, and so the price of silver will rise, so you might argue that the real stock of MOE = (Qg/Pf + Qs.Ps/Pf) (where Pf is the gold price of fruit, and Ps is the gold price of silver) will increase, which creates an excess supply of MOE, which increases the volume of trade in fruit.

I don't want to be (more) repetitive to what I just said above, but I don't think the first paragraph is right at all. It's not demand for the MOE that has increased. and it's also not demand for Gold+Silver that has increased. As you said in the second paragraph, demand for silver will increase and demand for gold will decrease due solely to the increased supply of the MOE. Supply of the MOE has increased, supply of gold+silver solely as jewelry is flat, and demand for the MOE and for jewelry are presumably unchanged.

[JP Koning]

"Now suppose that someone invents a way to test the purity of silver easily, so that silver can be used as a MOE too. So the stock (supply) of MOE increases from gold to gold+silver. But if the existing stock of silver were already willingly held (because of the jewelry demand) at the existing price of silver, we have to add that jewelry demand to the demand for gold+silver, so the quantity of MOE=gold+silver demanded will exceed the original demand for MOE=gold, by the same amount that the supply has increased. Nobody has any extra incentive to get rid of gold+silver."

This doesn't seem right to me. When silver suddenly becomes liquid, it should now be regarded as a joint product, providing both a flow of jewelry related consumption and a flow of liquidity. (This is like dlr's camera in phones point, where a phone becomes a joint product of photo-taking services and communication services)

This means that the stock of MOE-ness (or liquidity) has not increased from "gold to gold + silver." Rather, the stock has increased from a sum of gold's liquidity services to a sum of gold's liquidity services and silver's liquidity services.

Your conclusion that "you also increase the demand for MOE by exactly the same amount" only comes about because you've added silver's quantity-of-jewelry-services-demanded to the total quantity of liquidity services demanded. But we shouldn't be mixing apples and oranges. The total supply of liquidity services has increased while its demand stays the same.

[Scott Sumner]

Nick, I hope I'm not too late here, and I haven't read the entire comment thread. My initial take is that adding the drachma would reduce the demand for the euro MOA, because the euro is also a MOE.

I agree recessions aren't about the wrong real wage, but they are about the wrong W/NGDP. So the drachma must lower that ratio by raising NGDP (assuming W is sticky in the short run.) And you can't raise NGDP without lowering the demand for the MOA (assuming its supply is fixed.)

[Nick Rowe]

Scott: Never too late! We basically agree.