Friday, November 25, 2011

The Price of Money

I have stayed out of macro-economics in my work as an economist for a number of reasons, but it is a hot political subject at the moment and several times of late I have gotten involved in online macro arguments, so I decided it would be worth learning a little more about it. Someone sent me a copy of a recent book of essays by Tim Congdon, who has the interesting distinction of being both a monetarist and a fan of Keynes, and I have started reading it. 

The central claim of the first essay is that the views of the British Keynesians of the sixties and seventies were strikingly inconsistent with Keynes' own views. They saw inflation as a cost push phenomenon to which the proper solution was wage and price controls. Keynes, like later monetarists, saw it as a result of too much money and the solution as tight monetary policy. He was against wage and price controls, not for them.

One other thing struck me about the first essay: Congdon repeatedly refers to the interest rate as "the price of money." This is a very common error, and one that is not only wrong but dangerously wrong.

If the price of an apple is fifty cents, that means that if I give a seller fifty cents he will give me an apple in exchange. If the interest rate is five percent and that is the price of money, I ought to be able to buy money for five cents on the dollar. I doubt that Congdon, or anyone else, will be willing to sell it to me at that price. 

The price of money is what you have to give up to get it—the inverse of the price level. If the price of an apple is fifty cents, the price of a dollar is two apples. The interest rate is the rent on money, measured in money. A change in the price of money affects both the money you are renting and the money you are paying as rent, leaving the ratio of the two unchanged.

Suppose that at midnight tonight every dollar bill in the world twins, along with a similar change in the accounting entries for bank deposits, other forms of money, and all obligations denominated in money. By morning, there is twice as much money as before—and nothing else has changed.

I would ask Congdon whether, under those circumstances, he would expect the interest rate to drop. If his answer is yes, my next question is whether he would expect a much more extreme drop if we relabeled pennies as dollars and dollars as hundred dollar bills, thus increasing the money supply, measured in "dollars," a hundredfold.

The reason the description of the interest rate as the price of money is not only wrong but dangerously wrong is that it implies a simple relation between money and the interest rate—in the extreme (but not uncommon) version, the belief that interest rates are set by central banks, with high interest rates the result of a tight monetary policy.

A central bank can create money and lend it out, increasing the supply of loans (which reduces the interest rate) and increasing the money supply. That is the one element of truth to the relationship. But what is affecting the interest rate is not the amount of money but the amount of loans; the government could get the same effect by collecting more in taxes than it spends and lending out the difference.

The interest rate is a market price—the price paid for the use of capital—and the central bank controls it only in the same sense in which the government can control the price of wheat by choosing to buy or sell some of it. The central bank does not have an unlimited amount of capital from money creation to lend and so has only a limited ability to shift interest rates from what they would otherwise be. Furthermore, a continued expansion of the money supply creates the expectation of future price rises, which pushes the nominal interest rate up, not down. 

I have been unable to locate an email address for Tim Congdon, so am unable to point out his error to him directly. If any of my readers has one, I would be grateful if you would send it to me.

[Two people have now provided me with his email, I emailed him and received a friendly response.]

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47 Comments:

At 1:22 PM, November 25, 2011, Anonymous Nightrunner said...

> If the interest rate is five percent and that is the price of money, I ought to be able to buy money for five cents on the dollar.

Strawman

 
At 2:44 PM, November 25, 2011, Anonymous HH said...

I wouldn't call it a strawman as much as a failure of language. Whenever I hear "the price of money" I tend to think "the price you have to pay to rent money for a year" but I did study economics so it's probably now been indoctrinated in me. But it basically reminds me of many english linguistic shortcuts.

"Have a nice day" or "have a good flight" are in, literally read, nonsensical statements. You can't command someone to have a nice day or good flight. If they had the choice, they'd of course have a nice day or a good flight. In football, announcers often praise receivers for "catching the ball at its highest point," obviously meaning the highest point in the receiver's own jump (the ball's highest point is usually out of everyone's reach). They also refer to "all purpose yards" when they really mean "all source yards" - all yards in football have the same purpose.

I understand that language can be misleading. But I'd be surprised if this turn of phrase misleads as many people you'd think if you assumed everyone takes it literally.

 
At 2:47 PM, November 25, 2011, Blogger John David Galt said...

I always assumed the reason you stayed away from macroeconomics was that you considered it bogus.

Certainly macroeconomics, as I learned it in college, seems to be a lot of mumbo jumbo which purports to prove propositions such as "Government stimulus spending works" by making assumptions such as "Consumption is consumption, whether it's an individual buying what he wants or bureaucrats following poorly-thought-out plans" (a notion implicit in the concept of GDP).

If there is such a thing as a libertarian macroeconomics (which I envision as something that would have to be deduced "from the bottom up" from such sources as Mises' Human Action), I don't think anyone has published it yet. You could be the first!

 
At 4:02 PM, November 25, 2011, Anonymous Anonymous said...

The demand for bank reserves is perfectly inelastic, and the central bank is the monopoly supplier. It isn't necessary for the CB to really "do" much of anything; it just announces the rate.

The interbank rate doesn't automatically affect long term bonds, since the CB can change it at any time. The market has to guess what the CB will do in the future in order to set the price of long term bonds. Hence, the bond market will react to whatever economic variables the Fed uses in its decision making process.

Hope this helps. :-)

 
At 5:03 PM, November 25, 2011, Blogger Kim Mosley said...

Here are the email address(es) you requested:

Tim Congdon
Institute of Economic Affairs (IEA) timcongdon@btinternet.com

 
At 5:30 PM, November 25, 2011, Blogger Ryan said...

Can you convince Parkin to remove the real interest rate from the y-axis in the market for money? See ch. 25 in the current version of the textbook.

 
At 6:07 PM, November 25, 2011, Blogger David Friedman said...

I'm afraid I don't know Parkin's textbook--it's been thirty years or so since I last taught macro. The nominal interest rate is the price of holding money, so belongs on the y axis for money demand. I don't know why someone would put the real interest rate there.

In response to another question, I avoided macro for two reasons. One is that I don't have a good intuition for it. The other is that it was my father's field, and I have enough problems as it is getting classified as his son.

 
At 6:22 PM, November 25, 2011, Blogger JDTapp said...

Might I hypothesize that the answer depends on whether the doubling of money is ex ante or ex post? If you announce that money will double, its value will be less and interest rates, which are forward-looking, will rise. Such an announcement of a devaluation of currency would stimulate demand as people would want to spend it before it became worth less. But prices, including interest rates, would rise.

If the doubling has already taken place (ex post) then what happens with interest rates depends on the market's expectation of whether it will happen again.

Milton Friedman forever convinced many good economists (like Scott Sumner) that high interest rates mean money has been too loose, not too tight. Congdon seems to have fallen for the Keynesian liquidity trap fallacies.

 
At 12:43 AM, November 26, 2011, Blogger skylien said...

I agree with HH that it mostly is a sloppy way of expression. You should not do this if you are arguing economics of course.

You could also ask Congdon if the price to borrow a DVD is the same as the price to buy it.

I have a related question, because this topic seems to me to be a big blind spot issue. Is it sound to make a simple supply and demand analyzes of the interest rate, which is as you seem to agree with me the price to borrow capital?

The supply to borrow capital is given, no matter how much the central bank expands the money supply. So if the central bank expands the money supply to push down the interest rates, everything else equal, then the market will start to use/borrow more capital (investing) since it is cheaper now, and it will produce less capital for loaning purposes because it doesn't pay you well enough. So over time, as in any other market where you decrease the price artificially (how you push the price below the market rate doesn't change this cause and effect relationship) you will get a shortage. In this case a shortage of capital that expresses itself in a recession.

Is this simple supply and demand analyzes sound, or not? If yes why is the supply and demand think clear in any market to all economists but not in the loaning market for capital?

 
At 12:46 AM, November 26, 2011, Blogger skylien said...

The last "think" should read "thing" of course..

 
At 3:22 AM, November 26, 2011, Blogger Single acts of tyranny said...

I think when Congdon and others talk about the price of money thay are talking about the rental cost, ie say 5% per annum.

 
At 9:40 AM, November 26, 2011, Blogger David Friedman said...

"The supply to borrow capital is given, no matter how much the central bank expands the money supply. "

Not if it and the fractional reserve banks that use its money for reserves use the revenue from money creation as a source of capital to lend out. That, in my view, is why monetary expansion has some relation to a lowering of the interest rate

...

So over time, as in any other market where you decrease the price artificially (how you push the price below the market rate doesn't change this cause and effect relationship) you will get a shortage. In this case a shortage of capital that expresses itself in a recession."

I don't think that is correct. The central bank isn't pushing the interest rate down via price control, it's pushing it down (possibly) by increasing the supply of capital.

 
At 9:48 AM, November 26, 2011, Anonymous Allan Walstad said...

If every dollar twinned: if I owed someone $1000 would I now owe $2000? Presumably not. I owe $1000. So at the same 5% rate, my payments would be lower in real terms. Incumbent creditors would be harmed and incumbent debtors benefited. How does that affect their future behavior, and how might that changed behavior influence the interest rate? To the extent that creditors and debtors differ systematically in time preference, at first glance I suspect interest rates would rise as individuals with low time preference are in a poorer position to continue to save, while individuals with high time preference would continue to spend and borrow.

 
At 9:51 AM, November 26, 2011, Anonymous Allan Walstad said...

Sorry, I went back and noticed the proviso that obligations would be doubled numerically too.

 
At 11:32 AM, November 26, 2011, Anonymous filc said...

I stopped 3 paragraphs in. Interest is not just a money phenomena. You can have interest in apples, oranges, or any good. It is a time phenomena.

As normal with most Chicagoan based economists they seem to be oblivious to the time factor(missing a solid capital theory). Von Böhm-Bawerk demonstrated to us over a century ago that immediate goods are valued higher than more distant goods. An apple today is worth more to us than two apples 6 months from now.

100 dollars today is worth more to many of us us than 110 dollars a year from now. Your missing the time factor. Time.

Now this time preference is clearly different from person to person (Subjective theory of value). It is clear that people in situations of abundance(Marginal Utility) have a lower time preference and are in a position to lend their goods out in hopes of gaining interest overtime.

OTH people with higher time preferences, those who need money now, are more willing to take out that loan. Money is worth more to them in the immediate now than it is to the rich lender.

http://en.wikipedia.org/wiki/Eugen_von_B%C3%B6hm-Bawerk

 
At 2:57 PM, November 26, 2011, Blogger Fearsome Pirate said...

This poor understanding of money and interest, and the deduction that the interest rate can be pushed down by increasing the supply of money, goes back to Keynes himself. There's this really bizarre section later on in the General Theory where the guy gets himself so turned around that he convinces himself the central bank can render capital nonscarce.

 
At 3:00 PM, November 26, 2011, Blogger skylien said...

Hm.. This is not se easy.

"I don't think that is correct. The central bank isn't pushing the interest rate down via price control, it's pushing it down (possibly) by increasing the supply of capital."

I don’t see how expanding the money supply adds to the available capital. Though money is a part of capital its only use is in the form of exchange and any amount can render that full service/utility. I am sure you would agree that no matter if we have 1000$ or 2000$ in the money supply the world is not richer in wealth/utility in the later case.
In contrast to that it does make a huge difference if we have capital in the form 1000t of iron available or 2000t. Here the utility derived in the later case clearly is higher.

It seems you agree that if the interest rate was determined by price controls in the form of laws, then the effect I described would happen. Do you also agree that the shortage of capital would express itself in the form of a recession?

There clearly is no market in the feds fund rate at work. No matter if it was set by congress or the Federal Reserve board, they just decide on a number and push that through. Of course they use different means and I am not saying the effects are completely the same. But I would argue that a shortage of capital would manifest itself in both cases.

As explained in the beginning, more money does not add to the available capital that might be invested to increase productivity. It is only used for allocating all the other lets call it real capital (resources, machines, land…). A different amount of money doesn’t enhance that.

The effect that more money can push down the interest rate at all is not depending on the supply of money but on the change in supply, since the market process needs time to adjust the prices. So through injecting new money through the loan market the interest rate can be pushed down. The evidence for this is that if the increase is stopped, and the supply is then kept stable, everything else equal, the interest rate will go up.

 
At 3:50 PM, November 26, 2011, Anonymous Patrick R. Sullivan said...

The first time I encountered the fallacy, 'interest is the price of money', was by Walter Heller, debating David's father at NYU in the early 1960s. Needless to say, he was quickly apprised of his error.

Interest is the price of renting money, not of buying it. What one gives in exchange for the ownership of some other person's money is 'the price of money'. Often it is one's labor.

This is an important distinction because the two prices can, and often do, move in opposite directions; hence Milton Friedman's famous hostility to conducting monetary policy through a focus on interest rates. Which is a mistake our current Fed seems to be making right now.

Btw, David does a fine job explaining this in his 'Price Theory' text.

 
At 5:15 PM, November 26, 2011, Anonymous Anonymous said...

I think David is unwittingly setting up a strawman here. The nominal interest rate can be identifed with the opportunity cost of holding money as opposed to an interest-paying asset.

When the monetary authority expands the money supply, folks are essentially forced to hold more money balances, so they have less use for the money they hold, hence the interest rate falls as they lend it away. But they will do more than that, since lending ultimately depends on real decisions about investment and present vs. future consumption. So folks will also try to exchange the money away for real goods or assets, but since the money stock is controlled by the monetary authority all this does is increase velocity of circulation, until the general price level rises and everyone is happy with their money balances again.

The reverse process occurs when the monetary authority tightens money, with folks holding onto their money balances and trying to acquire more by selling real goods at lower prices, until the price level falls, real balances rise and everything settles.

Aside from these dynamics, interest rates are usually set in real terms, with "natural" nominal interest rates depending on expected inflation via the Fisher effect.

Postscript: When folks' willingness to hold money balances changes for some reason, the same processes happen in reverse, with velocity of money changing until the price level settles at a different value. This is essentially what causes Keynesian effects, and why a monetary stabilization policy (with a nominal anchor) is a good thing: the monetary authority can offset these exogenous shifts in velocity.

 
At 5:19 PM, November 26, 2011, Blogger David Friedman said...

Skylien writes:

"I don’t see how expanding the money supply adds to the available capital."

Suppose the government taxed something, say income, and instead of spending the money lent it out. Do you agree that that would add to the available capital?

If so, then consider money creation as a form of taxation--a tax on money balances. The central bank gets resources by that tax, lends them out, and so increases the supply of capital.

 
At 7:40 PM, November 26, 2011, Blogger Fearsome Tycoon said...

David, would it add to the available real capital--factors of production--or would it result in capital being shifted around to different enterprises? For example, consider the case of Solyndra. Government loans resulted in lots of real capital--engineers, factory workers, real estate, steel, other minerals, etc--being allocated to a solar energy firm. But would they have existed without the government loan? I suspect so and would in fact be used by other ventures in the absence of a government loan.

 
At 7:53 PM, November 26, 2011, Blogger David Friedman said...

It adds to the real capital--think of it as forced savings.

The government taxes people--whether income tax or via inflation doesn't matter for these purposes--and lends the money to someone who uses it to hire people to build a factory. Resources are being used to build that factory, a capital asset, that would otherwise have been used to buy consumption goods to be consumed.

 
At 2:47 AM, November 27, 2011, Anonymous Anonymous said...

The government taxes people--whether income tax or via inflation doesn't matter for these purposes--and lends the money to someone who uses it to hire people to build a factory.

This is actually very wrong. Money creation is a market exchange of equally-priced assets: a government bond (which is removed from the market as the central bank now holds it) and a central bank liability. There is no transfer in value at all.

You may argue that money creation increases seigniorage revenues, but seigniorage is not lent away either; the central bank transfers it to the government, which uses it to offset government debt. But the quantities involved are tiny.

 
At 8:32 AM, November 27, 2011, Blogger Jan Foltyn said...

"The government taxes people--whether income tax or via inflation doesn't matter for these purposes--and lends the money to someone who uses it to hire people to build a factory. Resources are being used to build that factory, a capital asset, that would otherwise have been used to buy consumption goods to be consumed."

David, You are commiting here the same "homegoneus capital" fallacy as most mainstream macroecenomists.
You don't take into account the fact, that such action will not make suddenly more steel/bricks etc. to appear, only shift their use from diffefent businesses. So even if there are more people available for the construction industry, they still lack the necessary tools and materials, which need time and resources to be created.
Plus the form of tax in this case makes a huge difference - if taxed directly, consumers can adjust their consumption spending level according to the new tax rules, and eventually the economy will shift to adapt to the changed saving preference. (That is ofc assuming optimistically, that the taxing will not result in an overall reduction in personal savings that offsets it)
In contrast, if the government taxes via inflation, consumers don't know how much they need to adjust, and many are not aware they need to adjust at all, due to the lack of knowledge about the impact of money printing on their personal finances. And thus You get a situation described in the austrian business cycle theory.

 
At 9:47 AM, November 27, 2011, Anonymous Allan Walstad said...

[Jan Foltyn] "In contrast, if the government taxes via inflation, consumers don't know how much they need to adjust, and many are not aware they need to adjust at all, due to the lack of knowledge about the impact of money printing on their personal finances. And thus You get a situation described in the austrian business cycle theory."

I think this is a very important point. An income tax increase takes away money that would have been spent on some things and, when the government lends it out, allows it to be spent on other things. This can result in a fairly clean-cut (if misguided) net transfer of resources from consumption to capital goods formation. An increase in the money supply doesn't have the first of those effects, not immediately. Consumption continues unabated while resources are also directed into capital formation. The resources have to come from somewhere. I think Strigl, in Capital and Production, had a very effective way of looking at what happens: depletion of the "subsistence fund," the saved supply of consumption goods available for sustaining capital formation. This is an unsustainable distortion of the structure of production, which must lead to a downturn.

 
At 11:15 AM, November 27, 2011, Blogger skylien said...

"Suppose the government taxed something, say income, and instead of spending the money lent it out. Do you agree that that would add to the available capital?"

With available capital, I didn’t mean only the capital dedicated to investment, but all capital. At this point still undecided how much of it should be consumed or invested. That was my fault, should have made that clear.
So yes I agree the government can increase the part that is dedicated to investment this way, but not the whole pool of capital available for investment and consumption.

"If so, then consider money creation as a form of taxation--a tax on money balances. The central bank gets resources by that tax, lends them out, and so increases the supply of capital."

I also agree, money creation is a form of taxation, yet I think there is a big difference between taxing directly and indirectly by money creation. However I realize that this finally would become a discussion of Cantillon effects, which is and was not my intention to bother you with, since I think you had that discussion often enough already (If you have a paper or something about them and their effects, would be great if you could point me to them). Anyway you finally showed me that I have lots of further thinking and studying to do here.

And my initial question is answered: No, it is not that simple.

Thanks! You really have lots of great thought provoking posts! Regards.

 
At 12:24 PM, November 27, 2011, Blogger Fearsome Pirate said...

David--

I don't think it's so obvious when you take several things into account. First of all, when the central bank pushes interest rates down (and yes, it does affect interest rates across the market), it decreases the tendency of individuals to prefer saving. If I can only get 0.1% interest on a savings account, I might as well spend. So you don't know whether the net preference for consumption over saving has increased or decreased as the result of central bank policy.

Second, a lot of money-creation goes directly into government bonds. As very little government spending is investment in even the most generous sense of the word, this is no different than a consumer loan. And most government investments go bust rather than turning into profitable enterprises, since politicians are terrible investors.

 
At 12:38 PM, November 27, 2011, Anonymous Anonymous said...

An income tax increase takes away money that would have been spent on some things and, when the government lends it out, allows it to be spent on other things. This can result in a fairly clean-cut (if misguided) net transfer of resources from consumption to capital goods formation.

Yes. Stated another way, a budget-neutral increase in taxes and government spending does not affect the demand side of the economy.

An increase in the money supply doesn't have the first of those effects, not immediately. Consumption continues unabated while resources are also directed into capital formation. The resources have to come from somewhere.

These two assumptions are mostly incompatible. Consider the equation of exchanges MV=PY. If MV increases, then P and Y will increase in some combination, depending on the amount of idle resources. If the economy is at sustainable resource utilization, the increase will mostly be in P, so the sum of consumption + investment will not in fact increase. Of course, to the extent that Y does increase (e.g. due to sticky prices being pushed closer to marginal cost) that increase will be unsustainable.

 
At 12:53 PM, November 27, 2011, Anonymous Anonymous said...

First of all, when the central bank pushes interest rates down (and yes, it does affect interest rates across the market), it decreases the tendency of individuals to prefer saving.

(1) It's not clear that central banks can affect long-term interest rates, as opposed to responding to exogenous changes in natural rates

(2) Empirically, long-term interest rates tend to increase with easier money, due to a combination of Fisher effects and increase in expected AD. These swamp the effect of lower convenience yield on money balances. This is IMHO a key reason why talking about monetary policy in interest rate terms is needlessly confusing.

 
At 3:25 PM, November 27, 2011, Blogger Don Geddis said...

David Friedman: if you're really just starting to "learn a little more" about macro, then you really owe it to yourself to at least become familiar with Scott Sumner (at themoneyillusion.com), and his notions that changes in nominal GDP are the best explanation for the Great Depression, and the recent Great Recession.

Sumner also suggests that "inflation" is not a particularly well-formed concept.

Unfortunately, Sumner is somewhat wordy, and not a particularly good writer. But leaving that skill aside, he almost certainly is the most brilliant macroeconomist blogger out there. He's been pushing his NGDP explanation for the last three years. People originally dismissed him as a crank from a backwater university; but as time goes on, more and more economists are realizing that Sumner really has figured out the right answer. He may not explain 100% of macroeconomics, but his theory explains by far the biggest chunk of it.

 
At 5:33 PM, November 27, 2011, Anonymous Eric Shierman said...

Perhaps the phrase "the price of money" is a short way of saying the price of RENTING money. The market price of money is the goods and services that it can be exchanged for. The market price of renting money is the interest rate.

 
At 5:39 PM, November 27, 2011, Anonymous Allan Walstad said...

[Anonymous] "If the economy is at sustainable resource utilization..."

The whole point is that the monetary injection throws the economy out of sustainability. Please read the rest of my post. In order to maintain a sustainable structure of production, there must be a store (or supply) of consumer goods to support people who are working to produce capital goods (whether new or replacement) that will not themselves generate consumer goods until later. This is most easily seen in a Crusoe economy, but the physical reality is the same. If you toss more greenbacks out there, they will be spent and more will be consumed but it takes time for prices to adjust. The result is depletion of the capital structure, whether capital goods conventionally defined or the store (or supply) of consumer goods that is needed to maintain capital. This is why I don't trust the simplistic mathematical models of the neoclassical mainstream, like MV = PY. I'm not sure even the Austrians appreciate the subsistence fund concept. Richard Strigl, Capital and Production.

 
At 7:01 PM, November 27, 2011, Anonymous Anonymous said...

Allan, I think I understand your theory, but I find it quite problematic. Yes, prices are sticky in the short run, so e.g. a perfectly competitive firm may run down their inventory of goods if demand increases following a monetary expansion. However, such a firm would anticipate shortages and higher future prices, so they would either raise prices or ration trades. (Keep in mind that firms are quite well-informed about current and future AD, since AD expectations directly influence general business confidence.)

By contrast, a monopolistically competitive firm is always pricing above marginal cost, so they are quite readily inclined to supply the market even when short-run stickiness forces prices down closer to marginal cost. Anecdotally, monopolistic competition is quite ubiquitous so this effect is quite relevant.

 
At 7:28 PM, November 27, 2011, Blogger Jan Foltyn said...

"Allan, I think I understand your theory, but I find it quite problematic. Yes, prices are sticky in the short run, so e.g. a perfectly competitive firm may run down their inventory of goods if demand increases following a monetary expansion. However, such a firm would anticipate shortages and higher future prices, so they would either raise prices or ration trades. (Keep in mind that firms are quite well-informed about current and future AD, since AD expectations directly influence general business confidence.)"

You are missing the point here, as in fact the only way for most of firms on a non-regulated market to get information about demand for their products or services is VIA PRICES. So they cannot be well informed if monetary authorities tamper with the amount of money, as it distorts signals they're getting. New money doesn't apper at once in every purse, is moves slowly throughout the whole economy (most central banks estimate around 18 months for their actions to take full effect), and that is waaaay more than enough time to make distortions to the production structure & deplete the subsistence fund, that cannont be painlessly undone.

 
At 2:54 AM, November 28, 2011, Anonymous Anonymous said...

Jan, a rational firm will use all relevant signals to gauge the state of demand for their products, not just prices. (Think about a monopolist firm, which is a price-setter for their product, and must gauge the level and elasticity of market demand.) And even then, monetary policy expectations affect asset prices with no lag at all. (We saw a distinctive example of this when rumors of QE2 led to rising asset prices even before the policy was started). The effect on AD starts around the same time, as investment demand will change and folks throughout the economy will seek to opportunistically alter their money balances.

Nevertheless I do agree that erratic monetary policy is more difficult to correctly anticipate, and hence is detrimental in the long run. Ideally, the central bank will stabilize MV at a constant value or keep it growing along a path which is known in advance. Free banking would lead to the same result. (Stabilizing M is not enough, since e.g. the government could use changes in fiscal policy to shift V and affect prices+output.)

A second-best solution is to add missing markets such as a prediction market for nominal GDP. Firms will then be able to use prices in that market to gauge the monetary policy stance. Nevertheless, the private sector has shown limited interest in similar markets so far, which suggests that improving market signals is not considered a priority.

 
At 9:33 AM, November 28, 2011, Blogger Jan Foltyn said...

"Jan, a rational firm will use all relevant signals to gauge the state of demand for their products, not just prices. (Think about a monopolist firm, which is a price-setter for their product, and must gauge the level and elasticity of market demand.) [...]"

Hence my usage of the words "most firms" (as only a small fraction has enough turnover and a wide enough client base to warrant expensive market research and other non-price means of obtaining demand information) and "non-regulated market".

A nominal GDP futures to help stabilize the money volume, or even outright NGDP targeting, as advocated by Sumner, (mentioned somewhere above), would be a big improvement in contrast to the inflation targeting that is being practiced atm.
That being said, I cannot agree that stabilizing MV is better than M alone. Money velocity is not something one can accurately measure, and its changes are reflections of peoples preferences for increased or decreased economic activity (thus it actually conveys important information throughout the system), so if one tries to temper with M to offset the changes of V, one comes back to the same problem of having to inflate/deflate the money stock and thus distort money signals.

The best policy in my opinion would be to simply leave M alone at a fixed amount, or increase it very slightly (no more than 1%/yr) in a predictable manner. This idea was actually proposed by no other than Milton Friedman in his earlier days :) To this day I wonder why he abandoned the concept, though his proposition involved an increase of M by 3 or 4%/yr iirc, which is I think too much, as even a 3% rise would halve the PPM within a generation (25 years), thus inhibiting the population's ability to save.

 
At 10:34 AM, November 28, 2011, Anonymous Allan Walstad said...

Jan has said it better than I could. I would just point out that it's not so much price stickiness as simply the time it takes for the market to adjust (unlike the mathematical functions which, again, I think tend to be misleading, particularly as they generally refer to equilibrium results while the real action has to do with the dynamic processes). At one level, the time delay is obvious. I take my freshly printed greenback to a store where the price reads $10 and I buy the item for $10. It's only when the more rapid depletion of stocks is noticed that there is an incentive to raise the price. Some large firms may be able to anticipate, I dunno, but Bob the builder and Joe the plumber etc don't have the money or time to try to model their business prospects from changes in Fed monetary policy, and accurate market forecasting is notoriously iffy anyhow. Another thing is that if the increase in money supply comes through the banking system, as it surely does, then the first people to get their hands on the new money are borrowers, and this biases the increased demand toward goods that tend to be bought with borrowed money. It's only later, when the first wave of sellers spends their increased revenue, that the increase in demand shows up in other markets. So prices do not all rise in unison, and again, the ripple effect through the economy takes time. It also induces distortions in the structure of production as unintended consequences.

 
At 1:04 PM, November 28, 2011, Anonymous Anonymous said...

Lars Christensen responds:
http://marketmonetarist.com/2011/11/28/david-friedman-on-the-price-of-money/

 
At 9:53 PM, November 28, 2011, Anonymous js290 said...

http://www.psupress.org/Justataste/justatasteRNelson.html

 
At 10:19 AM, November 29, 2011, Blogger Julien Couvreur said...

This comment has been removed by the author.

 
At 4:46 AM, December 03, 2011, Blogger Maurizio said...

David Friedman wrote: "The central bank isn't pushing the interest rate down via price control, it's pushing it down (possibly) by increasing the supply of capital."

It seems to me you are not considering the effect on consumers of decreasing the interest rate: to consumers, saving becomes less attractive and consumption becomes more attractive. So people will consume more and save less. So it does not follow that the amount of real savings has increased on net.

This might be relevant: in the Austrian Business Cycle Theory literature, they use to say that the artificial lowering of interest rates "stretches the capital structure in two opposite directions", meaning the following: on the one hand, lower interest rates induce entrepreneurs to start more long-term projects, as if the total amount of real savings in society had increased; but they have not really increased; they have actually decreased, because people are saving less and consuming more (for the reason stated above); therefore, the real savings necessary to complete all those projects do not exist; so they cannot all be completed, and they will turn out unprofitable in the future, causing firms to go bankrupt all at once; (depression).

 
At 10:29 AM, December 12, 2011, Blogger David Friedman said...

Maurizio writes:

"So it does not follow that the amount of real savings has increased on net."

If I correctly understand you, you are making a mistake which shows up in lots of other contexts. If the net effect were not to push down the interest rate, consumers would not be consuming more and saving less, so their doing so cannot entirely cancel the effect of the additional capital being provided by the central bank.

For an analogous case, consider the effect of building a new highway. It is sometimes claimed that a new highway will have no effect on commute times, because its existence will cause more people to commute, cancelling any benefit. But its existence will cause more people to commute only if it, on net, reduces commute time, so in equilibrium there has to be some net effect.

 
At 2:46 AM, December 16, 2011, Blogger Maurizio said...

If I correctly understand you, you are making a mistake which shows up in lots of other contexts. If the net effect were not to push down the interest rate, consumers would not be consuming more and saving less, so their doing so cannot entirely cancel the effect of the additional capital being provided by the central bank.

Thank you very much for pointing out the logical error. Would you be so kind as to tell me if you think the same error is also present in this brief exposition of the Austrian business cycle theory (especially pages 6 to 8)?

I know I am asking a lot, but it seems with these few comments you have unknowingly falsified Austrian business cycle theory, and this can be a big deal for lot of people. :)

 
At 10:00 AM, December 16, 2011, Blogger David Friedman said...

Maurizio asks about Austrian Business Cycle theory.

I'm not an expert on macro, but so far as I can tell, the theory requires that entrepreneurs make a mistake, and make it repeatedly--the mistake being interpreting a temporary drop in interest rates as a permanent, or at least long term, drop. If the cause of the temporary drop is something the central bank is visibly doing at the moment and cannot be expected to continue doing, that seems a surprising mistake.

The simple monetarist model also requires lots of people to make a repeated mistake—employers failing to offer and employees to accept reductions in nominal wages when the price level is falling, or the equivalent mistake when it is rising more slowly than expected. It's a little more plausible, since one would expect employees to be less expert in such matters than entrepreneurs, and there is no point in offering a lower wage if the employee will not accept it.

So far as the point of mine you were responding to, it assumes that individuals are rational. Once you assume they make mistakes, more or less all bets are off. If many commuters overestimate the effect of the new freeway and relocate accordingly, the result could be that traffic on that line is slower than before.

 
At 9:41 PM, December 28, 2011, Blogger Reds Fan said...

Commenting as an uneducated bumpkin, I note that much of the discussion seems to assume the peasants will meekly go on participating in the formal financial system.

The patrician pickpockets wax voracious as mosquitos at the approaching frost. Meanwhile, the infelicities of the fractional reserve system seem to multiply the effects of the collusion between the elected crooks and those who circulate between the financial industry and the alleged regulatory agencies. The treasury and Federal Reserve pursue a reckless tandem course of "fiat currency" printed and digital; the administration hands out bundles of loot to its pals and bribes to participating fellow swindler institutions around the globe.

But that which can be conjured from a puff of smoke...

Even we simpletons eventually grasp that we are being swindled.

Some of us viewed with alarm the news in 1993 that the Democrat-dominated House of Representatives was even then developing legislation to confiscate individual retirement accounts, leaving in their stead a pile of IOU's, redeemable only at their discretion.

This is making a large component of the peasantry * scurry toward an underground barter economy. I would style their spending as rather an investment in commodities that they regard as having real value: freeze-dried foods, medical supplies, water filters, non-hybrid seeds, garden implements, high-efficiency camp stoves, hand tools, screws, bolts... things that promote self-reliance.

Maybe Bernanke and Co. can keep the charade going, and people will gradually regain some confidence.

Miracles happen.


* by "peasantry" I mean those of us who are not part of the ruling elite.

 
At 10:48 PM, April 08, 2012, Blogger Mark Humphrey said...

There is a distinction that seems to be partly overlooked, between fiat money and capital. Fiat money is not scarce; it is conjured from nothing whenever desired. Capital is scarce; it consists of real goods that someone must produce with labor and costly capital or consumer goods (which when used to make capital goods become themselves a kind of capital good).

When the Fed and fractional reserve banks increase fiat money, they depress the rate of interest below the rate that would otherwise obtain. But doing so does not increase the supply of real goods needed for various productive or of consumptive activities. Instead, the fiat money pumping merely misallocates scarce real goods into wasteful lines of production or consumption.

The waste is the unavoidable result of money pumping, because interest rate tampering alters the structure of relative prices. People are induced to embark on capital spending or durable consumer goods spending that they cannot afford, in light of the limits of scarcity. The limits of scarcity are imposed by the quantity of consumer goods saved ("real savings")that fund all activities, including productive ventures. The quantity of saving, in turn, reflects time preference.

The more and faster the Fed-and-banks make new money, the more that interest sensitive projects gain maket favor over stodgy consumer businesses that now must endure rising costs. Of course, this shift is not sustainable, because consumer demands push prices back into alignment with the reality of scarcity.

That's the false boom of central bank inflation--an idea that David Friedman is familiar with but, if I'm not mistaken, doesn't buy.

But still, I couldn't resist.

 
At 5:07 AM, December 01, 2014, Blogger Chris Jones said...

The price of money is the exchange rate.

The interest rate is the opportunity cost of holding money or the price of credit.

 

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