In Search of Monetary Stability

I have been discussing a multitude of issues including quantitative easing, Ricardian Equivalence, and the current state of monetary policy with Scott Sumner over the in comments of his excellent blog and it has given me the inspiration to provide a more thorough outline of my thinking.

I think that the best way to think about money is, as Leland Yeager might say, in terms of monetary equilibrium. In other words, if we view money as being just one other good in a Walrasian general equilibrium model, then an excess demand (supply) of money is accompanied by an excess supply (demand) of goods and services. Thus, maintaining monetary equilibrium is essential to achieving economic stability. What’s more, the particular problem with an excess demand (or supply) of money is that money has no market of its own. Or as Keynes would say, labor cannot be shifted away from the production of goods where there is an excess supply to the manufacture of money. Further, the fact that money does not have a market of its own implies that an excess demand (supply) of money will have an impact on all markets because money is a medium of exchange.

My view here is not unique. In fact, Nick Rowe recently wrote an excellent post on this very topic that rightfully referenced the work of Robert Clower. The central point is that individuals have notional demands for money, goods, and services. Notional demand is understood as the intended demand. Thus, suppose for example that everyone arrives at some centralized market with their own plans for consumption and ultimate real money balances. If there is an excess demand for say lemonade, individuals can bid up the price of lemonade and the market will clear. If the excess demand is for money, however, there exists no price to adjust to clear the market and the effective demand for goods and services will fall short of supply.

A very simple way to think about monetary equilibrium is in the context of the equation of exchange:


where M is money, V is velocity, P is the price level, and Y is real output. Thus, M is the supply of money and V can be seen as the demand for money. (A particular note: velocity is understood as the number of times that the average dollar — or other medium of account* — is turned over. Thus an decrease in velocity reflects an increase in the demand for money.) Monetary equilibrium therefore implies that the product MV should be constant (and thus so should nominal GDP, or PY. Keep in mind that this is a static analysis).

The maintenance of monetary equilibrium essentially implies that monetary policy should be aimed at satisfying money demand (or nominal income) rather than the price level (as is currently the case). Thus, in a growing economy, the price level should actually be falling as increases in real output and productivity put downward pressure on prices. This type of thinking loosely forms the basis for what George Selgin calls the productivity norm. Such a maintenance of monetary equilibrium has a rich history in the course of economic thought (see Selgin, 1995).

So how does this framework relate to the current situation? Scott Sumner believes that the current recession could have been avoided using a nominal income target (more specifically, using nominal income futures targeting). I am not sure that I agree with this assertion, but it does fit with this framework. Allow me to explain.

If Sumner is correct, then (using our simple equation of exchange model) anticipations of lower nominal income would be reflected in an increase in the demand for money or a decrease in spending (a fall in V). (Alternatively, it is possible that the increase in the demand for money could be an exogenous event such as described by Keynes when there is an increase in uncertainty.) If the central bank was targeting nominal income, they would respond by increasing the money supply to offset the fall in velocity such that nominal income remains at the target level.

Sumner, however, likes to view this phenomenon through the lens of nominal income and expectations rather than through a monetary equilibrium framework (or at least that is my impression). Thus, in his mind, the nominal income target signals to economic agents that the Federal Reserve will do everything that it can to make sure that nominal income does not fall. If the Fed is credible on this point, then nominal income will not fall because people expect the Fed to follow through on this promise. I actually think that my view of monetary equilibrium is consistent with this view, but that Sumner simply has a different way of describing the policy.

In any event, Sumner has recently expressed his concern with the productivity norm view because (as I understand it) he is concerned with nominal wage rigidity. Thus, the falling prices implied by the productivity norm might actually produce malign effects. He would prefer a broader idea of a nominal income target. He might be correct, but I do not share this concern about wage rigidity. The reason is because wage rigidity should only be a concern when prices are falling due to adverse aggregate demand shocks. Falling prices due to productivity advances should have no effect on the nominal wage. In fact, rising productivity should be consistent with higher real wages (in this case due to falling prices). In any event, one need not worry about this problem under the current circumstances because the decline in nominal income is the result of a severe adverse aggregate demand shock.

I am inclined to think that nominal income targeting is certainly more desirable than the current regime. However, the ultimate question is whether or not the current situation could have been avoided under a nominal income targeting regime. Scott Sumner believes that we could have avoided the recession and simply experienced a burst of the housing bubble had we followed a nominal income target. I actually think that we might not have even had a housing bubble if we had a nominal income target (that allows for falling prices). In any event, the current situation has raised interesting questions about the state of monetary policy and monetary stability. Hopefully, we will also stumble upon some of the answers.

* “Money is here called a medium and not, as customary, a unit of account because, clearly, money itself is not a unit, but the good whose unit is used as the unit of account” Niehans (1978).

8 responses to “In Search of Monetary Stability

  1. Thanks Josh!

    And you are also right to reference Leland Yeager. I think Yeager was also influential in the thinking behind my post. It’s just I don’t remember his writings as clearly as I do Clower’s. He edited that little book, that your post title possibly alludes to. “In search of a monetary constitution”? Was that it?

    It’s hard to know how much of my own thinking in that post was distilled essence of Clower, Yeager, and of course my teacher David Laidler, who also emphasises monetary disequilibrium, and its role as medium of exchange.

    But does maintaining monetary equilibrium necessarily involve keeping MV constant? Following Laidler’s definition, I would define monetary disequilibrium as changes in either money supply or money demand that would require sudden changes in the time path of prices to restore equality between demand and supply of money.

  2. “Further, the fact that money does not have a market of its own implies that an excess demand (supply) of money will have an impact on all markets because money is a medium of exchange.”

    Monetary transmission is via financial services, and that has normal supply and demand characteristics. Money is just a simple technology that aids the financial services As another supply and demand sector, financial services would have overshoot and cyclic behavior, (gluts and shortages) like an other business. Over shoot would be inflation, which is characteristic of growing economies.

  3. Nice summary Josh, Until yesterday I thought that the only difference between my view and George Selgin’s was that I preferred a slightly higher NGDP growth rate. But George pointed out that his plan is not precisely a NGDP norm, it allows nominal income to grow according to real total factor growth (which I gather includes labor and capital.) Pure technological change reduces prices in George’s plan. Indeed, that is also true in my plan, in the weaker sense that faster technological growth means a lower rate of inflation.

    Whereas you and Nick seem to emphasize the role of money as a medium of exchange, I emphasize its role as a medium of account. I see the key characteristic of money as being its fixed nominal price. Thus when the real price of money must adjust, due to a supply/demand imbalances, it can only occur through all other prices adjusting—aka macroeconomic disequilibrium. In the end, I don’t know how important this difference actually is, as a NGDP rule would seem to address the problem from either perspective. Thus my futures targeting idea would automatically produce the “right” monetary base for macro stability, which must logically be the monetary base expected to produce the “right” level of M1, unless I am mistaken.

  4. Thank you for commenting Nick.

    Yes, Yeager did indeed edit that text. I am much more familiar with his collection of work in The Fluttering Veil.

    Yeager actually has an excellent paper that appeared in the Cato Journal in 1986 on this very topic entitled, “The Significance of Monetary Disequilibrium.” Although it is excellent in and of itself and is featured in the aforementioned collection, the actual article in the CJ is followed by a response from Axel Leijonhufvud that is also excellent.

    In any event, perhaps I should clarify what I mean by monetary disequilibrium and the corresponding role of monetary policy. You are correct that under monetary disequilibrium the path of prices must change in order to bring about a new equilibrium. However, that is my concern. The adjustment of prices in all other markets to the change in the supply or demand for money will (likely) not be equiproportionate and thus relative prices changes will occur that may lead to the misallocation of capital and other goods and services. What’s more, an excess demand for money can lead to malign deflation. On this I would refer you to David Beckworth’s excellent paper:

    Rather, I would prefer that the central bank target nominal income thereby offsetting changes in money demand with changes in the money supply. If the policy is effective the only changes in prices would be due to real factors.

  5. Scott,

    Your view very much reminds me of a pure gold standard view in which the “price of gold” is fixed and thus when there is a change in money demand, the prices of all other goods must adjust.

    In any event, I think that our goals for monetary policy are quite similar. However, as I alluded to in my comment to Nick above, I think that I am much more concerned with the changes in relative prices from having a positive inflation bias in the nominal income target.

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