Are Money and Bonds Perfect Substitutes?

Frequent reader might recall that I recently posed a simple thought experiment:

Suppose that banks increase their demand for bank reserves. Now suppose that the Federal Reserve increases bank reserves correspondingly. What happens to the broader money supply? What happens to nominal income? What happens to inflation?

I suggested that the answer was “nothing” given that the Fed was merely increasing the money supply to satisfy an increase in money demand.

Now suppose that money demand is constant. Arnold Kling then poses the following thought experiment (such experiments are apparently spreading like viruses around the blogosphere):

Suppose that your net worth is $100,100, of which $100,000 is in various assets, such as home equity, mutual fund shares, and checking and saving accounts. You carry $100 in cash in your wallet. One day, you wake up with $99,900 in other assets and $200 in your wallet. By how much does your spending go up? Well, if V is constant, then PY doubles. Instead, I think that V will fall by half.

Personally, I prefer to believe that my spending rate has almost nothing to do with my wallet cash. If I have a lot of cash, I can still resist buying stuff I do not want. If I have only a little cash, I have no problem using a credit card or writing a check.

In response to Arnold Kling, Scott Sumner recently posed a related thought experiment:

Why would doubling the supply of currency cause people to hold twice as much currency in real terms? What am I missing? Is this how you’d behave?

I am similarly puzzled by Arnold’s example. This is partly due to the fact that I often use a similar thought experiment with principles students where I ask them what they would do if they came to class one day and I gave everyone $X and prices remained fixed. I have never heard the answer Arnold provides.

Nevertheless, I am not as concerned with Arnold’s initial claim as I am with his subsequent response to Sumner:

Here is my thought experiment. Suppose that the government retired lots of $10 bills, giving $5 bills in exchange, at the fair rate of two fives for one ten. Suppose that this doubled the supply of $5 bills in circulation. In order to keep the real supply of $5 bills constant, the price level would have to double. Do we think that people would go on a spending spree with their excess $5 bills and cause the price level to double?
I don’t think so. I think people would adapt to having more fives and fewer tens.

Next, suppose that instead of retiring $10 bills with $5 bills, the government retires 30-day Treasury bills with $5 bills. Suppose that this doubles the supply of $5 bills in circulation. Do we think that people want to hold only a constant real quantity of $5 bills, so that the only way we can get back to equilibrium is to have people spend to the point where the price level doubles?

Again, I don’t think so. Exchanging $5 bills for 30-day Treasury bills probably will be more consequential than exchanging $5 bills for $10 bills. But I don’t think it will be so much more consequential.

In other words, Arnold thinks that money and bonds are perfect substitutes. This also suggests that we are ALWAYS in a liquidity trap. If the Fed buys bonds with $5 bills, then agents simply hold the cash instead of the bonds. Monetary policy, at least that conducted through open market operations, is impotent.

In reality, money and bonds are not perfect substitutes. If you don’t believe me, show up at your local grocery store with a 30-year bond and try to spend it (let alone at par value). What’s more, the evidence that I have cited (here, here, and here) shows that changes in monetary policy — measured by some measure of the monetary base or otherwise — has real effects. If money and bonds were truly perfect (or near perfect) substitutes, open market operations would have no real effects.

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