Category Archives: Macroeconomic Theory

The Law of Reflux Returns

One could make the case, quite convincingly, that all of the major monetary debates are between those whose arguments are based on classical monetary theory and those whose arguments are based on the quantity theory of money. This would be fine if one theory or the other was always correct. However, the model that is appropriate for any given debate depends on the particular monetary institutions in place. For example, if money is convertible into some commodity, such as gold, then classical monetary theory is appropriate. If we have a system of inconvertible paper money, then the quantity theory is appropriate. Thus, to put my original point differently, the history of thought in monetary economics essentially consists of one side using the appropriate model and the other side mis-applying the lessons of the other model.

The quantity theory is perhaps sufficiently well-known that it does not require a long summary. The basic idea is that with a system of inconvertible paper money, the value of that money is determined by the interaction between the supply and demand. An excess supply of money leads to inflation. An excess demand for money leads to deflation. In contrast, under classical monetary theory, the price level is pinned down by the price of gold through arbitrage. The money supply then varies directly with money demand. If banks (or a central bank) issues too many bank notes, then they will experience a wave of redemptions (people start converting their bank notes to gold). This causes a drain of gold reserves and the banks (or central bank) will have to restrict bank note issuance to ensure that they do not lose all of their reserves. (This is known as the Law of Reflux. I will return to this idea later.)

So, if we can summarize this concisely, the quantity theory implies that there can be deviations between the supply of and demand for money that cause price level fluctuations. The classical theory implies that the money supply will move in conjunction with money demand and have no effect on prices.

As I said, a great many of the debates in monetary history involve misapplications of one theory or the other. During the Bullionist Controversy, the British suspended the convertibility of bank notes into gold at the Bank of England. One group, the Bullionists, argued that the subsequent inflation was caused by excess note issuance. The other group, the Anti-Bullionists, argued that this could not be true. In fact, some of the Anti-Bullionists cited Adam Smith as the authority on the topic and argued that it was impossible for an excess supply of money to cause inflation because the money supply only fluctuated with money demand. The Bullionists were essentially applying the quantity theory of money. The Anti-Bullionists were applying the classical theory. As my forthcoming paper in the JMCB shows, the Bullionists were correct. And they were correct because they were applying the correct theory given the circumstances. In fact, if the Anti-Bullionists had read Adam Smith carefully, they would have realized that Adam Smith had assumed a convertible money. They failed to realized that the Law of Reflux does not apply when there is an inconvertible paper money.

The subsequent debate between the Banking School and the Currency School in the U.K. was similarly plagued by misapplications. The Currency School wanted limits on the quantity of notes the Bank of England could issue. The Banking School argued that this was unnecessary, that the Law of Reflux applied. If the Bank of England issued too many notes, they would be converted into gold and the Bank would have to reduce its note issuance. An excess supply of money would not cause inflation. This time it was the Banking School that was correct. Under the gold standard, the quantity theory is not the appropriate framework to apply.

Critics of monetary explanations of the Great Depression like to point to the monetary base and argue that the Fed “did all it could.” However, this mis-applies the Quantity Theory of Money. Economists like Earl Thompson, David Glasner, and Scott Sumner explain that it is more appropriate to look at the gold market for the monetary explanation. Changes in the relative price of gold were the important source of fluctuations in the economy during the early stage of the Depression, 1929 – 1933. In other words, the classical theory is the appropriate framework. (This is complicated by the fact that while the Law of Reflux applies, it is still possible to have an excess demand for money because the central bank has a monopoly over currency issuance and if they fail to increase the money supply, this can cause disruptions in the economy as well. So I view the Thompson-Glasner-Sumner view as the appropriate way to look at the Depression with Friedman and Schwartz as a complement.)

In the 1970s, macroeconomists debated the causes of inflation. On the one side, the Keynesians pointed to the Phillips Curve, which appeared to be a stable negative relationship between the unemployment rate and the inflation rate for an explanation. Specifically, they argued that as labor markets tighten this puts upward pressure on wages, increasing firms costs, and causing higher prices. On the other side of the debate were the Monetarists who argued that the growth rate of the money supply was the source of inflation. The Monetarists were applying the Quantity Theory of Money. The Keynesians meanwhile made a crucial error. What they failed to consider is the data generating process that produced the Phillips Curve. The negative relationship between inflation and unemployment was identified during periods in which money was convertible into gold. Thus, the appropriate model to use to explain these fluctuations is Classical Monetary Theory. According to this view, fluctuations in the gold market were the source of fluctuations in the price level. Such fluctuations were often unexpected. In addition, since prices were relatively constant over long horizons, so were nominal wages. Thus, unexpected fluctuations in the gold market would result in unexpected fluctuations in the price level. With stable nominal wages, this meant that unexpected increases in the price level led to unexpected decreases in real wages and therefore lower unemployment rates. The Keynesian explanation of inflation therefore failed on two fronts: (1) they failed to realize that the relationship might not be robust across monetary regimes, and (2) they reversed the direction of causation in the Phillips Curve. This latter point being an under-appreciated aspect of both Friedman’s and Lucas’s critique of the Phillips Curve.

I bring all of this up because there is once again a debate in monetary economics in which one side is misapplying one of the two theories. This time, it is the Classical Theory that is being misapplied. Specifically, the Law of Reflux is back in vogue. When I discuss paying interest on excess reserves (IOER) and why IOER is contractionary, I am regularly met with the following critique: “the central bank determines the supply of reserves. Individuals banks can try to reduce their reserve balances, but collectively the banking system must hold this supply of reserves.” This is just a modern version of the Law of Reflux. Allow me to explain. The relevant question is not why banks are holding this quantity of reserves. The relevant question is why banks are holding this quantity of excess reserves. It is true that the central bank determines the aggregate quantity supplied of reserves. However, the banking system determines whether these reserves are held as required reserves or as excess reserves. For example, if the bank lends out some of these reserves, they also create a new deposit liability. This new deposit liability increases the amount of required reserves that the bank must hold. If the banking system creates enough new deposits then all of these reserves will be required reserves and banks will not be holding excess reserves (despite the fact that the aggregate supply of reserves is still the same). So when someone says that the banks have no choice but to hold the quantity of reserves the Fed supplies, they must either be (a) confused as to this distinction between aggregate reserves and aggregate excess reserves, or (b) invoking some modern version of the Law of Reflux in which the banking system is unable to convert excess reserves into required reserves.

A better explanation for why banks are holding such a large quantity of excess reserves is not that they have no choice, but rather that they have been given an incentive to do so. In particular, Dutkowsky and VanHoose provide perhaps the most compelling explanation. What they argue is that a good rule of thumb is to compare the interest rate paid on excess reserves to the federal funds rate. If the interest paid on excess reserves is higher than the federal funds rate, then the wholesale market for loans between banks just breaks down. In other words, we should expect to end up in either one or two different corner solutions. In one corner solution, banks hold no excess reserves and engage in wholesale lending. In the other corner solution, banks hold a lot of excess reserves and do not engage in wholesale lending. (It is possible to end up in an interior solution, but only in rare cases.)

As I have written elsewhere, whether or not this matters for monetary policy depends on the monetary transmission mechanism. If you think that monetary policy works solely through the short term nominal rate, then the interest rate paid on excess reserves just replaces the federal funds rate as the relevant policy rate. However, if you think that monetary policy works by altering portfolio composition, including those of banks, then paying IOER actually hinders the monetary transmission mechanism and makes it harder for the central bank to hits its target. (This is incidentally the mechanism Bernanke cited over and over again during rounds of QE.) Regardless, this isn’t the time to revive the Law of Reflux and the implications thereof.

Economists Say the Darndest Things, Gold Standard Edition

I often hear economists say things like “look, the vast majority of economists think the gold standard is terrible.” I have no idea if this is true (many economists outside of macro likely have no opinion on the gold standard), but it is incredibly misleading even if we believe the quote to be true. The reason I say that this quote is misleading is that whether or not the gold standard is a good or bad institutional regime depends on the precise institutional characteristics of the gold standard. In other words, which gold standard are we talking about? Are we talking about a free banking regime in which banks issue their own notes that are redeemable in gold? Are we talking about a system in which there is a central bank that has a monopoly over currency issuance that redeems its notes in terms of gold? Or are we talking about a Bretton Woods-type system? The institutional characteristics matter when we are evaluating the benefits and costs of the system. In general I find that the “consensus view” in economics is not that the gold standard is bad, but that particular experiences with the gold standard were bad. In other words, there is a difference between saying that the gold standard is inherently bad and saying that our experience with the gold standard is bad. Allow me to elaborate.

When I hear economists say that the majority of their colleagues oppose the gold standard, what they are typically referencing is a critique of the international gold standard that existed during the interwar period. In fact, in my experience, I have found that there are few economists outside of the field of monetary economics who actually know much about the gold standard beyond the interwar experience. This is problematic. If I ask an economist if the gold standard is bad, I would expect them to answer based on carefully thinking through the costs and benefits of the gold standard relative to alternative monetary institutions. One should not expect that they simply point to a very negative experience and conclude that it was bad. This is not good economics. One must consider the counterfactual.

With regards to the interwar experience, people often point to the role that the gold standard played in the Great Depression and conclude that the gold standard is bad. For example, Earl Thompson and Scott Sumner have argued that the Great Depression can be explained by fluctuations in the real price of gold. Barry Eichengreen (and others) have discussed how the recovery of a particular country from the Great Depression can be predicted by the timing of their decision to leave the gold standard. Milton Friedman and Anna Schwartz argued that China avoided the worst of the Great Depression because it was on a silver standard.

If this is all you knew about the gold standard, you might naturally conclude that it was a terrible monetary system. However, it is important to understand the particular details of the monetary system during the interwar period. For example, an important characteristic of the interwar period was the fact that the gold standard was managed by central banks. Why is this important? Well, one reason is that the functioning of any monetary system depends on participants following particular rules of the game. As Doug Irwin has shown, the Bank of France did not follow the rules of the game for the gold standard. Instead the French hoarded gold, creating an artificial shortage of gold reserves that, in turn, created significant, exogenous deflationary pressure amongst those countries on the gold standard.

So, if one wanted to judge the gold standard based on the interwar experience, the correct conclusion would be that the gold standard can produce massive costs when mismanaged by central banks. Based on the magnitude of the costs it would therefore not be unreasonable to say that “the gold standard can be terrible when managed by central banks.” In fact, I have made this argument many times! However, note that I have qualified the statement that the gold standard is terrible by placing it in a particular institutional context. This is a much weaker statement than concluding that the gold standard is always and everywhere bad.

The qualification that I outlined in the previous paragraph is important. A number of economists, such as Larry White, George Selgin, and others have written about competitive note issuance under a commodity standard. If one is to conclude that the gold standard is always and everywhere terrible, then one must not only assess the performance of the gold standard in the presence of central banks, but also in the absence of central banks. Larry White’s pioneering work demonstrated that a free banking system actually worked quite well.

Another problem is that economists often compare the actual performance of the gold standard to the theoretical possibilities of central banking under a fiat standard. If a country maintains the gold standard, then fluctuations in the real price of gold can have real effects on economic activity. Thus, dispensing with the gold standard eliminates these sorts of effects. Not only that, but in theory a central bank under a fiat standard can adjust the money supply to maintain relative price stability while also potentially minimizing fluctuations in real economic activity. However, it is unfair to compare the experience of the gold standard with the theoretical possibilities of central banking. For example, Jurg Niehans (1979: 140) writes:

Commodity money does not exist today. It is also not ideal in the sense that it is relatively easy to imagine noncommodity systems that are intellectually more satisfying than commodity money. In fact, a noncommodity system, since it gives monetary policy more freedom, can, if it is ideally managed, always do at least as well as any commodity money system and probably better.

The emphasis is my own. It is easy to argue that, in theory, a fiat money managed by a central bank is preferable to the gold standard. However, the question is whether central banking in a fiat regime actually produces better outcomes than a gold standard. This is a much more complicated question than people think. We cannot look to the interwar period and conclude that the gold standard is bad any more than we can look at the 1970s in the U.S. or the hyperinflation in Zimbabwe and conclude that fiat regimes are bad — yet this is precisely what people on both sides of this debate often do! Similarly, we cannot look at idealized versions of the gold standard or central banking under a fiat regime to draw our conclusions.

To assess whether the gold standard, or any monetary system, is “good” or “bad” requires careful consideration of the institutional characteristics of the system. A gold standard can work quite well within the right institutional structure. But the same could be said for a fiat regime. To argue that one or the other is inherently bad — or worse, claim that everyone agrees with you — is to do a disservice to those who want to learn about monetary economics.

Free Banking and the Friedman Rule

Imagine that there are two types of people in the world — recognizable and unrecognizable. Recognizable people can develop reputations, which can have either positive or negative effects. If a recognizable person develops a reputation for being trustworthy, then he or she will likely be able to issue debt to finance the purchase of goods and services. If the person is not trustworthy, but is easily recognized, then he or she will not be able to issue debt. All else equal, people who are recognizable will have an incentive to be trustworthy so that they can issue IOUs to pay for stuff. People who are not recognizable don’t have the same incentives. Since nobody can recognize them, they will never be able to issue IOUs.

Let’s think about this in the context of general equilibrium theory (without a Walrasian auctioneer and without any exogenously specified thing called “money”). In the absence of some auctioneer to price and distribute goods and in the absence of money, people must meet with every other person in the market to determine whether trade is possible. Recognizable people will be able to issue IOUs in order to trade as long as they are trustworthy and there is a mechanism to punish them if they do not repay their debts (e.g., exclude them to a world of autarky if they don’t repay their debts). But how can the non-recognizable people trade? Well, they could sell their goods to recognizable people in exchange for an IOU, but then all they have is an IOU. And what exactly does the IOU provide?

Assuming that each recognizable person can produce some good, the IOU would represent a promise to produce some quantity of the good in the future. A non-recognizable person could then present the IOU for this good at some future date or the person could turn around and use this IOU to purchase some other good. The seller in this circumstance would be willing to accept a third party IOU if (a) they want the good that IOU promises, or (b) they think they can pass on the IOU to someone else. Whether or not condition (b) is satisfied depends on the good the IOU-issuer is promising. Ultimately, what happens in this scenario is that certain goods will be found to satisfy condition (b) and those IOUs will start to circulate as a medium of exchange.

What this example resembles is a sort of free banking regime. People with good reputations are able to issue IOUs that can end up circulating like bank notes — these are banks. Eventually an IOU can be redeemed by whoever is holding it for some fixed quantity of a good that the IOU-issuer promised.

This implies that there is a key feature of free banking regimes. In actual free banking regimes, bank notes could be redeemed for one particular good, gold. The value of one bank note, consistent with our example, was defined as a particular quantity of gold. This implies that the price of gold in terms of bank notes is necessarily fixed. However, the relative price of gold to an index of all other prices is not fixed. In a growing economy, under these conditions, prices would decline on average with increases in productivity. As a result, the promise to pay a fixed amount of gold at a future date would actually entail a positive rate of return.

Thus, under a free banking regime, if (1) productivity is growing, (2) the decline in prices due to rising productivity completely offset the real interest rate, then a free banking regime naturally reproduces the Friedman rule.

Some Myths About Interest on Reserves

There are two myths that I see repeated about interest on reserves that I would like to address:

1. “Of course the banking system is holding more reserves. They have no choice. The quantity of reserves is set by the Federal Reserve.”

That last sentence is correct. However, the relevant question is why banks are holding these reserves as excess reserves rather than as required reserves.

The typical way that we teach students about open market operations is as follows. Suppose that each component of the bank’s balance sheet is consistent with profit-maximization given a binding reserve requirement. The central bank conducts open market operations by buying bonds from the bank and crediting the reserve account of the bank. The bank now finds itself holding excess reserves. If the central bank is not paying interest on reserves, this is costly for the bank since it is now holding more reserves than it would prefer. As a result, the bank would lend out these excess reserves. What follows is the process of multiple deposit creation. When this process concludes, the quantity of reserves in the system will not have changed, but since the reserve requirement is binding, no bank will be holding excess reserves. Each bank is holding the required amount of reserves.

To say that banks are holding excess reserves because they have no other choice is therefore incorrect. While it is true that banks must hold the quantity of reserves determined by the Federal Reserve, their decision-making will determine whether they hold these reserves as excess reserves or required reserves. If banks are holding excess reserves, this implies that there is no operative mechanism of deposit creation. We might want to ask ourselves why this is the case.

On this point, Dutkowsky and VanHoose have written an excellent paper that looks at the profit-maximizing behavior of banks. Their model provides for the possibility of three different equilibria: (1) an interior solution in which banks hold excess reserves and participated in the wholesale loan market, (2) an equilibrium in which banks participate in the wholesale loan (fed funds) market, but do not hold excess reserves, and (3) an equilibrium in which banks hold excess reserves, but do not participate in the wholesale loan (fed funds) market.

What they show is the equilibria that we end up in depends critically on the relationship between the interest rate on excess reserves and the fed funds rate. In particular, they show that the interior solution equilibrium is operable under very narrow restrictions on the relationship between rates. In other words, we tend to either be in an equilibrium in which there are no excess reserves OR in an equilibrium in which there is no wholesale lending. While it is slightly more complicated than this, a general rule-of-thumb from my reading of the paper is that if the interest rate on reserves is higher than the fed funds rate, then this results in an equilibrium in which banks hold excess reserves and do not participate in the wholesale loan market.

The interest rate on reserves has been higher than the fed funds rate since 2009. Dutkowsky and VanHoose show a corresponding precipitous decline in interbank lending that has taken place in the period since.

Why is this important?

Typically banks are not willing to hold excess reserves because doing so is costly. In fact, if the required reserves constraint is binding, then banks will never want to hold excess reserves because they do not even want to hold the required amount. However, if banks are willing to hold excess reserves, then this process of multiple deposit creation will not be operable — or at least not to the extent that it would be traditionally.

This leads me to the second myth about interest on reserves.

2. “Interest on reserves gives the central bank flexibility to provide liquidity without sacrificing its ability to conduct monetary policy.”

The idea behind this statement is that when the central bank pays interest on reserves, banks are willing to hold more reserves which helps to better facilitate payments and provide liquidity to the banking system. At the same time, or so the argument goes, the interest rate on reserves becomes the relevant policy interest rate. As a result, by paying interest on reserves, the central bank can increase the amount of reserves in the system, streamline the payment process, provide liquidity, and still conduct monetary policy as it normally does.

This argument, however, presumes that the monetary policy works solely through the short term interest rate. However, monetarists like Friedman and Schwartz and Brunner and Meltzer, argued that monetary policy worked through open market operations by adjusting the relative supply of assets. This change in the composition of assets required changes in relative prices since assets are not all perfect substitutes. The process of relative price adjustment continues until everyone is satisfied with their new portfolio. For example, consider Friedman and Schwartz’s description of the monetary transmission mechanism in their paper “Money and Business Cycles”:

Let us now suppose that an unexpected rise to a new level occurs in the rate of change in the money stock, and it remains there indefinitely…To be definite, therefore, let us suppose it comes from an increased rate of open market purchases by a central bank.

Although the initial sellers of the securities purchased by the central bank were willing sellers, this does not mean that they want to hold the proceeds in money indefinitely. The bank offered them a good price, so they sold; they added to their money balances as a temporary step in rearranging their portfolios. If the seller was a commercial bank, it now has larger reserves than it has regarded before as sufficient and will seek to expand its investments and its loans at a greater rate than before. If the seller was not a commercial bank, he is not likely even temporarily to want to hold the proceeds in currency but will deposit them in a commercial bank, thereby, in our fractional reserve system, adding to the bank’s reserves relative to its deposits. In either case, therefore, in our system, commercial banks become more liquid. In the second case, in addition, the nonbank sellers has a higher ratio of money in his portfolio that he has had hitherto.

Both the nonbank seller and commercial banks will therefore seek to readjust their portfolios, the only difference being that the commercial banks will in the process create more money, thereby transmitting the increase in high-powered money to the total money stock…

They go on to explain that this portfolio reallocation will result in changes in relative prices and ultimately economic activity until equilibrium is restored.

Similarly, Ben Bernanke has described the monetary transmission mechanism as follows:

I see the evidence as most favorable to the view that such purchases work primarily through the so-called portfolio balance channel, which holds that once short-term interest rates have reached zero, the Federal Reserve’s purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public.

Specifically, the Fed’s strategy relies on the presumption that different financial assets are not perfect substitutes in investors’ portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets. Thus, our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration. For example, some investors who sold MBS to the Fed may have replaced them in their portfolios with longer-term, high-quality corporate bonds, depressing the yields on those assets as well.

The logic of the portfolio balance channel implies that the degree of accommodation delivered by the Federal Reserve’s securities purchase program is determined primarily by the quantity and mix of securities the central bank holds or is anticipated to hold at a point in time (the “stock view”), rather than by the current pace of new purchases (the “flow view”). In support of the stock view, the cessation of the Federal Reserve’s purchases of agency securities at the end of the first quarter of this year seems to have had only negligible effects on longer-term rates and spreads.

Implicit in these discussion is that there isn’t one particular asset price that matters for transmitted monetary policy. Rather, what matters are the relative quantities of the assets and the relative price adjustment necessary to get to an equilibrium in which everyone is satisfied with their portfolio.

If Bernanke and the monetarists are correct, then the change in the Federal Reserve’s operating procedures should give one pause about the ability of monetary policy to continue unaffected in a world of interest on reserves. Dutkowsky and VanHoose’s model suggests that open market operations should largely be irrelevant because we are currently in an equilibrium in which the interest rate on reserves is higher than the fed funds rate. As a result, banks are likely to hold excess reserves rather than engage in portfolio reallocation. Thus, one must rely on “the” short term nominal interest rate, in this case the interest rate on reserves, to influence economic activity. Whether or not this mechanism is sufficient depends on the sensitivity of macroeconomic variables to the short term interest rate. The empirical evidence suggests that the responsiveness of things like investment to interest rates is actually quite weak. As a result, there is some reason for concern about the ability of monetary policy to work as it normally does.

Are Helicopter Drops a Fiscal Operation?

This is meant to be a quick note on what I think is a common misconception about helicopter drops. I am not advocating that the Federal Reserve or any other central bank undertake the actions I am going to describe nor do I care about whether it is legal for the Federal Reserve or any other central bank. All I am concerned with is helicopter drops on a theoretical level. With that being said, let me get to what I believe is a misconception.

First, some context. Typically, when the Federal Reserve wants to increase the money supply, they buy assets on the open market in exchange for bank reserves. These are called open market operations. One potential problem is that the Federal Reserve is typically purchasing short-term government debt. When short term nominal interest rates are near the zero lower bound, many believe that open market operations are impotent since the central bank is exchanging one asset that does not bear interest for another asset that does not bear interest. Banks are indifferent between the two. The exchange has no meaningful effect on economic activity.

Given this problem, some have advocated a “helicopter drop” of money. Typically, they don’t mean an actual helicopter flies overhead dropping currency from the sky. What they are referring to is something like the following. Suppose that the U.S. Treasury sends a check to everyone in the United States for $100 and issues bonds to pay for it. The Federal Reserve then buys all of these bonds and holds them to maturity. This is effectively a money-financed tax rebate. Thus, it resembles a helicopter drop because everyone gets $100, which was paid for by an expansion of the money supply. However, many people are quick to point out that this is actually a fiscal operation. The U.S. government is giving everyone a check and the Federal Reserve is simply monetizing the debt.

But are helicopter drops really a fiscal operation? Certainly if we think about helicopter drops as I have described them above, it is correct to note that such action requires monetary-fiscal cooperation. However, let’s consider an alternative scenario.

The Federal Reserve has a balance sheet just like any other bank. The Fed classifies things on their balance sheet into 3 categories:

1. Assets. Assets include loans to banks, securities held, foreign currency, gold certificates, SDRs, etc.
2. Liabilities. Liabilities include currency in circulation, bank reserves, repurchase agreements, etc.
3. Capital.

The balance sheet constraint is given as

Assets = Liabilities + Capital

Let’s consider how things change on the balance sheet. Suppose that the Fed took large losses on the Maiden Lane securities purchased during the financial crisis. What would happen? Well, the value of the Fed’s assets would decline. However, the liabilities owed by the Fed would not change. Thus, for the balance sheet to remain in balance, the value of the Fed’s capital would have to decline.

So imagine the following scenario. We all wake up one morning to discover that actual helicopters are lifting off from the rooftops of regional Federal Reserve banks. The helicopters fly through each region dropping currency from the sky. People walk out of their homes and businesses and see money raining down upon them. They quickly scoop up the money and shovel it into their pockets. It is a literal helicopter drop of money!

But how can this be? How could the central bank do such a thing?

If the central bank were to do such a thing, think about what would happen to its balance sheet. Currency in circulation increases thereby increasing Fed liabilities. However, asset values are still the same. So capital declines. (The latest Fed balance sheet suggests that the Fed has $10 billion in surplus capital. This would decline dollar-for-dollar with the increase in the supply of currency.)

What this implies is that a central bank could (in theory) conduct a helicopter drop by effectively reducing its net worth. In the future, the Federal Reserve could restore its capital by reinvesting its earnings into new assets. Thus, the helicopter drop is a form of direct transfer to the public that is paid for by the Fed’s future earnings.

[Now, some of you might be saying, “Ah ha! If the Fed is retaining earnings these are earnings that would have otherwise gone to the Treasury and so it is still a fiscal operation.” I would argue that (a) this is semantics, and (b) there is no reason to believe this is true. The Fed, for example, could simply have used those earnings to furnish new offices at the Board and all of the regional banks — in that case it would be a transfer of wealth from the staff to the general public.]

Money and Banking

You might be able to teach an entire course on the microeconomics of money and banking based on the following thought experiment.

Imagine the following scenario. I want to start a business, but I need to borrow $10,000 to get started. You offer to provide me with that $10,000. However, since you won’t get to consume using that $10,000 and you won’t get to invest that $10,000 in anything else you require that I pay you some interest. I give you a piece of paper that promises to pay you back, with interest, at some future date in time. Intrinsically, that piece of paper that I have given you is worthless. It is just a piece of paper. However, if that piece of paper represents a legally binding agreement, then we call that piece of paper a bond. You are willing to accept that piece of paper from me because you anticipate that I am going to do something productive with your money. In the event that I don’t, you will be entitled to the assets of my business. So, the value of the bond is the expected value of the bond over the duration of the loan plus the value of the option to seize my assets in the event that I cannot/do not pay you back. Now, of course, there is some chance that between now and when I have promised to pay you back you will want to spend money. As a result, a market emerges that allows you to sell this piece of paper to other people.

Now imagine the following alternative scenario. Suppose that you want to save, but you don’t want to deal with trying to figure out how to invest that savings. Fortunately, we have a mutual friend who likes to do this sort of thing. So you give your $10,000 to our friend and he promises to give you your money back plus some interest payment. I also make a visit to our mutual friend, but I ask him to borrow $10,000. He agrees to lend me $10,000, but I have to pay him back with interest (slightly higher than what he is offering you). Since our mutual friend knows that you might need cash for unexpected expenditures in the future, he promises to give you the right to show up and demand your $10,000 (or some fraction thereof) at any moment you want. Thus, to our mutual friend, the value of the loan is the expected value of the loan over the duration agreed upon plus the expected value of the option to seize my assets in the event that I cannot/do not pay him back. The value of the contract for you is the expected value of the loan that you have given our mutual friend plus the value of the option to get your $10,000 back whenever you want plus the value of the option to seize the assets of our mutual friend in the event that the value of his assets decline below what he owes you.

What is the difference between these two scenarios?

Some would say that in the latter scenario the problem is that our mutual friend is offering to give you dollars that he himself does not have to give. Thus, he is “creating dollars out of thin air.” In fact, if he doesn’t have actual dollars, he might give you a piece of paper that promises to give you those dollars in the future. If you are able to trade these pieces of paper in exchange for goods and services, it would appear as though our mutual friend has really created money out of thin air. But has he really? Or is he merely allowing you to transfer some fraction of what he owes you to another individual?

Why might people be willing to accept these pieces of paper printed by our mutual friend and use them in transactions?

Replace “$10,000” with “7.5 ounces of gold.” Do your answers to these questions change?

Reasoning from Interest Rates

A quick note…

We can think of long-term yields as consisting of two components, the average expected future short-term rate and the term premium. However, it is important to note that the average expected future short-term rate itself is a function of the rate of time preference, expectations of future growth, and expectations of inflation. Also, the term premium is a function of duration risk, a liquidity premium, and a safety premium.

So suppose that you see long-term yields change, what can you learn about the stance of monetary policy?