A few weeks ago Michael Woodford and his Columbia colleague Mariana Garcia-Schmidt made an initial response to the Neo-Fisherian argument advanced by, among others, John Cochrane and Stephen Williamson that a central bank can achieve its inflation target by pegging its interest-rate instrument at a rate such that if the expected inflation rate is the inflation rate targeted by the central bank, the Fisher equation would be satisfied. In other words, if the central bank wants 2% inflation, it should set the interest rate instrument under its control at the Fisherian real rate of interest (aka the natural rate) plus 2% expected inflation. So if the Fisherian real rate is 2%, the central bank should set its interest-rate instrument (Fed Funds rate) at 4%, because, in equilibrium – and, under rational expectations, that is the only policy-relevant solution of the model – inflation expectations must satisfy the Fisher equation.
The Neo-Fisherians believe that, by way of this insight, they have overturned at least two centuries of standard monetary theory, dating back at least to Henry Thornton, instructing the monetary authorities to raise interest rates to combat inflation and to reduce interest rates to counter deflation. According to the Neo-Fisherian Revolution, this was all wrong: the way to reduce inflation is for the monetary authority to reduce the setting on its interest-rate instrument and the way to counter deflation is to raise the setting on the instrument. That is supposedly why the Fed, by reducing its Fed Funds target practically to zero, has locked us into a low-inflation environment.
Unwilling to junk more than 200 years of received doctrine on the basis, not of a behavioral relationship, but a reduced-form equilibrium condition containing no information about the direction of causality, few monetary economists and no policy makers have become devotees of the Neo-Fisherian Revolution. Nevertheless, the Neo-Fisherian argument has drawn enough attention to elicit a response from Michael Woodford, who is the go-to monetary theorist for monetary-policy makers. The Woodford-Garcia-Schmidt (hereinafter WGS) response (for now just a slide presentation) has already been discussed by Noah Smith, Nick Rowe, Scott Sumner, Brad DeLong, Roger Farmer and John Cochrane. Nick Rowe’s discussion, not surprisingly, is especially penetrating in distilling the WGS presentation into its intuitive essence.
Using Nick’s discussion as a starting point, I am going to offer some comments of my own on Neo-Fisherism and the WGS critique. Right off the bat, WGS concede that it is possible that by increasing the setting of its interest-rate instrument, a central bank could, move the economy from one rational-expectations equilibrium to another, the only difference between the two being that inflation in the second would differ from inflation in the first by an amount exactly equal to the difference in the corresponding settings of the interest-rate instrument. John Cochrane apparently feels pretty good about having extracted this concession from WGS, remarking
My first reaction is relief — if Woodford says it is a prediction of the standard perfect foresight / rational expectations version, that means I didn’t screw up somewhere. And if one has to resort to learning and non-rational expectations to get rid of a result, the battle is half won.
And my first reaction to Cochrane’s first reaction is: why only half? What else is there to worry about besides a comparison of rational-expectations equilibria? Well, let Cochrane read Nick Rowe’s blogpost. If he did, he might realize that if you do no more than compare alternative steady-state equilibria, ignoring the path leading from one equilibrium to the other, you miss just about everything that makes macroeconomics worth studying (by the way I do realize the question-begging nature of that remark). Of course that won’t necessarily bother Cochrane, because, like other practitioners of modern macroeconomics, he has convinced himself that it is precisely by excluding everything but rational-expectations equilibria from consideration that modern macroeconomics has made what its practitioners like to think of as progress, and what its critics regard as the opposite .
But Nick Rowe actually takes the trouble to show what might happen if you try to specify the path by which you could get from rational-expectations equilibrium A with the interest-rate instrument of the central bank set at i to rational-expectations equilibrium B with the interest-rate instrument of the central bank set at i + ε. If you try to specify a process of trial-and-error (tatonnement) that leads from A to B, you will almost certainly fail, your only chance being to get it right on your first try. And, as Nick further points out, the very notion of a tatonnement process leading from one equilibrium to another is a huge stretch, because, in the real world there are “no backs” as there are in tatonnement. If you enter into an exchange, you can’t nullify it, as is the case under tatonnement, just because the price you agreed on turns out not to have been an equilibrium price. For there to be a tatonnement path from the first equilibrium that converges on the second requires that monetary authority set its interest-rate instrument in the conventional, not the Neo-Fisherian, manner, using variations in the real interest rate as a lever by which to nudge the economy onto a path leading to a new equilibrium rather than away from it.
The very notion that you don’t have to worry about the path by which you get from one equilibrium to another is so bizarre that it would be merely laughable if it were not so dangerous. Kenneth Boulding used to tell a story about a physicist, a chemist and an economist stranded on a desert island with nothing to eat except a can of food, but nothing to open the can with. The physicist and the chemist tried to figure out a way to open the can, but the economist just said: “assume a can opener.” But I wonder if even Boulding could have imagined the disconnect from reality embodied in the Neo-Fisherian argument.
Having registered my disapproval of Neo-Fisherism, let me now reverse field and make some critical comments about the current state of non-Neo-Fisherian monetary theory, and what makes it vulnerable to off-the-wall ideas like Neo-Fisherism. The important fact to consider about the past two centuries of monetary theory that I referred to above is that for at least three-quarters of that time there was a basic default assumption that the value of money was ultimately governed by the value of some real commodity, usually either silver or gold (or even both). There could be temporary deviations between the value of money and the value of the monetary standard, but because there was a standard, the value of gold or silver provided a benchmark against which the value of money could always be reckoned. I am not saying that this was either a good way of thinking about the value of money or a bad way; I am just pointing out that this was metatheoretical background governing how people thought about money.
Even after the final collapse of the gold standard in the mid-1930s, there was a residue of metalism that remained, people still calculating values in terms of gold equivalents and the value of currency in terms of its gold price. Once the gold standard collapsed, it was inevitable that these inherited habits of thinking about money would eventually give way to new ways of thinking, and it took another 40 years or so, until the official way of thinking about the value of money finally eliminated any vestige of the gold mentality. In our age of enlightenment, no sane person any longer thinks about the value of money in terms of gold or silver equivalents.
But the problem for monetary theory is that, without a real-value equivalent to assign to money, the value of money in our macroeconomic models became theoretically indeterminate. If the value of money is theoretically indeterminate, so, too, is the rate of inflation. The value of money and the rate of inflation are simply, as Fischer Black understood, whatever people in the aggregate expect them to be. Nevertheless, our basic mental processes for understanding how central banks can use an interest-rate instrument to control the value of money are carryovers from an earlier epoch when the value of money was determined, most of the time and in most places, by convertibility, either actual or expected, into gold or silver. The interest-rate instrument of central banks was not primarily designed as a method for controlling the value of money; it was the mechanism by which the central bank could control the amount of reserves on its balance sheet and the amount of gold or silver in its vaults. There was only an indirect connection – at least until the 1920s — between a central bank setting its interest-rate instrument to control its balance sheet and the effect on prices and inflation. The rules of monetary policy developed under a gold standard are not necessarily applicable to an economic system in which the value of money is fundamentally indeterminate.
Viewed from this perspective, the Neo-Fisherian Revolution appears as a kind of reductio ad absurdum of the present confused state of monetary theory in which the price level and the rate of inflation are entirely subjective and determined totally by expectations.
Uneasy Money 
” The interest-rate instrument of central banks was not primarily designed as a method for controlling the value of money; it was the mechanism by which the central bank could control the amount of reserves on its balance sheet and the amount of gold or silver in its vaults.”
Lovely! You are tying it all together. With your old posts on the gold exchange standard, and the Bank of France. It’s all making sense now. Though it did presumably affect the value of money indirectly, by varying the world stock of gold and silver outside the vaults, and so what was left over to satisfy the “industrial demand”..
“…in the real world there are “no backs” as there are in tatonnement.”
I understand what you are saying there, but is “no backs” some sort of sporting term, like “no do-overs”, or “no Mulligans”?
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Great post JP. I found it really helpful to understand the Neo-Fischerian debate. Your point that we have no theoretical framework that explains the value of money is interesting as well.
Along those lines, I’m curious: it seems to me that the value of money today is tied to our expectation of the value of money tomorrow. In other words, each dollar buys a share of NGDP today (1/NGDP of it), and buys an share of expected NGDP tomorrow. If we could assume that real output was stable, and assume the central bank stabilized the level-path of NGDP, then we would know the future value of the dollar with certainty. So, in a world with an NGDP level targeting central bank, I think you could provide a firm theoretical basis for the present value of fiat currency. It buys you a predictably diminishing share of the total real output of the dollar-denominated economy.
Does that hang together?
Thanks,
-Ken
Kenneth Duda
Menlo Park, CA
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Sorry, you are David Glasner, not JP Koning. I got my favorite bloggers confused. Apologies!
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Thanks, Nick. Glad to see that we are on the same page. “No backs” is a term that I think I remember from when my daughters were in elementary school. As I recall it means that you can’t change your mind after you have made a deal with someone.
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Ken, No problem, we all get confused (at least I do) sometimes. My initial response is skepticism that ngdp targeting would pin down the value of money, at least in a strict causal sense. I think you would need some explicit mechanism of indirect convertibility such as I outlined in my book Free Banking and Monetary Reform. I think that Scott actually approves of the indirect convertibility idea.
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” Nevertheless, our basic mental processes for understanding how central banks can use an interest-rate instrument to control the value of money are carryovers from an earlier epoch when the value of money was determined, most of the time and in most places, by convertibility, either actual or expected, into gold or silver.”
This is a very important idea. It needs developing further. Central banks’ use of interest rates to control the value of fiat money is an anachronism. It’s like using reins to steer a car. And it draws a false analogy between central banks and commercial banks. But you can see how it must appear “natural” to central bankers, since it is what their predecessors did under the gold exchange standard, and what their counterparts do in commercial banks. But it isn’t natural at all, with inconvertible fiat money.
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Following up on our twitter exchange on how best to determine the value of money. I’ve done some work on the subject and would love to share if you have interest.
Prices are determined by supply and demand. In the case of money, the price is the interest rate. However, since money is denominated in itself, there is an ex-post identity between the supply and demand for money. Accordingly, we cannot observe directly the ex-ante demand for money. Instead, (per Keynes’ insight from the General Theory) an ex-ante imbalance between the supply and demand for money causes fluctuations in nominal incomes and asset prices as to enforce the ex-post identity.
This prompts another question – is the price for money right? In other words, is there an ex-ante equilibrium between the supply and demand for money at the prevailing market interest rates? Not necessarily. Due to banking and the exogenous nature of the monetary base, the market can accommodate any interest rate. If the interest rate is below the equilibrium rate, banks can meet excess demand for borrowing by creating bank money resulting in money supply in excess of ex-ante money demand and causing nominal incomes and prices (including asset prices) to increase above expectations. If the interest rate is above the equilibrium rate, there is a shortage of borrowing hence money supply comes below ex-ante demand for money causing nominal incomes and asset prices to decline below expectations. This variance between actual and expected outcomes initiates a feedback loop which is at the heart of the business cycle.
To assess whether the price of money is right (interest rate above or below equilibrium rate) one should look no further than the velocity of bank money (M2 less Monetary Base). Velocity is a measure of money demand. M2 Velocity is measure of both the asset and exchange motive while bank money velocity is a measure of only the exchange motive (money held for purposes of accommodating spending in the short-term). In a perfect world, the monetary base would equal the asset motive for money demand and bank money would equal the exchange motive for money demand. Rising bank money velocity indicates base money in excess of the asset motive for money demand, which pushes interest rates below the equilibrium rate. Falling bank money velocity indicates shortage of base money pushing interest rates above the equilibrium rate.
This line of reasoning requires a change in perspective in regards to Y=MV identity. The residual is Y not V.
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The textbooks always said we have a fiat monetary system. I always taught we have a fiat fiduciary money system. The government prints on the bill ONE DOLLAR. But its value is determined by the public. The quantity of goods and services exchanged for one dollar.
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This! This! This! This is what I meant with my earlier comments concerning Germany using ISLM – ISLM is directly from Keynes – concerning a Gold Standard world. The Germans still believe that the interest rate ‘shows’ whether money is easy or tight!
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I really enjoyed the article but got lost a bit at the end on the discussion of monetary policy under the gold standard.
You say: “The interest-rate instrument of central banks was not primarily designed as a method for controlling the value of money; it was the mechanism by which the central bank could control the amount of reserves on its balance sheet and the amount of gold or silver in its vaults”
I assume that the CB exchanged money for gold in order to stabilize the exchange rate between money and gold, and did this via adjustments to the interest rate – is that correct ?
If so – how did that enable it to control it own gold reserves ? Wouldn’t the size of gold reserves be a side-effect of its main target of stabilizing the value of its currency against gold ?
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Blog author: “According to the Neo-Fisherian Revolution, this was all wrong: the way to reduce inflation is for the monetary authority to reduce the setting on its interest-rate instrument and the way to counter deflation is to raise the setting on the instrument. That is supposedly why the Fed, by reducing its Fed Funds target practically to zero, has locked us into a low-inflation environment.”
If the author had any sense of history–he does link his background graphics to an old monetarist dude whose name escapes me–he would understand the Neo-Fisherian Revolution is nothing more than a pro-cyclical “real bills doctrine”. But the irony is that money is in fact neutral so regardless of what the Fed does, the market adjusts and finds its own levels.
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David & Kenneth, Jason Smith put up a post today related to a paragraph in your above post (that Kenneth commented on) that you might be interested in.
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“Once the gold standard collapsed, it was inevitable that these inherited habits of thinking about money would eventually give way to new ways of thinking, and it took another 40 years or so, until the official way of thinking about the value of money finally eliminated any vestige of the gold mentality….If the value of money is theoretically indeterminate, so, too, is the rate of inflation.”
On indeterminacy, I thought we worked this all out on these posts:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/04/from-gold-standard-to-cpi-standard.html
If the value of money wasn’t indeterminate while on a gold standard, why would it be indeterminate on a CPI standard? (Assuming that under the latter, a central bank must commit to hit its inflation target.)
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“For there to be a tatonnement path from the first equilibrium that converges on the second requires that monetary authority set its interest-rate instrument in the conventional, not the Neo-Fisherian, manner, using variations in the real interest rate as a lever by which to nudge the economy onto a path leading to a new equilibrium rather than away from it.”
I didn’t read Nick’s post closely, but this is surely the crux of the critical intuition.
And it’s almost embarrassing to think that one needs to juxtapose “critical” with “intuition” in this case – where the problem should be self-evident through a bit of common sense about how the prevailing policy approach works now – as the starting point for any change to it.
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JP, That was a long time ago (over three years is a long time), so I hardly even recognize what I wrote in the post that you linked to (not that I retracting anything I said, but I would have to read it over carefully before I could say that I still agree with it in detail). You need to explain to me how you think this was all worked out and what it means for a central bank to be committed to hitting its inflation target.
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Nick, So I think that this line of thought is bringing us back to your distinction between alpaha banks and beta banks. Under a gold standard, even central banks were beta banks. In a world in which there nothing external to link the value of money created by the central bank to, how can the central bank control the value of what it creates? Conventional monetary theory has not really addressed that question in a satisfactory way.
H Publius, The interest rate may serve as the price of money in a certain limited sense, but the interest rate is not determined by the supply of and demand for money. That is where Keynes got himself terribly confused. And your assertion that there is an ex-post identity between the supply of and demand for money, with the implication that this ex-post identity tells us something empirically useful about the world, suggests to me that your macroeconomic theory is also confused. I’m afraid that it will take me a while to follow the specifics of your argument, but for starters it’s not at all clear to me why assume that a change in velocity is evidence of a disequilibrium. If the demand for money rises, and the banks respond by increasing the quantity of money to match the increase in demand, observed velocity would go down, and there would be no disequilibrium.
Robert, Sorry but I can’t figure out what point you are trying to make.
Jean, The idea that the interest rate is an indicator of whether money is easy or tight was not invented by Keynes. It preceded Keynes by well over a century.
Rob, You said:
“I assume that the CB exchanged money for gold in order to stabilize the exchange rate between money and gold, and did this via adjustments to the interest rate – is that correct ?”
The CB exchanged money for gold at a fixed exchange rate, because it was under a legal obligation to do so under the gold standard. I don’t know what you mean when you say: “and did this via adjustments to the interest rate.” What is “this?”
Try thinking of it this way. If a bank raises the interest rate it’s charging borrowers, the rate at which it is making new loans will rise and the rate at which old loans are being paid off will increase. So the bank will be experiencing a net inflow of funds, which will be associated with an increase in the amount of gold reserves in its vault.
Ray, You can find the name under the title of the blog.
Is your assertion that money is in fact neutral meant as an empirical law, like, say, the second law of thermodynamics or as a statement about monetary theory?
The real bills doctrine is actually a heading for a number of distinct theoretical propositions that are not necessarily equivalent. It would be helpful if you would specify exactly which version of the real-bills doctrine you are referring to.
Tom, Thanks for the link. I’ll try to have a look.
JKH, Sorry, but your comment is just a tad too subtle for me to comprehend.
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David, a key bit from Jason’s post is this:
“…at some point e.g. the world will end and there won’t be a greater sucker, the expected value [of fiat money] should be zero today. Note that the idea of the future rushing into the present is a general problem of expectations… Now I think the information transfer framework* gives us a way to invert that value argument — that if you don’t accept money, you are the greater sucker. The argument creates a stable system of fiat currencies.”
*The “information transfer framework” is the one that Jason is the author of (adapting a more general model of “information transfer” in physical and social systems to economics).
Anyway, that’s what I found interesting.
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David, in his post, Nick used an interesting series of portraits that “slid” from a gold standard to our modern fiat standard, implying that the monetary theory used to explain the first is just as relevant as the second.
You disagreed with him, pointing out that a modern central bank lacks a precise legal obligation to engage in a specific set of transaction whereas a central bank operating under a gold standard is burdened by such an obligation. However, as you both pointed out in the comments of your response, if the modern central bank were to directly target a futures contract for something like CPI, then it inherits the same legal obligation as a gold standard bank.
Which brings things back full circle, a central bank operating on a CPI standard (that requires it to carry out a specific set of transactions) is very much like a central bank on the gold standard. Since the price level under the latter was determinate, isn’t the price level under the former determinate?
In any case, I don’t want to belabour this point since the key message in your post concerns neo-Fisherianism and I’m only pushing the conversation further away from that topic.
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JP, Yes, I think that some sort of indirect convertibility via a futures contract, an arrangement Earl Thompson thought up over 30 years ago, which I described in my book Free Banking and Monetary Reform, would work. No central bank has ever adopted such as system, and I am not optimistic that a central bank ever will. Hence, the very negative tone of this post. Aside from you, me, Nick Rowe, Scott Sumner, and maybe five other people, no one seems to get it.
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David,
Thanks for the explanation. When you say “If a bank raises the interest rate it’s charging borrowers, the rate at which it is making new loans will rise and the rate at which old loans are being paid off will increase” – (not to be pedantic but just to make sure I understand) did you mean “the rate at which it is making new loans will fall” rather than ” the rate at which it is making new loans will rise” ?
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“If the value of money wasn’t indeterminate while on a gold standard, why would it be indeterminate on a CPI standard? (Assuming that under the latter, a central bank must commit to hit its inflation target.)”
Does the USA have a CPI standard or a CPI target?
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Same question as Rob at 8:38.
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Rob, Sorry, poor choice of words on my part. I meant to say that if a bank raises the interest rate it’s charging borrowers it will be lending less money than it was before while loans will be paid back more rapidly than they were before.
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Target. See my reply to Rob.
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I would like to go over the target part in a little more detail.
Assume there is a gold standard. There is a fixed exchange rate between gold and currency. It will stay there. The reserve requirement for gold to currency is 100%. The reserve requirement will stay there. The price inflation target is 2%.
Assume gold starts growing by 10% per year causing price inflation to be 7% per year.
What the central bank really needs is for gold to grow by 5% per year causing price inflation to be 2% per year.
Other than the gold amount being unrealistic, are the mechanics correct?
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Very interesting post, which analyze for me what I saw intuitively first time I read about it. Intuition is not academically correct, sure, but sometimes it should be the fist proof of sanity. Because I don’t see much of it in all that.
“The Neo-Fisherians believe that, by way of this insight, they have overturned at least two centuries of standard monetary theory, dating back at least to Henry Thornton, instructing the monetary authorities to raise interest rates to combat inflation and to reduce interest rates to counter deflation. According to the Neo-Fisherian Revolution, this was all wrong.”
Strong, indeed. In any case, thanks to you David and Nick Rowe
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My theory of the NFers, is that they’ve simply come up with a shrewd and novel way to dress up an old demand-to raise interest rates-in new bottles.
Basically Krugman’s inflationphobes who for years were warning us to raise interest rates less we be overwhelmed by inflation are now calling themselves NFers and warning us to raise interest rates less we be overwhelmed by lowflation.
A very clever change of wardrobe for the same exact policy.
http://lastmenandovermen.blogspot.com/2015/08/have-inflationphobes-learnt-anything-in.html
But what Krugman misses is that the inflationphobes have learnt something-to change their rationale for raising interest rates. At the end of the day, though, they just want higher interest rates because they believe that ZIRP rates are ‘not normal.’
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Fed Up, You can’t have both an inflation target and a fixed gold price unless the monetary authority has a sufficiently large available stock of gold and enough resources at its disposal to control the supply of and demand for gold to make the value of gold correspond to the desired inflation rate.
Miguel, Thank you.
Mike, You may be right, but I am not going to try to guess what their motives are.
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That’s my thing-I like to have a motive. For me to have no theories as to motive is somehow unsatisfying,
But you can follow it etymologically. Stephen Williamson and John Cochrane warned many times about galloping inflation and now they are warning about lowflation due to low interest rates.
What’s interesting is that the policy prescription never changes.
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Look at it this way. Economists say that ‘All models are wrong but some are useful’; I think my speculation works in this way. If you proceed as if this is what NF comes down to it explains a lot even if it is an oversimplification.
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Ok my last observation: it’s intersting that the rise of the NFers has led to Woodford and company suddenly doubting Rational Expectations.
http://www.themoneyillusion.com/?p=30042
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“Fed Up, You can’t have both an [price] inflation target and a fixed gold price unless the monetary authority has a sufficiently large available stock of gold and enough resources at its disposal to control the supply of and demand for gold to make the value of gold correspond to the desired inflation rate.”
Make gold a medium of exchange. Now replace gold with demand deposits from solvent commercial banks. Lastly, have a central bank that is ECB-like. I’d say that is pretty close to how the system works now. The reserve requirement may not be 100%.
There is a demand deposit of the solvent commercial banks standard with a 2% price inflation target.
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David: a rather belated follow-up post by me:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2015/08/interest-rate-control-as-beta-anachronism.html
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Mike, I have no problem with your theorizing about motivations, but I would have to be more interested in the theory or theorists than I am to be interested in the motivation for neo-Fisherism.
Fed Up, Sorry, but I really can’t understand what you are saying.
Nick, Thanks for taking the trouble to follow-up. I had a quick look, but I have been busy with other stuff and struggling to write my latest post on Romer and Lucas. Otherwise, I might have weighed in with a comment on your blog. Sorry about that.
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OK. I will try again.
Demand deposits of solvent commercial banks are just like gold in a gold standard. They can be redeemed for currency at a fixed exchange rate. So if demand deposits of solvent commercial banks start growing too fast there will be price inflation in terms of demand deposits ***and*** currency.
I will try this way too. Demand deposits of solvent commercial banks starting growing a lot causing a lot of price inflation in terms of demand deposits. Entities do not like this and try to redeem the demand deposits for currency hoping they are in less supply (less price inflation). If the commercial banks are solvent, the central bank will make an open-ended and unconditional commitment to act as a lender of last resort to maintain the fixed exchange rate by increasing the supply of currency. The supply of currency goes up so price inflation in terms of demand deposits and currency are the same. It is not like a foreign currency where the peg is one way. It is both ways.
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Demand deposits of solvent commercial banks are not just like gold in a gold standard. Gold has non-monetary uses, demand deposits have no non-monetary use. The value of gold is determined by the supply of and demand for gold. The value of demand deposits is determined by a promise to maintain a one-to-one conversion rate. Those are big differences. If too many demand deposits are created by banks (i.e., more demand deposits are created than the public is willing to hold), the issuing banks will have a problem remaining solvent. The value of gold is not necessarily affected. The value of gold is affected by the quantity of demand deposits created only insofar as people choose to hold demand deposits instead of gold thereby reducing the demand for gold. So your whole premise is fallacious.
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To make my point, I would want to start by assuming there is no non-monetary use for gold. I want to assume gold and demand deposits have only two uses, as a savings vehicle and as a exchange vehicle. I can add the non-monetary use back in if necessary.
“The value of demand deposits is determined by a promise to maintain a one-to-one conversion rate.”
1) What about the assets?
2) Is the conversion rate promise both ways?
Those two bring me to:
“If too many demand deposits are created by banks (i.e., more demand deposits are created than the public is willing to hold), the issuing banks will have a problem remaining solvent.”
Are you saying there would be a bank run?
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Fed Up, You said:
“I would want to start by assuming there is no non-monetary use for gold. I want to assume gold and demand deposits have only two uses, as a savings vehicle and as a exchange vehicle. I can add the non-monetary use back in if necessary.”
If that’s what you want to do, fine. But then you have to explain why gold has any value. If it’s not providing real non-monetary services now or in the future, then it’s not clear how it has any present value. Demand deposits are valuable because they are convertible into something that is valuable. Why is gold valuable? If you can’t explain to me what gives gold value other than providing some real non-monetary service, then this discussion is going nowhere.
You asked:
“1) What about the assets?
2) Is the conversion rate promise both ways?”
I don’t understand what question 1) means. I also don’t understand what “both ways” means. A bank providing demand deposits is promising to convert a deposit into currency at the rate of 1 unit of currency per unit of deposits a unit of deposits into a unit of currency.
You asked:
“Are you saying there would be a bank run?”
I’m saying that a bank that has created more deposits than the public wants to hold will find that its asset portfolio will shrink as holders of deposits or other banks which receive those deposits from customers will want to cash in their claims on the overissuing bank. That’s not a bank run, but if it doesn’t allow its excess deposits to be drawn down, but continues to create excess deposits, it will continue to find that its assets are being drained and its solvency may be impaired. So the bank, in its own self-interest, cannot go on creating more deposits than the public wants to hold.
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Maybe I did not say that correctly.
One economy has gold and currency. I want to assume gold and currency have only two uses, as a savings vehicle and as an exchange vehicle. An exchange vehicle means both gold and currency are medium of exchange. Gold and currency have a permanent fixed exchange rate.
Another economy has demand deposits and currency. I want to assume demand deposits and currency have only two uses, as a savings vehicle and as an exchange vehicle. An exchange vehicle means both demand deposits and currency are medium of exchange. Demand deposits and currency have a permanent fixed exchange rate.
“I also don’t understand what “both ways” means. A bank providing demand deposits is promising to convert a deposit into currency at the rate of 1 unit of currency per unit of deposits a unit of deposits into a unit of currency.”
Both ways means if the commercial bank(s) is/are solvent, the central bank will not allow there to be a shortage of currency so the 1 to 1 fixed exchange rate remains intact. In other words, if there is a bank run on solvent commercial bank(s), the central bank will act as a “lender of last resort” of currency to the commercial bank(s) by increasing the supply of currency so the commercial bank(s) do not have to sell assets.
“I’m saying that a bank that has created more deposits than the public wants to hold will find that its asset portfolio will shrink as holders of deposits or other banks which receive those deposits from customers will want to cash in their claims on the overissuing bank.”
I need to know what “cash in their claims” means.
I may have left out a detail. These extra demand deposits were created to purchase new bonds/loans from the private sector (private debt has increased) so the private sector issuers can purchase goods/services and/or financial assets. I thought that was understood.
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Fed Up, I am still not understanding you. How did we get two economies?
You said:
“One economy has gold and currency. I want to assume gold and currency have only two uses, as a savings vehicle and as an exchange vehicle. An exchange vehicle means both gold and currency are medium of exchange. Gold and currency have a permanent fixed exchange rate.”
You can’t assume that gold has a value and provides no current or future use and claim that it has a positive value. If you insist on doing so, I give up.
You said:
“I need to know what “cash in their claims” means.”
It means that they demand that they present the liabilities of the bank to the bank (directly or via a clearinghouse) to be redeemed in terms of whatever instrument the bank has promised to redeem its liabilities in.
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“It means that they demand that they present the liabilities of the bank to the bank (directly or via a clearinghouse) to be redeemed in terms of whatever instrument the bank has promised to redeem its liabilities in.”
There are too many demand deposits because private debt increases. Entities cash them in for currency. The bank does not have enough currency. The bank is solvent (the assets/loans are/will perform). The bank goes to the central bank for a “loan” of currency. The central bank does its elastic currency/lender of last resort function for a solvent bank to maintain the 1 to 1 fixed exchange rate even if that causes price inflation to go above target. The bank does not sell assets.
“You can’t assume that gold has a value and provides no current or future use and claim that it has a positive value. If you insist on doing so, I give up.”
Let’s start with an economy where gold is MOA and MOE. Gold has no “jewelry” use and no industrial use. It is a candy bar economy. The price of the candy bar is 1 oz of gold (MOA). The store accepts gold (MOE). I have 1 oz of gold and spend it on 1 candy bar. I exchange 1 oz of gold for 1 candy bar. There is a total of 100 oz of gold with a velocity of 2 so that with a price of 1 oz of gold 200 candy bars are sold.
Next, add currency with a permanent fixed exchange rate of $1 = 1 oz of gold. Half of the gold gets converted to currency with the same velocity. There are 50 oz of gold and $50 of currency. The price of the candy bar is 1 oz of gold (MOA) or $1 of currency (MOA). The store accepts gold (MOE) or currency (MOE). There is a total of 50 oz of gold with a velocity of 2 so that with a price of 1 oz of gold 100 candy bars are sold. There is a total of $50 of currency with a velocity of 2 so that with a price of $1 of currency 100 candy bars are sold.
200 total candy bars are sold in both cases. I have tried to set up a scenario where both gold and currency have the same value and use. Is there any reason currency and gold can’t have the same value and use?
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Fed Up, You said:
“There are too many demand deposits because private debt increases. Entities cash them in for currency. The bank does not have enough currency. The bank is solvent (the assets/loans are/will perform). The bank goes to the central bank for a “loan” of currency. The central bank does its elastic currency/lender of last resort function for a solvent bank to maintain the 1 to 1 fixed exchange rate even if that causes price inflation to go above target. The bank does not sell assets.”
The only criterion for there being too many demand deposits is the unwillingness of the public to hold the amount of demand deposits that the banks have created. Such a situation can arise for reasons that have nothing to do with the amount of private debt. If banks borrow from the central bank, they are indebted to the central bank and will have to discharge their liabilities to the central bank rather than to holders of deposits.
You said:
“Let’s start with an economy where gold is MOA and MOE. Gold has no “jewelry” use and no industrial use. It is a candy bar economy. The price of the candy bar is 1 oz of gold (MOA).”
I told you already that I am not discussing a gold standard with you if you assert that gold has no real current of future use. If you insist on making that assumption, then you are saying that gold is fiat money. I am not interested in having a conversation with you about gold when what you are talking about is fiat money.
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I wanted to do the gold fiat as an example. Next, I wanted to drop the gold part and replace it with demand deposits from solvent commercial banks.
I want there to be a demand deposit of the solvent commercial banks standard (a permanent 1 to 1 fixed exchange rate). The central bank promises to keep currency 1 to 1 convertible. The solvent commercial banks promise to keep demand deposits 1 to 1 convertible. If I have that backwards, then flip them. The currency supply is basically unlimited. The supply of demand deposits from solvent commercial banks is unlimited. Then I want entities to “mine gold” (create demand deposits) by borrowing from the commercial banks.
“The only criterion for there being too many demand deposits is the unwillingness of the public to hold the amount of demand deposits that the banks have created. Such a situation can arise for reasons that have nothing to do with the amount of private debt. If banks borrow from the central bank, they are indebted to the central bank and will have to discharge their liabilities to the central bank rather than to holders of deposits.”
If commercial banks borrow from the central bank, I can’t imagine any scenario where the central bank would require repayment of the liabilities in currency and cause the commercial banks into forced asset sales.
If there are too many demand deposits than the public is willing to hold, the public “cashing in their claims” for currency will probably not help because the central bank will create more currency to maintain the fixed 1 to 1 exchange rate. In other words, the central bank will hold the demand deposits the public does not want. The public is most likely going to end up holding more currency than it wants.
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Fed Up, You said:
“I wanted to do the gold fiat as an example.”
An example should clarify, treating gold as fiat money was a confusing distraction.
“Next, I wanted to drop the gold part and replace it with demand deposits from solvent commercial banks.”
So your focus is on how the banking system operates. Fair enough, gold has nothing to do with how the banking system operates.
“I want there to be a demand deposit of the solvent commercial banks standard (a permanent 1 to 1 fixed exchange rate).”
You don’t have to want it, that’s the legal definition of a demand deposit.
“The central bank promises to keep currency 1 to 1 convertible. The solvent commercial banks promise to keep demand deposits 1 to 1 convertible. If I have that backwards, then flip them.”
I don’t know what point you think you are making here. The legal definition of a demand deposit is what it is. The central bank makes no commitment to the solvency of commercial banks. They exercise their discretion in lending to private banks. Deposit insurance is provided by the government, but it does not provide an absolute guarantee; not all deposits are ensured.
“The currency supply is basically unlimited. The supply of demand deposits from solvent commercial banks is unlimited.”
I don’t know what this means, other than that there is no numerical maximum on the amount of currency or demand deposits that are created. That does not mean that there is an unlimited supply.
“Then I want entities to “mine gold” (create demand deposits) by borrowing from the commercial banks.”
Stop the confusing gold-talk already!
“If commercial banks borrow from the central bank, I can’t imagine any scenario where the central bank would require repayment of the liabilities in currency and cause the commercial banks into forced asset sales.”
Are you saying that commercial banks get to borrow from the central bank but don’t have to repay their loans? I can’t imagine any scenario in which the central bank lends to commercial banks but banks don’t have to repay those loans.
“If there are too many demand deposits than the public is willing to hold, the public “cashing in their claims” for currency will probably not help because the central bank will create more currency to maintain the fixed 1 to 1 exchange rate.”
There is a routine mechanism by which excess deposits are withdrawn from circulation. The public is constantly repaying their loans from the bank. As they do, excess deposits are being extinguished. In making new loans banks are estimating how many deposits they can expect their customers to keep in their bank accounts and that determines the volume of new loans that they will be making. That’s what keeps the stock of demand deposits roughly in balance with the public’s demand to hold demand deposits.
“In other words, the central bank will hold the demand deposits the public does not want. The public is most likely going to end up holding more currency than it wants.”
No, the demand deposits that the public does not want are extinguished as the public pays back their outstanding loans from the banks, and banks estimate how many new loans they can make without suffering a drain on their assets as a result of adverse clearings at the Fed clearinghouse.
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“An example should clarify, treating gold as fiat money was a confusing distraction.”
“So your focus is on how the banking system operates. Fair enough, gold has nothing to do with how the banking system operates.”
I am trying to show the importance of a fixed permanent exchange rate. Let me try this way. Are demand deposits of the commercial banks both medium of account (MOA) and medium of exchange (MOE), just like currency?
On 1 to 1 convertibility and unlimited supply of currency, the point is if the number of demand deposits goes up, the amount of currency could go up too. The fixed exchange rate is maintained. It is not like gold and currency where you wanted to adjust the exchange rate.
“There is a routine mechanism by which excess deposits are withdrawn from circulation. The public is constantly repaying their loans from the bank. As they do, excess deposits are being extinguished. In making new loans banks are estimating how many deposits they can expect their customers to keep in their bank accounts and that determines the volume of new loans that they will be making. That’s what keeps the stock of demand deposits roughly in balance with the public’s demand to hold demand deposits.”
And, “No, the demand deposits that the public does not want are extinguished as the public pays back their outstanding loans from the banks, and banks estimate how many new loans they can make without suffering a drain on their assets as a result of adverse clearings at the Fed clearinghouse.”
I agree demand deposits can be used to repay the principal of loans. I don’t think I agree with some of the other points. If there are too many demand deposits, entities could exchange them for currency. They could also spend them on goods/services, probably driving up quantities and prices.
Let me try it this way. No entity wants demand deposits. Now I want to get an interest-only mortgage loan. I am able to. I have to accept demand deposits (liability of the commercial bank). I immediately convert the demand deposits to currency. The bank does not have enough currency. They go to the central bank. It agrees the commercial bank is solvent. They grant the request for currency (maintaining the fixed exchange rate of 1 to 1). The central bank buys the liability of the commercial bank (the demand deposit) and sells currency. I spend the currency. Now there is more currency circulating in the real economy, probably pushing up quantities and prices. The central bank will do this even if it means prices of goods/services rise above target. I think I am talking about maturity mismatch here.
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Fed Up, You ask:
“Are demand deposits of the commercial banks both medium of account (MOA) and medium of exchange (MOE), just like currency?”
Demand deposits are a medium of exchange. Since their value is derived solely from being convertible into currency, I would say that they are not a medium of account.
You said:
“If there are too many demand deposits, entities could exchange them for currency. They could also spend them on goods/services, probably driving up quantities and prices.”
If excess demand deposits are spent rather than held, the banks making the loans that created them will not earn the expected profit from making loans and will thus reduce the amount of loans they are making. So the effect on prices will be minimal and transitory.
I suggest you read James Tobin’s essay “Commercial Banks As Creators of Money” http://cowles.yale.edu/cfdp-159.
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“Demand deposits are a medium of exchange. Since their value is derived solely from being convertible into currency, I would say that they are not a medium of account.”
That is what I thought. That is what my “gold fiat” example you dislike so much was trying to show.
The general principle I am trying to demonstrate is that if something is MOA and something else has a fixed exchange rate to it, that something else also becomes MOA (dual MOA).
Let me try this way. Green “currency” is MOA, MOE, and fiat “money”. There is $1 trillion of it with a velocity of 2. NGDP = $2 trillion.
Now introduce blue “gtu” that is MOE and fiat “money”. Next, have a permanent 1 to 1 fixed exchange rate between currency and gtu. Assume the same velocity of 2 for gtu. Now create $6 trillion of it. Prices in terms of gtu start rising. People do not like this. They exchange gtu for currency hoping prices will not rise in terms of currency. To maintain the fixed exchange rate, more currency needs to be created. All of the gtu gets converted. $6 trillion more of currency gets created. $7 trillion with a velocity of 2 means NGDP = $14 trillion with most of that being a rise in prices.
Entities discover that prices in terms of currency and gtu are the same. There is a dual MOA. It is not like a foreign currency with a one-way peg to the dollar.
I think I have this the right way. If not, flip it. The commercial bank promises to keep the fixed exchange rate between demand deposits and currency so demand deposits do not rise in value. The central bank promises to keep the fixed exchange rate between demand deposits and currency so demand deposits do not fall in value.
Now replace gtu with demand deposits from solvent commercial banks.
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Fed Up, Why should I care whether your general principle is true or not?
I am sorry, but I really can’t follow what you are saying in the last 5 paragraphs of your comment.
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“Fed Up, Why should I care whether your general principle is true or not?”
The reason is because you told me demand deposits from solvent commercial banks are MOE, but not MOA.
I am showing they are both MOA and MOE. I am pretty sure that changes how the system works.
1) Demand deposits are MOE, but not MOA
2) Demand deposits are MOE and MOA
Won’t those two systems work differently?
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Fed Up, I suggest you read Nick Rowe on the difference between alpha banks and beta banks. You have not demonstrated that the central bank is obligated to maintain the convertibility of demand deposits into currency. You have just shown that sometimes the central banks lends to commercial banks that lending is provided at the discretion of the the central bank not as a legal obligation to keep currency convertible into the demand deposits of any bank. You just keep going over the same point over and over again.
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“Fed Up, I suggest you read Nick Rowe on the difference between alpha banks and beta banks.”
I’ll check.
“You have not demonstrated that the central bank is obligated to maintain the convertibility of demand deposits into currency. You have just shown that sometimes the central banks lends to commercial banks that lending is provided at the discretion of the the central bank not as a legal obligation to keep currency convertible into the demand deposits of any bank.”
What about elastic currency (Federal Reserve Act) and/or lender of last resort?
“You just keep going over the same point over and over again.”
Yep. I consider saying demand deposits of solvent commercial banks are not MOA as one of the huge mistakes almost all economists make.
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I tried to find out about alpha and beta banks. Here is my impression. Gold was alpha at one time, and central banks were the beta. Drop the gold standard. Central banks are alpha, and commercial banks are beta. The commercial banks somehow work to keep the value of demand deposits near the value of the monetary base.
I found this:
“What is it that makes the BoC, and not BMO, the one that chooses Canadian monetary policy? How come it is the BoC that chooses and implements the 2% inflation target, and not BMO choosing and implementing whatever target it is that BMO would choose?
This is my answer: Because it is BMO that makes the commitment to peg its dollar to the BoC dollar, and not the BoC that makes the commitment to peg its dollar to the BMO dollar. It’s an asymmetric peg. Just like if the US Fed decided to peg the US dollar to the Canadian dollar, and the BoC made no such commitment in return, but did whatever it wanted to do, then US monetary policy would be set in Ottawa. That’s what makes BoC the alpha bank and BMO the beta bank. The alpha bank chooses the direction for its money, and the beta bank just follows along.
But if there’s a run on the BMO, and the BoC steps in to act as lender of last resort, their roles are temporarily reversed. It is now the BoC that does what is needed to ensure the exchange rate remains fixed at one-to-one.
If the BoC’s commitment to act as lender of last resort to BMO were open-ended and unconditional, then BMO would become the alpha bank, and Canadian monetary policy would be set in Montreal Toronto, and not in Ottawa any more. BMO could do whatever it likes with its dollar, and the BoC would just follow along.
The only reason this does not happen is that the BoC’s commitment to act as lender of last resort to BMO is not open-ended and unconditional. The BoC would insist that BMO get its act together soon, or shrink its balance sheet, or have its balance sheet forcibly shrunk.”
I am going to say that if the commercial bank(s) is/are solvent, then the BoC’s commitment to act as lender of last resort to BMO is open-ended and unconditional. Both BMO and BoC are “alpha” banks, and usually “monetary policy” is carried out by the commercial bank(s).
Demand deposits are both MOA and MOE.
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“This is my answer: Because it is BMO that makes the commitment to peg its dollar to the BoC dollar, and not the BoC that makes the commitment to peg its dollar to the BMO dollar. It’s an asymmetric peg.”
I am going to say it is BMO that makes the commitment to peg its “dollar” to the BoC “dollar”, and the BoC makes the commitment to peg its “dollar” to the BMO “dollar” if BMO is solvent. It is not an asymmetric peg.
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Fed Up, The peg is aymmetric because because the BMO’s solvency depends on its commitment to maintain the peg. The BoC’s solvency does not depend on maintenance of the peg, so it is within the discretion of the BoC to lend to the BMO or not. BMO has not discretion about maintaining the peg.
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I am not sure I am completely getting your 12:52 comment.
“The peg is aymmetric because because the BMO’s solvency depends on its commitment to maintain the peg.”
I believe solvency depends on how well the loans perform in nominal terms. If price inflation rises above target and is distributed well enough, the loans should keep on performing in nominal terms. There is probably maturity mismatch.
“The BoC’s solvency does not depend on maintenance of the peg, so it is within the discretion of the BoC to lend to the BMO or not.”
Assume the commercial bank(s) is/are solvent with no asset/loan sales. The loans cause price inflation in terms of demand deposits to go above the price inflation target. All entities want to convert demand deposits to currency. This could lead to forced asset/loan sales and insolvency of the commercial bank(s).
The central bank is going to perform its lender of last resort function with the only discretion being how well the assets/loans perform with lender of last resort help. It is not going to allow (nor should it allow) maturity mismatch to cause insolvency even if price inflation goes above target.
The central bank will “lend” to the commercial bank and maintain the fixed peg.
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http://newmonetarism.blogspot.com/2011/11/ecb-and-last-resort-lending.html
“What is a lender of last resort? A key role for a central bank of course, is in acting as a lender-of-last-resort to the private banking system. The conventional view of banking is that the key function of banks – transforming illiquid assets into liquid liabilities – leaves an individual bank open to runs. According to the standard logic an otherwise sound bank could fail due to an illiquidity problem. Depositors run to the bank to withdraw their deposits under the assumption that everyone else will do so. The bank is unable to sell its assets at their “full value” so as to satisfy withdrawal demand, and it fails. However, a central bank willing to accept the bank’s assets as collateral can lend to the bank, allowing deposits to be converted into currency, and this can quell the panic. In a full-blown systemic financial panic, the central bank can extend this credit to the entire banking system.
The key problems for a central bank are in determining what will qualify as eligible collateral for a central bank loan, what the haircut might be on such collateral, and at what rate the central bank should lend. Moral hazard comes into play, and central banks are leery of extending the lives of banks which are actually insolvent and not simply illiquid.”
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Fed Up, My assertion that the solvency of the BMO depends on its commitment to maintain the peg to the currency issued by the BoC was not quite exact. Obviously, financial intermediaries can create liabilities and remain solvent with pegging those liabilities to a currency. So what I meant was that those liabilities can serve as a widely accepted medium of exchange only if financial intermediary maintains the peg. My point is that the acceptability of the BoC’s currency does not at all depend on its being pegged to the deposits created by the BMO. The BoC may have reasons of its own for assisting the BMO in keeping its deposits pegged to the currency of the BoC, but it is up to the discretion of the BoC to provide such assistance. That assistance does not affect the acceptability of BoC currency as a medium of exchange. So the peg is very much an asymmetric peg. I am assuming that you think the quote from Williamson about the lender of last resort in some way conflicts with what I said, but I don’t know why you would think that.
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I believe nick tried to use foreign exchange as an example.
I am going to put together a mostly realistic scenario.
Assume there is a store right on the border of the USA and Mexico. Now have the Mexican peso pegged to the dollar. The dollar is not pegged to the peso. It is an asymmetric peg.
The price of a candy bar is $1 or 1 peso. Now have something kind of monetary shock so the price of candy bar goes to 1.20 pesos. The dollar price need not change by the same amount. The candy bar goes to $1.02.
Now have something kind of monetary shock so the price of the candy bar goes to $1.20. The peso price should need to change to 1.20 pesos. Asymmetric peg.
Next, the price of a candy bar is $1 of currency or $1 of demand deposits so that demand deposits are in the “Mexican peso position”. Now have something kind of monetary shock so the price of candy bar goes to $1.20 in demand deposits. The dollar price does change by the same amount. The candy bar goes to $1.20 in currency.
Now have something kind of monetary shock so the price of the candy bar goes to $1.20 in currency. The demand deposit price should need to change to $1.20. Symmetric peg.
That symmetric peg is what is seen in the real world. Excluding fees, I have never seen currency and demand deposits have a different price. The commercial banks make loans and try to stay solvent. They only worry about interest rates and do not worry about the fixed exchange rate unlike the peso example. If prices go above target, they happen in terms of demand deposits and currency.
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“However, a central bank willing to accept the bank’s assets as collateral can lend to the bank, allowing deposits to be converted into currency, and this can quell the panic. In a full-blown systemic financial panic, the central bank can extend this credit to the entire banking system.”
“That assistance does not affect the acceptability of BoC currency as a medium of exchange. So the peg is very much an asymmetric peg. I am assuming that you think the quote from Williamson about the lender of last resort in some way conflicts with what I said, but I don’t know why you would think that.”
I agree “that assistance does not affect the acceptability of BoC currency as a medium of exchange”. It would affect prices.
Converting all demand deposits to currency means prices should be the same in terms of demand deposits and currency unlike the peso example above.
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Fed Up,
Your peso-dollar example is simply irrelevant. The Mexcian government or monetary authority can target an exchange rate with the dollar as it pleases, but it is under no contractual obligation to do so. Allowing the dollar-peso exchange rate to vary would therefore not imply any default on its contractual obligation as would a failure to pay interest on its outstanding sovereign debt. The legal definition of a bank deposit is an obligation by the bank to convert a deposit into a specified currency at the demand of the deposit holder or someone designated by the deposit holder to receive payment from his deposit account. You don’t seem to understand the difference between an “asymmetric peg” and a contractual obligation.
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Would the fed ever allow the contractual obligation of the demand deposits of commercial banks to be broken because the demand for demand deposits fell and the demand for currency rose along with a shortage of currency (maintain an asymmetric peg)?
Never mind. This is my last post on this. You are hopelessly stuck in a gold standard state of mind.
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Fed Up, Well thanks for putting up with me for so long. You are probably not the only one who thinks I am hopeless, but you may be the only one who thinks I am hopeless because I am excessively attached to the gold standard.
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