Milton Friedman said (somewhere) that money is like a refrigerator. Both are consumer durables that yield a flow of services to their possessor.
But in one important way that is a very bad analogy. Money is a medium of exchange, and refrigerators aren't. The stock of money, and the stock of refrigerators, are determined in very different ways.
What determines the stock of refrigerators held by the public? The short answer is: supply and demand. What determines the stock of money held by the public? The short answer is: supply. The suppliers of money, whether those be central banks, commercial banks, or counterfeiters, can force people to hold more money than they wish to hold. The suppliers of refrigerators can't.
There is an important sense in which all increases in the stock of money are like helicopter operations. The helicopter increases the stock of money without first persuading us we want to hold more money. We pick up the money whether we want to hold it or not. We plan to exchange that unwanted money for something we do want to hold. Friedman's refrigerator metaphor conflicts with his helicopter metaphor.
The modern debate over Quantitative Easing is a rehash of the very old debate over the Law of Reflux.
Start in equilibrium, where the existing stock of refrigerators in public hands (i.e. not counting inventories held by fridge producers) is exactly equal to the desired stock. And then the producers of refrigerators want to increase that stock.
Suppose, for example, the fridge producers have an inventory of 100 fridges in stock, that they suddenly decide they want to sell. In other words, the demand curve for fridges stays the same, but the supply curve shifts right by 100 fridges. In order to sell that extra 100 fridges, the producers will need to lower the price, in order to increase the desired stock of fridges by 100. If they don't lower the price, and if nothing else changes to increase the quantity of fridges demanded, they will fail to increase the stock of fridges at all.
Take an extreme example. Suppose the demand curve for fridges is perfectly inelastic. Every household wants to own exactly one fridge, regardless of the price of fridges and anything else. If each household were already owning one fridge, it would be totally impossible for the producer to increase the stock of fridges in public hands. You wouldn't be able even to give them away. Any extra fridges would be left lying on the sidewalk.
The actual change in the stock of fridges is determined by the short side of the market: new fridges sold equals whichever is less: additional quantity demanded; additional quantity supplied. Let Q be the stock of fridges in public hands. Delta Q = min{Qd-Q;Qs-Q}. The short side of the market determines quantity traded.
[Update: that formula doesn't work quite right for negative values. If fridge producers buy back fridges from the public, the reduction in the stock equals whichever is less in absolute value. And if Qd-Q is negative, and Qs-Q positive, or vice versa, delta Q =0. But for money, delta Q=Qs-Q works regardless of negative or positive values.]
Money is different. That's because everyone holds inventories of money. We buy money only in order to sell it again. In a monetary exchange economy we buy money when we sell any other goods, but that does not mean we plan to hold the money we buy.
Start in equilibrium, where the initial stock of money in public hands is exactly equal to the desired stock. And then the producers of money want to increase that stock, by $100. The producers of money do not need to increase the desired stock of money in order to increase the actual stock. Instead, they simply go out and buy something for $100. Suppose they buy a bicycle. The seller of the bicycle prefers the $100 to the bicycle, clearly. But that does not mean he wants to hold an extra $100 in his wallet. By assumption he doesn't, since we started at equilibrium. He wants to spend that $100 on something else. The supplier of money doesn't offer a price that makes him prefer holding the money to holding the bicycle. He offers a price that's sufficient to buy the skateboard he prefers to hold instead of the bicycle.
There is now an excess supply of money. The actual stock of money exceeds the desired stock. And that excess supply of money will hot potato around the economy, bidding up prices of goods and assets, and increasing quantities of goods bought and sold, until prices and quantities eventually rise enough so that the extra $100 is now willingly held.
Unlike refrigerators, the stock of money held by the public is supply-determined. We accept new money in exchange for goods, not because we necessarily want to hold that new money, but because we know we can always pass it on to someone else in exchange for something we do want. The seller of the bicycle didn't want the money; he wanted a skateboard. He only accepted the money because he knew it was the easiest way to get a skateboard in exchange for his bike. That's what money is supposed to do. It's the medium of exchange. We accept it only because we know someone will want to accept it from us. I might buy a fridge even if I could never sell it again. I would never buy money if I could never sell it again.
When a commercial bank offers me a loan of $100 and I accept, the bank credits my chequing account $100 as payment for my IOU. The stock of money has increased by $100, even if I have no desire to hold an extra $100. Almost certainly, I borrowed $100 not because I wanted to leave it sitting in my chequing account, but because I wanted to spend it. And when I spend it, the next person who gets it doesn't want to hold it either.
The counterfeiter doesn't have to increase the desired stock of money in order to profit from his trade. He just prints it, and spends it.
Take an extreme example. Suppose that the demand for money is perfectly price inelastic, income inelastic, and interest inelastic. Every person wants to hold exactly $100 on average, regardless of anything. And suppose every person were holding exactly $100 on average. Each individual would still accept new money, because he knows he can pass it on to someone else. They won't leave $20 bills lying on the sidewalk. They will pick them up and spend them.
For refrigerators, delta Q = min{Qd-Q;Qs-Q}. For money, delta Q = Qs-Q.
In an important sense, all money is like helicopter money. The suppliers decide how big a stock will be held, regardless of the desire to hold it. People will pick it up whether they want to hold it or not. If they don't want to hold it they will spend it, to try to get rid of it in exchange for something they do want to hold. And it hot potatos around the economy until prices rise enough or incomes rise enough that they do want to hold it.
An open market purchase of bonds is still helicopter money. It's a helicopter increase in the stock of money, plus a vacuum cleaner reduction in the stock of bonds.
Most economists disagree with me on this. They think that the stock of money is determined by supply and demand in just the same way that the stock of refrigerators is determined. And if the supply curve is perfectly elastic, as under the gold standard or when the central bank targets a rate of interest, they say that the stock of money is determined by the quantity demanded at the price set by the supplier's supply curve. They believe in the "Law of Reflux", which says there cannot be an excess supply of money, because if there were that excess would immediately return to the issuer. This ignores the fact that money, unlike refrigerators, is bought and sold in all markets. The excess supply of refrigerators will appear only in the market for refrigerators. The excess supply of money will appear in all markets, not just the single market where it is issued.
I know I'm way out of the "mainstream" in arguing against the Law of Reflux. The mainstream has not understood that money is not like other assets. We *always* accept the medium of exchange when we sell other goods. It wouldn't be the medium of exchange if we didn't. We do not ask whether we want to hold an extra $100 when we sell a bicycle. We ask whether $100 is enough to buy other goods that we want more than the bicycle. We would never accept that $100 if we had to hold it forever, even if we could get it for next to nothing.
This post is a response to David Glasner's post. The "mainstream" view is so widely held that even some Market/neo/quasi-monetarists hold it. And this is a very old debate in monetary economics. I am arguing alongside Yeager against James Tobin. This very old debate over the Law of Reflux is what is at the root of the very modern debate about whether Quantitative Easing can work. Those who argued for the Law of Reflux argued that an excess supply of money could not cause inflation [update: because any excess supply of money would immediately flow back to the issuer]. Banks could only cause inflation by lowering the price of money in terms of gold. Modern proponents of the Law of Reflux argue that banks can only cause inflation by lowering the rate of interest.
(Anyone got a good link for the Law of Reflux?)
[Update: Here is Mike Sproul (pdf) defending the Law of Reflux.]
[Update 2: My arguments in this post are very much a result of what I learned from David Laidler. I waited to get email confirmation from David that I had understood him correctly on some points before adding this. Responsibility for errors and opinions is still my own, of course. He may or may not agree with everything here.]
Worthwhile Canadian Initiative 
rsj: “Nick, no when a bank buys a bond, it is not increasing its deposits.”
It is increasing some bank’s deposits, maybe not its own.
When BMO buys a bond, it pays for it with a BMO cheque. If the seller of that bond has a BMO account, BMO’s deposits increase when he deposits that cheque. If he has an account at TD, TD’s deposits increase.
It’s exactly the same as when I get a loan from BMO, but I have a chequing account at TD. The total money stock has increased when any bank makes a loan or buys a bond. We don’t know at which bank it will be held. It will potato around all the banks.
vjk: we live in a monetary exchange economy. All other goods are bought and sold for one good, that we call “money”. An excess supply or excess demand for that one good can disrupt trade in all other markets. But that’s a topic I have covered a lot in many other posts. So I’m not going to repeat myself further here.
reason. You are talking about the demand for loans. I am talking about the demand for money. They are not the same thing. Here’s rsj’s definition of the demand for money: “The only possible demand for a stock of money — in a dynamic economy — is as a buffer to smooth gaps between expenditures and revenues.”
It’s the desired stock of money we wish to hold — understood as the average level of an inventory to act as a buffer between fluctuating flows of receipts and payments of money.
Scott: “Unlike the Tobin view, I don’t think Glasner’s view differs in terms of any testable implications.”
This is something I plan to reflect on more, but I think it does have testable implications. For example, whether and under what conditions an increase in the money supply could be effective even if there’s no fall in bond yields.
Mike: I checked the spam folder, and your comment is not there. Sorry about whatever glitch caused that.
Suppose I had a monopoly on shopping bags. Suppose I could produce shopping bags at zero cost. Would they still be worth something, if I limited supply? They do make the shopping easier. People would be prepared to hold them, even at a positive opportunity cost. If you owned 2 bags, you need only go to the store half as often. A downward-sloping demand curve. Your money demand curve seems to be horizontal. And yet you recognise that with zero money shopping is hard. Might shopping get progressively easier, the more money you held?
Nick: “It’s exactly the same as when I get a loan from BMO, but I have a chequing account at TD. The total money stock has increased when any bank makes a loan or buys a bond. We don’t know at which bank it will be held. It will potato around all the banks.”
Just for the sake of this discussion, lets assume there is one rate on bonds and loans. It really doesn’t matter, and it really complicates things for no good reason if you want to introduce lending costs/credit spreads. And lets say the bank makes this bond purchase independently, and not in reaction to any new information in the market. Now the rest of the economy is holding less bond and more money. Now lets imagine that the bond yield didn’t change (I know, it would, but lets just imagine for a second). The rest of the market didn’t want to hold more money and less bond at the old yield. So they take their money and they pay off a bank loan (repay a line of credit or whatever). The only way for the bank have increased the amount of money is if the bond yield declined (which is what would happen if the rest of the market was not permitted to repay a loan or buy the bond from some other bank). Your arguments (and those of other monetarists) often have the hidden assumption that the demand for money is perfectly elastic. It isn’t.
K: “Your arguments (and those of other monetarists) often have the hidden assumption that the demand for money is perfectly elastic. It isn’t.”
I think you meant to say that our hidden assumption is that the demand for loans is perfectly elastic? (People used to accuse old monetarists, not totally without justification, that their hidden assumption was that the demand for money was perfectly interest-inelastic.)
If a bank made a new loan, that may or may not reduce the interest rate on loans. That depends not just on the interest-elasticity of the demand for loans, but on the whole macroeconomic model. When you create an excess supply of money, everything across the whole economy will change as a result. Prices, real income, interest rates, etc.
Will some of that excess supply of money be used to repay existing loans? Yes, very probably. But if the banks wanted to increase the supply of loans (which they did, by assumption), they would lend it right back out again, as soon as any loans were paid off.
Nick: “I think you meant to say that our hidden assumption is that the demand for loans is perfectly elastic?”
I’m OK with that characterization.
“Will some of that excess supply of money be used to repay existing loans?”
I said that if “the bond yield didn’t change” (cause banks refused to change it, for example) then people would convert all of the new money back to interest bearing instruments (they would repay loans or buy bonds from the banks). They will restore exactly the same equilibrium that they had before because a) they can and b) it’s an equilibrium.
If, on the other hand, the bank simply buys the bond, the bond yield will decline a bit, there will be some more money in the economy and agents may bid up real estate or other assets, and buy back some of the bonds and pay off lines of credit from other banks. But there will more money in the economy, though of course, not by the full amount of the initial bond purchase. However, this new amount of money will be exactly the same amount that would have occurred if the banks had just lowered their lending rate to the new equilibrium yield. People would have borrowed a bit more and the exact same equilibrium would have occurred. There is a one to one correspondence between independent actions of banks in terms of setting rates and their actions in purchasing bonds. The demand curve for money vs bonds being fixed, these are just two different ways of
specifying the equilibrium price: either by stating the price (interest rate) or by stating the quantity. Chose one.
Choose one, I meant to say.
The reason I didn’t fully endorse your “characterization” is that I am used to models where the “bank account” (ie the compounded value of t-bills) is the numeraire. So I usually think of medium of exchange as just another asset. But I don’t mind.
Nick:
Yes; if you had a monopoly on shopping bags they could sell at a premium. And if you had a monopoly on paper money it could sell at a premium. There. I’ve stepped into your world of monopolized money and approved of what I see.
Now let me drag you into my world of competitive money, where any monetary premium would create a profit for the issuers of rival moneys, and thus would be competed away. In this world, money would be worth its backing. I’m not sure if you’d argue against this point. I don’t see how anyone could.
The next question is, do we live in a world of monopolized money or competitive money? For starters, people can’t carry groceries in a claim to a shopping bag, but they can trade with a claim to money. So right off the bat, government-issued monopolized money must compete against derivative moneys like checks, credit cards, gift certificates, etc, which might outnumber government-issued money 10 to 1. The dollar even has to compete against eurodollars. What’s to stop a Cayman bank from issuing paper eurodollars, and what’s to stop those from being used abroad, or even in the home country? Then there’s foreign money, which circulates in border towns all the time, especially in countries that are small, weak, and close together.
The concept of fiat money was invented when people saw money that was not convertible into metal and concluded that it must be valued only because of its scarcity. But those people clearly overlooked the fact that there is more than one kind of convertibility, and just because a bank doesn’t redeem dollars for metal doesn’t mean that all forms of convertibility have ended.
Given the choice of explaining the value of paper money as being a result of backing or a result of scarcity, the backing theory is straightforward. Money has value equal to its backing, just like any other liability. The money-scarcity view is convoluted. “Paper money is valued because people demand it, and people demand it because it is valuable.”
The dollar doesn’t compete against the eurodollar. They are the same. Unless you confuse euro-dollar (dollars deposited in a foreign located bank) with the euro, a mistake common amongst journalists ( And yes there are euro-euros…).
Waht do you mean exactly?
K, Presumably through lower rates, but perhaps non-pecuniary factors might occasionally play a role. I wasn’t trying to say anything controversial, just agreeing with someone else before drawing a distinction elsewhere.
Jacques:
If you have a dollar-denominated deposit in the Cayman islands, those are eurodollars. If you write a check to buy groceries, you have just used eurodollars, as opposed to US dollars. There is no reason why that cayman bank can’t issue its blue paper dollars, each a claim to 1 green paper dollar. Stores located near that bank could accept those paper dollars, and if the bank is known around the world, people anywhere could accept them.
“It is increasing some bank’s deposits, maybe not its own.”
When BMO buys a bond, it pays for it with a BMO cheque. If the seller of that bond has a BMO account, BMO’s deposits increase when he deposits that cheque. If he has an account at TD, TD’s deposits increase.”
That is a very strange partial equilibrium model, because whoever gets that deposit will turn around and purchase a bond with it — they are not forced into holding the deposit.
As they purchase the bond, they are withdrawing a deposit from BMO, and BMO needs to make up the difference. Over the very short term, it can borrow from the central bank or from other banks, but beyond a few days, it will need to sell a bond to make up for that deposit outflow.
Therefore BMO is forced into selling a bond for every bond it buys, if the non-bank sector is already holding the level of deposits that they want.
So on net BMO does not have the choice of determining what proportion of its liabilities remain as deposits.
Moreover, Banks cannot decide to “lend” more money — they can only offer to lend. A loan is an obligation therefore cannot be forced on anyone. All the bank can do is lower the rates it charges and increase its marketing. But banks are (supposedly) already earning the minimum return on capital that they need to earn.
Note the binding constraint is return on capital, not return on reserves.
By increasing the quantity of reserves a bank has, you are not increasing its capital, and you are not granting it a lower cost of capital, therefore the bank is not able to increase lending — even if it wanted to!
In reality, by increasing the quantity of reserves, you are making it harder for the bank to grant more loans, because it has fewer interest bearing assets, and this effectively raises the spread banks need to earn when making loans.
K and rsj: stop thinking about bonds and IOUs (loans), and start thinking about bikes. It clears the mind enormously. BMO buys a bike. It might raise the price of bikes when it does this, OK. The seller of the bike doesn’t want to hold the money, he wants a skateboard. (Now that the price of bikes is higher, he prefers a skateboard instead of a bike.) This might raise the price of skateboards, OK. The seller of the skateboard doesn’t want to hold the money either, and so on.
If you like, you could add bonds and IOUs to the list of assets that people hold, along with bikes and skateboards. As the prices of assets like bikes, skateboards, bonds, and IOUs all rise; and the price of pure consumption goods like restaurant meals rise; and as the price of labour rises, yes, this will eventually affect the demand for money, increasing it. That’s how the hot potato process eventually comes to an end, when those prices all rise by enough to make money demand once again equal to the new higher stock of money.
After we’ve thought it through with BMO buying a bike, we can add a preliminary step. Instead of buying the bike itself, BMO buys an IOU from Harry, who buys a bike from Fred, who buys a skateboard from Mabel, etc. Adding that extra preliminary step to the beginning of the chain doesn’t really make much difference. Then make Harry’s IOU a bond instead, which doesn’t make much difference either.
Nick: OK, let’s play on your terms!
Bank buys a bike, the cost of bikes rises to the price, B. Or equivalently, the bank announces that the cost of bikes is now B. Since B is the price at which the market wants to own one less bike, the market sells one bike to the bank. Same equilibrium. So the bank can set the price of bikes, or it can set the quantity. But not both. It certainly can’t say “I’m raising the price of bikes but the quantity in the market shall remain the same”.
So I don’t have an issue with your description. I’m just saying that there are two ways to frame the supply of money: either in terms of quantity or in terms of rates. They are equivalent, given the structure of the money demand function. But what’s lost if we frame the problem in the standard way in terms of rates alone?
K: “So the bank can set the price of bikes, or it can set the quantity. But not both.”
Agreed.
“I’m just saying that there are two ways to frame the supply of money: either in terms of quantity or in terms of rates.”
Shouldn’t that be the supply of loans?
“BMO buys an iou from harry,”
help me please. why?
is it the capital requirements that rsj, mentions in order to back up loans? or was Harry just giving a good rate, returns of scale financial intermediation…
There is no difference between harry getting a loan to buy a bike, and the bank buying a bond off harry who buys a bike, right?
So its going to depend on how much harry’s iou is worth.
And how again does money fall out of this. The price level has risen due to harry’s seduction of bmo. and the law of reflux, says that the price level will go back down, when harry defaults.
ok sounds good.
so in mark sprouls vesion, either the new currency is backed by harry, or its value comes from gov’s ability to tax harry’s great investment idea, or an economy wide future on harry’s potential, that dwindles in value as he gets closer to default. or …
I’ll let you guys get back at it. I’m just frustrated.
I know I was joking but if harry defaults will money come out of circulation? or is just the loan destroyed.
Nick
“You are talking about the demand for loans. I am talking about the demand for money. They are not the same thing. Here’s rsj’s definition of the demand for money: “The only possible demand for a stock of money — in a dynamic economy — is as a buffer to smooth gaps between expenditures and revenues.”
– No I am talking about the supply of money – a new loan creates money (when people take out a loan that is what they get, money). But a bank decides to create a loan based on peceived risk/reward. There are always people wanting loans, but not at any asking price. It is perception of risk that is the key here.
Goods are not costlessly produced.
The price of goods is not set by expected CB policy.
The binding constraint here is one of selling, not buying. It is easier to buy a good than to sell it — you cannot tell a firm to “go sell more”, because it is trying to sell as much as it can, subject to the constraints that it must earn a certain profit.
Similarly, you cannot tell a bank to go “lend more”. It is lending as much as it can, subject to earning a certain return on capital. The bank cannot force anyone to incur obligations. The correct analogy with bank loans is not of buying but of selling. All it can do it attempt to lower the lending rates in order to attract more borrowers, just as firms must lower the price in order to attract more customers.
Yes, there is certainly a relationship between the quantity of loans and interest rates. But banks cannot choose the rates anymore than firms can lower prices to sell more goods. Both are constrained by return on capital requirements that force them to maintain certain margins.
In the case of banks, the margins are set by the market, and the base off which the margins are calculated are set by the government. So banks have no option in setting the price OR the quantity.
Households choose the quantity of loans supplied just as buyers choose the quantity of goods sold.
The freedom of choice in the banking system is, in a simple model, non-existent.
In a more realistic model, we understand that banks can lobby regulators to ignore lending standards, they can mislead customers as to the loan terms, and they can mislead investors as to their balance sheet etc. In practical terms, there is a degree of freedom under the control of banks to increase or decrease lending, but this comes only at the expense of a reduction in prudence or honesty. That is the only degree of freedom that banks have.
Nick: Try as I may (and I really thought about it last night), I can’t square your “bikes are bonds” analogy. Bonds are costlessly produced. If you give me a loan, you are long bond, I’m short bond. Net bond is unchanged. It’s impossible create a bond without someone else being short a bond. As rsj points out, this is totally different from bikes from an equilibrium price perspective. The bike analogy doesn’t help me at all – it just messes me up. I don’t think it maps to the economy we live in. If you want to work with a simplified economy that maps to the one we live in this is about as simple as I think we can make it:
1) one basket of consumer goods that everybody holds in the same proportions. Banks don’t buy this stuff.
2) Default free floating rate bonds that earn the risk free short rate. Anyone can issue these bonds and anyone can buy them. They always trade at par. There is net zero of these bonds in the economy.
3) Banks can buy or sell bonds with money that earns no interest. Forget about loans. The bank just buys a bond with new money.
Bikes? That’s in the consumer basket. Banks trade money and future money. If you want to talk about bike banks I’m all for it. But I don’t think it can settle anything about the economy we live in.
rsj: “Goods are not costlessly produced.
The price of goods is not set by expected CB policy.”
Replace “goods”, or “bikes”, with “gold”.
Gold is not costlessly produced. But the price of gold was set by CB policy.
The only reason for “bikes” vs “gold” was to stop the gold bugs and the MMTers going off on tangents (in opposite directions). Plus to show it could be anything.
Too much to think about right now. Sorry. May do a new post exploring this bikes/gold/bonds question sometime.
Nick: “May do a new post exploring this bikes/gold/bonds question sometime.”
If you want to map, e.g., bicycles to bonds, keep the following in mind:
1) Bicycle prices can be infinite in practice (this is the equivalent of zero bond yield)
2) there are no bicycles: if I have a bicycle, you must have a negative bicycle
Looking forward to your post or follow up comment!
Nick’s post said: “K and rsj: stop thinking about bonds and IOUs (loans), and start thinking about bikes. It clears the mind enormously. BMO buys a bike.”
If BMO buys a bike, will it have a net interest margin problem?
edeast said: “There is no difference between harry getting a loan to buy a bike, and the bank buying a bond off harry who buys a bike, right?”
Let’s assume Harry owns a gov’t bond. BMO buying the gov’t bond is an * attempt * to get Harry to stop saving and buy the bike (spend now). There’s no reason to believe that will work. Why can’t Harry then just put the demand deposit in his savings account (so he continues to save)?
It seems to me Harry getting a loan to buy the bike is different. Harry went into currency denominated debt to buy the bike (spend now).
This all comes back to the argument about lower interest rates. If lower interest rates don’t get excess savers to spend (probably not much of an effect) and almost no one goes into currency denominated debt (most important) then what happens?
Let’s keep it simple.
EDIT: “in his savings account (so he continues to save)?”
TO: “in his savings account at BMO (so he continues to save)?”
tmf, my comment was not thought out. assumed harry issued bond, did not own bond.
rsj is sounding like jkh.
maybe this post on capital constraints. http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/05/quantitative-easing-circumvents-banks-capital-constraints-to-increase-m1.html
Nick,
to be more conciliatory – I agree the Fed could put money into circulation by buying something. It just that that is what people normally call fiscal policy.
Let me see if I get what you are saying: Most economists disagree with me on this. They think that the stock of money is determined by supply and demand in just the same way that the stock of refrigerators is determined. There is no demand for money in the normal sense, because money is the pure intermediate good. There is demand for goods and services (both in the present and intended in the future) which, in a monetary economy, are purchased by using the pure intermediate good of money. With minor exceptions, no one knocks back money because it is not money that they have demand for, it is the goods and services one can get in exchange. One has a certain desired stock of money — to cope with uncertainty and intended purchases — but that is not money demanded qua money but for its use in achieving future utility via purchase of goods and services.
So worrying, for example, about the marginal cost of money is beside the point, because it is not a normal supply-and-demand good.
And that is exactly what we mean when economists talk about “the demand for money”. We mean the desired average size of that buffer stock. Which is what I thought, but every so often I come across an economist who seems to be talking as if “the demand for money” includes money spent.
And we hold that stock because it’s too costly to spend all of our paycheque the minute after it hits our bank account. That strikes me as either false or misleading. Speaking as a (very) small businessperson, I try hard not to spend all my paycheque because of uncertainty about my income flow.
Lorenzo: “That strikes me as either false or misleading. Speaking as a (very) small businessperson, I try hard not to spend all my paycheque because of uncertainty about my income flow.”
Misleading, perhaps. “Spending” (in this context) includes (say) spending it on shares, or bonds, which you could sell again if your future income drops.
includes (say) spending it on shares, or bonds, which you could sell again if your future income drops
What a nice idea: at the moment, I am trying to simply build up my bank balance. Surely a buffer is a buffer, not something that is “too costly” to spend except in a rather strained sense of ‘cost’.
Also, going back to my attempt to paraphrase your very thought-provoking post, I wonder if ‘pure transaction good’ might describe money better than ‘pure intermediate good’.
edeast said: “There is no difference between harry getting a loan to buy a bike, and the bank buying a bond off harry who buys a bike, right?”
And, “tmf, my comment was not thought out. assumed harry issued bond, did not own bond.”
OK. With that stipulation, it seems to me they are the same. Harry went into currency denominated debt, meaning the debt level rose. The real question is where did the demand deposit come from.
Lorenzo from Oz said: “Speaking as a (very) small businessperson, I try hard not to spend all my paycheque because of uncertainty about my income flow.”
What about retirement?
rsj said: “The only possible demand for a stock of money — in a dynamic economy — is as a buffer to smooth gaps between expenditures and revenues.”
Lorenzo from Oz said: “One has a certain desired stock of money — to cope with uncertainty and intended purchases — but that is not money demanded qua money but for its use in achieving future utility via purchase of goods and services.”
What about companies like Microsoft and Apple?
Here,
Brad De Long says it better:
http://delong.typepad.com/sdj/2011/09/teaching-keynesian-economics-to-your-bulldog.html#tp
Lorenzo from Oz said: “Speaking as a (very) small businessperson, I try hard not to spend all my paycheque because of uncertainty about my income flow.”
Speaking as a permanent employee of a large corporation, I try hard not to spend all my paycheque because of uncertainty about my expense flow.
Any buy/sell in the market leads to leakage of money in the form of taxes (say sales tax) therefore an injection of $100 might lead to a temporary hot potato effect dissipating over time. If inventories (and productive capacity) are sufficient to accommodate $100 then there will be no price effect and the stock of money as you define will slowly revert to its initial level.
And surely helicopter money can be used to pay back bank loans or purchase bank bonds and therefore will NOT be a hot potato raising price level.
Sergei “If inventories (and productive capacity) are sufficient to accommodate $100 then there will be no price effect and the stock of money as you define will slowly revert to its initial level.”
Nope. If I spend money on buying goods that does not cause the money to disappear. It goes from my pocket into the seller’s pocket. The hot potato just gets passed around.
If the hot potato causes output and/or prices to permanently increase, then the demand for money will permanently increase too. This means the hot potato is no longer hot, so we are at a new equilibrium level of output and/or prices.
“Any buy/sell in the market leads to leakage of money in the form of taxes (say sales tax) therefore an injection of $100 might lead to a temporary hot potato effect dissipating over time.”
That’s the MMT assumption that taxes reduce the stock of money rather than the stock of bonds. Given that assumption (no, let’s not argue it here, because it’s mostly semantic) then agreed.
To the extent that some of the excess supply of money does get used to pay down loans, and if the banks don’t immediately re-loan that money to rebuild their loan portfolios to the original desired level, then the hot potato will slowly dissipate over time.
“If I spend money on buying goods that does not cause the money to disappear”
Nick, it is not about MMT but about how this world works and whether a particular model has any relevance in it. The model you describe here does not have any relevance because taxes ensure the stock of money goes down (the result of your bike purchase) as the volume of economic activity goes up (the act of your bike purchase). That is why (demand driven) inflation is inherently dis-inflationary and taxes ensure such outcome. And on the opposite, fiscal policy is inflationary when economic activity goes down. Surely you know that this is called automatic fiscal stabilizers.
You can assume away bank loans and fiscal policy but such model has no relevance in this world. If you agree that they exist then you at least have to say that hot potato dissipates over time. Slowly? What is slowly? It might not even it exist at all for all practical purposes.
Sergei:
Bonds are not money. Most governments issue bonds, and they (and their central banks) sell those bonds to the public and buy those bonds back from the public. If governments (and their central banks) never bought or sold bonds from the public, only then it would be true that the change in the stock of government money would equal government expenditure minus taxes.
That model might have been a good approximation for Zimbabwe a couple of years back. It is a very bad description of the real world in Canada. The government of Canada buys and sells bonds.
And don’t call me “Shirley”.
Nick, to draw a reasonable model which is focused on money stock you need to at least understand the workings of interbank market, OMO, CB and technicals of its interest rate policy. When you say that bonds are not money it might be true for certain purposes but it is completely wrong for the purpose of taxes, fiscal injections, OMO and interest rates. Your argument about Zimbabwe makes it clear that you do not understand the existing system and therefore draw your model which can be valid only in another universe.
In the real world, including Canada, central banks normally buy and sell bonds to regulate the volume of base money and satisfy the split between reserves and cash as demanded by the private sector. When someone pays taxes this volume changes because the account of the central government is outside of the private sector. That is why taxes are a leakage. However this leakage (as well as any injection) is mundanely replaced by the CB in its OMO. Any OMO is triggered by the private sector showing willingness to pay more or resistance to pay the running CB base rate if there is any excess demand or surplus of base money. This happens daily and it means that at the end of each day the system, which was disturbed during the day due to settlements, is back to equilibrium regardless of the volume of actually paid taxes or fiscal injections. And what allows this system to adjust is the ownership of government bonds held by the private sector. So for this purposes money and bonds are perfect substitutes. Technically you do not pay your taxes with bonds (or receive injections), but if the banking system is lacking base money then it automatically obtains it from the CB. The opposite is true as well. In the worst case the banking system relies on the deposit facility or discount window. However their usage is normally discouraged by all central banks which only emphasizes the automatic nature of base money management by the CB. And that is why you need to ask how slowly the effect of hot money dissipates over time and that is why I said that in can be zero time for all practical purposes.
The institutional structure can be more complex than the somewhat straightforward description above. In the USA, for instance, the central government runs TT&L accounts but the purpose of those is only to make the life of central bank easier. And TT&L have to be fully backed by government bonds.
This is something that rsj keeps on saying that as long as you ignore institutional structure of the economy of this real world all your models will be wrong in this real world. They might be correct in some other universe but not in this one.
Sergei: this what my brain hears when I read your comment:
“In the real world the producer of refrigerators sets a price at which it will buy and sell unlimited quantities of refrigerators. So the supply curve of refrigerators is perfectly elastic in the real world and the stock of refrigerators is determined by where the demand curve cuts that horizontal supply curve. And there can never be an excess supply of refrigerators because if there were people would immediately sell them back to the producer.”
And I’m saying that money is not like refrigerators. And you ignore my point and just keep repeating the standard theory, just like everyone else, and adding “Look! That’s how the real world is!”
Well, you assume away the complexities of the real world which would force you to ask for instance “how slowly/fast does the hot potato effect dissipate”. You do not ask such questions but this is the only thing which is interesting. If you want to talk about fiscal multipliers then it is a completely different topic which on itself requires a lot of clarifications about many things. And again which forces you to ask questions about how fast/how slow.
The hot potato itself is dead boring and wrong especially for the general case that you rely on. The excess supply of money is not pushed around the economy like a hot potato. It is pushed onto the banking system which pushes it over to the central bank. Yes, your bike seller got an additional deposit from $100 injection, but somebody else “lost” his $100 deposit because he just bought a bond from the CB running its OMO. If you say that the buyer was a bank then, because banks do not spend much, you can argue with many additional assumptions about some hot potato (but in the asset prices, not consumer prices). You do not describe the story like this and therefore just like everyone I tell you that the real world is different and your model is wrong. The assumptions I have in my mind do not have to be equal to the assumptions you have in your mind even assuming that our understanding of this real world is correct and we agree on it.
Sergei: one of the most important “complexities of the real world” is that the medium of exchange is an asset that is very different from an asset like refrigerators. And that is precisely the complexity of the real world I am trying to elucidate in this post. And you are ignoring that complexity of the real world, and want to drag the discussion into other complexities that merely obfuscate the issue that I want to elucidate here.
We have already agreed (or have we?) that the seller of the bike now holds a $100 deposit that he does not want to hold. And he buys a skateboard, so the seller of the skateboard now holds a $100 deposit he does not want to hold. And he buys a…etc.
This process could never even get started if we were talking about refrigerators. And if the producer of refrigerators had a perfectly elastic supply curve and were willing to buy or sell unlimited quantities of refrigerators at a fixed price, then even if it did get started, because someone bought a fridge by accident that he did not want to hold, he would immediately return it to the producer. But money is not like refrigerators. The process will stop in some different way.
Take an extreme but simple example. Ignore the commercial banks (“But that’s unrealistic!”) and suppose the central bank makes unlimited loans to the public at a fixed interest rate (“But that’s unrealistic!”) and that the demand for loans depends on the rate of interest, but the demand for money does not depend on the rate of interest (“But that’s unrealistic!”).
Start in equilibrium, where the net flow of loans is zero. Then the CB lowers the rate of interest. The net flow of loans is now positive, so the stock of money is growing over time. The stock of money will be growing over time, and the excess supply of money will also be growing over time. Even if the CB raises the rate of interest back up again, so we are back to zero net loans, that excess supply of money does not disappear. Output and/or prices must rise until it is willingly held. And if it takes time for prices and output to adjust, the hot potato will continue long after the CB has stopped making new loans.
Yes, must do a post on this thought-experiment sometime!
Surely, money IS different from refrigerators. But you argue that its difference is realized in a permanent hot potato effect and that is what I can not agree with because it is based on very-very-very strong assumptions which are not really applicable in this world. There can be many other ways how the $100 injection dissipates without affecting price level and I tried to describe that the most natural way for it to happen in the short term is for the central bank to sell a $100 bond and therefore break the chain and in the long term additional taxes draw on $100 injection as every buy/sell of goods leads to tax liabilities. And we did not even touch fx-market or any other asset market where prices are not consumer goods prices and where bubbles do not even need any injections to happen.
Sergei: OK. Then maybe I wasn’t clear enough.
Eventually the potato will either cool down (i.e. prices and/or quantities rise until the extra money is willingly held), or else disappear (i.e. return to the banking system). To my mind, the question is “how much of each?”. And the answer will depend on how the central bank operates. For example, if the central bank sees prices rising faster than the inflation target, it may tighten monetary policy to buy back the hot potato. How long the hot potato circulates, and how much prices rise, will depend on how quickly the central bank reacts.
The main point I am trying to make is that even if the central bank sets a rate of interest at which it is willing to buy and sell bonds for money in unlimited amounts, doesn’t mean there cannot be a hot potato. The (stock/flow) quantity of loans demanded and supplied by the banking system is not the same as the (stock/flow) demand for money. If the original new loan from the banking system can create an excess supply of money, there is nothing that says that excess supply of money must necessarily disappear when it is spent by that first person, or re-spent by the second, and so on. Whether and how it eventually disappears, or cools down, will depend….on a lot of things.