Leland Yeager's (ed.) "In search of a monetary constitution" was the book that most excited my thinking about monetary economics as a PhD student. He asked the contributors to the volume to design a monetary system from scratch. He told them to think "blue sky". I can't remember all the contents. The answers given were less important than the question he asked. It forced you to think deeply about what you wanted a monetary system to do.

I may do more posts like this, so I have called this post "Blue sky money one". I will explain the "dual mandate" bit later.

The blue sky monetary system here is loosely based on: James Buchanan's proposal for "brick money" in the Yeager volume; something Brad DeLong once said in passing about the unemployed panning for gold; and various MMT economists (I've forgotten exactly who, but I don't feel I have to stick to what anyone else said).

Imagine an economy in which physical gold was used as the medium of exchange and medium of account. Gold is money. And imagine that every household had access to a nearby stream where anyone could pan for gold, and the average worker could collect one ounce of gold per day, using labour only, with no diminishing returns.

Any unemployed worker would go panning for gold and earn a wage of 1 ounce per day. If wages in regular jobs ever fell below 1 ounce per day, workers would quit their jobs to go panning for gold. If wages in regular jobs ever rose above 1 ounce per day, workers would stop panning for gold and get a regular job instead.

This monetary system has some very nice equilibrating properties. It would be a "full employment" economy, in the sense that anyone who wanted a job and was prepared to work for 1 ounce of gold per day would have a job, even if it was panning for gold. The economy would also have a nominal anchor, in that the long run equilibrium level of money wages for unskilled labour would be pinned down to 1 ounce of gold per day.

The flow supply of new money responds automatically to: unemployment; and the level of nominal wages. If regular unemployment increased, more workers would pan for gold, and so the money stock would automatically grow, which would increase demand for goods and labour, and so increase regular employment. If regular unemployment fell, fewer workers would pan for gold, so the money stock would grow more slowly. If this were a growing economy, with a growing demand for gold, either as money or for industrial use, this would mean the supply of money would grow more slowly than demand, and so regular unemployment would rise again. In equilibrium, there would be just enough workers panning for gold to make the supply of gold grow at the same speed as the demand for gold.

The flow supply of new money also responds automatically to money wages. If money wages fell below 1 ounce per day, the flow supply of new money would increase, pushing money wages back up. If money wages rose above 1 ounce per day, the flow supply of new money would fall, pushing money wages back down.

It's a bit like a "dual mandate" monetary policy, with both a full employment target and a price level (or rather wage level) target. Except, and this is critically important, "full employment" is not defined in the normal way. Rather, "full employment" is defined as every worker who is willing to work at the target nominal wage has a job.

Normally we follow Phelps and Friedman in saying that any monetary policy that targets "full employment" is doomed to either accelerating inflation or deflation, because there is no nominal anchor. But this monetary system escapes the Phelps/Friedman problem because "full employment" is defined relative to the nominal anchor. If you aren't working, and are searching for a job, but are unwilling to work panning for gold at 1 ounce per day, then you are not "unemployed", by this definition of the full employment target.

Maybe it's not a very efficient system, because a lot of workers would be panning for gold, even in full equilibrium, when paper money would work just as well and with far less effort wasted to produce the money. And we don't all have a gold stream just down the street either.

So suppose the central bank creates an artificial gold mine, where workers can pan for paper money. Why not just call it Employment Insurance. Any unemployed worker can collect EI benefits, whether they lost their job, were fired, or just quit. And EI benefits are financed by newly-printed money, which is the only way new money can be created. It's exactly like a paper gold mine.

The key point is that EI benefits must not be indexed to inflation. The unemployed can mine a fixed 1 ounce of gold per day, or a fixed $W of paper dollars per day. If EI benefits were indexed to (price) inflation, you would lose the nominal anchor in the system. Instead, the level of EI benefits must be fixed in nominal terms. Or else rise at some fixed rate like 3% per year (for 1% equilibrium real wage growth plus 2% price inflation).

That system should work just like the original gold panning system. It has a nominal anchor. Any rise in unemployment or slowdown in wage inflation will set in motion a faster growth in the money supply that will tend to reduce unemployment and increase wage inflation. Any fall in unemployment or rise in wage inflation will set in motion a slower growth in the money supply that will tend to increase unemployment and reduce wage inflation.

But those equilibrating forces could be slow to act. Why not have the central bank speed them up by using open market operations? Otherwise a sudden large increase in demand for money will cause a prolonged period of unemployment while the unemployed produce enough new money to match the increased demand.

Here's a revised proposal. EI benefits still grow at some fixed path like 3% per year. But the central bank has a target rate of unemployment, say 6%. If more than 6% of the labour force is collecting EI, the central bank does open market purchases and creates as much money as is needed to push unemployment back down to 6% as soon as is reasonably possible. (I'm leaving that targeting horizon unspecified). If less than 6% of the labour force is collecting EI, the central bank does open market sales and destroys as much money as is needed to push unemployment back up to 6% as soon as is reasonably possible.

Why 6%? What happens if the central bank targets a lower or higher level of unemployment? And isn't there some natural rate of unemployment out there somewhere? What happens if the natural rate is above or below 6%?

There is a natural rate out there somewhere. But the natural rate of unemployment depends on real (inflation adjusted) EI benefits. The higher are real EI benefits, the lower the penalty to being unemployed, and the higher will be the natural rate of unemployment.

Now in this monetary system it is nominal EI benefits that are fixed exogenously. Given that level of nominal EI benefits, if the central bank chooses a lower unemployment target, the consequence will be a rise in the equilibrium price level, and a fall in equilibrium real EI benefits. If the central bank sets too low a target for unemployment, the price level would rise, and real EI benefits would fall, until workers were desperate enough to take any job rather than starve on EI. A civilised level of real EI benefits would require a higher target unemployment rate.

It's a theoretically interesting monetary system. It shows that it is possible, at least in principle, for a central bank to have a dual mandate. It can target a particular level of unemployment and have a nominal anchor at the same time. It is the exogenously fixed path of nominal (unindexed for inflation) EI benefits that provides the nominal anchor for the monetary system. (Government make-work projects with a fixed nominal wage could also play the same role as the EI paper gold mine.)

But I'm not sure if it's a good monetary system. Any exogenous real shock to employment might require large changes to the equilibrium price level and real EI benefits for the system to re-equilibrate itself.