"If the central bank permanently doubles the stock of (base) money: all nominal variables will double [that's the Quantity Theory of Money]; all real variables will stay the same [that's the Neutrality of Money]."
The Quantity Theory of Money and the Neutrality of Money go together. It is very hard to have one without the other. They are only exactly true under very strict conditions (see e.g. Patinkin's "Money, Interest and Prices"), which I will ignore here.
As stated above, the QT and NM implicitly assume that (base) money is exogenous. But it is easy to define versions of QT and NM that are applicable when money is endogenous.
For example, suppose the central bank fixes the exchange rate, which means it must allow the stock of money to adjust endogenously.
"If the central bank permanently doubles the price of foreign exchange: all nominal variables will double [that's the Quantity Theory of Money]; all real variables will stay the same [that's the Neutrality of Money]."
Or, suppose the central bank targets NGDP, which also means it must allow the stock of money to adjust endogenously.
"If the central bank permanently doubles the target level of NGDP: all nominal variables will double [that's the Quantity Theory of Money]; all real variables will stay the same [that's the Neutrality of Money]."
And so on. A doubling of the price of foreign exchange (or the NGDP target, or whatever nominal variable the central bank picks), will cause the stock of money to double, along with all other nominal variables. The stock of money is now endogenous, and the exchange rate (or NGDP) is now exogenous.
Whether true or false, the Quantity Theory of Money and the Neutrality of Money, are equally applicable in a world where the stock of money is determined endogenously. The same underlying idea of the classical dichotomy, that nominal variables (those with $ in the units) and real variables (those without $ in the units) are independent of each other (under some conditions), is equally applicable regardless of what is assumed exogenous.
But all this is just comparative statics, comparing one equilibrium time-path for nominal variables with another. The question of the stability of that equilibrium time-path is another question. For example, I think that stability would be much greater under NGDP level-path targeting than under base money stock targeting.
(Just an aside, for JW Mason.)
Worthwhile Canadian Initiative 
“On Monday people might bring paper dollars to the Fed as a loan repayment and the Fed might accept them. On Tuesday the Fed might stop accepting paper dollars for a day or two, but the fed might make an open market sale of its bonds in exchange for its own deposit dollars. Reflux can happen at the instigation of the fed, or at the instigation of the public. It’s still reflux either way.”
I don’t think people bring paper dollars (currency) to the fed as a loan repayment. I’d say this usually happens: Some entity does not want currency anymore. It takes the currency to a commercial bank to get demand deposits. The commercial bank can then take the currency to the fed for central bank reserves. The reflux of currency can always happen. The Tuesday part above does not happen. It would violate the elastic currency part of the Federal Reserve Act (at least that is how it was explained to me).
The commercial banks may want to reflux the central bank reserves back to the fed. The fed may or may not allow that reflux part.
Min said: “Err, in the US, it is the Treasury that issues currency.”
Is currency ever a liability of the Treasury/Bureau of Engraving?
Min:
That link you provided discusses Treasury-issued currency, but the paper money that we use every day is issued by the Federal Reserve.
Too much Fed:
“GM bonds and Ford bonds are not fixed convertible to each other or to currency and demand deposits. Currency and demand deposits are fixed convertible.”
Wells Fargo chooses to make its checking account dollars convertible into Fed dollars, but the Fed does not make its dollars convertible into WF dollars. Also, WF dollars are WFs liability, and fed dollars are the fed’s liability. But the Fed’s paper dollars and the fed’s deposit dollars are BOTH liabilities of the fed.
If a private bank has unwanted central bank reserves, it can swap them for paper dollars, which you say can reflux to the fed. It’s the leaky vacuum hose again.
Max:
My mistake. I was using “cover” to mean “assets”
NIck: an unexpected way of presenting it, but helpful, thanks.
Rene: Yes, it was understood that was Peel’s intent. It is still very unusual.
Mike Sproul: This is beginning to look like a case of shifting goal posts. If the cover ratio determines the value, why did the value of currencies not move around according to the cover ratio? As it happens, the exchange rate with gold mattered directly, not as adjusted for cover ratio. If the cost of remaining on the gold standard (typically in outflow of gold) got too difficult, countries simply left the gold standard. The credibility of the promise to exchange is what mattered, not the cover ratio per se. The value of the franc did not change as the BoF stockpiled gold (1928+) and the cover ratio got higher and higher. Indeed, gold continued to flow in precisely because the franc remained “undervalued”, just as gold flowed out of the UK because the pound was “overvalued”.
On the peso case, that presumes every monetised transaction is up for use by any money. Clearly, not how it works. Network effects are very strong, since money needs expected transaction chains to retain value. That is a large part of why CSA$ spectacularly hyper-inflated: the expected duration of the transaction chains kept getting shorter and shorter …
Too Much Fed: “Is currency ever a liability of the Treasury?”
The US Treasury accepts US dollars in payment of taxes. 🙂
Mike Sproul: “the paper money that we use every day is issued by the Federal Reserve.”
I showed you mine. You show me yours. What act of Congress authorizes the Fed to issue currency?
Besides, do you think that the bills and coins issued by the Treasury do not circulate in the economy?
Lorenzo: here’s a second way to think about Mike’s perspective: Mike wants to liken money to shares in (say) a mutual fund. But suppose the directors of a closed end mutual fund used their discretion to pay varying amounts to charity (or the government) from the income earned from the assets of the fund, rather than returning it all to the mutual fund shareholders. Those shares would not trade at Net Asset Value.
Lorenzo:
I’m still paying for saying “cover” when I meant “assets”. It’s assets that determine value, not cover. (At the risk of misusing words again, cover=reserves)
So if the fed had 100 oz worth of assets as backing for $100, then $1=1 oz. Complications arise quickly. If the fed’s assets are worth 140 oz, but the fed maintains convertibility at $1=1 oz, then the dollar will still be worth 1 oz, since the fed is refusing to use its extra 40 oz to back its dollars, and so the 40 oz might as well be on the ocean bottom.
On the other hand, if assets fell to 90 oz, and the fed maintained convertibility at $1=1 oz, then there would be a run on the bank, and you get a situation like you described in the UK.
“money needs expected transaction chains to retain value.”
Not if the money is backed. In the case above, $1=1 oz whether or not the dollar is used as money, since you can always get 1 oz worth of assets from the issuer of the dollar.
Nick:”It is still very unusual.” And that’s the point. Since 1884, the British discussed and understood the limits of the system, just where you can go, when to intervene before it is too late so you don’t need to break the rules and so on.
Something the BCE didn’t do and the Franco-Germans don’t even begin to understand.
In the end, Texans are right: better be judged by twelve than carried by six.
Jacques Rene: you are responding to Lorenzo, not to me! (Names are below the comments.)
Nick: my old eyes again . One day everyone will be as old as I am and this blog will be a paradise of cross-talk…
Mike Sproul: if assets fell to 90 oz, and the fed maintained convertibility at $1=1 oz, then there would be a run on the bank, and you get a situation like you described in the UK
But currencies did not have runs on them merely because the cover ratio expanded. What people cared about was whether the commitment to exchange notes for gold/silver/specie was credible. Currency exchange rates would tend to hover within “gold points” (the rates at which it was worthwhile transporting gold rather than notes). The problem in the UK in 1926-31 was that the rate of exchange of UKP for gold was set too high (i.e. pounds were overvalued in terms of gold) so gold would buy more outside the UK. (Conversely, the franc was undervalued in terms of gold, so gold would buy more in France, and so flowed in, driving up the franc’s cover ratio, which never hit 100%.) A problem that worsened as the BoF, aided and abetted by the Fed, drove demand for gold up. When it appeared that the BoE would run of out gold to make the exchange rate credible, then the UK went off the gold standard.
Not if the money is backed. Were cowrie shells “backed”? Because they were by far the most widespread form of money, across time and space. But history is full of (sometime unexpected) local monies, because they were what had high transaction utility in local transaction chains.
Spanish “pieces of eight” were used as money in Chinese maritime provinces extensively from 1565 onwards, typically exchanging at higher value than weighted silver because the “brand” was so reliable.
So perhaps backing theory only applies to paper money. But, as I am intimating, a gold/silver/specie standard worked rather more like fractional reserve banking: as long as confidence was fine, notes could be issued well in excess of the gold/silver/specie “backing”.
(I keep saying gold/silver/specie because the fetishisation of gold annoys me. Silver was a much more important monetary metal than gold and there is a good argument that the classical gold standard was less stable than the some-on-gold, some-on-silver, some-on-specie structure that preceded it.)
Nick: nice try, but I am not a finance brain, so that does not help.
Rene: Matthew Morys paper on Monetary Policy Under the Classical Gold Standard suggests that the Reichsbank may have been more central in running the 1873-1914 system that folk have previously thought.
Click to access Morys_20110204.pdf
Lorenzo: as I say to my admiring students, If I seem to know everything, it’s because I learn everything. So mucho thanks for the link.
Which begs the question: what made them lose their proficiency?
Lorenzo:
1. I want to stop using the word “cover”. The backing theory says it’s assets that matter, not cover. If assets are enough to buy back every unit of money issued at par, then people will believe that a convertibility promise is credible.
2. Cowries are a commodity. The backing theory doesn’t apply. The backing theory applies to moneys that are the liability of the issuer.
3. How big was the premium on pieces of eight? Any significant premium would be arbitraged away.
4. I agree about silver vs gold.
Jacques Rene: Excellent question. By the time of the hyperinflation, the Reichsbank was in la-la land. But the “real bills” doctrine possibly makes more sense when your other experience is gold/silver/specie standard. Indeed, as long as the offer to exchange is credible, then issuing notes for “real bills” is fine.
More recently, it is clear that the Euro-elites hated floating exchange rates. (Down here in Oz, we love them. But we don’t aspire to signing up to some ever-closer union.)
Marc Flandreau and others published a paper in 1998 which looked at the gold standard and which warned that it would not work if the ECB was too restrictive.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=108211
BTW, have you seen this paper? It has amusement value (in a black humour sort of way). Particularly given the timing of its release.
Click to access publication16345_en.pdf
A nice summary by a political scientist is here:
http://www.craigwilly.info/2012/07/28/we-told-you-so-how-u-s-economists-predicted-the-euro-crisis/
Mike Sproul: Well, yes, the gold/silver/specie standard was “backed”. But in a straightforward exchange-for-metal way in the “core” countries. (The “periphery” countries were a bit different.) If the cover ratio was greater than 1:1, then that is a problem for backing theory, surely? Unless it is to be restricted to money’s not up for explicit exchange.
On the Spanish dollar premium in China, it varied, but sometimes got quite high. A paper on the matter reports the following:
“However already in 1797 Morse reports that they were at par with sycee [weighted silver]. From 1811 the same source indicates that the coins enjoyed a premium over sycee despite their lower content of fine silver, and in 1829 the premium was already around 6 to 8 %. … The premium only continued rising in the 1830s to 14 and 15%, and in the 1850s it was 20-30%, as Eduard Kann reports for 1852. The rate overshot at the time of the Taiping when it went up as high as 50%, yet in 1863 the coin still enjoyed a premium of 15% upcountry.”
The paper by Alejandra Irigoin is available here: http://eprints.lse.ac.uk/49082/
The author makes the point that it was demand for a currency standard (i.e. a medium of account) which drove the premium, remembering that the Chinese state issued no silver coins, and took taxes in weighted silver. It was, of course, possible to separate the unit of account and the medium of exchange (it was done a lot when there was a lack of reliable coin) but it is not very convenient.
Money is a very particular type of asset–its transaction utility is not only tied to being widely exchangeable but also use as a unit of account. It is both an asset and a network good. Makes it odd.
Mike S. said: “Wells Fargo chooses to make its checking account dollars convertible into Fed dollars, but the Fed does not make its dollars convertible into WF dollars.”
Let’s say a lot of demand deposits are created from banks. Next, everyone redeems their demand deposits for currency. As long as the banks are solvent, the fed will allow this increase in currency. The fed does not run out of currency. The fed does not disallow this exchange. If somehow a lot of currency is created, an increase in demand deposits could happen if people redeemed their currency for demand deposits. That is what is important.
“Also, WF dollars are WFs liability,”
OK.
“But the Fed’s paper dollars and the fed’s deposit dollars are BOTH liabilities of the fed.”
I’m going to skip the paper dollars (currency) part for now. The fed’s deposit dollars (what I call central bank reserves) are liabilities of the fed.
“If a private bank has unwanted central bank reserves, it can swap them for paper dollars, which you say can reflux to the fed. It’s the leaky vacuum hose again.”
For a bank, central bank reserves and currency can be swapped at the fed. The banks can’t force the fed to give up some assets in exchange for central bank reserves and/or currency if the banks have too many central bank reserves and/or currency.
Min’s post said: “Too Much Fed: “Is currency ever a liability of the Treasury?”
The US Treasury accepts US dollars in payment of taxes. :)”
I’m not sure that is answering my question. The US Treasury accepts demand deposits for payment of taxes too.
Lorenzo: once again,thanks. As I sometimes acknowledge, I am an humble IO guy. I come on monetary thread to get a lot of knowledge and, I hope, a bit of wisdom. I gained a lot in the last few hours. As Walpole said “Life is a tragedy for those who feel and a comedy for those who think”…
The French seems to have been AWOL on economic thinking since the days of Say, Bastiat and Cournot. Even in the ’60, De Gaulle was making long speeches about gold, a great military tactician and stategist, a brilliant politician caught in a “ne supra crepidam” hell. As for the Germans, you just gave us some insights.
This being said. Mundell was in favor of the euro. Seemingly because he was also a hard-money type and a social conservative who enjoyed the idea that a neo-gold standard would let the working class suffer the downward adjustments while the anti-inflation clauses of the pact would take care of any improving wage situation.
Optimism? Well, polito-bureaucrats had seen French-German enmity disappear, the Cold war blocs vanished and, almost within their living memory,seen France complete its economic unity and what where at the time seemingly impossible feats, the creation of a somewhat workable Italy and a (maybe too much) well-functionning Germany out of thin air. Could we fault them for optimism? What will be history’s judgment a century hence, remembering that Germany very nearly broke up in 1918-19?
Jacques Rene: Well, yes, there certainly was a lot of optimism. And perhaps sheer political bloodymindedness will make the Euro work. BTW, the comment on the paper by Flandreau et al should have said “they warned that the Euro would not work if the ECB was too restrictive”.