Thursday, June 7, 2012

Easy Guide to Monetary Policy

What money is
We use money to transact and the money we use is fiat money, money backed only by government decree. In economic terms, money is a transaction good and all that fiat money is, is a transaction good; the only point in holding such money is to be able to engage in transactions—its expected swap value(s) in exchange is its only value.

The use of money as a transaction good is driven by expectations. People take your money because they expect to use it in future transactions. You offer money in transactions because of that expectation. (Since there is no information from the future, we can only ever act on the basis of expectations; expectations that are derived from existing information.)

Anything that is used in a transaction for its swap value is being used as a medium of exchange. That does not, however, make it money. It is only money if it is also embodies the unit of account. Something that is used as a medium of exchange and embodies the unit of account is a medium of account and so money; something used to both quantify and pay exchange obligations.

(Money is also a store of value, but that is the least distinctive thing about it; many things are stores of value. Money’s role as a store of value comes from its swap value, which takes us back to it being a medium of account. Yes, we use it because of expectations about its future ability to operate as a medium of account, but that is what is distinctive about it, not being a store of value.)

In modern economies, the central bank—the Reserve Bank of Australia (RBA); the Bank of England (BoE); the US Federal Reserve (the Fed); in the Eurozone, the European Central Bank (ECB); the Bank of Japan (BoJ)—is the monopoly provider of local money, the money issued and used in your country. (Or, in the case of the Fed, the monopoly provider of the global reserve money which is also US local money.) The RBA, like the Fed, has a "dual mandate" of keeping inflation down and employment up. Such a mandate is, in effect, a legal obligation imposed on the central bank to neither flood the economy with excess money (causing inflation) nor to starve it of money (causing a fall in transactions from people maintaining their preferred level of money holdings by cutting back on spending and thus transacting). Since—for a given level of prices—the level of transactions determines the level of spending, and thus income (everyone's money income is someone else's spending), the latter matters; serious transaction "crashes" are known as recessions and depressions.

Unbalanced credibility
The ECB has price stability as its primary objective, with other objectives being subordinated to it. The BoE has a growth and employment objective, but it is subordinate to price stability. The BoJ just has a price stability objective. The problem with such inflation targeting by the central bank is that the central bank then explicitly promises (or is strongly expected) not to provide excess money but has no such explicit or implicit commitment to provide sufficient money to keep the level of transactions up. The central bank then acquires unbalanced credibility—people believe that their money will retain value but have much less basis for confidence in the future direction of income; unlike expectations about future prices (and so the future value of money), the future direction of income lacks any policy anchor. So, if people increase their holdings of money, and the central bank fails to adjust for this, people then cut back on spending, transactions fall so income falls, so people cut back on spending to maintain their preferred holdings of money, and the downward spiral is on. People (quite rationally) have lowered expectations of income and so engage in less spending, which confirms (and magnifies) the lowered expectations of income.

The level of money provision (and associated expectations) being required to stop actual deflation (which the central bank is expected to do to maintain an inflation target) being less than the level of money provision (and associated expectations) required to have transactions recover (which the inflation targeting central bank is not expected to do), an economy can remain "stuck" in output being well below capacity—the most obvious manifestation of which is unemployment, where labour use is well below labour supply—for a considerable period. (Or, in a milder version, stuck with much lower levels of capacity increase than would have been otherwise possible—Japan has been a manifestation of this as the Bank of Japan has regularly clamped down to maintain its, very low, inflation target; thereby offsetting any stimulatory effect from the amazing run of government budget deficits that have driven Japan’s public debt to the highest in the developed world.)

If an economy has high debt levels, then the level of economic stress from any significant fall in transactions (and so income) is even higher, as people struggle to pay back debts with lowered income. (For an example, see the Eurozone.) If the stress is sufficiently great, the potential for debt defaults—and so significant destruction of financial assets (one agent’s debt being another’s asset)—and consequent threat of major damage to, or even the collapse of, the financial system then further encourages a flight to "safe assets" and away from spending. (Again, see the Eurozone.)

In such a situation, the central bank (as the monopoly provider of local money and so dominant generator of expectations about same) is doing what monopoly providers normally do—it is under-providing its product (in this case, expectations coverage rather than actual currency) to maximise return (in this case, its credibility as an inflation targetter). Once an economy is in this situation, it can be hard for the central bank to change course, because that would have serious reputational effects on the officials running the bank, as it would be an implicit (or explicit) admission that their failure had caused the transaction crash and consequent economic misery in the first place. (For an example, see the Fed.)

As Danske Bank economist Lars Christensen has pointed out in his excellent Market Monetarist blog, failure by the Fed and the ECB to respond to increased demand for dollars and euros in the second half of 2008 is what caused the Great Recession to be The Great Recession—the largest peacetime crash in US money income (i.e. transactions) since 1938 and the largest crash in overall OECD money income since the organisation was founded.

Failed accountability
Both the Fed and the ECB have since behaved as monopoly providers, under-providing (expectations about) money to maximise their credibility as inflation targeters and, in refusing to shift policy, minimising reputation damage from their failure to react to changes in demand for money. The failure of the bulk of the economics profession to call them on it (a constant frustration for Scott Sumner) means that the reputation effect continues to militate against policy change.

[Read the rest at Skepticlawyer. Cross-posted at Critical Thinking Applied.]


  1. Hi Lorenzo. Apologies if you have already done so, but I think you'd get a real kick out of marxist/anarchist Anthropologist Debt by David Graeber. It has provoked ecstasy among Anglo-American leftist academic types.

    1. Hi Peter

      Had a glance at the first chapter. Moralism parading as analysis. Which is not to say he is not on to something. The Menger-Mises theory of the origins of money is pretty hopeless and not supported by the archaeological record. But he does not seem to have much idea of what money is.

    2. I bought the Kindle version and downloaded it onto my iPad. His idea of money is more confusingly put than incoherent and the moralism only sometimes overrides the analysis. With some caveats--particularly about problems with terminology and consistency--I am finding it a deeply enlightening economic history.

  2. p.s. Not that I'm implying you, yourself, are on those types! :)

    1. You are safe, I did not take that implication ;)