In a previous post I argued that money is important because it pins down nominal variables like the price level and NGDP.  In this post and the next couple, I’ll explain how money determines the price level.  Let’s start with the most common monetary system in modern world history—the silver standard.  Indeed let’s assume that the unit of account is one pound of sterling silver, or “pound sterling” for short.  Silver itself is the medium of account.

Money can be defined in many ways, including the medium of account, the medium of exchange, or highly liquid assets.  I believe the medium of account definition is the most useful, as it will allow us to quickly zero in on the key issues, without the distractions of media of exchange that might or might not be convertible into silver.

As noted earlier, the value of the medium of account (let’s call it “money”) is equal to 1/P.  The price level is determined in the silver market.  Modeling the (long run) price level is a microeconomic problem.  However the various effects of changes in the price level are macroeconomic problems.  Here’s how simple it is to model the (long run) price level when silver is money:

When there is a new silver discovery that shifts the supply of silver to the right, the value of silver falls and the price level rises inversely proportionately to the fall in the value of money—by definition. There is no quantity theory of money yet; that will come later with fiat money (although ironically the theory was invented during a commodity money period where it doesn’t quite apply.)

Eventually most nations switched onto a gold standard regime; in the US the unit of account was the dollar, defined as 1/20.67 ounces of gold (until 1933.) Because governments generally don’t operate gold mines, monetary policy consists of one tool, and one tool only, shifts in the demand for gold.  This can be done in all sorts of ways, such as changing the amount of gold backing each paper dollar via OMOs or discount loans, or by changing reserve requirements so that banks demand more currency, which leads to a greater derived demand for gold to back that currency.  Less demand for gold was expansionary (shown on graph), and vice versa.  Small countries obviously had little impact on the value of gold, which was determined in global markets.

Under a gold standard there was a “zero lower bound problem” for gold reserves, which Keynes misdiagnosed as a liquidity trap.  Thus it’s easier to do tight money than easy money, because easy money is constrained by the fact that central bank gold demand (gold reserves) cannot fall below zero.

Most people think this is why the US left the gold standard in 1933.  However we didn’t really leave the gold standard, we just temporarily suspended it, and we were never even close to running out of gold reserves.  It’s not clear what the real problem was—perhaps FDR couldn’t get the Fed to inflate as much as he wished, and thus did an end run by raising the price of gold.  Even so, the dollar was re-fixed to gold in 1934, and stayed fixed until 1968, when we finally stopped using gold as a medium of account.

The long phase-out of gold lasted for 34 years, and saw a very large rise in the price level.  This inflation can be attributed to three factors, two of which reflected decisions of FDR, and the third was luck:

1.  The revaluation of gold from $20.67 per ounce to $35/oz.  This alone raised prices by 69%.

2.  FDR reduced global gold demand by making it illegal for Americans to hoard gold.  Later American presidents reduced the gold/currency ratio.

3.  Most of the remaining gold demand was in Europe.  The Depression, rearmament, and WWII put enormous pressure on their economies, leading to a dramatic reduction in European gold demand.

Even so, by the mid-1960s US policy was so expansionary that there were expectations that we’d eventually leave the gold standard.  Finally in 1968 we closed the gold window to foreigners (other than governments) and the free market price rose above $35.  The gold standard was finished, never to return.

Why the 34 year phase-out?  People today cannot imagine how entrenched gold standard thinking was back in 1933.  Contrary to widespread belief even Keynes was vehemently opposed to a pure fiat money regime—instead favoring an adjustable peg to gold.  The post-WWI hyperinflations were fresh in peoples’ minds, and if you talked about the virtues of fiat money in 1933, any “Very Serious Person” would have simply pointed to Weimar Germany.  End of discussion.

By 1968 the post-war Keynesian model was dominant, and money had been pushed into the background—not to reappear until the Great Inflation reminded people of its importance.

Next we’ll develop a model of fiat money.  It will also feature a price level determined by the supply and demand for the medium of account (which is now cash), but there are several important wrinkles that lead to dramatically different policy implications.

PS.  You might wonder why all the inflation didn’t occur between 1933 and 1945, instead of continuing during 1945-68.  After all, the three factors I discussed above all occurred in the earlier period.  The answer is that the Fed hoarded vast quantities of gold during 1933-45, which held down inflation.  Then they gradually reduced their demand for gold after WWII, and hence prices kept rising during the 1945-68 period.

PPS.  Doesn’t silver now cost about 300 pounds per pound?  That’s some serious currency debasement.

PPPS.  I hope Brad DeLong is right, as I’ve spent most of my adult life studying the Great Depression:

Second, you never know what parts of history may turn out to be useful and very important. Ten years ago I thought that my curiosity about and interest in the Great Depression was an antiquarian diversion from my day job of understanding the interaction of economic institutions, economic policies, and economic outcomes. The fact that we had gone through the Great Depression, had learned lessons from it, and had incorporated those lessons into our institutions and policy processes meant that there was little practical use to going over it once again. Boy, was I wrong. History may not repeat itself, but it certainly does rhyme””and nothing made an economist better-prepared and better-positioned to understand what happened to the world economy between 2007 and 2013 than a deep and comprehensive knowledge of the history of the Great Depression.

Here’s Bill Woolsey:

I sometimes have the impression that microeconomists smugly look down upon macroeconomists.    Microeconomics is scientific and empirical.   Macroeconomics is a mess of conflicting theories that apparently cannot be distinguished empirically.

But then…

What about the debate regarding the minimum wage?

As soon as microeconomics becomes politically relevant and controversial, suddenly the basic model (supply and demand) is subject to dispute and the empirical evidence becomes doubtful.

This reminds me of debates I occasionally get into about whether economics or physics is more “scientific,” or more “successful.”  To me it’s a nonsensical question, as one is comparing apples and oranges.  Physics can be used to predict planetary motions more accurately than economics can predict GDP and inflation.  But economics can predict GDP and inflation more accurately than applied physicists can predict earthquakes or long range weather conditions—something we care about far more than planetary motions.

Comparisons only make sense when two distinct fields are trying to explain the same thing.  Thus you might want to examine whether economists or sociologists are better able to explain crime.

Speaking of crime, I love this Alex Tabarrok comment:

Australia has great natural beauty. The British should have left the convicts behind and moved everyone else.

I agree with the entire post.  He forgot to mention that Australia’s government is just as small as the US government, but they lack all sorts of problems that American progressives claim are caused by the fact that the US government is smaller than European governments.  I hope to visit Queensland this summer.

In a recent post I argued that money matters for real variables like the unemployment rate.  But it’s surprisingly hard to explain why, requiring a roundabout analysis.  First we’ll need to explain why money matters for nominal variables like inflation and NGDP.  Only then will we be able to return to the even more difficult problem—the business cycle.

This post will cover a few basics that experienced readers will wish to skip.  The key concept with be the “value of money,” which can be defined as:

Value of money = 1/(price level)

This definition actually comes out of basic microeconomics.  In upper level micro classes we move away from simple supply and demand curves, and start talking about “relative prices,” or “real prices.”  Thus if the CPI rises 10% per year, then goods going up 8% are seeing their price fall in relative terms and those experiencing 12% price increases see their relative price increase.  The relative price is the actual price relative to the price of all other goods in the economy.  Now let’s do the same with money.  What’s the nominal price of money?  The answer is one.  What’s the real price?  It’s the purchasing power of money, how many goods you can buy with each dollar, which is simply 1/price level.  Thus if the price level doubles then the purchasing power of money, i.e. its value, falls in half.

The field of monetary economics exists for one reason, and one reason only—money is the medium of account, the good we use to measure all other values.  Most textbooks oversimplify this concept, combining two ideas into “unit of account.”  Currency notes are the medium of account, the thing used to measure value.  Abstract accounting units like the US dollar, the Canadian dollar, and the euro are examples of a unit of account.

Because money is the good in terms of which all other goods are priced, changes in the value of money are associated with changes in the price level, and in other nominal variables as well.  Note that this is not a “theory,” it’s a definition.  Theory will come in later, when we ask whether government policymakers can control the price level via “monetary policy.”

Irving Fisher liked to use the metaphor of money as a measuring stick (of value.)  First we’ll do an example with the price level, then the same example with measuring sticks:

Year      Income    Price level  Real Income

1978     $20,000        1.0           $20,000

2013    $120,000       3.0          $40,000

So prices have tripled over the past 35 years.  The person’s income rose by 6-fold.  How much better off are they?  They can now buy twice as many goods and services.  Technically this is derived as follows: real income = $120,000*(1.0)/(3.0).  Now let’s do the same example with the height of the child:

Year      Height    Real height

1978      1 yard         1 yard

2013      6 feet          2 yards

The child grew 6-fold in nominal terms, but is only twice as tall in real terms.  Everyone would scoff if a proud father claimed his son was now 6 times taller, and yet someone who claims to be making 6 times as much money in 2013 as in 1978 is making the exact same mistake.  They are implicitly assuming that 1978 dollars are the same thing as 2013 dollars.  But each dollar today only has 1/3 the value of a 1978 dollar.  We would say they suffer from “money illusion.”

Suppose something other than cash had been used as money.  If apples were money, then a huge apple harvest that lowered the value of apples would cause lots of “inflation.”  In fact every time the relative price of apples falls sharply we do have lots of “apple inflation.”  And when the relative value of silver soars we have lots of “silver deflation.”  Why do we only care about money inflation, not the other types of inflation and deflation?  That’s a surprisingly hard question to answer.  In textbooks it’s covered in two different sections:

1.  The welfare costs of inflation.

2.  The welfare costs of business cycles.

In theory measuring sticks should not matter very much.  Whether you measure things using foot long rulers or yardsticks doesn’t affect their actual size.  But imagine a kingdom where for some strange reason people made contracts to supply 100 “units of wheat” 12 months in the future, where units were left unspecified.  Or they agreed to work for the next year at a wage of 2 units of wheat per hour.  Also assume the king could change the units from kilos to pounds to ounces whenever he wished.  Now a change in units certainly would affect the public.  And that’s the primary reason why monetary inflation is important and apple inflation matters very little (except for apple farmers and consumers.)  Our measuring stick of value (money) is itself always changing in value, and this causes all sorts of problems.

An economist once said; “money is a veil [hiding the real economy], but when the veil flutters, real output sputters.”

Next we need to explain why the value of money changes over time.  Another couple posts.

PS.  A NASA satellite once crashed because some parts had been measured in inches rather than centimeters, and were mismatched.

PPS.  Some journalists define the value of money in terms of its ability to buy other monies.  This is an odd definition, but the math is the same.  The dollar price of euros is 1/(euro price of dollars).  Even weirder are those who define the value of money in terms of a very scarce but heavy yellow metal.  Later we’ll see that there is one arbitrary definition of the value of money that might be even more useful than the standard definition:  The share of nominal GDP that can be bought with each dollar.

Suppose a big investment bank went into 2013 as a Keynesian institution, believing that “fiscal headwinds” would lead to a growth slowdown, and then was mugged by reality.  What would it sound like if they came to the conclusion that monetary policy would offset fiscal austerity, indeed more than offset fiscal austerity.

This is what it would sound like.

They’ve just raised their Q1 growth forecast from 1.5% to 3.0%, and full year growth forecast to 3.5%.

Market monetarists:  Keynesians and Austrians who have been mugged by reality.

PS.  I do not think growth will be as strong as they do, but I do think the recent fiscal austerity will have almost no impact on growth, as it will be offset by monetary stimulus.

Here’s Frances Coppola:

Plenty of people have questioned why small depositors had to be hit at all. The German financial minister, Wolfgang Schäuble, who appears to have masterminded the bailout plan, wanted large depositors to take a much larger hitso that small depositors could be protected. The IMF took a similar view. It seems that the Cypriot government did not agree. There is considerable speculation as to why the Cypriot government preferred to see small depositors hit. To me it seems most likely that it has to do with the Cypriot government’s wish to avoid upsetting Russia, given Nicosia’s hope that Russia will contribute to the bailout by softening the terms of its existing sovereign loan, and the considerable amount of money (some of it undoubtedly dirty) from Russian oligarchs that is held in Cypriot banks. But it is also possible that Nicosia is still hoping to maintain its foothold in the international tax haven network. Even with the 2.5% increase imposed as part of this bailout, corporation tax is a very competitive 12.5%, and the Cypriot government has encouraged growth of the financial sector by attracting deposits from overseas investors.  Frankly I think this is pie in the sky.

It’s interesting to note that all eight EU countries on the Mediterranean (or close by in the case of Portugal) opted to get into the euro, whereas most of the countries in the far north stayed out (Sweden, Denmark, Britain, and of course Iceland and Norway stayed entirely out of the EU.)  What explains this pattern?  Perhaps this is just the standard problem of clubs; those who see themselves as better than average prefer to stay out, and vice versa.

The Nordics and Britain look at the corruption in some of the Mediterranean countries with distaste, and stay away.  The Russians feel an affinity with the Mediterranean countries.  Putin is very close to Berlusconi, and Russian oligarchs like to put their ill-gotten gains in Cypriot banks.  And which country is stuck right in the middle of this Nordic-Mediterranean-Russian triangle?  Germany, which partly for historical reasons feels it must stay fully committed to “Europe.”  I’m less sure about the Benelux countries, but would note that they were founding members of the EU, and hence are more psychologically committed than the Nordics.  Finland has historical reasons for wanting to bond closely with Europe.  Germany’s misfortune is that it has two thirds of the northern eurozone population, whereas if the 5 standoffish northerners had joined, it would be only 40%.

The market monetarists have lots of good posts on Cyprus.  Here’s Nick Rowe:

Governments usually provide deposit insurance to prevent bank runs.

If the banking system is too big, and the banks’ losses are too big, relative to the government’s capacity to pay that insurance claim, that’s a problem.

But the problem is very different if the government (unlike Cyprus) can print currency to pay bank deposits that are liabilities in that same currency. If worse comes to worst, the government just prints as much currency as is needed to pay the depositors what they are owed. If that means is has to print “too much” currency, that’s a problem, because it means inflation will be “too high”. But that inflation will adversely affect the real value of currency and bank deposits equally. So even if people expect it might happen again, this doesn’t cause a bank run, where people try to get out of bank deposits into currency.

It’s a very different sort of problem in a country like Cyprus where the government cannot print money. If people see a “one-time tax” on bank deposits happen once, they might expect it to happen again. And if they expect it to happen again they will try to get out of bank deposits into currency. Which is a bank run.

The difference is that inflation from printing too much money is a tax on currency too. Cyprus cannot tax currency; it can only tax bank deposits.

If the banking sector is too big, and if bank losses are too big, relative to the country’s ability to pay, deposit insurance as a way to prevent bank runs is not credible and won’t work in a country that cannot print.

And David Beckworth:

What the EU and IMF did to Cyprus today is poised to be a repeat of what happened to U.S. banking in 1933. In February of that year, the governor of Michigan declared a statewide banking holiday as a means to resolve an impasse on how to wind down an important bank in Detroit. Like the Cyprus action today, the governor’s actions back then sent chill waves across a continent, as depositors in other states began to wonder if their governors would also call bank holidays to prevent withdrawal of funds. The fear was so poignant, that the Ohio governor made it a point to declare the bank holiday would not happen in Ohio. But it was too late, the die had been cast. By March 1933, 48 states had declared some form of bank withdrawal restrictions as the bank panic spread and fed upon itself. Only with FDR’s national bank holiday and the advent of national deposit insurance in March, 1933 was the bank panic stopped.

What is crazy about the Cyprus heist today is that it has the potential to create the same self-fulfilling bank panics across Europe, but without the benefits of a unified treasury to credibly commit to Eurozone deposit insurance. I can’t help but hear the echoes of 1933 now unfolding in Europe.

And Lars Christensen:

I am not arguing that Cyprus would not have had problems if the ECB had targeted NGDP, but I am arguing that if the ECB had followed a proper monetary policy rule like NGDP targeting then a banking problem or a sovereign debt problem in Cyprus would never had become an issue for the entire euro area.

My sense is that taxing the big depositors was sort of like letting Lehman fail–a very good idea that was very poorly timed.  Taxing the small depositors is a bad idea, badly timed.