Now we’re talking! Nick Rowe has a new post up responding to my claim that the medium of account (MOA) is the essence of money, not the medium of exchange (MOE.) Nick disagrees, as do all the other market monetarists who have weighed in. But that’s never stopped me before. Let’s think of a basic monetary model of the price level:
P = Ms/(Md/P), Where Ms = Md.
Oops, that’s a tautology, not a model. Let’s try again:
Md/P = f(i, Y) Where real (base) money demand is negatively related to i and positively related to Y.
Ms is set by the Fed.
Now consider what we mean by “M.” If M is the medium of account, but not the medium of exchange (as in my Zimbabwe example) then the model works fine. If M is the MOE but not the MOA, then it doesn’t work at all.
Scott Sumner argues that it is the medium of account function that matters. My view is different. Here is my view:
Demand and supply of the medium of account determine the equilibrium price level.
Demand and supply of the medium of exchange determine whether the economy is in a boom or a recession.
If the MOA determines the equilibrium price level, then ipso facto it determines NGDP. So unless I’m mistaken Nick agrees that the market for the MOA determines NGDP. I claim that business cycles are caused by NGDP shocks in the presence of nominal wage stickiness, or perhaps both wage and price stickiness. Once one accepts that MOA shocks cause NGDP shocks, it seems to me that the battle is over. In my Zimbabwe example the MOA got more valuable due to higher gold demand, and the MOE got almost worthless from excessive money printing, and yet Zimbabwe experienced deflation as the Z$ price of gold soared. But maybe I am missing something.
Nick’s a very smart guy who knows monetary economics better than I do, so let’s try to figure out where the disagreement comes from:
1. I look at recessions as big drops in output, associated with involuntary unemployment. I am pretty sure that Nick views them as big drops in spending, where monopolistically competitive firms are not able to find buyers. Perhaps that’s why he focuses on the MOE. But in the end, gross domestic expenditure equals gross domestic production. So that really shouldn’t be the decisive difference.
2. Nick seems to assume a disequilibrium model, whereas I assume the MOA and MOE markets are continually in equilibrium. Here’s Nick:
But what determines Y when we are out of equilibrium, because the Emperor Diocletian has issued an edict forbidding any price changes?
Thought-experiment 1. Start in equilibrium, hold all prices (update: both Ph and Ps) fixed, then halve the stock of gold (medium of account). What happens?
There is an excess demand for gold in the gold market, but nothing else happens. The market for haircuts continues as before. People want to sell some of their silver for gold, but they can’t, because nobody wants to take the other side of the trade. The production and sale of haircuts for silver continues just as before, because there is no change in the relative demands for silver and haircuts. There is no change in the marginal utility of silver, the marginal utility of getting a haircut, or the relative price of haircuts and silver Ph/Ps. So trade of silver for haircuts continues just as before.
An excess demand for the medium of account does not cause a recession.
But why would the gold (or money) market ever be in disequilibrium? In the early 1930s when a big increase in the demand for the medium of account (gold) was causing worldwide deflation and depression (remember sticky wages), anyone could freely get gold any time they wanted it. There was no shortage at all. Indeed the same is true for currency, which is easily available via ATMs, even when a reduction in the growth rate in the currency stock is triggering a recession (as in late 2007 and early 2008.) A shortage is very different from a reduction in supply. A shortage means people are unable to hold the currency or gold balances that they wish to hold.
But what if prices are sticky in the short run? In that case wouldn’t a big reduction in gold, or currency, cause a shortage of that MOA? No, interest rates are flexible, and the liquidity effect of interest rates is what equilibrates the MOA market until prices have had time to adjust. Then over time NGDP begins to fall, so people don’t need as much MOA, and thus interest rates begin to fall. In the very long run the NGDP will adjust by enough to fully offset the MOA shock, and interest rates will return to their original level. At no time is the MOA market out of equilibrium, it’s just that different variables are equilibrating the market; first interest rates (the opportunity cost of holding MOA), and then NGDP, and in the long run only prices change—money is neutral in the long run.
I can’t make sense of macro unless I think in terms of one set of markets always being in equilibrium (stocks, bonds, forex, currency, gold, etc) and another set of markets being out of equilibrium during business cycles (labor, and perhaps some monopolistically competitive goods.) My opponents talk about scenarios where it seems like almost everything is out of equilibrium. I’m just not smart enough to figure out what’s going on in that case—it’s like trying to keep track of all the leaves swirling outside my window last night.
One other point. Assume there is a negative gold market shock, and gold is the MOA but not the MOE. Also assume a dual MOA, with paper currency being the MOE. I do realize that in order to maintain convertibility the central bank may have to reduce the currency stock, and that this could be viewed as causing a recession. Indeed this is precisely what happened in Canada in the early 1930s. But it’s very strange to attribute that early 1930s deflation/depression to a falling Canadian currency stock. That response was endogenous. Rather it makes more sense to view the global hoarding of gold as the cause of the Canadian deflation. After all, why would the Canadian central bank decide to run a highly contractionary monetary policy in the early 1930s?
When there is a negative monetary shock from the MOA market, lots of other things will happen. The nominal interest rate might shoot up in the short run. And the Keynesians will say monetary policy is really all about interest rates. The central bank will be forced to contract the currency stock, and the non-Sumnerian (non-insane?) market monetarists will say monetary policy is all about adjustments in the stock of MOE, relative to shifts in demand for MOE. But isn’t the heart of the matter that the MOA got more valuable, forcing global deflation on any country using gold as the MOA?
There is a Canadian Nobel laureate in economics who would understand my argument. His Nobel lecture claimed that the Great Depression was caused by too much demand for gold. Maybe he’ll leave a comment.
Paging Siena, Italy . . .