Many people continue having trouble with the “hot potato effect,” which to me is the sine qua non of monetary economics. You either understand it, or you understand NOTHING. They want explanations they can understand at the individual behavior level. But that just won’t work in this case. Part of the problem is that people want to think in terms of a Real —> Nominal transmission mechanism, which seems natural in a world of sticky prices. “Why would Joe buy a new car?” But that won’t work either. It’s a dead end.
I’ve tried to explain the hot potato effect using analogies with the apple market, but I think I’ve found a better way: gold. When compared to apples, gold has properties much more similar to money. Even better, it used to be money!
I’ll walk you through the HPE effect step by step, and you tell me where you get off the train:
1. Assume gold sells for $1200. Interest rates are low, so the expected future price is roughly the same, maybe a bit higher. Now assume a company discovers a gold hoard so vast that world output soars. Over a period of years the extra output causes gold prices to fall in half. But why? Because before the discovery people were already in equilibrium, they held as much gold as they wanted to hold at existing prices. The extra gold is a sort of “hot potato” that people try to get rid of. But obviously not by throwing it away! They get rid of it by selling it. But notice that while that works at the individual level, it doesn’t work in aggregate. Now someone else has the extra gold. (That’s why attempts to understand money at the level of the representative consumer fail.) The only way for society as a whole to get rid of the extra gold is by driving down the price of gold until people want to hold the new and larger quantity. Assume the price falls in half. That also means the value of gold relative to other goods and services falls in half.
2. Same thing, but assume the company merely announces the big gold discovery, but it is credible. Now gold prices would plunge on the announcement.
3. Same thing except the company announces that radar has detected the vast gold deposit, but it will take 2 years to dig down and get it out. Again, prices will plunge right away, almost as much as in case 2. (I hope everyone is still with me, this is just microeconomics 101.)
4. Now let’s do the same three examples but assume gold is the medium of account. How does that change things? Obviously the price of gold can no longer plunge, as the price of the MOA is fixed by definition. But it’s value will still fall sharply, as the price of other goods and services rise. Now for the first key difference: In cases 1 through 3, the fall in the value of gold was nearly instantaneous. Now with sticky prices the fall in the value of gold (the MOA) will be more gradual. But the long run effect will be the same. Still with me? The smartest people that don’t agree with me on the final steps (people like John Cochrane) would still be with me here. As I recall Cochrane is essentially a “market monetarist” for a commodity money system.
Notice that so far these changes can be fully explained using the basic principles of microeconomics. There is no need to resort to “transmission mechanisms” such as interest rates. Just S&D. However the following is important; if prices are sticky then other things will change to bring about a short run equilibrium in the gold market, before the price level has had time to fully adjust. And obviously one of those “other things” might be a change in interest rates. Other “other things” include changes in asset prices and real output.
But I keep coming back to the notion that no matter how important those other factors are, the HPE is still in some sense primary. It’s what explains the long run effect of more gold on the value of gold. It’s still econ 101. The other effects are side effects that help nudge us toward that final equilibrium.
5. Now switch the medium of account from gold to cash. I claim that changes nothing essential. There are three cases:
a. Positive interest rates: The base becomes a hot potato, just as in the previous examples. IOR changes that slightly, but less than you’d think. Peter Ireland showed that the quantity theory still applies in the long run, even with IOR. By which I mean than a one-time permanent increase in the base is still expected to lead to a proportional increase in the long run price level, even with IOR. Money is still neutral.
b. Nominal rates are zero and expected to stay zero forever. Now open market operations are meaningless. Bonds are essentially cash, and pay no interest. It’s like swapping a $20 bill for two $10 bills. Fiscal policy is powerful but currently inefficient, as the national debt is too small.
c. Rates are zero but expected to be positive in the future. Now a permanent increase in the base has an inflationary effect, for the same reason we discussed in the case of the gold reserve that would take two years to dig down to. A temporary increase in the base? Little or no effect, but then that’s true even if rates are positive.
6. Now let’s assume the MOA is cash plus reserves. There’s still no change. Reserves are also a hot potato. Indeed 100 years ago all reserves were cash.
7. Now let’s assume a cashless economy where the MOA is 100% reserves. Still no change; reserves are still a hot potato. And as I said, IOR changes nothing fundamental. Banks have X demand for reserves at an IOR of Y%. If you double the quantity of reserves and keep the IOR at Y%, banks will suddenly be holding excess reserves. The HPE kicks in. Zero bound? See case 5.
Did anyone fall off the train on the way to market monetarist enlightenment? I think I see a few MMTers in the ditch along the way, still scratching their heads.