# Money and Inflation, Pt. 4 (Answers, plus the role of expectations)

[Read my previous post first, if you have not already done so.  Also note that Marcus Nunes has some excellent graphs illustrating these points.]

I didn’t get as many answers as I expected, but there were a few good ones.  Phil got the ball rolling but fell a bit short on the last two questions.  George wins the gold star for getting there first, with honorable mention to Don and Steve who also nailed it.  Others came close.

Here’s how I analyze the Barro data set (which I’ll reproduce on the bottom of this post.)

1.  The eyeball test suggests the Quantity Theory of Money (QTM) works dramatically better for high inflation countries than low inflation countries.  (Also true of PPP and the Fisher effect, for much the same reason.)  In fact, money growth affects prices in all countries, but other factors are relatively more important when inflation is low.  Let’s suppose that the gap between money growth and inflation does not vary with the average rate of money growth.  For instance, suppose the gap is 3% on average, when examining very long run data.  In that cases the gap will seem almost trivial when money growth rates become very large, say more than 30%/year.

If you see the QTM as claiming money growth and inflation rates are highly correlated, then the theory works better for high inflation countries.  If you view it as it claiming that a given one time increase in the money supply will cause a proportionate increase in prices in the long run, then it should work equally well in low and high inflation countries.  Indeed even at the zero interest rate bound.

2.  In the vast majority of countries the money growth rate exceeded the inflation rate.  That means the money demand curve tends to shift to the right over time, at least when you describe money demand as a function of the value of money (1/P).  Many people prefer to visualize this pattern with the Equation of Exchange:  M*V = P*Y.  If V is fairly stable, and Y increases over time, then inflation will be less than money growth.  RGDP growth is deflationary!!  (Something our textbooks ignore—and check out Singapore below.)  In Barro’s sample of 83 countries, only one experienced falling RGDP on average over the entire 30 year period.

3.  Why does the money growth/inflation gap exceed 10% in only one of the 83 cases?  Partly because RGDP growth averages less than 10% in all 83 countries.  But it also requires velocity to be relatively stable.  Keep in mind that a 30% change in velocity over 30 years is fairly large, and yet is still less than 1% per year on average.  For money growth to exceed inflation by more than 10% you need the RGDP growth rate minus the change in velocity to exceed 10%, which occurred only in Libya.

4 and 5.  In order for the inflation rate to exceed the money supply growth rate you’d need the change in velocity to exceed the RGDP growth rate.  That would be a fairly large increase in velocity, and occurred in only 12 of the 83 countries.  The vast majority of these situations occurred in the high inflation countries.  (Seven of twelve in the 13 highest inflation countries.)  This is because velocity is positively correlated with nominal interest rates.  For velocity to rise sharply you normally need a large increase in interest rates, which usually implies a large increase in inflation (or more precisely NGDP growth) expectations. Unfortunately the table doesn’t show the change in inflation expectations. However it stands to reason that a very large increase in inflation expectations is more likely to occur in countries where the average rate of inflation is higher, and that’s what we observe.

To summarize, in equilibrium:

P = Ms/(Md/P)

Let’s assume real money demand is k*Y.  The parameter ‘k’ is the share of gross income that the public chooses to hold in the form of base money.  In that case:

P = M/(k*Y)  (or MV=PY, if you prefer.)

Now let’s assume that k is negatively relative to the opportunity cost of holding base money, and that base money doesn’t earn interest:

P = M/[k(i)*Y],

where i is positively related to both the level of NGDP relative to trend, and the expected rate of NGDP growth.

If you are more interested in NGDP than the price level (and if you aren’t you should be), then we have:

P*Y = M/k(i)

That’s my version of the QTM.  Until I see something better I’m not interested in alternative Keynesian, MMT or fiscal theories of inflation/NGDP.  Barro’s data set is the one I use to judge all competing theories of money and inflation.

However the fact that expectations play a role in the inflation process makes things far more complicated than the early QTM proponents assumed.  In the next post we’ll see how expectations shifts can lead to some results that look wildly inconsistent with the simple QTM.

PS.  Lars Christensen is forming a Global Monetary Policy Network.  I’ve already joined.

Country     MB growth    RGDP growth    Inflation   Time period

Brazil              77.4%             5.6%                 77.8%        1963-90

Argentina        72.8%             2.1%                 76.0%        1952-90

Bolivia             49.0%            3.3%                  48.0%        1950-89

Peru                49.7%             3.0%                 47.6%        1960-89

Uruguay          42.4%             1.5%                 43.1%         1960-89

Chile               47.3%             3.1%                 42.2%        1960-90

Yugoslavia       38.7%             8.7% (FWIW)     31.7%         1961-89

Zaire               29.8%             2.4%                  30.0%       1963-86

Israel               31.0%             6.7%                 29.4%        1950-90

Sierra Leone     20.7%            3.1%                  21.5%        1963-88

.  .  .

Austria             7.1%             3.9%                   4.5%         1950-90

Cyprus            10.5%            5.2%                   4.5%         1960-90

Netherlands      6.4%             3.7%                   4.2%         1950-89

U.S.                 5.7%              3.1%                   4.2%        1950-90

Belgium           4.0%             3.3%                   4.1%         1950-89

Malta               9.6%             6.2%                    3.6%        1960-88

Singapore       10.8%            8.1%                     3.6%        1963-89

Switzerland       4.6%             3.1%                   3.2%        1950-90

W. Germany     7.0%             4.1%                    3.0%        1953-90

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51 Responses to “Money and Inflation, Pt. 4 (Answers, plus the role of expectations)”

1. TallDave
26. March 2013 at 07:29

George wins the gold star

Is that freely convertible to bitcoins, or does the gov’t set the price?

2. marcus nunes
26. March 2013 at 08:37

http://thefaintofheart.wordpress.com/2013/03/26/scotts-quiz-illustrated/

3. TallDave
26. March 2013 at 09:11

Possibly interesting — real estate prices as a function of age demographics.

I can think of a few objections.

4. ScottÂ´s Quiz Illustrated | Historinhas
26. March 2013 at 10:05

5. Georges
26. March 2013 at 10:31

Thanks! 🙂

6. Scott Grannis
26. March 2013 at 10:53

Scott, in yesterday’s post you said “Individuals can get rid of the cash they don’t want, but society as a whole cannot, at least not in nominal terms.” Based on that assumption, you suggest that Treasury could pay people with cash instead of with a check, and that would essentially guarantee an expansion of the money supply.

I submit that you have made an incorrect assumption. Society as a whole can indeed get rid of unwanted cash, by taking the unwanted cash to the bank and exchanging it for a deposit. The banks, in turn, would take the unwanted cash and return it to the Fed, in exchange for bank reserves. In short, neither the Fed nor Treasury can unilaterally increase the amount of currency in circulation if the public is unwilling to hold it.

In the case of Argentina, with which I’m very familiar, the government paid salaries with cash (printed up 24/7 by the central bank), and cash in circulation expanded rapidly as a result. But the key difference with the U.S. is that most Argentines back then did not have deposit accounts. It was largely a cash economy. So the government could and did inflate everything by “printing money.”

7. Geoff
26. March 2013 at 12:37

Dr. Sumner:

“In the vast majority of countries the money growth rate exceeded the inflation rate.”

Velocity (red line) has been falling (cash preference has been rising) since 1980:

http://research.stlouisfed.org/fredgraph.png?g=gTD

CPI and NGDP growth was stable from around 1985 to 2008, and yet cash preference continued to rise. It is still rising to this day despite CPI and NGDP being on a 3 year growth trend.

A likely explanation is that there is a “real side” phenomena occurring alongside a “nominal side” phenomena. For some reason there has been a long term trend of a lengthening of the period of time that people are holding onto money before they use it in their exchanges. Despite stability in CPI and NGDP growth, this trend has continued.

8. J
26. March 2013 at 13:00

Scott Grannis:

The classic definition of the monetary base is reserves + currency. I believe that Scott is not distinguishing between the two. Indeed, when the Fed buys bonds from a bank, they add to that bank’s reserves. They do not send trucks filled with currency.

9. Scott Grannis
26. March 2013 at 13:23

J:

I don’t think you have understood my point. While the Fed can unilaterally increase the base by buying bonds and paying for them with bank reserves, currency is typically created only when banks exchange reserves for currency. Banks must use reserves to get currency, and that occurs only in response to the public’s demand for currency. Neither the Fed nor Treasury can do a “helicopter drop” of currency and expect it to last, because unwanted currency will eventually find its way back into bank reserves.

10. Georges
26. March 2013 at 14:03

Scott grannis, well the fed can choke off currency though, if it provides less than what people need, right?

11. J
26. March 2013 at 15:24

Scott Grannis:

I don’t think you have understood my point.

You said: “Scott, in yesterday’s post you said “Individuals can get rid of the cash they don’t want, but society as a whole cannot, at least not in nominal terms.” Based on that assumption, you suggest that Treasury could pay people with cash instead of with a check, and that would essentially guarantee an expansion of the money supply. I submit that you have made an incorrect assumption.”

An expansion of reserves is an expansion in the monetary base like an expansion of currency. Both contribute to an expansion in the money supply (through the deposit-currency ratio or the deposit-reserves ratio). You are right that a helicopter drop may not lead to any more currency, but it will lead to more currency and/or reserves, and so will lead to more high-powered money, and so will lead to a higher money supply (unless the deposit-currency and/or deposit-reserve ratios fall enough to outweigh the increase in high-powered money).

Cash is not relevant. What is relevant is cash plus reserves because reserves are effectively cash that is stored in a vault at the bank.

12. Nick Rowe
26. March 2013 at 15:24

Scott: I think your answer to Q1 makes sense; it’s just standard OLS econometrics that if Y=bX+e you need big variance in X relative to the variance in e to be able to estimate b accurately.

But I would suggest an alternative answer: most countries with low inflation probably have Milton Friedman’s thermostat controlling M, so you cannot see any correlation between P and M because M is deliberately being made correlated with Y/V.

13. kebko
26. March 2013 at 15:44

Scott,

This article was in yesterday’s WSJ. It makes some claims about historical Fed policy that seem like they would be impossible to implement. I can’t figure out what to make of it. Are they wrong about this, or is there some confounding detail that they have left out of their telling?
http://online.wsj.com/article/SB10001424127887323393304578364661082431422.html

14. TravisV
26. March 2013 at 16:28

(Sigh) this is REALLY not helpful……

“Shiller: ‘We’re Living In A Totally Artificial Real Estate Economy'”

15. Scott Grannis
26. March 2013 at 17:03

Georges: The Fed always supplies currency on demand, exchanging \$1 of currency for every \$1 of reserves. But banks can “use up” reserves very quickly if cash withdrawals become large. That’s because it takes \$1 of reserves to get \$1 of currency, but it only takes \$1 of reserves to back up \$10 of deposits.

If the Fed supplies ample reserves, as it is doing today, then banks have no effective constraint on their ability to acquire currency. The only limiting factor on currency today is the public’s willingness to hold currency vs. other forms of deposits.

16. Negation of Ideology
26. March 2013 at 18:19

“George wins the gold star”

Congratultions George – but shouldn’t that be the NGDP star?

On the role of expectations – money demand seems to be inversely related to inflation expectations (or perhaps NGDP expectations?). In Marcus Nunes’ Brazil graph, he shows base/GDP tripling after inflation is credibly defeated. And in the long run NGDP growth has no effect on real growth. Then wouldn’t slow NGDP growth maximize long term real seignoriage without any loss in real growth?

Obviously, I’m not talking about a sudden nominal shock like 2008-2009 – I’m talking about gradually resetting expectations.

17. ssumner
26. March 2013 at 19:17

Scott, When I said cash I actually meant base money. I was trying to simplify by considering a simple regime were all bank reserves are vault cash–the sort of system the US had in 1900. All my comments are still accurate if you replace “cash” with “monetary base.”

In any case, banks don’t want to hold substantial bank reserves unless interest rates are zero–which obviously wasn’t the case in the Great Inflation, which is what I am considering here.

Nick, Yes, I was thinking the same thing. Another way of considering the same issue is to look at something like Bretton Woods. Suppose PPP keeps all the inflation rates the same. Then M growth will vary with RGDP growth, not inflation. It will look like poor countries can get rich by printing money!

Negation, You were on the right track until the final conclusion. The real tax revenue from seignorage is delta M/M times real cash balances. So there is the Laffer curve problem. As you make the tax rate higher (faster M growth) the tax base gets smaller (less Md/P) As usual, there is some money growth rate that maximizes the flow of real seignorage–and it’s surprisingly high, unless perhaps you consider the broader damage to the economy that reduces other types of tax revenue.

18. ssumner
26. March 2013 at 19:41

kebko, The Fed did hold rates down close to zero until 1951, but the comparisons with current Fed policy are silly. The Fed is not trying to make it easy for the Federal government to run big deficits–if they wanted to do that they’d increase the NGDP growth rate sharply.

19. Geoff
26. March 2013 at 19:55

“In any case, banks don’t want to hold substantial bank reserves unless interest rates are zero-which obviously wasn’t the case in the Great Inflation, which is what I am considering here.”

Or unless banks’ appetite for risk has decreased.

20. kebko
26. March 2013 at 22:17

Scott,
I don’t understand, all else being equal, how the Fed could “hold rates” down by announcing that they would buy bonds to keep pushing rates under 2.5% without creating some sort of hyperinflation that would lead to a failure of the policy.
Was the policy only possible because the federal government was countering any inflationary pressures by massively dismantling war expenditures in the late 40’s?

21. Dan
26. March 2013 at 22:41

Scott. Thanks for answering my question yesterday on Australia.

By “keeping [Australian] NGDP growing along a fairly stable trend line”….I am presuming this is because of the MP flexibility the RBA has to achieve inflation of 2-3% on average, over the business cycle (i.e. 4% inflation at peak of cycle people are comfortable with). Resulting from this is a naturally higher NGDP than a hard maximum 2% inflation target. Australia therefore avoids the zero lower bound.

Lastly, regarding the scale of the resource boom in Australia. From an RBA discussion paper: the resource economy accounted for around 18 per cent of gross value added (GVA) in 2011/12, which is double its share of the economy in 2003/04. (Rayner, Bishop). I accredit this substantial change to pushing Australian NGDP above 6% and assisting greatly in dealing with the effects of the Global Financial Crisis.

22. Petar
27. March 2013 at 01:13

Great posts Scott, wish I had a chance to learn these thing in college. We basically had half page on QTM.

I still find Yugoslavian data very interesting. It is funny how easily they stopped teaching yugoslavian economic history after the break up, there is really a lot to learn from their economic policies… Ill have to see if i can get more data from that time…

23. dtoh
27. March 2013 at 02:46

Regarding Point 1. This should be obvious… at lower inflation rates the real cost of holding money is less so increases in M are more likely to lead to drops in V.

It seems to me this analysis is just a pretty straightforward exposition of some basic arithmetic identities. Not sure why people don’t get this, but your analysis certainly makes it very clear.

I think the more interesting question is how changes in M translate into changes in RGDP, inflation, and V over the short run and how (as you say) expectations impact this. (Actually, the impact on V seems pretty obvious and therefore not so interesting.) I’ll be looking forward to your next post on expectations.

In anticipation of that post, I think the mechanism is quite dynamic, varies greatly from sector to sector, involves game theory, is dependent on a) past inflation, b) changes in expected NGDP growth, and c) the rate at which those expectations change.

24. Money and Inflation, Pt. 4 (Answers, plus the role of expectations) | Fifth Estate
27. March 2013 at 02:54

[…] See full story on themoneyillusion.com […]

25. Bill Woolsey
27. March 2013 at 03:17

In accounting, and throughout the business community, “cash” means something like M4. It is made up of a variety of short term debt instruments. It surely includes balances in checking accounts, but also savings accounts, C.D.s, commerical paper, T-bills, and so on.

I suppose for retailers, we talk about paying with “cash” or “check.” My deposit slip at the bank distinguishes between “cash” and a place to list “checks.” When I was a cashier, we would add up the “cash” and the checks and credit card receipts separately.

But I think even in retailing, and certainly outside of retailing, the difference is paying “cash” which means right now, or paying with credit. When one firm pays “cash” rather than with credit, that doesn’t mean a sack full of currency but rather immediate payment by check or wire.

Outside of retailing paying with credit means paying in 60 or 90 days. It creates accounts receivable and accounts payable in accounting.

I use the term “currency” to mean the tangible, hand-to-hand currency. I suppose in international trade, “currency” is even broader, referring to different units of accounts. Like, the pound and the dollar are different currencies. When these currencies exchange with one another to determine exchange rate between “currencies” the transactions are for checkable deposits.

In banking, it is common to speak of “vault cash” to refer to hand-to-hand currency at the bank.

The Federal Reserve statistics say “currency held by the public,,” to refer to coins and notes in the hands of firms and households.

When I learned about the money multiplier, there was a reserve deposit ratio and a currency deposit ratio. There was nothing about “cash.”

26. Anonymous
27. March 2013 at 05:53

[…] […]

27. ssumner
27. March 2013 at 06:19

Geoff, You think 3 month T-bills are risky? Seriously?

kebko, They’ve held rates close to zero in recent years. As to the question of why it wasn’t even more inflationary in the late 1940s, polls suggest that people expected deflation after WWII. So that held down the Wicksellian equilibrium nominal rate. By 1951 it was clear that we were moving toward inflation, not deflation, and that’s when the Fed was forced to raise rates to bring inflation back under control.

Dan, The bigger factor explaining high Aussie NGDP growth is a higher trend rate of RGDP growth, partly due to immigration.

Commodities did help the economy in the years leading up to 2008, but nominal commodity output fell in 2009, AFAIK. And Australia did not have recessions when commodity prices were weak in 1998 or 2002. So it’s more than commodities.

Petar, The data isn’t just “interesting”, it’s inaccurate.

dtoh, You said;

“Regarding Point 1. This should be obvious… at lower inflation rates the real cost of holding money is less so increases in M are more likely to lead to drops in V.”

This is not accurate. A one time increase in M leads to a proportionate increase in P at any inflation rate. A change in the growth rate of M leads to V moving in the same direction as the change in the growth rate of M. If M growth accelerates, then V increases.

Bill, I was taught that M1 = C + DD, where C was cash held by the public. I thought that was standard terminology.

28. Rob Rawlings
27. March 2013 at 06:53

“Scott, When I said cash I actually meant base money.”

So in Monday’s example of people getting \$200 of a regular payment paid in newly printed money the relevant detail is not the fact they get cash rather than a check but that the new money adds to the monetary base? If so the same effect on the base could have been achieved just by crediting the acct of the govt agency that issues the checks by an equivalent sum ?

In both cases (it gets new paper money or just a bigger balance in its acct) the agency is richer and if it chooses to spend the new money it will affect the price level via the normal mechanism that you describe.

If so this adds to my view that in your example the “people with more money will spend more” is indeed what is happening, at least to kick-off the price increase process.

With OMOs new money is used to buy assets which the CB holds to implement its monetary policy. Because in this case the fed is assumed to be acting “altruistically” the policy is neutral compared to helicopter drops.

29. Geoff
27. March 2013 at 06:54

Dr. Sumner:

“Geoff, You think 3 month T-bills are risky? Seriously?”

Bid to cover is almost always greater than zero, and recently has been significantly greater than zero:

http://www.bloomberg.com/quote/USB3MBC:IND

Not every bank that wants to buy \$X t-bills, can buy \$X t-bills. To the extent that bids are greater than covers, low risk appetite can be associated with holding reserves.

At any rate, to address your question, I do indeed hold that there is risk associated with 3 month t-bills. The risk of future unforeseen inflation (devaluation) is positive. The risk of sovereign default (remote, but possible, see Russia 1998) is positive. The risk of “operation twist” like policies that could lower 3 month prices (and raise long term prices) is positive. This is a less important point than the point above.

30. TallDave
27. March 2013 at 07:09

Bill, I was taught that M1 = C + DD, where C was cash held by the public. I thought that was standard terminology.

The wiki has a nice chart where M1 also includes minor things like “Traveler’s checks of non-bank issuers” and “Other checkable deposits”: http://en.wikipedia.org/wiki/Money_supply

kebko — Has that ever actually happened, though? Every instance of hyperinflation I’ve read about has happened because a country tried to monetize its fiscal spending. Expectations uber alles.

31. Mike Sproul
27. March 2013 at 16:30

In 1844, Thomas Tooke reported that his (massive) data set showed that changes in the price level PRECEDED changes in the money supply.

In 1980, Thomas Sargent reported the same results in “The Ends of Four Big Inflations”.

Both sets of data refute the quantity theory.

The backing theory explanation is that (1) The money-issuer lost 10% of its assets, (2) this loss of backing caused the money to lose 10% of its value, (3) Peoples’ real balances were 10% lower than desired, (4) Those people brought their assets to the money-issuer, to exchange for 10% more money (5) the money issuer obliged by issuing 10% more money.

32. Lorenzo from Oz
27. March 2013 at 16:31

Scott: I made the point about Australia not suffering the previous global recession in a comment on your previous post and now I see you have made it with more detail here.

Dan: Another difficulty is the other point I made in the aforementioned comment. The commodity boom also complicates monetary policy since it creates a “two-speed” economy where the mining sector (notably in Western Australia and Queensland) has booming exports while manufacturing and services exports (notably in Victoria) are harmed by the high \$A.

33. Lorenzo from Oz
27. March 2013 at 16:57

Is a simple take-away that, to the extent that the Quantity Theory is a supply-theory, it is wrong; to the extent that it is a supply-and-demand theory, it is right? I am thinking of all those people who look at the huge surges in the monetary base in the 1930s, or contemporary Japan, US etc and predict inflationary surges to come. They seem to have a simple supply theory. One that all those folk hanging onto all that base money clearly did/do not share.

And by supply-and-demand I mean money actually used in transactions. With expectations about movement in the price level affecting willingness to hold base money and expectations about income affecting asset mix. (So, if one expects the price level to be stable or falling then poor income expectations leads to lots of holding of base money and low-risk bonds. To change that requires either to create expectations of rising price level and/or higher incomes where one can lead to the other.)

Oh, and I have worked out why you like 1/P and I like ‘swap values’. I am a medievalist; I don’t assume a specific, coherent price level since I am aware of societies with high transport and transaction costs plus extensive regulation (where the latter includes transactions embedded in webs of obligations and connections) leading to a lot of fairly disparate local price levels. But it just complicates the application of 1/P, it does not invalidate it.

34. ssumner
28. March 2013 at 06:06

Rob, No, the people that get the \$200 are not any better off, that’s the whole point of my example. If they hadn’t gotten cash they would have received checks.

Geoff, You are talking gibberish. Why do you feel a need to write long comments when you have absolutely nothing intelligent to say? Why?

Mike, No, the QTM plus ratex plus the EMH predicts that price changes will precede anticipated changes in M. I just wrote an entire book on that subject.

What if the money issuer had not “obliged” by issuing more money? Why did western countries get 2% inflation instead of 10% when central banks adopted that policy, despite fiscal authorities paying no attention to inflation?

Lorenzo, Good comment. I think there is some ambiguity as to whether the QTM is a supply theory, or a supply and demand theory.

35. Geoff
28. March 2013 at 06:24

Dr. Sumner:

“Geoff, You are talking gibberish. Why do you feel a need to write long comments when you have absolutely nothing intelligent to say? Why?”

I’ll take this churlish comment to be what it likely is: a concession.

Nothing intelligent to say = Intelligent comments I cannot seriously challenge.

36. Rob Rawlings
28. March 2013 at 07:45

“Rob, No, the people that get the \$200 are not any better off, that’s the whole point of my example. If they hadn’t gotten cash they would have received checks.”

But you are saying that P will increase as a result of the newly crated money, right ?

Can you spell out precisely how that happens in this simple example ?

37. Bill Woolsey
29. March 2013 at 03:22

http://research.stlouisfed.org/fred2/graph/?s%5B1%5D%5Bid%5D=CURRENCY

The only mention of “cash” I see is “vault cash.”

I was taught that C = Currency. (and I have been teaching it that way for years.)

The currency component of M1, sometimes called “money stock currency,” is defined as currency in circulation outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions. Data on total currency in circulation are obtained weekly from balance sheets of the Federal Reserve Banks and from the U.S. Treasury. Weekly currency in circulation data are published each week on the Federal Reserve Board’s H.4.1 statistical release “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.” Vault cash is reported on the FR 2900 and subtracted from total currency in circulation. For institutions that do not file the FR 2900, vault cash is estimated using data reported on the Call Reports.

38. ssumner
29. March 2013 at 03:51

Rob, Prices will rise when the supply of money increases for exactly the same reason that the price of apples falls when the supply of apples increases. Do you agree with the apples example? If not, why not? If you do, why should the monetary base be any different. When you supply more of something its relative price falls.

The mechanism is the hot potato effect. When you attempt to get rid of an asset you don’t want to hold, its relative price falls. This will often involve more goods and services being purchased, but it need not. During currency reforms the price level changes without any change in the amount of goods and services being purchased.

Bill, We must have had different textbooks.

39. Max
29. March 2013 at 05:30

As we’ve seen central banks can increase the quantity of money without affecting the price level. The “trick” is simple – decrease the cost of holding money (seigniorage). This can be done deliberately by paying interest on reserves, or accidentally by hitting the zero bound.

Once the transaction demand for money is saturated, it becomes just another investment, competing with safe liquid bonds. The demand at a given price level is determined by the relative yield of money and bonds, and there is no limit to the demand if the central bank is willing to issue money at a higher yield than bonds.

40. Max
29. March 2013 at 05:36

I guess I should qualify, there’s no limit to the money demand as long as the central bank is perceived to be solvent (either because of its assets, or because it is backed by a government).

41. Rob Rawlings
29. March 2013 at 08:00

“When you attempt to get rid of an asset you don’t want to hold, its relative price falls”

I think I see how your example works – (I replied on the other thread – http://www.themoneyillusion.com/?p=20216&cpage=3#comment-237722)

So in this case it will be banks initially that hold an asset they want to get rid of (base money as a result of the smaller value of the checks) – and they will get rid of it by lending it out or buying other assets, right ?

42. Mike Sproul
30. March 2013 at 13:03

Scot:

I take it that you are not a believer in sticky prices, but rather that prices anticipate changes in M.

Once again, you and I find ourselves with an observational equivalence problem. You see the data as supporting the view that inflation happens to the degree that M outruns real output, while I see inflation resulting to the extent that M outruns the issuer’s assets. I guess we’ll have to wait for some natural experiments to support one view over the other. Periods of credit rationing provide a possible case:

“This recourse to a rationing of credit caused renewed stringency in the money market in the spring of 1796 and evoked loud protests from the City (London).
It is not easy to reconcile these complaints about the continued scarcity of money during this period with the no less insistent complaints about high prices, and with the continued unfavorable course of the exchanges.” (Hayek, 1933, p. 40)
From a Real Bills perspective, it is easy to reconcile the two sets of complaints. If the Bank of England were issuing notes on insufficient security, then each issue would cause the Bank’s ratio of assets to liabilities to fall and thereby reduce the value of the pound. Meanwhile, since the Bank was issuing pounds in exchange for security worth (say) .98 pounds, customers would eagerly buy any pounds the Bank offered. Assuming the Bank dealt with the resulting surge in demand by rationing credit, we would naturally expect people to complain of a shortage of credit.

43. ssumner
31. March 2013 at 03:04

Mike, I believe in both sticky prices, and prices anticipating M. There is no contradiction. (Some) prices change gradually, but when they do change they are set on the basis of expected future M.

You said:

“Once again, you and I find ourselves with an observational equivalence problem. You see the data as supporting the view that inflation happens to the degree that M outruns real output, while I see inflation resulting to the extent that M outruns the issuer’s assets.”

So you agree that discretionary Fed open market purchases are inflationary, even if used to buy assets of equal value? It sounds like you don’t. But if not, why isn’t the obvious impact of OMOs on prices a test of the backing theory? Indeed a refutation.

44. Mike Sproul
31. March 2013 at 10:02

Scott:

So you expect that prices will be set too low about as often as they are set too high? Half the time resulting in underemployment and the other half in overemployment?

OMO’s can be inflationary
(1) if assets don’t keep up with liabilities
(2) if the issuing bank maintains the value of its money at a lower level than its assets could support (which is an effective default by the money issuer)
(3) if the price level rose first (e.g., because of a loss of backing) and people therefore demanded more cash, and the money issuer obliged by issuing more.

The trouble with those close correlations between M and P is that we don’t know if we might get a closer correlation by observing the money issuer’s assets and liabilities.

45. ssumner
1. April 2013 at 06:25

Mike, I wasn’t referring to the close correlation between M and P, but rather the market response to Fed policy initiatives. I don’t see how the backing theory can explain those market reactions, but maybe I’m missing something.

46. Mike Sproul
1. April 2013 at 08:59

Scott:

The backing theory says that money is valued just like corporate stocks and bonds, and finance professors tell me that they have a very hard time empirically verifying the proposition that stocks and bonds are valued in accordance with their issuers’ assets and liabilities. So I’m not swayed much when I see empirical results pointing one way or the other. To me it’s mostly the logic of the backing theory that is compelling. It makes much more sense that money is valued according to its issuer’s assets and liabilities, just like all other financial securities, than to say that it’s valued because people want it, at the same time that people want it because it is valued.

47. dtoh
2. April 2013 at 02:46

Scott,
You said,

‘This is not accurate. A one time increase in M leads to a proportionate increase in P at any inflation rate. A change in the growth rate of M leads to V moving in the same direction as the change in the growth rate of M. If M growth accelerates, then V increases.”

1. Short term no. If M goes up, this can push real asset prices up (real interest rates down), which lowers the cost of holding money and thus reduces V. Medium/ longer term, one would expect an increase in the growth of M to increase real interest rates pushing V up.

2. It also depends on what’s happening

Depends on what’s happening to output. If output is growing faster than M, you’ll see a decrease in the price level.

48. ssumner
2. April 2013 at 05:36

Mike, It doesn’t seem at all logical to me, because cash seems more like a wallet than a bond. But lets move the discussion to a newer money post.

dtoh.

1. Yes, but I was referring to the long run.

2. An one time increase in M raises prices by an equal percentage regardless of what happens to output. If output rises at a 6% rate, then a ten percent increase in M results in inflation rising from minus 6% to 4%, which is a 10% increase.

49. dtoh
2. April 2013 at 20:43

Scott,

1. We agree.

2. Not if a one time 10% increase in M causes a one time 10% increase in output.

(Which is why I’m pushing you in other threads for an explanation of the transmission/trigger mechanism by which an increase in M translates into and breaks down between an increase in prices and an increase in output.)

50. Chandrasekhar Ramakrishnan
13. April 2013 at 13:01

Scott,

I wanted to delve into the Barro data a little further, but I couldn’t find it online. I got ahold of his more recent textbook, Macroeconomics: A Modern Approach, which also contains a similar table, but with data from 1960-2000.

I’ve made some interactive scatterplots and include a link to the data in CSV format on my site: http://www.illposed.com/lucre

Thanks for putting this material together,

Sekhar

51. Mike
5. October 2013 at 19:49

RGDP growth is deflationary!!

Agree 100%