Libertarian Monetary Policy, Part Deux

So far we have two rules for monetary policy:

1. Don’t screw up the medium of exchange and unit of account functions of money, and

2. Shifts in money demand should be met by equal shifts in money supply so as not to create a disruptive change in the value of money itself.

In this post, I want to further explain why rule 2 is necessary. To do so, I have to explain a bit of monetary theory. It’s not hard, and once you understand it, you’ll be ahead of 90 percent of the people who write about money and the economy in the popular press, including at least one Nobel Prize winner with a column in the New York Times.

Well over 200 years ago, the French economist Jean-Baptiste Say popularized what has become known as Say’s Law, which says, in it’s simplest form, that demand arises from production. Suppose you lived in a simple barter economy. You exchange your labor and/or goods you produce in exchange for goods and services produced by other people. If you don’t produce anything of value to others and your labor is not of value to someone, you have nothing to exchange, and so your demand for the other people’s production is zero. If you do produce stuff, you either consume it yourself or exchange it for something someone else made. This is true for everyone, so there is no possibility that there will ever be insufficient demand for goods in the economy, because everything produced is consumed by somebody, and nobody can consume what hasn’t been produced.

Notice that I haven’t said anything here about the rates at which one good will be exchanged for another. If one person produces a large amount of some good, it’s quite likely that the resulting relative abundance of that good will lessen it’s unit value in exchange. If there’s a bumper crop of apples, an apple grower will probably have to offer more apples to get an orange than he would if apples were relatively scarce. All Say’s Law says is that he will, in fact, trade or consume all of his apples. It doesn’t say anything about how relative prices (the terms of those trades) will behave.

We don’t live in a barter economy, we live in a monetary one. We sell our labor and production for dollars and then exchange those dollars for other people’s production and labor. Let’s start by assuming that the only reason anyone wants money is to exchange it for something else, and consider our apple-grower again. An environmentalist group scares people into thinking that apples are covered with nasty pesticides and suddenly hardly anyone wants to buy apples. What happens? The price of apples drops until it is low enough that somebody will buy them, or if nobody wants them at all, the price goes to zero and the apple grower is effectively out of the economy. The total value of goods produced in the economy drops because the apples are worth less (maybe even worthless), but since the apple growers income has also fallen, the demand for goods falls by the same amount. Say’s Law still holds: total demand is equal to total supply.

However, what happens if the supply of money changes? Back when gold was money, a major gold strike could create a lot of new money in a hurry without increasing the supply of other goods and services. When people tried to exchange all that new money for the same limited supply of goods, there wasn’t enough to go around. Shortages and inflation resulted. Recall from my last post that since money is the unit of account, the only way for it’s relative price to change is for the general price level to change. This takes time, and in the meantime there was both an excess supply of money and an excess demand for goods.

If we relax the assumption that people only want to hold money for exchange purposes, we can get other kinds of trouble as well. One fine day the public discovers that many of the investments they thought were safe are actually managed by Bernie Madoff disciples. Suddenly everyone wants to hold something really safe, and what could be safer than holding money itself? Now at least some of the producers arriving at market find people much less willing to part with their money in exchange for what is on offer. Sales and employment fall. There is an excess demand for money, and it is exactly equal to the excess supply of goods and services.

What economists call aggregate demand is the total demand for goods and services. What we’ve just seen is that a shortfall in aggregate demand is matched by an excess demand for money. If the supply of money were increased by that same amount, the shortfall in aggregate demand would go away.

This, of course, is pretty much the story of the last two years. Rising mortgage delinquencies and falling home prices changed people’s beliefs about how safe their funds were in banks and hedge funds that owned a lot of mortgage-backed securities. The “safe-harbor” demand for money, particularly U.S. dollars, rose drastically. Instead of meeting the higher money demand with higher money supply, the Federal Reserve increased the demand for money even more by starting to pay interest on reserves. The recession was an inevitable result.

My third rule for monetary policy is next.

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