Why does the value of strawberries change over time? How about the value of houses? How about gasoline?
Most people use some form of a supply and demand model to explain changes in the value of goods. These models actually explain “relative prices”, not nominal prices. Thus in EC101, a 3% increase in the price of strawberries occurs when the nominal price rises 5% at a time of 2% overall inflation. It’s the relative price that is explained in basic S&D models.
Think about how we explain the effect of a big strawberry harvest. Wholesalers are temporarily holding more strawberries than they wish to hold, so they cut prices to move the inventory. Then stores are flooded with strawberries, so they cut prices to sell the excess supply.
There’s sort of a “hot potato effect”, where the initial increase in production leads to more strawberries than people want to hold at existing prices. As people try to get rid of these excess supplies, the price gets bid down to a level where people are willing to hold (and ultimately consume) these strawberries. The same is true of houses, gasoline, and other goods. But is it true of money?
Monetarists are the group that explains changes in the relative price of money using a basic supply and demand model. Because the nominal price of a dollar bill is fixed at 1, the relative price of money changes inversely to the price level. If the price level rises by 2%, then the relative value of money falls by the same ratio, by definition.
Monetarists believe that an increase in the supply of money temporarily creates excess cash balances. Due to the hot potato effect, the value of money will decline until consumer prices rise to a level where people are willing to hold those larger balances. Monetarists do not believe that money creation causes inflation because of how it affects interest rates, or the exchange rate, or the unemployment rate, or some other variable. It’s all about the supply and demand for money. We treat money just like any other good.
Of course things can get complicated, even in S&D models. If there is a temporary surge in the number of houses (or other durable assets), but homeowners expect the supply of houses to revert back to normal after a brief period, then prices will not decline sharply. Expectations matter. The same is true for a temporary injection of money, which is also a durable asset. It has little impact on the value of money.
If the new strawberries merely displace an equal number of raspberries, then the decline in strawberry prices will be much milder, as raspberries are close substitutes. The same is true of exchanges of cash for zero interest T-bills. S&D models need to be used thoughtfully.
But monetarists do not believe that it’s helpful to visualize monetary policy in terms of interest rates, exchange rates, etc. We would not write news headlines like the following:
Central banks are locked in currency wars they cannot win
The entire FT article is based on confusion between real and nominal exchange rates. All central banks cannot simultaneously reduce the value of their currencies relative to each other. But all central banks can simultaneously reduce the value of their currencies relative to goods and services.
Or this Project Syndicate headline:
Could Ultra-Low Interest Rates Be Contractionary?
It makes no sense to argue over whether low interest rates are expansionary or contractionary, using an implicit assumption that the low rates reflect monetary stimulus. Interest rates are merely a side effect of monetary policy. The expansionary or contractionary impact of monetary policy does not depend on its impact on interest rates. Indeed, the most highly expansionary monetary policies (i.e. the 1970s) have tended to raise interest rates.
One reason you might want to consider becoming a monetarist is that it helps one avoid spouting nonsense about monetary policy. I may be wrong in my estimation of the importance of temporary vs. permanent currency injections, or how close a substitute T-bills are for cash, but at least I’m working with a well-grounded economic model that has a track record of hundreds of years of success in explaining changes in the relative price of goods like strawberries, houses, gasoline and . . . money.
So don’t say to me, “I don’t see why you think printing more money would create inflation.” Of course you see why I think that—it’s supply and demand. Be more specific. Maybe you think the currency injections would be viewed as temporary. Or maybe you think that currency and T-bills are currently near perfect substitutes. Those are good arguments. It’s not a good argument to suggest that more money won’t change the interest rate or that it won’t change the unemployment rate, because inflation is not caused by changes in the interest rate or the unemployment rate. Changes in those variables are a side effect of monetary injections. Inflation is caused by changes in the supply and demand for money.
READER COMMENTS
Brian Donohue
Oct 1 2019 at 12:44pm
Superb post, excellent blogging.
Pierre Lemieux
Oct 2 2019 at 10:44am
I agree. A very good and concise defense of monetarism and the difference between the price level and relative prices.
Mark Barbieri
Oct 1 2019 at 1:54pm
I was a firm believer in “nonsense about economic policy” during the 2007/2008 slowdown. I was convinced that the fed lowering interest rates would lead to higher inflation. It didn’t and I was confused as to why. That’s when I found your Money Illusion blog. Your monetarist views were the only ones that I saw that fit the facts and made sense. I’ve been a follower ever since. Thanks.
Scott Sumner
Oct 1 2019 at 2:11pm
Thanks Brian and Mark.
bill
Oct 1 2019 at 5:53pm
Great post.
I’ve always wished Keynesians would say more about the ZLB with money supply like we had since 2009 and money supply of like a quintillion dollars more. Just saying “pushing on a string” is pathetic.
Lorenzo from Oz
Oct 1 2019 at 11:24pm
Well done that man. 🙂
Kenneth Duda
Oct 2 2019 at 1:29am
Really great post, Scott. I just love the way you explain this stuff.
I also like your bus-driver-steering-on-a-windy-mountain-road analogy (who controls the bus, the driver or the road? Why can’t the driver just make up his mind on the right angle for the steering wheel? LOL) Next time, try to work that one in 🙂
-Ken
Scott Sumner
Oct 2 2019 at 7:32pm
Yes, good analogy. And if the driver turns the steering wheel, that’s a “change in driving policy” even if it is to keep the bus in the center of the road.
Alex
Oct 2 2019 at 2:45am
Thanks for your post. There are a lot of voices that zero or negative interest rates in Europe/Japan have unintended consequences, e.g. asset inflation or mispricing of bond risks. What’s your take on that?
Scott Sumner
Oct 2 2019 at 7:35pm
Alex, For any give flow of future earnings (rents, etc.) assets should be more expensive at lower rates. I can’t imagine why anyone would view that as a problem.
Years ago, I predicted that in this century there would be many more claims of “bubbles”. So far I’ve been correct.
P Burgos
Oct 2 2019 at 3:16am
Is there a point at which some kind of real world evidence would convince a monetarist that they are wrong? Or would they just keep adding epicycles like “temporary vs. permanent increase in the money supply”? I believe that a skeptic would look at the last 10 years of monetary policy in the US, and start to doubt that the monetarists have a good theory (due to the missing inflation in spite of a vast increase in the money supply). I feel like the typical response would be “the hot potato effect never took hold because the increase was temporary”. Well okay, but shouldn’t then at some point in time we see a large run up in inflation once folks figure out that the large increase in the money supply isn’t temporary, but permanent? To put it another way, how do monetarists explain such a large increase in the money supply with such little inflation? The obvious response is that demand for money surged and money supply didn’t keep up, but then that seems to point to a need to develop a theory of demand for money, and a theory that accounts for whether the demand for money is influenced by the supply of money, and why or why not.
A Guim
Oct 2 2019 at 10:02am
Not to put words in Scott’s mouth, but I think the answer is fairly simple. When the Fed started paying interest on excess reserves, it made reserves and t-bills very close substitutes for banks and this killed the hot potato effect. So while all the quantitative easing by definition dramatically increased the monetary base, very little of the new money was high-powered and it created little inflationary pressure.
Scott Sumner
Oct 2 2019 at 7:38pm
Burgos, You asked:
“Or would they just keep adding epicycles like “temporary vs. permanent increase in the money supply”?”
If that’s what had happened then people should be skeptical. But in 1993, I published a paper on how temporary currency injections were not inflationary. So the epicycles are not being added to fit the data, rather the data is tending to prove the models that already were out there.
Economists have been studying money demand for decades.
Michael Rulle
Oct 2 2019 at 12:04pm
Nice. Well explained—need to read it many more times to try and lock it in. Econlib.0rg is such a great website. It requires seriousness on the part of both writers and readers.
Scott Sumner
Oct 2 2019 at 7:39pm
Unlike MoneyIllusion. 🙂
Thaomas
Oct 2 2019 at 8:36pm
But if you have a model (meaning that how you really think the economy approximately works)) in which everything — money, employment of labor and other resources, prices, interest rates, exchange rates — is inter-related does it make any more sense to say interest rates are a side effect or that money supply and demand are side effects? Doesn’t it depend on which variable is the instrument? And to be fair to non-“monetarist” economists, they are not writing the headlines that you rightly criticize.
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