I don't find "monetary disequilibrium" to be a useful concept
By Scott Sumner
I’ve been doing some reading on the subject of “monetary disequilibrium”, and have trouble seeing how it’s a useful concept. Here I’ll try to explain why. Warning, this stuff is really confusing (at least to me.)
Suppose there is a bumper crop of wheat. Does this create disequilibrium in the wheat market? In the absence of price controls the answer would seem to be no. The price of wheat declines rapidly, insuring that quantity supplied continues to be equal to quantity demanded.
But many prominent economists, particularly monetarists, like to use the concept of monetary disequilibrium. What does this mean? Suppose the supply of money rises sharply at a time when money demand is stable. Why does that create monetary disequilibrium? Why doesn’t the price of money adjust smoothly, as wheat prices adjust? Why don’t adjustments in the price of money equate money supply and money demand?
There are many possible answers, mostly revolving around concepts like wage and price stickiness, or monetary misperceptions, or nominal debt contracts. This kind of disequilibrium is hard to see at the individual level. If there is disequilibrium in the wheat market it’s easy for me to see—I can’t find wheat to buy, or perhaps anyone to sell it to. But I’ve never had any problem making sure that my stock of money was in equilibrium, that’s what ATMs are for. Instead, the disequilibrium shows up in the markets for the things we spend money on—goods and services and labor (but generally not assets, which often have highly flexible prices.)
One way to maintain monetary equilibrium would be for the monetary authority (or private banks under free banking) to insure that the supply of money changes along with shifts in the demand for money, assuring that the price of money stays stable. But which price of money? There are an almost infinite number of choices. Thus the Koreans might stabilize the price of Korean won in terms of dollars. That’s one definition of the price of money—the exchange rate.
Some of the people who discuss monetary disequilibrium point to the price level as the relevant price of money (or more specifically the inverse of the price of money.) In that case, the supply of money might be adjusted over time to reflect shifts in demand, in such a way as to keep the price level stable. But which price level? Consumer goods? All goods? All transactions including assets?
Many economists now believe that a stable price level will not create a broader macroeconomic equilibrium, and that a stable NGDP might be better. So does monetary equilibrium occur when NGDP is stable, or at least rising at a steady and predictable rate? Maybe, but what if the population suddenly increases by 10%, due to a surge in immigration. Might it be better to increase the money supply to match the larger population, so that wages don’t need to be cut sharply? So perhaps we should stabilize NGDP per capita? But what if we are Kuwait and the price of oil surges in value? Should the non-oil part of Kuwaiti GDP be cut to offset this? I think not. So maybe we should stabilize a wage index?
I hope you see where I’m going with this. Monetary disequilibrium is not something we measure directly, as we might try to measure the shortages of apartments in New York due to rent control. Rather, monetary disequilibrium requires a theory of macroeconomic disequilibrium. There are literally hundreds of ways of measuring monetary equilibrium, and for each option, achieving monetary equilibrium will imply disequilibrium using any of the other options. Thus if monetary policy stabilizes NGDP, it will lead to fluctuations in prices and wages and NGDP per capita.
We have no way to directly measure monetary disequilibrium; rather it’s a situation that we infer is occurring when our preferred macro policy target is showing instability. If I’m a NGDP targeting guy, I’ll claim there is monetary disequilibrium whenever NGDP is moving around erratically. An inflation targeter will see monetary disequilibrium whenever the inflation rate is unstable. There is no direct objective measure of monetary disequilibrium, just a variety of ways to infer its existence from observations of various macro variables. Or micro variables such as the price of gold, if you are a gold bug. Or exchange rates if you are Robert Mundell.
Monetary disequilibrium reminds me of the “stance of monetary policy”. Recall that I often claim that on this topic “the emperor has no clothes”, that economists frequently talk about easy and tight money without having any coherent definition as to what those concepts mean. More specifically, they each have a vague idea, and assume others share their intuition. But in fact there is no standard definition, and indeed that the various ways the concept is defined are not even used consistently. Economists who insist that the stance of monetary policy can be measure by looking at X, often ignore their own advice and ignore X. How many economists paid attention to the huge rise in real interest rates during July to November 2008? Or the stoppage in base growth during late 2007?
Similarly, economists talk about “monetary equilibrium” as if it’s a well-defined concept, whereas all the definitions I’ve seen are just hopelessly vague. People might say that disequilibrium occurs when the supply of money increases faster than the demand. What does that even mean? Demand in terms of what? When the Fed injects new money through an open market operation, short-term interest rates immediately fall to a new and lower level, low enough so that the public willingly holds these larger cash balances. Yes, this also sets in motion changes in NGDP, which due to sticky prices have real effects. But monetary disequilibrium has no value added here. It’s enough to say there was a nominal shock in an economy with sticky wages and prices, and hence there were suboptimal changes in real output.
The search for “monetary disequilibrium” is actually the search for the most useful way of thinking about macroeconomic equilibrium, or alternatively the search for the optimal monetary policy rule. You could say that monetary equilibrium occurs when we’ve adopted the optimal monetary policy rule, but then why not cut out the middleman and just talk about optimal rules? What is gained by a discussion of monetary equilibrium? If anything, it might make more sense to just talk about monetary stability.
Even worse, real harm is done when we suggest that the macro problem is easy—just set up a system where the supply of money adjusts to keep up with changes in the demand for money. Unfortunately, things aren’t that simple, as there are hundreds of definitions of the demand for money. Yes, it’s the amount of money people want to hold, but at what price? The gold standard provided monetary equilibrium in terms of stabilizing gold prices, and Bretton Woods did the same for exchange rates. But neither of those regimes provided macroeconomic equilibrium.
Free banking is sometimes said to provide monetary equilibrium, but free banking isn’t even a monetary policy, it’s a banking policy. Free banking with banknotes redeemable into Zimbabwean currency at a fixed rate would not provide macroeconomic equilibrium. Nor would making them redeemable into gold solve the problem, especially if the Chinese suddenly bought massive quantities of gold. Nor would free banking with currency redeemable into a fixed monetary base.
There are no easy solutions to the very difficult problem of providing macroeconomic stability, although I certainly have opinions on which regime I think is best for the USA.