In search of monetary equilibrium
By Scott Sumner
The title of the post has a double meaning: the search for a policy that leads to monetary equilibrium, and the search for a coherent definition of the concept. Later I’ll show that these two meanings could be more closely related than you might suspect. I’ll use an imaginary dialogue to illustrate the problem.
Me: The country of Costaguana has a money market that is not in equilibrium. The government has set the bolivar/dollar exchange rate at a completely unrealistic level and there is a shortage of dollars. Resources are wasted in black market activity.
Costaguana central banker (CCB): OK, we’ll adjust the money supply to the point where it equals money demand at the fixed exchange rate. We’ll equate the official rate with the market exchange rate. Are you happy now?
A year later:
Me: Things are somewhat better, but I still see a problem. Costaguana has an unstable price level, caused by changes in the real exchange rate. Because the nominal exchange rate is fixed, any change in the real rate requires a move in the price level. There’s no black market in money, but when the equilibrium price level falls there is an excess demand for money at the original price level. The adjustment process is painful, due to sticky prices.
CCB: OK, we’ll let the bolivar float, and adjust the exchange rate as needed to keep the price level stable. Are you happy now?
A year later:
Me: Things are somewhat better, but I still see a problem. Last summer, a crazy populist was elected president and started nationalizing key industries. Productivity fell sharply, reducing real GDP. Because the price level is being stabilized, lower real GDP drags down NGDP. At the original level of NGDP there was an excess demand for money after the productivity shock, and this pushed NGDP lower. This increased unemployment.
CCB: OK, we’ll stop targeting prices and start targeting NGDP. Are you happy now?
A year later:
Me: Things are certainly better, but I still see a problem here. Last spring, the price of silver tripled. Because silver exports are 20% of Costaguana’s GDP, the soaring silver prices boosted silver export revenues and forced non-silver NGDP sharply lower. Silver production is capital intensive and requires few workers, and the fall in non-silver NGDP had the effect of reducing total labor compensation sharply. There was an excess demand for money at the original level of total labor compensation, pushing it lower. Because wages are sticky, unemployment soared.
CCB: OK, OK, we’ll target total labor compensation. Are you happy now?
A year later:
Me: Things are certainly better, but last fall there was a huge surge of refugees from Venezuela. Because you are targeting total labor compensation, there was not enough money to pay all those new workers at the existing hourly wage rate, which is somewhat sticky. Most of the Venezuelan refugees remained unemployed.
CCB: OK, OK, OK, we’ll target total labor compensation per capita. Are you happy now?
A decade later:
What does this example tell us? Monetary disequilibrium can be defined in many different ways. One definition is when there is a difference between the quantity of money supplied and the quantity demand, taking everything into account. That’s the first example above and it results in a black market in money.
A second definition is when a change in the money supply or money demand creates disequilibrium at the original level of a key macro variable, such as the price level, NGDP, total labor compensation, or total labor compensation per worker in an economy with sticky wages and/or prices.
In the second case, there is no monetary disequilibrium if all wages and prices are flexible, as during a currency reform. In that case, prices, NGDP, etc., instantly move to the new equilibrium.
In the real world, wages and prices are generally sticky, so a disequilibrium in money at the existing price level (or NGDP, etc.) leads to disequilibrium in the goods and/or labor markets. Importantly, it does not lead to a black market in money, as interest rates immediately adjust so that each person can obtain the cash balances they prefer without queuing at an ATM and without engaging in black market activity.
The second type of monetary disequilibrium is what monetarist economists have in mind when they discuss “monetary disequilibrium.” That’s OK, but always keep in mind that the second use of the term ‘monetary disequilibrium’ can be justified in only two ways, AFAIK:
1. A situation where shocks originating in the money market create disequilibrium in goods and/or labor markets.
2. A situation where a change in the supply or demand for money would have led to a shortage of money and black markets at the original level of prices and interest rates, if those variables did not change.
PS. This isn’t a great book, but it might appeal to fans of Nostromo.