Monetarism

This article draws principally from Allan Meltzer’s article on Monetarism at the Liberty Fund’s Concise Encyclopedia of Economics.

THE THREE MONETARIST PROPOSITIONS

1. Sustained periods of growth in the money supply in excess of the growth of output produces inflation; to end inflation or produce deflation, money growth must fall below the growth of output.

There is not a one-to-one relation between inflation and currency depreciation. Other factors-such as growth of defense spending, government purchases, tax rates, productivity growth at home and abroad, and foreign decisions-affect currency values.  That is, growth in money supply is a necessary but not sufficient condition; exceptions occur (e.g. low inflation in late 80s despite high money growth)

Nevertheless it is obvious that a strong correlating exists.  To see this, run a lagged regression between money growth and inflation to see a good correlation.  (or a lagged log-regression on money supply and CPI)

2. When inflation is EXPECTED to be high, interest rates on the open market are high and the foreign-exchange value of a currency falls relative to more stable currencies.

These effects occur because expected inflation leads to a flight to more stable currencies.  Governments may attempt to restrain inflation via price controls at this point, but it does not work for reasons outside the scope of this article.

3. The first effects of changes in money growth are on output; later, the rate of inflation changes.

The reverse is also true, this is what makes fighting inflation such a painful process once expectations get built in.  E.g. in the early 90s when central banks around the world produced a recession as a consequence of getting inflation back in the box.

A History of Monetarism

Rising money growth and rising inflation after 1964 (see table 1) brought the Bretton Woods system of fixed exchange rates to an end.

Oil shocks in the 70s: A lesson learned from these different approaches to the common experience, and the analyses of that experience, is that oil shocks can change the price level, but if money growth remains moderate, the surge in prices will be temporary and short-lived.

Academics and professionals now accept many monetarist propositions.  For example, central banks no longer offer a laundry list of important objectives.  They now most often describe their principal task as the maintenance of price stability.  Countries with a history of inflationary policy tie their currencies to more stable ones to borrow credibility from the successful, low-inflation policies of the Federal Reserve or prior to the creation of the Euro, the Bundesbank.

Inflationary expectations have been effectively tamed in many countries, giving central bankers much more flexibility to deal with short-term crises without affecting the price level.

Keynesians vs. Monetarists

Keynesians tried to use a combination of government spending and monetary policies – back by Phillips curve theory, governments would use wage and price controls and jawboning (threats) to control prices while using inflation to keep the economy at full employment.  They used complicated economic models to know when and how much to intervene.

In contrast, monetarists felt that government would serve the economy best by committing itself to following stable and simple policies rather than using complicated models.

By the 1970s Phillips curve theory had been refuted by persistent stagflation.  Oil prices added to the problem of rising prices.  Systematic studies of forecasting showed they were ineffective at predicting future economic events.

This inflation put at end to the Bretton Woods system of fixed exchange rates.  This freed countries to pursue their own monetary policies.  Many followed monetarist prescriptions though they might not have followed them as rigidly as monetarists would prescribe.  (e.g. Britain under Thatcher in the 80s.)

Skepticism about Monetarism

Although many principles of monetarism have been broadly accepted, Monetarists did not predict the severity of the recession in 1982.  This has led to increased skepticism that rigid rules can be effective.  In a future article we will discuss the current status of the monetary policy debate.

How interest rates, the money supply and the exchange rate are related and influenced by a central bank

How does the Bank of Canada increase or decrease the supply of money in the economy?  How does this affect interest rates?  How does this affect our exchange rate?  Do reserve requirements effectively sanction the private creation of more money?  This article will answer those questions.

As previously noted, we can consider M2 to be a measure of the money in the Canadian economy.

When the Bank of Canada mints new physical currency, it is used to replace older bills and coins as they are retired.  This occurs as a part of normal operations when a commercial bank takes deposits of physical currency.  So simply by printing money the Bank of Canada does NOT necessarily expand the money supply.  Instead, the Bank of Canada has three main (“policy instruments”) of influencing the supply of money:

1. Open market operations

Conducted with primary dealers – in the US a group of 20 banks.

Buy and sell government securities on the open market to change the supply of money.  BUT: Aren’t government securities considered to BE money (i.e. M2)?

Banks typically conduct open market operations on securities in order to influence their yield.  By trading government securities they can affect the Bank Rate, resulting in it being:

1.   Set directly by the bank

1. Floating, usually at 25 points above the yield on 3-month T-bills.
2. Since 1996: 50-point “operating band”.

The Bank of Canada affects the interest rate by using its infinite power to create money to buy and sell instruments at the rate of its choosing.  This effectively forces other market participants to follow the same rate, since they would not be able to make a successful transaction at a less desirable price.

To affect the Bank Rate, the bank uses SRAs and PRAs.

SRA (Sale and Repurchase Agreement): If government securities are generally trading below the target rate, at 11:45am the BoC offers to sell overnight securities at the target rate of interest.

a.       This means the BoC is taking money out of the economy.

SPRA (Purchase and Resale Agreement): If government securities (T-bills or bonds (?)) are trading generally above the target rate, at 11:45am the BoC offers to buy from designated counterparties (i.e. primary dealers) overnight securities at the target rate of interest.

b.      By buying (with money it just conjured up), the BoC is injecting money into the economy.

Note that there is no one interest rate in an economy.  The interest rate on a loan is the sum:

r = risk free rate (pure time preference) + nonpayment risk + liquidity risk + maturity risk

Notice that a central bank can control either the interest rate or the exchange rate, but not both.  This is a consequence of the Mundell-Fleming model’s trilemma, in which it is possible to have only 2 of: Free Capital Flow, Independent Interest Rate Policy, and Fixed Exchange Rate.  The Impossible Trinity became the foundation of open economy macroeconomics in the 1980s.  Notice that in the modern economy capital controls are easily evaded, so in practice a country can only choose either to smooth exchange rate volatility or run a stabilizing monetary policy.  To see the mechanism behind this, please study the Mundell-Fleming model.

A central bank has different responsibilities for a currency on the gold standard.  In particular, it must uphold the value of gold.  This can be regarded as a special case of having fixed exchange rates.

2.      Reserve Requirements

Central banks rarely change their reserve requirements because it would immediately cause liquidity problems for banks with low excess reserves.  Instead they prefer to use open market operations.

With a deposit of X and required reserves of r%, the bank can use the deposit to create a maximum of X+X/r money.  Here’s the process.

Bank takes deposit of $100.  Then they loan out $90 of this money.  This creates $90 of new money.  Now imagine that the borrower deposits his loan.  The bank can then loan out $81 of this money.  Continue this process to see that the total $100 + $100(.9)+$100(.9)^2 +… = $100 + $100 / .9 = $1000.

In the US the required reserve is 10% on M1.  In the UK reserves are voluntary and stand at about 3%.

reserves held at the fed do not pay interest, so can reserve requirements be thought of as a kind of tax?

Reserve requirements vs. capital adequacy (set mostly by the BIS, not individual central banks)

3.      Moral suasion

Wealth, Money and Happiness

The concepts of wealth, money and happiness are often treated as interchangeable when in fact they are separate but related concepts. Many people think that since there is a finite amount of wealth in the world, for one man to become richer he must immiserate another. Where does money come from, and how does it end up in our pockets and bank accounts? Let’s define all three concepts, see how they are related, and then decide whether there truly is only fixed amount of them.

Let’s begin with “wealth”. Wealth is an accumulation of resources, tangible or intangible. A person’s wealth includes their land, possessions, as well as intangible assets like personal relationships and skills.

“Money” is but a type of wealth. Economists usually consider all risk-free highly liquid resources to be money, so dollar bills in a wallet, deposits in a bank account, and debt instruments with original maturities of less than 90 days are also considered money.

“Happiness” – a concept economists call “utility” – depends on a person’s subjective valuation of their wealth, rather than a uniform objective valuation. For example, someone who owns a mansion in Norway might have lower utility than someone with a shack on the beach in Australia if they both enjoy surfing.

These concepts are all related: How much money a good or service (“wealth”) is worth depends on supply and demand, with demand being a function of utility. An extremely rare piece of art will have a price of 0 if no one wants it (i.e. no one derives utility from it).

Now – is there a fixed amount of wealth? Because goods and services are constantly being generated from business processes, it seems clear that our accumulation of resources is not a 0-sum game.

Is there a fixed amount of happiness? In other words, does any economic transaction necessarily enrich one person and impoverish another? Assuming no government intervention, which two parties agree to a transaction they must both believe they are better off undertaking the transaction than doing nothing. When I sell you a couch for $100, I would prefer the money to keeping the couch, and you would prefer to part with $100 a gain a couch than to keep your $100. Therefore, our respective level of utility must have risen. Assuming no externalities, aggregate utility (or happiness), has increased.

Someone unfamiliar with economics might think that there is a fixed amount of money. Since 1949, in Canada the money supply has been controlled exclusively by the Bank of Canada, which has an independent parliamentary charter to make decisions at arm’s length from parliamentary supervision. Economists measure the total amount of money in the economy in various ways. First, there are the actual number of bills and coins in circulation (called “M0”). Add to that the amounts held in demand accounts (chequing and current accounts) to obtain M1. M2 is M1 + savings accounts, money market accounts, and certificates of deposit.

There is virtually no risk that M2 accounts held by a person will not be convertible to M0. Therefore we consider M2 (and consequently M1) to be money in the same way that physical cash is money. Note that the entire M0 supply (using American figures to approximate Canadian ones) is only about $2500 per person, and even M2 is only $23000 per person.

The Canadian Dollar is fiat currency, meaning that it is not redeemable for some tangible asset such as gold. Instead, everyone simply agrees to use it in economic transactions and its value arises from the need to use it in such transactions. You accept a paycheque in Canadian dollars because you know that you can buy goods and services with it. Merchants accept Canadian dollars for the same reason. The whole system depends, however, on there being faith in the value of the dollar. If enough people do not believe that the currency will be valuable, then its value will drop, in a self-fulfilling prophecy.

The Bank of Canada is able to print more M0 at the Royal Canadian Mint. It can also influence the supply of M2 via open market operations and interest rate operations. In a process I will discuss in more detail in a forthcoming article, if they want to increase (decrease) inflation they inject (withdraw) money into (from) the economy.

Now the price level depends on the amount of money in the economy. If the Bank of Canada doubles the M2 supply, it stands to reason that prices will double, and no one will be better off. From this we can see that changing the money supply does not change a person’s wealth, and therefore does not affect a person’s happiness.