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What is sound money? A macroeconomic perspective

March 9, 2015

The term “sound money” means different things to different people. Some stress the stability of purchasing power over time. Some stress the money’s ability to facilitate exchange. Some stress the money’s ability to promote macroeconomic stability. And, at least historically, some have stressed the sound a money makes when clinking against a glass or dropping to the table—perhaps to assess the metallic content of that money.

For me, the important aspects are the ability to facilitate exchange—which any money will do but some might do better than others—and the degree of macroeconomic stability enabled by that money. When comparing monies along these margins, then, we must establish a benchmark. In what follows, I’ll try to establish a benchmark for the second of those aspects: namely, the degree of macroeconomic stability enabled by a money.

My view is informed, in large part, by George Selgin’s work, Less than Zero. I have also discussed the relevant issues in a comment with Alex Salter. In brief: a good money is one that expands to offset increases in money demand and contracts to offset decreases in money demand.

Let’s start with a very simple equation: MV = PT. M refers to the stock of money; V is the transactions velocity of money—that is, the number of times money changes hands over a period of time—and is equal to 1/Md, where Md is the demand for money; P is the price level; and T is the real value of transactions conducted over a period of time. The equation just states that the amount of money changing hands (left hand side) must equal the total amount spent/received in transactions (right hand side).

We know that prices convey important information about relative scarcity. Likewise, P conveys important information about the relative scarcity of goods transacted over time. If we become more productive, and the value of transactions T increases, the price level P should decrease to reflect that goods, in general, are less scarce today than in the not-so-distant past. On the other hand, when the value of transactions T decreases—perhaps because a natural disaster or policy change that reduces productivity—the price level P should increase to reflect that goods are more scarce today than in the not-so-distant past.

Another way of stating this is that the left hand side of the equation should be held constant, allowing any change in T to be offset by a change in P. Alternatively, we could say that any change in V should be offset by changes in M, so as to keep MV constant. And, since V=1/Md, we can say that the money supply should vary to offset changes in money demand.

The implicit model employed above is quite simple. We could employ a marginally more complex model by including expectations and allowing for a gradual increase in prices over time. We might then conclude that the growth rate of M should vary to offset changes in the growth rate of velocity. Still, the underlying idea is left more or less in tact. And it provides us with a convenient way to express how an ideal money should behave. That’s good news, since such a benchmark is required for considering alternative monetary systems.

4 Comments

  1. bionic mosquito March 15, 2015 11:03 PM

    Sound (or as close to sound as is possible) money is whatever results from a market set free. Just my two cents!

  2. @RalphMus March 10, 2015 9:13 AM

    “..a good money is one that expands to offset increases in money demand..” Certainly private banks or a free banking system supplies everyone with the amount of money they want AT ANY GIVEN LEVEL OF AGGREGATE DEMAND.

    But what if the private sector is not spending enough to keep the economy at capacity (aka full employment) because households and firms don’t think they have an adequate supply of money? There’s no point in any individual household borrowing more from their bank and spending the money because they’ll just lose that money to other households and firms. Then the original household/s will be back where they started, expect that they’re further in debt to their bank.

    I.e. given inadequate aggregate demand, a free banking system does not save the day: it requires government / central bank to create and spend money into the economy. The recent bout of fiscal stimulus followed by QE was an example of the state doing just that.

    Of course IT CAN be argued that the free market has cures for inadequate AD namely the Pigou effect and Says’s law. But frankly the two latter don’t seem to work too well.

    • vikingvista March 12, 2015 4:19 PM

      I don't think the idea of the post is so much how to fix an existing recession, as it is how to keep the monetary system from making the recession worse, and perhaps how to keep the monetary system from potentiating future recessions. When production precipitously drops during a recession, the decline in the money supply might exceed that drop, resulting in a monetary and price deflation that is what is meant by not having "the amount of money they want". The mere inability of prices to adjust rapidly enough results in even more bankruptcies and unemployment than the recession would otherwise have produced.

      You want to do better than that. You want to fix the production issues that are the cause of a recession. But that is not a simple monetary phenomenon (at least not once it has happened). Conversion and re-accumulation of capital takes time and widely distributed expertise.

      You refer to the recent bout of QE as an example of the state doing what you think it should do, and what this post allegedly thinks it shouldn't. But you are wrong on both accounts. This post says that a sound money maintains a nominal GDP. But by that standard, it can be argued that the amount of QE was insufficient, not too much. You are not separating out what today's central bank did that matched the post's recommendation, and what the central bank did that not match it.

      And in general the empirical observation of such efforts is not encouraging, as you seem to think. Central banks' management of the money supply is notoriously procyclical, which nearly everyone seems to think is not how things should work. And the record of economic stability post-central banking compared to pre-central banking is equivocal at best.

  3. vikingvista March 9, 2015 11:12 PM

    So you are saying that the nominal GDP of an economy that uses a particular sound money would either be constant, or gradually increasing at some predetermined rate. But the reason you give, is that the price level across time should be comparable (with perhaps a predetermined formulaic adjustment).

    Why should that be the case? How does an unpredictable change in price level relate to economic instability?