Tuesday, July 13, 2010


Pennies and Nickels and Arnold Kling's monetary idea

Arnold Kling is a libertarian economist who seems to always be grasping at some new idea that I’m sure he hopes will be the Next Great Economic Theory (to unseat Keynes). More often than not, though, he seems to reinvent the wheel arriving back at Keynes. This sometimes provides for some good insights. In this quest he posts this hypothetical about monetary stimulus:

For example, suppose that the Fed swaps dimes and pennies for nickels, cutting
the supply of nickels in half. I contend that nominal GDP, measured in dollars,
will stay unchanged. Scott Sumner is prepared to argue differently, but I find
that odd on all sorts of counts. If you think of currency as the key nominal
aggregate, exchanging dimes and pennies for nickels does not change the total
amount of currency outstanding, so why should it change nominal GDP, even if you
believe the quantity theory of money?

I’m not sure I’m following him here. Assuming the # of dimes and # of pennies are the same then an even swap leaves money supply unchanged (lucky penny owners now have a nickel, unlucky dime holders now have a nickel). If nickels are then reduced by half the economy has less money than before and one would expect deflation. If you don’t believe me ask yourself how the supply of nickels would be cut in half? Would every other nickel holders suddenly see their nickels disappear into a puff of smoke? If so aggregate demand falls, prices fall, nominal GDP falls.
Suppose Kling meant, though, that the Fed ‘up swaps’ every coin. Pennies are worth 5 cents now, nickels twenty five, dimes fifty and so on. In that case I’d agree that nominal GDP wouldn’t really change except for the change in dominations. But why?

Well return to the quantity of money theory and think deeply about it.


Or Money times Velocity equals the Price times the Number of things. PT can be thought of as transactions as can MV. A quarter gets used once every 4 months, that’s four transactions a year. In general more transactions means more GDP since transactions are voluntary and presumably both sides would not do them if they didn’t both see a gain.

Changing coins around doesn’t change the quantity of money, only the quality. And by “quality” I don’t mean “good versus bad” but “quality” in the sense of what properties does the money have (metal or paper, round or rectangle, what color is it, is it called ‘dollars’ or ‘cents’ or ‘lire’ or ‘pounds’ etc). At the end of the day more transactions cannot happen because more money isn’t in the economy to facilitate them.
More money means more transactions or “PT” in the equation. The same effect can be generated, though, by using the same amount of money faster....instead of that quarter being used once every four months its used once every two months. In simply swapping coins, though, the Fed is not actually increasing the number of coins (aka quantity of money) in the economy. Without more money more transactions cannot happen (unless velocity changes). The Fed doesn’t do this though, when it moves it creates new money in the economy without pulling out any old money. The penny holders are unmolested as are the dime holders but nickels are added to the economy. Now those selling goods have new nickel holders as well as old penny and dime holders as potential customers. More transactions have to happen or if the economy is already at full capacity and cannot do anymore transactions the price in each transaction has to increase. Nominal GDP has gone up.

If you choose the monetary base, you will have a big problem with the fall 2008 episode, when the Fed pretty much doubled the monetary base and nominal GDP did not even rise, much less double. If you choose a broader definition of money, then you are choosing an aggregate that the Fed does not exactly control.

Indeed, but this is hardly perplexing. This is Keynes’s old liquidity trap. The economy is gripped by uncertainty so it would rather hoard money than spend it. The Fed prints the bills but the people who get them won’t spend them. Trying to push up nominal GDP becomes like ‘pushing on a string’ to use another well known Keynes saying. To get even a few dollars more spent the Fed has to print tens, even hundreds of dollars.

Some with a more monetary bent like Scott Summer seek to solve the problem by having the Fed print money and give it to those more likely to spend. Instead of buying short term Treasury bills (from people and institutions that are mostly into locking their money into super-safe investments) buy from other types. So they argue the Fed should buy things like mortgages, credit card debts or other assets. The sellers are believed to be more willing to turn around and use the funds they got towards making more loans which means more spending from those who borrow.

Keynesians like Paul Krugman or Brad De Long see the solution in fiscal stimulus. Let the gov’t buy things which by definition requires transactions. Push the monetarists hard enough and they start to look like Keynesians except they would have the Fed making the purchases rather than the Federal Government through the democratic process.

There is an advantage to the fiscal side, though. The advocates of pushing all the stimulus to the Fed have to consider what happens if the economy picks up and inflation becomes an issue. The Fed has to turn around and sell its assets to collect some of that cash. But if the Fed didn’t buy wisely it may discover the market doesn’t want to give it as much cash for the assets as the Fed brought them for. If the stimulus is fiscal the money supply hasn’t been drastically increased and the Fed remains a barrier against excessive gov’t spending.

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