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description= Commentary on monetary policy in the spirit of R. G. Hawtrey;
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world trades are not validated in advance agents relying instead on the credit worthiness of counterparties establishing the creditworthiness of counterparties is costly so specialists financial intermediaries emerge to guage traders creditworthiness it is the possibility of expectational disappointment which are excluded a priori from the adm general equilibrium model that creates both a demand for and a supply of credit money not vice versa at times this had been done directly but it is overwhelmingly done by intermediaries whose credit worthiness is well and widely recognized intermediaries exchange their highly credible debt for the less well or less widely recognized debts of individual agents the debt of some these financial intermediaries may then circulate as generally acceptable media of exchange but what constitutes creditworthiness depends on the expectations of those that judge the creditworthiness of an individual or a firm the creditworthiness of agents depends on the value of assets that they hold their liabilities and their expected income streams and cash flows loss of income or depreciation of assets reduces agents creditworthiness expectational disappointments always impair the creditworthiness of agents whose expectations have been disappointed their expected income streams having been reduced or their assets depreciated insofar as financial intermediaries have accepted the liabilities of individuals or businesses suffering expectational disappointment those financial intermediaries may find that their own creditworthiness has been impaired because the foundation of the profitability of a financial intermediary is its creditworthiness in the eyes of the general public the impairment of creditworthiness is a potentially catastrophic event for a financial intermediary the interconnectedness of economic and especially financial networks implies that impairments of creditworthiness in any substantial part of an economic system may be transmitted quickly to other parts of the system such expectational shocks are common but under some circumstances the shocks may not only be transmitted they may be amplified leading to a systemic crisis because expectational disappointments and disturbances are ruled out by hypothesis in the adm model we cannot hope to gain insight into such events from the standard adm model it was precisely hicks s temporary equilibrium model that provided the tools for such an analysis but unfortunately those tools remain underemployed 1 to be clear the assumption of unit elasticity of expectations means that agents conclude that any observed price change is permanent if agents believe that an observed price change is permanent they must conclude that to restore equilibrium relative prices all other prices must change proportionately hicks therefore posited that rather than use their understanding given their information of the causes of the price change agents automatically extrapolate any observed price change to all other prices such mechanistic expectations are hard to rationalize but hicks s reasoning entails that inference thoughts and details on the fiscal theory of the price level published july 21 2024 adam smith bimetalism chris sims earl thompson eric leeper fiscal theory of the price level gold standard james tobin john cochrane keynes michael woodford 6 comments tags economics economy finance inflation money the fiscal theory of the price level has been percolating among monetary theorists for over three decades eric leeper being the first to offer a formalization of the idea with chris sims and michael woodford soon contributed to its further development but the underlying idea that the taxation power of the state is essential for the acceptability of fiat money was advanced by adam smith in the wealth of nations to explain how fiat money could be worth more than its minimal cost of production the smith connection suggests a somewhat surprising and non trivial intellectual kinship between the fiscal theory and modern monetary theory that proponents of neither theory are pleased to acknowledge while the fiscal theory has important insights it seems to promise more than it delivers presuming to offer a more robust explanation of price level or inflation fluctuations than the simple quantity theory not that high a bar it shares with its counterpart an incomplete account of the demand for money paying insufficient attention to the reasons for and the responses to fluctuations in that demand in this post and perhaps one or two more to follow i use a 2022 article by john cochrane showing how the fiscal theory accounts for both recent and earlier inflationary and disinflationary episodes more persuasively than do other theories of the price level whether monetarist or keynesian regardless of specific orientation those interested in a fuller exposition of the fiscal theory will want to read cochrane s recent volume on the subject let s start with cochrane s brief description of the fiscal theory p 126 the fiscal theory states that inflation adjusts so that the real value of government debt equals the present value of primary surpluses most simply money is valuable because we need money to pay taxes if on average people have more money than they need to pay taxes they try to buy things driving up prices in the words of adam smith 1776 1930 book ii chap ii a prince who should enact that a certain proportion of his taxes be paid in a paper money of a certain kind might thereby give a certain value to this paper money taxes are a percentage of income thus as prices and wages rise your dollar income rises and the amount of money you must pay in taxes rises a higher price level soaks up excess money with tax payments equivalently the real value of money the amount of goods and services a dollar buys declines as the price level rises but the real value of taxes does not change much so a higher price level lowers the real value of money until it equals the real value of tax payments it s useful to quote adam smith about how to account for the value of intrinsically worthless pieces of paper but smith was explaining the source of the value of fiat money not necessarily the actual value of any given fiat money at any particular time or the causes of fluctuations in the value of fiat money over time precious metals were originally used as media of exchange only because they had a value independent of their being used as media of exchange but once they are so used their value in exchange rises above the value those metals would have had if they had not been used as media of exchange for a century or more before the mid 1870s when both gold and silver were widely used as media of exchange an ounce of gold had been worth between 15 and 16 times more than an ounce of silver many countries including the us before the civil war operated on a bimetallic standard in which the legal or mint value of gold in terms of the local currency was set between 15 to 16 times the mint value of silver in terms of the local currency as long as the relative market values of gold and silver remained close to the legal ratio bimetallic systems could operate with both gold and silver coins circulating but when the market value of one of the metals appreciated relative to the other legally overvalued coins would disappear from circulation being replaced by the legally undervalued coins gresham s law bad money drives out good money in action but inasmuch as increased monetary demand for the overvalued metal tended to raise the market value of that metal relative to that of the other bimetallic systems had a modest stabilizing property after the north prevailed in 1865 over the south in the civil war and the unification of germany in 1871 both the us and germany opted for a legal gold standard rather than a bimetallic standard and by 1874 the increased demand for gold had raised the value of gold sufficiently to breach the historical 16 to 1 upper bound on the value of gold relative to silver the countries remaining on a legal or de facto bimetallic silver standard experienced inflation to avoid importing inflation by way of gresham s law countries on the silver standard began refusing silver for coinage thereby accelerating the depreciation of silver relative to gold and promoting the international transition to the gold standard which by 1880 was more or less complete so once there is a monetary demand to hold fiat money the simple fiscal theory of the value of money cannot provide a full account of the value of money any more than a theory of the value of gold based on the non monetary demand for gold could account for the price level under the gold standard the limitations implicit in the fiscal theory are implicit in cochrane s summary of the fiscal theory inflation adjusts so that the real value of government debt equals the present value of primary surpluses in other words the fiscal theory treats both bonds and money issued by the government or the monetary authority i e the monetary base or outside money as government debt but that s true only if the monetary base and government bonds are perfect or at least very close substitutes cochrane argues that the monetary base is if not perfectly at least easily substitutable for bonds so that the real value of government debt is at least to a first approximation independent of the ratio of government bonds held by the public to the monetary base held by the public however if the demand for the monetary base apart from its use in discharging tax liabilities is distinct from the demand for government bonds the monetary base constitutes net wealth not merely a liability the basic proposition of the fiscal theory must then be revised as follows inflation adjusts so that the real value of government debt does not exceed the present value of primary surpluses the corollary of the amended proposition is that if the monetary base constitutes net wealth inflation need not be affected by the real value of government debt if the fiscal constraint isn t binding so that the primary budget surplus exceeds government debt exclusive of the monetary base the monetary authority can control inflation by conducting open market operations exchanging outside money for government debt or vice versa by creating outside money to purchase government debt the monetary authority decreases the real debt liability of the government correspondingly however the extent to which outside money constitutes net wealth depends on the real demand of the public to hold outside money rather than government debt or inside money if the real demand to hold outside money declines the wealth represented by the stock of outside money is diminished correspondingly unless outside money is retired by way of a government surplus or by the sale of government debt by the monetary authority the price level will rise explaining why outside money and government debt sold to the public are equivalent cochrane argues in the monetarist story assets such as checking accounts created by banks satisfy money demand and so are just as inflationary as government provided cash thus the government must control checking accounts and other inside liquid assets in the basic fiscal theory only government money cash and bank reserves matter for inflation your checking account is an asset to you but a liability to the bank so more checking accounts do not make the private sector as a whole feel wealthier and desire to spend more the government need not control the quantity of checking accounts and other liquid assets however in the basic fiscal theory government debt which promises money is just as inflationary as money itself reserves and cash are just overnight government debt cochrane is correct as james tobin explained over 60 years ago that inside money supplied by banks is not inherently inflationary but what is true of bank liabilities which are redeemable on demand for government issued outside money is not necessarily true of government outside money in a footnote at end of the quoted passage cochrane acknowledges that difference reserves are accounts banks hold at the federal reserve banks may freely convert reserves to cash and back the fed issues cash and reserves and invests in treasury debt just like a giant money market fund because the interest the fed pays on reserves comes from the interest it gets from treasury securities and since it remits any profits to the treasury we really can unite fed and treasury balance sheets and consider cash and reserves as very short term and liquid forms of government debt at least to first order since banks began receiving interest on reserves held at the fed the distinction between treasury liabilities held by the public and treasury liabilities held by the fed was to first order nullified as was the operational distinction between the treasury and the fed but the conceptual distinction between money and debt is not inherently a nullity and insofar as the operational distinction has been nullified it s because in 2008 the fed began paying competitive interest on bank reserves held at the fed so insofar as the fiscal theory relies on the equivalence of government debt and government fiat money it relies either on a zero nominal interest rate or a policy of paying competitive interest on reserves held at the fed i shall return to this point below keynes in chapter 17 of the general theory despite erroneously explaining interest as merely a reward for foregoing the exercise not of time but of liquidity preference argued correctly that the expected return on alternative assets held over time would be equalized in equilibrium expected returns from holding assets net of holding costs can accrue as pecuniary payments e g interest as flows of valuable in kind services or as appreciation keynes s insight was to identify the liquidity provided by money as an in kind service flow for which holders forego the interest payments or expected appreciation that they could have gained from holding non monetary assets the predictions of the fiscal theory therefore seem contingent on blurring the distinction between inside and outside money outside money is created either by the government or the central bank instruments convertible into outside money such as commercial bank deposits and treasury debt are alternatives to outside money and may therefore affect the demand to hold outside money so even if treasury debt is classified money it is properly classified as inside not outside money as long as the demand of the public to hold high powered money is distinct from its demand to hold other assets the monetary authority has sufficient leverage over the price level to conduct monetary policy if there s no distinct demand for outside money aka the monetary base then differences during a given time period between the quantity of outside money demanded by the public and the stock created by the moneta...
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