Eleventh Installment
Money and Monetary Policy
Money distorted the economy
The position taken by Professor Robert Lucas of the University of Chicago, i.e., that the recent financial crisis was essentially caused by the disappearance of money via a mechanism similar to a bank run, is continuing to gain wide acceptance among economists. In addition to Professor Lucas, experts in financial economics such as Gary Gorton have also asserted that the same mechanism is behind this financial crisis.
In this instance, the money that disappeared is the medium of exchange for economic transactions. As I have argued in this series of articles, discussions on introducing money into economic models that focused on money's role as a medium of exchange did not arise within mainstream policy analysis. Within the New Keynesian framework that has established itself as the mainstream for monetary policy analysis over the past dozen years or so, almost all analysts have presumed the "nominal rigidities" to be the sole route by which the presence of money has an impact on the real economy.
The current financial crisis, however, has reminded macro-economists that the disappearance of money as a medium of exchange is capable of causing major economic fluctuations, which need not arise simply by an amplification of the nominal rigidities.
Thus far the policy recommendation stemming from (primarily neoclassical) research that sought to use money's character as a medium of exchange for policy analysis has been exceedingly unrealistic, and this is believed to be a key reason that the economic theory introducing money as a medium of exchange has failed to become mainstream policy analysis. This neoclassical policy recommendation entails sparking deflation as the optimal monetary policy, calling to mind the famous Friedman rule in macroeconomics. This rule derives from a statement made by Professor Milton Friedman of the University of Chicago, renowned as the leader of the monetarists, that the optimal way of eliminating market friction caused by money is to make the returns on money the same as the returns on other financial assets.
Friedman's argument is as follows. Economic distortions arising from the need to hold currency as a medium of exchange for economic transactions stem from the fact that money earns no interest. Persons who have no choice but to hold currency in order to conduct economic transactions do not earn the interest they likely would if they were to hold bonds instead, and that difference is the opportunity cost. This creates distortions in the economy as a whole. Implementing an economic policy whereby money would in fact earn interest would be an effective means of eliminating these distortions, but a policy that causes prices to fall would indeed be the same as paying interest on money. Consequently, the optimal monetary policy for eliminating the distortions to the economy caused by money as a medium of exchange would be a deflationary policy that steadily reduces the money supply and forces price levels down. This was Friedman's logic.
Drawbacks to the Friedman Rule
Both Friedmanian and neoclassical economics feature ideal economic models with no price stickiness. Given that the real interest rate on bonds and other such instruments would be determined by market equilibrium through the productivity of the economy and household preferences, there would be no changes regardless of the monetary policies adopted. On the other hand, the real interest rate on money would be the same as the deflation rate (e.g., if 2% deflation occurs, the real interest rate on money would be 2%). Hence monetary policies that cause deflation can be used to change the real interest rate on money to match it to the real interest rate on bonds. Friedman postulated that the optimal policy for eliminating money-driven economic distortions is to equalize real interest rates for both bonds and money, i.e., to generate deflation at the same rate as the real interest rate on bonds (which would not change even with a change in monetary policy); the nominal interest rate on bonds in this case would be zero.
The Friedman rule - that a deflationary policy is the optimal monetary policy - is an extraordinarily robust conclusion. Almost all macroeconomic theories other than New Keynesian theory, which is rooted in the nominal rigidities, have adopted the Friedman rule. This is true, for instance, even for neoclassical macroeconomic models such as the cash-in-advance model introducing money as a medium of exchange and for the search theory of money, which I will discuss next time.
As one might well imagine, however, the Friedman rule is never taken up as a serious policy prescription in the actual discussions of monetary policies at central banks. Were a central bank to intentionally adopt deflationary policies in the real world, economic activities would slow forcing up the unemployment rate. The assertion that the Friedman rule is optimal is premised on the hypothesis that the real interest rates for bonds and capital are determined as a result of equilibrium and that real interest rates do not change with monetary policy. This hypothesis is not realistic. Deflationary policies (policies to reduce the money supply) would in fact be implemented by raising interest rates, which would in the short term force up real interest rates for companies and households. Production activity would thus decline, investment and consumption would also decrease, and the unemployment rate would rise. In any case, the neoclassical monetary theory that regards the Friedman rule as the optimal policy cannot unfortunately escape being criticized as doctrinarism, and it appears unlikely that such an approach will find a place in practical policy discussions at central banks.
Presupposing the rigidity of prices is one method of obtaining the result that monetary policies (in other words, changes to nominal interest rates) bring about changes in real interest rates. This is New Keynesian, and such a framework has been used in monetary policy analysis research for the past dozen years or so, earning the status as the standard framework for policy analysis. Nevertheless, the financial crisis that followed the Lehman shock has exposed its limitations.
Another orientation for avoiding the spell of the Friedman rule and connecting the role of money as a medium of exchange to practical policy analysis would be to move not only outside money such as paper currency and coinage but also scrip money to center stage as money.
* Translated by RIETI from the original Japanese article in the series, "Gödel's money" published in the October 26, 2009 issue of Kinzai Financial Weekly
