Everyone's a monetarist (except when it comes to money) By Scott Sumner

Why does the value of strawberries change over time? How about the value of houses? How about gasoline?

Most people use some form of a supply and demand model to explain changes in the value of goods. These models actually explain “relative prices”, not nominal prices. Thus in EC101, a 3% increase in the price of strawberries occurs when the nominal price rises 5% at a time of 2% overall inflation. It’s the relative price that is explained in basic S&D models.

Think about how we explain the effect of a big strawberry harvest. Wholesalers are temporarily holding more strawberries than they wish to hold, so they cut prices to move the inventory. Then stores are flooded with strawberries, so they cut prices to sell the excess supply.

There’s sort of a “hot potato effect”, where the initial increase in production leads to more strawberries than people want to hold at existing prices. As people try to get rid of these excess supplies, the price gets bid down to a level where people are willing to hold (and ultimately consume) these strawberries. The same is true of houses, gasoline, and other goods. But is it true of money?

Monetarists are the group that explains changes in the relative price of money using a basic supply and demand model. Because the nominal price of a dollar bill is fixed at 1, the relative price of money changes inversely to the price level. If the price level rises by 2%, then the relative value of money falls by the same ratio, by definition.

Monetarists believe that an increase in the supply of money temporarily creates excess cash balances. Due to the hot potato effect, the value of money will decline until consumer prices rise to a level where people are willing to hold those larger balances. Monetarists do not believe that money creation causes inflation because of how it affects interest rates, or the exchange rate, or the unemployment rate, or some other variable. It’s all about the supply and demand for money. We treat money just like any other good.

Of course things can get complicated, even in S&D models. If there is a temporary surge in the number of houses (or other durable assets), but homeowners expect the supply of houses to revert back to normal after a brief period, then prices will not decline sharply. Expectations matter. The same is true for a temporary injection of money, which is also a durable asset. It has little impact on the value of money.

If the new strawberries merely displace an equal number of raspberries, then the decline in strawberry prices will be much milder, as raspberries are close substitutes. The same is true of exchanges of cash for zero interest T-bills. S&D models need to be used thoughtfully.

But monetarists do not believe that it’s helpful to visualize monetary policy in terms of interest rates, exchange rates, etc. We would not write news headlines like the following:

Central banks are locked in currency wars they cannot win

The entire FT article is based on confusion between real and nominal exchange rates. All central banks cannot simultaneously reduce the value of their currencies relative to each other. But all central banks can simultaneously reduce the value of their currencies relative to goods and services.

Or this Project Syndicate headline:

Could Ultra-Low Interest Rates Be Contractionary?

It makes no sense to argue over whether low interest rates are expansionary or contractionary, using an implicit assumption that the low rates reflect monetary stimulus. Interest rates are merely a side effect of monetary policy. The expansionary or contractionary impact of monetary policy does not depend on its impact on interest rates. Indeed, the most highly expansionary monetary policies (i.e. the 1970s) have tended to raise interest rates.

One reason you might want to consider becoming a monetarist is that it helps one avoid spouting nonsense about monetary policy. I may be wrong in my estimation of the importance of temporary vs. permanent currency injections, or how close a substitute T-bills are for cash, but at least I’m working with a well-grounded economic model that has a track record of hundreds of years of success in explaining changes in the relative price of goods like strawberries, houses, gasoline and . . . money.

So don’t say to me, “I don’t see why you think printing more money would create inflation.” Of course you see why I think that—it’s supply and demand. Be more specific. Maybe you think the currency injections would be viewed as temporary. Or maybe you think that currency and T-bills are currently near perfect substitutes. Those are good arguments. It’s not a good argument to suggest that more money won’t change the interest rate or that it won’t change the unemployment rate, because inflation is not caused by changes in the interest rate or the unemployment rate. Changes in those variables are a side effect of monetary injections. Inflation is caused by changes in the supply and demand for money.