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Why money matters

Summary:
Some commenters who are sympathetic to MMT seem unfamiliar with the standard view of why money matters. They argue that swapping base money for an equal dollar value of bonds doesn’t matter, because the recipient of the new money is no better off than before. It’s true they are (approximately) no better off, but that’s NOT why economists think money matters. It would be nice if commenters showed they understood the traditional view, and then explained why it’s wrong and MMT is right.Conventional economists believe that an injection of new base money creates a situation of excess cash balances. Keynesians believe the attempt to get rid of these excess cash balances causes bond prices to rise (i.e. interest rates to fall), and this boosts AD. Monetarists believe that the

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Some commenters who are sympathetic to MMT seem unfamiliar with the standard view of why money matters. They argue that swapping base money for an equal dollar value of bonds doesn’t matter, because the recipient of the new money is no better off than before. It’s true they are (approximately) no better off, but that’s NOT why economists think money matters. It would be nice if commenters showed they understood the traditional view, and then explained why it’s wrong and MMT is right.

Conventional economists believe that an injection of new base money creates a situation of excess cash balances. Keynesians believe the attempt to get rid of these excess cash balances causes bond prices to rise (i.e. interest rates to fall), and this boosts AD. Monetarists believe that the attempt to get rid of excess cash balances causes the price of a wide range of assets to rise, not just bond prices. Thus the Fed announcements of January 2001 and September 2007 caused only a small decline in short-term interest rates, but a big rise in stock prices. (BTW, long-term rates actually rose both times due to the Fisher effect—a factor ignored by MMTers.)

Monetary stimulus boosts the prices of T-bills, stocks, commodities, real estate and foreign exchange. I.e., it depreciates a currency. During normal times such as the 1990s, the difference between Keynesians and monetarists is just a theoretical curiosity. They both agree that monetary policy drives NGDP; they merely differ in how they see the transmission mechanism.

When rates fall to zero, however, the monetarist model is clearly superior. In March 2009, the Fed announced a QE program and as a result stocks rose and the dollar sharply depreciated against foreign currencies. That’s consistent with the monetarist model and inconsistent with the (extreme) old Keynesian view that monetary injections don’t matter at zero rates. (In fairness, New Keynesians have a more nuanced view.) MMTers seem to think money never matters, even at positive interest rates, although as I pointed out in this post it’s hard to be sure, as their statements are so contradictory.

Here’s an analogy. When there’s a big apple crop, the new apples are sold at market prices. The wholesalers who buy the apples do so at competitive prices and thus don’t feel any richer. They see no need to go out and spend more. But they do have excess apples, which puts downward pressure on the value of apples.

Inflation is a fall in the value of cash. A big crop of new money puts downward pressure on the value of cash. If the government sells me a briefcase full of $1 million cash in exchange for an equal value of bonds, I’m no richer than before. I won’t go out and buy a new Ferrari. But I will have much cash than I prefer to hold, and I’ll get rid of that extra cash.

And here’s where the fallacy of composition comes in. While I can get rid of the extra cash by purchasing bonds, stocks, commodities, real estate or foreign exchange; society as a whole cannot get rid of the excess cash by purchasing other assets. Doing so is merely “passing the buck”.

But the public’s attempt to get rid of excess cash balances will drive up the price of a wide range of assets, leading to more total spending, more NGDP. Eventually NGDP will rise high enough so that people are willing to hold the larger cash balances, and a new equilibrium is established.

All of this is ignored by MMTers. They seem to think that swapping cash for bonds is “irrelevant”, even when interest rates are positive.

In fact, an exogenous and permanent increase in the money supply of X% will cause prices and NGDP to rise by X% in the long run. Money is neutral in the long run; just as changing a country’s measuring stick from feet to meters doesn’t change the actual (“real”) length of objects.


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Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

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