Monday , July 22 2019

Fiat Bling

Summary:
I visited a country where people wore paper money as jewelry. Richer people wore larger denomination notes, to signal how wealthy they were, and poorer people wore smaller denomination notes. Only the very poorest wore none at all. Then I learned the paper money wasn't used as money. They only produced one homogeneous good called "corn", so didn't need a medium of exchange. What I thought was money was in fact bling. Bling was issued by the central bank. It wasn't bling unless it had the authorised signature of the central bank's governor, and wearing forged bling was severely punished by ridicule. The governor's signature was performative; the Governor said "Fiat bling", and there was bling. Commercial banks also issued bling. But commercial bank bling was convertible on demand, at

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I visited a country where people wore paper money as jewelry. Richer people wore larger denomination notes, to signal how wealthy they were, and poorer people wore smaller denomination notes. Only the very poorest wore none at all.

Then I learned the paper money wasn't used as money. They only produced one homogeneous good called "corn", so didn't need a medium of exchange. What I thought was money was in fact bling.

Bling was issued by the central bank. It wasn't bling unless it had the authorised signature of the central bank's governor, and wearing forged bling was severely punished by ridicule. The governor's signature was performative; the Governor said "Fiat bling", and there was bling.

Commercial banks also issued bling. But commercial bank bling was convertible on demand, at par, into central bank bling. And commercial banks need sufficient assets (central bank bling, corn, promises to pay future corn or bling) to give people confidence that convertibility could be maintained.

Different banks issued bling in different colours. And different people preferred different colours, with some preferring a mix of colours. So the varieties of bling were substitutes, but imperfect substitutes.

It is easy to understand that commercial bank bling would be valuable, given commercial banks' promise to maintain convertibility at par into central bank bling. But what made central bank bling valuable? In the olden days central bank bling had been redeemable for gold, but fashions had changed, so paper bling had replaced gold bling (it was more comfortable), and gold convertibility had been suspended, temporarily at first, and then permanently.

What made fiat bling valuable was simply demand and supply. The demand for bling (Md = P.L(Y,r), where Md is the stock of bling demanded, P the price of corn in terms of bling, Y the level of corn income, and r the nominal interest rate on loans of bling, and thus the opportunity cost of wearing bling), together with a central bank that limited the supply of bling, created an equilibrium with a positive stock of bling (M > 0) with a positive value (P < infinity). Some academic theorists worried about a possible second equilibrium, in which a self-fulfilling belief that fiat bling was worthless would cause people to stop wanting to wear worthless bling; but normal people's customary belief that fiat bling was valuable prevented that happening. Plus they knew the central bank had enough assets to buy back all the bling if it really needed to.)

There are many ways the central bank could limit the supply of bling. Simply fixing Ms (or the growth rate of Ms) would be one way. But the central bank in this country instead chose to control the rate of interest r at which it would lend bling. If the price of corn in terms of bling was rising too quickly, the central bank would raise r to discourage borrowing of bling; and if the price of corn in terms of bling was rising too slowly the central bank would cut r to encourage borrowing of bling. So the stock of bling in public hands was determined by the stock of bling demanded at the rate of interest set by the central bank.

A shortage or surplus of bling might affect people's ability to signal their wealth. But central bank policy didn't affect the rest of the economy. Self-sufficient people kept on consuming the corn they produced regardless of anything the central bank did, lending or borrowing corn between themselves depending on who had a relatively better or worse harvest. The only thing that caused aggregate production to fall was bad weather across the whole country.

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