A lot of my conclusions here aren't much different from those of a previous discussion, but I'm going to frame/derive them slightly differently.
Suppose two agents are exogenously matched and given an exogenous date in the future for which they can construct a bilateral derivative; maybe we even require zero NPV, or maybe we allow for some cash transfer now, but either way if they're infinitely clever (and assuming e.g. that they don't anticipate future opportunities to insure before that date, etc.) then I believe the negotiations should leave the ratio of marginal costs of utility for the two agents at that date pre-visible. If we add constraints we modify that, but probably in relatively intuitive ways; if we can only condition on certain algebras of events (coarser than what would in principle be measurable at the final date), for example, then there's an expected value on each of those events that should give the same ratio, and if in some states an agent is unlikely to be able to make a payment, that agent is allowed to be better off than the other agent in that state relative to the usual ratio. Further, if there are a bunch of pairs of agents doing this, and the agents can be put into large classes, but need then to have very similar contracts, I'm probably doing more averaging over agents in each class.
I don't know whether this gets me any closer to an answer, but perhaps this is a useful framework for thinking about monetary policy as the medium of exchange consists increasingly of electronic (even interest-bearing) accounts and centrally-managed money is mostly about the unit of account. Buyers and sellers and debtors and lenders still referencing a given unit of account will tend to have certain risk similarities intraclass and differences interclass that one can try to optimize; if a surprise causes borrowers more pain than lenders, I try to weaken the unit of account, and if a surprise causes sellers more pain than buyers[1], then I try to strengthen the unit of account, and everyone ex ante looks at this and says "doing my contract (legal and explicit or customary and implicit) in this unit of account affords me a certain amount of insurance".
[1] A further note on the inclusion of "buyers" and "sellers" here: on some level this only matters for forward contracts, i.e. if we're entering an agreement to an immediate transaction there's none of this sort of uncertainty that resolves itself between the creation of the contract and its conclusion. Parties to a forward contract take on a lot of the properties of borrowers and lenders, insofar as there is a (say) dollar-denominated transfer in the future to which they've committed. Further, in principle borrowers, lenders, and parties to forward contracts can, as above, create their own risk-sharing contract. As a practical matter, of course, this is likely to be impossible to do perfectly, and it's likely that the extent to which it can be done practically leaves a lot of room for a central bank to come in and improve things. This is a usual theory-meets-practice kind of dynamic, especially in monetary theory; somewhat famously, perfect Walrasian economies don't need money, so a useful theory of money will have to figure out what parts of reality outside of Walrasian economics matters, and incomplete contracts would seem to be a biggie.
I believe, though, that more important than difficulties in contracting formally are informal contract-like substances that result from various incompletenesses in information. Buyers and sellers form long-term relationships that may be "at will" for each party, but are formed typically because one or both parties would incur some expense in looking anew for a counterparty each time a similar transaction was to take place. It seems likely to me that this would result in similar long-term dynamics to a contract, and is likely to involve prices that are sticky in some agreed-upon unit of account, whereupon a benevolent manager of that unit of account would again be trying to optimize as discussed above.
Showing posts with label central banking. Show all posts
Showing posts with label central banking. Show all posts
Tuesday, November 10, 2015
Thursday, April 16, 2015
monetary policy and the theory of money
I have several dollars on top of my dresser, but most of my money (in pretty much any sense in which economists regularly use the word) exists as electronically-recorded liabilities of financial institutions. For most of my bills, it is more convenient to pay them out of such intangible money than the tangible money. Supposing we can still count the zero-interest-rate environment that has persisted for more than six years "abnormal", we have mostly shifted to a medium of exchange that pays interest, and the trajectory of technology (both information technology and financial technology) is toward more of that.
Traditional explanations of how monetary policy work often run more or less like this: the fed controls short-term interest rates, which affect the trade-off people make between holding their money in more liquid versus less liquid forms, and if they increase the amount they have in more liquid forms they spend more.[1] As the most liquid form of money starts to pay interest at a rate that moves more or less one-to-one with other interest rates, we face something of a paradox; the interest rate is effectively zero in terms of the actual medium of exchange, and the "interest rate" that the fed targets simply measures the rate at which the value of the dollar declines relative to that.
If people at that point are largely using interest-bearing deposits and funds as the actual store of value and medium of exchange in the economy, to what extent does this "dollar" whose value declines relative to it even matter? At least at first, it can continue to serve as a unit of account. Indeed, at this point it seems to have retained that function in the United States, even as it has largely lost the others; even where you see contracts with "indexing" of some sort, it's far more often to a price index than to something connected to interest rates per se. Perhaps over time contracts could start to have future cash flows stipulated in terms of the amount of money that would be in a bank account at that point in time if a specified amount had been deposited at the beginning of the contract, but there's no logical reason why the new medium of exchange would need to take over this last function of money.
Thus the dollar, increasingly, serves only as a unit of account, and will maintain its relevance only if it continues to serve for many purposes as a better unit of account than some alternative.[2] What makes a good unit account is not necessarily entirely the same thing that makes a good store of value or medium of exchange. To the extent that it does not, this new separation is in fact liberating for the Fed; it can focus on making the dollar a good unit of account, possibly allowing more volatility in its value than would be optimal if it were also a widespread store of value.
A business, for example, will typically have inputs that it purchases as it goes along, but will also require long-term inputs into the production process — a lease on a retail store, for example. (Employees who may, in principle, be freely dischargeable at-will employees, are probably in practice at least somewhat long-term inputs due to firm-specific knowledge and training and the costs of hiring and firing.) It also will produce products that may include short-term sales, longer-term contracts to supply clients, or both. It is likely that there will be some "duration mismatch" between inputs and outputs. In each case where the company is locked in to a decision years ahead of time, it risks a change in circumstances; if it is mostly selling as it goes along, it might wish to respond to an unexpected drop in demand by finding a way to cut production costs, but if it is selling mostly by long-term contract but has to buy its inputs day-to-day, it is subject to an increase in costs that it can't pass along. To the extent that it can specify prices in long-term contracts in terms of a unit of account that will drop in value if demand for its product goes down, or increase in value as competition for its supplies goes up, it will be easier for the company to responsibly engage in this business. A central bank that is trying to optimize its currency for use as a unit of account, therefore, will tend to devalue its currency when the economy in general is slowing down and increase its value (at least relative to expectations) when the economy is especially robust. These kinds of fluctuations in the value of actual holdings of the currency — long-term, as a store of value, or even short-term, as a medium of exchange, between the sale of one good or service and the purchase of another — will tend to make it less useful for those purposes. In a world where the central bank doesn't have to trade off these costs against the benefits of a countercyclical unit of account, it can focus on a better unit of account, while the other functions of money are provided elsewhere.
[1] There are (perhaps more compelling) arguments related to intertemporal substitution as well, but note that those explanations implicate the real interest rate rather than the nominal interest rate. You therefore need a story about how inflation and interest rates are simultaneously determined, and in particular why a decision by the fed to raise interest rates would reduce inflation expectations. These stories and explanations typically themselves come back to a "liquidity effect", so we're left with the same conundrum as the role of non-interest-bearing money atrophies.
[2]To some extent, as long as the government is using it as a unit of account — specifying tax liabilities, contract payments, and social security benefits in dollars, and even taxing the deviation between our new electronic currency and the dollar as "interest income" — it can be kept relevant by fiat.
Traditional explanations of how monetary policy work often run more or less like this: the fed controls short-term interest rates, which affect the trade-off people make between holding their money in more liquid versus less liquid forms, and if they increase the amount they have in more liquid forms they spend more.[1] As the most liquid form of money starts to pay interest at a rate that moves more or less one-to-one with other interest rates, we face something of a paradox; the interest rate is effectively zero in terms of the actual medium of exchange, and the "interest rate" that the fed targets simply measures the rate at which the value of the dollar declines relative to that.
If people at that point are largely using interest-bearing deposits and funds as the actual store of value and medium of exchange in the economy, to what extent does this "dollar" whose value declines relative to it even matter? At least at first, it can continue to serve as a unit of account. Indeed, at this point it seems to have retained that function in the United States, even as it has largely lost the others; even where you see contracts with "indexing" of some sort, it's far more often to a price index than to something connected to interest rates per se. Perhaps over time contracts could start to have future cash flows stipulated in terms of the amount of money that would be in a bank account at that point in time if a specified amount had been deposited at the beginning of the contract, but there's no logical reason why the new medium of exchange would need to take over this last function of money.
Thus the dollar, increasingly, serves only as a unit of account, and will maintain its relevance only if it continues to serve for many purposes as a better unit of account than some alternative.[2] What makes a good unit account is not necessarily entirely the same thing that makes a good store of value or medium of exchange. To the extent that it does not, this new separation is in fact liberating for the Fed; it can focus on making the dollar a good unit of account, possibly allowing more volatility in its value than would be optimal if it were also a widespread store of value.
A business, for example, will typically have inputs that it purchases as it goes along, but will also require long-term inputs into the production process — a lease on a retail store, for example. (Employees who may, in principle, be freely dischargeable at-will employees, are probably in practice at least somewhat long-term inputs due to firm-specific knowledge and training and the costs of hiring and firing.) It also will produce products that may include short-term sales, longer-term contracts to supply clients, or both. It is likely that there will be some "duration mismatch" between inputs and outputs. In each case where the company is locked in to a decision years ahead of time, it risks a change in circumstances; if it is mostly selling as it goes along, it might wish to respond to an unexpected drop in demand by finding a way to cut production costs, but if it is selling mostly by long-term contract but has to buy its inputs day-to-day, it is subject to an increase in costs that it can't pass along. To the extent that it can specify prices in long-term contracts in terms of a unit of account that will drop in value if demand for its product goes down, or increase in value as competition for its supplies goes up, it will be easier for the company to responsibly engage in this business. A central bank that is trying to optimize its currency for use as a unit of account, therefore, will tend to devalue its currency when the economy in general is slowing down and increase its value (at least relative to expectations) when the economy is especially robust. These kinds of fluctuations in the value of actual holdings of the currency — long-term, as a store of value, or even short-term, as a medium of exchange, between the sale of one good or service and the purchase of another — will tend to make it less useful for those purposes. In a world where the central bank doesn't have to trade off these costs against the benefits of a countercyclical unit of account, it can focus on a better unit of account, while the other functions of money are provided elsewhere.
[1] There are (perhaps more compelling) arguments related to intertemporal substitution as well, but note that those explanations implicate the real interest rate rather than the nominal interest rate. You therefore need a story about how inflation and interest rates are simultaneously determined, and in particular why a decision by the fed to raise interest rates would reduce inflation expectations. These stories and explanations typically themselves come back to a "liquidity effect", so we're left with the same conundrum as the role of non-interest-bearing money atrophies.
[2]To some extent, as long as the government is using it as a unit of account — specifying tax liabilities, contract payments, and social security benefits in dollars, and even taxing the deviation between our new electronic currency and the dollar as "interest income" — it can be kept relevant by fiat.
Tuesday, June 17, 2014
instruments of Fed policy
If the fed raised the reserve requirement (not now; under the sort of circumstances that we persist in calling "normal" more than five years since they were last seen), that should steepen the yield curve as long-term credit becomes scarcer relative to the supply of demand deposits and other short-term highly liquid investment. In periods historically where the yield curve becomes inverted I imagine some benefit might have been derived from somewhat tighter constraints, and where it's steepest perhaps somewhat looser; perhaps it would make sense to change reserve requirements in tandem with a target for the steepness of the yield curve.
The tl;dr version of the previous post is that, in the short term — on the order of an eighth of a year — the FOMC is likely to continue to ask the New York Fed to aim at something that is readily monitored in something like real-time, and it seems like the difference between long-term rates and short-term rates is a better target over that kind of period than short-term rates alone; in particular, if long-term rates go up over the weeks after an FOMC meeting, presumably that means the market has come to believe that inflation and/or returns to sunk capital will be higher than was believed at the last meeting and a somewhat high short-term rate is appropriate.
So I'm now suggesting that the FOMC set a target for the steepness of the yield curve, and, just as it customarily used to change the deposit rate in lockstep with the FOMC federal funds target, the board of governors would then customarily change the required deposit ratio in lockstep with the target for the steepness of the yield curve. There are clearer reasons for deviating from this from time to time than was the case with the deposit rate, and I'm not denying the board of governors the ability to do that, but rather than "leave them unchanged" as the default, I would suggest something slightly procyclical as the default instead.
The tl;dr version of the previous post is that, in the short term — on the order of an eighth of a year — the FOMC is likely to continue to ask the New York Fed to aim at something that is readily monitored in something like real-time, and it seems like the difference between long-term rates and short-term rates is a better target over that kind of period than short-term rates alone; in particular, if long-term rates go up over the weeks after an FOMC meeting, presumably that means the market has come to believe that inflation and/or returns to sunk capital will be higher than was believed at the last meeting and a somewhat high short-term rate is appropriate.
So I'm now suggesting that the FOMC set a target for the steepness of the yield curve, and, just as it customarily used to change the deposit rate in lockstep with the FOMC federal funds target, the board of governors would then customarily change the required deposit ratio in lockstep with the target for the steepness of the yield curve. There are clearer reasons for deviating from this from time to time than was the case with the deposit rate, and I'm not denying the board of governors the ability to do that, but rather than "leave them unchanged" as the default, I would suggest something slightly procyclical as the default instead.
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