Monday, April 20, 2009

A special theory of interest and money

Greg Mankiw --

At one of my recent Harvard seminars, a graduate student proposed a clever scheme to do exactly that. (I will let the student remain anonymous. In case he ever wants to pursue a career as a central banker, having his name associated with this idea probably won’t help.)

Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.

That gets filed under too clever by half. If the central bank announces that one in every ten dollars will be worthless in a year's time, anyone selling anything now bumps up their prices by ten percent to compensate for the average loss in value in a year's time [Think about what happens if everyone decides to wait till a year minus one day to do this, and so on].

Thus there is an immediate 10 percent loss on the value of all money holdings. But then what? If this is just a one-time scheme, then prices after the year has passed will fall (since money no longer has a risk of disappearing) and now the return to holding money once the initial jump has happened is positive. You wait to spend -- the exact opposite of the policy objective!

In short, why do we need complicated schemes that need some tricky mathematics to figure out when the government has simple things it can do, like more fiscal expansion or more purchases of government debt? Perhaps they sound like things that conservative economists can't be "for" -- while money confiscation schemes are fine. It's a strange world.

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