The Monetary Mechanism

I reject the notion that each level of nominal GDP is consistent with one and only one level of a measure of the money supply. That is true only in pristine economic models.

In the real world, when one type of M is in short supply, people substitute other forms of M. So for any given definition of M there can be a wide range of possible levels of nominal GDP for a given quantity of that M.

Bryan, the problem is that during a financial crisis, banks do *not* increase lending by (1-RR)100. They need to shore up their reserves by more than the marginal required amount because of falling asset values.

Prof. Caplan,

I might be wrong, but I believe that it's generally accepted that the velocity of money tends to be stable absent extreme situations.

Bryan Caplan:

Suppose a wealthy landowner collects rent from his tenants, and the rent is stated in ounces of silver. When the landowner buys groceries, he pays with his own paper IOU's (call them guilders), which he himself accepts in payment of rents at the rate of 1 oz./guilder. Those guilders will circulate as money, and they will be valued based on the landowner's assets and liabilities. Local banks might issue checking account guilders, each of which is redeemable at the bank for 1 paper guilder. They can be considered 'derivative' guilders, since they are each a claim to a 'base' guilder.

Change the word 'landowner' to 'government', and 'rent' to 'taxes', and you have a reasonable description of our modern mix of paper dollars and checking account dollars.

Now ask your question: "What if you woke up with 100 guilders (presumably paper, presumably not counterfeit) in your pocket?" The right question to ask is "Where did they come from?" If they were a gift from a friend, or from the landowner, then you are richer and he is poorer. If you got the guilders because you sold goods to the landowner or the friend, then again there is no change in total demand. But if the landowner's assets and liabilities are both initially 1000 guilders, and he gives you 100 newly-issued guilders without getting anything in return, then the landowner now has 1100 guilders of liabilities, backed by only 1000 guilders of assets, and the value of his guilders must fall by 10%.

I've been enjoying this exchange of posts. To summarize: economists can't decide if they should eat out or not; economists are bemused if they find an extra $100 in their wallets; and lets not even mention if they find a $10 note on the sidewalk.

And you get paid to do this!

Kit,
you should see what mathematicians do all day.

Mathematicians work in abstraction and proof, and while what much of what they do is useless, its at least true and never masquerades as useful.

I'm still trying to figure out how macroeconomic models are any different than political opinion.

I'll answer your question! I would buy gold or silver, and bury my treasure anticipating a financial collapse.

Which is essentially what I'm doing now.

Wait, is this a real life question, or one of those hypotheticals, like if you have $100 on a training heading to Cleveland, and your tax increase left Philadelphia at 4pm, how much money would you have left when you got to Cleveland?

Then my answer is I got off at Indianapolis.

This all is really interesting. I've been studying this in school, and its nice to see what my teacher's mentioned outside of school.
All of you comments are also very interesting.