Why would doubling the supply of currency cause people to hold twice as much currency in real terms?
Here is my thought experiment. Suppose that the government retired lots of $10 bills, giving $5 bills in exchange, at the fair rate of two fives for one ten. Suppose that this doubled the supply of $5 bills in circulation. In order to keep the real supply of $5 bills constant, the price level would have to double. Do we think that people would go on a spending spree with their excess $5 bills and cause the price level to double?
I don't think so. I think people would adapt to having more fives and fewer tens.
Next, suppose that instead of retiring $10 bills with $5 bills, the government retires 30-day Treasury bills with $5 bills. Suppose that this doubles the supply of $5 bills in circulation. Do we think that people want to hold only a constant real quantity of $5 bills, so that the only way we can get back to equilibrium is to have people spend to the point where the price level doubles?
Again, I don't think so. Exchanging $5 bills for 30-day Treasury bills probably will be more consequential than exchanging $5 bills for $10 bills. But I don't think it will be so much more consequential.
The other issue where Sumner and I differ is the formation of expectations for inflation. I do not believe that there is any policy that the Fed could have followed that would have resulted in expectations for high inflation from September of 2008 through September of 2009. Perhaps the government can convince people that the price level will be high ten years from now (it has convinced me of that). But it cannot manipulate near-term inflation expectations.
Yes, if an asset is now priced at $100 and I peg the price at $150 three years from now, the price has to go up now. But the prices that go into the Consumer Price Index or the GDP deflator are not asset prices. The prices of ordinary goods and services will not start rising until more people get used to them rising. It takes a while for expectations of inflation to become self-reinforcing.
Note that because I have been arguing that monetary policy is rather impotent, I cannot agree with David Beckworth's recent post arguing that monetary policy set the stage for the financial crisis. He writes,
There are at least two reasons why monetary policy was important here: (1) it helped create macroeconomic complacency and (2) it created distortions in the financial system via the risk-taking channel.