The Price of Money

I have stayed out of macro-economics in my work as an economist for a number of reasons, but it is a hot political subject at the moment and several times of late I have gotten involved in online macro arguments, so I decided it would be worth learning a little more about it. Someone sent me a copy of a recent book of essays by Tim Congdon, who has the interesting distinction of being both a monetarist and a fan of Keynes, and I have started reading it. 

The central claim of the first essay is that the views of the British Keynesians of the sixties and seventies were strikingly inconsistent with Keynes' own views. They saw inflation as a cost push phenomenon to which the proper solution was wage and price controls. Keynes, like later monetarists, saw it as a result of too much money and the solution as tight monetary policy. He was against wage and price controls, not for them.

One other thing struck me about the first essay: Congdon repeatedly refers to the interest rate as "the price of money." This is a very common error, and one that is not only wrong but dangerously wrong.

If the price of an apple is fifty cents, that means that if I give a seller fifty cents he will give me an apple in exchange. If the interest rate is five percent and that is the price of money, I ought to be able to buy money for five cents on the dollar. I doubt that Congdon, or anyone else, will be willing to sell it to me at that price. 

The price of money is what you have to give up to get it—the inverse of the price level. If the price of an apple is fifty cents, the price of a dollar is two apples. The interest rate is the rent on money, measured in money. A change in the price of money affects both the money you are renting and the money you are paying as rent, leaving the ratio of the two unchanged.

Suppose that at midnight tonight every dollar bill in the world twins, along with a similar change in the accounting entries for bank deposits, other forms of money, and all obligations denominated in money. By morning, there is twice as much money as before—and nothing else has changed.

I would ask Congdon whether, under those circumstances, he would expect the interest rate to drop. If his answer is yes, my next question is whether he would expect a much more extreme drop if we relabeled pennies as dollars and dollars as hundred dollar bills, thus increasing the money supply, measured in "dollars," a hundredfold.

The reason the description of the interest rate as the price of money is not only wrong but dangerously wrong is that it implies a simple relation between money and the interest rate—in the extreme (but not uncommon) version, the belief that interest rates are set by central banks, with high interest rates the result of a tight monetary policy.

A central bank can create money and lend it out, increasing the supply of loans (which reduces the interest rate) and increasing the money supply. That is the one element of truth to the relationship. But what is affecting the interest rate is not the amount of money but the amount of loans; the government could get the same effect by collecting more in taxes than it spends and lending out the difference.

The interest rate is a market price—the price paid for the use of capital—and the central bank controls it only in the same sense in which the government can control the price of wheat by choosing to buy or sell some of it. The central bank does not have an unlimited amount of capital from money creation to lend and so has only a limited ability to shift interest rates from what they would otherwise be. Furthermore, a continued expansion of the money supply creates the expectation of future price rises, which pushes the nominal interest rate up, not down. 

I have been unable to locate an email address for Tim Congdon, so am unable to point out his error to him directly. If any of my readers has one, I would be grateful if you would send it to me.

[Two people have now provided me with his email, I emailed him and received a friendly response.]