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Helicopter Money: Irredeemable Fiat Money and the Liquidity Trap

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Helicopter Money: Irredeemable Fiat Money and the Liquidity Trap Helicopter Money Irredeemable fiat money and the liquidity trap Or: is money net wealth after all? Willem H. Buiter * ** Chief Economist and Special Counsellor to the President, European Bank for Reconstruction and Development, CEPR and NBER 6-11-03 Revised 31-01-04 * © Willem H. Buiter 2003/4 ** The views and opinions expressed are those of the author. They do not represent the views and opinions of the European Bank for Reconstruction and Development. I would like to thank Niko Panigirtzoglou and Anne Sibert for assistance and Richard Clarida, Greg Hess, Richard Burdekin, Danny Quah, Nobu Kiyotaki, Lucien Foldes and other seminar participants at Columbia University and LSE for helpful comments. Abstract The paper provides a formalisation of the monetary folk proposition that fiat (base) money is an asset of the holder (the private sector) but not a liability of the issuer (the monetary authority, as agent of the state). The issuance of irredeemable fiat base money can have pure fiscal effects on private demand. With irredeemable fiat base money, weak restrictions on the monetary policy rule suffice to rule out liquidity trap equilibria, that is, equilibria in which all current and future short nominal interest rates are at their lower bound. In a model with flexible prices, liquidity trap equilibria cannot occur as long as the private sector does not expect the monetary authority to reduce the nominal money stock to zero in the long run. In a New-Keynesian model, liquidity trap equilibria are ruled out provided the private sector expects the authorities not to reduce the nominal stock of base money below a certain finite level in the long run. Liquidity trap equilibria can exist if and for as long as the private sector expects that the monetary authorities will ultimately reverse any current expansion of the monetary base in present value terms. JEL classifications: E31, E41, E51, E52, E62, E63. Key words: Helicopter money drop; irredeemable money; monetary policy effectiveness; zero bound, liquidity trap. Author: Willem H. Buiter, European Bank for Reconstruction and Development, One Exchange Square, London EC2A 2JN. UK Tel. #44-20-73386805 Fax. #44-20-73386110/6111 E-mail (office): [email protected] E-mail (home): [email protected] Web page: http://www.nber.org/wbuiter/index.htm 1 Introduction “Let us suppose now that one day a helicopter flies over this community and drops an additional $1000 in bills from the sky, …. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated,” (Friedman [1969, pp 4-5]. This paper aims to provide a rigorous analysis of Milton Friedman’s famous parable of the ‘helicopter’ drop of money. A related objective is to show that even when the economy is in a liquidity trap (when all current and future short nominal interests rates are at their lower bounds and there is satiation with real money balances), a helicopter drop of money will stimulate demand, unlike a helicopter drop of government bonds. The argument involves a number of steps. The first is a formal statement, in an optimising dynamic general equilibrium model with money, of the ‘folk proposition’ that (fiat base) money is an asset to the private holder but not a liability of the issuer - the government. This is done through an asymmetric specification of the solvency constraints of the households and the government, motivated by the assumption that fiat base money is irredeemable. The model has two financial stores of value: base money and one-period risk-free non-monetary interest-bearing nominal debt. The solvency constraint for the household is the requirement that the present discounted value of its terminal net financial wealth (the sum of its money holdings and its net non-monetary financial assets) be non-negative. The solvency constraint for the government is the requirement that the present discounted value of its terminal non-monetary net financial debt be non-positive. The government does not view its monetary debt as a liability that will eventually have to be redeemed for something else of equal value. This formalisation of the concept of irredeemable base money is the central new idea in this paper.1 1 The American Heritage Dictionary (2000) defines an irredeemable object as one ‘that cannot be bought back or paid off’ or ‘not convertible into coin’ The Concise Oxford Dictionary (1995) gives: ‘(of paper money) for which issuing authority does not undertake ever to pay coin.’ The meaning attached to it here is ‘does not represent a claim on the issuer for anything other than the equivalent amount of itself’. 1 From the point of view of the individual private holder of base money, it is an asset that can be realised, that is, exchanged for other goods, services or financial instruments of equal market value, at any time. The fact that the private sector as a whole cannot dispose of base money at its discretion is not a constraint that is internalised by the individual household. Each individual household believes and acts as if it can dispose of its holdings of base money at any time, at a price in terms of goods and services given by the reciprocal of the general price level at that time: the ‘hot potato theory of money’ is not perceived by any household as a constraint on its own, individual ability to get rid of money balances. The aggregation of the intertemporal budget constraints of the individual private households also does not incorporate the irredeemability property of fiat base money. Neither the individual household’s intertemporal budget constraint nor the aggregated household sector’s intertemporal budget constraint incorporate the constraint recognised by the government that the only claim a private holder of fiat base money has on the issuer is the right to exchange X units of fiat base money for X units of fiat base money. The next step is to show how the existence of irredeemable fiat base money implies that fiat base money is, in a precise but non-standard way, net wealth to the consolidated private and public sectors, and that this bestows on monetary policy a pure fiscal effect: in a representative agent model with rational expectations, changes in the stock of nominal base money can change real private consumption demand by changing the permanent income or comprehensive (financial plus human) wealth of the household sector, after consolidation of the private and government sectors’ intertemporal budget constraints. The definition of a pure fiscal effect holds constant the sequences of current and future price levels, nominal and real interest rates, real endowments and real public spending on goods and services. This additional channel for monetary policy effectiveness is only operational, that is, only makes a difference to equilibrium prices and quantities, real and/or nominal, when the economy is in a liquidity trap, defined as an equilibrium when all current and future short 2 nominal interest rates are at their lower bounds (conventionally zero). Next I show that, with irredeemable fiat base money, liquidity trap equilibria cannot exist as rational expectations equilibria, provided the monetary policy rule satisfies some simple and intuitive properties. This is demonstrated both for a model with flexible prices and for a model with a New- Keynesian Phillips curve.2 These same restrictions on the monetary policy rule also rule out the existence of deflationary bubbles in models where money is not the only financial asset (see Buiter and Sibert (2003)).3 Finally, the paper considers briefly the practical modalities of implementing a helicopter drop of base money in an economy in which monetary policy and fiscal policy are implemented through different institutions or agencies. How can the monetary authorities, either on their own or jointly with the fiscal authorities, implement a helicopter drop of money? Central to the approach is the nature of government fiat base money as an irredeemable final means of settlement of private sector claims on the public sector. In what follows, ‘irredeemable’ is used as a shorthand for ‘final and irredeemable’. To the best of my knowledge, the particular formalisation proposed in this paper of the notion that (fiat base) money is an asset to the private sector but not a liability to the public sector, has not been proposed before. It was not part of the transmission mechanism of a helicopter drop of money proposed by Friedman (1969). Whether and in what way ‘outside’ money is net wealth to the private sector or to the consolidated private sector and public sector was the subject of much discussion in some of the great treatises on monetary economics of the 1960s and 1970s, including Patinkin (1965), Gurley and Shaw (1960) and Pesek and Saving (1967). None of these contributions proposes the approach advocated in this paper, however. Clower (1967) stressed the unique properties of the monetary medium of 2 It would also hold with an Old-Keynesian supply side, e.g. an accelerationist Phillips curve. 3 Obstfeld and Rogoff (1983, 1986, 1996) have shown this for models in which money is the only financial asset. Without irredeemable base money, deflationary bubbles cannot be rules out in the models of this paper which have both fiat money and non-monetary, interest-bearing government debt as stores of value. 3 exchange (money buys goods and goods buy money but goods do not buy goods), but the cash-in-advance constraint he proposed did not require the monetary object to be an irredeemable IOU of the state. The discussions in Hall (1983), Stockman (1983), King (1983), Fama (1983), Sargent and Wallace (1984) and Sargent (1987) of outside money, private money and the payment of interest on money ask some of the same questions as this paper, but do not propose the same answer.
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