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While bitcoin could one day kill most of the roles that the Fed plays, monetary policy will probably stay intact. The reason for this, as I'll show, is that the no matter what happens to all its other functions, the Fed will probably continue to define the economy's unit of account. Let's start in the present day US. Most modern transactions involve transfers of dollar banknotes, reserves, or dollar-denominated bank deposits. A small minority of transactions are made with bitcoin. But these transactions are rarely priced in terms of bitcoin. Rather, a merchant's website will typically display prices in terms of dollars, and then compute the amount of bitcoin that a customer must fork over by referring to the current dollar-to-bitcoin exchange rate. The dollar is very much the the unit of account in the US, not bitcoin. The first of the Fed's functions to be killed off by bitcoin will inevitably be the issuance of paper banknotes. Bitcoin enjoys all the benefits of c

Santiago skyline This post continues on the topic of the separation of the medium-of-exchange function of money from the unit-of-account function. My previous post discussed how the medieval monetary order was characterized by both a medley of circulating coins and one universal £/s/d unit of account. This post introduces a modern example of medium-unit divergence: the Chilean peso and Chile's Unidad de Fomento . I'll explain how the Chilean system works and end off by asking some questions about the macroeconomic implications of this separation, specifically what happens at the zero lower bound . Like most modern currencies, the peso is issued by the nation's central bank; the Banco Central de Chil e. Local banks offer peso-denominated chequing and savings accounts. Chileans use these pesos as the nation's medium-of-exchange. They pay their bills with pesos, settle rent with it, and buy food with it. The differences between Chile's monetary system and those of ot

...once the supply of reserves is sufficient to drive the short-term riskless rate to zero..., there is no reason to expect further increases in the supply of reserves to increase aggregate demand any further... Once banks are no longer foregoing any otherwise available pecuniary return in order to hold reserves, there is no reason to believe that reserves continue to supply any liquidity services at the margin; and if they do not, the Mod igliani-Miller reasoning applies once again to open market operations that increase the supply of reserves, just as in the model of Wallace. -Michael Woodford, 2012 .   On a whim, I wrote an email to Michael Woodford last week. Woodford, a macroeconomist at Colombia University, is the authour of Interest and Prices ( pdf ), an important contribution to modern monetary policy. I'll be the first to admit that I haven't been able to work my way through his book—too few words and too many equations. But I have read two excellent papers by him.

Florentine florin Last year Scott Sumner introduced the econ blogosphere to what he likes to call the medium-of-account function of money, or MOA, defined as the sign in which an economy's sticker prices and debts are expressed. Here and here are recent posts of his on the subject. I think Scott's posts on this subject have added a lot of depth to the interblog monetary debates. However, I've never been a big fan of Scott's terminology. As I've pointed out before , what Scott calls MOA, most modern economists would call the unit-of-account function of money. Older economists like Jevons and Keynes[1] referred to the unit-of-account as the money-of-account, and modern economic historians also prefer money-of-account. Terminological differences aside, in today's post I want to focus on what I'll call from here on in the unit-of-account function of money. Scott's UOA posts often emphasize the idea of separating the unit-of-account function from the me

Don Randi Trio +1 at the Baked Potato , Poppy Records, 1971. [ link ] In this post I'll argue that: 1. When it comes to financial assets, the hot potato effect is irrelevant. 2. The hot potato effect is born the moment we begin to talk about non-financial instruments — things you can touch and consume, like gold or cows or houses or whatnot. 3. Because central bank reserves are simultaneously financial assets and a tangible consumables, they are capable of generating a hot potato effect. 4. The moment that central bank money ceases to be valued as a consumer good, its hot potato effect dies. Here's a short illustration of the hot potato effect that should serve as my definition of the term. Imagine that a gold miner finds several huge gold nuggets and quietly brings them to town to sell. The gold miner approaches the town's merchant with an offer to exchange gold for supplies, but at current prices the merchant is already happy with the size of his gold holdings. He wil

Let's not get carried away by the idea that central banks set overnight interest rates. Central banks exercise direct control over the economy by pushing down on one shiny red button, the convenience yield on reserves . By modifying the convenience yield, a central banker nudges agents to either flee from reserves or flock to them. This causes a change in the purchasing power of reserves, the mirror image of which is the general price level. So how do overnight interest rates like the fed funds rate figure into the picture? Reserves are scarce and convenient, so agents will only part with them if they are compensated with an adequate amount of "rent". The higher the marginal convenience of reserves, the more rent they require. The market in which reserves are rented out for very short periods of time, usually 24 hours, is referred to as the overnight market. By conceptualizing monetary policy this way, it immediately becomes apparent that overnight interest rates are litt