Thursday, November 29, 2012
Discussions of the medium-of-account could be more well-done
Nick Rowe, Scott Sumner, and most recently, David Glasner, all say that the US's current medium of account is the dollar. I disagree. I think that the current medium of account is CPI units. Here's why.
First, there's been some sloppiness with definitions in the links above, so let's define the term. The medium of account is whatever defines the unit of account. I think this a pretty standard definition. That's Bill Woolsey's definition here. David echoes this definition in his comment here.
Take an old-style central bank that holds 100% gold reserves in its vault. It chooses the word "dollar" to stand as the unit of account. The bank then goes on to define the dollar as equal to x grains of gold. Thus the medium of account is gold. Our central bank issues paper notes which are to be used as the medium of exchange. Shopkeepers post prices in terms of the unit of account, the dollar, and accept notes as payment. Some shopkeepers might even choose to post prices in grains of gold rather than the dollar unit of account. If they do, this won't affect the fact that gold remains the medium of account.
Inspired by the Bank of Canada, our 100% gold bank chooses to sell all its gold for bonds. Next it chooses to redefine the value of the dollar as an idealized basket of consumer goods that declines in size by 3% a year. It threatens to do open market operations in a manner that ensures that its definition sticks.
What has changed? Shopkeepers continue posting prices in the unit of account, the dollar. Notes issued by the central bank are still the medium of exchange. But the definition of the dollar, the medium of account, has changed from a quantity of gold to a gradually shrinking quantity of consumer goods.
Some shopkeepers might even post prices in terms of this imaginary basket of goods. When shoppers arrive at the till to pay, they obviously can't hand over CPI baskets. Rather, the shopkeeper will download the central bank's most recent CPI-to-dollar ratio and quote the customer their final price in terms of notes, the medium of exchange.
To sum up, in moving from a fully-reserved gold bank to a modern CPI targeter, all that's happened is that our central bank has changed the medium of account from gold to CPI. Nick has to understand where I'm coming from since I'm just using the same technique he used in this post.