As part of the midterm exam in my “Monetary and Financial Theory” class, I wrote a set of multiple-choice questions based on my Powerpoint file “Breaking Through the Zero Lower Bound.” It occurred to me that those of you who have been following the electronic money theme on my blog might want to try your hand at the quiz generated by extracting those questions from the exam. I think your understanding will be deepened by doing this quiz and then looking at the answers. (Do try it in that order!)
A. Suppose that a time-varying paper currency deposit fee is used to keep the paper currency interest rate below the target rate in Japan. Which of the following things could create a zero lower bound even with paper currency out of the way?
- Foreign Currency
- An interest rate of zero on the balances of money in (government-run) postal savings accounts.
- Being able to pay off debts with paper currency at its face value.
B. Filling in a bit what he meant, when Ben Bernanke came to the University of Michigan, what did he say about the unconventional monetary policies of quantitative easing and forward guidance?
- Forward guidance has failed; that is why the Fed has abandoned forward guidance and turned to quantitative easing as its primary tool of monetary policy.
- Forward guidance is an absolute commitment. The Fed uses quantitative easing primarily to convince the markets of that.
- Because the Fed is worried about the side effects of unconventional policies such as quantitative easing, the Fed has stimulated the economy less than it would have if it could have just lowered interest rates.
- Quantitative easing and forward guidance can work when the inflation rate is 1% or above, but when inflation is below zero as in Japan, they won’t work. So the Fed is deeply worried about Japan.
- None of the above.
C. Which of the following does Miles point to as an advantage of monetary policy over fiscal policy for economic stabilization (that is, for keeping the economy at the natural level of output)?
I. Monetary policy does not raise the budget deficit
II. Monetary policy can push the costs of economic stabilization onto other countries
III. There is a strong tradition of technocratic monetary policy, but no institutional framework for technocratic fiscal policy (other than automatic stabilizers, which aren’t enough).
- I and II
- I and III
D. From earlier to later, which of the following is a correct order of events for the US?
- The Great Moderation, the Great Recession, the Great Inflation (ended by the Volcker disinflation)
- The Great Recession, the Great Moderation, the Great Inflation (ended by the Volcker disinflation)
- The Great Moderation, the Great Inflation (ended by the Volcker disinflation), the Great Recession
- The Great Inflation (ended by the Volcker disinflation), the Great Depression, The Great Recession
- The Great Inflation (ended by the Volcker disinflation), the Great Moderation, the Great Recession
E. Suppose the electronic dollar is used by everyone (including all units of the government) as the unit of account (and unit of price setting) and the inflation rate relative to that unit of account is zero. If an exchange rate between paper currency and electronic money makes the “inflation rate” relative to the paper dollar positive, which of the following would be costs of that “inflation rate” relative to the paper dollar?
- Messing up price signals
- Menu costs
- Messing up the tax code in unintended ways
- Unpredictability of inflation messing up contracts
- None of the above.
F. Eliminating the zero lower bound with a paper currency interest rate that can go negative is likely to lead governments (in particular central banks) to lower inflation in both rich, basically well-run countries, and poor, not-so-well-run countries, for two different reasons:
- There would no longer be any need to push down price cost markups with inflation in order to make the economy more efficient, and there would no longer be any need for inflation to make it easier to lower real wages for some workers.
- There would no longer be any need to push down price cost markups with inflation in order to make the economy more efficient, and it would be possible to earn substantial seignorage without any inflation relative to the unit of account.
- There would no longer be any need to steer away from the zero lower bound with inflation, and there would no longer be any need for inflation to make it easier to lower real wages for some workers.
- There would no longer be any need to steer away from the zero lower bound with inflation, and there would no longer be any need to push down price cost markups with inflation in order to make the economy more efficient.
- There would no longer be any need to steer away from the zero lower bound with inflation, and it would be possible to earn substantial seignorage without any inflation relative to the unit of account.
G. “On the Need for Large Movements in Interest Rates to Stabilize the Economy with Monetary Policy." Which of the following could increase aggregate demand as a result of the Fed lowering interest rates to deep negative rates?
I. Purchases of durable goods for storage
II. Purchases of foreign assets
III. Higher asset prices
- I and II
- I and III
- II and III
- I, II and III
H. Treating the electronic dollar as the unit of account, what is the paper currency interest rate for 2019 if at the beginning of the year a paper dollar is worth $0.96 electronic dollars, while at the end of the year, a paper dollar is worth $0.98 electronic dollars? Closest to:
J. Treating the electronic dollar as the unit of account, what is the paper currency interest rate for 2019 if at the beginning of the year a paper dollar is worth $0.90 electronic dollars, while at the end of the year, a paper dollar is worth $0.90 electronic dollars? Closest to:
K. Which of the following is false?
- It is possible to get a 1.5% rebate on all purchases with a Capital One Quicksilver Visa card and a 2% rebate on all purchases with a Fidelity Investment Rewards American Express card
- The fees retailers pay when people use American Express cards are generally higher than the fees retailers pay when people use Visa cards.
- If the paper currency deposit fee that banks paid at the cash window of the Fed was 1%, retailers would still be better off getting paid in cash than being paid by credit card even though paper currency would be below par.
- With rare exceptions, retailers always refuse to accept credit cards when they would net less money (after fees) from a credit card purchase than from a cash purchase.
- All of the above are true
L. Think of a situation like that in late 2008. Inflation is fairly sticky. (Note that inflation being sticky is a stronger statement than prices being sticky.) Imagine that there are only 3 monetary zones in the world: A, B and C. To begin with, A has inflation of -1%, B has inflation of 0%, and C has inflation of +2%. After a serious financial crisis that makes all three countries want to do a major monetary expansion, Countries B and C keep their paper currency at par, but Country A uses a time-varying paper currency deposit fee to keep the paper currency interest rate below its target rate. What would be a good prediction for what would happen to net exports (NX) in these countries?
- NX is likely to decrease for A, but increase for C.
- NX is likely to increase for B, but decrease for C.
- NX is likely to increase for A, but decrease for B.
- NX is likely to decrease for A, but increase for B.
- NX is likely to increase for all three because all three have a monetary expansion to deal with the effects of the financial crisis.
The single source that covers the most ground, though a bit cryptically, is my "Breaking Through the Zero Lower Bound” Powerpoint file. Someday, I hope to get a video made of one of these talks.
Guaranteeing an interest rate of zero over all horizons and in unlimited quantities in government-run banks is very similar to guaranteeing an interest rate of zero over all horizons and in unlimited quantities on government issued pieces of paper. It would also make people unwilling to lend at a rate significantly below zero.
Gold, Bitcoin and foreign currencies all have prices that fluctuate relative to the electronic dollar unit of account. Other things equal, they are all likely to go up quite a bit in price relative to the e-yen unit of account when interest rates are cut and then to have expected capital losses as those prices gradually come back to earth. That expected capital loss brings their expected rate of return of these assets down. In any case, there is no riskless arbitrage to be had.
Also, purchasing foreign currencies tends to put yen (electronic or paper) in the hands of people who don’t want the yen, so that the exchange rate adjusts until those dollars are absorbed by an increase in net exports from Japan. (See International Finance: A Primer.)
If people increase gold production, that actually looks like an increase in consumption or investment and raises aggregate demand. It is not the kind of increase in aggregate demand I would wish, but it is an increase in aggregate demand. (If the gold is bought from abroad, that tends to cause a depreciation which stimulates production of other things domestically to export or to replace imports that won’t be imported because gold is being imported.)
As far as debt contracts go, the value of the old debt contracts may be changed by the option to pay them off in below-par paper currency, but since the old debt contracts are in fixed supply, they just adjust in price. Paper dollars that can be used to pay off old debts don’t go up in value as a result–their value is pegged by the central bank. Instead, the old debt goes down in value, making the debtor less in debt.
D. 5. The Great Recession was in the 1930’s. The Great Inflation was in the 1970s and the Volcker disinflation that ended it was in the early 80’s. The Great Moderation was from the mid 1980’s until the Financial Crisis in late 2008. The Great Recession began in earnest with that Financial Crisis. Its aftereffects have dragged on until now.
F. 5. For rich, basically well-run countries, the primary reason for inflation is the desire of central banks to steer away from the zero lower bound. For countries with weak tax systems, earning seignorage has sometimes been an important motivation for inflation. Both the zero lower bound and seignorage have to do with "inflation” relative to paper currency rather than inflation relative to the unit of account when the unit of account is electronic. So once a country goes off the paper standard, there is much less reason or temptation for inflation. (There is still the temptation to overstimulate the economy to go above the natural level of output, which can cause inflation.)
G. 5. All three. Durables purchases count as investment or consumption. Higher asset prices should have a wealth effect on consumption and a Q-theory-type effect on investment, as I discuss in “Monetary Policy and Financial Stability." Foreign asset purchases lead to higher net exports according to the logic I explain in ”International Finance: A Primer“ and my international finance Powerpoint file that I use in teaching.
H. 4. Since the electronic dollar would be the unit of account (and is the numeraire for the analysis), the paper currency interest rate is equal to the capital gain rate on paper currency. Since the value of a paper dollar is increasing at (very close to) 2% in a year, the paper currency interest rate is equal to that capital gain of 2%. (An additional year at that rate would bring paper currency back to par.)
J. 3. Even though paper currency is away from par, if the effective exchange rate with unit-of-account electronic money is constant, there is no capital gain or loss, and the paper currency interest rate is 0.
K. 4. This question is relevant to my argument that retailers are likely to accept paper currency at par up to about a 4% paper currency deposit fee. In ”A Minimalist Implementation of Electronic Money“ I make this argument as follows:
At the grocery store or other shops, it might be a while before merchants discouraged customers from using paper currency. As it is now, merchants accept credit cards despite the fact that must pay to accept credit-card payment. For example, in the UK, Barclay Card currently advertises that it charges businesses 1.5% on credit card transactions.
So currently, getting paid by credit card is something like 1.5% less attractive than getting paid in paper currency. If, in order to avoid alienating customers, businesses were willing to continue accepting paper currency at par even if it was 1.5% less attractive to them than credit card payments, that might allow a 3% swing before things changed for retail customers: retail customers might be able to pay with paper currency at par even if banks had to pay a 3% penalty to the central bank for paper currency deposits.
Since then, I have read things that suggest that typical charges for credit cards are higher than this. In particular, it seems unlikely that credit card companies would give me an across-the-board rebate bigger than the fees they receive. You can see at these links that the Fidelity Investment Rewards American Express card gives a 2% rebate for everything and the Quicksilver Visa gives a 1.5% rebate for everything. I have both of these in my wallet (the Visa card for places that don’t accept American Express).
Besides providing evidence about how much less retailers are now willing to accept from credit card payments than cash payments, the other reason these rebates are interesting is that they will encourage the use of electronic money, as more and more people get bigger and bigger discounts by paying with their credit cards. I now think that at least in the near term, increases in competition will make the effective fees that credit card companies charge narrow more by bigger and bigger rebates than by a reduction in the direct fee paid by retailers.
The fact that retailers now put up with getting so much less from credit card payments is an important fact that deserves more economic modeling.
L. 3. The real interest rate is the nominal interest rate minus inflation. Since Country A can push its nominal interest rate as low as needed, it can also push its real interest rate very low. Country B can only get its real interest rate down to 0. Country C can only get its real interest rate down to -2% (a zero nominal rate minus inflation of 2%). I take the statement that they all want a vigorous monetary expansion to mean that Country A pushes its real interest rate significantly below -2%. So there will be substantial extra capital outflow from Country A, fleeing the low real interest rates. Extra capital outflow puts domestic currency in the hands of people outside the currency zone for whom it is a hot potato. Exchange rate adjustments recycle that currency to its home area through encouraging more net exports. The opposite happens for country B: because of its high real interest rate of 0 (compared to -2% for country C and below that for country A), foreign funds flow into country B. To do that, investors in Country B must buy up Country B currency that is available abroad, which prevents other people outside Country B from using that currency to buy exports from Country B. So Country B’s exports fall. Alternatively, Country B’s imports could rise to put more of Country B’s currency in the hands of foreigners. Country B’s residents are unlikely to put much currency in the hands of foreigners by buying foreign assets because they can get a zero real interest rate domestically, but face negative real interest rates abroad.