A penny for Macpherson’s thoughts on the nominal anchor

In this guest post, a former Bank of England economist argues with a former HMT official about the penny.

That’s the former Treasury Permanent Secretary, who apparently disapproves of HMT plans to to abolish the 1p and 2p coins in the UK.

He seems to believe that retaining the smallest denomination of the currency prevents a country like the UK from becoming a “banana republic” as far as monetary policy is concerned. In other words, the penny is a nominal anchor for expectations about prices and the value of money.

It’s uncontroversial that “banana republic” monetary policy leads to the abandonment of small currency denominations. But could causality run from denomination mix to inflation stability?

Fluctuations in expected inflation can plausibly become self-fulfilling. Higher expected inflation lowers the real interest rate. Other things being equal, this will boost consumption and investment, and thus inflation itself. The central bank can choke off this transmission by raising its short-term nominal interest rate, which will ensure that other things aren’t equal. This is the central bank’s job under its current mandate. But perhaps it won’t raise rates for some unspecified reason.

The question is whether abandoning the 1p and 2p coins would actually affect inflation expectations in the first place? Many countries have done it without hazard. The signal sent by discarding the 1p and 2p is more likely to be that we are copying the well-trodden route of other well-regulated low-inflation countries concerned about the sound practical operation of physical currency — not that we are set to become hyperinflationary.

What if the central bank targeted a fixed ratio of currency denominations, combined with insisting that denominations issued by the Mint and the BoE are those that are demanded by users?

The make-up of denominations we want in our wallets depends on the price level. If the price level doubled, buyers would tilt towards higher denominations and sellers would move toward coarser gradations in their pricing strategies. Getting the central bank to preserve as far as possible the existing mix of denominations in circulation would be equivalent to targeting the existing price level. With a bit of empirical money demand work you could work out the implied change in the denomination spread consistent with the existing positive inflation targets of modern economies.

If you think that is overly complicated and crackpot, it is. But sadly it is not even as simple as stated thus far.

First, the Government would have to freeze the current design of notes and coins, or at least indulge in only neutral modifications. Any change that affected the preference by the private sector for any particular coin or note would screw up the denomination target.

For example, if you made the 1p prettier or harder to counterfeit, people would want more of them, and the central bank’s knee-jerk response would be to increase money creation to raise the price level and lower the demand for 1p.

A second problem is the black economy. Changes in the level of illicit activity will affect the relative demand for high-denomination notes. Changes in the confidence in digital currency — often used for illegal transactions — will also affect demand for large-value notes. A really successful crackdown on crime would force the central bank to push people back towards higher denominations with inflation. The spread of digital currency could reduce criminal demand for high-denomination paper, so that would also cause an inadvertent inflation by a central bank blindly following the target.

This is not a very serious proposition, but a thought experiment to demonstrate how bonkers Macpherson’s argument is. The idea does have one thing going for it, though: the denomination anchor doesn’t require the central bank to record anything except the notes and coins that went out of the door. Any idiot could run this system, as long as we were okay ignoring the real economy or credit…

Some interesting/perplexing things follow from that. But that might be for another post.

Tony Yates was Professor of Economics at the University of Birmingham in the UK, teaching MSc international macro. Before that he was a Reader in Economics at Bristol University, and before that he worked for 20 years in the Bank of England on monetary policy issues.

Related links:
Why getting rid of the penny piece is a good move — The New Statesman

Copyright The Financial Times Limited 2018. All rights reserved. You may share using our article tools. Please don’t cut articles from FT.com and redistribute by email or post to the web.

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A penny for Macpherson’s thoughts on the nominal anchor

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