The Government's Commitment to the Value of Money and The Limits of Monetary Policy : From the Gold Standard System to the Present

ABSTRACT

The gold standard was a currency system where the unit of money was tied to a specified amount of gold. Even when this system was in place, however, the value of money was not automatically stable. Buttressing this system was the commitment of the government (here in the wider sense that includes the central bank) to sustain the value of money at a fixed level. In this respect, it is not any different from the managed currency system that is in place today.

The appropriate value of money that it is the government's commitment to sustain can be formulated by a hypothetical balance sheet that encompasses both the government and the central bank. Through this, one can understand the importance of the people's expectations with regard to the government's future fiscal conditions. If people are expecting an enlargement of the fiscal surplus, an upward pressure on monetary value emerges. If they expect the surplus to shrink, a downward pressure on monetary value emerges.

The pressure on the value of money (i.e. the general price level) that results from the expectations of future fiscal conditions, however, can be eased or amplified by monetary policy. This type of interaction between fiscal and monetary conditions, from the time of the gold standard system to the present time of the managed currency system, can be analyzed as a continuous whole by using the framework of fiscal theory of the price level (FTPL).

The influence of monetary policy over the general price level, however, is not an all-purpose solution. This is because, as we learn from FTPL, monetary policy merely redistributes the predicted changes in the value of money between the present and the future. Thus, if the economy were to fall into a liquidity trap, where the nominal interest rate gets stuck at the zero lower bound, it becomes impossible to redistribute monetary value and postpone deflation through monetary policy.

The impasse that the Japanese economy currently finds itself in is a result of placing the entire burden for escaping deflation on a monetary policy that is facing this limitation. In order to halt deflation, it is necessary to adjust the people's expectations toward fiscal conditions.