Frances Coppola has written an entertaining critique of my Smaug post, which is kind of her. We’ve tweeted a bit. Go read her post.
As is often the case when reasonable people wildly disagree, we are almost certainly addressing different propositions. My basic point was that the MxV = PxY relation doesn’t much specify transmission mechanisms, and “reduced form” analysis suggests you can be confident the relation holds over a reasonable timescale without diving into all the mechanisms in detail. History, particularly under the gold standard, gives considerable backing to this.
It was not to say that transmission mechanisms never matter, which would be rude to people like Frances who specialise in that sort of thing. Nor was it to say – as her post sort of implies – that the wealth of the people of the local economy is assured no matter what happens. It is the dwarf gang who are made directly wealthier. The prosperity of “Laketown” relies on the assumption that the rising price level raises activity, and that there are sufficient nominal rigidities, debt overhang etc, to see much of that activity being real not just inflation. Previous posts by other people determined its state of depression.
Obviously the risk of writing fantasy stories is that all sorts of fantasy assumptions can be thrown back. If the gold is simply re-hoarded to the same convincing degree at having a fire breathing lizard sit on it, then the effect may be less. But if I had clarified that in this fable gold only has function as currency (except if you are a dragon), and you throw some reasonable assumptions about expectations in there (eventually the gold gets out, and people anticipate this), the conclusion that the price level would respond pretty strongly to the release of so much hard currency is pretty well founded.
Massive discoveries of X make the price of X fall. If X is the medium of account, this by definition means the price everything denominated in X rising.
The final point, as an impressed observer of market monetarists, is that this sort of story demonstrates the point I see Sumner making about monetary policy having long and variable leads. For the best recent example, the pre-election response of markets to Abe. My dumb and clearly confusing story was to make this point. A totally credible promise to inflate the currency massively ought to have a real reaction now, if believed. Money demand weakens when you know its quantity will soon explode/price fall./NGDP will rise. So merchants buy assets and goods and so on.
I think MM’s need this sort of story to explain things. I think it works quite well at times. I believe that happened under FDR in 1933. I sort of believed “Dragon slain/huge mountain of gold descends on village” was a similarly credible story. Maybe I was wrong.
This was meant to be playful and entertaining, and may now be tedious; I promise to try not to blog on it for a while!
Freethinking Economist 
hehe. No, it’s still entertaining!
Actually I think MV=PY does work reasonably well under a strict gold standard – much better than it does in a fiat currency endogenous money system with fractional reserve banking. I suspect this is why Scott Sumner determinedly ignores banks and persists in talking about the monetary base as if it is the only form of money in circulation. Banks and endogenous money are a serious complication. Trouble is, ignoring them gives rise to fallacies of composition. (I did say this to him once. He was not amused.)
In our discussion, of course, banks were irrelevant. My point was that, even ignoring banks, the economic response – including price movements and expectations – would depend on the distribution.
I thought I concluded that the wealth of the people of Laketown was NOT assured?
I have been confusing. I meant that I never intended in MY post to imply the laketown people were necessarily going to end up minted.
It occurred to me later that a more elegant way of framing the debate is this: does it make a difference if we dig up a a trillion dollars worth of Gold or of diamonds? When only the former are medium of account. I think it does…
“Medium of account” is not a given. It can be changed, and often is. Sometimes we have more than one at once – bimetallism, for example. If the consequence of digging up a trillion dollars worth of diamonds was that people started to transact in diamonds instead of gold, it would be as inflationary as digging up a trillion dollars of gold. Or not, of course, depending on how it was distributed.
Indeed, how do you know that Laketown is even using gold as the medium of exchange at all? Using gold as the medium of exchange when you have a dragon on your doorstep doesn’t strike me as very bright. You’d think they would have adopted something less likely to attract Smaug’s interest, if only to save their lives. Diamonds wouldn’t do it, though – Smaug liked those too. I think he was a Dwarf under a spell, really.
When was the last time any major economy changed its medium of account? The reason the Populists fought against the cross of Gold was that it would be a huge deal. Germany post war is the last case I can think of.
A small economy needing to trade widely may have little choice. I won’t trade guesses about what Laketown would do. But if it dug up a huge amount of X and used it as currency, of course it would produce a huge amount of inflation in terms of X. It would be like the end of the Restaurant at the End of the Universe when they crash land on ancient Earth and decide to use leaves as currency.
Dangerous move from fantasy to scifi there…