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Monetary equilibrium and price stickiness reconsidered: A reply to Bagus and Howden


Bagus and Howden (Review of Austrian Economics 24(4): 383–402, 2011) argue that price stickiness is a poor justification for advocating a flexible money supply through the issuing of fiduciary media under central or free banking. They view the contraction in output following an exogenous increase in money demand as an optimal response, worry about redistribution effects from the issuance of fiduciary media, and claim a changing money supply complicates economic calculation. Accepting their view that the contraction in output is an optimal response to an exogenous change in money demand, we still find a potentially beneficial role for monetary policy (under central banking) or fractional reserve note issue (under free banking). We show that even if all prices were perfectly flexible, changes in the money supply to offset changes in money demand might still be desirable. We point out several errors and mischaracterizations in their article, justify our decision to disregard wealth transfers, and discuss how a flexible money supply might facilitate economic calculation.

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  1. The authors define “money proper” as high-powered money. Given their opposition to fiduciary media, we suppose they have 100%-backed commodity monies in mind. They claim that, in a free market, the supply of money proper would be governed by the “general profit rate prevailing in the economy” (Bagus and Howden 2011, p. 398). Unfortunately, they give no further indication as to how they believe the supply of money would expand and contract in response to various shocks. In our view, White (1999, pp. 28–37) offers an excellent explanation of the mechanism governing the supply of commodity monies.

  2. Although it is not a necessary implication of viewing the observed fluctuation in output as the optimal response path to an exogenous shock, the authors make the stronger claim that there is no better alternative to the sluggish correction of monetary disequilibrium (Bagus and Howden 2011, p. 399). In other words, the sluggish adjustment of prices and output is not only narrowly optimal, but also optimal in a broader sense that takes into account alternative sets of institutions.

  3. The authors repeat this mischaracterization elsewhere in the text (pp. 395, 396).

  4. To put it somewhat differently, there are two ways to reach a long run equilibrium in response to an increase in money demand: allow prices to adjust downward (as Bagus and Howden propose) or maintain prices at their pre-shock level through monetary expansion (as monetary equilibrium theorists propose).

  5. Contrary to their claim (p. 386, footnote 5), “stating that one price level is more optimal [sic] than another” is not equivalent to deeming “stable output as preferable to stable prices.” In the absence of productivity gains, monetary equilibrium theorist typically prefer stable output (at the natural level) and a stable price level (so as not to incur unnecessary adjustment costs), whereas Bagus and Howden would seem to prefer neither stable output (accepting short run deviations) nor a stable price level (allowing the price level to change in response to monetary shocks).

  6. Selgin (1997) makes a similar argument in the context of productivity growth.

  7. We say “potentially greater” since sticky prices might be indicative of significant adjustment costs (i.e., prices are sticky because it is more costly to change prices than under the flexible regime), but also might arise from some other source.

  8. If the money supply adjusted with a lag, flexible prices would adjust in the short run and then readjust back to reflect the changing money supply. Sticky prices, by definition, are not changed in this regime.


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Correspondence to Alexander W. Salter.

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The authors wish to thank the Mercatus Center at George Mason University for its generous support.

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Luther, W.J., Salter, A.W. Monetary equilibrium and price stickiness reconsidered: A reply to Bagus and Howden. Rev Austrian Econ 25, 263–269 (2012).

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  • Austrian economics
  • Central banking
  • Commodity standard
  • Fiat money
  • Free banking
  • Macroeconomics
  • Money
  • Monetary equilibrium theory
  • Monetary standard
  • Sticky information
  • Sticky prices

JEL classifications

  • B53
  • E31
  • E32
  • E40
  • E42
  • E43
  • E44
  • E50
  • E51
  • E52