| Mar 08, 2013
Helicopters are useful aircraft for commuters, warfare and search and rescue missions. A lesser known fact is that helicopters play an important role in monetary theory as the means for generating inflation. Like many economic paradigms, at first this seems absurd...take another look and the absurdity devolves to pure fantasy.
In a previous blog, I touched on the point that generating inflation in equilibrium models of economic activity is very, very difficult. The best that we can do at present is to use a 'cash-in-advance' constraint which requires that (a) consumption today is paid for out of fiat money (paper) that was saved yesterday and (b) agents are forced to spend all cash on hand in the current period. These are difficult assumptions to justify in the modern economies since, after all, how many of us carry more than 100 bucks in our wallets and empty it out at the supermarket every night before sleeping? Credit cards substitute for cash quite easily so the constraints in (a) and (b) are quite ridiculous.
So what about inflation? Here is where the helicopter comes in. In order to generate inflation, the monetary authorities are assumed to take to the skies and drop money from helicopters. This is skillfully, evenly distributed and collected by economic actors who fill their wallets with the manna from heaven. Next, on the way home, they spend all their new cash on a fixed supply of goods therefore bidding up prices!
And that, your honour, is how inflation is created. The defence rests...
Hardly convincing, is it? Yet this is the best the top thinkers can do to have any chance of justifying an active monetary policy for a Central Bank. If the conditions (a) and (b) don't hold then, no matter how well they pilot their helicopters, the Fed, the BoJ, the ECB or any other inflation intentioned monetary authority is helpless in achieving their goals.
This, I believe, is the problem facing the monetary authorities in the modern era. The trillions of dollars of liquidity being provided to the money markets is simply not being spent on consumption goods. Instead, it is being held in any number of alternative assets as reserves, never finding its way into the wallets or cash registers because, quite simply, it is not needed for transactions purposes.
This is why the bond markets are holding firm and will continue to offer value to investors.