Controlling the price level

American Journal of Economics and Sociology, The, Jan, 2005 by Robert E. Hall

I

Introduction

MODERN ECONOMISTS GENERALLY THINK about the price level within the framework of the monetary institutions of the United States and other advanced economies. The central bank controls the quantity of money. The price level--in the longer run--equates the demand for money to the supply. But what about economies without central banks? What determines their price levels? Can an economy use different principles to control its price level besides the tried-and-true central bank paradigm?

In modern economies, the government is responsible for determining standards for weight, volume, distance, and value. It is helpful to think about the determination of the price level as an exercise of the government's standard-setting power. The government establishes the national unit of length by a reference unit. In the United States for many years, a metal bar stored in Washington determined the length of the yard (now the reference unit is a multiple of the wavelength of cesium). The government can set a national standard for the length of the yard without producing and selling yardsticks itself. The ultimate function of the government in this and other standards is rooted in contract law: when a contract calls for the delivery of a specified number of yards of wire, the legal standard to determine if the seller has complied with the contract is whether the length of wire is the agreed amount in terms of the government's reference standard.

The determination of the unit of value operates in precisely the same way. Article I of the U.S. Constitution grants Congress the power to determine the monetary unit in the same sentence as it grants the government the power to determine units of weight and measure. The government develops a monetary unit as an abstraction. Just as the yard is a certain number of wavelengths of cesium, the dollar, as originally defined by Congress, was 0.04838 of an ounce of gold. We teach today in the context of modern monetary institutions that the dollar is both a unit of value and a store of value. But the functions can be separated. The government need not produce dollars in order to define the dollar, any more than it has to produce yardsticks in order to define the yard.

Once the government has established a monetary unit, the rest of the economy typically adopts the unit for many different purposes. One central application is that merchants place prices on goods, stated in terms of the monetary unit. A second is that accounts are kept in the unit. And a third is that the unit denominates securities that are used to carry out transactions and to store wealth. In all modern economies, the government provides some of those securities itself. In particular, governments monopolize the supply of currency denominated in the national monetary unit. Because all modern governments issue currency denominated in their own monetary units, monetary economics has blurred the distinction between the monetary unit as an abstract unit, like the yard, and the store of value, analogous to the yardstick.

History provides one way to see the distinction. The U.S. government did not issue any currency until the Civil War. For the first 70 years of the country's history, the government defined the dollar and controlled the price level without supplying currency or any other security that had a role in transactions. There is considerable confusion in many accounts of how the government controlled the price level in that regime. The confusion arises from trying to answer the question within the framework of modern institutions, where control of the quantity of money is central to controlling the price level.

II

A General Framework

To DEFINE THE UNIT of value, the government makes a definition of the following generic form:

The unit of value is [x.sub.i], units of resource y.

Here are some examples:

Provenance         Name of      Resource           Rule for Number
                   Unit of                         of Units
                   Value                           of Resource

U.S. before the    Dollar       Gold               0.04838oz.
Civil War
Modern U.S.        Dollar       Paper dollar:      1
                                bearer security
                                issued by the
                                Federal Reserve
Proposal by        Dollar       Gold               Amount needed
Irving Fisher                                      to buy the
-1913                                              cost-of-living
                                                   bundle
Modern Chile       Unidad de    Paper peso:        Number required
                   Fomento      bearer security    to buy the
                                issued by Bank     cost-of-living
                                of Chile           bundle
Argentina,         Peso, FEC    U.S. dollar        1
Burma

Let [r.sub.t] be the value of one unit of the resource relative to the cost-of-living bundle. Then the purchasing power of the unit of value is