Central bank power: a matter of coordination rather than money supply

Abstract: After an introductory chapter, the hypothesis is made in chapter two: that central bank power to control the rate of inflation rests on the bank’s ability to achieve a role as a focal point for inflation. Inflation is a measure of changes in the general price level, the price level is an index of individual prices, and to predict future price levels is thus to predict future prices on individual items. At every moment, all prices are fixed and we are thus able to state unambiguously what the price level is. As we consider an increasingly distant future, increasingly many prices become flexible and our predictions about the price level become increasingly dependent on our forecast of those future prices. To forecast those prices is to imagine how the people who set the prices think. They too, want a prediction of the future price level that is as correct as possible, to use as basis for future prices. That is, they too need to forecast how other price setters think. Now, we clearly see the picture of a coordination game; I need to predict how you predict that I will act, and so on. Chapter three concerns three issues: the growing gap between descriptions about actual central banking and the ultimate reasons why central banking is at all possible; the problems that traditional monetary theory is facing in its attempt to derive a determinate price level in a cashless society; and the absence of a discussion about central banks’ apparent role of coordination - evident, for example, in the success for ‘open mouth operations’. From chapter four and onwards, the thesis is concerned with the establishment of a theory around the hypothesis made in chapter two. To accomplish this, we need to understand the role of money and nominal prices from the perspective of an individual agent. Thus, in chapter four, we try to understand the particular decision situation that price setters face, and how money can help. In chapter five, we analyze the use of payment techniques and units of accounts as techniques to reduce the need to engage in sequential transactions during attempts to exploit the advantages of a division of labor. We look at different kinds of payment techniques that people has used throughout history and pay special attention to the interdependence between the use of payment techniques and units of account. In chapter six, we make use of what we have learned about the function of money, and in particular units of accounts, to build a theory of price level determination. We explicitly account for the simple fact that a price level is an index of individual prices, which are the result of decisions by individuals, who in turn base their decisions on their best judgement of future price levels. In chapter seven, eventually, we consider the concept of focal points more explicitly and try to answer the question whether the central bank is a suitable focal point for inflation expectations.