Aaron Careaga

Research Analyst,

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The Marginal Utility of Central Banking

Economists often discuss the marginal utility of goods and services. For instance, your second donut is less satisfying than the first and by the fifth donut the value of one additional donut is slim. With each passing donut the marginal value of another donut is small. The question we now pose is does monetary policy and by extension all central banking have a marginal utility curve, and if so what is the optimal amount?

On one extreme you get the popular mantra “Abolish the Fed”. Free market advocates often side here explaining that central bankers have a terrible track record throughout history and most often make the problem worse. The Nobel Prize winner Milton Freidman was an advocate for this style of monetary policy well before it was in fashion. He went on record saying we should do away with the Federal Reserve and instead tie interest rates to inflation. One of the primary strengths of this strategy is that excesses are quickly cleared from the system often through deflation and liquidation. Famed investor Jim Rogers explains simply that recessions are like small forest fires that clean out the system of excess. If the fire is prevented the kindling accumulates until a larger crisis occurs.

The major downside of a Fed-free model is that the economy and asset prices become extremely volatile. In fact, the process that often clears out excesses is an increase in either inflation, deflation, or both. These periodic shocks make corporate planning very difficult, which in turn would create a higher reluctance to hiring, leading to higher unemployment. Moreover, a more volatile economy would likely lead to corporations holding more cash (like we have now), which leads to underinvestment and sub-optimal efficiencies... (continued after jump)


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    Aug 6 2012: "Milton Freidman was an advocate for this style of monetary policy well before it was in fashion"

    and ludwig von mises advocated this policy half century before friedman, also explaining in detail why is it bad, and what is the source of volatility. sad that hundred years later most people still never heard of him.
  • Aug 7 2012: "Marginal Utility" -- Are you talking about a curve where one side measures the power of the Fed?

    Is this discussion about how much power the Fed should have, and what kind?
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      Aug 7 2012: I understood the question as asking whether a particular kind of common economic model could be applied to the question of "how much" central banking might be optimal. Your question in which you ask "how much" and "what kind" points, I think, to why this sort of model is not well built to examine the question. Utility curves have on their x-axis amounts of one kind of a thing or cases in which variation in kind can safely be ignored.
      • Aug 7 2012: My question resulted from the linked article, which suggested limitations on the power of central banks. I find "marginal utility" confusing and thought that perhaps it was intended to be allegorical.
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    Aug 7 2012: I too wonder how the comparison can be made between central banking and marginal utility?

    From a pragmatic perspective the results of the FED have been dubious their shrinking the money supply at the exact wrong time, the beginning of the great depression and Greenspan increasing it at the exact wrong time.

    The Fed was created by a very dubious president who also gave us income tax and took away a good chunk of the republic through the senatorial election process and Edward Bernays. Me thinks that a group of this many insidious effects I have to say that the FED fits in with this group of accomplishments that should be abolished.

    Let me see could we do worse than the FED yes it could all be controlled by Congress, or we could do what Mises and Friedman are saying. Since the FED is killing us I say lets go with the guys who know what they are talking about and do not have an agenda.
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    Aug 6 2012: Just for clarification, as monetary policy, or any policy, isn't a big chunk of uniform products, I am having trouble with the idea of marginality here. If we were talking about movies, we might ask after seeing fifty movies in the year, what is the marginal utility of one more. In your question, what does the first increment look like? the hundredth? It seems very unlike the distinction between the first and hundredth movie.
    I am not talking about comparing the marginal utility of the first or hundredth unit, which we can for now assume to be different without problem. My problem is with understanding the denominator rather than the numerator.