Eli Dourado

Bitcoin and endogenous nominal rigidities

One supposed problem with Bitcoin taking over the world, critics say, is that lack of a central bank precludes countercyclical monetary policy. When aggregate demand grows more slowly than expected, you want the central bank to increase the money supply in order to induce people to spend. The argument is fair enough as far as it goes, but it is undercut somewhat by the growing literature on endogenous nominal rigidities.

At the core of New Keynesian models of monetary non-neutrality is price stickiness: how quickly do firms and workers update prices and wage demands in light of new information about nominal shocks? Most models follow Calvo in assigning producers an exogenous frequency of price changes.

But the endogenous nominal rigidities literature asks an important question: what if instead of changing prices according to an assigned schedule, firms can choose how often they update their prices? Furthermore, what if they make that choice in response to monetary policy? When monetary policy focuses on price stability, firms will choose to update their prices less frequently, conserving on the resource costs of changing prices (menu costs, as Mankiw calls them). When monetary policy focuses on the output gap (or, by extension, when monetary policy is erratic, which is important for analysis of Bitcoin), they will choose more price flexibility in spite of the higher menu costs. More price flexibility means both that nominal shocks have less bite and that monetary policy is less effective.

What does this mean for Bitcoin? If we simply model the Bitcoin money supply as set by an incompetent central banker, it means that in a world in which Bitcoin rules the currency roost, firms and workers will choose nearly complete wage and price flexibility and nominal shocks won’t matter as much.

That’s not such a bad world. The big downside is the menu costs—people will need to adopt systems that ensure complete pricing flexibility—but with improvements in information technology, menu costs are lower than ever before. For long-term contracts, people would index to a basket of goods, or as I’ve suggested, to GDP.

This world is also not unprecedented: for most of human history, we have not had central banks, and therefore humans have taken steps to decrease price rigidity. Consider Polonius’s advice, “neither a borrower or a lender be,” or the prohibitions on lending in the Abrahamic religions. These make sense when there is an erratic (or no) central banker. If cryptocurrencies displace fiat currencies, then we’ll say, “always index your debt contracts,” which is approximately an update of Polonius.

The bottom line is that recent advances in monetary economics somewhat undercut the macro-stability argument against Bitcoin. I would like to see this basic point acknowledged more widely, especially by people who style themselves the defenders of conventional economics against Bitcoin crackpottery.