Money and Markets: Essays in Honor of Leland B. Yeager

148 Robert L. Greenfieldwould be redeemable in and issuable against a designated conversion medium – itmight even be gold – not a predetermined physical quantity of the conversionmedium, however, but whatever physical quantity had the same market value as acomprehensively defined bundle of goods and services. 3 No scope would exist for thecomprehensively defined bundle’s relative price to change; any change in the bundle’scomposite price would be a change in the general price level and thus a sign thatthe quantity of money had become either too big or too small in relation to the public’sdemand for money holdings.Say, then, that either because the public wanted to hold less money than it didbefore or because the bank itself had over expanded, the bundle’s composite pricebegan rising toward $2. In this circumstance, I could do better with a $1 deposit (orbanknote) than just spend it on goods and services. For $1, the bank would give mea quantity of gold that I could sell for $2. Then, I could turn the $2 in for gold worth$4 and start over again. Arbitrage would thus shrink the quantity of money, matchingit to the demand for money holdings and preventing the bundle’s compositeprice from rising in the first place.In the opposite case, either because the public wanted to hold more money than itdid before or because the bank had for some reason scaled back its operations, thebundle’s composite price would start falling, say toward $0.50. Now, for whateverquantity of gold I delivered to it, the bank would give me enough new money to buytwice that quantity of gold. Arbitrage would thus expand the quantity of money, againmatching it to the demand for money holdings and this time preventing the postulatedrise of the bundle’s composite price.As a means of shrinking the money supply and thus of resisting any tendency thebundle’s composite price might show of rising above par, decreased lending wouldsupplement and probably even supercede actual money redemptions. The bankwould have just minimal gold reserves to conduct redemptions with, anyway; holdinggold reserves would give the bank no protection, because the dollar would be redeemablenot in a pre-specified quantity of gold (as under an ordinary gold standard) but,instead, in whatever quantity of gold would permit buying the comprehensivebundle. 4 Say, again, then, that the bundle’s price rose toward $2. Again, in redeeminga dollar, the bank would have to pay out twice as much gold as the dollar would actuallybuy. To avoid arbitrage losses on actual redemptions, the bank would quicklyshrink the quantity of money through decreased lending.In the opposite case, again, the bundle’s price would show signs of falling toward$0.50. The bank would see the arbitrageurs coming, gold in hand and, in exchangefor the gold, entitled to twice as many dollars as they had just paid for it. Preferringinterest bearing assets to non-interest bearing gold, the bank would pre-empt thearbitrageurs by expanding its loans and thereby, too, the quantity of money.Indirect convertibility would appropriately link the bank’s lending and thus theactual quantity of money to the public’s demand for money holdings. Under indirectconvertibility, the bank could not inflict forced saving upon an unwilling public. Norcould the bank fail, however innocently, to transform the public’s intended saving intoreal capital.