By Dan Kervick
Scott Sumner attempts to explain the so-called “hot potato effect” which has played such an important role in the theories and policy recommendations of the Market Monetarists. But the explanation contains two weaknesses. The first weakness is a muddle of inapt metaphors which seem to run together the concepts of diminishing marginal value and negative marginal value. The second weakness is more serious: Sumner and company refuse to take cognizance of the important institutional differences between the banking sector – an unusual and limited sector of the economy where only money and money-denominated financial assets are traded – and all of the other sectors of the economy where money is exchanged for everything else that can be bought and sold. As a result they seem to be incapable of distinguishing between realistic changes in the central bank’s patterns of doing business with the financial sector and imaginary changes in the central bank’s pattern of doing business with the rest of the world. And they mistakenly conclude that central bank statements about the former should have a major impact on beliefs about the latter.