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The Price Theory of Money, Prospero's Liquidity Trap, and Sudden Stop: Back to Basics and Back

  • Guillermo A. Calvo

Fiat money contains the seeds of its own destruction. It has no intrinsic value and, yet, it can be exchanged for valuable consumption and production goods. As Hahn (1965) shows, this situation puts fiat money's market value or liquidity premium at the brink of collapse. In this paper I will argue that (1) sticky prices, especially when staggered, provide output backing to fiat money, helping to sustain fiat money's liquidity premium and, thus, lowering the risk of a liquidity meltdown. I call this view the Price Theory of Money; (2) fixed-income assets linked to fiat money, especially if they are perceived to have low counter-party risk (like US Treasury bills, AAA bonds or Asset-Backed Securities) can take advantage of point (1) to become quasi-moneys; (3) this gives incentives to the private sector to create those assets; (4) however, unless protected by a Lender of Last Resort, the new assets' liquidity premium can quickly and massively evaporate in what I call (with a wink to the Bard) a Prospero's Liquidity Trap; (5) the latter lowers the market value of loan collateral and clogs the credit channel, bringing about a credit event or Sudden Stop, with severe output and employment consequences.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 18285.

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Date of creation: Aug 2012
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Handle: RePEc:nbr:nberwo:18285
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  1. Guillermo A. Calvo & Fabrizio Coricelli & Pablo Ottonello, 2012. "Labor Market, Financial Crises and Inflation: Jobless and Wageless Recoveries," NBER Working Papers 18480, National Bureau of Economic Research, Inc.
  2. Ana Fostel & John Geanakoplos, 2011. "Tranching, CDS and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes," Cowles Foundation Discussion Papers 1809R, Cowles Foundation for Research in Economics, Yale University.
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  4. Arvind Krishnamurthy & Annette Vissing-Jorgensen, 2012. "The Aggregate Demand for Treasury Debt," Journal of Political Economy, University of Chicago Press, vol. 120(2), pages 233 - 267.
  5. Guillermo A. Calvo & Alejandro Izquierdo & Luis-Fernando Mejía, 2008. "Systemic Sudden Stops: The Relevance Of Balance-Sheet Effects And Financial Integration," NBER Working Papers 14026, National Bureau of Economic Research, Inc.
  6. Maurice Obstfeld & Kenneth S. Rogoff, 1981. "Speculative hyperinflations in a maximizing models: can we rule them out?," International Finance Discussion Papers 195, Board of Governors of the Federal Reserve System (U.S.).
  7. Guillermo A. Calvo, 2006. "Monetary Policy Challenges in Emerging Markets: Sudden Stop, Liability Dollarization, and Lender of Last Resort," Research Department Publications 4504, Inter-American Development Bank, Research Department.
  8. Jordi Gal� & Tommaso Monacelli, 2005. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Review of Economic Studies, Oxford University Press, vol. 72(3), pages 707-734.
  9. John Kareken & Neil Wallace, 1981. "On the Indeterminacy of Equilibrium Exchange Rates," The Quarterly Journal of Economics, Oxford University Press, vol. 96(2), pages 207-222.
  10. Reinhart, Carmen & Reinhart, Vincent, 2010. "Diminished Expectations, Double Dips, and External Shocks: The Decade After the Fall," MPRA Paper 24969, University Library of Munich, Germany.
  11. Jeremy C. Stein, 2012. "Monetary Policy as Financial Stability Regulation," The Quarterly Journal of Economics, Oxford University Press, vol. 127(1), pages 57-95.
  12. Gary Gorton & Andrew Metrick, 2010. "Securitized Banking and the Run on Repo," NBER Chapters, in: Market Institutions and Financial Market Risk National Bureau of Economic Research, Inc.
  13. Reinhart, Carmen & Calvo, Guillermo, 2002. "Fear of floating," MPRA Paper 14000, University Library of Munich, Germany.
  14. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "Varieties of Crises and Their Dates
    [This Time Is Different: Eight Centuries of Financial Folly]
    ," Introductory Chapters, Princeton University Press.
  15. Guillermo A. Calvo, 2005. "Emerging Capital Markets in Turmoil: Bad Luck or Bad Policy?," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262033348, June.
  16. Calvo, Guillermo & Coricelli, Fabrizio & Ottonello, Pablo, 2012. "The Labor Market Consequences of Financial Crises With or Without Inflation: Jobless and Wageless Recoveries," CEPR Discussion Papers 9218, C.E.P.R. Discussion Papers.
  17. Friedman, Milton, 1977. "Nobel Lecture: Inflation and Unemployment," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 451-72, June.
  18. Aizenman, Joshua & Marion, Nancy, 2011. "Using inflation to erode the US public debt," Journal of Macroeconomics, Elsevier, vol. 33(4), pages 524-541.
  19. Guillermo A. Calvo, 2007. "Interest Rate Rules, Inflation Stabilization, and Imperfect Credibility: The Small Open Economy Case," NBER Working Papers 13177, National Bureau of Economic Research, Inc.
  20. Starr, Ross M, 1974. "The Price of Money in a Pure Exchange Monetary Economy with Taxation," Econometrica, Econometric Society, vol. 42(1), pages 45-54, January.
  21. Calvo, Guillermo, 2012. "Financial crises and liquidity shocks a bank-run perspective," European Economic Review, Elsevier, vol. 56(3), pages 317-326.
  22. Blejer, Mario I & Leiderman, Leonardo, 1980. "On the Real Effects of Inflation and Relative-Price Variability: Some Empirical Evidence," The Review of Economics and Statistics, MIT Press, vol. 62(4), pages 539-44, November.
  23. Borio Claudio, 2011. "Implementing a Macroprudential Framework: Blending Boldness and Realism," Capitalism and Society, De Gruyter, vol. 6(1), pages 1-25, August.
  24. Obstfeld, Maurice & Rogoff, Kenneth, 1986. "Ruling out divergent speculative bubbles," Journal of Monetary Economics, Elsevier, vol. 17(3), pages 349-362, May.
  25. Alejandro Izquierdo & Ernesto Talvi & Guillermo A Calvo, 2006. "Phoenix miracles in emerging markets: recovering without credit from systemic financial crises," BIS Working Papers 221, Bank for International Settlements.
  26. Lucas, Robert E, Jr, 1980. "Equilibrium in a Pure Currency Economy," Economic Inquiry, Western Economic Association International, vol. 18(2), pages 203-20, April.
  27. Guillermo A. Calvo & Carmen M. Reinhart, 2000. "Fixing for Your Life," NBER Working Papers 8006, National Bureau of Economic Research, Inc.
  28. Uribe, Martin, 1997. "Hysteresis in a simple model of currency substitution," Journal of Monetary Economics, Elsevier, vol. 40(1), pages 185-202, September.
  29. Kiyotaki, Nobuhiro & Wright, Randall, 1989. "On Money as a Medium of Exchange," Journal of Political Economy, University of Chicago Press, vol. 97(4), pages 927-54, August.
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