The Price Theory of Money, Prospero’s Liquidity Trap, and Sudden Stop

Guillermo Calvo Columbia University and NBER www.columbia.edu/~gc2286 July 23, 2012 Abstract. 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. Hence, this approach shows that the creation of money is the original sin that comes back to haunt us in different, more sophisticated and insidious forms by the hand of the financial sector. These insights are employed to shed new light on, among other things, the perils of floating exchange rates at national and global levels.