A Communication from Your Central Bank

Nick Rowe recently argued that there can be certain types of products for which the market might allow multiple equilibria.  This can happen because the willingness of an individual to buy some product might depend on how many other people buy that product.  The upshot, Rowe suggests, is an unusual, non-functional shape to the demand curve characterizing the market for the product in question, resulting in two distinct equilibrium demand quantities corresponding to the same price.

Rowe applies this model to cases in which the supply of a product is determined by a monopoly supplier.  Rowe says that in most cases it does not matter, for theoretical purposes, whether we think of a monopolist as setting the optimum output level and then letting the price go to the equilibrium determined by the intersection of the demand curve with that output level, or as setting the optimum price and then supplying output until it reaches the level the market demands at that price.  In each case, we get the same result.  But if a non-functional demand curve describes the market for some product, then it does make a difference, he claims, whether the monopolist targets a price or targets an output level, because there might be multiple equilibrium output quantities for some prices, but only one equilibrium price for each output quantity.

The kind of case Rowe is discussing, which he illustrates with an example of a hypothetical electronic communications device – a “gizmo”, is theoretically interesting in itself.  But what I want to focus on is an application he makes of it, an application which appears to be his main reason for offering the model in the first place.   Appealing to some 1970 work by William Poole, Rowe applies the multiple equilibrium model to the central bank, which they view as a monopolist setting either the “price” for money – an interest rate – or the quantity of money.  The monopolist in this case is constrained by a “money demand” relation that might be non-functional in the manner described above.

[Read the rest at New Economic Perspectives]