monetary-policy, central-bankImagine that a smallish country with its own currency suddenly discovers a huge amount of gold or oil, and the government wants to use the new wealth to make life easier for its citizens. I can imagine two possible routes:
First, the central bank could maintain the exchange rate by printing lots of its currency. In effect, the central banks prints new money and uses it to buy the gold or oil from the government. Incomes would rise internally due to the tax cuts. I guess prices would rise, but not by as much. (Remember, there must be a higher standard of living due to the gold or oil, and therefore the incomes-to-prices ratio must increase.) Preexisting debts would, in effect, be made smaller. I guess this is the most ‘inflation-like’ scenario, but is it a bad thing? The central bank’s balance sheet is in good shape with all the gold and oil.
On the other hand, the central bank might not turn on the printing presses and the government would instead have to buy up its own currency and use this to fund the tax cuts and spending increases. On the international exchange markets the value of the currency would soar. In theory, the incomes-to-prices ratio should still increase, but I suspect this is a more ‘deflation-like’ scenario as prices might fall due to the great demand for currency by the state. If a truly huge amount of gold was found, the government might buy up all existing currency and still have some gold left over!
In such a scenario, should the central bank print the money or not? Should its target be to maintain the existing exchange rates, or to maintain the internal prices? I suspect that it’s natural to allow internal prices to rise in this case, as the rises are due to the people becoming more affluent and lazy, and is not a symptom of a badly-managed currency.
If a country discovers a great amount of Gold, nothing changes unless Gold is put on good use. If we assume the country is closed to Trade, the gold will simply be cheaper in the country and more women will wear Gold as jewelry. Actually, if it is really a lot of Gold, women won’t refer wearing Gold at all (thee Aluminum case). Actually let’s look at the case of Aluminum because we can translate it as “A HUGE amount of Aluminum was discovered.”
So I imagine the story of abundant Gold wouldn’t be too different, it will be more heavily used in electronics and other products (there were Gold would increase its usefulness).
The case of Oil, well… it’s a different resources and if new discoveries of oil are made the price simply goes down and we will become more oil dependent.
So yes, we will live better but ONLY on the margin that the science finds good use of it, otherwise the consequences will be very much like those of agricultural comodities (when supply increases and demand is inelastic, farmers end up losing money)
So the best Monetary policy to do when discoveries are made is: DO NOTHING!
No, the central bank does not need to expand the base money supply in order to account for a sudden and unexpected increase either in a largely-useless commodity with an arbitrary price, such as gold, or a commodity that’s useful insofar as it’s allowed to have negative price externalities, such as oil.
In neither case do these represent an increase in real wealth.
Furthermore, in general in modern economies, increasing economic activity will start with a growth in broad money (savings and loans), which may later manifest as an increase in narrow money (government-printed money). So the Central Bank can wait and see what happens to its indicator variables, before making any policy decisions on monetary easing or tightening. And that’s true whatever combination of exchange rates, interest rates, inflation rates, GDP, or employment, that it’s targeting
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