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At one of my recent Harvard seminars, a graduate student proposed a clever scheme to [make holding money less attractive].

Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.

Of course, some people might decide that at those rates, they would rather spend the money — for example, by buying a new car. But because expanding aggregate demand is precisely the goal of the interest rate cut, such an incentive isn’t a flaw — it’s a benefit.

Mankiw's idea is to generate inflation (in this case defined as rising prices), so that people will spend their money instead of holding on to it. Mankiw clearly thinks rising prices and borrowing no matter how much debt people have is a good thing. I will come back to that issue in a bit in a discussion about "inflation targeting" but first let's take a look at this so called "clever scheme".

Flaws In The Clever Scheme

Mankiw overlooks the obvious point that currency in people's possession is but a tiny percent of money supply. Indeed some 90% or so is sitting in checking accounts, savings accounts, etc with no serial number. So the schemed is flawed from the start.

Now let's consider what would happen is such a bill were to pass anyway. I will even be generous and ignore the likely possibly of sheer financial panic occurring immediately on the declaration.

Given that the proposed scheme was to take place in a year, for 11 months not much would happen. Then we would start seeing a shift away from large denomination bills to dollar bills and coins. The reason is that someone might be willing to sit on a few dollars to buy a cup of coffee at the cafeteria but not much more. Actually even that would fail because ......

The Cash Economy Would Grind To A Halt

What exactly would vending machine operators do? Would owners program all machines to stop accepting dollar bills with a certain digit? What about the bills already accepted? On that line of thinking, I propose a complete shutdown of all vending machines that accept dollar bills would occur several days to a week before the drawing date.

What about merchants? On the date of the drawing and even a few days before, would any merchant accept anything but credit cards, debit cards, checks, or coins? I think not.

No one in their right mind would hold or accept any digit denominated currency. However, quarters would be hoarded! Think of the mounds of quarters people would be hold. A quarter, nickel, and dime shortage would be 100% guaranteed under such a "clever scheme".

Other than buying candy with quarters, the cash economy would literally grind to a halt. And given that people would be carrying less cash than before, spending would actually decline if such a bill were passed.

Thus Mankiw's proposal would do the exact opposite of what he intended.

Inflation Targeting

Mankiw goes on to say ....

Ben S. Bernanke, the Fed chairman, is the perfect person to make this commitment to higher inflation. Mr. Bernanke has long been an advocate of inflation targeting. In the past, advocates of inflation targeting have stressed the need to keep inflation from getting out of hand. But in the current environment, the goal could be to produce enough inflation to ensure that the real interest rate is sufficiently negative.

I will debate Mankiw or anyone else on Inflation Targeting. My take can be found in Does Inflation Targeting Make Any Sense?

Ok Mankiwor Krugman, have at it. By the way, I do not know if Krugman supports inflation targeting or not.

What I do know is Mankiw's proposal is so preposterous and the flaws so easily seen, that unless this is some kind of delayed April Fool's joke, it is time for him to either resign or be fired.