Glasner, Keynes, and the Fisher effect
David Glasner has an excellent new post on Keynes’s views on the Fisher effect. I’m going to come at this from a slightly different angle, which I hope will help illuminate Keynes’s thinking. But I’ll end up in a similar place to David.
Here’s Keynes in the General Theory:
The expectation of a fall in the value of money stimulates investment, and hence employment generally, because it raises the schedule of the marginal efficiency of capital, i.e., the investment demand-schedule; and the expectation of a rise in the value of money is depressing, because it lowers the schedule of the marginal efficiency of capital. This is the truth which lies behind Professor Irving Fisher’s theory of what he originally called “Appreciation and Interest” – the distinction between the money rate of interest and the real rate of interest where the latter is equal to the former after correction for changes in the value of money. It is difficult to make sense of this theory as stated, because it is not clear whether the change in the value of money is or is not assumed to be foreseen. There is no escape from the dilemma that, if it is not foreseen, there will be no effect on current affairs; whilst, if it is foreseen, the prices of exiting goods will be forthwith so adjusted that the advantages of holding money and of holding goods are again equalized, and it will be too late for holders of money to gain or to suffer a change in the rate of interest which will offset the prospective change during the period of the loan in the value of the money lent. For the dilemma is not successfully escaped by Professor Pigou’s expedient of supposing that the prospective change in the value of money is foreseen by one set of people but not foreseen by another. (p. 142)
David talks about how this conflicts with Keynes’s more sophisticated treatment of the Fisher effect in the Tract on Monetary Reform. In my view that’s because Keynes was (perhaps subconsciously) addressing different monetary regimes in the two books. The Tract really should have been called “A Tract on Fiat Money Regimes,” as it was written in the wake of the big European hyperinflations and has a real monetarist slant. The GT should be called “The General Theory of Business Cycles under a Gold Standard and/or Bretton Woods-Type Regime.” I once published an entire paper arguing that the GT was essentially a gold standard book, as the expected rate of inflation was implicitly assumed to be near zero (which was true of the actual gold standard.)
Here’s the difference. Under a fiat money regime you can have changes in the trend rate of inflation that are in some sense “equilibrium” cases. Thus if trend inflation rises from 0% to 10%, then all nominal prices wages and assets prices eventually adjust to that new reality, and nominal interest rates also rise by roughly 10%. Nothing real changes in the long run, except real cash balances. In contrast, the trend rate of inflation never really changes (much) under a gold standard, where the price level follows a random walk with near-zero trend. Thus actual price movements are mostly unexpected, and there’s not much of a Fisher effect. But that doesn’t fully explain Keynes’s comments; we need to add one more factor.
Under the gold standard there were two very important groups of prices; flexible prices and sticky prices. (Today sticky prices are more dominant.) The flexible prices included the prices of commodities (then a far larger share of GDP), real estate, and stocks—which are claims to the ownership of real corporate assets. A positive monetary shock would immediately raise the prices of the flexible price assets, and that is clearly what Keynes is thinking about in the quote above. At the same time the CPI inflation will play out gradually over time, and thus there will be some expected inflation at the CPI level. But in those days most economists focused on the WPI, which was dominated by flexible prices. Furthermore, and this is a point modern economists sometimes overlook, the Fisher effect applies more to expected flexible price inflation, rather than CPI inflation. That’s because commodities, real estate, and stocks are closer substitutes to holding money that are toasters and haircuts.
This interpretation makes Keynes’ statements somewhat more understandable, but still not correct. First Keynes:
The mistake lies in supposing that it is the rate of interest on which prospective changes in the value of money will directly react, instead of the marginal efficiency of a given stock of capital. The prices of existing assets will always adjust themselves to changes in expectation concerning the prospective value of money. The significance of such changes in expectation lies in their effect on the readiness to produce new assets through their reaction on the marginal efficiency of capital. The stimulating effect of the expectation of higher prices is due, not to its raising the rate of interest (that would be a paradoxical way of stimulating output – insofar as the rate of interest rises, the stimulating effect is to that extent offset) but to its raising the marginal efficiency of a given stock of capital. If the rate of interest were to rise pari passu with the marginal efficiency of capital, there would be no stimulating effect from the expectation of rising prices. For the stimulating effect depends on the marginal efficiency of capital rising relatively to the rate of interest. Indeed Professor Fisher’s theory could best be rewritten in terms of a “real rate of interest” defined as being the rate of interest which would have to rule, consequently on change in the state of expectation as to the future value of money, in order that this change should have no effect on current output. (pp. 142-43)
And then Glasner:
Keynes’s mistake lies in supposing that an increase in inflation expectations could not have a stimulating effect except as it raises the marginal efficiency of capital relative to the rate of interest. However, the increase in the value of real assets relative to money will increase the incentive to produce new assets. It is the rise in the value of existing assets relative to money that raises the marginal efficiency of those assets, creating an incentive to produce new assets even if the nominal interest rate were to rise by as much as the rise in expected inflation.
Like Krugman and many other new Keynesians, Keynes insists on thinking of stimulative effects via the transmission mechanism of interest rates. But as David points out, the rise in existing asset prices is expansionary, in and of itself. My only suggestion would be to talk about a rise in the value of existing assets relative to nominal wages, not money. But since nominal wages are sticky in money terms, it amounts to essentially the same thing. March to July 1933 is a great example. Asset prices soared, nominal wages were steady, and firms responded by producing lots more commodities and investment goods.
PS. This analysis may also relate to the following observation by Glasner:
I think that one source of Keynes’s confusion in attacking the Fisher equation was his attempt to force the analysis of a change in inflation expectations, clearly a disequilibrium, into an equilibrium framework. In other words, Keynes is trying to analyze what happens when there has been a change in inflation expectations as if the change had been foreseen.
In my view Keynes saw unexpected shocks leading to unexpected changes in flexible prices, and then subsequently to expected changes in the broader price level.
PPS. Paul Krugman recently wrote the following:
Just stabilize the money supply, declared Milton Friedman, and we don’t need any of this Keynesian stuff (even though Friedman, when pressured into providing an underlying framework, basically acknowledged that he believed in IS-LM).
Actually Friedman hated IS-LM. I don’t doubt that one could write down a set of equilibria in the money market and goods market, as a function of interest rates and real output, for almost any model. But does this sound like a guy who “believed in” the IS-LM model as a useful way of thinking about macro policy?
Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.
I turns out that IS-LM curves will look very different if one moves away from the interest rate transmission mechanism of the Keynesians. Again, here’s David:
Before closing, I will just make two side comments. First, my interpretation of Keynes’s take on the Fisher equation is similar to that of Allin Cottrell in his 1994 paper “Keynes and the Keynesians on the Fisher Effect.” Second, I would point out that the Keynesian analysis violates the standard neoclassical assumption that, in a two-factor production function, the factors are complementary, which implies that an increase in employment raises the MEC schedule. The IS curve is not downward-sloping, but upward sloping. This is point, as I have explained previously (here and here), was made a long time ago by Earl Thompson, and it has been made recently by Nick Rowe and Miles Kimball.
I hope in a future post to work out in more detail the relationship between the Keynesian and the Fisherian analyses of real and nominal interest rates.
Please do. Krugman reads Glasner’s blog, and if David keeps posting on this stuff then Krugman will eventually realize that hearing a few wisecracks from older Keynesians about various non-Keynesian traditions doesn’t make one an expert on the history of monetary thought.