Archive for the Category Monetary Theory

 
 

Andolfatto interviews Woodford

David Andolfatto is a very knowledgeable monetary policy blogger, and here he interviews Michael Woodford, perhaps the world’s leading monetary theorist.  I’ll just focus on one issue:

Andolfatto

There is a conventional wisdom of how these tools might work. Can you explain to us the findings of your own research, how they might corroborate these findings or these beliefs? Or go against them in some manner? Is there something surprising that emerges from what you’ve discovered?

Woodford

I think so. I think a lot of the discussion that you see of the point of asset purchases suggests that there should be a lot of similarity between the effects of purchasing long-term assets and the effects of cuts in the federal funds rate, the Fed’s traditional tool. People say the whole point of cutting the federal funds rate is longer-term bond yields would also go down, and if you can just buy longer-term bonds, push up their prices, that’s doing the same thing with a different mechanism. It’s a different way of doing the same thing. And if you can’t cut the federal funds rate further, then there’s an obvious reason to use the other method.

And our analysis suggests that this analogy between the two tools is not nearly as strong as you might have expected.

Andolfatto

Why is that exactly?

Woodford

Well, one reason is that the question of whether it’s clear that Fed purchases of longer-term assets can affect the prices of those assets as directly as traditional interest rate policy would. But I think the more surprising thing is that our analysis suggests that even under circumstances when the central bank finds that its purchases do affect the market price of the longer-term assets, the connection between that and spending in the economy, and then the effects on inflationary pressure, are not necessarily at all similar to those of conventional interest rate policy.

Andolfatto

So you’re suggesting that it is possible, at least in theory, that the Fed engages in the large purchase of a certain class of assets? Injects money into the economy by purchasing a particular class of assets? And that this may, in fact, have very exact opposite sort of effects than conventional data might suggest?

Woodford

Right. We clearly show that that’s at least a theoretical possibility. And obviously then deciding whether you think that’s actually happening is another thing. But I think the analysis points out that you shouldn’t assume that the mere fact that you could raise the price of the bonds answers then the question about what effect you’re having on the economy.

Andolfatto

So can you explain the economic intuition for that effect and whether or not it has some bearing as to the conduct of Fed policy today?

Woodford

I think the point is a fairly simple one, and it has to do with the question of why the central bank purchases should be able to move the market price anyway, which, again, people thought was kind of obvious. They said if you’re buying more of something, surely that will tend to make it more expensive. But when you ask whether that should actually happen with a lot of sophisticated traders out there in the market that are also trading against the central bank, what we argue is that if the other traders in the economy aren’t constrained in the financing they can mobilize to take the positions that make sense for them, they will tend to automatically have an incentive to trade against the central bank and to neutralize then the effects of the central bank’s trades.

Two things struck me.  First, Woodford has a contrarian view of the effects of QE on long-term interest rates.  Second, market monetarists have a similar counterintuitive view, but for very different reasons.

Woodford starts by pointing out that people expected QE to reduce long-term rates, just as traditional fed funds rate cuts reduce long term rates.  But MM doesn’t even accept the premise. Some of the most dramatic Fed moves toward cutting short-term rates have actually boosted long term rates, via the inflation and income effects.  We think QE also has an ambiguous impact on rates, for similar reasons.  In contrast, Woodford focuses on the risk channel (you should read the whole thing to get his explanation.)

Then Woodford suggests that the relationship between long-term rates and the economy is not as clear as with traditional tools.  We agree that it’s not at all clear (never reason from a price change), but we think that’s also true of traditional tools.  One cannot assume that lower interest rates produced by the Fed will lead to strong growth in AD.  It depends on the relative strength of the liquidity, income and Fisher effects.

In the final paragraph I quote, Woodford points out that most people think that Fed purchases “obviously” boost the price of the asset being purchased.  They misuse the S&D model.  Some commenters are outraged that the Fed is helping group X, because group X owns lots of the assets that the Fed is buying.  They see dark conspiracies.  But the purchase of bonds is also the sale of cash.  And more cash boosts inflation, which reduces bond prices.  During the 1964-81 period the Fed radically increased the amount of bonds it was buying, this led to rapid growth in the monetary base, higher inflation, and much lower bond prices.  So much for Cantillon effects. 

Yes, there are cases where large asset purchases are associated with low inflation (such as recently); my point is that there is no consistent relationship between Fed asset purchases and the price of that asset.

HT:  Tom Brown, TravisV.

David Glasner on me on IS-LM

Here is David Glasner:

Scott is totally right, of course, to point out that the fall in interest rates and the increase in the real quantity of money do not contradict the “money hypothesis.” However, he is also being selective and unfair in making that criticism, because, in two slides following almost immediately after the one to which Scott takes such offense, Foote actually explains that the simple IS-LM analysis presented in the previous slide requires modification to take into account expected deflation, because the demand for money depends on the nominal rate of interest while the amount of investment spending depends on the real rate of interest, and shows how to do the modification. Here are the slides:

.  .  .

Thus, expected deflation raises the real rate of interest thereby shifting the IS curve to the left while leaving the LM curve where it was. Expected deflation therefore explains a fall in both nominal and real income as well as in the nominal rate of interest; it also explains an increase in the real rate of interest. Scott seems to be emotionally committed to the notion that the IS-LM model must lead to a misunderstanding of the effects of monetary policy, holding Foote up as an example of this confusion on the basis of the first of the slides, but Foote actually shows that IS-LM can be tweaked to accommodate a correct understanding of the dominant role of monetary policy in the Great Depression.

Was I really so unfair?  Did I actually accuse Foote of not understanding that tight money can reduce nominal rates.  You be the judge:

Note the very last comment on the slide, about the significance of deflation.  The rest of the PP slides develop this idea further, and correctly show that while tight money might raise real interest rates, it could lower nominal rates through the Fisher effect. Thus it could shift the IS curve.  That helps, but it seems to suggest that the IS-LM model can be rescued by switching the argument from nominal to real interest rates. Alas, that won’t work.  The Fisher effect is only one of the ways that monetary shocks impact interest rates.  Tight money also reduces expected future real GDP, and this also shifts the IS curve.  So it isn’t just nominal interest rates that fall, real rates also fell during the 1930s, as expected future real GDP plunged.

It sure looks like I’m suggesting that Foote “correctly” understood the distinction between the impact of monetary policy on real rates and nominal rates.  I’m not sure where David got the idea I was being critical of Foote.  Then David simply ignored my observation that switching from nominal to real interest rates in no way rescues the IS-LM model.  Tight money can also reduce real interest rates.  Ex ante real rates did fall during the 1930s.  So IS-LM cannot be “tweaked to accommodate a correct understanding” of the role of money Depression.  It’s rotten to the core.

David continues:

The Great Depression was triggered by a deflationary scramble for gold associated with the uncoordinated restoration of the gold standard by the major European countries in the late 1920s, especially France and its insane central bank. On top of this, the Federal Reserve, succumbing to political pressure to stop “excessive” stock-market speculation, raised its discount rate to a near record 6.5% in early 1929, greatly amplifying the pressure on gold reserves, thereby driving up the value of gold, and causing expectations of the future price level to start dropping. It was thus a rise (both actual and expected) in the value of gold, not a reduction in the money supply, which was the source of the monetary shock that produced the Great Depression. The shock was administered without a reduction in the money supply, so there was no shift in the LM curve. IS-LM is not necessarily the best model with which to describe this monetary shock, but the basic story can be expressed in terms of the IS-LM model.

I agree that the best way to visualize the Great Contraction is through a large increase in the demand for monetary gold.  But I’m confused by David’s claim that this would not shift the LM curve.  Gold was the medium of account.  Unless I’m mistaken, an increase in the demand for gold would certainly be expected to shift the LM curve to the left, wouldn’t it?  (But then IS-LM is not my forte, so please tell me if I am wrong.)

PS.  In case you think I cherry-picked a quote, here’s the opening to my post, where I describe the quality of Foote’s PP slides:

Commenter Joseph sent me an excellent set of PP slides by a professor at Harvard named Chris Foote.  He has a very clear derivation of the AD curve from the IS-LM model.

If I’m going to be accused of being unfair to someone, at least give me the satisfaction of trashing their work!  My post had no criticism of Foote at all.  Just some criticism of ideas he listed on one slide as things other people have claimed might have caused the Depression.  I never assumed that was his view, and indeed he himself criticized some of those arguments in later slides.

PPS.  And how does David know I am “emotionally committed” to the view that IS-LM is worthless? Perhaps I have rational reasons for holding that view.  I’ve claimed that monetary policy can shift the IS curve, or else one has to assume the IS curve is upward sloping (Nick Rowe’s view.) I haven’t seen anyone rebut that view, emotionally or unemotionally.

IS/LM and AD

Commenter Joseph sent me an excellent set of PP slides by a professor at Harvard named Chris Foote.  He has a very clear derivation of the AD curve from the IS-LM model.  This slide caught my attention.

Screen Shot 2014-07-16 at 3.32.54 PM

 

The “spending hypothesis” obviously cannot explain the Great Depression.  In 1987 we saw an equally big stock market crash, and GDP kept booming.  (And don’t bother trying to concoct excuses about how things were different in 1987—I’ve swatted them all down 100 times.)

An investment backlash? Does that mean people switch from investment goods to consumer goods? If so, why did consumption also fall?  

Hoover actually favored public works projects, so fiscal policy explains nothing until at least 1932, when he raised taxes.   Was there a Great Depression in 2013?  I don’t think so.  And yet we had “savage” austerity in 2013.

OK, so it was tight money.  We’ve known that for 50 years, ever since Friedman and Schwartz. What interests me is the suggestion that the “money hypothesis” is contradicted by various stylized facts. Interest rates fell.  The real quantity of money rose.  In fact, these two stylized facts are exactly what you’d expect from tight money.  The fact that they seem to contradict the tight money hypothesis does not reflect poorly on the tight money hypothesis, but rather the IS-LM model that says tight money leads to a smaller level of real cash balances and a higher level of interest rates.

To see the absurdity of IS-LM, just consider a monetary policy shock that no one could question—hyperinflation.  Wheelbarrows full of billion mark currency notes. Can we all agree that that would be “easy money?”  Good.  We also know that hyperinflation leads to extremely high interest rates and extremely low real cash balances, just the opposite of the prediction of the IS-LM model.  In contrast, Milton Friedman would tell you that really tight money leads to low interest rates and large real cash balances, exactly what we do see.

Note the very last comment on the slide, about the significance of deflation.  The rest of the PP slides develop this idea further, and correctly show that while tight money might raise real interest rates, it could lower nominal rates through the Fisher effect.  Thus it could shift the IS curve.  That helps, but it seems to suggest that the IS-LM model can be rescued by switching the argument from nominal to real interest rates. Alas, that won’t work.  The Fisher effect is only one of the ways that monetary shocks impact interest rates.  Tight money also reduces expected future real GDP, and this also shifts the IS curve.  So it isn’t just nominal interest rates that fall, real rates also fell during the 1930s, as expected future real GDP plunged.  The IS-LM model is useless, and should be discarded.  The fact that it is used to derive the AD curve probably explains why I can’t seem to understand how Keynesians use the concept of AD; they are basing it on ideas that make no sense to me.

Here’s a simpler model.  AD is a hyperbola (a given level of NGDP).  This model does not assume NGDP targeting, just as the current AD model does not assume money supply targeting.  Changes in NGDP are caused by monetary policy.  The P/Y split for changes in NGDP is determined by the slopes of the SRAS and LRAS curves.  The LRAS curve is vertical.  Interest rates?  Yeah, they fluctuate a lot.

BTW, the PP slides end up with an excellent Greg Mankiw post from December 2008.  Mankiw recommends the Fed commit to a price level 30% higher in 10 years time.  Had they done so the recession would certainly have been much milder.

On the other hand if Mankiw had been head of the Fed in December 2008 they would have done almost exactly what they did under Bernanke, not what Mankiw recommended in 2008.  Mankiw’s policy views are pretty similar to Bernanke’s views.  Unfortunately there is also the formidable “FedBorg.” Had Mankiw been in charge, it would have been Bernanke who wrote the blog post suggesting the Fed should commit to a 30% higher price level in 10 years.  We are all just puppets, filling out the roles determined for us by blind fate.

Off topic:  Ramesh Ponnuru is right, I see lots of interest in NGDPLT among conservatives.

I have a post on AD over at Econlog, for those not burned out on the issue.

Just to show you that MMs don’t agree on everything, David Beckworth has a excellent post arguing against the Great Stagnation hypothesis.  Marcus Nunes is also skeptical.  In contrast, I accept the Great Stagnation hypothesis.  Fortunately it doesn’t matter for our monetary policy views, as we all favor targeting NGDP and ignoring RGDP.

Tony Yates on market monetarism

Tony Yates has a fairly extensive discussion of his views on market monetarism.  Before dissecting on the specifics, a few general comments:

1.  It’s hard for an outsider to grasp the nuances of any macro framework.  God knows I’ve been criticized for misstating the views of Austrians, MMTers, Keynesians, and many other groups. Yates does better than most.

2.  The views expressed here are my own, and as Nick Rowe indicated in the comment section to Yates’s post, market monetarism is a set of views that share a family resemblance (as is true of Keynesianism, Austrianism, etc.)  Nick’s comments are well worth reading.

So the following will sound more negative than I actually intended.  Let’s go over Yates’s points one at a time.  He starts by listing 10 tenets of market monetarism (these are not his views on policy, but rather his interpretation of our views):

1.  Monetary policy is never ineffective at stabilising inflation or the real economy, even at the zero bound.

Nope.  Monetary policy may be unable to stabilize the economy when there are real shocks. Monetary policy is pretty good at stabilizing the economy when the instability is due to a combination of sticky nominal wages and fluctuating nominal spending.

2.  Fiscal policy is ineffective [at, see above...] always.

Nope.  Fiscal policy can work in many different ways.  If the central bank is targeting inflation (including indirect taxes) then fiscal policy can boost employment if the government reduces VAT taxes, or employer-side payroll taxes.  Under a fixed exchange rate regime the government can boost output with more spending on goods and services.  The US in 1940-41.  My point was that if the central bank is targeting something like “aggregate demand” (as it should), then it’s silly for fiscal policymakers to attempt to influence “aggregate demand.”  That doesn’t mean that certain government projects might not become more desirable at low real interest rates, for standard classical cost/benefit reasons.

3.  Fiscal policy is effective [at...], but not desirable.

I mostly agree, with the caveat of the final sentence in my previous comment.  I do understand that fiscal and monetary policy are not identical, and hence one can construct models with a role for both.  But I don’t find those models persuasive.  To call fiscal policy a “blunt instrument” would be an understatement.

4.  Those New Keynesian models omit to model money, and so don’t capture why monetary policy is effective.

Yes and no.  I happen to think that omitting money makes it harder to see the importance of monetary policy.  However on purely theoretical grounds any story told with changes in the supply and demand for money can also be told with a description of the future path of interest rates relative to the future path of the Wicksellian equilibrium interest rate.  But I could also create models where the key variable was the difference between the actual price of zinc, and the Wicksellian equilibrium price of zinc (where the latter term is defined as the nominal zinc price consistent with 5% NGDP growth.) How do we know of the price of zinc is above the Wicksellian equilibrium price of zinc?  Simple, if NGDP growth is above target.

5.  If you look at New Keynesian models carefully, they show that monetary policy is effective, even at the ZLB, which demonstrates why it, and not fiscal policy, should be used for stabilisation purposes always.

I think it’s more accurate to say that those models allow for the effectiveness of monetary policy at the zero bound.  You can graft onto the NK models something like Krugman’s “promise to be irresponsible.”  Or Lars Svensson’s “foolproof plan” for escaping a liquidity trap.  Of course it’s also possible to construct NK models with expectations traps that do not allow for effective monetary policy.  I don’t accept the assumptions that underlie those pessimistic versions of the model.

6.  Unlike in NK models, monetary policy isn’t just about OMOs, or even buying long dated government securities.  Expansions of the money supply can be used to buy all sorts of assets.

Yes and no.  I certainly don’t believe that developed countries would need to buy non-government securities to hit a reasonable target, such as 4% or 5% NGDP growth, level targeting.  But my deeper objection is that NKs frame the ineffectiveness issue backwards.  They start by asking what the central bank can do at the zero bound, when they should start by asking why we are at the zero bound.  More specifically, imagine a “do whatever it takes” central bank that keeps buying assets until inflation or NGDP growth expectations are on target.  What then?  This reframes the debate in a way that focuses on the real “zero bound” problem, the zero bound on the availability of eligible assets for the central bank to buy.  When framed this way it becomes apparent that the zero bound on interest rates is not the real issue, as a central bank could theoretically run out of eligible assets even at positive rates.

For example, a few years ago the Australian national debt had fallen close to zero.  Nominal interest rates were positive.  Now let’s suppose that the RBA were only allowed to buy Australian government debt.  That constraint would make monetary policy ineffective.  And it would have nothing to do with the zero bound on interest rates, which were (and are) positive in Australia.

Now consider a country at the zero bound like the US.  Suppose that the Fed committed to unlimited “QE” in order to raise NGDP growth expectations up to the old 5% trend line.  They committed to buy T-securities until there were no more, then agency securities until those were exhausted, then Germany, Japanese, Canadian, British, etc., government bonds until those were exhausted, then AAA corporate bonds until those were exhausted, etc., etc.  Is that monetary policy effective?  It’s effective if the Fed can create expectations of sufficiently fast NGDP growth before running out of eligible assets.  Thus the real zero bound problem is not zero interest rates, but the possibility that the Fed might be legally prevented from buying assets that it needed to buy in order to satisfy the public’s demand for base money when NGDP growth is on target.

NKs tend to assume that since the Fed’s balance sheet has ballooned from 6% of GDP to over 20%, a still higher number would be needed if they had adopted a 5% NGDPLT policy in 2008.  Actually just the opposite is true.  With that 5% NGDPLT policy, we never would have hit the zero bound, and hence our monetary base/GDP ratio would be much lower (as is the case in Australia–which never hit the zero bound.)  NKs are monetary policy pessimists because they see interest rates as the lever of policy, whereas it’s more useful to think of them as the outcome of the policy regime.  Yes, NKs are correct that there is a liquidity effect and that easy money today is likely to lead to lower short-term interest rates today.  But as Woodford points out easy money today is not at policy at all; a policy is a change in the expected future path of monetary policy from today to the end of time.  It’s a policy regime.  And an expansionary policy by that criterion may well raise nominal interest rates.

7.  Societies should adopt nominal GDP targeting.

8.  [And/or] It follows from some combination of 1-6 that societies should adopt some form of nominal GDP targeting.

That’s basically right, although I certainly don’t think NGDP targeting is precisely optimal, just a good, pragmatic, easy to understand target that is superior to IT.  I’d prefer something like a nominal total labor compensation target, especially for countries like Kuwait where NGDP can be distorted by commodity price shocks.

9.  The crisis was caused by inflation targeting.  Following a MM perspective, including a nominal GDP target, would have averted it.

Yes and no, there were many causes.  If the Fed had adopted a “target the forecast” approach in their meeting after Lehman failed, monetary policy would have become dramatically more expansionary and the recession would have been significantly milder.  Ditto for replacing an inflation target with a price level target.  But I believe NGDPLT would have been better yet.

10.  Fiscal policy is ineffective away from the ZLB because it prompts an offsetting monetary policy response.

See my response to points 2 and 3.  Note that Yates ignores the “market” part of market monetarism.

A few general remarks:

1.  I accept the fact that it will never be possible to write down a macro model with microfoundations where NGDP targeting is optimal.  However, I also believe that we don’t know enough about the relative importance of price and wage rigidity, or the relative importance of various types of price rigidity, to construct useful models of that sort.

2. It’s a fair criticism of MM to point out that we don’t have much in the way of either sophisticated theoretical models or empirical studies to support our claims.  Like Keynes (1936) we rely heavily on a combination of basic economic models (AS/AD for me, where AD is a hyperbola), stylized facts that are highly suggestive, criticism of alternative approaches, and logic.  If someone bothered to write down the MM model (at least my version of it), the model would be as simplistic as the Keynesian cross.

3.  The real innovation of MM is that we’ve suggested that mainstream economists are thinking about the issues in the wrong way, and we have done so using many concepts that have come from those very same mainstream economists.  I tend to endlessly bore my readers with quotes from famous respected economists who used to claim that low interest rates don’t mean easy money, or that monetary policy remains highly effective at the zero bound.  In late 2008 these mainstream views were abandoned by the profession (including the famous economists I quote), for all the wrong reasons. For example, many economists simply misread the events in Japan (1993-2012) and become pessimistic about monetary policy.  A great deal of MM is simply reminding the profession that if the BOJ does what it did in fact do in 2013, that policy will be effective.  Ditto for the Swiss policy adopted a couple years earlier.

4.  Speaking for myself, I view MM partly as a sort of Deirdre McCloskey-like critique of modern macro methodology.  Milton Friedman (my hero) was famous for not having a well-defined “model.” Or for thinking in partial equilibrium terms.  His best ideas were not his “monetarist” ideas such as the 4% rule, but rather his critique of Keynesianism (low rates aren’t easy money, permanent income hypothesis, natural rate hypothesis, etc.) In my view MM is most effective as a critique of mainstream macro since 2008, and least effective when promoting NGDP targeting.

HT:  Ben Southwood.

The one thing you cannot do with cash

There are many theories of why people are willing to hold fiat money without any explicit backing. One theory that I’ve never been very fond of is that the ability to pay taxes with cash is what gives fiat money value.  This caught my attention:

DENVER (AP) — A marijuana business in Colorado has filed a lawsuit against the Internal Revenue Service for assessing a penalty for paying taxes in cash.

The IRS charges a 10 percent penalty on cash payments for federal employee withholding taxes. But many marijuana businesses are forced to pay taxes in cash because of difficulty accessing banking services

Thus it seems like taxes are one of the very few things that you cannot pay for in cash, at least not without a sizable penalty.