Archive for the Category Monetary Theory


Question for David Glasner

Here’s David Glasner:

I can envision a pure barter economy with incorrect price expectations in which individual plans are in a state of discoordination. Or consider a Fisherian debt-deflation economy in which debts are denominated in terms of gold and gold is appreciating. Debtors restrict consumption not because they are trying to accumulate more cash but because their debt burden is so great, any income they earn is being transferred to their creditors. In a monetary economy suffering from debt deflation, one would certainly want to use monetary policy to alleviate the debt burden, but using monetary policy to alleviate the debt burden is different from using monetary policy to eliminate an excess demand for money. Where is the excess demand for money?

Why is it different from alleviating an excess demand for money?

As far as I know the demand for money is usually defined as either M/P or the Cambridge K.  In either case, a debt crisis might raise the demand for money, and cause a recession if the supply of money is fixed.  Or the Fed could adjust the supply of money to offset the change in the demand for money, and this would prevent any change in AD, P, and NGDP.

Perhaps David sees the debt crisis working through supply-side channels—causing a recession despite no change in NGDP.  That’s possible, but it’s not at all clear to me that this is what David has in mind.

Williamson on monetary policy and interest rates

In the past, Stephen Williamson has attracted some fierce criticism for his views on the relationship between money and interest rates, specifically some posts that seemed to deny the importance of the “liquidity effect.”  Nick Rowe and others criticized Williamson for seeming to suggest that a Fed policy of lowering interest rates would actually lower the rate of inflation–via the Fisher effect. Williamson has a new post that seems to have somewhat more conventional views of the liquidity effect, but still emphasizes the longer term importance of the Fisher effect:

If the central bank experiments with random open market operations, it will observe the nominal interest rate and the inflation rate moving in opposite directions. This is the liquidity effect at work – open market purchases tend to reduce the nominal interest rate and increase the inflation rate. So, the central banker gets the idea that, if he or she wants to control inflation, then to push inflation up (down), he or she should move the nominal interest rate down (up).

But, suppose the nominal interest rate is constant at a low level for a long time, and then increases to a higher level, and stays at that higher level for a long time. All of this is perfectly anticipated. Then, there are many equilibria, all of which converge in the long run to an allocation in which the real interest rate is independent of monetary policy, and the Fisher relation holds.

Before discussing Williamson, let me point out that back in 2008-09, 99.9% of economists thought the Fed had eased policy, and that the deflation of 2009 occurred in spite of those heroic easing attempts.  That 99.9% included the older monetarists.  Only the market monetarists and the ghost of Milton Friedman insisted that money was tight and that interest rates were falling due to the income and Fisher effects.  I’d like to think that Williamson agrees with us, but of course he’d be horrified by the specifics on the MM model, indeed he wouldn’t even recognize it as a “model.”

Williamson continues:

A natural equilibrium to look at is one that starts out in the steady state that would be achieved if the central bank kept the nominal interest rate at the low value forever. Then, in my notes, I show that the equilibrium path of the real interest rate and the inflation rate look like this:

Screen Shot 2014-09-13 at 10.41.23 AM

Is that really monetary tightening?  After all, inflation rises.  Here’s the very next paragraph by Williamson:

There is no impact effect of the monetary “tightening” on the inflation rate, but the inflation rate subsequently increases over time to the steady state value – in the long run the increase in the inflation rate is equal to the increase in the nominal rate. The real interest rate increases initially, then falls, and in the long run there is no effect on the real rate – the liquidity effect disappears in the long run. But note that the inflation rate never went down.

The scare quotes around “tightening” suggest that Williamson is also skeptical of the notion that tightening has actually occurred.  Indeed inflation increased, then policy must have eased. However to his credit he recognizes that “conventional wisdom” would have viewed this as a tightening.  Nonetheless the final part of the paragraph has me concerned.  Williamson refers to the disappearance of the liquidity effect, but in the example he graphed there is no liquidity effect, as the rise in interest rates was not caused by a tightening of monetary policy.  If it had been caused by tighter money, inflation would have fallen.

So how can the graph be explained?  As far as I can tell the most likely explanation is that at the decisive moment (call it t=0) the equilibrium Wicksellian interest rate jumps much higher, and then gradually returns to a lower level over the next few years.  And the central bank moves the policy rate to keep the price level well behaved.  I suppose you might see this as being roughly the opposite of the shock that hit the developed economies in 2008, except of course it was more gradual.

Suppose there had been no change in the Wicksellian equilibrium rate, and the central bank simply increased the policy rate by 100 basis points, and kept it at the higher level.  In that case, the economy would have fallen into hyperdeflation. When you peg interest rates in an unconditional fashion, the price level becomes undefined.

Is there any other way that one could get a path like the one shown by Williamson? Could the central bank initiate this new path? Maybe, at least if you don’t assume a discontinuous change in the interest rate, followed by absolute stability.  To explain how you could get roughly this sort of path lets look at the reverse case.

Suppose the Fed had been increasing the monetary base at about 5% a year for many years, and the markets expected this to continue.  This led to roughly 5% NGDP growth.  The markets assumed the Fed was implicitly targeting NGDP growth at about 5%.  But the Fed actually also cared about headline inflation, which suddenly rose higher than desired (due to an oil shock.)  The Fed responded by holding the base constant for a period of 9 months.  (For those who don’t know, so far I’ve described events up to May 2008.)

This unexpectedly tight money turned market expectations more bearish.  As expectations for NGDP growth became more bearish, the asset markets fell and the Fed responded by cutting interest rates.  And since inflation did not immediately decline, real short term rates also fell (still the mirror image of the Williamson graph.)  BTW, we know that even 3 month T-bill yields FELL on the news of policy tightening at the December 2007 FOMC meeting.  Williamson would have approved of that market reaction!!

Normally the Fed would have realized its mistake at some point, and monetary policy would have nudged us back onto the old path.  In this case, however, market rates had fallen to zero by the time the Fed realized its mistake.  And the Fed was reluctant to do unconventional stimulus.  There was a permanent reduction in the trend rate of NGDP growth, as well as nominal interest rates. This showed up in lower than normal 30-year bond yields.  The process played out even more dramatically in Europe (and earlier in Japan.)

I do have one quibble with the Williamson post.  He seems too skeptical of the claim that the ECB recently eased policy.  But before I criticize him let me say that I find his error much more forgivable than the conventional wisdom, which views low interest rates as easy money.

Williamson points out that the ECB recently cut rates, and that if the ECB leaves rates near zero for an extended period of time, then inflation is likely to stay very low, as in Japan.  All of this is correct.  But I think he overlooks the fact that while the overall policy regime in Europe is relatively “tight”; the specific recent actions taken by the ECB most definitely were “easing.”  We know that because the euro clearly fell in the forex markets in response to that action.

I think this puzzles a lot of pundits.  It’s very possible for central banks to take relative weak actions that are by themselves expansionary, even while leaving the overall policy stance contractionary, albeit a few percent less so than before. That’s the story of the various QE programs in America.

I encourage all bloggers to never reason from a price change.  Do not draw out a path of interest rates and ask what sort of policy it is.  First ask what caused the interest rates to change—the liquidity effect, or the income/Fisher effects?

PS.  Of course I agree with most of the Williamson post, such as his criticism of “overheating” theories of inflation.

HT:  TravisV

Don’t show this St. Louis Fed article to Nick Rowe

A commenter sent me a paper from the St. Louis Fed:

This view can also be represented by the so-called “quantity theory of money,” which relates the general price level, the total goods and services produced in a given period, the total money supply and the speed (velocity) at which money circulates in the economy in facilitating transactions in the following equation:


In this equation:

  • M stands for money.

  • V stands for the velocity of money (or the rate at which people spend money).

  • P stands for the general price level.

  • Q stands for the quantity of goods and services produced.

Oh, so that’s the quantity theory of money.  In fairness, they do mention stable velocity later on. But stable velocity is the QTM, it’s where you start the explanation.  They continue:

And why then would people suddenly decide to hoard money instead of spend it? A possible answer lies in the combination of two issues:

  • A glooming economy after the financial crisis
  • The dramatic decrease in interest rates that has forced investors to readjust their portfolios toward liquid money and away from interest-bearing assets such as government bonds

In this regard, the unconventional monetary policy has reinforced the recession by stimulating the private sector’s money demand through pursuing an excessively low interest rate policy (i.e., the zero-interest rate policy).

If only the Fed had joined the ECB in raising interest rates back in 2011.  Then we would have had a much faster recovery.

Base money is just as special as it ever was

Here’s Frances Coppola:

Technology changes and post-crisis monetary policy are making financial assets and money indistinguishable. Central banks now need to work in partnership with fiscal authorities.

Several economists at the Lindau meeting were severely critical of central banks’ conduct of monetary policy in the light of continuing depression in the US, Japan and much of Europe, and called for greater use of fiscal policy to bring about recovery. Among the most critical was Christopher Sims, who gave a trenchant presentation on “Inflation, Fear of Inflation and Public Debt”.

He started by announcing the death of the quantity theory of money, MV=PY. Due to interest on reserves and near-zero interest rates, “money” can no longer be clearly distinguished from other financial assets. This is a fundamental point which requires some explanation.

These days, nearly all forms of money bear interest, which makes them indistinguishable from interest-bearing assets. For Sims, the paying of interest on bank reserves, coupled with the decline of physical currency, all but eliminates the distinction between interest-bearing safe assets such as Treasury bills and what we traditionally call “money”. All assets can be regarded as “money” to a greater or lesser extent: the extent to which assets have “moneyness” is really a matter of liquidity.

Sometimes words can get in the way of meaning.  There is no point in arguing about what the term “money” really means, it obviously means different things to different people.  But the term “base money” still has a pretty clear meaning; currency in circulation and bank deposits at the Fed.  The Fed happens to have a complete monopoly on the (US$) monetary base.  Prior to 2008 it could determine the supply of base money through OMOs and discount loans, and it could influence the demand for base money through changes in reserve requirements.  After 2008, a 4th tool was added—interest on reserves, which also impacts the demand for base money.  With these four tools the Fed can push the value of the dollar (in terms of euros) to anywhere between zero and infinity.  That’s a lot of power.  Nothing fundamental has changed, at least nothing relating to the validity of the quantity theory of money.

A few other points:

1.  The quantity theory of money has NOTHING to do with the equation of exchange.  That equation is best viewed as a definition of velocity, nothing more.  Definitions are not theories.

2.  Currency is not “declining.” The currency stock is growing faster than GDP.  It is also becoming a steadily larger share of the monetary aggregates.

HT:  Marcus Nunes

Why macro stabilization policy rarely fixes problems

A big demand slump isn’t just an economic disaster; it’s also a prediction of an economic disaster. And that means it’s a prediction of policy failure.   At least that’s the implication of the Woodfordian view of macro (which I accept.)  Changes in current AD are mostly driven by changes in the future path of AD.  Changes in near-term NGDP are mostly driven by changes in expected NGDP 1, 2, 5 and 10 years out in the future.  Call it the term structure of NGDP.  And those are driven by the future expected path of monetary policy.

And of course whenever we have crashes like 1920-21, 1929-30, 1937-38, 2008-09, we also tend to have asset market crashes.  Asset markets aren’t perfect (1987) but when there’s a very big economic slump on the way they are pretty good at sniffing it out.

So here’s the problem for macro policy.  It’s good at preventing disasters, as we saw with the Great Moderation.  But when it fails, it’s really, really hard to fix the problem, because doing so requires policymakers to be more effective than the markets predict.  I won’t say that things are hopeless when markets predict disaster, but I wouldn’t put much hope on stabilization policy.  In the textbooks, the purpose of stabilization policy is to “fix problems.”  In reality it will usually fail at that.  Rather it’s good at preventing problems.  If you’ve got a problem, you’ve already failed.  Like the old joke—”if you are headed there, I wouldn’t start from here.”

I was reminded of all this while reading a Brad DeLong post that discusses a debate between Nick Rowe and Simon Wren-Lewis.  DeLong looks at the possibilities offered by monetary and fiscal stimulus when you have a “deficiency in demand.”

Let’s look at this from a different perspective.  The problem is not “demand deficiency” it’s expected demand deficiency.  Policymakers try to steer the nominal economy, they implicitly or explicitly target NGDP one or two years out in the future.  If 12 month forward expected NGDP is right on target, then no policy changes are needed.  And if 12 month forward NGDP is below target, then the markets have predicted policy will fail, and their forecast counts for far more than the views of any academic economist or government policymaker.  At that point, we really shouldn’t expect much from macro policy.  It’s likely to fail.  No wonder people are so pessimistic about monetary policy! Markets have observed the behavior of the relevant central bank (Fed, ECB, etc.) and come up with the optimal forecast of the result.  If there’s an expected demand shortfall, markets have already given a vote of no confidence to the policymaking apparatus.

From that perspective, DeLong is asking the wrong question.  It’s not, “how do we fix this problem?”  It’s, “how to we make it so that Brad DeLong and Simon Wren-Lewis never ask, ‘how do we fix this problem.’”  I see two ways, and only two ways of doing that.  Both methods involve abandoning the Keynesian policy of interest rate targeting.  Interest rate targeting doesn’t work at the very moment when good monetary policy is most essential—in a very deep demand slump. Would you buy a car that had a brake that failed just 1% of the time—only on twisty mountain roads with no guardrail? Then why do you (Keynesians) buy interest rate targeting as the appropriate policy instrument?

1.  One method would have the central bank peg the price of one year forward NGDP futures, and do OMOs until the market price is right on target.  Now you don’t have to worry about what to do if there is an expected demand deficiency, because there never is an expected demand deficiency.  At least not one expected by the market.  There may be a current demand deficiency, but if it isn’t expected to persist, then stabilization policy is right on target.

2.  Let’s say you don’t buy the “market” part of market monetarism.  You think markets are irrational.  ”Better leave this to the wise mandarins who will control policy in the optimal fashion.” What then?  It’s very simple, you do what Lars Svensson suggested, you set the monetary instrument at a position where the central bank’s internal forecast is equal to the policy target.  But which instrument?  Recall that we have abandoned interest rate targeting.  Don’t ask me, I’m the NGDP futures market guy–ask the mandarins.  Anything with no zero bound.  It might be the monetary base, it might be the trade-weighted exchange rate, it might be the nominal price of zinc. There is an infinity of possible choices.  (Now do you see why I’d rather let the markets set policy?)

In his post, DeLong cites Wren-Lewis saying he’s heard the MM arguments, but doesn’t buy them. Then he goes on to conclusively show he has not heard the MM arguments, by using the metaphor of employing both a regular brake and an emergency brake in a car careening down a hill.  This metaphor is supposed to provide justification for using fiscal stimulus “just in case” to back up monetary stimulus.

But that won’t work if you have monetary offset.

In any case, monetary policy is a brake that never fails, and if it does fail you don’t end up crashing, you end up with the Bank of England owning the entire world.  A level of global domination that makes Victorian-era Britain seem like a 98 pound weakling by comparison.  Global GDP is around $100 trillion.  So Piketty would say that global wealth must be around $500 trillion.  Could the Brits live on 5% of that?  I think so.  But wait until the Scots secede, those ingrates don’t deserve any of it.

As Dylan said on his greatest album:

.  .  . there’s no success like failure . . .