Archive for the Category Monetary Theory


Does monetary policy “cause” changes in NGDP?

Suppose that there are 6 ways the government could have prevented the 2008 financial crisis.  One might be abolishing moral hazard (FDIC, TBTF, the GSEs, etc.)  Another might have been to ban subprime mortgages made with taxpayer-insured funds.  Another might have been higher capital requirements.  Another might have been to require bankers to post personal bonds in case their bank failed (or needed to be bailed out), like on the old days.  Another might have been NGDPLT. Etc., etc.  In that case one might argue that failure to do one of those things “caused” the crisis.  Of course there are many ways of thinking about causation, but I find policy counterfactuals to be one of the most useful ways of describing causation.

Before considering whether money causes NGDP, I like to consider some related questions.

1.  I would argue that between 1879 and 1968 monetary policy “caused” the price of gold.  For most of the period the price was fixed by the monetary policymakers.  But even in 1933-34, when the price rose sharply, I’d argue it was “caused” by monetary policy, in the sense that the Fed was targeting the price of gold.  In contrast, the Fed was not targeting the price of gold in recent years, so the increase was not caused by the Fed in any useful sense of the term ’cause.’

2.  So if the Fed targeted gold prices from 1879-1968, does that mean other variables like the price level and NGDP were endogenous, and hence not caused by the Fed?  It’s debatable whether they were completely endogenous, but let’s say they were.  I’d still argue that the sharp decline in the price level and NGDP during 1929-33 was caused by the Fed.  And that’s because I’d argue that gold price targeting was not a wise policy, and that a desirable counterfactual policy would have been to stabilize either the price level of NGDP during 1929-33.  The Fed’s failure to do so caused the Depression.

3.  Now suppose the Fed is targeting inflation.  In that case any change in RGDP growth will lead to an equal change in NGDP growth.  Changes in NGDP will have nothing to do with monetary policy. Or at least it seems that way.  But not necessarily.  Suppose inflation is a bad target, because labor market instability (due to sticky nominal wages) and debt market instability (due to nominal debts) is much more closely related to NGDP fluctuations than to inflation fluctuations.  In that case a central bank that is targeting prices could be said to have “caused” a deep recession by letting NGDP fall, even if it was hitting its inflation target perfectly, and RGDP was falling for other reasons.  Of course it’s debatable as to whether its useful to consider the central bank to be to blame for the deeper recession, but it’s certainly not implausible, and indeed is the prediction of the standard AS/AD model used in econ textbooks.  In the graph below when you are targeting P and there is a negative supply shock, then NGDP will fall.  In that case you go to point E6, a deep recession.  If you were targeting NGDP when this supply shock hit, you’d have a mild recession (E7)Screen Shot 2014-11-04 at 8.28.43 AM.

It’s certain fair game to blame the Fed for depressing AD in response to a negative supply shock, even if 100% of the fall in NGDP is “caused” by a fall in RGDP.

Nominal GDP growth is the sum of a real and a nominal variable; real GDP growth and inflation. And yet (paradoxically) NGDP growth is a 100% nominal variable, completely under the control of monetary policymakers.  Whether it is useful to think in terms of NGDP fluctuations “causing” recessions depends on how you think the business cycle would be affected by a counterfactual policy of NGDPLT.

Similarly, changes in the nominal price of a gold (a 100% nominal variable) are the sum of a nominal and a real variable (inflation, and changes in the relative price of gold.)  In 1933-34 it was useful to think of the rising price of gold at an indicator of easy money.  More recently (in the early 2010s) it was not useful to think in terms of the rising price of gold as indicating an easy money policy.  In 1933-34 the price of gold was used as a signaling device for the future path of monetary policy.  That was not true in 2010-12.  I’d like to use some of these ideas to analyze part of a Tyler Cowen post from a couple years back:

My worry is that some Market Monetarists speak of ngdp as if it is some block of stuff, handed down from on high (of course in the past our central banks have not been targeting ngdp).  It’s as if ngdp determines the size of the room, and a carpenter is then asked to build a house within that room.  If the room is too small, a large house cannot be built.  Or, if you are not given enough clay, you cannot build a very large sculpture.  Along these lines, if the growth path of ngdp is not robust enough, the economy cannot do well.

I get nervous at how ngdp lumps together real and nominal in one variable, and I get nervous at how the passive voice is applied to ngdp.

My framing is different.  My framing is that the private sector can manufacture its own ngdp.  It can do so by trade and it can do so by credit and of course velocity is endogenous to the available gains from trade.  Most of the major central banks are, today, not obsessed with snuffing out recovery and increases in real output.

The value of money can be defined in terms gold, other currencies, all goods and services, and share of NGDP that can be bought with a dollar.  These all involve an inverse relationship; 1/Pgold, or 1/price of foreign currency, or 1/price level, or 1/NGDP.  Thus NGDP can be viewed as a single thing (one way of describing the value of money), or of course it can also be viewed as a composite (P and Y, or M and V).  If someone is used to viewing policy in terms of money supply targeting, or price level targeting, then an NGDP discussion can seem odd—adding together two very different things.  As I said, if you target P (or M) then NGDP will seem to fluctuate due to “non-monetary factors” like supply shocks (or V shocks.)

But that tells us nothing about whether it is useful to think in terms of NGDP being causal, i.e. whether NGDPLT is a useful policy counterfactual.  So while Tyler’s argument is defensible, the average reader would probably assume that Tyler has spotted a logical error in the NGDP fanatics, which is actually not there.  (In fairness, elsewhere he explicitly denies doing so.)

Go back to the opening analogy in this post.  I favor eliminating moral hazard.  But it wouldn’t be fair of me to accuse someone who favored higher capital requirements for banks as having ignored the real cause of banking crisis.  At best I could argue my solution was more useful. Perhaps Tyler should have discussed which alternative monetary policy targets are the most useful.  The commenter who sent me this post thought (probably wrongly) that Tyler was criticizing NGDPLT.  I don’t see that.  He was claiming it’s not the cure-all some of its proponents seem to think it is.

To say “ngdp is low,” or “ngdp is on a low growth path,” or “ngdp is below trend,” and so on — be very careful!  Those claims do not necessarily have causal force.  Arguably they are simply repeating, in a new and somewhat different language, the point that the private sector has not seen fit to engage in more trade, credit creation, velocity acceleration, and so on.  Formally speaking, the claims are not wrong, but I don’t find them useful as an explanation for why economic growth or recovery, at some point in time, is slow.  It is one way of repeating or re-expressing the slowness of economic growth, albeit with some transforms applied to the vocabulary of variables.

This paragraph touches on both the “causality” and the “usefulness” perspectives I discussed earlier, but in what seems to me to be a somewhat unsatisfactory fashion.  Start with the final two sentences.  He’s saying that by 2012 enough time had gone by so that wages and prices should have adjusted.  That’s an eminently plausible argument.  The final sentence can be thought of as an alternative hypothesis.  Say we are targeting P or M, and output is slowing for Great Stagnation reasons.  In that case NGDP will also slow (or might slow in the M targeting case) and MMs like me might wrongly attribute the slowdown in RGDP to a slowdown in NGDP.  And that’s certainly possible.

When Tyler wrote the post the most recent reported unemployment rate was 8.1%, for August 2012.  Now it’s 5.9%.  I believe the most useful explanation for that sharp fall is that NGDP has been rising faster than nominal wages in the US.  Tyler says central banks were not trying to snuff out the recovery.  But we do know that in 2011 the Fed was trying to speed up the recovery while the ECB was trying to reduce inflation by raising their target interest rate.  And we know that NGDP in 2011-13 grew much more slowly in the eurozone than the US.  And we know that unemployment rose sharply in the eurozone, while it fell sharply in the US.  So while Tyler is right that movements in NGDP need not have any causal effect on RGDP, I believe that it just so happens that we live in a universe where it does have a causal effect, or at least that it is useful to talk in terms of causal effects from NGDP.

This matters when we consider sticky nominal wages.  Sometimes it is suggested that the “inside workers” have frozen up or taken up so much ngdp with their sticky wage demands that the outsiders cannot find the ngdp to fuel their activities.  It’s as if there is not enough ngdp to go around, just as there was not enough clay to make a sufficiently large sculpture.

Yes, workers and firms can behave in a way that overcomes any shortages of NGDP. Indeed Tyler and I agree that in the long run they WILL behave in a way that overcomes any shortage of NGDP. But these metaphors are expressed in a slightly misleading way.  The average reader would have a great deal of trouble figuring out whether Tyler is expressing a new classical argument that nominal shocks don’t matter, and that real GDP is determined by real factors, or a NK/monetarist argument that nominal shocks matter in the short run but not the long run, and that September 2012 is now the long run, or the hybrid theory that nominal shocks might matter in the short run, but not if the short run NGDP changes are caused by real factors such as less aggregate supply.  A close reading of his other posts shows he believes the nominal shocks matter in the short run, but many of the (skeptical) NGDP metaphors employed here are also applicable to the short run.  Do they apply to a case where AS and AD are entangled?

So for instance, suppose a central bank is targeting inflation.  Then suppose an adverse supply shock reduces RGDP by two percent in the short run, even in the best of circumstances (i.e. stable NGDP).  But also suppose that NGDP falls with the supply shock (as Tyler correctly noted might happen.)  My claim is that in that case RGDP would fall by more than 2%, perhaps 4%. What does Tyler believe?  The metaphors he employs seem to suggest that he is skeptical of this claim, but elsewhere he argues that nominal shocks do matter in the short run, so falling NGDP should make the recession worse.

PS.  Two years ago I did a post in response to this same Tyler Cowen post.  I did this post without looking at my earlier post, and ended up with something very different.  Maybe in two more years I’ll do a third.

PPS.  I do agree with Tyler that framing effects are important.  In microeconomics there is one dominant framing method, and hence you don’t see as many cases of microeconomists who are Nobel Prize winners call each other idiots as you do in macro, where different framing effects lead to almost a complete failure of communication.

PPPS.  Election today?  All I care about are the referenda.  Both major parties have sharply declined in quality over the past 20 years.  Both deserve to lose.

Will it matter when the Fed has “traction?”

People have made all sorts of arguments against “monetary offset,” but there’s only one that actually makes much sense.  The argument is that the Fed does not like doing “unconventional policies” like QE, because they feel “uncomfortable” with a large balance sheet.  (Put aside the fact that QE is perfectly conventional monetary policy–open market operations—and that there is no reason at all to feel uncomfortable with a large balance sheet.  The Fed is effectively part of the Federal government.)

Nonetheless, there is a sort of plausibility to the theory; Fed officials will occasionally say they would cut interest rates further if they could.  But what is the implication of this theory?  It seems to me that this theory implies that Fed policy should become much more aggressive when the Fed is no longer hamstrung by the zero bound.  When they can stimulate without adding to the balance sheet.  But this raises an interesting paradox—the Fed is conventionally viewed as being “stimulative” when they cut rates.  Thus the Fed should want to cut rates as soon as they can do so, which means right after they raise them!

Of course I’m half-kidding.  More realistically the implication is that once the Fed stops doing the “uncomfortable” QE, there will be a long period of zero rates before they raise them.  And perhaps there will be, but right now the Fed suggests it will be raising interest rates in less than a year.

Here’s a graph from a Marcus Nunes post:

Screen Shot 2014-10-30 at 6.15.21 PMNGDP had been rising at about 5% per year in the 17 years before the recession, and it’s been rising about 4% per year in the “recovery.”  Because wages and prices are flexible in the long run, the real economy has been recovering despite the lack of any demand stimulus.  We have fallen from 10% to 5.9% unemployment.  But most people think the economy is still in the doldrums, and needs more stimulus.  President Obama just instructed the Department of Labor to increase unemployment compensation benefits (without any authorization from Congress of course–why do you think would Congress be involved in spending decisions?) This was done because unemployment is at emergency levels, requiring extra-legal remedies.

Fortunately the Fed is no longer doing the “uncomfortable” QE policy, which adds to the balance sheet.  So if you believe the fiscal policy advocates, the Fed should be raring to go with stimulus. How do they do that?  By promising to hold rates near zero for a really long time, or until the labor market is really strong.  But instead, they are suggesting that they will probably raise interest rates soon.  There will be no attempt to get back to the old trend line; the new one seems just fine.

Let’s consider an analogy.  A bicycle rider has a “policy” of maintaining a steady speed of 15 miles per hour.  Then he hits a long patch of ice, and slows to 10 miles per hour, perhaps due to a lack of traction, perhaps because he decided to go slower.  How can we tell the reason?  How about this, let’s put a strong headwind in his face, and see if the speed slows even more.  But now he petals harder and keeps maintaining the 10 miles per hour speed.  That suggests it’s not a lack of traction. But the pessimists insist it must be a lack of traction, why else would he have slowed right when he hit the ice?  Then the bicycle final comes to the end of the ice.  The lack of traction proponents expect him to suddenly speed up, exhilarated by the sudden traction of rubber on asphalt.  Oddly, however, the bike keeps plodding along at 10 miles an hour.  Nothing seems to have changed even though the ice patch is long past.

[In case it's not clear, the headwinds were the 2013 austerity, and the end of the asphalt was the end of the liquidity trap.]

Here’s my claim.  The Fed promise to raise rates soon is not the sort of statement you’d expect from a central bank that for the past 5 years had been frustrated by an inability to cut rates.  (Nor is their other behavior consistent—such as the on and off QE.)  Rather it’s the behavior of a central bank that has resigned itself to pedaling along at a slower speed.  Ten miles per hour is the new normal.

I don’t want to sound dogmatic here.  Obviously monetary offset is not “true” in the sense that Newton’s laws of mechanics are true; the concept only applies in certain times and places.  Oh wait, that’s true of Newton’s laws too .  .  .

Opponents of monetary offset face two big problems.  In theory, the central bank should target some sort of nominal aggregate, and offset changes in demand shocks caused by fiscal stimulus. And in practice it seems like they do, as we saw in 2013, even at the zero bound.  So if monetary offset is not precisely true, surely it should be the default baseline assumption.  Instead, as far as I can tell 90% of economists have never even considered the idea.

PS. Totally off topic, I love this sentence from an article on why a million dollars no longer makes you rich:

Although it sounds like a lot of cash, $1 million of today’s money is only worth $42,011.33 of 1914 dollars, which is less than today’s median household income.

Someone should collect all these amusing claims in the media.  They could have added that today’s median income of $42,011 is only equal to $1764 in 1914 dollars, roughly equal to the per capita GDP (PPP) of Haiti.  I guess I was wrong, the American middle class really is struggling.

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.