Archive for the Category Monetary Theory


In economics, price changes don’t have any effect, they are effects

I don’t know how many times I have to keep saying this before the rest of the profession figures it out.  Never reason from a price change.  [Update:  I mean an equilibrium price change.] It makes no sense to argue whether a higher price will increase or decrease quantity.  Here is a S&D diagram.  I dare you to show me how price changes affect quantity.

Screen Shot 2014-11-11 at 10.56.48 AM

And here is an IS-LM diagram.  Interest rates are the price of credit.  Changes in interest rates do not have any effect on quantity of output, price of output, or any other variable.  It’s not even an “other things equal” deal; price changes have no effect.

Screen Shot 2014-11-11 at 10.57.43 AM

At this point some economists will say; “I meant an interest rate change caused by a change in monetary policy.”  The problem is that higher interest rates can be produced by both easier and tighter monetary policy.  And easier and tighter monetary policy have opposite effects on prices and output.  So I’m sorry, but it’s still a meaningless debate.  It’s not that there is a right or wrong answer; there is no coherent question.  Monetary policy can shift the LM curve, the IS curve, or both.

Consider this analogy:  A debate over whether high oil prices increase or decrease global oil consumption.  The debate is meaningless.  Price has no effect.  Here’s how the issue should be discussed:

A.  An Arab oil embargo caused higher prices and lower consumption in 1974.

B.  Booming Chinese auto sales caused higher oil prices and higher consumption in 2007.

Prices are not a cause of anything; they are an effect.  And interest rates are a price.  So please stop these silly posts discussing the impact of a change in interest rates.  Talk about the effect of expansionary and contractionary monetary policies—that’s an interesting question.

This criticism applies to both sides of the debate.  John Cochrane and Noah Smith should not be discussing the possibility that higher rates lead to higher inflation, and Paul Krugman should not be claiming that the standard model suggests that higher rates lead to lower inflation.  Actually, both claims are true in specific situations.  But without specifying the specific situations in which each claim is true (especially the path of the money supply and IOR) the claims becomes utterly meaningless.

Truly a debate about NOTHING.

PS.  If you are still having trouble with this, consider the following.  A 1/4% rise in the fed funds rate today can be accompanied by a near infinite number of simultaneous expected changes in the future expected path of variables like the fed funds target, the monetary base, the interest rate on reserves, the reserve requirement, and all sorts of other policy levers.  Those variables in turn have a near infinite number of effects on all sorts on market variables other than short term interest rates, including TIPS spreads, commodity prices, forex prices, future expected real estate prices, stock prices, corporate bond risk spreads, etc., etc.  And all that happens immediately.

Here’s another example.  Assume Japan has run zero percent inflation for 20 years while the US has a credible 2% inflation target.  Zero inflation is expected to continue in Japan.  Suddenly they depreciate the yen 17% and set up a rigid currency board with the US.  PPP tends to hold in the very long run; so long term Japanese inflation expectations immediately rise from 0% to 2%. Interest parity holds even in the short run, so Japanese interest rates immediately rise to US levels. That’s a case where Cochrane is right, and it’s 100% consistent with IS-LM.  In contrast, in January 2001 the Fed cuts rates more than expected, and TIPS spreads rise sharply on the news.  That’s a case where Krugman was correct, and it’s 100% consistent with IS-LM.

The correct answer is “it depends.”

PPS.  Question for Nick Rowe.  Does my yen/dollar peg solve the coordination problem you discuss in this post?

HT:  TravisV.

John Cochrane on the stability of interest rate pegging

Here’s John Cochrane replying to a post by Nick Rowe:

The last 5 years have brought us a delicious opportunity for measurement. Once we hit the zero bound, interest rates can’t move any more. So the whole problem of empirically verifying long run dynamics is a lot easier.

What happened when the Fed kept interest rates at zero for 5 years? Pretty much nothing! OK, you see inflation going up and down, but look at the left hand scale — one percentage point. Given the colossal scale of other events in the economy, that’s nothing. Japan has been at it even longer, with similar results.

We seem to have in front of us a pretty clear measurement that long run dynamics are stable.

“Nothing” is astounding. This dog that did not bark has demolished a lot of macroeconomic beliefs:

  • MV = PY. Sorry, we loved you. But when reserves go from $50 billion to $3 trillion and nothing at all happens to inflation — or at most we’re arguing about percentage points — it has to go out the window.

  • Keynesian deflationary spirals. Just as much as monetarists worried about hyperinflation, Keyensians’ forecast of a deflationary spiral just didn’t happen.

I can certainly understand why Cochrane would make this argument.  It seems to make a lot of sense.  But that’s only because the standard model is infected by Keynesianism, which leaves it vulnerable to attack. Here’s one reply:

Yes, the Taylor Principle stabilizes prices during normal times, when interest rates are positive. And yes a rigid and positive interest rate peg is supposed to lead to highly unstable dynamics.  But that’s because if you target interest rates at a positive level and if there is no interest on reserves, then you lose control over the monetary base, which flies off to zero or infinity.  In contrast, at the zero bound you regain control over the base.  Thus once the Fed and BOJ lost the ability to adjust interest rates, they started using QE to prevent deflation.  (Of course with IOR you hit the “liquidity trap” that much sooner, but regain control of the base that much sooner.)

That’s the sort of reply I’d expect from Nick Rowe.  But then I’d also expect Nick to go further, and point out that this just shows how dangerous it is to describe the stance of monetary policy by using interest rates.  Here’s what actually makes the Taylor Principle work:

1.  When inflation is above target you need to reduce the growth rate of the money supply (relative to the growth rate of money demand) enough to bring inflation back down to the target.  It just so happens that the sort of policy that would reduce the money supply growth by an adequate amount is also one that will result in nominal interest rates rising in the short run (due to the liquidity effect) by roughly 150% of the rise in inflation.  But that rise in interest rates is not why inflation falls back to the target path (it’s an epiphenomenon), it falls back because you’ve reduced the growth rate of the money supply relative to demand.  Inflation falls back for monetarist reasons, not Keynesian reasons.

2.  Now suppose you are at the zero bound.  The Keynesian model requires something radically different, whereas the monetarist model just keeps plugging along with the same old method—adjusting the money supply relative to changes in money demand.  No ad hoc additions are needed for the monetarist model, unlike the Keynesian model.

But what about Cochrane’s criticism of the M*V=P*Y model?  What about his observation that reserves have soared while prices have hardly budged?  Unfortunately, there is no such model.  No one has ever proposed an M*V=P*Y model.  No one has ever claimed that inflation is proportional to reserves.  The most distinguished monetarist of all time was Milton Friedman, who famously argued that reserves are not a good indicator, and that money was tight during the 1930-33 deflation despite the huge rise in bank reserves due to Herbert Hoover’s QE.  There’s nothing new under the sun.  Nothing to be explained here; just move right along.

Sophisticated quantity theorists have always understood that the demand for bank reserves can be very large at zero nominal rates, especially when interest is paid on reserves (but even if it is not.) At the zero bound expectations (which are always about 98% of monetary policy) become 99.5% of monetary policy.  So I guess I was exaggerating a bit; the zero bound really is slightly different, but only quantitatively, not qualitatively.

An interest rate peg can lead to hyperinflation or hyper-deflation precisely because it can lead to upward or downward spirals in the monetary base.  That spiral does not generally occur at the zero bound, and hence there is no “stability” mystery to explain.  Unless you are a Keynesian.

I don’t want to sound too negative here–for some reason I had never really thought about that flaw in the standard Keynesian model until I had to think about how to respond to Cochrane’s post. That’s what makes the blogosphere so great.


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.