Archive for the Category Monetary Theory


Aggregate demand and regional demand shocks

Here’s Jordan Weissmann:

The blue line traces the consumer-spending trend in states where home prices fell the least, while the red line traces it in states where they fell the most. Each group contains about 20 percent of the U.S. population. And as you can see, the crash states are still well behind.  .  .  .

Sufi and Mian have made the academic case that spending before the recession really was driven by the “wealth effect” of rising home prices. People saw their housing values rocket up, and felt richer. Often, they took out second mortgages to spend. When the market crashed, so too did their finances. It may sound like an intuitive point to some, but it’s a key part of understanding why the recovery has been so underwhelming. The difference between states that got the full brunt of the housing collapse and states that didn’t, as shown in this chart, suggests that its scars are still very much with us. And they probably will be for a long while.  (emphasis added)

It’s important to distinguish between regional shocks and aggregate shocks.  All parts of the US use the same type of money, and hence all are affected by the same monetary shocks.  On the other hand the relative performance of various regions is dependent on all sorts of real variables. The factors that cause some regions to do worse than other regions play absolutely no role in the slow growth in aggregate demand since 2008, which is 100% a monetary policy failure.

The following analogy might be helpful.  Imagine a lake where the water level is controlled by the operators of a dam.  Also assume that the surface of the lake is very choppy, due to high winds.  The factors that explain the peaks and troughs of each wave have nothing to do with the factors that explain the average level of water in the lake.  In the same way, Federal Reserve policy determines the rate at which NGDP rises in the typical state, whereas local real factors explain why NGDP grows faster in some states than others.

The real problem with the money multiplier

David Glasner argues the money multiplier is a useless concept.  I’m sympathetic to that claim, and yet I think he goes to far in his criticism of Friedman and other monetarists.  Although the concept is useless, it’s not wrong, and it’s hard to see how it does much damage.  Here’s David:

So in Nick’s world, the money multiplier is just the reciprocal of the market share. In other words, the money multiplier simply reflects the relative quantities demanded of different monies. That’s not the money multiplier that I was taught in econ 2, and that’s not the money multiplier propounded by Monetarists for the past century. The point of the money multiplier is to take the equation of exchange, MV=PQ, underlying the quantity theory of money in which M stands for some measure of the aggregate quantity of money that supposedly determines what P is. The Monetarists then say that the monetary authority controls P because it controls M. True, since the rise of modern banking, most of the money actually used is not produced by the monetary authority, but by private banks, but the money multiplier allows all the privately produced money to be attributed to the monetary authority, the broad money supply being mechanically related to the monetary base so that M = kB, where M is the M in the equation of exchange and B is the monetary base. Since the monetary authority unquestionably controls B, it therefore controls M and therefore controls P.

If I understand David correctly he’s a bit confused about the money multiplier.  It is simply a ratio, regardless of what David was taught in school. In his example the multiplier equals k, which is the ratio M/B.  But unless I misread him, he seems to believe multiplier proponents viewed it as a constant, which is clearly not true. Rather they argued the multiplier depends on the behavior of banks and the public, and varies with changes in nominal interest rates, banking instability, etc.  This is how it’s taught in the number one money textbook, and this is the version Friedman and Schwartz used in the Monetary History, which focuses heavily on explaining changes in the multiplier.

And yet I agree with David that the multiplier is useless, mostly for “Occam’s razor” reasons.  Think about the Equation of Exchange:

M*V = P*Y

If you want to model nominal GDP, and M represents M1, then you have to model both M1 and M1 velocity.  In that case:

M = k*B

So now the equation of exchange is:

B*k*V = P*Y

But in that case why not skip the middleman, and go right for:

B*(base velocity) = P*Y

After all, both k and V are positively related to the nominal interest rate.  You have one thing to model (base velocity), not two (the multiplier and M1 velocity).

In any case, it’s silly to focus on either B or M; focus on the goal/indicator of policy, NGDP.  The multiplier doesn’t help you do that, and hence is useless.  But if people want to use it, they aren’t making any sort of logical error as long as they understand how it changes in response to changes in interest rates and other variables, and the monetarists were able to do that.  The Monetary History is a masterpiece of multiplier analysis.

When people say “there is no such thing as a money multiplier,” they are literally saying there is either no such thing as B, or no such thing as M. Obviously they don’t mean that.  Rather they are trying to say “the multiplier is not fixed, as the monetarists and textbooks believe.” Except the monetarists and textbooks didn’t claim it was fixed.

Here’s Stephen Williamson:

The money multiplier is probably the most misleading story that persists in undergraduate money and banking and macroeconomics texts. Take someone schooled in the money multiplier mechanism, and confront them with a monetary system – such as what exists in Canada, the UK, or New Zealand – where there are no reserve requirements, and they won’t be able to figure out what is going on. Confront them with a system with a large quantity of excess reserves (the U.S. currently), and they will really be stumped.

Interesting.  I wonder if Friedman was “schooled in the multiplier mechanism”?  David Glasner says he was. And yet Friedman obviously would not be perplexed by either a lack of reserve requirements or massive quantities of excess reserves.  In fairness to Williamson, most undergrads would be perplexed, but then they are perplexed by lots of things.  I don’t think my students would be perplexed.

The definition of money doesn’t matter (and there are no “wrong” definitions)

In the comment section of a recent post lots of people objected to my definition of money, which is the “monetary base.”  Most did not seem to recall that Larry Summers once made the same argument (that falling interest rates are deflationary), in a paper explaining the Gibson paradox. And he used gold as the medium of account.  BTW, the fact that low interest rates being associated with low prices was considered a “paradox” shows that “reasoning from a price change” was a widespread problem until Larry solved the puzzle.  (credit also to his coauthor Robert Barsky (who probably did most of the work), and a slightly earlier paper by Chi-Wen Jevons Lee and Christopher Petruzzi.)

Of course we all know that monetary economics has regressed in the last 5 years, and based on recent comments I’ve received the Gibson paradox relationship is once again viewed as a “paradox,” not the natural implication (during periods where the supply of money was relatively stable) of the downward sloping demand for money as a function of nominal interest rates.

Another objection was that my monetary base definition of money is weird, and in some sense “wrong.”  If only I understood that demand deposits could also be used as money, I’d see how false my claims really are.  OK, just for today I’ll give you all your definition.  For today M2 is money, and the monetary base is called “SumNerdyProfessor’sObsession.”  Let’s shorten that to the base = SNPO. Now I want you to re-read all the posts I’ve written since February 2009, and replace “money” with “SNPO,” everywhere you see the term ‘money.’  Or at least pretend to.  OK, now all my posts are rewritten. Has anything changed?

Nope, all my arguments are equally valid for changes in the supply and demand for SNPO.

I’m begging everyone—no more complaints that I have the wrong definition for money.  A rose by any other name . . .

PS.  No one seems to research the demand for money anymore, but when I was young it was the most researched topic in all of economics.  There are 100s, maybe 1000s of old empirical studies that support my claim that falling interest rates are deflationary, holding the level of base money SNPO fixed.

Suppose the Fed always aims for 2% inflation

Tim Duy has a good post explaining why the Fed is unlikely to opt for “overshooting.”

I was re-reading some of the recent overshooting debate and it occurred to me that it is comical that we are even having this discussion.  The Fed is not going to deliberately overshoot inflation, period. That train left the station long ago. So long ago that you can’t even here the rumble on the tracks.

The train left the station on January 25, 2012, with this statement by the Federal Reserve:

The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.

On that day, the Federal Reserve locked in the definition of price stability.  They locked it in specifically to prevent even the appearance they might deliberately overshoot as a result of extraordinary monetary policy.  They locked it in as a commitment device to tie the hands of future policymakers as they would need to justify changing the definition of price stability, presumably a very high bar for any central banker to cross.

That’s probably correct.  But it does point to some confusion at the Fed.  The Fed seems pretty committed to their dual mandate, but doesn’t seem to understand what it implies.  Let’s start with a simple policy rule.  Suppose the Fed never aimed for above target inflation.  Also suppose they aim for 2% inflation, on average.  In that case it would be a logical necessity for the Fed to never aim for below 2% inflation.  Which means that they would always have to aim for exactly 2% inflation going forward.

Now that is a defensible policy (although I would oppose it.)  But it certainly is not a policy consistent with a dual mandate.  It would be a single mandate inflation target (IT), pure and simple.  Fed officials often seem confused on that point. They talk about the need to aim for 2% inflation, even when unemployment is high.  But that means they are behaving exactly as they would behave if Congress had given them an IT single mandate.  In other words, they are behaving exactly as they would if their mandate was set by the right wing of the Republican Party. Even now, under Janet Yellen, the tapering and prospective interest rate hikes are aimed at boosting inflation back up to 2%.  The policy is exactly the same as it would be if the Fed did not care about unemployment at all.

I suppose 99% of people would look at this picture and see all sorts of grand conspiracies.  The Fed is in the back pocket of the bankers, the bondholders, the creditors, the coupon clippers.  But I’m different, I’m a hopelessly naive fool who actually thinks the Fed is trying to do a good job, but just lost its way.  And why do I believe the Fed is actually not corrupt, despite all the evidence pointing to their violation of the dual mandate over the past 5 years?  Two reasons:

1.  The top Fed officials tend to be economists.  Both actual voters like Bernanke and Yellen, and also the all important staff people who set the agenda.

2.  As far as I can tell the vast majority (not all) of economists who are not at the Fed, who have no financial interest at all in helping bankers, even economists who favor increased welfare spending, a higher minimum wage, help for the unemployed, and all sorts of other left wing causes, seem equally confused about monetary policy as the economists who are at the Fed.

So one possibility is that clueless economists join the Fed, and instantly become both highly intelligent and corrupt at the same moment.  That’s what the critics who call me naive seem to think.  However I think it much more likely that when they join the Fed their competence and honesty don’t change very much. They are trying their best, and making the same mistakes as their private sector counterparts make when asked about monetary policy.  They think it’s “natural” that we have deflation in a deep slump like 2009, whereas their mandate actually implies that inflation should be countercyclical; above target when unemployment is high, and vice versa.

If this interpretation seems naive, then I plead guilty.

PS. Tim Duy has another good post on this subject:

If the most dovish member of the FOMC can tolerate no more than a 25bp upside miss on inflation, what does it say about the other FOMC members?  Regardless of whether this is Kocherlakota’s max or the best he thinks he can get, it tells you that 2% is really a ceiling, not a target.  Now, generously, it maybe that the FOMC believes that they cannot exceed 2% politically given the amount of extraordinary stimulus already in place.  But that still leaves 2% as a ceiling.

PPS.  I do realize there are lots of other interpretations (none good.)  For instance, the bubbleheads may have gained influence, and the worry about bubbles may be roughly offsetting worry about unemployment, leaving us with a 2% inflation target (which we will likely fall short of.)

HT:  Travis V

Low interest rates are deflationary (holding the base constant)

I was teaching the money multiplier the other day, and showing how lower interest rates tend to reduce the multiplier, and hence M1.  A student asked for clarification—they’d been told that lower interest rates were expansionary.  I knew how I was going to answer the question, but I sort of wondered how other (less heterodox) money and banking professors would respond to the question.  (Let me know in the comments.)  In any case here’s my answer.  First let’s see why low rates are contractionary:

Screen Shot 2014-03-20 at 9.37.58 AM

A fall in interest rates will increase the demand for base money (here I assume no IOR, or at least a fixed IOR.)  As money demand increases the value (or purchasing power) of a dollar bill increases. Here I use the standard 1/price level as the value of money, although I actually prefer 1/NGDP.

So that’s the answer.  But of course that’s not a sufficient answer for a student; you also need to explain to students why they had the false belief that low interest rates are expansionary.  So I draw another graph, this time showing the case where lower interest rates are caused by a fall rise in the monetary base.Screen Shot 2014-03-20 at 9.38.09 AM

In this case the supply curve moves first.  In the very short run we assume prices are sticky, so the interest rate must fall to equilibrate Ms and Md. In the long run expectations of higher future NGDP cause an increase in current AD. When all wages and prices have fully adjusted to the increased money supply, interest rates return to their original level, and the demand for money shifts back.  The value of money falls to point C, which means prices have risen.  So the myth that low interest rates are expansionary comes from the fact that in some cases low interest rates are caused by an increase in the base.  In that case the base is the expansionary impulse, and the accompanying fall in interest rates actually delays the inflationary impact of the higher money supply (point b).

What would be an example of the first case?  That’s easy.  Between August 2007 and May 2008 there was no change in the monetary base, and yet interest rates fell sharply.  Not surprisingly NGDP growth slowed and we tipped into recession.

Nick Rowe has a new post that argues the money supply is fully exogenous, even when the central bank is targeting interest rates.  I’m not sure I fully understand the post, but I’ll attempt to translate his argument into Ms/Md graphs, and then see if he corrects me.

Most students are used to a Ms/Md graph with interest rates on the vertical axis, not 1/P.  Suppose there was an increase in the demand for credit, Md shifted to the right on the interest rate graph, and the Fed had to raise the quantity of money (“money supply”) enough to keep interest rates from rising.  That’s what most people think of as “endogenous money.”  Here’s Nick:

P and Y will (eventually) adjust until the quantity of money demanded equals the quantity of money created by the supply (function) for money and the demand for loans. The supply (function) of money, and the demand for loans, together determine the quantity of money created, and that quantity created (eventually) determines the quantity of money demanded.

I believe Nick is saying that if the central bank increases the quantity of money to accommodate the loan demand (and hence keep interest rates from rising) that will boost AD, which will raise P and Y.  If you use my graph above, he seems to be saying that just because Md shifts right on an interest rate graph, doesn’t mean it shifts right on a Ms/Md graph with 1/P (or 1/NGDP) on the vertical axis. Instead on that graph only the Ms line shifts right, causing you to slide down to the right on the stable Md curve (point C on my graph.)  That’s what he means by more quantity of money demanded.

In other words, interest rate targeting creates a money supply function that causes quantity of money changes that are exogenous on a “1/P” graph, and hence the normal monetarist assumptions about money still hold.  I think that’s a good way to think about the whole “endogenous money” issue (which has spawned more nonsense than almost another other topic in economics.)

PS. I’m never too sure what the MMTers are trying to say, but in comments to my blog they seem to claim that if for some weird reason the Fed were to do an exogenous increase in M, interest rates would fall, we’d go to point b, and just stay there.