Archive for the Category Monetary Theory


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.

Lucas and Fama

Over at Econlog I have a new post discussing the legacy of my favorite economist—Milton Friedman.  Here I’d like to discuss how my view of macro has been shaped by Robert Lucas and Eugene Fama, two other famous Chicago economists.  In some ways these are odd choices. I focus on demand-side models of the business circle, and Fama seems to think AD doesn’t matter.  And I never even took a class from Fama. I did take several classes from Lucas, and he was my PhD advisor.  But I never really bought into his “microfoundations” approach to macro.  My “musical chairs” model of unemployment is about as far from Lucas as you can get.  He’d be horrified.  But great ideas can show up in all sorts of surprising and unexpected places.  And even though I think that Lucas and Fama overestimate the flexibility of labor markets, I believe they are right on the mark in some other important areas.  Here’s what I learned from Lucas:

1.  The long run is now:  I used to have a lazy belief that the term “in the long run” meant something like “in the future,” and short run meant the present, or very near future.  Lucas taught me that the long run is (also) right now.  The term ‘long run’ refers to situations where factor X effects factor Y with a long delay.  It has nothing to do with present and future.  And yet I often hear even professional economists talk as if the term “in the long run” meant in the future.

Here’s one example.  The short run effect of monetary policy is called the liquidity effect.  A change in the money supply causes interest rates to move in the opposite direction, in the short run.  The long run effects of monetary policy are called the income effect, the price level effect and the expected inflation (Fisher) effect.  These three effects all cause interest rates to move in the same direction as the money supply.   If you erroneously thought that “short run” meant “now” you would interpret any current change in interest rates through the lens of the liquidity effect.  That is, you’d assume falling interest rates reflect an easier monetary policy, and vice versa.  Lucas taught me that what’s going on right now is equally likely to be the long run effect of policies that happened earlier.  Thus falling interest rates might just as well be the long run effect of an earlier tight money policy.  How can you tell which is which?  Ben Bernanke says you look at NGDP growth and inflation.  And what happened to those two indicators in 2008-09?

2.  Think regimes, not discretionary policy choices:  It’s tempting to debate monetary policy without reference to a policy regime. People debate “what should the Fed do now,” as if the question makes sense in the absence of a clear policy framework.  Now in fairness there are some policies that are so obviously bad, under such a wide range of plausible policy regimes, that it’s tempting to just come out and say “money is too tight” (i.e. 1931) or “money is too easy (i.e. 1979).  But in most cases the discussion pits one plausible policy against another, with no agreed upon destination.  Unfortunately people play lip service to the need for clear policy rules, but in practice they don’t buy into this approach because they don’t trust policymakers to have the right policy rule.  Thus the Fed minutes show a confusing debate over how best to get to the right destination, among policymakers who don’t even agree on the correct destination.

And people may have good reason for not trusting the policymakers to adopt the correct rule, look at the BOJ in the 1993-2012 period, and the ECB in recent years, both clearly aiming at the wrong policy target.

3.  Rational expectations:  It makes no sense to have a model of the economy that assumes X, but which is filled with people who believe “not X.”  As Bennett McCallum pointed out this idea is better called “consistent expectations,” as the term “rational” has all sorts of connotations that have nothing to do with the public’s expectations being consistent with the model of the public’s behavior.  Rational expectations also underlies the “Lucas Critique,” the idea that a statistical relationship that is true under one policy regime, may not hold up if the policy regime is altered to take advantage of that statistical relationship.

4.  The “voluntarily unemployed” might still be miserable:  If someone loses a job as an accountant and turns down an open position at McDonalds, they might be considered “voluntarily unemployed.”  That makes me agree with Lucas that the term is pretty much useless.  I’d add that I don’t find either side of the “deserving/undeserving poor” debate to be making useful arguments, for similar reasons. I focus on how policy affects outcomes, and leave to God the question of who is or isn’t deserving of more out of life.

Fama is famous for the efficient market hypothesis, which underlies several important pieces of market monetarism, or at least my peculiar version of MM:

1.  No wait and see:  When a new policy initiative aimed at boosting AD is announced, it makes no sense to “wait and see” if it will work. The market reaction immediately tells us the expected impact of the policy, and anything different that occurs will reflect unexpected shocks that violate the “ceteris paribus” assumption.  If the Fed was expected to cut rates by either a 1/4% or 1/2%, and the fed funds futures market assigns probabilities to each outcome, then the actual response of TIPS spreads and stock prices to the policy announcement tells us almost all we will ever learn about the policy.  If we had a NGDP futures market we could even do better, but the markets we do have give us a pretty good idea of the impact of unexpected policy announcements.

2.  Target the futures price of the policy goal:  It’s silly to have intermediate targets such as the fed funds rate, or the exchange rate. Simply adjust the monetary base as necessary to keep the futures price of the policy goal variable on target.  But of course first you need to create a futures market for the policy goal variable (preferably NGDP.)

3.  Bubbles?  No such thing:  Or more precisely the bubble theory is completely vacuous–it doesn’t help us to better understand the world around us.  When house prices soared in the early 2000s in Canada, the US, Australia, New Zealand and Britain, people cried bubble. That did not help me to understand why in Australia they later soared even higher, in the US they plunged lower, and in the other three they mostly moved sideways.  When Bitcoin soared from $1 to $30, people cried bubble.  That told me nothing useful about why prices later rose to $1000 and then fell to $600.  When Robert Shiller said stocks were a bubble in 1996, it told me nothing useful about the future path of stock prices.  And I could go on and on.

4.  Ignore the financial system:  I know what you are thinking.  ”Wait a minute—surely Fama never said to ignore the financial system, that’s what he spent his whole life studying.”  But he did understand that money (MOA) and credit are completely different entities.  He suggested that the Fed could stabilize the price level (and by implication NGDP) simply by controlling the currency stock.  In a sense he was talking about control of the monetary base, but in those days the base was almost entirely currency and required reserves, and he thought reserve requirements were a silly regulatory policy that could be dispensed with.  So control of the stock of currency was all you need in order to control the value of currency.  And since the value of currency is (by definition) the inverse of the price level, that’s all you needed to control the price level, or any other nominal aggregate.  Monetary theory without banking and finance—the 2008 financial crisis shows us how important it is to divorce these concepts.  Economists who see them as being linked got 2008 all wrong.  They thought the real problem was banking distress, when in fact the real problem was nominal (GDP.)

MMTers should not read Fama’s currency paper; it would give them a heart attack.

Banking theory disguised as monetary theory?

[I wrote this yesterday but held off--as I often do for "spacing" reasons.  In the interim Nick Rowe did a post on the same paper.  I recommend you read his reaction if you only have time for one.  It's much better.]

The Bank of England was kind enough to send me a new report explaining monetary policy.  Unfortunately I think the report is way off target. On the other hand if they knew anything about my blog they would have known that would be my reaction.  Let’s start here:

This article has discussed how money is created in the modern economy. Most of the money in circulation is created, not by the printing presses of the Bank of England, but by the commercial banks themselves: banks create money whenever they lend to someone in the economy or buy an asset from consumers. And in contrast to descriptions found in some textbooks, the Bank of England does not directly control the quantity of either base or broad money. The Bank of England is nevertheless still able to influence the amount of money in the economy. It does so in normal times by setting monetary policy — through the interest rate that it pays on reserves held by commercial banks with the Bank of England. More recently, though, with Bank Rate constrained by the effective lower bound, the Bank of England’s asset purchase programme has sought to raise the quantity of broad money in circulation.

I hate the term ‘modern.’  The money directly produced or “printed” by the central bank is called base money. I don’t know about Britain, but in America the share of total money that is base money is actually higher than 100 years ago.  So there is nothing “modern” about our current system.  And the BoE does directly control the amount of base money, at least in the sense of “directly control” that the BoE uses when they describe direct control of short term interest rates.  Yes, if you set an interest rate target then the base becomes endogenous. But it’s equally true that if you set an inflation target then interest rates become endogenous.  However changes in the supply and demand for base money remain the lever of monetary policy.  And notice the BoE implies that once they stopped targeting interest rates they were no longer even doing monetary policy (or perhaps it’s just misleading language.) The BoE controls the base in such a way as to target interest rates in such a way as target total spending in such as way as to produce 2% inflation.  And yet in that long chain interest rates are singled out as “monetary policy.”

Reserves are an IOU from the central bank to commercial banks. Those banks can use them to make payments to each other, but they cannot ‘lend’ them on to consumers in the economy, who do not hold reserves accounts.

Lots of people use the term ‘reserves’ when they would be better off using the term ‘monetary base.’  Back in 2007 the part of the US monetary base that was “coins” was larger than “bank reserves.”  So it would have been more accurate to talk about central banks injecting coins into the system.  And prior to 2008 new base money mostly flowed out into currency in circulation within a few days, even if the first stop was the banking system.  Banks were not important for monetary policy, although of course they were a key part of the financial system.

I recall that Paul Krugman was once criticized for saying banks can “lend out” reserves.  I generally don’t say things like that because I ignore banks.  But there was nothing wrong with Krugman’s claim.  Yes, it’s true that when money is lent out and the borrower withdraws the loan as cash, the borrower does not literally “hold reserves.”  So the BoE is technically correct. But that’s a meaningless distinction, as it’s all base money, and reserves are just the name given to base money when held by banks, and cash is the name given to base money held by non-banks.

One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses.

In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.

I recall that once when Krugman was faced with this sort of argument he said something to the effect of “it’s a simultaneous system.” Banking is an industry that provides intermediation services.  Banks have balance sheets with assets and liabilities. It makes no sense to say that one side of the balance sheet causes the other.  If people want to borrow more, then bank interest rates on loans and deposits adjust in such a way as to provide a new equilibrium, probably with a larger balance sheet.  But that’s equally true of the situation where people want to hold larger amounts of bank deposits.  It’s completely symmetrical. Consider the real estate broker industry.  Does more people buying houses cause more people selling houses, or vice versa?

Another common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money — the so-called ‘money multiplier’ approach. In that view, central banks implement monetary policy by choosing a quantity of reserves. And, because there is assumed to be a constant ratio of broad money to base money, these reserves are then ‘multiplied up’ to a much greater change in bank loans and deposits. For the theory to hold, the amount of reserves must be a binding constraint on lending, and the central bank must directly determine the amount of reserves.  While the money multiplier theory can be a useful way of introducing money and banking in economic textbooks, it is not an accurate description of how money is created in reality. Rather than controlling the quantity of reserves, central banks today typically implement monetary policy by setting the price of reserves — that is, interest rates.

In reality, neither are reserves a binding constraint on lending, nor does the central bank fix the amount of reserves that are available. As with the relationship between deposits and loans, the relationship between reserves and loans typically operates in the reverse way to that described in some economics textbooks. Banks first decide how much to lend depending on the profitable lending opportunities available to them — which will, crucially, depend on the interest rate set by the Bank of England.

I’m not a fan of the money multiplier model, but it’s sometimes unfairly maligned. Textbooks don’t treat it as a constant, any more than they treat velocity or the fiscal multiplier as constants.  They may do an example where it is constant, but then they discuss reasons why it changes.

The real problem here is “binding constraint.”  In economics there are almost never binding constraints on anything.  If you at a binding constraint position then odds are you are not optimizing.  A reduction in the supply of apples will generally raise apple prices even if not at the binding constraint where one less apple would cause starvation.  By (permanently) adjusting the supply of “reserves” (again base money is what they actually mean) the central bank can affect the value of the medium of account (base money), and hence all nominal variables in the economy.  That includes the nominal size of the toilet paper industry, the nominal size of the steel industry, and the nominal size of bank balance sheets. Most importantly NGDP. If wages and prices are sticky they can also affect real GDP in the short to medium run.

Not sure why the Bank of England is so interested in the nominal size of the bank balance sheets, and not other industries.  Surely there are other nominal industry outputs that better correlate with the goals of monetary policy (NGDP) than the banking industry!  Why not focus on those industries?

The deeper problem here is the BoE mixes up microeconomics (the relative size of the banking industry) with macroeconomics (the determination of nominal aggregates), in a very confusing way.  You need to model the medium of account to have any sort of coherent explanation of monetary policy.  The interest rate approach combined with a banking sector and a “slack/overheating” model of inflation just won’t cut it.  Certainly the BoE report is not as bad as some of the things you see from MMTers, it nods to the old-style monetarists in its discussion the problems that might arise from of excessive growth of the aggregates.  But it nonetheless fails to come up with a model of the price level or NGDP. It can’t tell us why Britain has 20% inflation one year, and 2% another.  You need to explicitly model the supply and demand for base money to do macroeconomics.

PS.  And why doesn’t the BoE subsidize and run a NGDP prediction market?

PPS.  Perhaps my report was too negative. I suppose it’s a fine explanation of monetary policy if you go for the interest rate approach to monetary economics, it’s just that I hate that approach.