Archive for the Category Monetary Theory


Channels to nowhere

When there is a big crop of apples, the value of apples tends to fall.  There is no need to discuss obscure “channels” such as bank lending.  Apples are worth less for “supply and demand” reasons. When there is a big crop of money, the value of money tends to fall.  Again, no need to talk about “channels.”  This post was motivated by a recent comment, which is something I see pretty often:

The CB [central bank] interacts with counterparties that have little or no propensity to spend and the lending channel is blocked.

That’s a fairly common view, and yet it contains no less than three serious fallacies.  This is what the commenter overlooked:

1.  Counterparties don’t matter.  The Fed buys assets from counterparty X, who almost always immediately cashes the check and the new base money disperses through the economy almost precisely as it would if the Fed had bought assets from counterparty Y, or counterparty Z.

2.  The propensity to spend doesn’t matter for the same reason.  Once counterparties get rid of the new base money, the impact on NGDP depends on the public’s propensity to hoard money, and any change in the incentive to hoard.  In the long run money is neutral and NGDP changes in proportion to the change in M, regardless of whether the person receiving the money has a marginal propensity to consume of 90% or 10%.  Either way they’ll almost always “get rid of” the new money, either by spending it or saving it.  Saving is not hoarding, it’s spending on financial assets.

3.  The lending channel doesn’t matter.  In the long run all nominal prices rise in proportion to the change in M.  In the short run sticky wages and prices cause the new money to have non-neutral effects.  Those non-neutral effects reflect wage and price stickiness, not “channels” of spending.

Here’s where the confusion comes from.  As soon as we move from a world of flexible prices and money neutrality (as with a currency reform) to a sticky-price world, real effects become the most noticeable short run effect of monetary shocks.  This causes many observers to reverse causality. They assume that easy money boosts real GDP, and if output rises enough it eventually triggers inflation. Thus they see real shocks triggering nominal changes.  If that’s your view of the world then channels of causation would seem to make lots of sense.  Why does RGDP change?  And which types of output change first?  Does more real lending cause more RGDP?  Do changes in interest rates cause more RGDP?  These are the questions you would ask.

If instead you think in terms of nominal shocks having real effects then the “channels” approach is totally superfluous.  A change in M causes a change in NGDP for supply and demand reasons, and if wages and prices are sticky then the change in NGDP triggers a change in RGDP.  Because NGDP affects RGDP, it will also affect all sorts of other real variables like real lending quantities and real interest rates.  But those are the effects of monetary shocks, they aren’t monetary shocks themselves.

Because money is a durable asset, expectations of the future value of money play an important role in its current value.  I suppose that is a channel of sorts, but it’s merely a channel connecting future expected NGDP to current NGDP.  To go from there to real variables such as output and employment, you simply need sticky wages and prices; channels like lending and interest rates add no explanatory power.

PS.  Ramesh Ponnuru has an excellent new post on monetary offset.

PPS.  Totally off topic, have other bloggers picked up this story:

The latest attempt by academia to wall itself off from the world came when the executive council of the prestigious International Studies Association proposed that its publication editors be barred from having personal blogs. The association might as well scream: We want our scholars to be less influential!

Optimal policy rules and close substitutes

About 20 years ago I published a paper arguing that the Fed should use futures markets to target a nominal hourly wage index.  The intuition was as follows:

1.  Recessions are basically sub-optimal employment fluctuations.  They occur due to sticky wages.

2.  When the aggregate wage rate falls, the wage rate rises above its equilibrium value.  That’s because some wages are sticky.  So when wage growth declines (as in 2009) equilibrium wage growth is falling even more sharply, but some wages are sticky.  Hence (paradoxically) the average wage level is actually “too high.” The opposite is true when wage growth accelerates.

3.  In a large diverse free market economy, the law of large numbers assures that a monetary policy that keeps average hourly wage growth steady is likely to keep aggregate nominal wages close to the equilibrium level (think of “equilibrium” here as being analogous to the Wicksellian equilibrium interest rate.  The one that provide macro stability)

4.  More recently Greg Mankiw and Ricardo Reis reached a similar conclusion, for similar reasons, but much more rigorous modeling.

I’ve never seen an hourly wage target as being politically feasible, so I gravitated toward NGDP targeting, which had already been proposed by people like Bennett McCallum, and seemed most likely to replicate the good effects of a wage target. Here is how they are similar:

1.  Suppose you target nominal wage growth at 4%.  Now assume that the public’s preferred growth rate of hours worked is pretty steady, say about 1%/year.  Then a policy targeting 5% growth in aggregate nominal labor compensation should get you similar results.  Even better, it is much easier to measure, because many jobs do not have hourly wage rates.  So it might be better.

2.  And a NGDP target is likely to be similar to a total labor compensation target, as labor compensation is much more than 50% of GDP, and other key components like depreciation and indirect business taxes are non-volatile.

Those who find a wage target unrealistic, or who reject sticky wage models because of a misreading of the wage cyclicality data, are likely to move in a different direction, toward inflation targeting. And yet the logic of stabilizing the stickiest prices is so powerful that they may not move all that far away.  Here is Miles Kimball:

Since oil prices are flexible, the quickest way to get to the relative prices that will prevail in the medium-run is to have those flexible oil prices adjust, while the short-run price index emphasizing sticky prices stays unchanged. (This is why I am in favor of the Fed’s emphasis on “core inflation,” though I think the Fed does too little to focus on the especially important prices associated with especially interest-rate-sensitive goods.)

At first glance a core inflation target seems quite different from a NGDP target. But I see both as imperfect compromises–substitutes for wage targeting.  Indeed core inflation is heavily influenced by wage inflation, as it excludes the prices that most strongly deviate from wage inflation–food and energy.

Why do I trust NGDP more than core inflation?  I don’t think the inflation rate measured by the government is a particularly good proxy for the inflation rate that produces macroeconomic stability (when stabilized.)  Indeed Kimball alludes to that problem with his comment on interest rate sensitive goods.  Between 2006 and 2012 the core inflation rate showed housing prices rising about 10%, and housing is 39% of the core index.  Over the same period Case-Shiller showed housing prices falling 35%.  The official index looks at rental equivalent, not the price of newly constructed homes. Which one better explains what was happened to housing output?  Or employment in housing construction?

In an imperfect world I trust NGDP much more than core inflation, partly for reasons identified by Kimball:

Actually, contrary to conventional wisdom, I am not persuaded that there are many events commonly called “recessions” that have supply-side causes, except when supply shocks led to inappropriate monetary policy responses.

I agree.  NGDP includes RGDP growth, which is (by definition) highly cyclical.  The NGDP signal would have definitely told the Fed that money was too tight in 2008-09.  The core inflation signal?  Yes, but to a lesser extent.  And when you get to level targeting there is the possibility of mischief.  Core inflation had previously overshot the target, and thus a passive central bank could excuse inaction with a core inflation rate that had fallen 1% below trend in 2009 much more easily that a central bank with a NGDP target.  NGDP had fallen 9% below trend between 2008:2 and 2009:2. Note that the Fed’s preferred PCE inflation rate has averaged almost exactly 2% since June 2003. But only 1.2% since July 2008.  And if you don’t do level targeting of core inflation, there is the possibility of a Japanese situation, where year after year they claim they tried but failed to achieve price stability.

The case for NGDP is very much a pragmatic case.  You won’t find any DSGE models spitting out “NGDPLT” as the answer.  It’s a good compromise target that is robust to a wide range of flaws in our models, and our monetary policy apparatus.

BTW,  Miles Kimball’s post was a reply to a very good Bill Woolsey post.  Here’s an excerpt from the Woolsey post:

While I wouldn’t describe this as a reason why the price level should be kept stable, I might see this as a reason why stabilizing the growth path of wage income is better than stabilizing total nominal income.   Glasner and Sumner both have argued for stabilizing the growth path of a wage index for much the same reason.  These are the sorts of reasons why most of us understand that nominal GDP level targeting is not perfect, just better than inflation or price level targeting.


Jeffrey Frankel also sees NGDP as a robust target:

This is yet another instance of a long-standing point: if central banks are to focus attention on a single variable, the choice of NominalGDP is more robust than the leading alternatives. A target or threshold is a far more useful way of communicating plans if one is unlikely to have to violate it or explain it away when things change later.

PS.  I have a new post over at Econlog that is loosely related to this one.

PPS.  Here is a presentation that I did at an IEA conference in London.

If it’s an identity does that mean I’m right?

My musical chairs model of the economy assumes nominal hourly wages are sticky. In that case fluctuations in NGDP may be highly correlated with changes in the unemployment rate.  Arnold Kling doesn’t like the empirical evidence I found in support of the model:

Scott is fond of saying, “Never reason from a price change.” I say, “Never draw a behavioral inference from an identity.”

I think Arnold knows it’s not an identity.  If you graphed MV and PY, you’d observe only one line, as the two lines would perfectly overlap.  In the graph I presented the two lines were correlated but far from perfectly correlated.  So it’s no identity. I’d guess the gaps would be far larger in many other countries, such as Zimbabwe.

A better argument would be that the correlation doesn’t prove that causation goes from NGDP to unemployment.  After all, changes in NGDP could cause changes in hourly nominal wage rates, leaving unemployment roughly unchanged.  In that case the correlation I found would be spurious. If I left the impression that the correlation proved nominal wages were sticky that would have been a “behavioral inference,” and hence a mistake.  What I tried to do was assume nominal wages are sticky (as they obviously are), and then show the effect of NGDP shocks in a world where nominal wages are sticky.

My musical chair model doesn’t have the “microfoundations” that have been fashionable since the 1980s.  But which model with microfoundations can outperform the musical chairs model?  Indeed let’s make the claim more policy-oriented.  I claim that fluctuations in predicted future NGDP relative to the trend line strongly correlate with changes in future unemployment.  And of course NGDP futures prices are 100% controllable by the monetary authority.

There is no NGDP futures market?  You can’t use that against my claim as I’ve been advocating such a market since 1986.  It’s an embarrassment to the economics profession that this market doesn’t exist (yet.)

So yes, it sort of seems like a tautology, but perhaps that’s because I’m right.

PS.  Imagine one of the great controversies in physics (say string theory) could be settled with a particle accelerator that cost $500,000 to build.  But the physics profession was too lazy to ask the NSF for the money.  Replace string theory with the debate over demand-side vs. RBC models and you have described economics circa 2014.

An old monetarist interpretation of interest on money (money isn’t credit)

Nick Rowe has an interesting new post:

We can imagine a world where all central bank money is electronic money, and the central bank can alter both the quantity of money and the interest rate paid on that money, and can make Rm and Rb move by different amounts, or even in different directions, if it wants to.

To my monetarist mind, an increase in Rm increases the demand for money, and that causes an excess demand for money, just like a reduction in the supply of money causes an excess demand for money. An excess demand for money, or an excess supply of money, has macroeconomic consequences. Any change in Rb is just one symptom of those macroeconomic consequences. We would get roughly the same macroeconomic consequences even if Rb was fixed by law, or if lending money at interest was tabu.

Let’s begin by looking at this from an old monetarist perspective.  They would argue that “the money supply” is some sort of aggregate, such as M1 or M2.  Here are four ways of reducing the supply of that aggregate:

A.  Reduce the supply of base money:

1.  Do open market sales

2.  Raise the discount rate to reduce discount loans

B.  Raise the demand for base money:

3.  Raise reserve requirements

4.  Raise the interest rate paid on base money

The first two policies reduce the supply of base money, and the second two reduce the money multiplier.  All four policies reduce the monetary aggregates such as M1 and M2.  Milton Friedman would regard all four as essentially the same policy, a reduction in the supply of money.

[Because I regard money as "the base," I regard the first two as a lower supply of money and the second two as a larger demand for money.  But this is pure semantics; nothing of importance hangs on the difference between how I define 'money' and the definition used by old monetarists like Friedman.]

The interesting thing about interest on money is that it can be controlled even in a completely flexible price economy.  Recall that the only reason that changes in the monetary base lead to changes in market interest rates is that wages and prices and debt contracts are sticky.  If prices are completely flexible, as in a currency reform, a change in the money supply has no effect on interest rates. Indeed that’s even roughly true of a change in the aggregates caused by a change in the demand for base money (ignoring small “superneutrality” effect from a change in real base balances.)

A one time decrease in the money supply leads to a temporary rise in interest rates, but then when the price level adjusts interest rates fall back to their original level.

A one time increase in the interest rate on money causes a one time increase in market interest rates on bonds, but only because prices are sticky. In the long run the interest rate on money stays at its new and higher level, whereas the interest rate on bonds returns to its equilibrium level (consistent with money neutrality.)

Sticky prices make it seem like interest on money and interest on bonds are related, but that’s a cognitive illusion.  At a fundamental level a change in the interest on money is a change in the demand for the medium of account, and is a profoundly monetarist policy.  It is no different from changing the supply of base money.  In contrast, a change in the discount rate does have a direct effect on the cost of credit, and hence is a more “Keynesian” policy.  Unlike a change in the interest rate on money, which can be permanent, a change in the discount rate would lead to hyperinflation or hyperdeflation if permanent.  There is a long run Wicksellian equilibrium discount rate, whereas there is no long run Wicksellian equilibrium rate of interest on money.  The central bank is the monopoly supplier of base money and can attach any (reasonable) tax or subsidy it wishes, even in the long run.

Money is not credit.  That’s the whole point of this post.

Update:  Obviously the interest on money should not exceed the interest on bonds

Do monetary shocks matter? And what is a monetary shock?

Mark Sadowski recently discussed a study by Harald Uhlig on the effects of monetary shocks on RGDP.  Uhlig didn’t find much effect.  I suggested that there is a severe identification problem, and that NGDP fluctuations are the best indicator of monetary shocks.  Mark replied as follows:

Well if all NGDP shocks were treated as monetary shocks then we’re assuming that AD shocks are purely monetary in origin. Obviously that would result in much larger estimates for the proportion of RGDP variation attributable to monetary policy shocks.

That also seems like too strong an assumption to me. That is, I think that it is implicit that monetary policy is ultimately responsible for the level of NGDP at any point in time, but that doesn’t necessarily mean monetary policy is solely responsible for every shock to AD.

I don’t think there is any question that the vast majority of economists would agree with Mark and not me on this issue.  Let me try to explain why this stuff makes me a bit uncomfortable.  Here are some possible definitions of monetary shocks:

1.  Unexpected changes in the fed funds target

2.  Deviations of the fed funds target from the Taylor Rule value

3.  Unexpected changes in the monetary base

4.  Unexpected changes in M2

And there are many more.  For each proposed definition of a “monetary shock” you will get a different answer to the question; “How much impact do monetary shocks have on real output?” That makes it all seem quite arbitrary.

It might be helpful to return to the fiscal multiplier question as a point of comparison.  The multiplier might be defined as the impact of federal spending shocks on RGDP, holding both private investment and S&L spending fixed.  In fact, as far as I know economists tend to hold state and local spending fixed but not investment spending, which is allowed to vary for “crowding out” reasons when estimating the multiplier.  This makes no sense to me.  Federal authorities have no control over S&L spending.  Almost everyone agrees that the multiplier should be estimated holding monetary policy fixed, but no one seems to know what that means.

I have a completely different view.  I’m a pragmatist.  For me “the” fiscal multiplier is what happens when the federal fiscal authorities change federal spending, and all other sectors of the economy (S&L, the Fed, private investment) respond to that action in the way they actually do respond in the real world.  In other words, I want to know the counterfactual change in RGDP with or without that federal action, holding nothing constant.

Now let’s return to the puzzling problem of identifying monetary shocks.  To me the only interesting question is how much more volatile is RGDP as compared to an economy where the Fed has adopted the optimal policy.  That’s a pragmatic way to define the real effects of monetary policy.  It’s a definition with policy implications.  It tells us how much we can hope to improve things.  So if I knew how much more unstable RGDP has been over the past few decades, as compared to the volatility of RGDP in a policy regime that pegs the price of NGDP futures contracts to rise at 5% per year (assuming that policy is optimal), then that seems to me to be the most useful definition of the contribution of monetary shocks to the business cycle.  It’s a bit arbitrary, but every other definition I can think of is essentially 100% arbitrary.

Mark might reply that NGDP targeting cannot prevent all fluctuations in NGDP, which is true.  This is another reason why we need an NGDP futures market.  That market would provide a very good estimate of the amount of NGDP variation that was predictable, and hence preventable.  If we had that market, and if it was not targeted (and hence was volatile) it would be the ideal monetary shock indicator to put into these VAR studies.