Archive for the Category Monetary Theory


Don’t show this St. Louis Fed article to Nick Rowe

A commenter sent me a paper from the St. Louis Fed:

This view can also be represented by the so-called “quantity theory of money,” which relates the general price level, the total goods and services produced in a given period, the total money supply and the speed (velocity) at which money circulates in the economy in facilitating transactions in the following equation:


In this equation:

  • M stands for money.

  • V stands for the velocity of money (or the rate at which people spend money).

  • P stands for the general price level.

  • Q stands for the quantity of goods and services produced.

Oh, so that’s the quantity theory of money.  In fairness, they do mention stable velocity later on. But stable velocity is the QTM, it’s where you start the explanation.  They continue:

And why then would people suddenly decide to hoard money instead of spend it? A possible answer lies in the combination of two issues:

  • A glooming economy after the financial crisis
  • The dramatic decrease in interest rates that has forced investors to readjust their portfolios toward liquid money and away from interest-bearing assets such as government bonds

In this regard, the unconventional monetary policy has reinforced the recession by stimulating the private sector’s money demand through pursuing an excessively low interest rate policy (i.e., the zero-interest rate policy).

If only the Fed had joined the ECB in raising interest rates back in 2011.  Then we would have had a much faster recovery.

Base money is just as special as it ever was

Here’s Frances Coppola:

Technology changes and post-crisis monetary policy are making financial assets and money indistinguishable. Central banks now need to work in partnership with fiscal authorities.

Several economists at the Lindau meeting were severely critical of central banks’ conduct of monetary policy in the light of continuing depression in the US, Japan and much of Europe, and called for greater use of fiscal policy to bring about recovery. Among the most critical was Christopher Sims, who gave a trenchant presentation on “Inflation, Fear of Inflation and Public Debt”.

He started by announcing the death of the quantity theory of money, MV=PY. Due to interest on reserves and near-zero interest rates, “money” can no longer be clearly distinguished from other financial assets. This is a fundamental point which requires some explanation.

These days, nearly all forms of money bear interest, which makes them indistinguishable from interest-bearing assets. For Sims, the paying of interest on bank reserves, coupled with the decline of physical currency, all but eliminates the distinction between interest-bearing safe assets such as Treasury bills and what we traditionally call “money”. All assets can be regarded as “money” to a greater or lesser extent: the extent to which assets have “moneyness” is really a matter of liquidity.

Sometimes words can get in the way of meaning.  There is no point in arguing about what the term “money” really means, it obviously means different things to different people.  But the term “base money” still has a pretty clear meaning; currency in circulation and bank deposits at the Fed.  The Fed happens to have a complete monopoly on the (US$) monetary base.  Prior to 2008 it could determine the supply of base money through OMOs and discount loans, and it could influence the demand for base money through changes in reserve requirements.  After 2008, a 4th tool was added—interest on reserves, which also impacts the demand for base money.  With these four tools the Fed can push the value of the dollar (in terms of euros) to anywhere between zero and infinity.  That’s a lot of power.  Nothing fundamental has changed, at least nothing relating to the validity of the quantity theory of money.

A few other points:

1.  The quantity theory of money has NOTHING to do with the equation of exchange.  That equation is best viewed as a definition of velocity, nothing more.  Definitions are not theories.

2.  Currency is not “declining.” The currency stock is growing faster than GDP.  It is also becoming a steadily larger share of the monetary aggregates.

HT:  Marcus Nunes

Why macro stabilization policy rarely fixes problems

A big demand slump isn’t just an economic disaster; it’s also a prediction of an economic disaster. And that means it’s a prediction of policy failure.   At least that’s the implication of the Woodfordian view of macro (which I accept.)  Changes in current AD are mostly driven by changes in the future path of AD.  Changes in near-term NGDP are mostly driven by changes in expected NGDP 1, 2, 5 and 10 years out in the future.  Call it the term structure of NGDP.  And those are driven by the future expected path of monetary policy.

And of course whenever we have crashes like 1920-21, 1929-30, 1937-38, 2008-09, we also tend to have asset market crashes.  Asset markets aren’t perfect (1987) but when there’s a very big economic slump on the way they are pretty good at sniffing it out.

So here’s the problem for macro policy.  It’s good at preventing disasters, as we saw with the Great Moderation.  But when it fails, it’s really, really hard to fix the problem, because doing so requires policymakers to be more effective than the markets predict.  I won’t say that things are hopeless when markets predict disaster, but I wouldn’t put much hope on stabilization policy.  In the textbooks, the purpose of stabilization policy is to “fix problems.”  In reality it will usually fail at that.  Rather it’s good at preventing problems.  If you’ve got a problem, you’ve already failed.  Like the old joke—”if you are headed there, I wouldn’t start from here.”

I was reminded of all this while reading a Brad DeLong post that discusses a debate between Nick Rowe and Simon Wren-Lewis.  DeLong looks at the possibilities offered by monetary and fiscal stimulus when you have a “deficiency in demand.”

Let’s look at this from a different perspective.  The problem is not “demand deficiency” it’s expected demand deficiency.  Policymakers try to steer the nominal economy, they implicitly or explicitly target NGDP one or two years out in the future.  If 12 month forward expected NGDP is right on target, then no policy changes are needed.  And if 12 month forward NGDP is below target, then the markets have predicted policy will fail, and their forecast counts for far more than the views of any academic economist or government policymaker.  At that point, we really shouldn’t expect much from macro policy.  It’s likely to fail.  No wonder people are so pessimistic about monetary policy! Markets have observed the behavior of the relevant central bank (Fed, ECB, etc.) and come up with the optimal forecast of the result.  If there’s an expected demand shortfall, markets have already given a vote of no confidence to the policymaking apparatus.

From that perspective, DeLong is asking the wrong question.  It’s not, “how do we fix this problem?”  It’s, “how to we make it so that Brad DeLong and Simon Wren-Lewis never ask, ‘how do we fix this problem.’”  I see two ways, and only two ways of doing that.  Both methods involve abandoning the Keynesian policy of interest rate targeting.  Interest rate targeting doesn’t work at the very moment when good monetary policy is most essential—in a very deep demand slump. Would you buy a car that had a brake that failed just 1% of the time—only on twisty mountain roads with no guardrail? Then why do you (Keynesians) buy interest rate targeting as the appropriate policy instrument?

1.  One method would have the central bank peg the price of one year forward NGDP futures, and do OMOs until the market price is right on target.  Now you don’t have to worry about what to do if there is an expected demand deficiency, because there never is an expected demand deficiency.  At least not one expected by the market.  There may be a current demand deficiency, but if it isn’t expected to persist, then stabilization policy is right on target.

2.  Let’s say you don’t buy the “market” part of market monetarism.  You think markets are irrational.  ”Better leave this to the wise mandarins who will control policy in the optimal fashion.” What then?  It’s very simple, you do what Lars Svensson suggested, you set the monetary instrument at a position where the central bank’s internal forecast is equal to the policy target.  But which instrument?  Recall that we have abandoned interest rate targeting.  Don’t ask me, I’m the NGDP futures market guy–ask the mandarins.  Anything with no zero bound.  It might be the monetary base, it might be the trade-weighted exchange rate, it might be the nominal price of zinc. There is an infinity of possible choices.  (Now do you see why I’d rather let the markets set policy?)

In his post, DeLong cites Wren-Lewis saying he’s heard the MM arguments, but doesn’t buy them. Then he goes on to conclusively show he has not heard the MM arguments, by using the metaphor of employing both a regular brake and an emergency brake in a car careening down a hill.  This metaphor is supposed to provide justification for using fiscal stimulus “just in case” to back up monetary stimulus.

But that won’t work if you have monetary offset.

In any case, monetary policy is a brake that never fails, and if it does fail you don’t end up crashing, you end up with the Bank of England owning the entire world.  A level of global domination that makes Victorian-era Britain seem like a 98 pound weakling by comparison.  Global GDP is around $100 trillion.  So Piketty would say that global wealth must be around $500 trillion.  Could the Brits live on 5% of that?  I think so.  But wait until the Scots secede, those ingrates don’t deserve any of it.

As Dylan said on his greatest album:

.  .  . there’s no success like failure . . .

Lowflation? LOL. Try again!

The economics profession made a serious mistake a few decades ago when they latched onto “inflation” as a key macroeconomic indicator.  People were very upset about inflation during the Great Inflation of 1966-81, for reasons totally unrelated to the reasons macroeconomists think inflation is important.  Since everyone was talking about inflation, macroeconomists wanted to put it into their models.  Nobody was talking about nominal GDP.

[As an analogy, macroeconomists put short-term interest rates in their monetary models because central banks usually target that variable.  In the 1930s George Warren was mocked for saying that the price of gold is "the" indicator of monetary policy.  But how's that different from new Keynesians?  After all, when Warren was alive central banks did target the price of gold.]

In any case, it’s become increasing clear that inflation is not the right variable–it does not describe the nominal shocks hitting economies.  And Europeans in particular are paying a heavy price for this mistake, as when the ECB sharply tightened monetary policy in 2011 because a completely meaningless headline inflation number (including “austerity” VAT increases and imported oil) had briefly risen above their 2% target.

As inflation becomes more and more discredited, pundits try ever more clever techniques to make it seem relevant again.  Here’s a recent article from The Economist:

Against this background, it is unsurprising that inflation is stuck at just 0.5%. Although the European Central Bank (ECB) took steps to counter “lowflation” in early June, the worry is that it has still not done enough. In a survey of the euro-zone economy published on July 14th the IMF urged the ECB to adopt quantitative easing—creating money to buy assets including sovereign bonds—if inflation remains too low.

Lowflation represents a particular threat to highly indebted countries like Portugal.

It’s amazing the lengths to which pundits will go to NOT mention nominal GDP.

Let’s compare Portugal and Switzerland.  Over the past 6 years both have seen inflation fall from the low single digits, to near zero.  But look at the nominal GDP numbers (World Bank) for the two countries:

Year       Portugal   Switzerland

2007       169.3          540.8

2008       172.0          567.9

2009       168.5          554.3

2010       172.9          572.1

2011      171.1           585.1

2012      165.1          591.9

2013      165.7          603.2

Portugal’s NGDP is down over 2%, while Switzerland’s is up over 11%.  Not surprisingly, although both countries suffer from “lowflation,” Switzerland has seen RGDP grow 8% over this period, while Portugal’s RGDP has fallen by 7%.

And NGDP isn’t just the right metric for nominal shocks and the business cycle, it’s also the right variable for the debt crisis.  Nominal income is the resource that individuals, business, banks and governments have to repay nominal debt.  Why in the world would someone talking about a debt crisis mention “inflation?”  What does that have to do with debt?  What if a country has 0% inflation and 10% RGDP growth?

That’s not to say inflation is never correlated with demand shocks–most of the time it is.  But NGDP is 100% correlated with demand shocks.  So if you are worried about nominal shocks hitting the economy, why not use an accurate nominal shock measure like NGDP?  Why use a metric that is correlated with NGDP when the economy is hit by demand shocks, but not supply shocks?

Of course even NGDP isn’t going to explain all the movements in RGDP (but it will do better than inflation.)  Switzerland has better supply-side fundamentals, so even if the ECB had done enough monetary stimulus to cause Portugal’s NGDP to rise by the same 11% as in Switzerland, their RGDP performance might well have lagged Switzerland.  Nonetheless, Portugal would have done somewhat better in terms of growth, and their debt crisis would have definitely been much milder.

You want to see “lowflation?” China’s inflation rate (GDP deflator) averaged 0.75%/year between 1996 and 2003—pretty close to Japan.  Now check out the NGDP numbers for the two countries.

I’m begging the economics community.  Stop talking about inflation when you really mean nominal income.  And stop coining terms like ‘lowflation’ in a pathetic attempt to add epicycles to the obsolete inflation-oriented models of macroeconomics.

Inflation, interest rates, income inequality—the “i-words” don’t matter.  NGDP, nominal wages, consumption are what matter.  BTW, the current account deficit also doesn’t matter, as I point out in my newest Econlog post.

Andolfatto interviews Woodford

David Andolfatto is a very knowledgeable monetary policy blogger, and here he interviews Michael Woodford, perhaps the world’s leading monetary theorist.  I’ll just focus on one issue:


There is a conventional wisdom of how these tools might work. Can you explain to us the findings of your own research, how they might corroborate these findings or these beliefs? Or go against them in some manner? Is there something surprising that emerges from what you’ve discovered?


I think so. I think a lot of the discussion that you see of the point of asset purchases suggests that there should be a lot of similarity between the effects of purchasing long-term assets and the effects of cuts in the federal funds rate, the Fed’s traditional tool. People say the whole point of cutting the federal funds rate is longer-term bond yields would also go down, and if you can just buy longer-term bonds, push up their prices, that’s doing the same thing with a different mechanism. It’s a different way of doing the same thing. And if you can’t cut the federal funds rate further, then there’s an obvious reason to use the other method.

And our analysis suggests that this analogy between the two tools is not nearly as strong as you might have expected.


Why is that exactly?


Well, one reason is that the question of whether it’s clear that Fed purchases of longer-term assets can affect the prices of those assets as directly as traditional interest rate policy would. But I think the more surprising thing is that our analysis suggests that even under circumstances when the central bank finds that its purchases do affect the market price of the longer-term assets, the connection between that and spending in the economy, and then the effects on inflationary pressure, are not necessarily at all similar to those of conventional interest rate policy.


So you’re suggesting that it is possible, at least in theory, that the Fed engages in the large purchase of a certain class of assets? Injects money into the economy by purchasing a particular class of assets? And that this may, in fact, have very exact opposite sort of effects than conventional data might suggest?


Right. We clearly show that that’s at least a theoretical possibility. And obviously then deciding whether you think that’s actually happening is another thing. But I think the analysis points out that you shouldn’t assume that the mere fact that you could raise the price of the bonds answers then the question about what effect you’re having on the economy.


So can you explain the economic intuition for that effect and whether or not it has some bearing as to the conduct of Fed policy today?


I think the point is a fairly simple one, and it has to do with the question of why the central bank purchases should be able to move the market price anyway, which, again, people thought was kind of obvious. They said if you’re buying more of something, surely that will tend to make it more expensive. But when you ask whether that should actually happen with a lot of sophisticated traders out there in the market that are also trading against the central bank, what we argue is that if the other traders in the economy aren’t constrained in the financing they can mobilize to take the positions that make sense for them, they will tend to automatically have an incentive to trade against the central bank and to neutralize then the effects of the central bank’s trades.

Two things struck me.  First, Woodford has a contrarian view of the effects of QE on long-term interest rates.  Second, market monetarists have a similar counterintuitive view, but for very different reasons.

Woodford starts by pointing out that people expected QE to reduce long-term rates, just as traditional fed funds rate cuts reduce long term rates.  But MM doesn’t even accept the premise. Some of the most dramatic Fed moves toward cutting short-term rates have actually boosted long term rates, via the inflation and income effects.  We think QE also has an ambiguous impact on rates, for similar reasons.  In contrast, Woodford focuses on the risk channel (you should read the whole thing to get his explanation.)

Then Woodford suggests that the relationship between long-term rates and the economy is not as clear as with traditional tools.  We agree that it’s not at all clear (never reason from a price change), but we think that’s also true of traditional tools.  One cannot assume that lower interest rates produced by the Fed will lead to strong growth in AD.  It depends on the relative strength of the liquidity, income and Fisher effects.

In the final paragraph I quote, Woodford points out that most people think that Fed purchases “obviously” boost the price of the asset being purchased.  They misuse the S&D model.  Some commenters are outraged that the Fed is helping group X, because group X owns lots of the assets that the Fed is buying.  They see dark conspiracies.  But the purchase of bonds is also the sale of cash.  And more cash boosts inflation, which reduces bond prices.  During the 1964-81 period the Fed radically increased the amount of bonds it was buying, this led to rapid growth in the monetary base, higher inflation, and much lower bond prices.  So much for Cantillon effects. 

Yes, there are cases where large asset purchases are associated with low inflation (such as recently); my point is that there is no consistent relationship between Fed asset purchases and the price of that asset.

HT:  Tom Brown, TravisV.