Archive for the Category Monetary Theory


If the Fed had a meeting, how would that affect inflation?

Does that question seem incomplete?  Then try this one (from a commenter):

If the Fed raised interest rates how would that affect inflation?

Still maddeningly incomplete?  Then how about this one:

If the Fed adopted a more expansionary monetary policy, how would that affect inflation?

Finally we have a real question!  People often seem to forget that changes in interest rates are an effect of “the thing the Fed does” whereas monetary policy is “the thing itself.”

The first question should have been:

If the Fed adopts an expansionary monetary policy how will that affect interest rates?

Because of the liquidity and Fisher effect, there is no unambiguous relationship between interest rates and inflation.  But there is an unambiguous relationship between monetary policy and inflation.  Easy money leads to higher inflation (ceteris paribus) and vice versa.  But exactly what is easy money?  And why can’t we talk about changes in the fed funds rate as being “the thing itself?”

First of all, the fed funds rate is not always equal to the fed funds rate target, so obviously there are forces beyond Fed policy that influence that rate.  It is affected by Fed policy, but it isn’t the thing itself.  Here’s what I mean by easier money:

A policy that increases the supply of base money or reduces the demand for base money is expansionary.  Here are ways to increase the supply of base money:

1.  Open market purchases

2.  Discount rate cuts

Here are ways to reduce the demand for base money:

1.  Lower reserve requirements.

2.  Lower interest on reserves.

None of these policy changes will have much effect if temporary.

And here is a very reliable way to signal an intention to adopt an easier monetary policy (usually an intention to boost the base through open market purchases):

1.  Lower the fed funds target, relative to expectations.

That signaling device has been so reliable over the years that central banks have been able to see a clear connection between their policy signaling and asset prices linked to inflation expectations (such as stock and commodity prices, or TIPS spreads.)

It is that reliable response of asset prices to unexpected fed funds changes, i.e. unexpected changes in the expected future path of the base, that causes central banks to be absolutely confident the neo-Fisherites are wrong.  They see evidence of their policies “working.”  But here are two facts that lead to confusion:

1. The vast majority of the time interest rates and inflation are positively correlated—the Fisher effect dominates the liquidity effect.

2.  Central banks and their supporters in the academic community often talk as if interest rates are “the thing itself.”  That’s incorrect, and it leads them to often confuse easy and tight money, because of point 1.

Combine those two facts, and it’s easy to understand how intelligent, freethinking economists might reject the conventional wisdom, and end up as neo-Fisherites.

The solution is not to throw out mainstream Keynesian monetary theory and embrace neo-Fisherism, the solution is to throw out mainstream Keynesian monetary theory and embrace market monetarism.

Like Coke, it’s the real thing the thing itself.

PS.  Off topic, but I only hate Noah on days where he insults me or my friends on Twitter, otherwise I like his blog a lot.  Love the sinner, hate the sin.

And a person Miles and Izabella like can’t be all bad.  :)

Noah Smith on the Neo-Fisherites

Here’s Noah Smith:

First, the basic idea. The Fisher Relation says that nominal interest rates are the sum of real interest rates and inflation:

R = r + i

That’s not an assumption, that’s just a definition (actually it’s an approximation, but close enough). What I call the “Neo-Fisherite” assumption is that in the long term, r (the real interest rate) goes back to some equilibrium value, regardless of what the Fed does. So if the Fed holds R (the nominal interest rate) low for long enough, eventually inflation has to fall. This is exactly the opposite of the “monetarist” conclusion that if the Fed holds R very low for long enough, inflation will trend upward.

Noah Smith is making a very subtle error here, but before getting into the details let’s blow the neo-Fisherite model right out of the water.  We can do so with a couple points made in the comment section.  First Nick Rowe:

Here is one very big bit of empirical evidence against the “Neo-Fisherite” theory:

For the last 20 years the Bank of Canada has been targeting 2% inflation. And the average inflation rate over that same 20 years has been almost exactly 2%.

The Bank of Canada has said it has been doing the exact opposite to what Neo-Fisherites would recommend: whenever the BoC fears that inflation will rise above 2% it raises the nominal interest rate, and whenever it fears that inflation will fall below 2% it cuts the nominal interest rate.

If the BoC had been turning the steering wheel the wrong way this last 20 years, there is no way it could have kept the car anywhere near the centre of the road. Unless it was incredibly lucky. Or was lying to us all along.

No, they aren’t lying.  And if you don’t believe me, do you think financial and commodity market participants are also “lying,” and hence intentionally losing lots of money.  Here’s Kevin Donoghue, responding to Noah:

If the Neo-Fisherites are right, then not only is the Fed massively confused about what it’s doing, but much of the private sector may be reacting in the wrong way to monetary policy shifts.

The NFs are committed to RatEx, so if the private sector is reacting in the wrong way their theory has a serious problem.

So how come all these brilliant neo-Fisherite economists are making an elementary mistake?  It’s partly because the mainstream never really internalized Milton Friedman’s insight:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

.   .   .

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

At first glance that looks almost neo-Fisherite.  But of course Friedman had quite conventional views on the liquidity and Fisher effects.  Still it makes sense that if Friedman’s insights were mostly ignored, later economists who discovered the strong correlation between low rates and low inflation might easily draw the wrong conclusion.  Friedman believed that a tight money policy would initially raise rates, but over time would lower both interest rates and inflation.  So over the vast majority of time you’d see inflation move in roughly the same direction as the short term interest rate directly controlled by the central bank.  That’s the Fisher effect—conventional macroeconomics.  But because it was not internalized (remember how crazy everyone viewed me in 2009 when I said money was tight?), it pushed the door wide open for the neo-Fisherites and MMTers, and lots of other odd critters to walk into the house.

And now we can see the subtle error that Noah Smith made in the passage quoted at the beginning of the post:

This is exactly the opposite of the “monetarist” conclusion that if the Fed holds R very low for long enough, inflation will trend upward.

Reasoning from a price change!!!  If I had a crystal ball, and peered into that ball, and saw that Yellen was going to hold short term rates at zero for the next 10 years, I’d absolutely predict ultra-low inflation, condition on that interest rate forecast.  So no, the monetarist prediction is not that inflation will trend upward.  As Milton Friedman said, the monetarist prediction is that inflation would trend downward.

Noah Smith is thinking like a Keynesian.  He’s trying to translate monetarist ideas about monetary policy into a Keynesian (interest rate) language.  He knows that we think easy money is associated with higher inflation, so he assumes we must also think that an extended period of low interest rates is associated with higher inflation.  Not so.  We don’t think low rates imply easy money.

Noah Smith and the neo-Fisherites are confusing the situation described by Friedman, with a subtly different case. Suppose a madman is put in change of the Fed who is committed to zero rates over the next 10 years, come hell or high water.  Then I might forecast an upward drift in inflation; indeed I think hyperinflation would be quite possible.  It depends on what else the madman did. But if you simply told me that rates would be low over the next 10 years under Janet Yellen, I’d assume that inflation would be low, and that low inflation is precisely the reason why Yellen held rates down.

There are no paradoxes to be explained, and that’s why we need to keep the “market” in market monetarism.  Markets tell us that all theories of monetary policy ineffectiveness at the zero bound, and also all reverse causation theories, are wrong. (I.e. RBC, MMT, Neo-Fisherite, old Keynesian, etc., are all wrong.)  It doesn’t matter if your model predicts that a change on monetary policy should have X effect on the price level.  If commodity markets respond in the “wrong way” then you’ve lost.  Game over. Case closed.

PS.  Edward Lambert comments:

You sense the same thing that I do. I commented on Williamson’s post pretty much your thoughts. I am in agreement with the Fisher effect.
I simply want to thank you for having sufficient wisdom and constitution to write this post.

Yikes, if Noah has a friend in Edward Lambert then he doesn’t need any more enemies.

HT.  Tom Brown, TravisV.

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.