From Hume to Woodford . . . and back to Hume?

David Hume developed most of monetary economics back around 1750, partly by just sitting in a room and thinking.  He discussed a thought experiment where everyone in England woke up one morning and discovered their purses contained twice as many gold coins as the night before.  Hume argued that England wouldn’t be any richer in real terms; rather the price level would double.  But he also noted that there would be a transition period where the extra money would be spent and trade would expand.  So he understood the Quantity Theory of Money (QTM) and the Phillips curve.  In the 1970s Friedman argued that in the past 200 years macroeconomics had merely gone “one derivative beyond Hume.”  I.e., Hume looked at changes in the price level (as did Irving Fisher) and Friedman looked at changes in the rate of inflation.

Hume also understood the impact of an increase in money demand (or reduction in velocity):

“If the coin be locked up in chests, it is the same thing with regard to prices, as if it were annihilated.” David Hume — Of Money

Then people began to notice that when the supply of money increased there was a temporary decline in interest rates.  This occurred because wages and prices are sticky in the short run, and some variable needs to adjust to equate money supply and demand in the period before prices adjust.  Thus interest rates change until wages and prices adjust.  This led economics to take a momentous wrong turn.  Under the influence of Wicksell, and then later Keynes, macroeconomists began to see the change in interest rates as not some sort of epiphenomenon associated with an increase in the money supply, but rather as monetary policy itself.  This culminated in the work of Woodford, who developed monetary models without money, where interest rates were all that mattered.

But Woodford did more than that, he showed that aggregate demand depended much more on the future expected path of monetary policy than on the current stance of policy.  As we will see, that insight may have opened the door to a revival of Humean macroeconomics.

The QTM was based on the hot potato effect, the idea that if you double the supply of non-interest-bearing base money, people will try to get rid of excess cash balances.  But in aggregate they cannot do so, as the central bank controls the supply of base money.  Instead the attempt to get rid of excess cash balances drives up prices and NGDP until people are again willing to voluntarily hold the enlarged cash balances.  That occurs when prices and NGDP have doubled, so that real money demand and velocity return to their original level.

There is a flaw in Woodfordian macro.  No model lacking money can explain large changes in the money supply and price level.  That’s why the post-WWI hyperinflations caused even Wicksell and Keynes to briefly return to the quantity theory of money.  If you increase the monetary base by 87 times (and a number of middle income countries did this in the 1970s and 1980s) the monetary approach can give you a ballpark estimate of the price level (that it will rise by 87-fold), whereas the interest rate/economic slack approach to inflation is hopelessly lost.  So there’s not much doubt that in some sense the quantity of money is still driving the price level, at least in the long run.  But how can it be made relevant for our current situation, where inflation rates are quite low and velocity is quite unstable?

It seems to me that Woodford’s approach is capable of rescuing the QTM.  Think about it.  The QTM is criticized as only being able to explain price level changes in the long run.  And yet Woodford says that the current level of aggregate demand is mostly determined by the expected future course of monetary policy; i.e. the long run.  Keynes said in the long run we’re all dead, and now Keynes is dead and Woodford is saying in the short run AD is determined by (expected) long run changes.

For the moment let’s set aside the question of interest on reserves, and focus on non-interest-bearing currency.  Before the recession (in 2007) currency was about 6% of U.S. NGDP.  And if interest rates are positive in 2017 it will again be about 6% of NGDP, give or take 1%.  That means the question of whether 2017 level of NGDP is 30% or 60% or 90% higher than in 2007, will mostly depend on where the Fed sets the currency stock in 2017.  Not precisely, but approximately.  Admittedly they don’t control the currency stock directly, they control the base.  But in normal times the base is more than 90% currency.  If the Fed wants that proportion to drop, they can increase IOR and inject enough extra base money to keep currency where they want it.  If they don’t want it to drop they can lower the IOR, to zero if necessary.

The rate of growth in NGDP between now and 2014 will be strongly influenced by where people think NGDP will be in 2017.  There is no interest rate path that the Fed can describe that would give people even a ballpark estimate of NGDP in 2017.  But if they say they will set the currency stock at $1.6 trillion in 2017, (twice the 2007 level) then people will know that 2017 NGDP is also likely to be roughly twice 2007 NGDP.   And if they do that, NGDP will grow very rapidly over the next two years.

Of course the Fed shouldn’t do that, for two reasons.  First, that would create faster NGDP growth than is desirable.  And second, it’s not as precise an instrument as targeting the forecast.  Better to say they’ll provide as much base money as necessary in 2017 to produce an NGDP that is 30% higher than in 2012.

That’s the sort of monetary policy Hume would understand, and approve of.

PS.  Why 30%?  It would allow for 7% growth between now and 2013, and 5% thereafter.  It’s a reasonable compromise that would dramatically speed up the recovery, but not create the politically unacceptable inflation likely to result from returning to the pre-2008 trend line.

PPS.  Commercial banks?  I don’t recall Hume having anything to say about them, so I never studied the subject.

I dedicate this post to MMTers everywhere.


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77 Responses to “From Hume to Woodford . . . and back to Hume?”

  1. Gravatar of Left Outside Left Outside
    27. February 2012 at 07:30

    I was at a lecture a few days ago and somebody said Bentham was the greatest philosopher of the eighteenth century, I almost leapt out of my seat to defend Hume! Its really nice to see you locating your work in the broad sweep of intellectual history – too many people don’t think about how where they’re from influences where they’re at.

  2. Gravatar of Philo Philo
    27. February 2012 at 07:35

    You write: “Then people began to notice that when the supply of money increased there was a temporary decline in interest rates. This occurred because wages and prices are sticky in the short run, and some variable needs to adjust to equate money supply and demand in the period before prices adjust. Thus interest rates change until wages and prices adjust.”

    My question: Why are interest rates less sticky than wages and prices generally?

  3. Gravatar of Barry Barry
    27. February 2012 at 07:53

    “If the Fed wants that proportion to drop, they can increase IOR and inject enough extra base money to keep currency where they want it. If they don’t want it to drop they can lower the IOR, to zero if necessary.”

    You need to explain why the banks will shed their excess cash balances (reserves), even if IOR is at zero, otherwise I don’t have any reason to agree.

  4. Gravatar of Lars Christensen Lars Christensen
    27. February 2012 at 07:59

    Scott, I only have one comment on that… http://marketmonetarist.files.wordpress.com/2012/02/mvpy_lc.jpg

  5. Gravatar of K K
    27. February 2012 at 08:31

    Scott: “the monetary approach can give you a ballpark estimate of the price level (that it will rise by 87-fold), whereas the interest
    rate/economic slack approach to inflation is hopelessly lost.”

    This is backwards. The path of the price level is determined by the path of the natural rate, interest rate policy, price stickiness, etc. The money supply *results* from the price level + the demand for money. Think of the money supply as extraneous; a vestigial, economically irrelevant monetary appendix. Yes, given NGDP and the price level, we are going to need some cash to cover settlement uncertainties, small or illegal transactions, tax evasion, mandatory reserves, etc.

    “But if they say they will set the currency stock at $1.6 trillion in 2017, (twice the 2007 level) then people will know that 2017 NGDP is also likely to be roughly twice 2007 NGDP.”

    Not even close. That is entirely dependent on the yield curve being similar to 2007, *and* a lot of other stuff like no significant changes in settlements, transactions systems, reserve rules, etc. none of which is at all certain. The point is that all that other stuff is irrelevant to the real variables we care about. For those, we just need to know the path of the short rate contingent on variables like the price level and *real* variables such as growth, unemployment, whatever. Forget about M and V. They don’t matter.

  6. Gravatar of bill woolsey bill woolsey
    27. February 2012 at 08:58

    You should study commericial banks because the U.S. does not have a gold coin standard.

    Interest rates on base money make no difference. They just result in a larger demand for real balances. Yes, if you change them about, it will change that real demand for base money, but if you don’t, it doesn’t have that effect. And then, the nominal quantity and the real demand determine the price level, just like the gold coins, pretty much.

    For example, suppose the Fed promises to make the .25% earning reserve balance level increase by 87 times over the next 10 years. What would happen to the price level? It would increase by about 87 times. And, yes, to make it work, they would also have to meet currency withdraws so that the amount of noninterest bearing currency increases by 87 times too.

    If the currency were private banknotes, the banks would handle that. They would increase currency issue to meet the nominal demand that would be generated by a nominal income about 87 times higher.

    Since the Fed isn’t (and shouldn’t) make promises about the quantity of currency at some future time, but rather make promises about nominal GDP, then it must stand ready to decease rather than increase the quantity of currency if needed. While increases mean more resources for the issuer (the government) decreases mean fewer resources. This is more like a loan than magic gold coins.

    I favor private currency, and the currency issued by any one bank is obviously borrowing by that bank. Does it really make sense that the move between private currency and government currency means that money becomes like magic gold coins rather than some kind of debt instrument?

    To me, currency is a type of government debt. It bears zero interest, which represents the exploitation of a government monopoly.

    If private currency were legal, I think that under normal circumstances banks would pay interest on the checking accounts against which it was drawn until the currency clears. This would create an incentive for people to want to use currency drawn against their account and for those receiving it to deposit it. That this is illegal means that people don’t earn interest on their currency. All currency funds loans to the government, and rather than those holding the currency earning interest, the government gets a zero nominal interest loan. (And with 2% inflation, it is a negative 2% interest loan.)

    If government currency is treated like some kind of paper gold, whose quantity never decreases, then private currency issue would result in some kind of massive inflation. But with nominal GDP targeting, the government currency would mostly be withdrawn from circulation. There would be no inflation and base money would mostly take the form of reserve balances (and there would be very little of it under normal circumstances.) Paying interest on reserve balances at a rate somewhat less than the earnings on the short and safe parts of the Fed’s portfolio would make the opportunity cost fixed at that difference. Still, changes in the nominal quantity of the base money would lead to proportinoal changes in the nominal GDP and the price level in the “long run.”

    But, of course, banks would play a key role in the actual market process by which changes in the quantity of base money impact the price level.

    And, in reality, people with excess currency balances deposit them. Firms receiving currency payments deposit them. In reality, the banking system plays a key role in the actual market process by which changes in currency impact the price level.

    I grant, of course, that the interest rate targeting approach does miss something. But if the quantity of money is going to be adjusted to the demand given the target for nominal GDP, then it is a bit backwards to be doing an analysis that says, if this is the quantity of money, what will be the equilibrium level of nominal GDP.

    And, to get really crazy, if the Fed is doing open market operations based upon trades of a futures contact on Nominal GDP in the future, isn’t the role of the quantity of base money or interest rates in determining/interpredetating current monetary conditions up to each speculator?

  7. Gravatar of Benjamin Cole Benjamin Cole
    27. February 2012 at 09:15

    Once again, Scott Sumner is the Best Economist. Some day we will have to give a trophy, topped by a man holding a calculator, to Sumner.

  8. Gravatar of Max Max
    27. February 2012 at 09:30

    Ever heard of Goodhart’s Law?

    Just because some variable predicts inflation, doesn’t mean you can control inflation by controlling that variable. The moment you directly control it, it ceases to predict anything.

    By the way, Hume’s thought experiment doesn’t correspond to anything central banks do. Central banks don’t give away money. So why do you think Hume would agree with you?

  9. Gravatar of dwb dwb
    27. February 2012 at 09:48

    amen

  10. Gravatar of Greg Ransom Greg Ransom
    27. February 2012 at 09:52

    Hume understood the Cantillon Effect — i.e. understood how the microeconomic flow of money changed relative prices and alternative production processes, which establishes that Hume was NOT a Quantity Theorist exactly because of that fact. Quantity Theory assumes MAGIC — every individual waking up with exactly whatever money that does not change a single relative price or production choice. Hume pointed out this was NOT correct — when the size of money changes it changes via particular points in the economy and changes production choices, production processes, labor allocation and all relative prices, stuff which stands as a rejection and refutation of Quantity Theory monetary economics.

    And later economists such as Thorton etc. added to this, showing how credit creation or destruction changed these pathways in the same way, effecting interest rates. Bowhm-Bawerk, Wieser and Hayek then showed how there is a time-price structure to ALL production processes and relative prices — and how this time-value structure is pushed and pulled by changes in credit creation and destruction tied by a bungy cord to money demand, size, and flow changes.

    All of which refutes Quantity Theory by exposing Quanity Theory economics as the economics of magic — magical presupposititons which Hume identified and REFUTED.

    You can’t claim Hume — Hume was the first snd greatest refuter of the Quanitity Theory and its magical assumptions.

    The very example you cite in support of the QT is in fact a conversation ending objection to it — all forms of QT assume magic — that a miracle occurs — which is reject by science.

  11. Gravatar of bill woolsey bill woolsey
    27. February 2012 at 09:56

    K:

    All of those changes you described–

    Would they result in the price level going up only 78 times? Or would it be 96 times?

    And now.. you see what the point is.

    Sumner is aware that an 87 fold increase in the quantity of currency is unlikely to make nominal GDP and the price level rise exactly 87 fold.

    But please outline the path of interest rates, the nominal interst rate, and whatever else you want and say anything about what would happen.

  12. Gravatar of bill woolsey bill woolsey
    27. February 2012 at 09:59

    Barry:

    If the banks held 100% reserves on all of their 10 trillin in liabilies, they then we are liking at a 84 fold increase in the quantity of money held by the firms and households.

  13. Gravatar of Greg Ransom Greg Ransom
    27. February 2012 at 10:22

    Mises and Hayek are the ones to cite & discuss if its a serious convertation about cash balance considerations in light of expectations about money quantity and demand — and the role of expectations concerning interest rates in all of this. Mises and Hayek have this at the core of their macro and point to the significance of this constantly.

    Keynes got this stuff whprong consistently and his mono theory of the source of interest rates is an embarrassment to economic science.

    Hayek _rejected_ Fisher, Cassel, etc. after living the hyperinflation in Austria as a public official with monetary responsibilities.

  14. Gravatar of Mike Sax Mike Sax
    27. February 2012 at 10:23

    So this post in some way refutes MMT? Trying to scale that mountain again, huh? I hope someone tips them off-the feeding frenzy when they get into it is always fun.

    I’m not sure how you think you have refuted them here, maybe because you think they don’t believe in the Quanitty Theory of Money. Yet Scott Fullwiler actually says they do believe in QTM.

    For the details see

    http://diaryofarepublicanhater.blogspot.com/2012/01/its-on-tiime-for-market-monetarist-mmt.html

    http://diaryofarepublicanhater.blogspot.com/2012/01/market-monetarist-mmt-smackdown-20.html

    Of course the one thing I’m sure they don’t believe in is the money multiplier-and indeed they question money neutrality itself.

    Write a post debating money neutrality with them-that will give us a battle royale.

  15. Gravatar of bill woolsey bill woolsey
    27. February 2012 at 10:42

    Ransom:

    And what you need to understand is the Woodford point.

    If everyone knows the money has appeared (or has entered in particular points) and so the price level will end up at some point, then that expectation directly impacts what people do. Imagining that demand spreads like ripples in a pond and as a surprise to those receiving it fails to take into account changes in expected prices.

  16. Gravatar of David Pearson David Pearson
    27. February 2012 at 10:46

    -”Commercial banks? …I never studied the subject”

    -”If they don’t want it [ratio of base to currency] to drop they can lower the IOR, to zero if necessary.”

    Seems to me that second statement may have something to do with the behavior of commercial banks.

  17. Gravatar of ssumner ssumner
    27. February 2012 at 11:46

    Left Outside, You must be attending the wrong lectures.

    Philo, Any asset traded in auction-style markets tends to have non-sticky prices. That includes bonds (interest rates), stocks and commodities.

    Barry, If banks can earn 2% or 3% on short term T-bills, they have no reason to hold ERs unless they are paid IOR.

    Lars, Nice picture. I always wondered what you looked like.

    K, Nope. Currency demand isn’t particularly sensitive to interest rates as long as they aren’t zero, or very high. In the 1% to 10% range it makes relatively little difference.

    Monetary policy only affects interest rates because wages and prices are sticky in the short run. In the long run it’s the monetary base that drives the price level.

    If you think interest rates can explain an 87-fold rise in the price level, then by all means write down the interest rate path that predicts that sort of increase.

    Bill, I agree with much of what you have to say, but worry about wasteful non-price competition with private currency.

    Thanks Ben.

    Max. My argument is consistent with Goodhart’s law, because I’m not advocating use of the base as a policy target, nor am I claiming a strict proportionality between money and prices.

    You can decompose OMPs into two parts, the inflationary part is the increase in the currency stock, just like in Hume. The other part is different, but the accumulation of government debt has little or no impact on prices.

    The important point is that the demand for non-interest bearing currency (as a fraction of NGDP) tends to be pretty stable from year to year, as long as rates aren’t zero, or extremely high.

    dwb, Thanks.

    Greg, Yes; Hume, me, you, the Austrians, the Keynesians, the monetarists, we all agree money is non-neutral in the short run.

    The QTM is a long run proposition.

    Mike Sax, You said:

    “So this post in some way refutes MMT?”

    Does it really? I hadn’t noticed.

    I’m done debating MMTers. The debates go this way: I say “so you believe A” and they say, “no, we don’t believe A, we believe B” And I say “so you believe B” and they say “no, we don’t believe B, we believe C”, and so on and so on. It’s like playing whack a mole. I’ve seen them say the QTM is wrong, so I’m not at all surprised to hear you say they believe in it.

    David, Yes, I mentioned them, but only to show how unimportant they are.

  18. Gravatar of Rajat Rajat
    27. February 2012 at 11:57

    “There is no interest rate path that the Fed can describe that would give people even a ballpark estimate of NGDP in 2017.”

    What if the Fed committed to zero interest rates until 2017 without changing the current base?

  19. Gravatar of ssumner ssumner
    27. February 2012 at 12:00

    Rajat, In that case it would be very hard to forecast NGDP, because base demand is highly elastic near zero nominal rates.

  20. Gravatar of Greg Ransom Greg Ransom
    27. February 2012 at 12:11

    “Greg, Yes; Hume, me, you, the Austrians, the Keynesians, the monetarists, we all agree money is non-neutral in the short run.”

    It’s non-neutral always — because there are always several different types of money and several different types of money substitutes which are connected in differential ways to the price-time structure of constantly re-ordering alternative production processes, savings preferences, and consumption choices.

    And all of this is effectively pretended not to exist by monetarists and Keynesians thru the wonders of assumptiont that imply “and then a miracle occurs” processes of direct “aggregate relations” causal magic — relations that can’t possibly take place is you follow out the underlying causal “micro” relations underneath: compare how Lamarkian aggregate level constant conjunction relations not can be supported at a micro level using a non magical underlying causal process, given what we know about cell structure, DNA, etc.

  21. Gravatar of Greg Ransom Greg Ransom
    27. February 2012 at 12:12

    “It’s non-neutral always — because there are always several different types of money and several different types of money substitutes which are connected in differential ways to the price-time structure of constantly re-ordering alternative production processes, savings preferences, and consumption choices.”

    This structure is always partially out of kilter and adjusting in multiple directions at once.

  22. Gravatar of bill woolsey bill woolsey
    27. February 2012 at 12:41

    Ransom:

    How would a world where base money is $500 billion differ from one that is $1000 billion along the lines of:

    “It’s non-neutral always — because there are always several different types of money and several different types of money substitutes which are connected in differential ways to the price-time structure of constantly re-ordering alternative production processes, savings preferences, and consumption choices.”

    This structure is always partially out of kilter and adjusting in multiple directions at once.

    After say, one century, what would be the difference?

    Would the world with $1000b in base money have a different mix of these near monies effecting the structure of production in different ways? Why?

  23. Gravatar of Greg Ransom Greg Ransom
    27. February 2012 at 12:48

    No one needs an economist to know this insight, economists need the addition math construct to recall what their prior math constructs have blocked them from thinking:

    Bill Woolsey writes,

    “everyone knows the money has appeared (or has entered in particular points) and so the price level will end up at some point, then that expectation directly impacts what people do.”

    And note well, there isn’t one kind of money, money substitutes play many roles of money — and as a matter of unalterable fact people cannot know exactly where all of these different monies enter into the economy or where “the” price level will end up “at some point in time”.

    The math constructs assume “data” that doesn’t exist and isn’t “given” — and the process a single mind making stilulations to itself and building these contructs upon thse stipukations has fundamentally misled economists about the natue of the phenomena under study — it simply doesn’t have the form demanded by an construct that is built upon stipulated givens with stipulated relations fully surveyable by one mind.

    And a competent understanding of the role of these expectations can be damaged by model constructors who mistake “expectation” relations in a stipulated construct for expectations in the world. In effect economists are making an unrecognized pun when they us the same word “expectations” found natively in common speech for what is stipulated as a technical term in their stipulated constructs.

    Bill writes,

    “Imagining that demand spreads like ripples in a pond and as a surprise to those receiving it fails to take into account changes in expected prices.”

    No it doesn’t. This is an argument fail. The knowledge proble assures that expectations cannot defeat surprise. Only the assumption of “and then a miracle occurs” defeats surprise, i.e. magic. Magic proposed as “science” by tenured professors is a rival to genuine science, as is has always been (ask Charles Darwin, who was opposed by the tenured professors, who prefered magic.)

  24. Gravatar of Sculeeto Sculeeto
    27. February 2012 at 14:01

    “If you increase the monetary base by 87 times (and a number of middle income countries did this in the 1970s and 1980s) the monetary approach can give you a ballpark estimate of the price level (that it will rise by 87-fold), whereas the interest rate/economic slack approach to inflation is hopelessly lost.”

    Perhaps I am missing something here, but you can estimate this within the woodfordian model under exogenous money supply rule. Where is the problem?

  25. Gravatar of bill woolsey bill woolsey
    27. February 2012 at 14:03

    Ransom:

    Please give an example.

    What near money? How is it created. How does it impact the allocation of resources through time?

    What is the time horizon we are talking about?

  26. Gravatar of From Hume to Woodford…and Back to Hume? – Glimpse From a Height From Hume to Woodford…and Back to Hume? – Glimpse From a Height
    27. February 2012 at 14:13

    [...] How much monetary stimulus is the right amount? Mr. NGDP Targeting himself answers. [...]

  27. Gravatar of K K
    27. February 2012 at 14:18

    Bill,

    I’m not saying I know the NK model of the world. In reality, of course, one proceeds by dynamically fitting its parameters, in particular via observation of the unemployment rate and acceleration of the price level. What I’m saying is, the money supply isn’t one of the intermediating variables. It’s a branch; something you could calculate, if you really wanted to, given NGDP *and* velocity. So defining monetary policy as setting the money supply is just an obscure and roundabout way of setting the risk free rate and then you *still* have the uncertainty in the relationship between the risk-free rate and the real economy. What you have is the underlying NK model *plus* a pile of confusion about velocity.

    Scott, Bill,

    As far as an 87X price inflation goes: you can’t do that with risk free lending in a short amount of time starting from a liquidity trap. When you talk about expanding reserves 87X, what do you mean? You will have bought or repoed all outstanding treasuries 10X over. The only way you can achieve that is via unsecured lending or maybe buying all the $ risk assets in the world. That’ll work (if your goal is inflation), but it ain’t monetary policy. Monetary policy is risk free lending/borrowing (i.e. against sufficient collateral) of currency by the CB plus any communication strategy around that in order to achieve some macro target (inflation, NGDP level/futures, whatever).

    If you want to define monetary policy as purchasing of risk assets/NGDP futures, or unsecured lending by the CB, then fine, anything can happen, and it’s certainly not equivalent to setting the short rate. That ought to be obvious. But it also ought to be obvious that it’s pointless to debate the limits of the power of monetary policy if everyone merely conceives of monetary policy according to their own biases. Scott defined his instrument in a comment of a recent post as purchases of t-securities. I’m OK with that (because it’s economically equivalent to risk free term repos), but it doesn’t buy you 87X. What’s your definition of monetary policy?

  28. Gravatar of Floccina Floccina
    27. February 2012 at 14:26

    Along the lines of lines of what Bill said, it seems that it is always the deltas that mess with the economy.

  29. Gravatar of Dan Kervick Dan Kervick
    27. February 2012 at 14:32

    But if they say they will set the currency stock at $1.6 trillion in 2017, (twice the 2007 level) then people will know that 2017 NGDP is also likely to be roughly twice 2007 NGDP.

    I hate to be so fussy about the real world, Scott, but roughly what proportion of “people” do you believe form their expectations about future levels of aggregate spending – to the extent they have such expectatons at all – on the basis of beliefs they have about the future level of the currency stock? Such advanced expectation-forming, even in gross terms, seems to be confined to a relatively small percentage of economic agents and investors.

    Hume also understood the impact of an increase in money demand (or reduction in velocity):

    I don’t think that portion of “Of Money” has anything much to do with money demand. Hume was simply pointing out that whether an increase in the quantity of money in existence results in an increase in prices depends on whether or not the money is circulating. In the same passage he took note of the other side of the equation by noting that a change in the supply of some commodity in existence will not necessarily lead to a change in the price of the commodity. Changes in the stock of money, or the stock of some commodity, only effect the price of that commodity to the extent that the added stocks meet each other in markets. In speaking of money being “locked up in chests,” Hume might have been thinking of an increased propensity to hold money. But I suspect what he had in mind was mainly the treasure chests government. Coining specie does not affect prices until the money is circulated.

    Hume did advocate a policy of gradual continuous inflation and gradual increase in the money stock managed by the magistrate. He doesn’t say how he envisions the magistrate managing these tasks, but I believe what he has in mind is expenditures from the public treasury on the goods and services the government needs to acquire. He also seems to oppose private banks and paper credit, and wants control over the stock of circulating money to be entirely in the hands of the public, and a public bank. He seems to be envisioning and recommending a regime in which increased stocks of the metals coming into the country are hoarded by the government to cut off the business of “private bankers and money-jobbers”.

    The most interesting part of the essay, to my mind, is Hume’s attempt to wrestle with the paradoxical problem of the “want of money”, which is prima facie at odds with the his quantity theory. Initially, it’s hard to see how there could be a shortage of money in any particular region, since prices should simply adjust to whatever quantity of money happens to be in existence. But there are circumstances in which governments are unable to raise monetary revenues through taxes from a region, because the people in that region, though more-or-less prosperous have little money. It’s an especially tricky problem for Hume because Hume is is fully cognizant of the conventionally determined nature of whatever kinds of metal happen to be used to coin money.

    Hume argues that the problem is not that there is a shortage of money, but that the people in that region live in traditional, pre-commercial state of economic development that does not depend a great deal on trade and monetary exchange. He puts his emphasis here on the “customs and manners of the the people, ” a theme which he develops further in “Of Interest” and “Of Commerce.

  30. Gravatar of math math
    27. February 2012 at 14:35

    ssumner said,

    “Then people began to notice that when the supply of money increased there was a temporary decline in interest rates. This occurred because wages and prices are sticky in the short run, and some variable needs to adjust to equate money supply and demand in the period before prices adjust. Thus interest rates change until wages and prices adjust.”

    It’s an interesting concept. Could you please spell out what the exact mechanism of the prices (wages) adjustment you have in mind here? Otherwise you concept is incomplete.

    PS Btw, I was coming silently sometimes after our discussion over Krugman. Nice blog you have here.

  31. Gravatar of Major_Freedom Major_Freedom
    27. February 2012 at 15:42

    Hume argued that England wouldn’t be any richer in real terms; rather the price level would double. But he also noted that there would be a transition period where the extra money would be spent and trade would expand. So he understood the Quantity Theory of Money (QTM) and the Phillips curve.

    If the price level merely doubles with a doubled money supply, then trade (production) cannot also have expanded. If trade (production) expanded, then prices would rise by LESS than double.

    For example, suppose initial price level is P1=D/S, where D is aggregate demand in money terms, and S is aggregate supply in real goods terms. Suppose then that the money supply and hence aggregate demand doubles, but trade (production) expands by 10%. P2 would be 2D/1.1S = 1.81 D/S = 1.81 P1.

    Hume also understood the impact of an increase in money demand (or reduction in velocity):

    “If the coin be locked up in chests, it is the same thing with regard to prices, as if it were annihilated.” David Hume — Of Money

    It should be noted that velocity is a fudge factor in the Fisher/Friedman equation MV=PQ. It has no independent meaning outside of being the calculation of M/PQ.

    If demand for money increases, then saying velocity will decrease is really saying the quotient M/PQ will decrease.

    Then people began to notice that when the supply of money increased there was a temporary decline in interest rates. This occurred because wages and prices are sticky in the short run, and some variable needs to adjust to equate money supply and demand in the period before prices adjust. Thus interest rates change until wages and prices adjust. This led economics to take a momentous wrong turn. Under the influence of Wicksell, and then later Keynes, macroeconomists began to see the change in interest rates as not some sort of epiphenomenon associated with an increase in the money supply, but rather as monetary policy itself.

    Absolutely bingo. When you criticize Keynesians, you’re on.

    The QTM was based on the hot potato effect, the idea that if you double the supply of non-interest-bearing base money, people will try to get rid of excess cash balances. But in aggregate they cannot do so, as the central bank controls the supply of base money. Instead the attempt to get rid of excess cash balances drives up prices and NGDP until people are again willing to voluntarily hold the enlarged cash balances. That occurs when prices and NGDP have doubled, so that real money demand and velocity return to their original level.

    There is a flaw in Woodfordian macro. No model lacking money can explain large changes in the money supply and price level. That’s why the post-WWI hyperinflations caused even Wicksell and Keynes to briefly return to the quantity theory of money. If you increase the monetary base by 87 times (and a number of middle income countries did this in the 1970s and 1980s) the monetary approach can give you a ballpark estimate of the price level (that it will rise by 87-fold), whereas the interest rate/economic slack approach to inflation is hopelessly lost. So there’s not much doubt that in some sense the quantity of money is still driving the price level, at least in the long run. But how can it be made relevant for our current situation, where inflation rates are quite low and velocity is quite unstable?

    It seems to me that Woodford’s approach is capable of rescuing the QTM. Think about it. The QTM is criticized as only being able to explain price level changes in the long run. And yet Woodford says that the current level of aggregate demand is mostly determined by the expected future course of monetary policy; i.e. the long run. Keynes said in the long run we’re all dead, and now Keynes is dead and Woodford is saying in the short run AD is determined by (expected) long run changes.

    Here I must dissent. The flaw in the whole “QTM can only explain price levels in the long run” argument can easily be exposed by realizing that we are always in the long run, now in the present, on account of the quantity of money and volume of spending that exists in the present that is the result of all the inflation up to that point. The Fed is more or less constantly inflating the money supply, and so at any given time, we are always living at the “long run” of inflation.

    For the moment let’s set aside the question of interest on reserves, and focus on non-interest-bearing currency. Before the recession (in 2007) currency was about 6% of U.S. NGDP. And if interest rates are positive in 2017 it will again be about 6% of NGDP, give or take 1%. That means the question of whether 2017 level of NGDP is 30% or 60% or 90% higher than in 2007, will mostly depend on where the Fed sets the currency stock in 2017. Not precisely, but approximately. Admittedly they don’t control the currency stock directly, they control the base. But in normal times the base is more than 90% currency. If the Fed wants that proportion to drop, they can increase IOR and inject enough extra base money to keep currency where they want it. If they don’t want it to drop they can lower the IOR, to zero if necessary.

    The rate of growth in NGDP between now and 2014 will be strongly influenced by where people think NGDP will be in 2017. There is no interest rate path that the Fed can describe that would give people even a ballpark estimate of NGDP in 2017. But if they say they will set the currency stock at $1.6 trillion in 2017, (twice the 2007 level) then people will know that 2017 NGDP is also likely to be roughly twice 2007 NGDP. And if they do that, NGDP will grow very rapidly over the next two years.

    I think that estimate is too simplistic. A doubled currency stock would be a part of a pyramiding scheme of fractional reserve media creation that is multiples of times that stock, and that should be included in the aggregate money statistics, since they affect prices too.

    Of course the Fed shouldn’t do that, for two reasons. First, that would create faster NGDP growth than is desirable. And second, it’s not as precise an instrument as targeting the forecast. Better to say they’ll provide as much base money as necessary in 2017 to produce an NGDP that is 30% higher than in 2012.

    LOL at your begging the question about desirability. You’re saying it’s not desirable to increase currency that fast, and your first reason to support that judgment is that…it’s not desirable.

    I mean, desirable according to who?

    Your second reason I think is more reasonable.

    That’s the sort of monetary policy Hume would understand, and approve of.

    PS. Why 30%? It would allow for 7% growth between now and 2013, and 5% thereafter. It’s a reasonable compromise that would dramatically speed up the recovery, but not create the politically unacceptable inflation likely to result from returning to the pre-2008 trend line.

    False recovery and the creation of yet another, larger bubble and collapse.

    You sure the economy can handle that?

  32. Gravatar of Nick Rowe Nick Rowe
    27. February 2012 at 16:14

    Where Hume went wrong: “The good policy of the magistrate consists only in keeping it, if possible, still encreasing; because, by that means, he keeps alive a spirit of industry in the nation, and encreases the stock of labour, in which consists all real power and riches.

    That’s where Friedman comes in. The effects of a temporary increase in the money supply can be different from the effects of a permanently increasing money supply.

  33. Gravatar of Jim Glass Jim Glass
    27. February 2012 at 16:27

    I’m done debating MMTers. The debates go this way: I say “so you believe A” and they say, “no, we don’t believe A, we believe B” And I say “so you believe B” and they say “no, we don’t believe B, we believe C”, and so on and so on. It’s like playing whack a mole.

    Yes, I’ve had that experience many times over. Very frustrating. Also doesn’t do much for the credibility of MMT.

    Bernanke notably put “Friedman’s own list of eleven key monetarist propositions” on the Fed’s web site, so there’s no playing whack-a-mole with *them*.

    Perhaps we could try to persuade the MMTers to try to get together and agree on the Ten (or whatever) Key Principles of MMT. If they can. Get some solid, organized, agreed-upon analysis out of them. And publish it in one place for all to see.

    Until then — as long as they remain so quick to contradict each other for rhetorical convenience — there’s little point in discussing things with them, in my experience.

  34. Gravatar of dwb dwb
    27. February 2012 at 17:06

    @ Jim Glass

    the link does not work (make it http: instead of https: – i get a page not found error).

    There is a lot of really rich stuff in this one speech, i had not read it in quite a while, good link. I wish the new Bernanke would go back and read the old Bernanke…

    Here’s a gem:

    For example, Sargent and Wallace’s “unpleasant monetarist arithmetic” suggested that a near-term tightening of monetary policy, by making the long-term fiscal situation less tenable, could (in principle at least) lead to inflation, because the public will anticipate that the fiscal deficit must be financed eventually by money creation. More recently, Woodford’s fiscal theory of the price level suggests that nonsustainable fiscal policies can drive inflation, even if the central bank resists monetization. Following Woodford, Olivier Blanchard has recently argued that tight money policies in Brazil, by raising the government’s financing costs and thus worsening the fiscal situation, might have had inflationary consequences.

    So high interest rates in Europe are a) because investors fear default (there will still be some 0 < recovery of principal <100%); b) investors fear that eventually money must be printed to avoid default (thus fear inflation hence high rates) ; c) you can't tell the difference merely from interest rates, the net effect of debt devaluation from default or inflation are the same;

    As for his tenth proposition, we have this thing called nominal gdp….

  35. Gravatar of dwb dwb
    27. February 2012 at 17:11

    and another one:
    However, on the benefits of monetary stability, or as I would prefer to say, nominal stability, Friedman was not wrong. Many theories popular even today might lead one to conclude that increased stability in inflation could be purchased only at the cost of reduced stability in output and employment. In fact, over the past two decades, increased inflation stability has been associated with marked increases in the stability of output and employment as well, both in the United States and elsewhere.


    He identified the key empirical facts and he provided us with broad policy recommendations, notably the emphasis on nominal stability, that have served us well.

    i really really really wish the new Bernanke would go back and read the old one.

  36. Gravatar of Mike Sproul Mike Sproul
    27. February 2012 at 17:57

    The thought experiment Hume should have done: Suppose everyone in England sells enough bonds to the Bank of England that the quantity of paper money in their purses is double what it was the night before.

    Hume was right that nobody’s wealth would change, but if he had thought it through, he would have realized that the Bank of England’s wealth would also not change, and so each paper pound would be worth the same as before. And if he had thought a little harder, he would have realized that the following day, those people would have returned their extra cash to the bank in exchange for their bonds.

  37. Gravatar of Tommy Dorsett Tommy Dorsett
    27. February 2012 at 19:57

    Scott — it looks like the currency component of the M1 money supply has risen to more than 7.5% of nominal income, the highest level since 1959, which is when the Fed’s dataset begins. http://research.stlouisfed.org/fredgraph.png?g=5ks Thus, money demand has surged.

    Perhaps the Fed is getting Woofordian traction by intimating that a bit more of this non- bearing base money will be permanent. This may be why long rates have recently disconnected from the (more positive) macro data.

    Also, I think Woolsey is right that commercial banks are important, at least under a fiat money, interest rate targeting regime. Recently, bank credit has begun to grow. This too may be helping the Fed get some traction.

  38. Gravatar of Greg Ransom Greg Ransom
    27. February 2012 at 20:35

    “Along with the disappearance of the “shadow lenders,” there has been a dramatic decline in something called “shadow money.” The concept of shadow money was presented by two economists from Credit Suisse, James Sweeney and Carl Lantz, in a Bloomberg interview in May. As explained on DemandSideBlog, shadow money is money the market itself creates in order to finance a boom — “money” in the sense of a medium of exchange. In a boom there is not enough cash to go around, so collateral is used as near money or shadow money. Shadow money can include government bonds, private bonds, asset-backed securities, credit card debt (which can be incurred and paid off without drawing on the M1 money stock), and even real estate (when it is highly liquid and easily tradeable) . . .

    Lantz and Sweeney calculate that at the peak of the boom there were six trillion dollars in the traditionally-defined money stock (or money supply). The private shadow stock accounted for $9.5 trillion, and government-based shadow money accounted for another $11 trillion. Thus the shadow money stock dwarfed the traditionally-defined money stock. This can be seen in the chart below provided by Tyler Durden. The blue strips at the bottom, called “outside money,” are dollars printed by the Federal Reserve. The red sections, called “inside money,” are money created as loans by the banks themselves. The green sections, called “public shadow money,” are money created by the government and the Fed as debt (or loans). The purple sections, called “private shadow money,” are the money created as private debt securities by the shadow lenders.

    Lantz and Sweeney estimate the total drop in private shadow money (the purple blocks) during the current credit crisis at $3.6 trillion. This has been offset by an increase in public shadow money, both from the massive borrowing needed to finance the federal deficit and from the aggressive liquidity measures taken by the Fed in converting private securities into loans.  Those measures helped prevent an even worse drop in the commercial money supply than actually occurred, but they were not sufficient to eliminate the credit squeeze from lowered commercial lending, which continues to act as a tourniquet on the productive economy.”

    http://hayekcenter.org/?p=2954

  39. Gravatar of Greg Ransom Greg Ransom
    27. February 2012 at 20:38

    “My view is that the bubble was about amplification. A piece of the price of houses is always due to a type of “monetary bubble.” Equity in a house is collateral which can be used by the homeowner to borrow; the mortgage on the house can be packaged as a mortgage-backed security, and that security can be used in financial exchange, and as collateral, perhaps multiple times. Thus, through an amplification effect, the housing collateral potentially supports a very large quantity of credit, and that feeds back into housing prices. The financial crisis was about incentive problems that caused the monetary bubble to be larger than was socially optimal, and once financial market participants caught on, that piece of the bubble burst.” — Stephen Williamson

    http://newmonetarism.blogspot.com/2012/02/amplification-and-indeterminacy.html

  40. Gravatar of Greg Ransom Greg Ransom
    27. February 2012 at 20:40

    ““It is necessary to take account of certain forms of credit not connected with banks which help, as is commonly said, to economise money, or to do the work for which, if they did not exist, money in the narrower sense would be required.  The criterion by which we may distinguish these circulating credits from other forms which do not act as substitutes for money is that they give to somebody the means of purchasing goods [or securities] without at the same time diminishing the money spending power of somebody else. …. The characteristic peculiarity of these forms of credit is that they spring up without being subject to any central control, but once they have come into existence their convertibility into other forms of money must be possible if a collapse of credit is to be avoided.”

    http://hayekcenter.org/?p=2954

    A few examples requested by Bill Woolsey.

  41. Gravatar of Greg Ransom Greg Ransom
    27. February 2012 at 20:50

    “Wilmot, Sweeney, Klein, and Lantz then comment:

    “The economy can create its own media of exchange in order to economize on the use of inside and outside money when there is significant demand for some type of money for use in purchasing assets. Of course, when assets can themselves serve as collateral, allowing for leveraged purchases, then they take on money-like properties. And when financial assets serve as collateral for borrowing to purchase yet more financial assets (buying on margin) this form of shadow money can become particularly potent in driving asset price overshoots and bubbles.”

    – Wilmot, Sweeney, Klein and Lantz (Credit Suisse)

    http://faculty.unlv.edu/msullivan/Sweeney%20-%20Money%20supply%20and%20inflation.pdf

  42. Gravatar of nemi nemi
    28. February 2012 at 03:07

    Many countries, e.g. Sweden and Canada, has zero reserve requiremens. Shouldn´t they, according to your theory, have hyperinflation?

    What do you mean by “Money”?
    What do you mean by “Y”? Are the many many trillion of $ of transactions within the finansial markets included in Y?

  43. Gravatar of W. Peden W. Peden
    28. February 2012 at 04:36

    Nemi,

    “Y” stands for national income/output. There is some interesting research beginning with the MV = PT equation which shows that PT and PY can diverge over time and have done so in the last 30-40 years in the UK.

    Sweden and Canada must have cash ratios, either legally or through market pressures. In the UK at least, the cash requirement has traditionally been the key part of making banks dependent on the BoE; reserve requirements serve a prudential function rather than a control function. There are no mandatory reserve requirements in the UK, apart from the cash requirement.

    In the UK, some have argued that the key restriction on credit expansion (apart from the increased demand for base money) has been the recapitalisation movement, since a bank can only recapitalise via either (1) reducing the volume of its depository liabilities or (2) persuading people to swap broad money deposits/cash for shares. In both cases, the effect is to reduce the growth of deposits, which has been anemic since early 2008-

    http://www.bankofengland.co.uk/statistics/fm4/2011/dec/CHART1.GIF

  44. Gravatar of Barry Barry
    28. February 2012 at 05:04

    @Scott

    “Barry, If banks can earn 2% or 3% on short term T-bills, they have no reason to hold ERs unless they are paid IOR.”

    So your plan is for banks to dump their money into T-bills? Isn’t that contractionary?

  45. Gravatar of nemi nemi
    28. February 2012 at 06:48

    @ W. Peden
    They do of course have capital requirements, but they do not have any reserve requirements.

    According to the Swedish central bank, the money supply is pretty irrelevant. From their info about how they conduct monetary policy:
    http://www.riksbank.se/Upload/Dokument_riksbank/Kat_mop/Er01_1e.pdf

    e.g:
    “When banknotes ceased to be the only means of payment, the central banks’opportunities to use control of the supply of notes alone to influence the quantity of money, and thereby prices in the economy, were reduced. Most of the central
    banks introduced reserve requirements for the banks’ liquid deposits in order to increase the control over the broader concept of money. The reserve requirements forced the banks to invest some of their deposits from the general public in
    non-interest bearing accounts in the central bank.

    However, liquid securities markets, properly functioning overnight markets and effective payment systems have reduced the need to maintain liquid funds in the form of deposits and banknotes as a buffer to be able to execute transactions.
    Securities can be rapidly sold or pledged, for instance, and credit under takings can be rapidly transformed into means of payment by creditworthy banks. The rapid rate of development has made it difficult to find a measure for the concept of money that shows a stable connection with the inflation rate.

    Today, most central banks therefore aim their monetary policy towards influencing interest rate formation in the economy via the overnight interest rate (see later
    section) without directly aiming its effects at the quantity of money. The quantity of money is now mainly used as one inflationary indicator among many others by most central banks.”

  46. Gravatar of John John
    28. February 2012 at 06:50

    You don’t even need to resort to ill-defined terms like “the quantity of money” to figure out the height of prices. If you trace back the value of modern paper money to their original relationships to gold and/or silver, you can best understand why money has the value it has today. For instance, one yen was originally worth much less gold than a dollar, which was worth less gold than the british pound. By viewing money as a simple commodity (they all derived their original value from the industrial and exchange uses of gold and silver), supply and demand perfectly explains changes in prices over the years. The quantity theory of money fails to account for the demand side.

    Mises elaborated this original line of argument, applying the theory of marginal utility to money (something that stumped everyone else). In addition, he combined Wicksell’s ideas about interest and the British currency school’s theory of banking crises to show how expansion of money through the banking system lowers interest rates and misleads production, specifically encouraging longer term projects than the real rate of savings justifies. This inevitably leads to a bursting bubble. It’s time the monetarist economists read Mises. His understanding of money was head and shoulders above that of Fisher or Friedman.

  47. Gravatar of ssumner ssumner
    28. February 2012 at 07:09

    Sculeeto, I was talking about Woodford models that lack money.

    K, You said;

    “As far as an 87X price inflation goes: you can’t do that with risk free lending in a short amount of time starting from a liquidity trap.”

    I never said you could. When you are not in a liquidity trap, then as the base rises the nominal national debt also rises fast. Check out the history of hyperinflation in Latin America.

    Dan, You asked;

    “I hate to be so fussy about the real world, Scott, but roughly what proportion of “people” do you believe form their expectations about future levels of aggregate spending – to the extent they have such expectatons at all – on the basis of beliefs they have about the future level of the currency stock? Such advanced expectation-forming, even in gross terms, seems to be confined to a relatively small percentage of economic agents and investors.”

    I’d say almost no one does, but if the central bank started targeting the base then they would pay attention. The Fed uses other signals to indicate where the future monetary base is likely to end up, and the public looks at those other signals. Obviously the public pays a lot of attention to monetary signals, as stock prices can swing 5% in 10 minutes based in a signal from the Fed.

    I don’t agree about Hume and the demand for money. I think that quote does refer to an increase in the demand for money being deflationary. Perhaps Hume didn’t use that terminology, but he understood the concept at an intuitive level.

    Thanks for the other information on Hume. I read all those essays, but long ago.

    math. Thanks for the comment. There are lots of theories about how wages and prices adjust, and I imagine most are true for some wage and prices and not others. Some are based on menu costs, some on money illusion, and so on. But as far as I know they all assume money is neutral in the long run, and most assume it’s at least approximately super-neutral.

    Major Freeman, Some of your early comments are of course correct, but you are a bit confused about the “long run.” We are always in the long run vis a vis shocks that occurred in the distant past, but not in terms of shocks happening right now.

    Nick Rowe, That’s right.

    Jim Glass. Good idea.

    dwb, Good find, do you have a link?

    Mike Sproul, Your mistake is assuming gold and bonds are close substitutes, they aren’t. If the supply of apples increases and the dollar price falls in half, then apple NGDP doubles. That’s simple value theory, wealth need not change at all for this to occur. Wealth is not the issue. Instead, the measuring stick of value (apples) falls in half.

    Now consider a gold monetary economy. Bonds are not the medium of account, their nominal price changes. Gold is the medium of account, it’s nominal price never changes. So when the supply of gold goes up and it’s value falls, all other prices must change. The interesting example is where the central bank controls the base, and doesn’t let the public bring base money (gold) back to the central bank for redemption, that’s analogous to our current system.

    Tommy, Yes, and that’s exactly what you’d expect. Note that currency growth first slowed sharply, putting us into a recession and driving rates to near zero. Then demand rose because of the low op. cost of holding cash.

    Banks are important in a micro sense, but not very important in a macro sense.

    Greg, You quote someone (Hayek?):

    “It is necessary to take account of certain forms of credit not connected with banks which help, as is commonly said, to economise money, or to do the work for which, if they did not exist, money in the narrower sense would be required.”

    That’s what I’m saying. The broader aggregates only matter to the extent to which they affect the demand for base money. So I just focus on the supply and demand for base money.

    Nemi, You said;

    “Many countries, e.g. Sweden and Canada, has zero reserve requiremens. Shouldn´t they, according to your theory, have hyperinflation?”

    No, I favor eliminating RRs, and also IOR. Then in normal times currency would be 99% of the base, not 90%.

    Barry, No, that’s like the Fed doing an OMP. It’s expansionary.

  48. Gravatar of ssumner ssumner
    28. February 2012 at 07:11

    John, Some countries with currencies that were once linked to gold have seen hyperinflation, so the original gold link tells us little about the current value of a currency.

  49. Gravatar of dwb dwb
    28. February 2012 at 07:26

    http://federalreserve.gov/boarddocs/speeches/2003/20031024/default.htm

    {same link Jim Glass posted with typo corrected}.

  50. Gravatar of Barry Barry
    28. February 2012 at 07:27

    “Barry, No, that’s like the Fed doing an OMP. It’s expansionary.”

    How so? I mean OMP is traditionally expansionary through interest rates lowering as more T-bills are purchased, but I thought that was NOT the mechanism that market monetarists favour?

  51. Gravatar of math math
    28. February 2012 at 07:33

    Scott, I think you misunderstood my question.

    I asked if “temporary decline in interest rates” (you were talking about above) has an impact on the “sticky” prices / wages adjustment in your mind. Or if it just happens in a “parallel reality” without any real effect on the matters in question.

  52. Gravatar of Dan Kervick Dan Kervick
    28. February 2012 at 07:36

    I’d say almost no one does, but if the central bank started targeting the base then they would pay attention. The Fed uses other signals to indicate where the future monetary base is likely to end up, and the public looks at those other signals. Obviously the public pays a lot of attention to monetary signals, as stock prices can swing 5% in 10 minutes based in a signal from the Fed.

    Fair enough, Scott, although the “public” in this case are just those who actively pay attention to the stock market.

    As usual, I’m more inclined to look at the demand side of the economy than the supply side. I tend to view the stock market as just a bunch of folks swapping profits around and trying come away with a bigger pile of chips than the other folks playing in the same game, with minimal impact on real economic value and growth. Some make fortunes and some lose fortunes, but in aggregate it is more or less a wash. All the really important things are happening out in the real world, among people who barely pay any attention to the equity markets. The latter are a mostly parasitical, blood-sucking appendage that attaches itself to people doing real work and creating real value, and claims a share of the output of that work.

    Financing, I would say, is pulled out into the real economy as needed, by the existence of productive and creative people with real ideas. It isn’t pushed out into the real economy by financial markets.

  53. Gravatar of math math
    28. February 2012 at 07:56

    Dan Kervick said,

    “I tend to view the stock market as just a bunch of folks swapping profits around and trying come away with a bigger pile of chips than the other folks playing in the same game, with minimal impact on real economic value and growth.”

    My current view is different. I look at the money in economy as a pool divided between real economy and financial market where money are going back and force between these two places in search of a bigger profit. In that sense, the money allocated in the financial market has an impact on the real economy (since the flux and reflux of money has an impact on the real economy).

    Perhaps, I’ll change my view later but this is what I am contemplating about the matter now.

  54. Gravatar of Greg Ransom Greg Ransom
    28. February 2012 at 09:25

    If you want to stabilize base money you need to stablize the coordination of money substitutes whose value/size are inextricably linked to time-value, i.e. time discount conjointly mitigated by changing length of time and superior or inferior output. E.g. across that last 15 years you don’t stabilize base money unless you simultaniously stabilize finance/housing/finance/transportation. e.g.

    You’ve got these things in part backwards.

    Yet we agree that NGDP targetting will help with stabilization — we differi in this, you believe stabilizing base money alone is all that is necessary, I suggest that “stable” base money as you define it can generate instability in “the broader aggregates” (an expression which hides that structure which gives causal significance to the phenomena).

    Yes, it’s Hayek.

    Scott writes,

    “Greg, You quote someone (Hayek?):

    “It is necessary to take account of certain forms of credit not connected with banks which help, as is commonly said, to economise money, or to do the work for which, if they did not exist, money in the narrower sense would be required.”

    That’s what I’m saying. The broader aggregates only matter to the extent to which they affect the demand for base money. So I just focus on the supply and demand for base money.”

  55. Gravatar of Major_Freedom Major_Freedom
    28. February 2012 at 10:18

    ssumner:

    …you are a bit confused about the “long run.” We are always in the long run vis a vis shocks that occurred in the distant past, but not in terms of shocks happening right now.

    Of course, I thought that was obvious. I just wanted to express the idea that we are always in the long run when it comes to inflation. It’s never “not” occurring for people in the present, that’s all.

  56. Gravatar of Mike Sax Mike Sax
    28. February 2012 at 12:04

    Scott, understand I’m not saying they believe it, I’m going by what Scott Fullwiler says they believe-Fullwiler in the MMT world is sort of like you in the MM world.

    Maybe you think debating them is like whack a mole though I suspect that problem is that since MMT and MM come from such a different vantage point it’s really hard to have any kind of meeting of the minds.

    Like I said I think the real difference is money neutrality itself. If you say they deny it they won’t come back and say you’re wrong on that one.

    Essentially they are Chartalists which is the opposite of Monetarism. Essentially Monetarism is the modern day version of Metallism which is the historic opponent of Chartalism.

  57. Gravatar of Mike Sax Mike Sax
    28. February 2012 at 12:05

    In other words they I think will agree they deny money neutrality-I know for a fact they deny the money multiplier

  58. Gravatar of Max Max
    28. February 2012 at 12:10

    The concept of ‘non interest bearing base money’ seems to be obsolete since central banks are paying interest on reserves. The quantity of bank reserves doesn’t determine the interest rate. The quantity of currency has no macro implications, since people switch between currency and bank accounts at will.

    Under the old system, if there was an excess of base money, the interest rate was necessarily 0%. But the CB wasn’t committed to holding the rate at 0% since it could always drain the reserves. So setting the quantity of base money didn’t actually send any clear message about monetary policy.

  59. Gravatar of John John
    28. February 2012 at 14:04

    Scott,

    In the case of countries that had a hyperinflation, you’d just have to look at what they did to replace hyperinflated currency. The point is that you can tie the value of money to the valuations of the marginal buyers and sellers just like any other good. This “micro” understanding of money’s value makes a lot more sense to me than referring to the “quantity of money” which is a term that is very difficult to measure and quite subjective actually. The monetarists should learn from Mises’ writings on money. The approaches that don’t tie money to its marginal utility tend to make errors.

  60. Gravatar of K K
    28. February 2012 at 14:05

    Scott: “I never said you could. When you are not in a liquidity trap, then as the base rises the nominal national debt also rises fast.”

    I’m not sure I follow. If the short rate is below NGDP growth, debt/gdp falls. But anyways, I think we are moving away from the core of the discussion.

    I really don’t think you and the NK’s are that far apart. But I think what’s at the core of any possible disagreement is the meaning of “monetary policy.” By monetary policy, the NK’s really mean “the contingent path of the risk free rate.” It is my contention that *that* is exactly equivalent to “the contingent path of the money supply” (except that the money supply at the ZLB is irrelevant). But we need to be *really* careful what we mean when we say “money supply,” because there are so many possible ways to create money. NK’s therefore think of money creation via risk-free overnight, or possibly term, lending, since that is the simplest and purest way to do it, and it has no impact other than the creation of the additional money itself. In particular, the repo borrower retains full exposure to the market value of the collateral.  

    Any other mechanism can have any number of possible effects due the assets being swapped for the money. But NK’s would say that it is not right to count those effects as “monetary” since they were not an effect of the quantity of money being created; they were caused by the other leg of the asset swap. Therefore it’s best to think of any CB action as a combination of 1) a repo trade or t-bill purchase (monetary policy) and 2) a swap of t-bills for something else (fiscal/industrial policy).

    I think if you were really clear about which operations qualified as monetary policy, it would be impossible to have any disagreement within  a ratex framework. (However, I believe the simplest such framework is the NK model, and I’m really curious to know which assumptions of that model you disagree with.)

    So when you speak of an 87X expansion of the balance sheet, 1) it’s really hard to understand how that can be achieved via “monetary policy,” and 2) if it was achieved via monetary policy I don’t see why it would be inflationary.

  61. Gravatar of TheMoneyIllusion » Reply to Karl Smith TheMoneyIllusion » Reply to Karl Smith
    28. February 2012 at 14:31

    [...] Smith recently commented on my post about Hume and Woodford. I had argued that during “normal times” (when rates are positive) the future path of [...]

  62. Gravatar of Max Max
    28. February 2012 at 15:15

    K, that’s a very lucid post. You should have your own blog!

  63. Gravatar of K K
    28. February 2012 at 16:41

    Thanks, Max! I’ve thought about it many times, but I’m terrified of what it might do to my family/day job. Commenting is bad enough.

  64. Gravatar of ssumner ssumner
    28. February 2012 at 19:36

    dwb, Mucho thanks. I loved that piece, and have a new post up.

    Barry, No, OMOs are not expansionary through interest rates falling. Often large OMPs are followed by higher interest rates, but NGDP goes up nonetheless.

    math, Sorry, I misunderstood. I don’t think interest rates on T-bills have much impact on the economy, I think monetary policy works through other channels. More money makes NGDP rise (ceteris paribus) via the hot potato effect, and initially both P and Y increase, because some prices are sticky and some are flexible. Over time new catalogs are printed with new prices, and new wage contracts are signed, and the RGDP returns to the natural rate. Only wages and prices are affected. Is that what you are asking?

    Dan, You said;

    “Fair enough, Scott, although the “public” in this case are just those who actively pay attention to the stock market.”

    All asset prices are affected, not just stocks, and the public pays a lot of attention when all asset prices move in a big way. When they all crashed in late 2008 it certainly got the public’s attention, people became more pessimistic.

    Greg, I don’t want to target the base, as base velocity changes. I want to adjust the base as required to keep NGDP growth on track. In that case I’m implicitly adjusting the base to offset those financial shocks you mention.

    Mike Sax, They don’t even understand the money multiplier, so how can they “deny it” The money multiplier is the ratio of a monetary aggregate to the base. To deny the money multiplier is to say that there is no such things as the base or M2. They’d respond they are just denying the stability of the multiplier, and falsely claim that the textbooks assume the multiplier is constant. That’s silly. I teach out of Mishkin’s text and he shows graphs with big changes in the multiplier in the 1930s. They don’t seem to even understand the standard model, so they are in no position to criticize it.

    But saying the multiplier doesn’t exist is just silly. It’s like saying V doesn’t exist, or the MPC doesn’t exist. The real question is whether those parameters are stable.

    Joe Gagnon expressed exactly my views on MMT in the WaPo.

    Max, You said;

    “Under the old system, if there was an excess of base money, the interest rate was necessarily 0%.”

    Don’t go there, or you’ll end up like an MMTer. Under the old system the more rapidly the MB increased, the higher the level of inflation and the higher the level of nominal interest rates.

    I agree that they used interest rate targets to send signals, not the money supply. But the money supply was doing the heavy lifting, the interest rate was an epiphenomenon. Suppose they had used the US dollar/New Zealand dollar exchange rate as the target and signaling device. Do you think that exchange rate would have been the main transmission channel for monetary policy affecting AD?

    John, You are completely wrong, there is nothing ambiguous about the monetary base. It’s well-defined. You might not like the base, but your comment is flat out wrong. I almost always define money as the base.

    K, I’m afraid I disagree with just about everything you said.

    The monetary authority does not control interest rates, it influences then via changes in the money supply. They used to buy gold, and when they did so short term rates fell, and people like Wicksell called those low short term rates “easy money.” There’s a long history of monetary policy, which the NKs can’t ignore. It doesn’t have to be T-bills or repos. In the Middle Ages debasing coins was monetary policy. Yes, there’s some impact on gold mining from gold purchases but that’s trivial compared to the effect of the extra money on the macroeconomy.

    Now they don’t even buy gold, they just buy Treasury securities of various maturities. Conceivably maturity might matter a tiny bit at the zero bound, but during normal times even NKs thought operation twist was meaningless and they thought it didn’t much matter what the Fed bought.

    Monetary policy is injecting more money. Yes, it influences short terms rates regardless of what you buy, but it also influences the price of strawberries. Nobody says the price of strawberries is monetary policy.

    Money injections are two-sided, but only one side really matters when rates are positive. When rates are zero it’s possible that neither side will matter very much, if the injection is temporary.

    The 87 fold is no exaggeration. I don’t have time now but there were lots of countries in Latin America who did that in the 1970s and 1980s. Argentina and Brazil averaged 70% inflation for 30 years–that adds up quickly with compounding. With rapid inflation the base is only about 1% or 2% of GDP (low money demand). So base doublings merely need to finance a tiny bit of the national debt. Believe me, it happened. Also check out Turkey in the 1990s and early 2000s.

  65. Gravatar of K K
    28. February 2012 at 20:27

    Scott: “The monetary authority does not control interest rates, it influences then via changes in the money supply.”

    Not so. The bank of Canada keeps about $25m (yup, that’s million with an m) of net reserves in the system, while rates have ranged from 6 to 1%. Also, they pay IOR and have been for a long time. How exactly do they control the money supply? Rates, on the other hand, they control very effectively by the threat of interfering in the *rates* market.

    When they start buying, it matters quite a bit what they buy because it affects investor portfolios. If they started buying stocks it would have a huge impact on markets, and that would have nothing to do with the money supply. If they did unsecured lending the impact on the credit markets would also be huge, hundreds of times greater than a bit of risk free repo. If it didn’t matter how they create the money, why don’t they just do repos? Repos create money as much as treasury QE.

    As far as twist goes, as I’ve said I think it’s counterproductive because t-bonds are negative beta. That’s why I don’t mind letting you call treasury-QE monetary policy. It doesn’t make any difference to my argument, and anyways, buying a one year t-bill has exactly the same impact as doing a one year well collateralized repo.

    The countries you mention all ran huge money financed fiscal deficits. I never said fiscal policy (including helicopter drops) couldn’t cause inflation. On the contrary, that was my whole point. It’s way harder with monetary policy.

    You really can’t ignore how the money is created. The impact of varying the details is huge and instrumental in whether you actually achieve anything. The money supply itself is totally besides the point.

  66. Gravatar of From Hume to Woodford . . . and back to Hume? « Economics Info From Hume to Woodford . . . and back to Hume? « Economics Info
    28. February 2012 at 21:01

    [...] Source [...]

  67. Gravatar of ssumner ssumner
    29. February 2012 at 06:09

    K, The mistake Keynesians keep making is focusing on reserves and rate. In Canada the monetary base is roughly 99% currency. It is through control of the currency stock that the BOC determines rates. It looks like it’s reserves because the new money is often injected in through the banking system, but that’s an illusion, it is currency that dominates the monetary base. If Canada doubled the currency stock over the next three years, the base will roughly double. In that case the rise in the currency stock will drive NGDP, not whatever happens to interest rates or the price of strawberries.

  68. Gravatar of ssumner ssumner
    29. February 2012 at 06:13

    K, You said,

    “The countries you mention all ran huge money financed fiscal deficits.”

    This is another misconception. ALL open market purchases represent monetization of the debt, and almost all countries run deficits. So you could say the same thing about the US. But I thought you were denying that large money injections in the US could drive the price level up 87 fold. As I said, the amount of (real) money printing required for hyperinflation is surprisingly low, as real currency demand drops sharply with high inflation rates.

  69. Gravatar of math math
    29. February 2012 at 07:14

    ssumner said,

    “Only wages and prices are affected. Is that what you are asking?”

    Thanks. Fair enough. I thought you have some “unconventional channels” in mind.

  70. Gravatar of Max Max
    29. February 2012 at 08:32

    Scott, suppose that currency were abolished and through technical changes the need for bank reserves were eliminated. In that case, the quantity of base money would normally be zero. (The central bank would still be able to create base money, but it wouldn’t need to do so unless the system malfunctioned). In the interest rate view of things, the only difference is that the ZLB is eliminated. I’m curious how a quantity theory would deal with a system where the quantity is normally zero.

  71. Gravatar of Greg Ransom Greg Ransom
    29. February 2012 at 09:00

    Scott, you want to situate yoursel so that your stance is pro-active and you aren’t re-actively trying to fix your past mistakes. And you don’t want ill-grounded re-active “fixes” for small events actually unwittingly generating larger “shocks” down the road.

    I.e. you don’t want to be creating these financial shocks the way they were generated in the 2001-2007 period, when the Fed was fighting the “deflation” scare (rember that?), and the government was making a train wreck of housing finance, financial moral hazard, and fiancial regulation (TBTF, Greenspan Put, Freddie, CRA, SEC incompetence, FBI abandoning mortgage origination fraud, Continental Illinois, etc., etc. etc.)

    Scott wrote,

    “Greg, I don’t want to target the base, as base velocity changes. I want to adjust the base as required to keep NGDP growth on track. In that case I’m implicitly adjusting the base to offset those financial shocks you mention.”

  72. Gravatar of Greg Ransom Greg Ransom
    29. February 2012 at 09:08

    Scott, you rarely discuss the 2001-2007, I.e. the years when the Fed was fighting off the threat of deflation — Greenspan and Bernanke’s constant worry during those years.

    And the years when the economy was launches on a serious discoordination path.

    Is this because the spectacles of your “theory” don’t let you see much or say much about large domains of readily apparent macroeconomic phenomena — e.g. just like pre-Franklin flow models of electricity which didn’t allow for a recognition of large parts of electrical phenomena, e.g attraction and repulsion?

  73. Gravatar of Victor Victor
    29. February 2012 at 12:56

    Scott,
    QTM is only useful when monetary policy don´t answer agressively to inflationary pressures,this is what Sargent and Surico found out (http://www.aeaweb.org/articles.php?doi=10.1257/aer.101.1.109)

    So, as long as the monetary policy is answering to inflationary pressures, the QTM will not be valid.

  74. Gravatar of K K
    29. February 2012 at 18:35

    Scott: “ALL open market purchases represent monetization of the debt, and almost all countries run deficits.”

    But the monetization part is vanishingly irrelevant as rates tend to zero. Yet the fiscal deficit is still powerful. That’s what the NK (and ISLM for that matter) model says.

    “But I thought you were denying that large money injections in the US could drive the price level up 87 fold”

    Not at all. In fact, I’ve long advocated helicopter drops in the form of equal distributions to all citizens as a bombproof escape from the liquidity trap. It’s repos that are ineffective because of the commitment to unwind it all tomorrow. Why would anybody care if they had to borrow $10Tn overnight at the risk free rate against collateral and then return it tomorrow? They sure aren’t going to spend it. A helicopter drop (or any of the other methods I’ve reiterated several times above) is radically different. I would agree that the amount of helicopter drop required to produce a decent amount of inflation is extremely small. Maybe a few hundred Bn in the US would do the trick.

  75. Gravatar of ssumner ssumner
    1. March 2012 at 18:15

    Max, I’m no expert on moneyless models, but my understanding is that there is still a medium of account, which is a reserve asset. The trick is to keep the net balances of the banking system near zero. It’s not “moneyless” in the sense of no medium of account, it’s moneyless in the sense of zero net reserve balances. In that case monetary policy works via changes in the demand for that reserve asset, i.e. interest rates.

    The monetary approach to macro is based on the supply and demand for money. Monetarists traditionally focus on the supply, as that’s generally been the technique used by central banks (non-interest bearing base money), or at least currency (which is almost all of base money in normal times.)

    But it is supply and AND demand after all, so in principal monetary policy could rely on demand levers like interest rates and reserve requirements.

    In the future NGDP targeting should replace both approaches.

    Greg, I want to be proactive, that’s what targeting the forecast is all about, not waiting for problems to develop.

    I often talk about 2001-07, and see the mistake as being government-created moral hazard, which led to reckless over-lending. I’ve proposed all sorts of regulatory reforms to fix the financial system. Monetary policy can play some role (via NGDP targeting) but the big changes need to be abolishing the GSEs, FDIC, TBTF, mortgage interest deductions, non-recourse mortgages, sub-prime mortgages, etc etc.

    Victor, Those models are useful for Latin America, not for the US (so far—and for at least the foreseeable future.)

    K, We aren’t going to get anywhere unless we agree on what we are discussing. I thought you were talking about the transmission mechanism when interest rates are positive.

    It is not correct that NK models say OMPs are ineffective at the zero bound. The models say they are highly effective, unless temporary. A permanent 5 fold increase in the monetary base right now would cause hyperinflation within months, even though rates are currently 0%.

    But I find discussion of the zero bound always seems to miss the point. It’s not what monetary policy can or can’t do, it’s what they are trying to do. People confuse real world situations like today or Japan in the 1990s, with theoretical models of the “liquidity trap” which have absolutely nothing to do with what’s going on today. If we were actually in a liquidity “trap” the Fed would have already bought up the entire monetary base. So there is no trap, rather the Fed is not doing more QE because they fear it will create excessively high inflation.

    Now suppose you really do have a liquidity “trap.” The next question is what do you do?

    One option is a higher NGDP growth target.

    Another option is to have the Fed buy non-Treasury assets. Reasonable people can disagree as to what’s best, but since this scenario will never happen under NGDP targeting, level targeting, it’s all a moot point anyway, not worth debating.

  76. Gravatar of Max Max
    2. March 2012 at 10:37

    “I’m no expert on moneyless models, but my understanding is that there is still a medium of account, which is a reserve asset. The trick is to keep the net balances of the banking system near zero. It’s not “moneyless” in the sense of no medium of account, it’s moneyless in the sense of zero net reserve balances. In that case monetary policy works via changes in the demand for that reserve asset, i.e. interest rates.”

    Right. The point I’m trying to make is that the interest rate view is the most ‘general’ view of monetary policy. It’s not tied to technical details. It applies whether the system is 100% currency or 0% currency.

    A “permanent increase in base money” can be expressed more generally as a commitment to not react to inflation (should it occur) by raising interest rates. It’s the reaction function that matters, not the base money.

  77. Gravatar of ssumner ssumner
    2. March 2012 at 18:26

    Max, I think the supply and demand for the medium of account view is the most basic. It works even in economies with no financial system, with no interest rates. Just cash and goods & services. It explains what happened when coins were debased in the Middle Ages. It explains 1000 to 1 currency reforms.

    I hate the interest rate view because sometimes tight money makes the interest rate on three month T-bills go up and sometimes tight money makes the three month yield fall. Too ambiguous for me.

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