People have asked me for a summary of market monetarist ideas. Or a “model” of some sort. Not every market monetarist agrees with all these ideas, but most agree with most. I’ll start with policy, then cover the more difficult theory aspects:
1. We favor NGDP targeting.
2. Most of us favor level targeting.
3. Most favor targeting the forecast. Either the Fed’s internal forecast (Lars Svensson) or a market forecast of NGDP (myself and several others.)
Update: Andy Harless and Lars Christensen pointed out that there’s no logical reason why a market monetarist would have to favor NGDP targeting. I agree. Bill Woolsey thinks level targeting is more important, and I’m inclined to agree. There are lots of proposals that seem in the spirit of NGDP level targeting, but differ slightly: Bennett McCallum’s NGDP growth rate targeting, George Selgin’s productivity norm, Earl Thompson’s wage index target. I would never suggest that market monetarism is some sort of fixed category, rather it’s a constantly evolving set of ideas that individual economists are sympathetic to in varying degrees.
Now for the theory part:
4. Money matters, beyond the impact on interest rates. But we don’t make any assumption about the stability of V (unlike traditional monetarists.) Money matters because of the “hot potato effect.” That is, the Fed determines the supply of base money and the public determines the real quantity of base money and the “Cambridge k,” which is the ratio of the base to NGDP. In the long run “k” moves independently of once-and-for-all changes in the base. That’s because once-and-for-all changes in the base have little or no effect on interest rates in the very long run. Hence once-and-for-all changes in the base have a roughly proportional effect on long run NGDP. We believe that unless you explicitly model money, you can’t explain why NGDP is not 1000 times higher or lower.
Put simply, we assume that a big crop of new currency lowers the value of money (i.e. its purchasing power) for the same reason that a big crop of apples lowers the value of an apple.
5. Like monetarists, we assume many different transmission channels, not just interest rates. Money affects all sorts of asset prices. One slight difference from traditional monetarism is that we put more weight on the expected future level of NGDP, and hence the expected future hot potato effect. Higher expected future NGDP tends to increase current AD, and current NGDP.
6. Like monetarists (and like NKs such as Bernanke and Mishkin) we find interest rates to be a highly unreliable indicator of the stance of monetary policy. We agree with Mishkin that it’s better to use a wide range of asset prices, but also agree with Bernanke that NGDP growth is the best indicator of the stance of monetary policy. We disagree with the traditional monetarist view that the money supply (however defined) is a reliable indicator. Speaking for myself, I haven’t studied the Divisia index enough to have an intelligent opinion. Some market monetarists like that indicator.
7. Like Krugman, Woodford, and Eggertsson, we believe that temporary currency injections have little or no impact on AD. Instead, current AD and NGDP are determined by changes in the future expected path of NGDP. We differ from those NKs in that we think the expected future path of money is much more informative than the expected future path of interest rates, except at the zero bound. We believe that at the zero bound the important variable is the expected level of base money when the economy has exited the zero bound. My own view is that if the central bank pays interest on reserves, then the long run path of the non-interest-bearing currency stock may be more informative than the monetary base.
8. Because of point 7, there can be an “indeterminacy problem” in trying to model a fiat money regime. In practice I don’t think this is a big problem, as there is an implied promise at some future date to exchange fiat currency for some sort of real good. This might occur at the time we switch to all electronic money. Or it might involve NGDP futures contracts. I’m not an expert on indeterminacy, and would recommend reading Bennett McCallum. If you put aside the indeterminacy issue, then NGDP could be modeled roughly as follows:
The interaction of the supply of base money and velocity (or the Cambridge k) determines NGDP. The central bank controls the supply of money, and the demand for base money is mostly determined by nominal interest rates, but also tax rates (as currency is held for tax evasion.) When not at the zero bound, they aren’t close substitutes. Nominal interest rates are strongly and positively correlated with the output gap, and with expected NGDP growth. That means expected future base growth has a strong and positive impact on current interest rates (when not at the zero bound.) If the central bank does NGDP level targeting, then the specific NGDP growth path chosen is by far the most important determinant of nominal rates, and hence velocity. Output gaps are determined as in other natural rate models, by unexpected changes in NGDP. (Notice we use NGDP growth where other models use inflation.)
9. Market monetarists believe currency and T-bills are close substitutes at the zero bound, but not perfect substitutes. That’s because it’s costly to store huge quantities of cash (which makes legal investors prefer T-bills) and cash is anonymous (which makes tax evaders prefer cash.) (When not at the zero bound, they are not close substitutes.) Nonetheless, temporary currency injections will have little impact at the zero bound. But this is also true of temporary injections when not at the zero bound. Permanent monetary injections are effective whether at the zero bound or not. Market monetarists think Keynesians approach the liquidity trap from the wrong direction, seeing it as a barrier to expansionary monetary policy. Market monetarists believe it has never posed such a barrier, and instead central banks have been limited, if at all, by an unwillingness to use unconventional tools, AND EVEN MORE IMPORTANTLY, by an unwillingness to set an adequate nominal target, and/or to engage in level targeting. We believe the liquidity “trap” is not a trap at all, but merely a reflection of excessively tight money which has opened up a large output gap and/or led to subnormal expected NGDP growth.
10. Some of us are skeptical of fiscal stimulus, partly because we think monetary stimulus is more efficient for the usual deadweight cost of future taxes reasons, and partly because the central bank might offset the effect by targeting inflation or NGDP. Speaking for myself, I do agree with those who say lower real interest rates increase the number of public investments that meet cost/benefit criteria, and that some types of stimulus such as employer-side payroll tax cuts can “work” when the central bank stubbornly targets inflation or NGDP at the wrong level.
To summarize, we have many similarities to monetarism, but don’t favor a stable money supply rule, nor do we assume relatively stable velocity. I also disagree with their “long and variable lags” approach, but am not sure if other market monetarists agree with me. I think we all agree that monetary policy affects asset prices with no lag, and that traditional monetarists sometimes went off course by predicting inflation or deflation when asset market indicators were predicting no such thing.
We also overlap with new Keynesians, particularly in the emphasis on rational expectations and the importance of future expected path of policy. We think NKs misinterpreted real world “liquidity traps” such as Japan in the late 1990s, and hence developed a theory based on credibility problems that don’t actually occur in the real world. If a central bank promises to inflate and do level targeting, it will be believed. We also think NKs put too much emphasis on short term interest rates as an indicator of the stance of monetary policy, and hence miss events like December 2007, when an unexpectedly contractionary Fed announcement reduced three month T-bill yields, because the effect on near term NGDP growth expectations overwhelmed the liquidity effect. Nick Rowe says IS curves often slope upward, and I agree.
PS. I forget earlier to link to this excellent Christina Romer interview on the Great Depression. People often ask me what to read, and these are good choices.