At the individual level, nominal purchasing power is determined by nominal wealth. At the aggregate level, nominal purchasing power is determined by the supply and demand for base money.

People need to pay attention to the distinction between the micro level and the macro level.  Bill Gates does not refrain by buying a Ferrari today because he doesn’t happen to be holding any base money.  His nominal demand for goods and services is based on his nominal wealth. If the Fed buys $100 million in bonds from Gates and pays him cash, he doesn’t feel energized to go out and buy goods and services (his nominal wealth is unchanged), rather he puts the money in the bank and then invests it elsewhere.  Of course the aggregate NGDP will rise a tiny bit, and for that reason everyone, including Gates, will spend a tiny bit more on goods and services.

If the Fed spends $100 trillion on financial assets, then nominal expenditure in the aggregate will soar (mostly due to inflation, but output will rise slightly in the short run.)  Monetary policy operates at the aggregate level, it cannot be explained at the individual level, except by using the concept of the supply and demand for base money. The hot potato effect.  But here’s the problem.  In the short run prices are sticky, and individual people’s nominal purchases of goods and services depends on their nominal wealth.  So we have to get from here to there via some sort of “transmission mechanism.”  In the apple market we often assume a Walrasian auctioneer.  But in macro that assumption assumes away all that is interesting.  Hence people flounder, unable to conceive that monetary policy is all about debasing the medium of account by increasing its supply relative to demand. They want some sort of understandable mechanism that they can visualize at the individual level–the Keynesian interest rate, the Austrian Cantillon effect, but there just isn’t any.  Or perhaps I should say there are far too many, each of which plays only a tiny role.

Imagine trying to explain to a wheat farmer why increased wheat production will lower the price.  He’d say “I don’t notice any price drop when I sell more wheat.”

PS.  I see people are still confused by Cantillon effects.  It is not true that the Fed buying $100 billion in T-securities raises the price of T-securities, holding fiscal policy constant.  That’s because if you hold fiscal policy constant the alternative would be to inject the money via already existing government spending programs.  That would mean less borrowing.  So the Fed’s decision to buy $100 billion in T-securities increases both the supply and demand for T-securities by $100 billion, leaving the price unaffected (relative to the alternative injection method.)  Now obviously if you bought $100 billion in cars instead of T-bonds the car market would be impacted.  But that would be due to fiscal policy, not monetary policy.  The Richman quote that started all this specified that it mattered who got the new money (banks, bond holders, etc) because they would have more purchasing power.  That’s flat out wrong.


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67 Responses to “At the individual level, nominal purchasing power is determined by nominal wealth. At the aggregate level, nominal purchasing power is determined by the supply and demand for base money.”

  1. Gravatar of dtoh dtoh
    4. December 2012 at 12:03

    Scott,
    Hence people flounder, unable to conceive that monetary policy is all about debasing the medium of account by increasing its supply relative to demand. They want some sort of understandable mechanism that they can visualize at the individual level–the Keynesian interest rate, the Austrian Cantillon effect, but there just isn’t any. Or perhaps I should say there are far too many, each of which plays only a tiny role.

    Obviously I disagree. Not sure what it will take to convince you that you can explain everything by looking at the indifference curve between holding financial assets and spending on real goods and services.

    Or maybe you do see this because you say

    His nominal demand for goods and services is based on his nominal wealth.

    I’d quibble on your use of nominal and note that the cost for him to borrow is also important, but basically I agree with you, which is why the financial asset price model is so important to understand.

  2. Gravatar of Greg Ransom Greg Ransom
    4. December 2012 at 12:03

    “the Austrian Cantillon effect”

    Scott, have yet to pass *any* sort of even entry-level Turing Test showing that you have any small conception of what Austrian non-neutrality involves.

    What is it?

    There is no evidence anywhere that you have that concept.

  3. Gravatar of dtoh dtoh
    4. December 2012 at 12:05

    And…. NGDP goes because people spend a little more….not the other way around.

  4. Gravatar of Greg Ransom Greg Ransom
    4. December 2012 at 12:06

    Is there any reason Gates would sell to the Fed other than the fact that the Fed outbid everyone else?

    “If the Fed buys $100 million in bonds from Gates and pays him cash.”

  5. Gravatar of Morgan Warstler Morgan Warstler
    4. December 2012 at 12:12

    “Or perhaps I should say there are far too many, each of which plays only a tiny role.”

    Now if only you’ll admit that for some people, the overall effect tends to wildly accrue positive, and for some it accrues wildly negative…

    We can stop talking about this AND INSTEAD focus on who should get the goodies and why.

  6. Gravatar of Bill Woolsey Bill Woolsey
    4. December 2012 at 12:13

    I don’t assume a Walrasian Auctioneer to explain the apple market.

    Anyway, if the nominal anchor of a monetary regime is the growth path of nominal GDP, then I don’t think it is true that nominal demand for goods and services depends on the quantity of base money and the demand to hold it. In the long run, the quantity of base money depends on the demand to hold it. And in the short run, the demand for base money depends on the quantity.

    But if people come to believe that the quantity of base money won’t adjust to the demand to hold it–if they come to believe that the growth path of nominal GDP is not the nominal anchor, then suddenly, the short run will shift, with the demand for base money no longer adusting to the quantity.

    If the nominal anchor is the nominal quantity of base money, then that, and the demand to hold base money determines nominal demand in the economy.

    Well, maybe.

  7. Gravatar of Greg Ransom Greg Ransom
    4. December 2012 at 12:14

    Scott the conversation got started when:

    1) you claimed Richman must have your own understanding of what non-neutrality must mean for the economy.

    It was pointed out that Richman was assuming Hayek’s account of economic non-neutrality made possible by money and credit — a conception involving the structure of production in a way that is not part of post-Patinkin accounts of ‘neutrality”.

    2) You claimed that there was no advantage to trade involved in transactions with the Fed, and no relation to Hayek’s conception of non-neutrality related to these transactions.

    Scott writes,

    “The Richman quote that started all this specified that it mattered who got the new money (banks, bond holders, etc)”

  8. Gravatar of Greg Ransom Greg Ransom
    4. December 2012 at 12:16

    If there is no Smithian advantages to trade when transacting with the Fed, why do transactions with the Fed even exist?

  9. Gravatar of pct pct
    4. December 2012 at 12:21

    Just to be clear, as I understand your explanation, if the Fed implemented QE5 by going on Craigslist and buying up used futons (which would give the regional branches something to do), that would be fiscal policy, not monetary policy.

  10. Gravatar of Greg Ransom Greg Ransom
    4. December 2012 at 12:22

    I want again to point out using Google NGRAM that the whole English language conversation using the language of “neutral money” and non-neutrality of money and credit was launched in a MASSIVE way by Hayek’s discussion, particularly his famed and widely discussed LSE lectures and book, Prices and Production:

    http://www.themoneyillusion.com/?p=17965#comment-211234

    http://t.co/6Fag8QZA

    This may be a conception of non-neutrality unknown to Scott Sumner, but is is one well established in the economic literature, including within the contemporary peer reviewed scientific literature, including the empirical literature.

  11. Gravatar of Major_Freedom Major_Freedom
    4. December 2012 at 12:32

    People need to pay attention to the distinction between the micro level and the macro level. Bill Gates does not refrain by buying a Ferrari today because he doesn’t happen to be holding any base money. His nominal demand for goods and services is based on his nominal wealth. If the Fed buys $100 million in bonds from Gates and pays him cash, he doesn’t feel energized to go out and buy goods and services (his nominal wealth is unchanged), rather he puts the money in the bank and then invests it elsewhere. Of course the aggregate NGDP will rise a tiny bit, and for that reason everyone, including Gates, will spend a tiny bit more on goods and services.

    If the Fed is printing money to buy Gates’ wealth, then Gates will be able to receive $100 million, as opposed to say $95 million if he sold in the money constrained market.

    The assumption that the Fed pays “fair market values” is untenable, since the only way the CPI can rise over time is through initially higher prices that begins at the inflation injection points. If the initial injection points do not raise prices from what they otherwise would have been, then that would imply the CPI has been rising since 1913 without the Fed’s inflation.

    If the Fed spends $100 trillion on financial assets, then nominal expenditure in the aggregate will soar (mostly due to inflation, but output will rise slightly in the short run.) Monetary policy operates at the aggregate level, it cannot be explained at the individual level, except by using the concept of the supply and demand for base money. The hot potato effect. But here’s the problem. In the short run prices are sticky, and individual people’s nominal purchases of goods and services depends on their nominal wealth. So we have to get from here to there via some sort of “transmission mechanism.” In the apple market we often assume a Walrasian auctioneer. But in macro that assumption assumes away all that is interesting. Hence people flounder, unable to conceive that monetary policy is all about debasing the medium of account by increasing its supply relative to demand. They want some sort of understandable mechanism that they can visualize at the individual level–the Keynesian interest rate, the Austrian Cantillon effect, but there just isn’t any. Or perhaps I should say there are far too many, each of which plays only a tiny role.

    Speaking of “floundering”…

    The commodity used as a medium of account derives from its use as a medium of exchange. Dollars are used as a medium of account because they are used as a medium of exchange.

    Moreover, the Fed doesn’t only debase the medium of account. It debases the commodity used as medium of exchange. Bonds are bought and sold. Gold is bought and sold. DOLLARS are bought and sold (in typical goods for money exchanges).

    The aggregates are but statistical artifacts. They may communicate to us some rudimentary facts about the economy, but even there, the actual phenomena is taking place at the individual level. Nobody economizes aggregate statistics as objects of action, the way they economize dollars, apples, and bonds as objects of economic action.

    The “transmission mechanism” of going from here to there can be viewed at the individual level, because that is where all economic phenomena actually take place.

    The only way inflation can affect aggregates of individual action is if and only if it affects individual action. The Fed isn’t buying the CPI. The Fed isn’t spending NGDP. The Fed deals with particular individual market actors, and no others. The inflation enters the economy at those points, and no others. This affects those individual’s incomes, and no others. This affect the prices of they sell to earn such income, and no others.

    Inflation is actually a micro-economically grounded phenomena.

    Imagine trying to explain to a wheat farmer why increased wheat production will lower the price. He’d say “I don’t notice any price drop when I sell more wheat.”

    It is not true that the Fed buying $100 billion in T-securities raises the price of T-securities, holding fiscal policy constant. That’s because if you hold fiscal policy constant the alternative would be to inject the money via already existing government spending programs. That would mean less borrowing. So the Fed’s decision to buy $100 billion in T-securities increases both the supply and demand for T-securities by $100 billion, leaving the price unaffected (relative to the alternative injection method.)

    I see you’re still confused about the Cantillon Effect. It is indeed true that if the Fed buys $100 billion in t-bonds, that will, ceteris paribus, raise the price of t-bonds. Even if one held fiscal policy constant, and the alternative is for the inflation to finance government spending programs, like cash for clunkers, then that will raise the price of clunkers, and not raise the price of t-bonds. If you then include additional borrowing, then you are not talking about unchanged fiscal policy any longer. Unchanged government spending does not mean unchanged fiscal policy and unchanged affects on RELATIVE prices.

    You are trying to find a rather awkward way to justify unchanged bond prices, while ignoring the change in price of that which the inflation financed government spending adds a nominal demand component, in which case the Cantillon Effect will be one where clunker prices rise more than what they otherwise would have been, which is a change to relative prices.

    Now obviously if you bought $100 billion in cars instead of T-bonds the car market would be impacted. But that would be due to fiscal policy, not monetary policy. The Richman quote that started all this specified that it mattered who got the new money (banks, bond holders, etc) because they would have more purchasing power. That’s flat out wrong.

    You again contradicted yourself. If you can see how the car market would be impacted by the Fed buying cars, then you admit that car sellers would have higher nominal income and thus a relatively higher boost purchasing power than everyone else, or, equivalently, a relatively less negative loss of purchasing power.

    It doesn’t matter what name you give it. You can call it “schmiscal policy” and “schmonetary policy” if you want. That doesn’t change the economics of it. I mean really, who the heck argues economics by insisting things are different according to the names and labels one attaches to the same action (i.e. of inflation to buy X)?

    If you concede that the Fed impacts the prices of the things it buys, then you concede the Cantillon Effect!

  12. Gravatar of Major_Freedom Major_Freedom
    4. December 2012 at 12:34

    dtoh:

    And…. NGDP goes because people spend a little more….not the other way around.

    Yes, that’s right. However to be more accurate, NGDP goes up when SOME people spend more due to receiving newly created money first. That increases NGDP no less than if the same money was dropped by helicopters and everyone spend only a little bit more, instead of a few large banks spending LOTS more.

  13. Gravatar of Major_Freedom Major_Freedom
    4. December 2012 at 12:37

    Greg Ransom:

    If there is no Smithian advantages to trade when transacting with the Fed, why do transactions with the Fed even exist?

    Uh oh, Greg, are you sure we’re ready for that yet? That argument would require an introduction of marginal pricing analysis, and other “dull” micro-economic concepts.

    I thought we were still trying to educate people over the Cantillon Effect. If you start going down that road, then the dead horse will be turned to dust. We have to beat it a few more times.

  14. Gravatar of Doug M Doug M
    4. December 2012 at 12:40

    The Fed can’t buy $100 Trillion on financial assets, there are not $100 trillion in assets to go around…Unless, the fed is willing to bid up prices in the S&P 500 to 200 P/E ratios, in which case everything he said in the previous couple of posts is wrong.

    Explain your PS, you must have somehting backward because it makes no sense the way it is written…

    “It is not true that the Fed buying $100 billion in T-securities raises the price of T-securities, holding fiscal policy constant.”

    what does holding fiscal policy constant mean? If the Fed doesn’t inject $100 billion via OMO, then the federal government is going to spend an addtional $100 billion? I would not call that holding fiscal policy costant, but that does seem to be the suggestion.

    “That’s because if you hold fiscal policy constant the alternative would be to inject the money via already existing government spending programs. That would mean less borrowing.”

    No, it would mean more borrowing! The Treasury would sell T-bonds, borrow money from the market and pay it to its contractors.

    “So the Fed’s decision to buy $100 billion in T-securities increases both the supply and demand for T-securities by $100 billion”

    If the Fed buys T-Bonds it will be reducing the float of T-bonds directly, and vs. the alternative, it would be doubly reducing the float.

  15. Gravatar of JL JL
    4. December 2012 at 12:54

    Scott,

    I appreciate your effort in trying to educate us normal people.

    Microeconomics is straightforward, understandable and practical. We deal with it daily.

    But then we reason that macroeconomics is just microeconomics times six billion people.

    And thus we, the educated, serious people, commit the fallacy of composition and that is why we suffer economic depressions.

  16. Gravatar of Ritwik Ritwik
    4. December 2012 at 13:10

    “It is not true that the Fed buying $100 billion in T-securities raises the price of T-securities, holding fiscal policy constant”

    This is staggering Scott. Simply staggering. The whole holding xyz constant business is Wittgensteinian in the extreme. If you wish to reduce monetary (or fiscal) economics to Humpty-dumptyism, sure.

    I could paraphrase your comment thus – all money is helicopter money. Corollary is that an OMO isn’t really monetary policy. I suppose on an average day, when Bernanke talks about easing policy, what he really means is easing monetary policy while tightening fiscal policy simultaneously.

  17. Gravatar of Basil H Basil H
    4. December 2012 at 13:14

    You write: “[P]eople flounder, unable to conceive that monetary policy is all about debasing the medium of account by increasing its supply relative to demand. They want some sort of understandable mechanism that they can visualize at the individual level–the Keynesian interest rate, the Austrian Cantillon effect, but there just isn’t any. Or perhaps I should say there are far too many, each of which plays only a tiny role.”

    Meltzer has a great paper on this: Monetary, Credit and (Other) Transmission Processes: A Monetarist Perspective (1995)

    He points out, like you do, that many relative prices change; thus, there are too many transmission mechanisms to possibly classify in the simplified sort of way Mishkin does in his textbook.

    My favorite quote:

    “A monetary impulse changes the stock of money relative to the stocks of other domestic and foreign assets, and changes the marginal utility (or marginal product) of money relative to the marginal utility (product) of these other assets and the marginal utility of consumption. Money holders attempt to restore equilibrium by equating the ratios of the marginal utilities to the relative prices of all assets and current production and consumption. This involves changes in many relative prices, in spending and in asset portfolios.”

  18. Gravatar of Becky Hargrove Becky Hargrove
    4. December 2012 at 13:14

    While I don’t think Cantillon effects are significant, I’m concerned about this quote: “Hence people flounder, unable to conceive that monetary policy is all about debasing the medium of account…”

    Oh my. Didn’t you mean to say the medium of exchange, or money supply? It would seem no one wants to debase their own “version” (or benefit) of the medium of account: rather, what is in everyones’ interests is to increase the medium of account(their stake in value) and debase the medium of exchange in order to make that possible. Perhaps the Cantillon problem has something to do with the supposed inefficiency in that regard, with the medium of exchange. Someone is concerned the “wrong” debasing goes on when no one is looking!

  19. Gravatar of Greg Ransom Greg Ransom
    4. December 2012 at 13:55

    Nicolas Cachanosky:

    http://puntodevistaeconomico.wordpress.com/2012/12/04/scot-sumner-and-cantillon-effectspart-2/

    “The intense (heated?) debate around the Cantillon Effects after an injection of money has produced a new post by Scott Sumner. Scott Sumner argues that it doesn’t matter where money in injected first because all possible injection points produce the same initial result; buying T-Bonds. I don’t think that Sumner is wrong on this, I do think, however, that this is just a first step of analysis and that Cantillon Effects depend on what happens after the money gets into the market through the exchange of T Bonds.

    First things first. Sumner is not saying that there are no effects at all. When discussing the first myth, he acknowledges that the bond seller earns a commission when selling T Bonds. He thinks, however, that the amount of this benefit is trivial at a macroeconomic level. As I said on my previous post, it is different to say that there are no Cantillon Effects than to to say that the empirical relevance is considered to be trivial. Are all these trivial effects summed together still trivial? Could there be a mechanism such that this benefit is not trivial anymore? Is it the decision to bail-out or to not bail-out Lehman Brothers trivial? Even if the Lehman Brothers example falls outside Sumner’s scenario, it does exemplify a non-trivial effect on the first steps of a policy that buys assets from a financial institution.

    I think his treatment of the myth 4 helps to square what Sumner is trying to say. Sumner suggests that given the news of a monetary injection the prices of (financial) assets should rise instantaneously, so there’s no benefit in receiving the money first. This means, however, that there is a drawback if money is received later on (this is not mentioned by Sumner). Sumner says that a person that hears the news about the expansive monetary policy thinks the price of gold is going to raise and so he uses his cash or takes a loan to buy more units of gold. He, therefore, is not constrained to buy gold. Therefore, it doesn’t matter how the money gets into the economy. The bank can always lend to him the money he needs to buy more gold.

    I don’t see, however, how this goes against Cantillon Effects. There are two ways I can buy more gold. With money already in my balance or by taking a credit. To argue that someone uses his savings to buy more gold means that his money demand is decreasing. We have two, rather than one, effect. Injection of money and a change in money demand. We start to move away from the ceteris paribus analysis. But this also implies that the price of savings is going to change. Therefore, the relative prices of savings with respect to other goods is going to change. That is what Cantillon Effects are about, changes in relative prices.

    The second option is to get a loan a to buy the units of gold. If this person gets $100 in loan, means that those $100 cannot be given to someone else. Some buyers, and not others, can make use of the $100. What should happen for this to be immaterial with respect to Cantillon Effects? We need to distribute the $100 equivalently among all consumers. Namely, we need the helicopter.

    Now, regardless of this, I think is inaccurate to stop the analysis where Sumner does. The Cantillon Effect is the result of n-steps, not 1-step. Let’s say that step-1 is the same for any potential way to inject money in the economy as Sumner describes. What happens in steps 2 to n is as important as step 1. Cantillon Effects are not just about asset prices, but about all prices in the economy. Person 1 may use the $100 to buy gold. But person 2 to buy a new house and person 3 to buy a new car… etc. Financial asset prices can react immediately because the new money is already in the financial system, but goods and services outside the financial cannot raise if the purchasing power of their clients have not increased yet. The focus on the financial market risks to do away with the problems involved in the rest of the economy.

    Finally, Sumner says that “In aggregate, the total level of nominal purchases is constrained by the amount of currency in circulation. But not at the individual level. Hence being the first to get the new money doesn’t confer any advantage at all–as the new money has no more purchasing power than the existing money. A dollar is a dollar—and a $100 bill is a $100 bill.”

    It is true that the new money has no more purchasing power than the existing money. But is also true that there is more money in the economy and therefore the total purchasing power increases. How is the new purchasing power going to be distributed in the economy is what gives the initial kick of the Cantillon Effects. The final result depends on the complete sequences of kicks, not only in the first one.

    It is also true that the Fed buys bonds at market prices, and that therefore the operation is a swap of assets and the size of the balance sheet may remain the same. But it also true that the composition of the asset (how much cash versus how much T Bonds) can affect how much can be bought today by however receives the swapped cash first (that is, after the bank). Eventually the banks need to decide who to lend the new amount of money, or if they are going to invest it themselves. Wouldn’t, for instance, a policy favoring the housing market potentially result in a housing bubble and a financial crisis? The institutional framework can have a bearing on the empirical extent of the Cantillon Effects.

    Still, there are $100 extra that will land somewhere. Even if that somewhere immediately results on the same effect on the T Bonds, they will get into the economy afterwards with potential different paths. It may well be the case that it doesn’t matter who gets the money first, but it may well be the case that it matters who gets it second. The story in the broken window fallacy can help to illustrate the point. There are two ways the $100 value of the window can be spent in the economy. Give it to the window maker to repair the broken window or use it to buy a new suit by the shop owner (forget about the lost value of the window). In both cases the money flows differently through the economy even if the $100 were initially in the bank and got there through an exchange of T Bonds.

    Still. I’m not sure of what Sumner is trying to say. I think his second post would been much more clear if it had followed something like this: “Yes, there are Cantillon Effects. No, they do not depend on how money is initially introduced in the economy. No, I don’t think the empirical extent of the Cantillon Effect is important.” This is the best interpretation I can make of Sumner’s argument.

    PS: Note that Sumner is not saying (as far as I can tell) that there are no effects by the Fed buying Bonds. He’s saying that the effect is the same regardless of who he buys them from and that the difference between buying T Bonds through channel A or B is not economically relevant.”

  20. Gravatar of Bill Woolsey Bill Woolsey
    4. December 2012 at 14:09

    “I see people are still confused by Cantillon effects. It is not true that the Fed buying $100 billion in T-securities raises the price of T-securities, holding fiscal policy constant. That’s because if you hold fiscal policy constant the alternative would be to inject the money via already existing government spending programs. That would mean less borrowing. So the Fed’s decision to buy $100 billion in T-securities increases both the supply and demand for T-securities by $100 billion, leaving the price unaffected (relative to the alternative injection method.)”

    I don’t agree with this at all. With a consolodated balance sheet, an open market operation means the government is borrowing more by issuing base money and less by issuing bills, notes, or bonds. Fiscal policy would be lowering taxes or spending more on goods or services, which would increase the total amount borrowed by both means.

    The alternative to borrowing by issuing base money is to borrow by issuing interest bearing debt (other types, if base money bears inerest.) Borrowing less by interest bearing debt and more by issuing base money results in lower interest rates on the interest bearing debt and higher bond prices.

    There is, of course, no reason to claim that those government contractors or employees paid by the newly issued base money benefit more from the money creation that those who are paid by money raised by selling interest bearing bonds or by collecting taxes.

    Suppose the new base money is currency and is it painted blue. Is the new money more inflationary than the other money?

    But what if the central bank is independent? It just isn’t in the business of paying government contractors. It is an intermediary, borrowing when it issues base money and then lending to the government?

    And why is it essential to the nature of monetary policy that the central bank lend to the govenrment? Suppose it only lends to the private sector?

    Still further, the notion that government gets to grab all the seniorage is an institutional assumption. Suppose all the banks divide up the profits of the central bank? If the industry is competitive, the result should be a reduction in the interest rate margin–higher interest rates on deposits and lower rates on loans specific to banks.

    I think the easy assumption that of course money is zero interest currency that the goverment must prints and spend, and that is essential to monetary policy, is wrongheaded.

  21. Gravatar of George George
    4. December 2012 at 14:31

    If the fed starts buying cars is that a fiscal or monetary policy? I confess I do not have the absolute answer but I can imagine another scenarios:

    The fed buys t-bills then the treasury issues the same amount of t-bills and with the money generated goes and buy cars (for further simplification let us assume that it’s the same guy who sold to the fed then bought from the treasury the t-bills). The outcome is exactly the same as the first operation, is that a fiscal or monetary policy?.

    It makes perfect sense that “non-neutral” decision such as buying cars are done by an elected body the government and that more “monetary” policy are done by the “technocratic” fed.

    But in any case, if QE has an impact on t-bill that would be due to expectation, when the fed announces QE, rational people would anticipate that t-bills would go up in price and it’s not the actual transaction that have caused this increase so although t-bill holders profited from it, it’s not because they received the newly printed money but because of people’s expectations.

  22. Gravatar of Major_Freedom Major_Freedom
    4. December 2012 at 14:47

    George:

    If the fed starts buying cars is that a fiscal or monetary policy? I confess I do not have the absolute answer

    Does it matter if I call myself Major_Freedom versus my “real” name on this blog, when it comes to the actions I am taking and the arguments I am making? If you realize it doesn’t matter, then you should realize it doesn’t matter what you call the Fed buying bonds and the Fed buying cars. The Cantillon Effect is independent of nomenclature.

    It makes perfect sense that “non-neutral” decision such as buying cars are done by an elected body the government and that more “monetary” policy are done by the “technocratic” fed.

    Why? If a technocratic Fed can buy debt from the public, why can’t a technocratic Fed buy cars, or tacos, or stocks?

    In a free market of money, gold miners would be able to buy whatever the hell they want, and it all would be “free trade” activity.

    Isn’t it funny how when the state monopolizes something, people get distracted and sidetracked about whether to call the government printing money and buying X “shmirple” or “dirple”, and then, believing that the mechanics are different if we can convince people to call it “dirple” instead of “schmirple”?

    But in any case, if QE has an impact on t-bill that would be due to expectation, when the fed announces QE, rational people would anticipate that t-bills would go up in price and it’s not the actual transaction that have caused this increase so although t-bill holders profited from it, it’s not because they received the newly printed money but because of people’s expectations.

    People can’t increase their nominal demands for things unless they HAVE the money to do it. So if people are going to raise their demand for bonds, then either they will have to cut back on their demands for other things, or they will have to receive new money so that they don’t have to reduce their nominal demands for other things. And what’s that? Oh right, inflation brings about the latter alternative, which means those who receive the new money don’t have to reduce their spending elsewhere. They can keep the same spending and outbidding others for those things, AND they can buy other things with the new money they got from the Fed.

  23. Gravatar of George George
    4. December 2012 at 15:13

    I would agree with you if central banking was free but it’s not. It is as you describe it a monopoly so if you have to take a monopoly better take a monopoly that has limited power rather than being able to go and purchase whatever it want. But I agree no need to hassle over terminologies.

    On the second point, people are not getting new money, this is the whole point here, they are exchanging their bonds with cash, and they are exchanging it at market price, so they are not getting richer and are not getting additional money.
    The only thing I can see to get your point is the following:
    Let’s suppose the mentioned contractor has a neighbour who happens to have a t-bill but did not sell it to the fed. What you are arguing is that this t-bill is not worth the same as the cash that the contractor is now holding. But how can that be? If that is the case that means that the t-bill immediately dropped in price after the OMO. That does not make much sense does it?

  24. Gravatar of John S John S
    4. December 2012 at 15:21

    Prof. Sumner (or anyone else),

    May I get your reaction to George Selgin’s latest?

    http://www.freebanking.org/2012/12/03/fedophilia/

    With all do respect and politeness–it puzzles me how texts on Int’l Trade are crammed to the gills with abstract models like Heckscher-Ohlin, yet macro and monetary econ have nary a theoretical peep on free market money.

    Surely, before we can assume that a central bank is necessary, we must first demonstrate why the free market alternative is unworkable, no? If not, please explain how we can know a priori that central banking is better.

  25. Gravatar of Tyler Joyner Tyler Joyner
    4. December 2012 at 15:25

    Scott said: “It is not true that the Fed buying $100 billion in T-securities raises the price of T-securities, holding fiscal policy constant.”

    Has this not been exactly what the Fed has been doing for years? And if this fits Scott’s definition of “holding fiscal policy constant”, has there not be an upward movement in the price of government debt every single time?

  26. Gravatar of George George
    4. December 2012 at 15:29

    John, I will reply for myself here, although this debate is greatly interesting but this is not the place for it :) in here we are assuming that we do have a monopolistic central bank and examining the consequences of it, or at least that is what I am doing …

  27. Gravatar of John S John S
    4. December 2012 at 15:42

    George,

    Just planting the seeds for a future blog post from Scott. :) I know he respects you, and I look forward to his response.

    Although, to be honest, I think you’ve already checkmated any purported “free market economist” with this post.

    Lars Christensen at marketmonetarist.com has been quite supportive of your writings.

  28. Gravatar of Scott Sumner Scott Sumner
    4. December 2012 at 15:43

    dtoh, I agree that assets are part of the story.

    Bill, Yes, if you are targeting NGDP then the base is endogenous. But it is through control of the base that the Fed can target NGDP.

    pct, yes.

    Doug, There are $100 trillion in assets.

    I assumed the new cash would be injected via government worker wages, but for existing programs. No new fiscal stimulus was envisioned. It’s just that you pay with printed money, not tax money or borrowed money. No change in G or T.

    JL, Yup.

    Ritwik, I don’t think you understood what I am saying. Helicopter drops are fiscal policy. Monetary policy is swapping cash for financial assets.

    Bill, You clearly misunderstood my comment about fiscal policy being held constant. I agree with how you characterize fiscal and monetary policy, so you must have misread my comment. I’m not saying anything in the slightest controversial–just basic accounting. If the goverment pays workers with $1000 in new cash from the Fed, they don’t have to borrow that $1000. Basic accounting.

    Yes, it might matter if the central bank buys something exotic. But that’s not what Richman was saying. He was saying that if they simply buy bonds, it matters who gets the money because they have more purchasing power. But they don’t have more wealth, so the extra purchasing power doesn’t matter. If I give you a billion in cash for a billion in T-bills will you exclaim “now I’m rich, I’ll go out and buy something”? No, you’ll deposit the money in the bank. The money will eventually cause inflation, but not because you personally spend it on goods and services.

  29. Gravatar of Tom Tom
    4. December 2012 at 15:49

    If the Fed buys $100 million in bonds from Gates and pays him cash, he doesn’t feel energized to go out and buy goods and services (his nominal wealth is unchanged), rather he puts the money in the bank and then invests it elsewhere.

    What about if the Fed increases the monetary base and instead of buying bonds, merely give Gates $100 m? Or gives 1000 chosen (Dem donors) $100 000? Same “it doesn’t matter who gets it first”? Obviously not.

    Whatever decision maker gets the money first has more power than all those who don’t get the money first.

  30. Gravatar of ssumner ssumner
    4. December 2012 at 15:50

    Basil, Great quote.

  31. Gravatar of dtoh dtoh
    4. December 2012 at 15:51

    Scott,
    dtoh, I agree that assets are part of the story.

    Well we’re getting there! :)

    Next “big part” >>> “most of the story” >>>> “are the story” !

    Just a matter of time.

  32. Gravatar of ssumner ssumner
    4. December 2012 at 15:51

    Tom, Yes, it’s very different if the money is given away.

  33. Gravatar of Doug M Doug M
    4. December 2012 at 16:34

    What are you buying with your $100T?

    Publicly held US Treasury debt $6T
    All US debt (public and private) $20T
    US Equity $25T
    World supply of gold $10T

  34. Gravatar of John S John S
    4. December 2012 at 16:44

    Prof. Sumner,

    I’m a student trying my honest best to understand. I would just like to know: if the goal is to increase spending and NGDP, wouldn’t it be faster and more efficient for the Fed to mail out checks to taxpayers directly? With OMO, if there aren’t any many good lending opportunities (such as now), isn’t there a high likelihood that the money injections will just end up as excess reserves?

    If taxpayers get the new money, they will 1) spend it; 2) pay off debt; or 3) deposit it. (Right?) #1 would increase spending, #2 would accelerate de-leveraging. Aren’t these good outcomes (with #3 being no improvement over OMO)?

    Even if this is not permitted currently, in theory, what would be wrong with this approach? (Sorry if this post is dumb, but I’m literally quite ignorant on this).

  35. Gravatar of ssumner ssumner
    4. December 2012 at 17:17

    Doug, Your Treasury debt numbers may be wrong, that’s less than 40% of GDP. You’ve excluded foreign equities, foreign stocks, foreign bonds, etc. There’s well over $100 trillion.

    In any case, it was just a random number-do you think the Fed wants to cause hyperinflation? I don’t seriously expect them to inject that much.

    John, That would be a bad idea, as it would greatly increase the national debt, and thus worsen our fiscal situation (compared to an equal monetary stimulus done via OMOs.)

  36. Gravatar of JoeMac JoeMac
    4. December 2012 at 17:40

    Scott,

    There is something that I have never fully understood. You agree that the demand for base money and therefore the money multiplier is entirely endogenous. But if that is the case, then why would there be any necessary connection between the monetary base and the price level? If the demand for base money is entirely endogenous, then what economic force would necessitate the monetary base affect the price level or NGDP?

    I think this is the same argument endogenous money proponents make; that if the money multiplier is endogenous then there is no reason to believe that changes in the monetary base should necessarily affect the price level or NGDP.

    In other words, why should permanent changes in the monetary base affect the price level or NGDP if the CB has no control over what happens to the demand for base money? Why is it “necessary”?

  37. Gravatar of John S John S
    4. December 2012 at 17:49

    “it would greatly increase the national debt, and thus worsen our fiscal situation”

    Another dumb question from me–why would it increase the debt? Wouldn’t the banks just collect these checks as they were deposited and present them to the Fed in exchange for newly printed money?

  38. Gravatar of John S John S
    4. December 2012 at 17:56

    In other words, how would it differ from a helicopter drop?

  39. Gravatar of Jon Jon
    4. December 2012 at 19:03

    These debates hinge on how the reader interprets the phrase fiscal policy held constant. There are similar debates that hinge on the phrase monetary policy held constant.

    If the Fed buys an asset, a one time purchase has no lasting on the price–EMH. A commitment to keep buying the asset perpetually shifts the demand curve and so given an unchanged supply curve, raises the equilibrium price.

    So who benefits when the Fed buys treasuries? The government does. Who benefits when the Fed buys cars? Car manufacturers.

    It doesn’t matter who the Fed buys from. It only increases the intermediation if the fed does not buy direct. So, the money from the OMO always reaches the supplier of the asset whose income certainly increases.

  40. Gravatar of ssumner ssumner
    4. December 2012 at 20:07

    Joemac. The demand for base money is in real terms, the supply is in nominal terms. Suppose people want to hold enough base money to buy one week’s worth of shopping. That’s their demand for base money. Now the Fed doubles the supply of base money. In that case people will still hold enough base money to buy one week’s worth of shopping. In other words V is constant in this example. So prices double and people are still holding the same real quantity of money. But their nominal demand for money has doubled because NGDP has doubled.

    John, The debt doesn’t rise, but it rises relative to the alternative, which is OMOs. OMOs reduce the net debt held by the public. Helicopter drops do not. There will come a time when the extra cash needs to be removed to prevent hyperinflation. At that point you’ll have to raise taxes to remove the cash helicoptered in, but not the cash injected via OMOs.

  41. Gravatar of Doug M Doug M
    4. December 2012 at 20:17

    6 trillion comes from Barclays. It doesn’t count Treasury securities held by the Fed or loans from other branches of the Federal goverment to the Treasury, e.g. social security. I am not sure about Treasuries held by foreign central banks.

    The rest of the world’s bond markets is annother 20 Trillion….

  42. Gravatar of JoeMac JoeMac
    4. December 2012 at 20:40

    Scott,

    Would I be correct in understanding you that your argument hinges on the argument that the demand for money is a stable function of Income and its expectations? I thought that was controversial Monetarist view since the 1970s.

    Also, isn’t the demand for base money separate from demand for the monetary aggregate. The first is the multiplier and the second V.

  43. Gravatar of Saturos Saturos
    4. December 2012 at 23:21

    Scott, I think I’ve worked out what the Austrians are on about.

    Imagine a simple economy. Only consumer goods are produced, no capital. They are exchanged using only cash money. The central bankers conduct monetary policy by printing cash and purchasing consumer goods with it. Clearly, when money is expansionary the central bankers push up the prices of apples, bananas, whatever else they buy, by a tiny amount. But if expectations are not perfect, then whilst sellers of fruit are slightly richer, other people continue selling at the same price, which is low relative to the new equilibrium (which means minor shortages of course). So because other prices are slow to adjust those sellers are slightly shortchanged relative to people selling to the central bank in exchange for outside money. Although the price level of goods in general rises uniformly (ignoring cyclicality) in response to the increased quantity of money, because some prices rise faster than others as the outside money comes in, some sellers get slightly richer than others.

    When the Fed creates money to buy assets, the price of assets in general must rise against the money being paid for them, to clear the general market exchange of money for assets. People who sell assets first are selling for higher prices than otherwise, because more money is being paid them (by the Fed) than otherwise. If all other asset sellers immediately raised their prices to the new equilibrium exchange rate with money then no one loses. But if prices are sticky or with imperfect expectations, people who sell to the Fed get the higher prices, whereas other sellers of assets are slow to get equivalently higher prices for their assets.

    In short for new money to enter the general price of something in terms of money must rise, and sellers at that price are correspondingly richer. If the rise in the general price level is staggered, then it is possible that some people get more revenue gains than others, and some people get richer than others.

    So there is a Cantillon effect, but it is quantitatively insignificant. (The wheat farmer does lower the price when he sells more, by a fraction of a cent.)

    “That’s because if you hold fiscal policy constant the alternative would be to inject the money via already existing government spending programs.”

    If the government does not increase the flow of securities it issues, and the Fed creates money and uses it to buy outstanding securities from the market, wouldn’t the equilibrium price of securities against money rise on the spot market? T-bond holders get a (nominal) capital gain, however slight.

  44. Gravatar of Saturos Saturos
    4. December 2012 at 23:22

    EVERYONE: IMPORTANT NEW TIM DUY POST:

    http://economistsview.typepad.com/economistsview/2012/12/fed-watch-monetary-policy-to-become-easier-next-week.html

  45. Gravatar of Ritwik Ritwik
    5. December 2012 at 01:09

    Scott

    I have a feeling you don’t understand what you’re saying!

    You seem to imply that holding fiscal policy constant means holding the stock of t-bonds held by the general public constant (as a fraction of GDP, perhaps). Hence, when CBs swap cash for bonds, to “hold fiscal policy constant” would be to ensure that an equal value of bonds – and implied spending – are added back for public circulation.

    Hence, essentially, a monetary injection, while “holding fiscal policy constant”, is best modelled as a helicopter drop.

    Do you disagree with this characterization of what you’ve said in this post?

  46. Gravatar of Ritwik Ritwik
    5. December 2012 at 01:13

    Perhaps you might wish to reflect on this question : the CB decides to buy equities through the *new money*

    Does the price of equities rise?

  47. Gravatar of George George
    5. December 2012 at 01:36

    John S, I think you got me confused with prof. George Selgin, I only share my first name with him :)

    Saturos, this is indeed my impression as well about the austrian’s view, but it does sound a bit weak. So essentially, those who sell their T-bills to the fed are selling it at a higher price than those who are selling it to someone else??
    Even if it’s true, surely the price difference can’t be that big. Saying this is undermining the whole way of how market works, this is a clear arbitrage.

    If this was true, any arbitrageur, would buy a bond from someone in the market and then go and sell to the fed and make loads of free money, and therefore they are the ones really earning the money. Furthermore by doing this they would push this price differential to 0. Doubting this, is really doubting the whole way the market works …

  48. Gravatar of George George
    5. December 2012 at 01:47

    Then if the argument is that the fed buying assets is pushing the profits of arbitrageur up, although this is arguable and I’m not pretending to answer it here, but even if we assume this to hold, this would happen anytime you have a transaction in the financial system. When you are travelling and exchanging your currency, you are also potentially driving arbitrageur’s profits up.

    In general, wall street would profit from bigger volumes, so more financial transactions would usually mean more profit for them. But surely this is a very thin argument to say that the first receiver of money is benefiting …

  49. Gravatar of Prakash Prakash
    5. December 2012 at 01:59

    Suppose the treasury were to create a website where every person with a valid US ID could create their own 30 year bonds. The purchase of these bonds by the Fed (everybody gets the same terms, whatever they are) would give money to every individual, but at the cost of being personally indebted to the Fed. Call it a helicopter drop with chains attached.

    I’m not sure whether to call it fiscal or monetary policy, but I’m sure that people would love to have their own personal share of the monetary increase plus the price rise, instead of just the price rise which is what happens today.

  50. Gravatar of George George
    5. December 2012 at 02:21

    Prakash, the complication with your approach, is how do you price your bond, you have a credit risk that is way too different from the treasury.

    You are asking that you issue a bond, and then sell it to the fed through a website, why would the fed accept to do that and take all this credit risk?

    Isn’t it better to leave the market to assess your correct credit risk price. So if you want a debt, contact your bank, who will assess your credit risk and accordingly gives you a loan, then your local bank to fund this loan would let’s say issue a bond which is bought by a certain primary dealer, this primary dealer would fund this bond by let us say selling a T-Bill it possessed to the Fed.

    I’m having the impression people are really doubting the working of the financial system as a whole, if it is the case, then this is clearly not the place to discuss it (at least this discussion would not involve me ;) ).

  51. Gravatar of Ben Southwood Ben Southwood
    5. December 2012 at 04:01

    Scott,

    I’ve been following these posts with interest, and I still don’t understand. I think it’s because I’m a relative ignoramus on complex issues of financial policy.

    Here’s how I thought QE worked. The central bank buys £X of gilts with new money, created out of the aether so to speak, this drives up the price of guilts by basic effects of supply and demand. This ripples through yields/effective interest rates on all sorts of assets for obvious reasons. Anyone who owned these assets when the QE was a surprise (either before it was announced or before it happened, if unannounced).

    If QE will at some point be unwound, so in the long run this effect comes out in the wash, but in the short run it does drive the prices of these assets up, no? Since prices would rise for everyone, but these people would have seen their wealth increase, there would be a distributive effect, no?

    I apologise if I’ve made elementary errors. To be clear I’m not in any sense attacking your arguments, just trying to understand, both out of interest and because it’s actually part of my current job!

  52. Gravatar of Tim Tim
    5. December 2012 at 04:12

    Hi scott
    I agree with you, but theres an issue that i cant get my head around. Hopefully you can clarify it for me.
    What if some individuals have a greater incentive to hold the extra money, so they have a higher demand for base money at a given interest rate. Banks, for example, receive IOER, so they would have a greater incentive to hold the money than if it was received by non-bank institutions or companies, or even the public.

  53. Gravatar of Arthur Arthur
    5. December 2012 at 05:16

    ” Of course the aggregate NGDP will rise a tiny bit, and for that reason everyone, including Gates, will spend a tiny bit more on goods and services.”

    Actually I think it run the other way around. People will spend a tiny bit more, and for that reason NGDP will rise.

    People spending defines NGDP, not the other way around.

    NGDP is the measure of people’s spending, changes is reality causes changes in measurement, not the other way around.

  54. Gravatar of ssumner ssumner
    5. December 2012 at 05:28

    Joemac, No I don’t assume stable money demand.

    Ritwik, Stable fiscal policy means no change in taxes and spending. Ordinnary OMOs will reduce debt held by the public. That’s not fiscal. Injecting new money via gov. worker salaries will reduce debt held by the public exactly the same as OMOs. In that sense the two are identical. Neither affect G and T, and both affect debt held by the public by identical amounts. I was saying that when comparing two monetary policies for Cantillon effects, you should compare two with identical fiscal impacts. Otherwise the difference is due to fiscal differences. Everyone agrees that if the Fed buys perishable goods, that affects the markets selling perishable goods. BUT CENTRAL BANKS DON’T DO THAT.

  55. Gravatar of Major_Freedom Major_Freedom
    5. December 2012 at 05:40

    Ben Southwood:

    You ought not look down on yourself or doubt what you currently think, because you have it pretty much exactly right.

  56. Gravatar of Becky Hargrove Becky Hargrove
    5. December 2012 at 05:40

    Saturos,
    re: Tim Duy post
    Yeeeaaaahhhh! No more decaf (Operation Twist) but instead the real thing. It won’t be long now before I have a chance to make the move, to look for an actual job that could last…

  57. Gravatar of Major_Freedom Major_Freedom
    5. December 2012 at 05:51

    Arthur:

    ” Of course the aggregate NGDP will rise a tiny bit, and for that reason everyone, including Gates, will spend a tiny bit more on goods and services.”

    Actually I think it run the other way around. People will spend a tiny bit more, and for that reason NGDP will rise.

    People spending defines NGDP, not the other way around.

    NGDP is the measure of people’s spending, changes is reality causes changes in measurement, not the other way around.

    —————————–

    I agree with you, Arthur. That is exactly right. One of the unfortunate consequences of economists thinking in terms of aggregates (along with the unfortunate consequences that lead them to thinking in terms of aggregates in the first place), is a tendency to ascribe to the aggregate (such as NGDP) some sort of deux ex machina status that rises and falls completely independent of any individual action, that is, it is conceptually separate in its own “world”, and that it somehow presents “itself” as a force or motive activity that then leads all individuals to acting in certain ways rather than other ways.

    It is an unfortunate way of thinking that derives from Platonism, where singular perfect ideal types and concepts, are the “real” reality, and grounds all the empirical instances and happenstances of regular individual people, who are but mirror images of the one true ideal, and hence, we allegedly react (spend more) when the ideal type (NGDP) changes.

    But as you seem to understand, it doesn’t take much thinking to see that is the wrong way to think about the world. NGDP is, as you say, a result of individuals acting in certain ways. NGDP reacts to regular individual people, not the other way around. NGDP is a product of all individual spending. It doesn’t “determine” individual spending. If one holds a beginning thought as “NGDP goes up 5%”, then one is already presupposing that individuals, either one, or some, or all of them, are spending more than they did before. They didn’t spend more because NGDP went up. They spent more because they received more cash, and then that additional spending made NGDP go up.

    Keep thinking the way you are thinking Arthur, regardless of what anyone says, because that is how to think like an economist.

  58. Gravatar of Major_Freedom Major_Freedom
    5. December 2012 at 06:08

    ssumner:

    Ritwik, Stable fiscal policy means no change in taxes and spending. Ordinnary OMOs will reduce debt held by the public. That’s not fiscal. Injecting new money via gov. worker salaries will reduce debt held by the public exactly the same as OMOs. In that sense the two are identical. Neither affect G and T, and both affect debt held by the public by identical amounts. I was saying that when comparing two monetary policies for Cantillon effects, you should compare two with identical fiscal impacts. Otherwise the difference is due to fiscal differences. Everyone agrees that if the Fed buys perishable goods, that affects the markets selling perishable goods. BUT CENTRAL BANKS DON’T DO THAT.

    If you agree that if the Fed buys good X, the Fed will affect the markets selling good X, then what is the justification for disagreeing that if the Fed buys t-bonds, the Fed is affecting the markets selling t-bonds?

    Why does printing money to buy t-bonds not affect the markets selling t-bonds, if the Fed printing money to buys cars affects the markets selling cars?

    If the Fed buying t-bonds doesn’t affect the markets selling t-bonds, then, logically, those t-bond markets would not change the way they affect other markets, and those tertiary markets would not change in the way they affect quaternary markets, and so on. Thus, by claiming that the Fed buying t-bonds does not affect the markets selling t-bonds, one is literally denying that the Fed has any effect on “the economy” in totality, since the t-bond market is the sole “conduit” from which the Fed affects the greater economy.

    Oops.

  59. Gravatar of George George
    5. December 2012 at 06:27

    Even if we assume that the fact that the fed buying t-bills impacts t-bill prices, I can see that this would benefit all bond holders, and not only the ones who sold it to the fed, right?

    So it’s not the people who first received the money who benefited, but the holders of t-bill.

    Now, let us say the fed is committed to buy something in the economy, you need to keep fiscal policy constant, so that rules out buying cars and alike, so the fed can either buy the t-bill, or directly fund a government project, for example it can pay the salary of the government employees.
    If it buys T-bills or pays government employee’s salaries, it’s the same outcome, nothing changes, if you assume t-bills will appreciate in the first scenario, they would appreciate in the second as well.

    So the fact that the fed announced QE would have raised t-bill prices, and not the fact that they received money first!

  60. Gravatar of JoeMac JoeMac
    5. December 2012 at 07:09

    Scott,

    But how can money demand not be stable if you wrote, “In other words V is constant in this example.”

  61. Gravatar of dtoh dtoh
    5. December 2012 at 12:57

    Scott,
    I agree with the title of the post, but I still think you are giving short shrift to the mechanism. Let me pose a question.

    For OMO to have an effect on AD, there has to be a marginal increase in spending on real goods and services. So the question is where does this marginal increase initially take place and what causes it to take place. As you say, “Bill Gates does not refrain from buying a Ferrari today because he doesn’t happen to be holding any base money.” Further, I don’t think you can argue that Joe Public hears about OMP on the evening news and rushes out to spend money because he believes his cash holdings are being devalued.

    IMHO, the primary (if not only way) that OMO initially impacts spending on real goods and services (i.e. AD) is if someone who holds financial assets or who has the ability to issue financial assets decides to exchange financial assets for real goods and services.

    The second part of the question is what causes this initial exchange to occur. It seems to me that the answer is very clear. You’ve already stated with your Bill Gates analogy that it’s not the volume of money being held. Rather, what does cause the exchange is that OMP causes a change in the real price of financial assets relative to cost of real goods and services or produces a shift in expectations. If you consider an indifference curve between holding financial assets versus spending on real goods and services, OMP causes a movement along this curve and/or a shift in this curve.

    I have a very hard time thinking of what other effect or mechanism can cause that initial increase in marginal spending on real goods or services to occur.

    After the initial increase, you get a more general dispersion of money throughout the economy and I agree that you do then see an aggregate HPE, but the critical and indispensable mechanism for this whole process is financial asset prices.

  62. Gravatar of Prakash Prakash
    6. December 2012 at 08:57

    George,

    I’m not doubting the entire financial system. I’m doing the same that you mentioned in a previous comment. I’m assuming that a central bank exists. Now, how to spread the benefits and costs of it in an egalitarian manner?

    Assume the government be run by taxes alone. No government debt. Let the banks and mutual funds be as innovative as they want. The central bank is not going to bail any of them out.

    Let the central bank set the same terms for every person. Some will take the loan. Some will not. The interest rate that it sets will be the new tool of monetary policy. It’s weird, but doable. And needless to say, more egalitarian than what we have today.

  63. Gravatar of Pravin Pravin
    7. December 2012 at 02:24

    Prakash,
    Looks like what you have is an elaborate plan for the Central bank to replace the price mechanism of the market itself.
    Egalitarian? Or cookie cutter?

  64. Gravatar of ssumner ssumner
    7. December 2012 at 07:42

    JoeMac, Yes, in that example. I thought you were asking whether I thought V was constant in the real world.

    dtoh. I think current expenditure rises mostly because of expectations of the future HPE raising NGDP.

  65. Gravatar of Prakash Prakash
    7. December 2012 at 09:28

    Pravin, I’m not imagining the price system for ordinary loans going away. There will be normal market prices. Every person, when he approaches a private bank, will be offered a particular rate of interest or refused a loan altogether, same as it happens today.

    But, he will always have a backup option to take a limited loan from the central bank at publicly known terms. Now, what should that interest rate be? That is precisely, monetary policy in the new setup. If the central bank forecasts that it is missing its NGDP target, it will lower the interest rate. If it forecasts that it will overshoot its target, it will increase the interest rate. The money will simply flow bottom up in the suggested system instead of top down as it happens today.

  66. Gravatar of dtoh dtoh
    7. December 2012 at 14:13

    Scott,

    You said,

    dtoh. I think current expenditure rises mostly because of expectations of the future HPE raising NGDP.

    I think I would agree. As I have said repeatedly, monetary policy initially causes a marginal increase in the exchange of financial assets for real goods and services. That increase can be caused by either an increase in the real price of financial assets (movement along the indifference curve) or by change in expectations (a shift of the curve).

    I have nothing to back it up, my gut agrees with you that it’s mostly expectations with the caveat that it probably depends on how decisively the Fed acts and how effectively it communicates policy.

    If the Fed tomorrow announced negative IOR and a commitment to unlimited OMP to achieve 8% NGDP in 2013, I think you would actually see real bond prices not rise but drop because the change in expectations would cause such a large shift in the curve that the shift would dominate and actually cause the prices move in the opposite direction from what you would normally expect from Fed purchases.

    If the Fed continues with its ho-hum program of asset purchases, we’re probably going to have to rely more on the price change to impact AD, which IMHO is a much harder slog than if they were to strongly commit to a hard policy target.

  67. Gravatar of dtoh dtoh
    7. December 2012 at 14:40

    Scott,
    Correction- I mean to say, decisive Fed action is likely to cause bond prices to drop not rise….which having subsequently read you most recent post is I gather consistent with your views.

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