Students need to be taught monetarism first, then Keynesianism

Greg Ip seems to have a pretty low regard for monetarists:

But in the real world, the Fed sets a fixed interest rate and lets the money supply adjust. Back in 2000 David Romer proposed modifying the IS-LM model to reflect this reality. In his IS-MP model, the upward sloping LM curve is replaced by a horizontal MP curve.

.  .  .

The Fed influences the level of output by changing its interest rate, i.e. shifting the MP curve up or down.  At any given interest rate the money supply is infinitely elastic, which simply means it is determined by demand, rather than the other way around, as monetarists think.  I wish undergraduate courses used Mr Romer’s IS-MP model instead of the IS-LM model; students would have a much easier time applying their class work to the real world.

God help us if there are any monetarists out there who don’t understand that the money stock becomes endogenous when the Fed pegs interest rates.

Greg Ip continues:

This essentially explains why no major central bank targets the money supply. The money supply does matter, but for narrow, technical reasons.

Ip is right that central banks choose not to target the money supply, but it’s not for the reasons he suggests.  The real problem is that the demand for money (or velocity, if you prefer) is not stable.  Thus targeting the money supply might leave prices and/or NGDP quite unstable.  And the money supply matters for broad macroeconomic reasons, not narrow technical reasons.

Because the demand for money is unstable, and because there are lags between changes in monetary policy and observed changes in NGDP data, most central banks rely on intermediate targets like interest rates or exchange rates.  But these are still targets, monetary policy consists of control of the money supply.  Here’s how it works:

1.  The central bank determines a policy goal–say 2% inflation.

2.  The central bank doesn’t know how much money is required to generate 2% inflation, so they set targets for interest rates and exchange rates, and then adjust those targets as needed to stabilize inflation.

3.  Suppose a central bank sees inflation rising too fast.  They might decide to raise interest rates.  But higher interest rates don’t lower inflation, they raise inflation.  That’s because as interest rates rise, velocity rises.  Higher velocity raises inflation, it doesn’t lower it.  So why do central banks talk about “raising interest rates” to control inflation?

4.  Here’s what’s really going on.  Suppose the central bank sees inflation rising too rapidly.  They realize that the need to reduce money growth.  But they don’t want to target money growth, as that makes other variables too volatile.  So they they raise the target short term interest rate enough so that the money supply (now or later) will have to be reduced in order to hit the interest rate target.  They hope the reduction in the money supply reduces inflation.

Let me repeat, higher interest rates are inflationary.  They increase velocity.  If you don’t believe me, check out interest rates and velocity during any extremely high inflation episode.  When rates rise, inflation usually rises.  Higher interest rates are inflationary.  Repeat 100 times.  But the thing the Fed uses to generate higher short term interest rates—a reduction in the money growth rate—is deflationary.  To reduce inflation you must reduce money growth.  Interest rate targeting (or exchange rate targeting) is simply a tool.  It is changes in the money growth rate that actually drive macro nominal aggregates up and down.

It is precisely because students were taught IS-LM and IS-MP that we are in this mess.  Both models teach students that easy money reduces interest rates.  So 99.999% of people in 2008-09 inferred that the Fed was easing monetary policy, even as they adopted the tightest policy since 1938.

Woodford and Bernanke are right; the stance of monetary policy depends on outcomes like NGDP growth and inflation, not interest rates and the money supply.  But that is NOT what students are being taught.

PS.  I said money is endogenous when the central bank pegs interest rates.  It’s not endogenous in any long run sense when they target interest rates.  That’s because targets are adjusted to change the money supply.


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61 Responses to “Students need to be taught monetarism first, then Keynesianism”

  1. Gravatar of Saturos Saturos
    16. January 2013 at 09:45

    Mankiw has related comments over here: http://gregmankiw.blogspot.com.au/2006/05/is-lm-model.html

  2. Gravatar of Saturos Saturos
    16. January 2013 at 09:49

    And IS-LM can be taught in a more monetarist way, like Nick and Bill do in some of their blog posts (and Lars Christensen here: http://marketmonetarist.com/2013/01/04/daniel-lin-is-teaching-macro-lets-introduce-his-students-to-the-islm-model/). But we should get rid of the dinosaur Keynesianism still taught in intro-mediate macro courses around the world, teach it like this instead: http://marketmonetarist.com/2011/12/23/how-i-would-like-teach-econ-101/

  3. Gravatar of Nick Rowe Nick Rowe
    16. January 2013 at 09:49

    My fault, I think. It was a long time ago, and neither Greg or I can remember exactly who taught him what. But I may have taught him macro. Very probably ISLM. (He was a really great student.)

  4. Gravatar of JP0 JP0
    16. January 2013 at 09:54

    What’s your position on Austrians’ business cycle approach to this matter ? (not austrian, just genuinely curious)

  5. Gravatar of ssumner ssumner
    16. January 2013 at 10:00

    Saturos, Thanks for the links, but I don’t much like IS-LM, even if taught in a more monetarist way.

    Better to model the key variables, M, and NGDP, or M and P and Y.

    Nominal wages too.

    Nick, I don’t blame you; almost all my students think low rates mean easy money, even after taking my class. :)

  6. Gravatar of Geoff Geoff
    16. January 2013 at 10:19

    Dr. Sumner:

    “God help us if there are any monetarists out there who don’t understand that the money stock becomes endogenous when the Fed pegs interest rates.”

    I’m a monetarist (to the extent I support monetarism only if I am the sole primary dealer, of course), but I would argue that if any Fed activity which uses any variable as the policy instrument, from targeting price levels to interest rates to NGDP to my own personal nominal income (the ideal monetarist policy), then isn’t it the case that as long as the Fed is conducting OMOs to any degree, that money simply cannot “become endogenous”, as if the Fed isn’t adding to or taking away from the money stock themselves?

    I would argue that all OMOs, since they consist of an addition or subtraction of money from primary dealer accounts (preferably mine), that it would more correct to argue that the Fed AND “the market” would end up co-determining the money stock, by virtue of both of their money supply addition and subtraction activities.

    (Total money stock at time T) = (Money stock at time T-t) + (Change in Fed money from t to T) + (Change in market money from t to T).

    E.g

    Money stock of $1 trillion today = Money stock of $900 billion last year + $50 billion change in Fed money since last year + $50 change in market money since last year.

    My alarm bells go off any time someone says that the Fed is not directly (but not necessarily fully) responsible for the changes in the money stock, in an environment where the Fed is engaging in positive activity via OMOs, such as pegging interest rates and whatnot. OMOs add and subtract money from primary dealer accounts, and primary dealer accounts are a component of the money stock!

    At least two broad parties are affecting the money stock, the “exogenous” Fed via its OMOs, and the “endogenous” banks via their lending.

  7. Gravatar of bretton bretton
    16. January 2013 at 10:45

    When you say higher interest rates are inflationary, which is the chicken and which is the egg and how do you know?

  8. Gravatar of Tommy Dorsett Tommy Dorsett
    16. January 2013 at 10:55

    Scott — Here’s broad money velocity vs the long bond from the mid 1920s. Pretty powerful evidence for the *monetarist* view.

    http://research.stlouisfed.org/fredgraph.png?g=eBX

  9. Gravatar of Geoff Geoff
    16. January 2013 at 10:58

    Dr. Sumner:

    “Woodford and Bernanke are right; the stance of monetary policy depends on outcomes like NGDP growth and inflation, not interest rates and the money supply. But that is NOT what students are being taught.”

    NGDP growth and inflation are, as 2008-2010 has shown, not similar enough to be grouped together as “likes”. Price inflation can be 1% or 2% growth even while NGDP growth is -5%.

    I don’t think Woodford and Bernanke can be claimed as being “right” or “wrong” here. The stance of monetary policy is what people think the stance of monetary policy is based on which specific variable that is being observed.

    One person can point to NGDP and say “monetary policy has been “sufficient” during 1980-2007, because NGDP growth was roughly 5% per year”.

    Another person can point to wages relative to NGDP and say “monetary policy has been “insufficient” during 1980-2007, because wages relative to NGDP has fallen roughly X% per year, instead of rising at Y% per year as a “sufficient” monetary policy should generate”.

    I think that the statement “the stance of monetary policy depends on outcomes like NGDP growth” is like the statement “the stance of art depends on outcomes like happiness versus sadness”. I’ll say to both: “No, you’re just trying to make people overlook the fact that there is no “right” and “wrong” here, by using the rhetorical tactic of insinuating there is a right and wrong answer here that would make people think they’re wrong if they have a different opinion on this than you do.”

    The problem here, IMO, has an reconciliation, and I borrow from what Hayek emphasized: The ONLY source of information that can enable one to make such judgments of money, to say “that’s right” and “that’s wrong”, is via the information that is released solely by market forces. The market is where/how such information arises, that can enable one to make a definitive judgment by using that information.

    You will NOT find this information in my desk, nor in your desk, nor in the desk of any university, or college, nor at any think-tank, nor in the desk of anyone at the Fed, nor the Treasury.

    The information only comes from the mechanism of competition, of individuals buying and selling, based on property title transfers.

    It is not surprising, to me at least, why I see this tactic being used to make it seem like different non-market mechanism preferences, from NGDP targeting, to interest rate targeting, would be understood in terms of a list where this list here has “correct” stances of monetary policy, where that list there has “incorrect” stances of monetary policy.

    The people who are complaining to each other where those on one side say “My list is the correct one”, and those on the other side say “No, MY list is the correct one.”

    The only way these two parties can come to an agreement is, of course, some non-market mechanism, since they are arguing over which non-market mechanism is “correct.” Group A can ONLY “win” the dispute by having the state impose its preference, which squashes Group B’s preference with the force of obedience through intimidation, i.e. the law. Same thing with Group B. They can only “win” the dispute by having the state impose its preference on Group A via the same force of obedience through intimidation.

    Neither group is trying to win a pure intellectual battle, the way physicists and chemists and mathematicians use the market of ideas, not the state, to settle their disputes. No, for economists who want to “win” a non-market dispute, the dispute will necessarily be one where the “winning side” was the one that generated the most influence over the state, which will impose the winning group’s preference over everyone else through intimidation.

    Of course, none of this is to say I am refusing to support the principles involved here, since I would LOVE it if the state were to impose my monetary policy preference, where I am the sole primary dealer, and the Fed targeted NGDP via conducting OMOs with me only.

    I am not so foolish enough to believe that other monetarists who talk about this are trying to win a purely intellectual battle WITH ME. I know that all other monetarists, NGDP targeting theorists included, are trying to win a dispute that is settled by the state’s force, not by the marketplace of ideas, reason and logic, as what occurs in the natural sciences.

    So nobody has to “there there, Geoff” me at all. I know what’s up. I know that Dr. Sumner, and me too, don’t get me wrong, we are trying to basically hypnotize others in this “violence as ultimate arbiter” dispute, to delude themselves into believing that it is reason and logic which is deciding that NGDP, rather than interest rates or price levels, are the correct “stances” of monetary policy.

    I’ll use abracadabra too, and say “Razzle dazzle, pop filly smazzle…NGDP growth through conducting OMOs with only Geoff, is the correct stance of monetary policy. Repeat it to others. NGDP growth through conducting OMOs with only Geoff, is the correct stance of monetary policy.

    Come on everybody! Bernanke once said this to me too. While he was drunk, yes, but still, he said it: NGDP growth through conducting OMOs with only Geoff, is the correct stance of monetary policy.

    I know reason and logic are not the arbiter for settling any dispute you might have with this, but there’s nothing I can do about that. I am not so dogmatic so as to refuse to even play with the cards I have been dealt. I am working with what we have, and what we have is less than purely intellectual means to settle disputes. So let’s all try to use the hammer of the state to get what we want, and see who wins this dispute!

  10. Gravatar of Doug M Doug M
    16. January 2013 at 11:06

    The ciriculum is taught completely backards.

    Proceed in this order:
    Markets
    Employment
    Taxation
    Banking
    Finance — Government, Corporate, Personal
    The Fedral Reserve
    Monetary theory
    Ficscal policy
    Keynsian theory (optional)

    Avoid all models the depend upon perameters that cannot be seen. Remove most of the mathematics. Ditch AD and AS.

  11. Gravatar of Ron Ronson Ron Ronson
    16. January 2013 at 11:10

    “Let me repeat, higher interest rates are inflationary. They increase velocity. If you don’t believe me, check out interest rates and velocity during any extremely high inflation episode”

    Intuition says it is the other way round – inflation induces higher interest rates and higher velocity, which is why one see that correlation.

    I understand that if the supply of money is adjusted to meet the demand then (other things being equal) interest rates will be at their “natural level” and that if the money supply is too low then interest rates will likely be below this natural level too. But starting from equilibrium if the CB raise interest rates this should reduce the money supply and cause deflationary pressures not inflation.

    What is the mechanism that would cause an increase in interest rates to cause inflation to rise ? Isn’t it rather that too low interest rates initially cause expectations of inflation to rise which will eventually lead interest rates to follow ?

  12. Gravatar of Interest Rates as Monetary Policy « azmytheconomics Interest Rates as Monetary Policy « azmytheconomics
    16. January 2013 at 11:20

    [...] Reading: Smuner Share this:TwitterFacebookLike this:LikeBe the first to like this. from → Macroeconomics, [...]

  13. Gravatar of Suvy Suvy
    16. January 2013 at 11:22

    What students need to do is to read Keynes rather than be told someone’s wrong interpretation of Keynes. There’s a paper called The General Theory of Employment by Keynes; it was written in 1937 after The General Theory. It’s about 15 pages long and I suggest someone read that book and then tell me IS/LM is an interpretation of Keynes. What passes off as Keynesian has nothing to do with what Keynes actually said. Most people I know that bash Keynes have never even read his work. Not only that, but Keynes’ work on economics was based on much of his work on probability theory, yet most economists know nothing about probability theory. I’ve heard so many stories about how Keynes was pro-inflation and every time I hear that nonsense, it makes me want to punch a hole in the wall. Keynes’ work is based on uncertainty and most of his work comes from his ideas about probability theory. The only correct interpretation of Keynes that I’ve read comes from Hyman Minsky.

  14. Gravatar of Suvy Suvy
    16. January 2013 at 11:22

    What students need to do is to read Keynes rather than be told someone’s wrong interpretation of Keynes. There’s a paper called The General Theory of Employment by Keynes; it was written in 1937 after The General Theory. It’s about 15 pages long and I suggest someone read that book and then tell me IS/LM is an interpretation of Keynes. What passes off as Keynesian has nothing to do with what Keynes actually said. Most people I know that bash Keynes have never even read his work. Not only that, but Keynes’ work on economics was based on much of his work on probability theory, yet most economists know nothing about probability theory. I’ve heard so many stories about how Keynes was pro-inflation and every time I hear that nonsense, it makes me want to punch a hole in the wall. Keynes’ work is based on uncertainty and most of his work comes from his ideas about probability theory. The only correct interpretation of Keynes that I’ve read comes from Hyman Minsky.

  15. Gravatar of Suvy Suvy
    16. January 2013 at 11:39

    “Suppose a central bank sees inflation rising too fast. They might decide to raise interest rates. But higher interest rates don’t lower inflation, they raise inflation. That’s because as interest rates rise, velocity rises. Higher velocity raises inflation, it doesn’t lower it. So why do central banks talk about “raising interest rates” to control inflation?”

    How can you know how the velocity of money will change? That depends on people and their behaviors. The behaviors of people and the forecasts of market participants are nonlinear, which would make them highly sensitive to the initial conditions. To say that people will do this given this is naive. It depends on far too many factors and far too many things are interconnected for us to tell the way people behave.

  16. Gravatar of Suvy Suvy
    16. January 2013 at 11:41

    “Let me repeat, higher interest rates are inflationary. They increase velocity. If you don’t believe me, check out interest rates and velocity during any extremely high inflation episode. When rates rise, inflation usually rises. Higher interest rates are inflationary. Repeat 100 times.”

    So correlation is causation? You’ve got to be kidding me. This stuff is highly nonlinear and there are feedbacks. So in one situation, high interest rates can be a sign of high inflation. In others, it may be different. It depends on the initial conditions and the qualitative behavior of people.

  17. Gravatar of Suvy Suvy
    16. January 2013 at 11:45

    You can either target the quantity of money or the rate of interest. High growth in the rate of money does usually lead to high inflation; however, money can be created by the private sector(banks issuing credit) or by the government sector(printing money). If you lower the interest rate, you increase the demand for credit and the willingness for people to take on credit.

    Also, Milton Friedman is right when he says there is a difference between the short term and the long term. In the long term, increasing the money supply increases interest rates. In the short term, increasing the money supply decreases the rate of interest. The way the curves will move will depend on the initial conditions–again, very common of nonlinear systems.

  18. Gravatar of ssumner ssumner
    16. January 2013 at 11:50

    JPO, Can you be more specific? What “matter?”

    Geoff, Sorry, I can’t follow your argument.

    Bretton, Holding M constant, a higher i-rate is inflationary.

    Thanks Tommy.

    Ron, You said;

    “Intuition says it is the other way round – inflation induces higher interest rates and higher velocity, which is why one see that correlation.”

    Not my intuition!

    Suvy, I’ve read the GT, and I think IS-LM does describe his model.

  19. Gravatar of James Oswald James Oswald
    16. January 2013 at 11:52

    Another way to say this is:
    “Anything that’s not the central bank’s target is endogenous.”

    Interest rates, base money, etc are all determined by the goal the central bank is trying to achieve.

  20. Gravatar of Ron Ronson Ron Ronson
    16. January 2013 at 11:54

    ““Intuition says it is the other way round – inflation induces higher interest rates and higher velocity, which is why one see that correlation.””

    In which case I’m not seeing the transmission mechanism from higher interest rates to inflation that does not start with lower interest rates raising inflation expectations. Can you explain ?

  21. Gravatar of James Oswald James Oswald
    16. January 2013 at 12:04

    Ron Ronson: One mechanism is the interest rate is an approximate opportunity cost of holding currency. If you could be earning 10% on the bond market, you’re not going to want to hold a lot of cash. If the interest rate is 1%, it might not matter so much.

  22. Gravatar of Suvy Suvy
    16. January 2013 at 12:14

    Ssumner,

    Keynes would not think very highly about equilibrium models. Again, most of his work on economics is based on his work on probability theory. I’m actually reading his A Treatise on Probability right now and I’ve read much of his papers along with The Economic Consequences of the Peace and I don’t know how in the work IS/LM can be attributed to Keynes. You do know that IS/LM was developed by Hicks before Keynes published The General Theory and Hicks himself said it was a bad model and a poor interpretation of Keynes.

    An essential part of Keynes’ work was the existence of a financial sector that plays a very critical role in the formation of capital, his ideas on liquidity preference, and his emphasis on uncertainty. None of those exist in IS/LM and those are Keynes’s most important points. To say that IS/LM is Keynes’s model is a complete joke. It is not, it is simply not.

    This is the paper I was referring to earlier. There is now way how anyone could read this and tell me IS/LM is an accurate representation of Keynes. Note his emphasis on uncertainty.
    http://membres.multimania.fr/yannickperez/site/Keynes%201937.PDF

    Please point to the liquidity preference and uncertainty in the IS/LM model and tell me how IS/LM was Keynes’s model. If you can do both of those things, I will gladly concede the argument.

  23. Gravatar of Doug M Doug M
    16. January 2013 at 12:18

    Higher rates increase velocity — Sounds to me like you have cause and effect backwards. Higer velocity will increase rates.

    The interest rate is the price of money today, in terms of future dollars. An increase in the demand for money (V) drives up the price of money — higher rates. A reduction in the supply of money, will also drive up the price of money, raising rates, without affecting V.

  24. Gravatar of James Oswald James Oswald
    16. January 2013 at 12:24

    bretton: Interest rates are the chicken and inflation is the egg. But which came first?

    Seriously though, both variables are determined by the actions of the central bank. What the central bank actually does is open market operations and setting expectations of future OMOs. But they act with a purpose (hopefully), to hit those other targets (interest rates, inflation, etc). Everything moves simultaneously in the real world.

  25. Gravatar of Kailer Kailer
    16. January 2013 at 12:57

    This would seem to violate your “never reason from a price change” maxim. Couldn’t the interest rate go up either because banks don’t want to lend (uncertainty, new capital requirements) whatever, or because households and businesses want to borrow more (some new information indicates a better future). Wouldn’t velocity drop in the first case and jump in the second, and couldn’t the lower or higher demand for money be met by changes in the reserve ratio rather than with changes to the monetary base?

  26. Gravatar of ChargerCarl ChargerCarl
    16. January 2013 at 13:05

    Scott I think I understand this (I think). Higher i-rates are inflationary because higher i-rates are caused by expansionary MP right? Or are you saying that a higher i-rate by itself is expansionary?

    I think I need to get a textbook. Is this covered by Mishkin’s?

  27. Gravatar of ChargerCarl ChargerCarl
    16. January 2013 at 13:07

    I think James Oswald may have answered my question.

  28. Gravatar of Ron Ronson Ron Ronson
    16. January 2013 at 13:10

    OK.

    I suppose that if the fed announced that it was going to target 100% inflation by buying bonds we would quickly get to high interest rates and high inflation without interest rates falling first.

    But is that what happens in reality ?

  29. Gravatar of Geoff Geoff
    16. January 2013 at 13:17

    Dr. Sumner:

    “Geoff, Sorry, I can’t follow your argument.”

    My apologies.

    Which part(s)?

  30. Gravatar of Tyler Joyner Tyler Joyner
    16. January 2013 at 13:42

    Bretton: One intuitive mechanism would be a decrease in the desire to hoard, to borrow Keynes’ language from the very interesting link Suvy shared.

    Higher interest rates may persuade marginal hoarders to take their money out of the mattress and buy bonds with it, which is effectively an increase in the money supply and can cause inflation.

    That was my reading of Scott’s point, anyway. Someone can correct me if I’m wrong.

  31. Gravatar of James Oswald James Oswald
    16. January 2013 at 13:47

    Charger Carl: “Let me repeat, higher interest rates are inflationary. They increase velocity.”
    To me, that sounds like Scott is saying higher interest rates cause more inflation. That’s not very Sumnerian, IMO. Scott historically has deemphasized inflation and instead focuses on NGDP. Scott, you are disappointed in you! I think a better way to put this when the central bank raises it’s NGDP target, both interest rates and measured inflation will increase together. My point was that higher interest rates will reduce people’s desired cash holdings as a microeconomic effect. Textbooks likely won’t help you in this case. A lot of them view interest rates as causal.

    Ron: In my view, the evidence is that when the Fed signals they want more inflation, interest rates react pretty darn quickly:
    http://www.theatlantic.com/business/archive/2013/01/the-1-thing-the-worlds-smartest-people-dont-get-about-the-fed/266812/
    In reality, the Fed doesn’t have to do OMOs very often to set the Fed funds target. They just say what they want it to be and it goes there. It’s hard to disentangle this stuff. The little changes are ambiguous, but the big changes are not – inflation and interest rates move together.

  32. Gravatar of Ron Ronson Ron Ronson
    16. January 2013 at 15:16

    Thanks James

    So the fed signals higher growth targets and that leads to higher interest rates and these higher interest rates cause people to reduce cash balances (increase velocity) and lend to bank (who in turn lend to businesses) instead.

    Is that it ?

  33. Gravatar of Jon Jon
    16. January 2013 at 15:17

    Velocity is also unstable because of financial product innovation. Thus why the Germans were able to use an m2 target for years longer than everyone else. They had enough rules governing fp innovation to enable this.

    Trouble is these rules appear to hurt long term growth…

  34. Gravatar of Bill Woolsey Bill Woolsey
    16. January 2013 at 15:58

    Sumner’s argument, in IS-LM terms is that shifts consumption, investment, or government spending shift the IS curve to the right. This results in higher interest rates and higher real income. The higher real income is a rightward shift in the AD curve. Given an upward sloping AS curve, this results in a higher price level–inflation. The higher price level shifts the LM curve to the left, resulting in even higher interest rates.

    My prefered version is that a shift in the IS curve to the right, due, for example, to reduced saving or more investment, results in a higher natural interest rate. The IS cruve crosses potential output at a higher real interest rate.

    If there is no monetary disquilibrium, asset prices fall and market yields rise.

    If the interest rate on money is sticky (or fixed at zero,) then higher market interest rates results in lower money demand. If the quantity of money is fixed, monetary disequilibrium results.

    In the very short run, this might interfere with the increase market interest rates. That is, market rates will not rise to the new natural interest rate.

    In the short run, it might result in a boom–real output rising above potential. And this might also be associated with a higher price level too. Note that either or both of these effects are higher nominal income.

    Since the quantity of money is fixed by assumption, and nominal income increased, there is higher velocity.

    In the long run, the only effect is a higher price level, real output is at potential, and the interest rate is at the higher natural interest rate.

    Still, with real output at potential and the price level higher, nominal income is higher. Since the quantity of money is unchanged, velocity is higher.

    In the long run, there is higher interest rate, lower real demand for money, higher velocity, and a higher price level.

    Just think of “IS” and potential real output determining the natural interest rate, and it all becomes clear.

    Higher interest rates are inflationary.

  35. Gravatar of Bill Woolsey Bill Woolsey
    16. January 2013 at 15:58

    Sumner’s argument, in IS-LM terms is that shifts consumption, investment, or government spending shift the IS curve to the right. This results in higher interest rates and higher real income. The higher real income is a rightward shift in the AD curve. Given an upward sloping AS curve, this results in a higher price level–inflation. The higher price level shifts the LM curve to the left, resulting in even higher interest rates.

    My prefered version is that a shift in the IS curve to the right, due, for example, to reduced saving or more investment, results in a higher natural interest rate. The IS cruve crosses potential output at a higher real interest rate.

    If there is no monetary disquilibrium, asset prices fall and market yields rise.

    If the interest rate on money is sticky (or fixed at zero,) then higher market interest rates results in lower money demand. If the quantity of money is fixed, monetary disequilibrium results.

    In the very short run, this might interfere with the increase market interest rates. That is, market rates will not rise to the new natural interest rate.

    In the short run, it might result in a boom–real output rising above potential. And this might also be associated with a higher price level too. Note that either or both of these effects are higher nominal income.

    Since the quantity of money is fixed by assumption, and nominal income increased, there is higher velocity.

    In the long run, the only effect is a higher price level, real output is at potential, and the interest rate is at the higher natural interest rate.

    Still, with real output at potential and the price level higher, nominal income is higher. Since the quantity of money is unchanged, velocity is higher.

    In the long run, there is higher interest rate, lower real demand for money, higher velocity, and a higher price level.

    Just think of “IS” and potential real output determining the natural interest rate, and it all becomes clear.

    Higher interest rates are inflationary.

  36. Gravatar of flow5 flow5
    16. January 2013 at 16:07

    “The central bank doesn’t know how much money is required to generate 2% inflation”

    The Central bankers don’t but I do. Thornton’s close:

    See: http://bit.ly/yUdRIZ

    Quantitative Easing and Money Growth:
    Potential for Higher Inflation?
    Daniel L. Thornton

    His numbers prove the existence of a multiplier.

    —————

    “higher interest rates are inflationary”

    High rates are both a cause & an effect. They are of a re-inforcing nature (not self-regulatory).

    Income velocity is a statistical “stepchild”. If economists studied the transactions velocity of money (Vt) they would learn how to forecast. They would learn how money velocity actually works. Vt, at times, moves in the opposite direction of Vi. And there are surrogates for Vt.

  37. Gravatar of Petar Petar
    16. January 2013 at 16:09

    wouldn’t some of this imply that FED could influence not just supply, but demand too: by raising rates now causing a rise of the velocity, thereby solving the “problem” of too much money demand without even needing to accommodate the money supply fully?

    my understanding of the whole mechanism is not solid yet, so, maybe I wrote something stupid, then I apologize

  38. Gravatar of flow5 flow5
    16. January 2013 at 16:25

    The Fed can control both the money stock & money velocity (provided they have the committment). Volcker’s tightening during early 1980 caused both M1 & Vt to fall (the fall in Vt was not soley due to the Emergency Credit Controls program of March 14, 1980).

  39. Gravatar of ssumner ssumner
    16. January 2013 at 18:00

    Ron, If interest rates rise due to some factor other than easy money (say animal spirits among investors, or fiscal stimulus) then velocity rises. This raises AD and inflation.

    Suvy, You don’t think liquidity preference is in the IS-LM model? Then what is LM?

    Doug, You said;

    “An increase in the demand for money (V) drives up the price of money — higher rates.”

    An increased demand for money lowers V.

    Kailer, No, V should go up either way.

    ChargerCarl, Higher rates are expansionary all by themselves–as they raise V.

    Geoff, I’d suggest shorter comments that focus on one specific point. One can get lost reading your very long comments.

    James, OK, higher interest rates raise NGDP. And I’m not reasoning from a price change, because I’m holding M constant. Obviously if rates rise because M falls, you might get lower inflation.

  40. Gravatar of ssumner ssumner
    16. January 2013 at 18:03

    Bill, Good comment.

    Petar, Thay can’t raise rates without affecting money supply (or demand via IOR.)

  41. Gravatar of Ron Ronson Ron Ronson
    16. January 2013 at 18:33

    “Ron, If interest rates rise due to some factor other than easy money (say animal spirits among investors, or fiscal stimulus) then velocity rises. This raises AD and inflation.”

    I suppose so, but wouldn’t it be those exogenous factors causing high interest rates and inflation, not “Higher interest rates are inflationary” as stated in the post ?

  42. Gravatar of Suvy Suvy
    16. January 2013 at 19:35

    Prof. Sumner,

    As pointed to in the paper I posted, Keynes talks about how the views of the future impact what people do today. Where are the people’s views of the future in the IS/LM model? Where are their changes in expectations that come about as a result of the changes in the rate of interest?

    For example, decreasing the rate of interest has a present value effect in raising the price of capital assets. How does this effect change the behavior of the market participants? In the paper I posted, Keynes spends much time talking about all of the feedbacks involved in the economy and about how we simply do not know the way output will change when we change various variables. Not only that, but IS/LM is an equilibrium model while Keynes is talking about the various feedback affects that depend on the initial conditions. He spends an entire page talking about this(page 118 in the original work, the end of page 4 in the paper).

    It seems clear to me that Keynes is thinking in a dynamic manner where there are plenty of feedbacks and there is great sensitivity to the initial conditions. He specifically talks about how in certain situations with slightly different initial conditions could lead to two very different results and spends much of the paper talking about it. Keynes also talks about how the shifts in people’s expectations matter as well and how all of those factors put together means that we do not know how output and all of those various factors will change. Here’s a quote to prove my point:
    “It is not surprising that the volume of investment, thus determined, should fluctuate widely from time to time. For it depends on two sets of judgments about the future, neither of which rests on an adequate or secure foundation—on the propensity to hoard and on the opinions of the future yield of capital assets. Nor is there any reason to suppose that the fluctuations in one of these factors will tend to offset the fluctuations in the other. When a more pessimistic view is taken about future yields, that is no reason why there should be a diminished propensity to hoard. Indeed, the conditions which aggravate the one factor tend, as a rule, to
    aggravate the other. For the same circumstances which lead to pessimistic views about future yields are apt to increase the propensity to hoard. The only element of self-righting in the system arises at a much later stage and in an uncertain degree. If a decline in investment leads to a decline in output as a whole, this may result (for more reasons than one) in a reduction of the amount of money required for the active circulation, which will release a larger quantity of money for the inactive circulation, which will satisfy the propensity to hoard at a lower level of the rate of interest, which will raise the prices of capital assets, which will increase the scale of investment, which will restore in some measure the level of output as a whole.”

    None of those feedbacks exist in IS/LM. There is nothing about people’s expectations and the shifts in expectations in IS/LM. IS/LM says nothing about prospective future yields which is very different from the impact of interest rates on current yields. In other words, IS/LM misses Keynes’s central and most important points.

    In The General Theory of Employment, Keynes talks about how none of these things are calculable and all of them interact in very different and unknowable ways. This is the central idea to Keynes’ work and thinking. None of these things exist in IS/LM.

    Again, IS/LM misses Keynes’ essential work on uncertainty. It doesn’t account for the fact there is very little we can know about the future, that the future cannot be calculated in any reasonable fashion. Keynes’ idea about liquidity preference comes from the idea that we know very little about the future and that our perceptions of the future are very volatile.

  43. Gravatar of Suvy Suvy
    16. January 2013 at 19:55

    I’d also like to note that Keynes basically trashes much of what is taught in economics in this paper. For example, he completely destroys the idea of rational expectations. It is a terrible model for the future because the future is something inherently unpredictable. He single-handedly dissects almost all equilibrium models used in economics in the paper. Keynes makes the essential point about how our emotions play a huge role in the market place and that these are reflected in the price. Not only that, but there are feedbacks between the behaviors of the market participants and all of these things are factored in the market. Here’s another quote:
    “The orthodox theory assumes that we have a knowledge of the future of a kind quite different from that which we actually possess. This false rationalisation follows the lines of the Benthamite calculus. The hypothesis of a calculable future leads to a wrong interpretation of the principles of behaviour which the need for action compels us to adopt, and to an underestimation of the concealed factors of utter doubt, precariousness, hope and fear.”

    The neoclassical theory could be substituted for orthodox and it really wouldn’t make much of a difference. He basically says that the use of the “orthodox” theory would lead to a massive underestimation of the tails. That’s exactly what neoclassical theory has done over the past 30-40 years.

  44. Gravatar of Suvy Suvy
    16. January 2013 at 20:05

    I didn’t realize this until now, but Keynes was far ahead of his time. The way he thought about these things was in a very mathematical way. It seems to me like much of his work was based on his training in probability theory. I think his entire work on economics was centered around the fact that he did so much work on probability theory. He talks about things like “fat tails”, nonlinear behavior, complexity, feedbacks, etc when these things have not been well understood until very recently. This is, in my view, why most of the modern day “Keynesians” aren’t really Keynesians.

    The essence of Keynes’ work was on uncertainty and unpredictability. It was on the fact that we live in a world that we don’t understand, that our expectations of the world changes the world around us which changes our expectations, and the central idea that the future cannot be calculated to any real degree of accuracy. If we try to do so, we will fail massively in the tails. These items are the essence of Keynesianism.

  45. Gravatar of John Papola John Papola
    16. January 2013 at 20:16

    Why teach Keynesianism at all? They’ll just end up confused into thinking that consumption grows the economy, like most of the misinformed financial press.

  46. Gravatar of flow5 flow5
    16. January 2013 at 20:24

    Vi moving in the opposite direction of Vt (for an entire year):

    Transactions Velocity of money (money actually exchanging hands)

    The Fed calculates these velocity figures by dividing the aggregate volume of debits of these banks against their demand deposits:

    1974-Oct. ,,,,,,, 77
    1974-Nov. ,,,,,,, 70
    1974-Dec. ,,,,,,, 75
    1975-Jan. ,,,,,,, 75
    1975-Feb. ,,,,,,, 67
    1975-Mar. ,,,,,,, 72
    1975-Apr. ,,,,,,, 75
    1975-May ,,,,,,, 73
    1975-June ,,,,,,, 73
    1975-July ,,,,,,, 75
    1975-Aug. ,,,,,,, 72
    1975-Sep. ,,,,,,, 73

    Income Velocity (a contrived figure)

    1974-07-01 5.604
    1974-10-01 5.680
    1975-01-01 5.705
    1975-04-01 5.747
    1975-07-01 5.843
    1975-10-01 5.984

    FRBSTL: “Velocity is a ratio of nominal GDP to a measure of the money supply. It can be thought of as the rate of turnover in the money supply–that is, the number of times one dollar is used to purchase final goods and services included in GDP.”
    ————-

    “Keynes was far ahead of his time”

    “Keynes the stock market speculator, the insurance executive, the polemic journalist, the social reformer, the avid book collector, and, it must be reckoned,the devotee of Etonian Culture (as it might be called in a sex advertisement; Professor Harry G. Johnson, once remarking on the homosexuality of King’s College, recalled the professor who referred to the chapel there as First Church of Christ, Sodomite)”

    Right Keynes was a tailblazer.

  47. Gravatar of No school of thought to belong to? | Catalyst of Growth No school of thought to belong to? | Catalyst of Growth
    17. January 2013 at 02:30

    [...] in the past, I thought it was as a secondary issue, trumped by the large overlap of ideas. Scott Sumner might have just changed that with is attachment to quantity of money: Suppose a central bank sees inflation rising too fast.  They might decide to raise interest [...]

  48. Gravatar of DOB DOB
    17. January 2013 at 02:41

    Scott,

    I’ve got a response post here. Curious to hear your thoughts. Specifically, I’m curious if you agree with these two statements:

    The CB can always achieve any price-level target while keeping the money supply fixed (using the target rate and the IOR/target spread jointly)

    and

    Consider the following extreme example: assume the Fed announces tomorrow that IOR is -20% and Fed Funds target is -5%. The result will be: (a) a pickup in NGDP growth AND (b) a contraction of the monetary base.

  49. Gravatar of Suvy Suvy
    17. January 2013 at 07:08

    Prof. Sumner,

    This is a quote by Keynes about IS/LM by looking at some of his papers. Like The General Theory of Employment, this was also a paper written after The General Theory.

    “The alternative theory held, I gather, by Prof. Ohlin and his group of Swedish economists, by Mr. Robertson and Mr. Hicks, and probably by many others, makes it to depend, put briefly, on the demand and supply of credit or, alternatively (meaning the same thing), of loans, at different rates of interest. Some of the writers (as will be seen from the quotations given below) believe that my theory is on the whole the same as theirs and mainly amounts to expressing it in a somewhat different way.’ Nevertheless the theories are, I believe, radically opposed to one another”

  50. Gravatar of ssumner ssumner
    17. January 2013 at 07:16

    Ron, Nope, the higher interest rate raises V, which raises NGDP.

    DOB, Not any price level target, because cash earns no interest. But given the bloated curent level of ERs, they could hit almost any reasonable target in the near term, with IOR alone.

    Suvy: You said:

    This is a quote by Keynes about IS/LM by looking at some of his papers. Like The General Theory of Employment, this was also a paper written after The General Theory.

    “The alternative theory held, I gather, by Prof. Ohlin and his group of Swedish economists, by Mr. Robertson and Mr. Hicks, and probably by many others, makes it to depend, put briefly, on the demand and supply of credit or, alternatively (meaning the same thing), of loans, at different rates of interest. Some of the writers (as will be seen from the quotations given below) believe that my theory is on the whole the same as theirs and mainly amounts to expressing it in a somewhat different way.’ Nevertheless the theories are, I believe, radically opposed to one another”

    Yes, we all know he preferred the liquidity preference theory to the standard classical model of interest rates. So what’s your point? IS-LM has liquidity preference.

  51. Gravatar of Suvy Suvy
    17. January 2013 at 07:21

    The only correct version of Keynes that I have ever seen is the one proposed by Hyman Minsky. He puts forth a radically different proposal than any I have ever seen taught in any economics class. I have never been taught anything about Hyman Minsky from Keynes in any economics class. I think that anything taught about Keynes should be based on the principles Keynes actually put forward.

    The paper from which the quote was from is a paper called Alternative Theories of the Rate of Interest. Here is a link. Keynes even mentions some ideas about endogenous money here.
    http://www.scribd.com/doc/11399026/Keynes-1937-Alternatives-Theories-of-Int

    Every single instance of Keynesianism that is taught in school must actually be something Keynes wrote at discussed, not some bullshit model that Keynes never supported by some classical economist.

    Here’s a radical idea, when teaching Keynesianism, make the students actually read these kinds of papers that were written by Keynes.

  52. Gravatar of Suvy Suvy
    17. January 2013 at 07:31

    “Now,a pressure to secure more finance than usual may easily affect the rate of interest through its influence on the demand for money; and unless the banking system is prepared to augment the supply of money, lack of finance may prove an important obstacle to more than a certain amount of investment decisions being on the tapis at the same time. But ‘finance’ has nothing to do with saving. At the ‘financial’ stage of the proceedings no net saving has taken place on anyone’s part, just as there has been no net investment. ‘Finance’and ‘commitments to finance’are mere credit and debit book entries, which allow entrepreneurs to go ahead with assurance.”

    Here, Keynes is talking about the role a financial sector plays in investment and about how credit issued has very little to do with savings. Keynes is talking about endogenous money.

  53. Gravatar of DOB DOB
    17. January 2013 at 07:34

    Scott,

    Yes, the original post includes an explicit disclaimer for cash:

    (It goes without saying physical currency would have to be exchanged against digital currency at an exchange rate that drops 20%/year as per IOR to prevent money-under-mattress)

    And given the relatively extreme rates I quoted, I expect it wouldn’t take more than a few days for the $2tn of excess reserves to get shipped back to the CB.

    In any case, it sounded like you were in general agreement with my statement. How do you reconcile agreeing that “lower rates + lower base can lead to inflation” with your statement in this post which is roughly “higher rates = inflation and base is really what matter” ? I’m afraid I don’t get it..

  54. Gravatar of Suvy Suvy
    17. January 2013 at 07:34

    Prof. Sumner,

    The model by Hicks that Keynes was referring to was the IS/LM model. He basically says in that quote that Hicks’ model was not his model in his exact words. By the way, the entire paper is definitely worth reading.

    A bit of history may be important. IS/LM was not developed by Keynes, it was developed by Hicks. Keynes refers to Hicks in that quote when he says “The alternative theory held by Mr. Robertson and Mr. Hicks”, he refers to IS/LM.

  55. Gravatar of flow5 flow5
    17. January 2013 at 07:58

    Financial transactions as a percentage of total transactions vary & have noise. Obviously you don’t skew the call report by including all money center banks (the epicenter of financial & speculative transactions) & not any community banks.

    But cycle swings are easier to spot & are confirmed quicker because the percentage of financial transactions increases on the upside & decreases on the downside exacerbating an upcoming change.

    The G.6 releases’ obituary in the Federal Registered was a lie. “The usefulness of the FR 2573 data in understanding the behavior of the monetary aggregates has diminished in recent years as the distinction between transaction accounts and savings accounts has become increasingly blurred”

    Unless some data was hid from the public not much had changed in the data for 15 years. Its author didn’t understand what he wrote. With help from Barron’s “capital markets editor” I did the only subscriber survey asking how the G.6 debit & deposit tuurnover release was used. I forwarded some examples to its manager for one of the 4 year reviews (justification of publication).

    And the data was always published with classification errors. Since Mutual Savings Bank’s (MSB) inception, their account balances in the Member Commercial Banks (MCB)were designated as inter-bank demand deposits (IBDD’s –balances maintained by customer banks in correspondent banks), presumably because MSBs were called banks (with the exception of 6 MSB banks that had MCB regulations) & were insured by the Federal Deposit Insurance Corporation (FDIC) & not the Federal Savings & Loan Insurance Corporation (FSLIC), & not counted in M1.

    At the same time S&L’s deposits were insured by the FSLIC & their balances in the MCBs were not designated as IBDDs (were counted in M1); neither institution had the right to hold deposits transferable on demand, without notice, & without income penalty (the legal basis for becoming a MCB), prior to the Depository Institutions Deregulation & Monetary Control Act (DIDMCA); both were the customers of the MCBs; & neither had Regulation Q restrictions prior to 1965.

  56. Gravatar of Geoff Geoff
    17. January 2013 at 18:35

    Dr. Sumner:

    “Geoff, I’d suggest shorter comments that focus on one specific point. One can get lost reading your very long comments.”

    I’m sorry for that. Here’s the short version:

    I don’t think there is any right or wrong answer for which statistic shows the “stance” of monetary policy. One person can argue that NGDP shows the correct stance, while another can argue that wages/GDP shows the correct stance. There is no way for these two people to settle their disputes intellectually, since the requisite information is absent.

    My position, borrowed from Hayek, is that the only source of information that “right” and “wrong” judgments can be made on these issues, is from competitive buying and selling of private property titles. Only in this context can we make judgments of over or under-production of certain property titles. Those titles that are overproduced will incur losses, and those that are underproduced will incur profits. But since the Fed is not a competitive institution (it has a monopoly), the required competition-based information is not revealed, and so there is no grounding from which to rationally judge the stance of monetary policy. There are no profit or loss signals revealed by any statistic, because the only statistics available are monopoly stats.

    As such, there can only be a grounding for settling disputes in law enforcement, i.e. force of government.

  57. Gravatar of ssumner ssumner
    18. January 2013 at 15:14

    Suvy, Every version of Keynes is correct. Anyone who doesn’t know that Keynes took every side of almost every macro issue doesn’t understand Keynes. The only thing consistent about Keynes was his incosnsistency. And yes, I obviously know the 1937 paper by Hicks was the first IS-LM model. Keynes never rejected that model, he claimed that there was more to the GT than IS-LM, which is obviously true. But IS-LM gets at the point that made Keynes famous. Few people pay attention to the rest of the GT, which is a poorly written book (the Tract and Treatise are far better.)

    DOB, Lower IOR is inflationary, lower market interest rates are deflationary.

    Geoff, I don’t agree–I hope to convince others that NGDP is the right way to think about monetary policy.

  58. Gravatar of Geoff Geoff
    18. January 2013 at 15:57

    Dr. Sumner:

    “Geoff, I don’t agree–I hope to convince others that NGDP is the right way to think about monetary policy.”

    Thanks, but I am slightly confused by your response. I included NGDP in my post, and it shows the Fed is succeeding in raising NGDP by around 4 to 4.5% per year.

    If that’s not inflation, what is?

  59. Gravatar of Suvy Suvy
    22. January 2013 at 20:28

    ssumner,

    In the paper I posted, the first thing Keynes says is that IS/LM, the model and view developed by Hicks, was not his model. Even his biographer, Robert Skidelsky, talks about how IS/LM wasn’t Keynes’ model and that the correct interpretation of Keynes lies with Minsky. I’ve read a lot of Keynes’ work, all the way from The Economic Consequences of Peace to A Treatise on Probability all the way through his papers written after The General Theory.

    In fact, in one of the papers that I posted on this blog; Keynes specifically points to how low interest rates could cause people to hoard more cash and actually decrease the amount of money in circulation. Keynes, in all of the papers, points to a financial sector that actually creates investment that does not come from savings. None of those things are in IS/LM. IS/LM is not Keynes’ model and both Keynes and Hicks say it was a poor interpretation of Keynes. Steve Keen actually goes into this extensively as does Hyman Minsky.

  60. Gravatar of Suvy Suvy
    22. January 2013 at 20:32

    How can you read those papers I posted and say IS/LM was a good interpretation of Keynes? Especially when he says that IS/LM was not his model. It just doesn’t make sense.

  61. Gravatar of Suvy Suvy
    22. January 2013 at 20:33

    ssumner,

    Keynes is “diametrically opposed” to the IS/LM model of Hicks according to one of the papers that I posted.

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