Here’s Paul Krugman:
But in this more complex world, where even the definition of the money supply becomes highly dubious, why even talk about an LM curve? Well, before 2008 most macroeconomists didn’t! They talked instead about interest rate targets, Taylor rules, and all that. Mike Woodford, who is probably our leading macroeconomist’s macroeconomist, has even made one of his signature modeling tricks the building of models in which there is (almost) no outside money. Sensible macroeconomists have known for a long time that quantity-theory type models, if they were ever useful, aren’t much use in the modern economy.
In normal times central bank monetary policy is conducted in terms of, and best thought of in terms of, the target interest rate
This is certainly the conventional view, but I think it’s wrong. Let’s start with the fact that just as there are no atheists in a foxhole there are no non-monetarists during a hyperinflation. When prices rise 8700% (almost) no one tries to explain the path of prices by referring to the path of interest rates. Even Wicksell and Keynes became quasi-monetarists during the early 1920s hyperinflations. The reason is simple. Interest rates tell us nothing about the level of prices and NGDP, whereas the base does. Thus huge changes in the price level and NGDP can only be explained by looking at changes in the base.
[Matt Yglesias denies that money causes hyperinflation. But all he’s really saying is that the monetary deluge that causes hyperinflation has a REASON. I.e. Latin American countries would choose to spend more than they received in taxes, and printed money to cover the deficit. Countries with identical deficits, but good access to credit markets, would not print money and would not have hyperinflation. It’s not the deficit, it’s the money printing. As an analogy, Matt’s claim would be like asserting that fiscal stimulus did not boost employment in 1942, WWII did.]
And if money explains hyperinflation, it also determines the path of prices and NGDP at lower growth rates, it’s just that the effect is disguised by the relatively greater importance of money demand (or velocity) fluctuations. Conventional economists would claim that because velocity is volatile, interest rates are “more useful” way to think about monetary policy. But they are not.
In the standard model, fluctuations in NGDP are caused by movements in interest rates. And yet rates tend to be high during booms and low during recessions. So how is the interest rate approach “more useful?” Here’s where the NKs get clever; it’s not the interest rate that matters, it’s the market rate relative to the Wicksellian equilibrium rate. Does this sound familiar? Sort of like the monetary base relative to velocity. Except that MV = PY is a tautology, whereas they merely have a theory. At least unless you define the unobserved equilibrium rate as the one that produces steady growth in aggregate demand (PY). In that case it’s also a tautology. But how is it “more useful?”
Another problem with the nominal interest rate is that the policy lever locks up at zero rates, and hence central banks have trouble communicating at the zero bound. In contrast, the base has no zero bound, and hence there is no point at which central banks are unable to communicate by adjusting a policy instrument. For example, suppose the Fed indicated that they would keep increasing the size of their monthly QE purchases by 20% each month until expected NGDP growth got back on target. That’s a clear strategy. It would work very quickly (or else they’d own the entire universe quite quickly). But a promise of low interest rates until some objective is met is basically consistent with Japan’s performance over the past 15 years. You might do better, but you might not.
Another argument used in favor of the interest rate approach is that, out in the real world, people and policymakers think in terms of interest rates, not the base. But that’s exactly the problem. People think money has been easy since 2008 (even though according to Ben Bernanke’s criterion it’s been the tightest since Herbert Hoover was President), precisely because they’ve been taught that monetary policy is “best thought of” in terms of interest rates. They’ve been taught to look at not just a poor indicator, but one that is actually negatively correlated with the actual stance of monetary policy. A poorly informed public will make bad public policy decisions. And not just the public, even economists are confused.
At the same time the supply of base money is also an unreliable indicator (although less so than interest rates.) Thus we should also not view changes in base money as a good indicator of the stance of monetary policy. Rather changes in the base supply relative to base demand are what is important. As Ben Bernanke said, NGDP growth is the best indicator of whether money is easy or tight.
PS. OK, Bernanke said NGDP growth and inflation. But he had to say inflation, NGDP was his choice.