Lower interest rates are contractionary

No, this is not a NeoFisherian post.  I’m not claiming that a Fed policy that depresses interest rates is contractionary, I’m claiming lower interest rates are contractionary, ceteris paribus.  And ceteris paribus in this case means for any given money stock.  For simplicity, we’ll start with a simple model–no IOR— and then bring in IOR later.  And in doing so I’ll answer a question a commenter asked me: Is talking about the effect of IOR an example of reasoning from a price change?

Let’s start with this identity:

M*V = P*Y

Where M is the base and V is base velocity.  Now let’s build a model:

M*V(i) = P*Y

Since V is positively related to i, lower interest rates are contractionary, they reduce V and hence NGDP, AKA aggregate demand.  Larry Summers once wrote an article (with Robert Barsky) pointing this out, but only for the gold standard period.

So why do people not named Summers and Sumner not know this?  There are several reasons:

Sometimes, not always, reductions in interest rates are caused by an increase in the monetary base.  (This was not the case in late 2007 and early 2008, but it is the case on some occasions.)  When there is an expansionary monetary policy, specifically an exogenous increase in M, then when interest rates fall, V tends to fall by less than M rises.  So the policy as a whole causes NGDP to rise, even as the specific impact of lower interest rates is to cause NGDP to fall.

2.  Another problem is the Keynesian model, which hopelessly confuses the transmission mechanism.  Any Keynesian model with currency that says low interest rates are expansionary is flat out wrong.  That’s probably why economists were so confused by 2008.  Many people confuse aggregate demand with consumption.  Thus they think low rates encourage people to “spend” and that this somehow boosts AD and NGDP.  But it doesn’t, at least not in the way they assume.  If by “spend” you mean higher velocity, then yes, spending more boosts NGDP.  But we’ve already seen that lower interest rates don’t boost velocity, rather they lower velocity.

Even worse, some assume that “spending” is the same as consumption, hence if low rates encourage people to save less and consume more, then AD will rise.  This is reasoning from a price change on steroids!  When you don’t spend you save, and saving goes into investment, which is also part of GDP.  Now here’s were amateur Keynesians get hopelessly confused.  They recall reading something about the paradox of thrift, about planned vs. actual saving, about the fact that an attempt to save more might depress NGDP, and that in the end people may fail to save more, and instead NGDP will fall.  This is possible, but even if true it has no bearing on my claim that low rates are contractionary.

To see the problem with this analysis, consider the Keynesian explanations for increases in AD.  One theory is that animal spirits propel businesses to invest more.  Another is that consumer optimism propels consumers to spend more.  Another is that fiscal policy becomes more expansionary, boosting the budget deficit.  What do all three of these shocks have in common?  In all three cases the shock leads to higher interest rates.  (Use the S&I diagram to show this.)  Yes, in all three cases the higher interest rates boost velocity, and hence ceteris paribus (i.e. fixed monetary base) the higher V leads to more NGDP.  But that’s not an example of low rates boosting AD, it’s an example of some factor boosting AD, and also raising interest rates.

Again, I defy you to explain how low rates can boost NGDP, ceteris paribus.  If you think you have an explanation, it’s probably something that confuses consumption with total spending on NGDP.  An explanation that wrongly assumes the public’s desire to spend more on consumption, as a result of lower interest rates, is expansionary for NGDP.  Yes, an exogenous change in M will often cause short term rates to move in the opposite direction, but how often do you see exogenous changes in M?  If we were operating in a normal economy, with say 3% or 4% interest rates, and I told you rates would fall to zero in the next 12 months, would you predict a recession or boom?  Obviously a recession.  Yes, if the Fed perversely cut rates to zero in an otherwise stable economy, via fast growth in the base, that would be expansionary.  But more than 100% of the expansionary impact would come from the rise in the base (hot potato effect), and less than zero from the lower rates.

There is simply no mechanism in macroeconomics where low rates actually CAUSE more NGDP.  None.  Nada.  Lower rates reduce velocity, and that’s contractionary.  It’s not about “spending”, unless by “spending” you mean velocity.  If you mean “spending” vs. saving then you are hopelessly off track.  You aren’t even in the right train station.

Now for the hard part.  The Fed recently raised the fed funds rate, and did so without lowering the base.  So am I claiming that the Fed’s decision was expansionary?  No, but I wouldn’t blame you for seeing a contradiction here, especially if your last name is “Murphy.”

Suppose the Fed had raised the fed funds target, without raising IOR.  What then?  Then they would have had to reduce the monetary base enough to make the rate increase stick.  How much?  Fasten your seatbelts—by almost $3 trillion.  That’s right, without IOR, to even get a measly quarter point increase, they would have had to withdraw almost the entire previous QE (except the part that went into currency held by the public.)

Instead the Fed did something else, they raised IOR.  Even though IOR includes the term ‘interest,’ as part of its acronym, it actually has absolutely nothing to do with market interest rates as I’ve been discussing them so far.  It’s better to think of IOR as a tax/subsidy scheme.

Previously I claimed that higher interest rates are expansionary.  They are.  But higher IOR really is contractionary.  That’s why the New Keynesians love IOR so much.  It helps make their false “non-monetary” models of the economy less false, indeed sort of truish.  It really is true that higher IOR is contractionary.  So why the difference?  Let’s return to the simple model above.  I said that model applied to a world of no IOR.  If IOR exists, then the more general model is:

M*V(i – IOR) = P*Y

That is, velocity is positively related to the difference between the market interest rate and the interest rate on money.  This gap is the opportunity cost of holding reserves.  I wish there were no IOR, if only because it would make monetary analysis so much simpler.

In order to make monetary policy more contractionary, the Fed merely needs to shrink the gap between i and IOR.  That reduces the opportunity cost of holding base money, which causes more demand for base money (as a share of NGDP), which is contractionary.  Consider the weird situation we are in:

1.  Almost everyone assumed higher rates were contractionary, but almost everyone was wrong.

2.  Now IOR comes along, and higher IOR really is contractionary.

Now I fear that it will be even harder to slay the Keynesian dragon; the model now seems superficially even more plausible. If I was a conspiracy nut I’d think it was all a plot to make Woodford’s moneyless models appear more accurate.

To summarize, IOR is not really a market price, it’s a subsidy on base money, and negative IOR is a tax on base money. Just as it’s OK to reason from an increase in excise taxes on gasoline, it’s OK to reason from a change in IOR.  (Of course you also need to consider other changes that are occurring in monetary policy, as is always the case.)

So if lower interest rates are not the reason that monetary stimulus is expansionary, then what is the reason?  Why do more people want to go out and assume car loans when the Fed cuts interest rates via an easy money policy?  Here’s why:

1.  If the Fed lowers rates via an increase in the base, then more base money raises NGDP via the hot potato effect (AKA, laws of supply and demand).  Interest rates play no role, indeed NGDP would rise by even more if rates (and velocity) didn’t fall.

2.  The higher NGDP causes more hours to be worked, due to sticky nominal hourly wages.

3.  More hours worked means more output and more real income.

4.  Say’s Law says supply creates its own demand.  So as workers and capitalists produce more output and earn more income, they go to car dealers to splurge with their sudden newfound wealth.  Interest rates got nuthin to do with it.  Saving (and investment) as a share of GDP actually rises during booms created by monetary stimulus.  It’s not about “spending” (as in consumption), it’s about actual spending on C+I+G+NX, i.e. NGDP.

5.  Of course all this happens simultaneously, as we live in a Ratex world.

PS.  I’m begging you, don’t try to explain what you think is wrong with Say’s Law, unless you want me to be as insulting as possible in response.


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72 Responses to “Lower interest rates are contractionary”

  1. Gravatar of Benoit Essiambre Benoit Essiambre
    21. December 2015 at 07:20

    > Again, I defy you to explain how low rates can boost NGDP, ceteris paribus

    How about lower central bank rates “with the equilibrium rate being equal”.

    I think viewing rates as relative to the immediate equilibrium is a reasonable way to see it from a central bank perspective.

    Its an inverse pendulum type of problem. You can’t look at the position of the bottom to infer where the pendulum is going but you can look at different positions of the bottom compared to a counterfactual where the top position would remain equal. For comparing point in time counterfactual hypothetical scenarios, it is straightforwards (and I would say that’s the kind of comparison the words “ceteris paribus” sorta imply). For historical rates, there’s birds hitting the top of your pendulum and feedback loops from past maneuvers so it’s much more difficult but it still might be approximately possible if you try to take into account these impacts. Although like you say, its probably much easier to just look at NGDP, or at least using it as your main clue.

    But even if it’s difficult to get a good estimate of equilibrium, even if there are shocks and feedback loops muddling causality, the fact that people, businesses and banks make investment decisions based on interest rates makes it worth having a discussion using these terms.

  2. Gravatar of David R. Henderson David R. Henderson
    21. December 2015 at 07:23

    Never reason from a price change.

  3. Gravatar of John Hall John Hall
    21. December 2015 at 07:35

    Interesting post.

    I thought it was curious when the market rallied following the Fed rate hike. I wasn’t entirely convinced by Tyler Cowen’s risk-based explanation.

  4. Gravatar of Matt McOsker Matt McOsker
    21. December 2015 at 07:40

    I’d say it depends on other factors. Housing (large sector of the economy) is tied to interest rates, so low rates can be a boost there, where borrowing is driven by rates and rising equity values. Now if people are stretched with debt relative to income, and banks tighten lending standards, then the low rates may not propel that sector or the related lending. No HELOC to buy that car produced by Ford.

    Second is the interest income perspective, low rates mean less interest income paid into the economy.

    Low rates will cause low inflation using the forward pricing formula as the anchor. Then why does inflation run just under 2% with rates at 25-50 bps – Sticky wages. Wages are stable and workers manage to get meager raises of a couple of % because the labor market has tightened somewhat, and that is just how corporations work around compensation policies. Can I call it Sitcky Meager Raises?

    Cars are attractive to buy at low rates, and easy credit. Heck people are paying negative real interest on the car. So if a 2% wage hike makes me feel better, and I feel more secure in my job, and other job options are out there – then yeah I might trade in that old car. So rates do have some effect IMO – but not the only mechanism.

    Maybe the only thing I explained is why the Fed does not easily hit inflation targets. Just my quick thoughts.

  5. Gravatar of Ray Lopez Ray Lopez
    21. December 2015 at 07:50

    I largely agree with this Sumner post, except for the fact I would say lower rates *follow* a contraction, rather than being the “cause” of the contraction (money is neutral).

    Sumner’s model has a lot of moving parts, and any one of which breaking down would probably destroy his model (it’s rather like a chain, only as strong as the weakest link).

    And what to make of this? Sumner: “I’m begging you, don’t try to explain what you think is wrong with Say’s Law, unless you want me to be as insulting as possible in response.”

    Sumner believes in Say’s Law? Wikipedia: “Modern advocates of Say’s law see market forces as working quickly, via price adjustments, to abolish both gluts and shortages. The exception is when governments or other non-market forces prevent price adjustments.” -sounds reasonable to me.

  6. Gravatar of jonathan jonathan
    21. December 2015 at 08:29

    “I’m claiming lower interest rates are contractionary…for any given money stock.”

    How is this different than “The LM curve slopes up”?

  7. Gravatar of jonathan jonathan
    21. December 2015 at 08:41

    Also: I don’t understand the “hot potato” effect. How does a higher money supply boost NGDP if i doesn’t change?

  8. Gravatar of John Handley John Handley
    21. December 2015 at 08:41

    Scott,

    The problems with the post start when you write this: “And ceteris paribus in this case means for any given money stock.” You seem to have fallen into a bit of an Old Keynesian trap by assuming a one period model; a model in which an interest rate doesn’t even make sense. Per the Fisher equation, we know that the nominal interest rate is the sum of the real interest rate – determined by real factors such as the long run expected growth rate of the economy and the intertemporal elasticity of consumption as well as monetary factors in the short run because of e.g. sticky prices – and expected inflation – i.e. expectations about the growth of the money supply. By sticking to a ceterus paribus analysis, you are assuming that there is no change in expected monetary policy, so, by definition, the only thing that is changing in your analysis is the real interest rate. And, since you’re assuming that the money supply doesn’t change, you’re simply suggesting that a lower ‘natural’ real rate of interest is contractionary.

    I agree with you there, but the way you framed it is wrong for multiple reasons. For one thing, the monetary analysis is irrelevant for that conclusion; if the only thing that changes in your model is real, as you blatantly assumed in your first paragraph, then you should not be using a monetary model at all.

    Since nominal interest rates are intrinsically linked with expected money growth, perhaps a better analysis would be, assuming the current money supply doesn’t change, what happens if expectations of future money supply changes are reduced or increased. This would mean that a higher interest rate would be indicative of expectations of loose money in the future and, because of your assumptions about money demand, looser money in the present (prescribing to your definition of loose money, which I’m not sure I agree with, at least). Another way to look at it – the Keynesian way – is, given the expected path of the money supply, what happens when the current money supply is increased. In this case, lower interest rates are associated with more NGDP (assuming a calibration of the model in which the lower rates do not offset the increase in the money supply by correspondingly increasing money demand); they are expansionary according to your criterion. The third way to think about it is to assume there is a permanent increase in the money supply. In this case, (I’m pretty sure, interest elastic money demand functions complicate this a bit) the nominal interest rate would not change at all even though monetary policy became more expansionary.

  9. Gravatar of John Handley John Handley
    21. December 2015 at 08:51

    Ray,

    “I largely agree with this Sumner post, except for the fact I would say lower rates *follow* a contraction, rather than being the “cause” of the contraction (money is neutral).”

    I don’t see how the neutrality of money has anything to do with this at all. Sumner’s model isn’t even explicitly non-neutral because nominal rigidities don’t even show up in the model until the very end. He is restricting his analysis to nominal GDP, which is roughly in the central bank’s control unless the demand for real balances is indeterminate (which is impossible in the model he uses). Why would low interest rates follow a reduction in the money supply? Interest rates are a function of expected inflation – i.e. expected money growth – so past changes in the money supply should have nothing to do with the current interest rate. Unless money is non-neutral and caused the real interest rate to fall by reducing the money supply, that is.

  10. Gravatar of John Handley John Handley
    21. December 2015 at 08:56

    Scott,

    “confuses consumption with total spending on NGDP.”

    There are plenty of NK models with capital; interest rates still have the same effect. Not only is this criticism wrong, it is uncalled for. It’s just simpler to focus on consumption only because it makes the models a lot less complicated to work with. By ignoring the intertemporal effects of interest rates in your model above, you have missed the point. Low interest rates substitute future NGDP to the present. That is how they are expansionary in a New Keynesian analysis.

  11. Gravatar of Philip George Philip George
    21. December 2015 at 09:08

    You are right in saying that “V is positively related to i”. In fact changes in i can almost entirely explain changes in V for a period of more than half a century as the graph on http://www.philipji.com/item/2014-04-02/the-velocity-of-money-is-a-function-of-interest-rates shows.

    So why do people not named Summers or Sumner not understand that lower interest rates are contractionary? The answer is that your entire argument hinges on one error: a misunderstanding of what velocity is. Since this understanding is common to all macroeconomists I do not blame you.

    I know I am saying radical stuff so I need to explain at some length. A physicist would more easily understand what I am saying.

    The velocity of light is 300,000 km/sec. Now it does not matter whether this velocity is measured over a period of 1 hour or 1 second. The answer would still be the same.

    Now the velocity of money is commonly taken to be the ratio of GDP to money. Now assume an economy that is chugging along at an absolutely steady rate. The annual GDP is $12,000 and the quantity of money measured on the 1st of each month from January to December is $1000. So the velocity of money measured over a period of one year is 12. Now if we choose to measure instead the velocity during the month of January, we get a GDP of $1,000, giving us a velocity of 1.

    The only conclusion is that the common assumption that the velocity of money is the ratio of a flow to a stock is incorrect. The velocity of money has nothing to do with time. It is a pure number, the ratio of two stocks.

    An exhaustive argument may be seen in my Kindle ebook “Macroeconomics Redefined”.

    Theories must be judged by the accuracy of the predictions they make. NGDP targeting has supported a loose monetary policy for years, and my prediction is that the asset bubbles that have resulted will explode some time next year as a result of the (relative) monetary contraction that has been going on since January 2014.

  12. Gravatar of TravisV TravisV
    21. December 2015 at 09:40

    Roger Farmer: “Scott Sumner and Musical Chairs”

    http://rogerfarmerblog.blogspot.com/2015/12/scott-sumner-and-musical-chairs.html

  13. Gravatar of Gary Anderson Gary Anderson
    21. December 2015 at 10:16

    IOR is contractionary and yet higher interest rates as banks lend is expansionary. That makes perfect sense even to the non economist like me.

    It also makes sense that supply creates its own demand, but I don’t think that was the backbone of supply side economics. I think they were concerned with a supply of lending, not a supply of output. Sure seemed that way if you were in the housing bubble.

    Higher rates means banks make money on loans based on the long end, but now the long end will be forever low yield since bonds are in short supply. Supply and demand.

  14. Gravatar of o. nate o. nate
    21. December 2015 at 10:18

    I didn’t read the whole paper, but it looks like that Larry Summers paper never says that V is positively related to i, instead it’s saying that i is positively related to P (or was, during the gold-standard era).

  15. Gravatar of Kevin Erdmann Kevin Erdmann
    21. December 2015 at 10:36

    Great post.

  16. Gravatar of Scott Sumner Scott Sumner
    21. December 2015 at 10:41

    Benoit, The equilibrium rate is endogenous. If M is stable, and i falls, then the equilibrium rate falls even more.

    David. Yes.

    John, The market rallied on Yellen’s press conference, not the rate hike.

    Matt, You said:

    “I’d say it depends on other factors. Housing (large sector of the economy) is tied to interest rates, so low rates can be a boost there, where borrowing is driven by rates and rising equity values.”

    No, housing is not “tied” to interest rates—that’s reasoning from a price change. As rates plunged in 2006-09, housing also plunged. Holding M fixed, lower rates are contractionary, regardless of what happens to housing.

    Jonathan, Yes, it is related to the upward sloping LM curve, so why are so many people confused about this?

    You said:

    “I don’t understand the “hot potato” effect. How does a higher money supply boost NGDP if i doesn’t change?”

    If M doesn’t change, then V is stable, or falls by less, and thus NGDP rises by more. The mistake is to assume that rates are what are causing changes in NGDP.

    John, You said;

    “By sticking to a ceterus paribus analysis, you are assuming that there is no change in expected monetary policy, so, by definition, the only thing that is changing in your analysis is the real interest rate.”

    Not at all, inflation can change for reasons other than changes in the money supply.

    I disagree with your second paragraph, nominal things are changing in my model. NGDP is a nominal thing. When it changes, both P and Y change if the SRAS curve is upward sloping. BTW, if you were right, the Summers and Barsky’s paper would also be wrong, for the same reason.

    Any NK model that says low (market) interest rates are expansionary, for a given money supply, is wrong. I’d recommend you take a look at Summers and Barsky, I don’t think you understood my post.

  17. Gravatar of Scott Sumner Scott Sumner
    21. December 2015 at 10:45

    Philip, You lost me somewhere.

    O. Nate, Yes, he uses P instead of NGDP as the nominal indicator of demand, but it’s an identical argument. He says that for any given gold stock, lower i leads to more real demand for gold, which is deflationary. By implication, v also falls.

  18. Gravatar of John Handley John Handley
    21. December 2015 at 11:15

    Scott,

    “for a given money supply”

    That’s the problem I have. It doesn’t make sense to think of interest rates given a money supply. If you freeze the money supply in any neoclassical monetary model, then the nominal interest rate will only move if the real interest rate does. Monetary policy controls the nominal interest rate by moving expected inflation around. NK models don’t say anything about the money supply unless they have a money demand model, which none of the ones anyone ever refers to do. You shouldn’t assume that the money supply would be fixed given a rate change in an NK model.

    “NGDP is a nominal thing. When it changes, both P and Y change if the SRAS curve is upward sloping.”

    So, in other words, absent a change in the money supply nominal rigidities have still prevent the competitive equilibrium from occurring. Fair enough, but you miss my point: nothing monetary is causing the interest rate change; it’s all supply side and suggesting that the change was caused by a central bank that did nothing to the money supply is foolish. Note, if the gap between IOR and the nominal interest rate doesn’t change, then the MB shouldn’t change at all. This is what happened with the Fed rate change, not some magical increase in the interest rate that was not caused by a change in monetary policy or a change in the time preference rate or a change in long run growth expectations.

    “inflation can change for reasons other than changes in the money supply.”

    So inflation is not entirely monetary? What exactly are you suggesting controls inflation if not the central bank (when monetary policy is not impotent, as is the case when i is about equal to IOR)? As far as I know, inflation is entirely determined by the difference between the growth rate of the nominal money supply and real money demand. If the money supply doesn’t change and isn’t expected to change ever, then changes in inflation are simply bubbles and shouldn’t be considered an equilibrium. In fact, I think I linked you a paper about this exact topic a while ago… If inflation doesn’t change, then the only thing that could possibly change the nominal interest rate is the real interest rate, which, absent changes in the money supply, is entirely supply determined. If there happens to be slow adjustment to the new equilibrium because of nominal rigidity, then that is not caused by changes in monetary policy. All you’ve argued is that higher equilibrium real rates are consistent with higher levels of real output and the nominal rigidities will also happen to effect output at the same time.

  19. Gravatar of jonathan jonathan
    21. December 2015 at 11:32

    “If M doesn’t change, then V is stable, or falls by less, and thus NGDP rises by more. The mistake is to assume that rates are what are causing changes in NGDP.”

    [I assume you meant to write “If i doesn’t change…”]

    Isn’t this just the quantity theory of money, with the assumption that V is a function of i?

    What I’m really asking is, what is the mechanism by which nominal spending rises following an increase in the money supply, if it doesn’t happen through the interest rate?

    In other words, the “Keynesian” story is:
    M up -> r down -> C+I up -> Y up

    Your story seems to be:
    M up -> ? -> Y up

    I want you to flesh out how this happens, if not through the interest rate. I *think* this middle step is what you mean by “the hot potato effect”, but while this is an evocative phrase (reminiscent of Hume) I’m not sure exactly what you mean by it.

  20. Gravatar of jonathan jonathan
    21. December 2015 at 11:36

    Scott:

    “Yes, it is related to the upward sloping LM curve, so why are so many people confused about this?”

    I think because when people say “low interest rates are expansionary”, they’re talking about movements along the IS curve, not along the LM curve.

  21. Gravatar of jonathan jonathan
    21. December 2015 at 11:45

    p.s. I’m not trying to be hostile with my comments. I’m just trying to figure out if your model of the macroeconomy differs from standard broadly “Keynesian” views, or if you just have different views on policy (i.e. NGDP targeting).

  22. Gravatar of jknarr jknarr
    21. December 2015 at 11:51

    Thank you, Scott. Please keep on this one.
    i = V.
    Illuminating and clarifying, a great read!
    Consider also what happens to asset prices with lower velocity, there are wealth + debt effects in there too.
    That was a breath of fresh air in a stale monetary debate.

  23. Gravatar of Gary Anderson Gary Anderson
    21. December 2015 at 13:02

    So, with low interest rates as far as the eye can see, due to massive demand for long bonds, it looks like there will never be massive growth, ever. You guys may as well pack it in until you can figure out a way to diminish demand for long bonds. Lol. But even I want a little more growth. But it won’t happen because the Fed has created massive demand for treasury bonds. It has been said by O. Nate that a BIS paper said total treasury bond exposure as collateral would be in the 500 billion dollar range. Yet this fairly new list shows that triparty collateral exposure alone is 700 trillion dollars. https://www.newyorkfed.org/medialibrary/media/banking/pdf/nov15_tpr_stats.pdf?la=en So, already the BIS is WRONG.

  24. Gravatar of Gary Anderson Gary Anderson
    21. December 2015 at 13:10

    Sorry, 700 BILLION dollars.

  25. Gravatar of Vaidas Urba Vaidas Urba
    21. December 2015 at 13:25

    Scott,
    IOR is not a subsidy. Absence of IOR is a tax when interest rates are positive. At least that’s what Milton Friedman said.

  26. Gravatar of o. nate o. nate
    21. December 2015 at 14:02

    Gary, those numbers are for repo – not Treasuries being used as collateral for derivatives trades. Not sure how that ties into your argument about the Fed stoking demand.

  27. Gravatar of Benoit Essiambre Benoit Essiambre
    21. December 2015 at 14:08

    Ok I think I kind of get it. The point here is about the fact that the fed didn’t lower M as is usually the case with rate increases and has substituted it with adding IOR instead to lower V. This is a hack/subsidy to bank to pull down velocity instead of M.

    This does seem deeply misguided and inefficient. I don’t understand why they didn’t wind down QE first.

    But I still think it makes sense to think of it in terms of interest rates. They represent something concrete relevant to businesses whereas the excess reserve part of M which is standing idle and expected to be pull out before it is used, doesn’t represent much.

    the reason it works is related to your argument here:

    > some assume that “spending” is the same as consumption, hence if low rates encourage people to save less and consume more, then AD will rise. When you don’t spend you save, and saving goes into investment, which is also part of GDP. Now here’s were amateur Keynesians get hopelessly confused. They recall reading something about the paradox of thrift, about planned vs. actual saving, about the fact that an attempt to save more might depress NGDP, and that in the end people may fail to save more, and instead NGDP will fall.

    A thousand times this BTW. People are always confused about this.

    However resolving the confusion only requires the understanding that interest rates are mostly not about immediate final consumption. They are much more important for investment decisions. There is much more business and government debt out there than consumer debt and business debt is much more affected by central bank rate changes. Consumers don’t care that much for credit card rates are going from 21 to 20% and consumer debt is tightly restricted compared to debt used for investment.

    Interest rates are the expression of negotiation of consumption across time. At least if they are transparent and measured with a stable and predictable medium of account, they distill inter temporal consumption negotiations to a single number which embodies the trade off in people’s desire to work now and consume later versus the supply of stores of value, things that you can build now that generate consumable value later.

    They allow negotiation of the allocation between resources going to producing final goods and those going to new capital investment that make available final goods only later. In a lower rate environment it makes sense for a business to build more capacity and infrastructure that allows them to do more with fewer employees in the future.

    That is what is so fundamental about interest rates. That is what the “natural” rate is. Central banks can then play around this rate to affect M and V and keep the value of money on a useful path.

    Off course when central bank money becomes overly tight which makes money deposited in commercial banks retain value above risk adjusted real investment returns, that throws a wrench in the gears of the investment market screws up the inter temporal negotiation and leads to wasteful unemployment.

  28. Gravatar of Gary Anderson Gary Anderson
    21. December 2015 at 14:49

    Ok so O. Nate, repos are short term derivatives. So, this does not give an accurate picture of demand for long bonds in derivatives. Thanks for the information. But clearly, demand for long bonds is showing its scarcity by low interest rates.

  29. Gravatar of Doug M Doug M
    21. December 2015 at 15:40

    “I’m claiming lower interest rates are contractionary.”

    An increase in the money supply causes lower rates. I suppose many Fed watchers have this causality backwards and assume that it is falling rates themselves that is stimulative, rather than rates falling as a consequence.

    V(i – IOR) —
    I think this is a little bit simplified, but the sentiment is correct. There is not just one i. There are a multitude of interest rates that depend upon the borrower, the duration, etc.. Even in a world without IOR the spread between the “risk-free rate” and the rates accept risk are important drivers.

    “Many people confuse aggregate demand with consumption. Thus they think low rates encourage people to “spend” and that this somehow boosts AD and NGDP.”

    The focus on consumption is one place where Keynes gets it wrong. Changes in consumption don’t drive the business cycle. Consumption is more or less static throughout. Changes in Investment are the largest dynamic.

  30. Gravatar of Nick Rowe Nick Rowe
    21. December 2015 at 16:15

    Scott: what you say here about interest rates is correct, but it’s also consistent with the monetarist interpretation of the standard ISLM model of AD, (except that the ISLM model implicitly assumes that money pays 0% interest). A leftward shift in the IS curve will, for a given M, move the economy down along the upward-sloping LM curve, to lower i and lower Y and/or P. And it’s precisely because of the relationship between i and V that this happens.

    “To summarize, IOR is not really a market price, it’s a subsidy on base money, and negative IOR is a tax on base money.”

    Yep. IOR is like a negative Gesselian tax on money. Gessel himself said that a tax on money would increase V, so a subsidy would reduce V.

  31. Gravatar of Benjamin Cole Benjamin Cole
    21. December 2015 at 16:19

    I put the pedal to the metal. There is a lot of wind “drag” on my car. Does drag cause my car to go fast?

    Higher interest rates and higher velocity….

  32. Gravatar of Major.Freedom Major.Freedom
    21. December 2015 at 16:51

    “M*V = P*Y

    Where M is the base and V is base velocity. Now let’s build a model:

    M*V(i) = P*Y

    Since V is positively related to i, lower interest rates are contractionary, they reduce V and hence NGDP, AKA aggregate demand.”

    Ceteris paribus arguments are among the most challenging to make, since even attempts to hold all other things equal are often violated by the implicit relations of the variables,

    Sumner, you have to understand M*V = P*Y to be a mathematical identity, NOT a linear causal relationship. You can’t say lower interest rates are contractionary on M*V or P*Y, because interest rates are in part a function of the very variables you claim are affected by interest rate changes.

    All else equal, a decline in interest rates has ZERO “effect” on M*V, because changes in interest rates don’t cause changes to V, but rather, changes in V cause changes in interest rates.

    Spending cannot and does not fall when interest rates are lower, ceteris paribus. For even if we tried to borrow more and spend more on the basis of “cheaper money”, any additional borrowing is exactly offset by additional lending, and with additional lending, that reduces the money held by the lenders all the more, and their available money and ability to spend is exactly offset.

    In other words, velocity does not actuslly rise, ceteris paribus.

    This is ceteris paribus reasoning.

    The flaw in your argument is when you interjected an empirical correlation between velocity and interest rates, which is not based on ceteris paribus assumptions, and pretended that positive correlation will persist even with unchanged M. But the reason velocity is empirically positively correlated with interest rates is because both of those variables are positively correlated with M!

    It is the increase in M that increases velocity, and that also increases interest rates. That is why we observe the empirical correlation.

    In other words, if you hold ceteris paribus, then the correlation between velocity and interest rates disappears!

    It seems you want to skip steps and convince people, nay, mislead people, into believing that they should rabble rouse for more inflation even in the face of prevailing low interest rates.

    Shame!

  33. Gravatar of ssumner ssumner
    21. December 2015 at 17:00

    John, You said:

    “If you freeze the money supply in any neoclassical monetary model, then the nominal interest rate will only move if the real interest rate does.”

    That’s not at all true. All you need is predictable shocks to money demand, and then even with a stable money supply you can get predictable changes in the inflation rate. Any model that doesn’t allow for that is uninteresting.

    You said:

    “Monetary policy controls the nominal interest rate by moving expected inflation around.”

    Monetary policy can also affect the real interest rate if prices are sticky. In any case, I disagree about what you claim a stable money supply implies.

    You said:

    “You shouldn’t assume that the money supply would be fixed given a rate change in an NK model.”

    Why not?

    You said:

    “Fair enough, but you miss my point: nothing monetary is causing the interest rate change; it’s all supply side and suggesting that the change was caused by a central bank that did nothing to the money supply is foolish.”

    I don’t understand what you are trying to say. I was not suggesting anything about changes being caused by central banks, just the opposite. I’m simply talking about the effect of changes in i holding M constant. I don’t see why that’s considered strange. All of economics is about effects of X on Y, ceteris paribus.

    You said:

    “So inflation is not entirely monetary?”

    If by “monetary” you mean “supply of money” then the answer is yes, it’s not entirely monetary. If by “monetary” you mean having to do with the supply and demand for money, then the answer is no, inflation is entirely monetary. You need to define your terms precisely.

    Again, I suggest you look at the Barsky/Summers paper, we are not merely suggesting correlation. We are suggesting causation from low interest rates to falling AD.

  34. Gravatar of ssumner ssumner
    21. December 2015 at 17:18

    Jonathan, You asked:

    “What I’m really asking is, what is the mechanism by which nominal spending rises following an increase in the money supply, if it doesn’t happen through the interest rate?”

    Then hot potato effect is simply the laws of supply and demand. If there is more supply of money, then the value of money must fall until people are willing to hold that extra money. The value of money is 1/P, or 1/NGDP (my preference.) In terms of transmission mechanism, there are many. Expected future NGDP rises when M rises, that causes more spending today. Asset prices and flexible prices rise immediately, also causing more spending.

    You said:

    “I think because when people say “low interest rates are expansionary”, they’re talking about movements along the IS curve, not along the LM curve.”

    Yes, but my point is that they shouldn’t be! That’s why people got 2008 all wrong, they assumed low rates were caused by easy money, and hence were expansionary. I’m trying to get people to stop assuming that.

    Thanks Jknarr.

    Vaidas, Well I did say Tax/subsidy, so your point is really just semantics. Maybe the dividing line is not zero, as I assumed, but rather the market interest rate, as you seem to assume. In any case, since 2008 the Fed has paid above the market interest rate, so it’s been a subsidy.

    Benoit, The only “business” decision that matters for NGDP is the velocity of money spent by business. Lower rates lead to lower velocity of business spending.

    Nick, Yup, there’s nothing new here, it’s just another way of explaining how the profession got 2008 so wrong. They forgot that rates declines are contractionary, for any given M. For some reason, when you read articles by well known economists, there’s often a sort of implied assumption that changes in i are caused by the Fed, caused by changes in M, and hence are a short cut to talking about whether policy is getting more expansionary or not. From August 2007 to May 2008, i was falling and that was causing the US economy to tip into recession.

    The proper way to read this post is as a different way of framing the discussion, not a theoretical innovation.

  35. Gravatar of Matt McOsker Matt McOsker
    21. December 2015 at 17:20

    Scott the Fed Funds rate peaked at about 5.25% starting in July 2006, from a succession of rate hikes that started in June 2004 from a level of 1%. You don;t think that pushing up rates finally pushed the housing boom over the edge to capitulation? There must be some lag time.

    See chart:
    https://research.stlouisfed.org/fred2/graph/?g=2XUE

  36. Gravatar of Dan W. Dan W.
    21. December 2015 at 17:30

    Gary points out the conundrum the modern financial system has created. For 35 years a trend of declining interest rates has facilitated debt-leverage growth and asset accumulation. It was a virtuous cycle. Increased debt funded growth and asset purchases and lower rates allowed debt to be increased while maintaining the same interest expense.

    For long term interest rates to increase there must be sufficient growth and expectations of growth to pay for increasing borrowing costs. Such cost would be a tremendous drag on growth. The answer, of course, is to inflate away the debt. But such an approach begs the question: What is the stable inflation rate? The answer may not matter to ivory tower economists but it matters a lot to politicians.

    If the central bank unleashed the “animal spirits” of inflation expectations how is the leash put back on and at what cost?

  37. Gravatar of bill bill
    21. December 2015 at 17:57

    Tangent
    Can someone explain to me the difference between Animal Spirits and The Confidence Fairy? They seem so similar to me but one very well known Keynesian has always been very dismissive of The Confidence Fairy.

  38. Gravatar of Nick Rowe Nick Rowe
    21. December 2015 at 17:59

    Scott: “The proper way to read this post is as a different way of framing the discussion, not a theoretical innovation.”

    Ah! Got it. Yep.

  39. Gravatar of Gary Anderson Gary Anderson
    21. December 2015 at 18:46

    Will Rogers had a few quotes from the Great Depression:

    “You can’t break a man that don’t borrow; he may not have anything, but Boy! he can look the World in the face and say, “I don’t owe you Birds a nickel.” You will say, (if everyone stops borrowing) what will all the Bankers do? I don’t care what they do. Let ’em go to work, if there is any job any of them could earn a living at. Banking and After-Dinner Speaking are two of the most Non-essential industries we have in this country. I am ready to reform if they are.” WA #14, March 18, 1923

    “We never will have any prosperity that is free from speculation till we pass a law that every time a broker or person sells something, he has got to have it sitting there in a bucket, or a bag, or a jug, or a cage, or a rat trap, or something, depending on what it is he is selling. We are continually buying something that we never get from a man that never had it.” DT #1301, Sept. 24, 1930

    “The whole financial structure of Wall Street seems to have fallen on the mere fact that the Federal Reserve Bank raised the amount of interest from 5 to 6 per cent. Any business that can’t survive a 1 per cent raise must be skating on mighty thin ice… But let Wall Street have a nightmare and the whole country has to help get them back in bed again.” DT #950, Aug. 12, 1929

    “Borrowing money on what’s called ‘easy terms,’ is a one-way ticket to the Poor House. If you think it ain’t a Sucker Game, why is your Banker the richest man in your Town? Why is your Bank the biggest and finest building in your Town? Instead of passing Bills to make borrowing easy, if Congress had passed a Bill that no Person could borrow a cent of Money from any other person, they would have gone down in History as committing the greatest bit of Legislation in the World.” WA #14, March 18, 1923

    Will Rogers was pro business but anti speculation.

  40. Gravatar of Ray Lopez Ray Lopez
    21. December 2015 at 18:57

    @John Handley – thanks for the reply stating that money neutrality is not central to Sumner’s model, until the ‘very end’, which was the intuition behind my statement; you helped remind me the IS-LM model, which apparently is behind Sumner’s reasoning, deals with real interest rates and variables. “Why would low interest rates follow a reduction in the money supply?” – not sure what to make of this, except that the standard IS-LM model for LM has an upward sloping IM curve, so that reducing the money supply ‘results in’ (or is concomitant with) lower output Y and lower interest rates.

    @Philip George – saw your blog, and it seems you wrote an entire book based on a misunderstanding of the standard IS-LM model, or, to be more positive about it, you reconfirmed Fig. 4-2 of Blanchard’s freshman college textbook Macroeconomics (2nd ed.). Blanchard points out that M/$Y (money supply divided by nominal income), which is the inverse of velocity (by definition), is, inversely correlated to nominal income. So naturally the inverse, velocity, is correlated to national income, as you found. Money supply is positively correlated, says the LS-IM model, with both income and interest rates.

    @ssumner: please refresh our memories as to how this post, which Rowe points out is simply the IS-LM model re-framed, is consistent with your mystery post (somewhere on this site, which you never referenced) that states “I think the IS curve often slopes upward”. So when does the IS curve ‘often’ slope upward? Also a clarification on your cryptic comment on Say’s Law is kindly requested.

  41. Gravatar of E. Harding E. Harding
    21. December 2015 at 18:59

    Scott, you’ve totally lost me here. I don’t get any of this, and see interest rates as a price. Saying a price causes something is basically reasoning from a price change, isn’t it? Where’s my rookie mistake?

  42. Gravatar of Alexander Hamilton Alexander Hamilton
    21. December 2015 at 19:01

    @Gary Yeah saving up for fifty years to buy a house sounds like great fun

  43. Gravatar of ssumner ssumner
    21. December 2015 at 19:36

    Matt, No, the economy grew strongly during the period when rates were rising.

    E. Harding, No, but that’s worth a post. I’ll do one soon.

  44. Gravatar of Gary Anderson Gary Anderson
    21. December 2015 at 19:52

    Will Rogers was the most popular and beloved man in America and the Great Generation, who Rogers mentored, didn’t use much credit. Then bankers and their economists would have to find meaningful work. 🙂

    Rogers said something about confidence as well:

    “America already holds the record for freak movements. Now we have a new one. It’s called “Restoring Confidence.” Rich men who never had a mission in life outside of watching a stock ticker are working day and night “restoring confidence.” Writers are working night shifts, speakers’ tables are littered up, ministers are preaching statistics, all on “restoring confidence.”

    Now I am not unpatriotic, and I want to do my bit, so I hereby offer my services to my President, my country and my friends to do anything, outside of serving on a commission, that I can in this great movement. But you will have to give me some idea of where “confidence” is. And just who you want it restored to.” DT #1035, Nov. 19, 1929

    “I have been trying my best to help (the President) and Wall Street “Restore Confidence.” Confidence, is one of the hardest things in the World to get restored once it gets out of bounds. I have helped restore a lot of things in my time, such as cattle back to the home range. Helped to revive interest in National Political Conventions. Even assisted the Democrats in every forlorn pilgrimage, and a host of other worthy charities. But I tell you this “Restoring Confidence” is the toughest drive I ever assisted in. When I took up the work two or three weeks ago, confidence was at a mighty low ebb. Wall Street had gone into one tail spin after another…

  45. Gravatar of marcus nunes marcus nunes
    21. December 2015 at 20:20

    Scott, I must say that this one was of the same caliber as the ” “ancient” GDP=C+I+G+NX=Gross Domestic Partitioning!

  46. Gravatar of Carl Carl
    21. December 2015 at 20:50

    Let me see if I understand. I’ll use oil instead of money because I find money hopelessly complex to talk about.

    A low price of oil is an indication that demand for oil is down. A high price of oil is an indication that oil is in high demand. Sometimes but not always a decrease in the price of oil is due to an increase in the supply of oil. In this case, overall oil sales may increase because prices do not immediately adjust to the increased supply. If animal spirits cause people to feel optimistic about how much energy they will need to power their businesses they will drive up the price of oil. This in turn drives up oil sales. If oil prices are falling it probably means oil revenue is going down
    The Dept of Energy increased the price of oil without increasing the supply of oil. They did this by paying oil companies to hold more oil in storage.

    I could go on I suppose but my question is does my analogy hold up or have I missed the point?

  47. Gravatar of John Handley John Handley
    21. December 2015 at 21:28

    Scott,

    “That’s not at all true. All you need is predictable shocks to money demand, and then even with a stable money supply you can get predictable changes in the inflation rate. Any model that doesn’t allow for that is uninteresting.”

    That doesn’t change the fact that the shock you’re analyzing in your post is a supply shock. You seem to have gotten the causality backwards though; low interest rates don’t cause the contraction, negative supply shocks do. I find it a bit strange that you’d all of a sudden start thinking about 2008/9 as if a big negative supply shock hit the economy, though. It was always my impression that you thought implicitly tight monetary policy caused the contraction (I’d ask for some concrete steppes there, but that’s a whole other argument).

    “Monetary policy can also affect the real interest rate if prices are sticky. In any case, I disagree about what you claim a stable money supply implies.”

    I’m fairly sure I admitted that in that comment; a stable money supply should still imply no changes in inflation absent any real shocks or an off-equilibrium bubble.

    “I don’t understand what you are trying to say. I was not suggesting anything about changes being caused by central banks, just the opposite. I’m simply talking about the effect of changes in i holding M constant. I don’t see why that’s considered strange. All of economics is about effects of X on Y, ceteris paribus.”

    The thing is that the central bank controls i (because it generally controls expected inflation), so you’re saying “what if the central bank does something by doing nothing.” The only part of i that could change absent a change in expected monetary policy (or expected supply shocks, I guess) is the real interest rate which would only change because of a real shock if the money supply is constant.

    “If by “monetary” you mean “supply of money” then the answer is yes, it’s not entirely monetary. If by “monetary” you mean having to do with the supply and demand for money, then the answer is no, inflation is entirely monetary. You need to define your terms precisely.”

    I will quote you the explanation from my comment: “As far as I know, inflation is entirely determined by the difference between the growth rate of the nominal money supply and real money demand.”

  48. Gravatar of Gary Anderson Gary Anderson
    21. December 2015 at 21:34

    O. Nate, I am afraid that the BIS is wrong again. This is why there is a shortage of treasury bonds, fear of being short of treasury bonds. From this article http://m.treasuryandrisk.com/2013/06/11/demand-for-swaps-collateral-could-bolster-bonds

    New collateral rules for hedge funds, insurers and others in the $633 trillion over-the-counter derivatives market are poised to boost demand for U.S. Treasuries, potentially slowing rising yields as the Federal Reserve considers scaling back unprecedented stimulus.

    Swaps traders will need to come up with $800 billion to $4.6 trillion to meet Dodd-Frank Act regulations requiring that derivatives be backed by clearinghouses that collect upfront collateral such as cash or Treasuries, according to estimates from the Treasury Borrowing Advisory Committee. The regulations take effect today for the second group of firms designated by the Commodity Futures Trading Commission in the market for interest-rate and credit-default swaps.

    “This is going to be a new, very powerful engine that drives demand for Treasuries, so you have to expect it will impact yields,” said Ted Leveroni, executive director of derivatives strategy at New York-based trade-processer Omgeo LLC. “There are a lot of firms out there — I know because they’ve told me — that are concerned about having the available collateral.”

    So, you guys can kiss rampant economic growth goodbye. This demand for bonds is insatiable and will put a damper on growth going forward. Economists will be sadly, forever, stewards of austerity going forward.

    I am for stopping this use of bonds, but really, no one will ever allow that, IMO.

  49. Gravatar of Samuel Webber Samuel Webber
    21. December 2015 at 21:46

    Hi Scott,

    So this is a cool idea, I believe you’re saying that expansionary policy makes M go up (lowering rates) and that the next step is that those lower rates cause V to decline. A two step process instead of the traditional pull the lever on I,NGDP goes up

    Assuming I’m getting this, what are the policy implications? or this a post in the pure abstract?

    And the idea that an increase in NGDP would cause hours worked to increase sounds good on a chalkboard is there data proving this?
    Couldn’t you just as well argue that as NGDP rises the return on one hour of work falls while the cost is the same, causing a decrease in total hours worked?

    thanks

  50. Gravatar of Derivs Derivs
    22. December 2015 at 02:24

    “$633 trillion”

    Gary, Meaningless number. Notional is irrelevant. You pay a small initial margin on each contract but Margin demands are maintenance-risk based and has no scaling to notional.

    If I buy (one 95 call option) or I buy (1 95 call, buy one 105 call, and sell 2 100 calls). The second example is multiples and multiples the notional of the first, but it is well hedged-low risk and will require virtually no margin to maintain. Same concept with a long Feb position as opposed to a long Feb, Short March spread (twice the size with almost no calories)

    If someone told me I have had over a trillion on in notional all by myself I wouldn’t blink, I kept truly MASSIVE books but I NEVER had high margins because I kept risk neutral arb books.

    And remember… every trade has an opposing transaction which means all these trades cleared in one place, no matter the size, has no net risk. Clearinghouses job to keep counterparties within their risk tolerances, and they do a good job of it.

  51. Gravatar of Vaidas Urba Vaidas Urba
    22. December 2015 at 02:38

    “Maybe the dividing line is not zero, as I assumed, but rather the market interest rate, as you seem to assume. In any case, since 2008 the Fed has paid above the market interest rate, so it’s been a subsidy.”

    Scott, following Milton Friedman, I believe the dividing line is where the economic profit of central bank is zero.

    It is a bit hard to tell if the Fed has paid above market interest rates since 2008, as various financial instruments have different convenience yields and you need adjust for that. The key area where subsidy/tax is involved is the difference between the rates the Fed is paying to GSEs and the rate is is paying to commercial banks. In any case, other central banks do not have this problem the Fed has and yet macro outcomes are the same.

  52. Gravatar of derivs derivs
    22. December 2015 at 02:41

    “In this case, overall oil sales may increase because prices do not immediately adjust to the increased supply.”

    Carl,
    What’s interesting is what you are seeing now, and not unexpectedly, since so much commodity production is under state control, and they need revenue, at half the price the idea is to produce twice as much in order to maintain revenue. Since the state don’t care about amortizing sunk costs and other businessy stuff they don’t look at cost of production the same way, this is what leads to capitulation,
    forcing the market to say NO MORE, price is now $1 – there is NO place to store another drop…. Then even the state stops, investment has been zero, demand starts rising, no infrastructure projects in the pipe, and never before seen higher prices… the cycle of life…..

    Oh and da gubmint doesn’t set price nor do they pay companies to hold reserves, they come into the open market and buy themselves for the strategic national reserves that they themselves control.

  53. Gravatar of Postkey Postkey
    22. December 2015 at 03:31

    “And ceteris paribus in this case means for any given money stock.”

    For the ‘assumption’ that the money stock is exogenously determined?

  54. Gravatar of End. End.
    22. December 2015 at 04:39

    New Keynesian models are based on intertemporal optimization. If the nominal interest rate falls today, given inflation expectations, then the real interest rate falls as well.

    As the real interest rate is the price of consumption today in terms of consumption tomorrow, you want to increase your consumption todahy and decrease it tomorrow, i.e you borrow.

    As some commenters pointed out, this is mostly true for durable goods (housing, cars, etc.) plus investment. And it is perfectly consistent with what you observe.

    On the other hand, with MV(i) = PY, how do you explain that durable consumption and investment are much more affected than other sectors in a recession? How do you explain what are the determinants of investment?

  55. Gravatar of End. End.
    22. December 2015 at 04:45

    BTW., neither Old nor New Keynesian say that you can increase/decrease the nominal interest rate without changing the money supply. They assume, as it is the case in reality, that the central bank sets the nominal interest rate and provides enough money to meet for the demand at the given policy rate.

    They just realized that monetary frictions and monetary effects do not matter in comparison to the intertemporal effect.

  56. Gravatar of Jose Romeu Robazzi Jose Romeu Robazzi
    22. December 2015 at 04:56

    I loved the Say’s Law comment. Good post, this model provides a clear explanation for IOR effects.

  57. Gravatar of ssumner ssumner
    22. December 2015 at 05:34

    Carl, Not a good analogy, because interest rates are the price of credit, not money.

    John, You said:

    “That doesn’t change the fact that the shock you’re analyzing in your post is a supply shock. You seem to have gotten the causality backwards though; low interest rates don’t cause the contraction, negative supply shocks do.”

    Not at all, I’m talking about changes in NGDP, which are demand shocks. More specifically, I’m talking about non-money (supply) demand shocks, i.e. demand shocks due to changes in V.

    And no, Summers and I are both suggesting that causation goes from interest rates to falling NGDP.

    You said:

    “The only part of i that could change absent a change in expected monetary policy (or expected supply shocks, I guess) is the real interest rate which would only change because of a real shock if the money supply is constant.”

    You greatly overrate the importance of monetary policy in changes in i. Do you think monetary policy caused rates to fall from 5.25% in August 2007 to 2% in May 2008? If so, how did monetary policy do this? And your wording is confusing, does monetary policy in your statement refer to changes in the supply of M, or monetary policy more broadly? If it’s just changes in the supply of M, then clearly I disagree, inflation can change even if M is constant.

    You said:

    “As far as I know, inflation is entirely determined by the difference between the growth rate of the nominal money supply and real money demand”

    Yes, I know, that’s an identity, and it supports my claim.

    Samuel, The policy implication is don’t assume falling rates are the same as easy money.

    Yes, there’s a lot of data linking NGDP and hours worked, google one of my musical chairs posts that has a graph.

    Vaidas, What central banks have the same outcomes as the US?

    Postkey, No, holding M constant is not the same as assuming it is endogenously given.

    End, You said:

    “As the real interest rate is the price of consumption today in terms of consumption tomorrow, you want to increase your consumption today and decrease it tomorrow, i.e you borrow.”

    None of that has any bearing on NGDP. I am talking about the fact that a fall in V is contractionary for NGDP.

    All business cycle models (Keynesian, monetarist, RBC, Austrian, etc, have procyclical investment/GDP. That’s an implication of consumption smoothing.

    You said:

    “neither Old nor New Keynesian say that you can increase/decrease the nominal interest rate without changing the money supply. They assume, as it is the case in reality, that the central bank sets the nominal interest rate and provides enough money to meet for the demand at the given policy rate.”

    Um, the IS-LM model? A shift in IS, with fixed M? If you want real world, the interest rate fell from 5.25% in August 2007 to 2% in May 2008, without any change in M.

  58. Gravatar of jonathan jonathan
    22. December 2015 at 06:54

    Scott:

    Great! I think I finally understand how your view differs from standard Keynesian views. Let me know if this is right:

    You think that monetary policy (via an expansion of the money supply) works primarily by increasing current and expected inflation, which (through sticky wages) also increases current and expected real GDP growth. Since these move together, you prefer to think in terms of changes in NGDP, leaving the allocation between P and Y ambiguous. Interest rates may fall, stay the same, or even rise, since they’re just an equilibrium price.

    To contrast this with Keynesian views:

    New Keynesians take the “natural rate” as a roughly exogenous object, and then think about monetary policy as setting the policy rate equal to the natural rate, which stabilizes output and prices. You view the “natural rate” as an equilibrium object that monetary policy can and should affect directly by changing inflation and growth expectations, or more succinctly (using your preferred framing) NGDP growth expectations.

    In Old Keynesian terms (IS-LM), you think that the IS curve could be horizonatal, or even upward sloping, which really just means it’s the wrong framework for thinking about monetary policy in the first place. Or maybe more precisely, you think that monetary policy mainly works through growth expectations, which (in the IS/LM framework) mean shifts in the IS curve. So you think that a monetary policy shock in the IS/LM framework shifts the LM curve out, but *also* shifts the IS curve out, and the latter effect is really critical.

    In other words, good expansionary monetary policy can (and often should) show up as higher interest rates, since this means that the Fed has successfully raised growth expectations and thus the natural rate of interest.

    Is this roughly correct?

  59. Gravatar of Benoit Essiambre Benoit Essiambre
    22. December 2015 at 07:03

    OK but I still think a language without mention of interest rates is confusing.

    The “stable M” without IOR assumption is not credible. You said it yourself:

    >Suppose the Fed had raised the fed funds target, without raising IOR. What then? Then they would have had to reduce the monetary base enough to make the rate increase stick. How much? Fasten your seatbelts—by almost $3 trillion.

    Central bank raising rates implies some tightening. Putting a rate number on it quantifies the tightening and ties it together with business intertemporal investment decisions.

    Otherwise, how would central banks raise rates without IOR and stable M. Would they could just announce the higher rate and wait for V and inflation to pickup before doing anything concrete? This is, again, weird semantics. The rate here no longer represents cost/subsidy of money. Plus with a considerable amount of QE reserves starting to move, wouldn’t you potentially get hyperinflation or would you expect them to start lowering M at some point?

  60. Gravatar of Postkey Postkey
    22. December 2015 at 07:22

    For the ‘assumption’ that the money stock is exogenously determined?

    “Postkey, No, holding M constant is not the same as assuming it is endogenously given.”?

  61. Gravatar of John Handley John Handley
    22. December 2015 at 08:01

    Scott,

    “Not at all, I’m talking about changes in NGDP, which are demand shocks.”

    Supply shocks can change NGDP. If there were money added to an RBC model and the money supply never changed and the money demand function you proposed were in the model, then NGDP would change when supply shocks hit. You seem to think any change to money demand is a demand shock, but that makes every shock a demand shock given your money demand function.

    “You greatly overrate the importance of monetary policy in changes in i. Do you think monetary policy caused rates to fall from 5.25% in August 2007 to 2% in May 2008? If so, how did monetary policy do this?”

    The Fed chooses the Fed Funds Rate and satiates the demand for money as that interest rate. Monetary policy becomes impotent when money demand will rise match any level of the money supply.

    “Yes, I know, that’s an identity, and it supports my claim.”

    Only if money demand shocks are all demand shocks. I certainly don’t think this is the case for the money demand model you presented above. Effectively, what you’re post seems to me to be trying to figure out is “what would happen is all of a sudden people subjectively decided to demand more money.” Absent a change in the money supply, this would mean that the interest rate would fall and that output would fall. I agree with you there. The way you actually presented it is that the interest rate magically happens to change for no reason and that this somehow causes a contraction; this wording is, if anything, incredibly confusing. And, at least in my opinion, obfuscating what is actually happening in you thought experiment.

    “inflation can change even if M is constant.”

    If there are shocks to money demand; which are supply shocks.

    “And no, Summers and I are both suggesting that causation goes from interest rates to falling NGDP.”

    But what set the interest rates lower in the first place? You clearly don’t think it’s the Central Bank in your model…

    I’ll read your new post, maybe that clears it up a little.

  62. Gravatar of marcus nunes marcus nunes
    22. December 2015 at 08:28

    Sorry, that was supposed to be “Gross Deceptive Partitionung”!

  63. Gravatar of Gary Anderson Gary Anderson
    22. December 2015 at 08:47

    But Derivs, you missed the important number. Even with little risk, the derivatives market, especially interest rate derivatives, is so massive that 800 billion to 4 trillion dollars of treasury bonds were the estimated to be needed for collateral. The treasury bond market is only 12 trillion dollars. This new demand for bonds is forcing interest rates down. Market forces may not be as significant with this new normal, this new use of bonds. They have been collateral before, but never at this massive scale.

  64. Gravatar of derivs derivs
    23. December 2015 at 03:38

    “Derivs, you missed the important number.”

    Gary,
    Did not miss the number. Just thought what fucking moron gives an estimate wider than Kim Kardashians ass. Widen it just a bit, equidistantly, and you might as well say “somewhere between 0 and 4.8 trillion”, or we can just close our eyes and stick our finger in the air and test for the breeze.

    All said and done, every time I have seen a product go OTC to Clearing, it has been fairly orderly, companies ain’t posting Billions in collateral and will force their traders to take down positions so I would expect, at first, some odd movements (probably more an effort to buy lots and lots of way way way out of the money options)… but in short time I would expect the market to look just like a futures or equity market. Those are pretty big too, and you don’t see 4 trillion backing global oil trades.

    Time will tell.

  65. Gravatar of ssumner ssumner
    23. December 2015 at 13:24

    Jonathan, You said:

    “You think that monetary policy (via an expansion of the money supply) works primarily by increasing current and expected inflation, which (through sticky wages) also increases current and expected real GDP growth. Since these move together, you prefer to think in terms of changes in NGDP”

    It’s not that I prefer NGDP, I simply don’t think inflation matters.

    Most of the rest is about right.

    Benoit, You said:

    “Central bank raising rates implies some tightening.”

    Have you ever lived through a hyperinflation? It most certainly does not imply tightening.

    Postkey, That was a typo, I meant it does not imply it’s exogenously given.

    John, You said:

    “Supply shocks can change NGDP. If there were money added to an RBC model and the money supply never changed and the money demand function you proposed were in the model, then NGDP would change when supply shocks hit.”

    Ok, this is semantics. I’d call any change in NGDP a demand shock, even if triggered by a real factor. But I’m willing to go with your claim that it’s a supply shock. But I’ll still insist it’s not the supply shock that is causing unemployment, it’s the fall in V caused by lower interest rates (and the central bank’s refusal to offset.)

    You said:

    “The Fed chooses the Fed Funds Rate and satiates the demand for money as that interest rate. Monetary policy becomes impotent when money demand will rise match any level of the money supply.”

    So I take it that you disagree with people like Krugman, who say that if rates fall for reasons other than a change in the monetary base, then the Fed has not caused them to fall. If you are going to say that monetary policy caused rates to fall, despite no change in M, will you at least agree it’s a tight money policy? After all, stable M and a change in i that causes a change in V that reduces MV. (I’m planning a post soon at Econlog, on these issues.)

    You said:

    “The way you actually presented it is that the interest rate magically happens to change for no reason and that this somehow causes a contraction; this wording is, if anything, incredibly confusing. And, at least in my opinion, obfuscating what is actually happening in you thought experiment.”

    You are still missing the point. I’m saying that the reason output falls is not the same as the reason that i falls. Some shock causes i to fall, you are right about that. But that shock almost certainly doesn’t cause millions to lose their jobs. Instead, the fall in i leads to lower V, and, if not offset by the Fed, lower MV, and mass unemployment. But that shock need not cause mass unemployment, it’s only doing so because of the indirect effect on V, not any direct impact on labor markets.

    Suppose the shock is that Russians hoard US currency. That obvious has no real direct effect on the US production possibility curve, it doesn’t make us have less capital or labor or land. It doesn’t affect our “institutions”. It should not affect our output. But it does if not accommodated.

  66. Gravatar of Joe Eagar Joe Eagar
    23. December 2015 at 16:43

    The impression I get from monetarists on IOR is that they really, really hate how it ruins classic monetarist models, especially the money multiplier (which doesn’t exist under IOR, assuming it ever did).

    A lot of your posts on IOR strike me as normative: is it okay for central banks to fiddle with the demand for money, or should they be restricted to changing supply only?

    I would like to see more discussion on that normative point, since it seems to underlie everything else.

  67. Gravatar of Gary Anderson Gary Anderson
    24. December 2015 at 08:52

    Derivs, I will bet you a dollar I am right.

  68. Gravatar of ssumner ssumner
    24. December 2015 at 16:00

    Joe, There are different kinds of “hate”. There’s hating things because they are annoying, like mosquitoes and IOR, and there is hating things because they are really bad, like the monetary policy of 2008-09 and ISIS. If we went to NGDPLT I’d gladly accepting IOR.

  69. Gravatar of Gary Anderson Gary Anderson
    25. December 2015 at 09:20

    Speaking of ISIS, you should read up on Oded Yinon sometime to see how ISIS is really supported by Israel, and a three part Iraq has always been the goal. Regime change is evil, Scott, and you should consider that it is what drives American foreign policy, not some bogus war on terror. While it didn’t make the front page of Talkmarkets due to being off economic subjects, you may want to read the article at my personal blog there. It is linked to my name, Scott.

  70. Gravatar of ssumner ssumner
    26. December 2015 at 07:52

    Gary, You said:

    “you may want to read the article at my personal blog there”

    I think I’d rather spend the day sticking sharp needles under my fingernails. Or maybe get a root canal.

  71. Gravatar of Gary Anderson Gary Anderson
    4. January 2016 at 16:24

    Hey Scott one of your readers said: “Central bank raising rates implies some tightening. Putting a rate number on it quantifies the tightening and ties it together with business intertemporal investment decisions.

    Otherwise, how would central banks raise rates without IOR…”

    So, here is my take. Raising rates would be expansionary, if banks loaned more expecting more profit. But the Fed does not want the banks to lend more, and pays even more IOR. So, you have hinted at conspiracy. I think it is a conspiracy of sorts.

  72. Gravatar of Sumner Arguing That Low Interest Rates Are Contractionary Sumner Arguing That Low Interest Rates Are Contractionary
    6. January 2016 at 08:59

    […] has been posting some interesting stuff on this topic (one, two, three). Many of you–and Scott himself, at the tail end of this post–are bracing […]

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