Money and asset prices (the liquidity effect as epiphenomenon)
We’ve already seen how money affects prices and output in previous posts. I’d guess that 99.9% of economists would do money and asset prices first, and use those effects to explain the relationship between money and inflation and/or output. But then if I was 99.9% of economists, you wouldn’t be reading this blog.
Because wages and many consumer goods prices are quite sticky, the first place monetary shocks show up in in the flexible price asset markets; particularly stocks, bonds, commodities, real estate and foreign exchange. Let’s start with stocks, commodities and real estate.
Monetary stimulus has no long run impact on real stock, commodity and real estate prices, but does affect all three in the short run. When the economy is at full employment, a one time increase in M should cause a roughly proportional increase in expected future nominal asset prices. The impact on current prices depends on the effect of the monetary stimulus on nominal interest rates. Because one-time money supply increases often reduce nominal interest rates, current asset prices might rise by even more than expected future asset prices (as inflated future cash flows get discounted at a lower interest rate.) And because consumer prices are sticky in the short run, real and nominal asset prices move in tandem in the very short run.
If the economy is depressed, then a one-time money supply increase raises asset prices for the reasons just cited, and also because it raises real output, as we saw in the previous post. The real prices of stocks, commodities and real estate tend to be somewhat procyclical. However increases in the trend rate of inflation can reduce real stock prices, as it raises the real effective tax rate on capital income from corporate investments. Nonetheless, if the economy is deeply depressed then monetary stimulus is likely to be bullish for stocks, commodities and real estate.
Monetary stimulus will raise the price of foreign exchange for two reasons. One is obvious; money is neutral in the long run and hence any increase in M shows up as higher prices in the long run, and this includes the price of foreign exchange. In addition, a one time increase in M will often reduce the nominal interest rate. The interest parity condition says that the expected change in the price of a foreign currency is the domestic interest rate minus the foreign interest rate. Thus if the US interest rate is 7% and the Swiss interest rate is 4%, then the SF would be expected to appreciate by 3% per year against the dollar. If this was not the case, then arbitrageurs would take advantage of any discrepancy in interest parity.
If monetary stimulus causes the domestic nominal interest rate to fall, then the expected rate of appreciation of the domestic currency must increase. Paradoxically, an expansionary monetary shock will cause the expected future value of the domestic currency to drop, but the expected rate of appreciation of the domestic currency will actually increase. This can only occur if the current value of the domestic currency plunges sharply on the news of monetary stimulus, so much so that it’s expected to end up lower than before the stimulus, despite being expected to appreciate over time. A good example of this phenomenon occurred in March 2009, when the dollar plunged 6 cents against the euro on the day QE1 was announced. Rudy Dornbusch called this “overshooting.”
The most complex and misunderstood asset market reaction occurs with bonds. Most people are so convinced that monetary stimulus causes bond prices to rise than they equate bond price changes with monetary policy itself. Thus people will talk about “the Fed cutting interest rates” as if they are describing a monetary policy, whereas they are actually describing an asset price change that may or may not be attributable to monetary policy. Even worse, bonds are the most unpredictable of all the asset markets.
We can be fairly confident that monetary stimulus will boost the prices of stocks, commodities, real estate and foreign exchange, but it’s not at all clear how it will affect bond prices. Most asset prices rise in response to monetary stimulus due to higher inflation and/or higher real growth expectations. But both of those factors would tend to reduce bond prices, or raise interest rates, which is just another way of saying the same thing. Why then do people often equate monetary stimulus with rising bond prices and falling nominal interest rates?
It seems that bonds are viewed as being special because they are particularly close substitutes to cash. When people (and banks) are faced with excess cash balances, they initially try to get rid of those unwanted dollar bills. In the long run this is done through higher prices. But in the short run prices are sticky, so people attempt to buy close substitutes, assets such as T-bills and bank CDs. The price of those close substitutes rises, which means that short term interest rates tend to fall. This is called the “liquidity effect.” (It doesn’t occur because the Fed buys T-bills, the same effect would occur if they bought zinc. It’s the excess cash that creates the liquidity effect.) The effect on longer term bond prices is much more uncertain, as the inflation/output effect plays a much bigger role in the long term bond market.
Short term nominal interest rates have very little effect on the economy. The liquidity effect is a sort of epiphenomenon, something that happens, but which doesn’t have an important impact on the variables we really care about. The other asset markets are far more important.
Now let’s consider the impact of an unexpected, one-time, 5% boost in the money supply:
1. Short term nominal interest rates usually fall. This depresses velocity, and prevents any significant immediate rise in NGDP.
2. The real price of stocks, commodities and real estate rises, which boosts business investment in the construction of corporate assets, farm equipment, mining equipment, home building, etc. Over time these factors tend to gradually raise interest rates, and also velocity. As velocity rises, so does NGDP.
3. As foreign exchange prices rise, exports increase, which may also tend to gradually boost real interest rates, velocity, and hence current NGDP.
4. NGDP also rises because the monetary injection increases expected future NGDP. If the higher future NGDP is expected to show up in the form of higher prices, then that increases current inflation expectations, velocity, and hence current NGDP. If the higher future NGDP is expected to show up in the form of higher RGDP, then it will boost current investment and raise the real interest rate over time, which also boosts velocity and current NGDP. Either way, higher future expected NGDP tends to boost current NGDP. Even if real asset prices did not respond to monetary shocks, this channel would be enough for monetary policy to be effective.
So the asset market channel is another way in which monetary stimulus can boost NGDP, above and beyond the simple hot potato effect that causes a proportional rise in NGDP in the long run. To summarize, monetary stimulus raises NGDP for several reasons:
1. It raises expected future NGDP via the hot potato effect, which boosts current NGDP.
2. It raises various real asset prices, which may gradually boost real expected returns on capital, and hence velocity. On the other hand any liquidity effect that shows up will reduce velocity, but only in the short run. The liquidity effect goes away once wages and prices have fully adjusted.
The best way to study monetary economics is to first focus on the hot potato effect in order to understand why monetary policy impacts nominal aggregates in the long run. Then study the musical chairs effect to understand why shocks to nominal aggregates impact employment and output in the short run. The reaction of asset prices to monetary policy (while important) is a distraction that does more to confuse than illuminate for a student first trying to understand monetary economics. It’s the icing on the cake.
To summarize the entire model:
1. M —> NGDP (hot potato)
2. NGDP —> RGDP (musical chairs)
3. M and NGDP and RGDP all affect real asset prices (liquidity effect, inflation effect, real income effect)
4. Asset prices also affect NGDP (that’s for you dtoh)
I’ll put a link for the entire 9 post short course over in the right column.
PS. There is an interview of me in the Brazilian financial paper Valor. (HT: Marcus Nunes.)
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7. April 2013 at 07:24
Prof sumner, if we assume we are at the ZLB, all the above are dependent on the expectations channel right?
I’m assuming monetary policy is conducted by short term bond buying (regular OMO), and that no “technical” effect exist such as people preferring to hold cash over bonds or some portfolio balancing effect.
Because the asset prices are going up due to future expected inflation hence expectation channel. If long term rates increase this would also mostly be due to expected future inflation, right?
7. April 2013 at 08:10
I think you need to explain how this works when there is a level target for nominal GDP, especially if people think it is credible.
How does an excess supplly of or demand for money impact the economy?
Then, what happens if people think it won’t work. How does an increase or decrease in the quantity of money “make” it work despite ignorance or skepticism by the public.
Too much of this analysis is about the adjustmetn process when there is a permanent, exogenous change in the quantity of money.
7. April 2013 at 08:23
Georges, I’d say it’s primarily through the expectations channel. But that’s also true when not at the zero bound.
Bill, Those are interesting issues, but in these posts I was trying to focus on the core issue of how and why does money affect the economy. There are many other monetary issues that can and should be discussed once people understand the building blocks of the analysis.
7. April 2013 at 09:38
Scott,
I’m confused about definitions.
When you say, “The real price of stocks, commodities and real estate rises, which boosts business investment in the construction of corporate assets, farm equipment, mining equipment, home building, etc. Over time these factors tend to gradually raise interest rates, and also velocity. As velocity rises, so does NGDP.”
First, are you saying an increase of the price of financial assets causes velocity to go up twice? First, business investment goes up causing V to go up, and then interest rates go up, causing V to go up a 2nd time? Or, is that only one change in V?
Second, is all this the same thing as the hot potato effect? Or, is it something different? Is this the portfolio balance effect of Friedman/Tobin/Brunner/Meltzer? In other words, how many fundamentally separate channels are there? I remember Friedman/Schwartz arguing there were two, excess cash balances and and asset prices changes causing portfolio adjustment.
Also, does the “liquidity effect” only refer to interest rates of bonds, or does ir refer to ALL Financial Asset prices?
Also, I’m confused about your point about interest rates. Sometimes you say they are important, and other times not. In the third and fourth paragraph you emphasize interest rates, then later you say “Short term nominal interest rates have very little effect on the economy. The liquidity effect is a sort of epiphenomenon, something that happens, but which doesn’t have an important impact on the variables we really care about. The other asset markets are far more important.”
Then immediately after you say, “Short term nominal interest rates usually fall. This depresses velocity, and prevents any significant immediate rise in NGDP.”
Can you please clarify?
This is a very important post. But there is so much going on that I’m having trouble visualizing all this in front of me. I would recommended a carefully thought out diagram representing all aspects of this post for more clarity.
7. April 2013 at 11:59
So there’s a certain amount of bi-causality between NGDP and asset prices?
7. April 2013 at 13:20
“Monetary stimulus has no long run impact on real stock, commodity and real estate prices, but does affect all three in the short run.”
Price levels don’t exist. Arguing there is “no long run impact on prices”, implies that prices in the distant past can be compared to prices today. In other words, it implies that prices today are commensurable with prices in the distant past.
But what exactly is the standard of measurement here? What is constant over time that such comparisons can be made? It can’t be goods, because they change, and between two sufficiently distant points in time, radically so.
So given it’s not goods, then what? We can’t be referring to prices in some abstract sense, divorced from goods. We can’t compare an abstract price of “Abstract $1.00 price in 1950” with “Abstract $5.00 price in 2013”.
In other words, the argument that money is long run neutral, is in fact meaningless, because there is no common unchanging standard that would enable commensurable variable measurements.
But that is just a critique of a popular justification for claiming long run money neutrality. Is there a positive argument that can be made that shows money is not neutral on any time scale? Yes, there is. The argument can only be understood if we realize two closely related points. First, if there really is a common link between prices over time, and second, if there is a common link, whether or not it changes over time, and, as a corollary, whether or not this common link is affected by prices themselves.
So is there a common link? The only plausible common link that can allow us to compare prices in 1950 with prices in 2013 is we humans. Humans are the common link. Second question, are humans changing? Of course humans are changing. Humans are learning, adapting, and always setting new goals that are never exactly equal to prior goals. The corollary question: Are prices influencing our behavior? Yes. Prices influence what we produce, where, when, and thus what we learn, where, and when. That change in us, then brings about changes in prices, and so on.
So if we know that humans are the common link, and if we know that humans are changing, and if we know that we are changing due in part to prices, then it follows that money is not neutral, anywhere, for any length of time. Past inflation has affected prices, and prices have affected human activity, it a way that forever alters the course of human history.
We cannot set a monetary policy today that can erase thousands of years of monetary history, and make today a world that is the same as what would have occurred had monetary history been different than what it was. We are forever linked to our past in terms of knowledge, capital, and productivity.
It is a serious mental error to believe that inflation today has no long run effects on “prices”. Inflation today has a permanent effect on human history going forward.
If inflation during the Great Depression were different than what it was, then life today would have been different than what it is.
Money is not neutral. A neutral money is actually a contradiction in terms, if you understand money, that is, if you understand money as grounded on human activity, rather than treating money as some floating abstract concept in an impersonal technocratic positivistic sense.
7. April 2013 at 13:26
I can’t help but notice that there is zero consideration of human learning in this blog post. Humans are apparently automatons.
7. April 2013 at 14:16
“Over time these factors tend to gradually raise interest rates, and also velocity. As velocity rises, so does NGDP.”
Over how long a time? Velocity and interest rates are much lower now than prior to the biggest boosts to money supply in history.
If these channels take four or more years to work, how can NGDPLT ever operate effectively?
7. April 2013 at 14:30
“It doesn’t occur because the Fed buys T-bills, the same effect would occur if they bought zinc. It’s the excess cash that creates the liquidity effect.”
There is a first order demand effect on the T-bills, followed by a second order liquidity effect on all assets including T-Bills.
Are you saying that if a massive new buyer of zinc appeared on the market that the effect on the price of zinc would be equivalent to the effect on other asset prices?
7. April 2013 at 16:52
JoeMac, You asked:
First, are you saying an increase of the price of financial assets causes velocity to go up twice?”
No, I’m saying that higher prices of real assets (real estate, stocks, etc.) make interest rates rise, which raises V. If the price of a financial asset like bonds rises then V tends to fall.
It seems to me that anything that raises NGDP involves a sort of hot potato effect, although one can discriminate between changes in M and V. Perhaps that’s what Friedman meant.
When I talk about the liquidity effect I’m referring to interest rates on bonds, CDs, etc. I’m not saying that other assets don’t have some effect in that direction, but bonds and bank deposits tend to be closer substitutes for cash.
When I said short term rates were not very important, I meant that lower rates don’t do much to raise NGDP via the channel of encouraging investment. The effect of lower short term rates on V that you mentioned actually reduces NGDP, by reducing velocity. I meant the direct EXPANSIONARY effect of lower short term rates is trivial. But I do see what you mean, that was a bit confusing.
Mike Sax, Yes.
Geoff, OK, if the price level doesn’t exit, then I meant no long run impact on NGDP.
Paul, In this course I was mostly assuming nominal rates were positive, or if they were zero that the monetary injections were permanent. Also no IOR. None of those conditions are met today.
Yes, zinc would be affected by Fed purchases, but not by Icelandic central bank purchases. But the T-bill market is so big that the direct effects of Fed OMPs can be essentially ignored if rates are positive. That is, the effect on T-bill yields is pretty much the same whether the Fed buys T-bills or Apple stock.
7. April 2013 at 17:17
Scott,
“Yes, zinc would be affected by Fed purchases… but the T-bill market is so big that the direct effects of Fed OMPs can be essentially ignored if rates are positive. That is, the effect on T-bill yields is pretty much the same whether the Fed buys T-bills or Apple stock.”
OK so you agree there is a demand effect, but you believe it’s negligible.
Currently the Fed owns over 10% of the government debt on issue.
So it seems you see 10% of the market as being negligible – is that right?
7. April 2013 at 17:27
Scott,
Or you could say,
1. OMP > Higher Real Financial Asset Prices (FAP) & Higher NGDP Expectations
2. Higher FAP & Expectations > Increased spending on real goods and services (i.e. Higher NGDP)
3. Higher NGDP > Higher RGDP and/or Higher Price Level
4. Higher NGDP absorbs increased M
7. April 2013 at 18:08
Scott,
So now that we’ve clarified the model based on financial asset prices and NGDP expectations, the whole exposition becomes much simpler.
OMP increases the immediate demand for financial assets (Fed is buying Treasuries).
Higher NGDP will increase the longer term supply of financial assets (more corporate borrowing, more equity issuance, more credit card purchases, etc).
Because the demand (FED purchases) and supply (higher expected NGDP) are countervailing, the short term impact on the real price of financial assets is indeterminate.
If we express financial asset prices as real expected after-tax annualized IRRs, all financial asset prices will move in tandem, and the differences in nominal pricing between different financial assets just becomes a footnote.
Because of higher real financial asset prices and/or increased expectations for higher NGDP, there is an increased exchange of financial assets for real goods and services, i.e. increased NGDP.
Increased demand (or expected demand) for real goods and services alters the supply/demand balance causing the price of real goods and services to rise.
7. April 2013 at 18:26
Scott,
One other thing, I think the discussion of the impact of interest rates on V is irrelevant because it is so insignificant. Take a hypothetical company that has $40 million in debt and $4,000 in cash and deposits on its balance sheet. If rates move by 10 bp, that has a significant impact ($40k/year) on whether the company decides to invest money in a new production line. It has no impact ($4/year) on how much cash the company holds.
7. April 2013 at 20:30
Strange thought. So the CDO’s that were bundled during the crisis were more or less tied to mortgages. These were seen as a solid anchor because of the “realness” of land and houses. An anchor if you will. What if the hypothetical NGDP futures market gets set up with the full backing of the fed. Is it too far fetched to think that debt swap instruments will then use that as their anchor? Not saying it’s good or bad, just a thought.
8. April 2013 at 05:13
Paul, No, I don’t consider 10% to be negligible. I was discussing the effects of changes in the monetary base. Changes are usually much smaller than 0.1% of the stock of T-securities.
dtoh, You said;
“OMP increases the immediate demand for financial assets (Fed is buying Treasuries).”
I view this effect as being unimportant. The effect of M-policy would be virtually identical if the Fed bought gold instead of T-securities.
You said;
“Because of higher real financial asset prices and/or increased expectations for higher NGDP, there is an increased exchange of financial assets for real goods and services, i.e. increased NGDP.”
It seems to me that people rarely exchange stocks for goods. And I can’t tell why you connect “real goods and services” with NGDP. Why not RGDP?
Im afraid that you are wrong about interest rates and V. Changes in interest rates have a very important impact on V, there are numerous academic studies that show this.
Daniel, Perhaps, but I doubt it. I don’t see why the private sector would have much interest in NGDP futures contracts.
8. April 2013 at 06:15
Scott
“OMP increases the immediate demand for financial assets (Fed is buying Treasuries).”
I view this effect as being unimportant. The effect of M-policy would be virtually identical if the Fed bought gold instead of T-securities.
I agree they can buy any asset. The Fed can buy any financial asset (store of value) including gold and it will move all financial asset prices in tandem as long as you’re measuring prices in a consistent manner (e.g. after tax risk adjusted real expected real returns).
However, I don’t think you can reject this effect as unimportant because
1) Relatively small changes in asset prices will have a large impact on the overall cost of capital. The example I gave of a corporation with $4k in cash and $40 million in debt is not at all atypical. To believe that a change in interest rates will effect their cash holdings more than it will impact the debt holdings makes no sense at all.
2) If you look at real prices, the change will generally be much larger than the change in the nominal price of the asset because of change in expected inflation. Take recent BOJ action. Nominal rates moves a few bp. But if the market now expects real inflation to rise from -1% to + 2%, that a dramatic change in the real prices of financial assets even though nominal prices have been relatively stable.
“Because of higher real financial asset prices and/or increased expectations for higher NGDP, there is an increased exchange of financial assets for real goods and services, i.e. increased NGDP.”
It seems to me that people rarely exchange stocks for goods.
Not stocks explicitly. Any financial asset. For example, a corporations could issue stock or an individual could sell share they own, but the more likely case is that a very liquid corporation would sell Treasuries it is holding. A more typical corporation would draw down on a line of credit or increase its issuance of CP. In the case of individuals, it might be a new auto or home loan or increase purchase on credit. When I talk about an exchange of financial assets, I’m not just talking about assets actually held. I’m talking about any decrease in financial assets held by the non-financial sector which could take the form of increased indebtedness as well as a reduction in financial asset actually held.
And I can’t tell why you connect “real goods and services” with NGDP. Why not RGDP?
Because increased demand for real goods and services will push up both the quantity purchased as well as the price.
Im afraid that you are wrong about interest rates and V. Changes in interest rates have a very important impact on V, there are numerous academic studies that show this.
I think you’re outdated on this. Read the recent stuff by Serletis and others. The correlation is small, declining and very path dependent. I don’t say there is no impact. I just think it is very small compared to everything else especially when nominal rates are very low.
8. April 2013 at 12:41
Scott,
You said:
“(It doesn’t occur because the Fed buys T-bills, the same effect would occur if they bought zinc. It’s the excess cash that creates the liquidity effect.)”
I said:
“There is a first order demand effect on the T-bills, followed by a second order liquidity effect on all assets including T-Bills. Are you saying that if a massive new buyer of zinc appeared on the market that the effect on the price of zinc would be equivalent to the effect on other asset prices?”
You said:
“Yes, zinc would be affected by Fed purchases, but not by Icelandic central bank purchases. But the T-bill market is so big that the direct effects of Fed OMPs can be essentially ignored if rates are positive. That is, the effect on T-bill yields is pretty much the same whether the Fed buys T-bills or Apple stock.”
I said:
“OK so you agree there is a demand effect, but you believe it’s negligible. Currently the Fed owns over 10% of the government debt on issue. So it seems you see 10% of the market as being negligible – is that right?”
You said:
“Paul, No, I don’t consider 10% to be negligible. I was discussing the effects of changes in the monetary base. Changes are usually much smaller than 0.1% of the stock of T-securities.”
You were actually discussing the effects of purchases of T-Bills – “It doesn’t occur because the Fed buys T-bills…”, one of which is a change in the monetary base.
In any asset market, a participant that has purchased more than 10% of the available stock has had a non-negligible effect on the price of the asset. It seems you disagree with this, is that correct?
8. April 2013 at 13:44
[…] Money and asset prices (the liquidity effect as an […]
8. April 2013 at 15:52
dtoh, When you say a corporation has $4 million in cash, what do you mean by cash? If not currency, then we are talking past each other.
You’ll have to send me the link to the study disproving a correlation between interest rates and V. I doubt it, as there are 1000s of studies showing a strong effect. And I mean 1000s. But let’s say I’m wrong. Why is it that when the Fed suddenly increases the monetary base, V falls in the short run? What mechanism do you see reducing V, if not lower short term rates?
Paul, You said;
“In any asset market, a participant that has purchased more than 10% of the available stock has had a non-negligible effect on the price of the asset. It seems you disagree with this, is that correct?”
The effect would be significant if the amount were purchased all at once, or sold all at once. But ordinary OMOs only affect a tiny percentage of that amount.
Suppose Bill Gates owned 10% of the world’s gold stock, but each day purchased and sold trivial amounts. Then those daily purchases and sales would have almost no impact on the value of gold.
8. April 2013 at 16:40
Scott,
“When you say a corporation has $4 million in cash, what do you mean by cash? If not currency, then we are talking past each other.”
I said $4 thousand not $4 million, and I mean base money (i.e. currency).
“You’ll have to send me the link to the study disproving a correlation between interest rates and V. I doubt it, as there are 1000s of studies showing a strong effect. And I mean 1000s. But let’s say I’m wrong. Why is it that when the Fed suddenly increases the monetary base, V falls in the short run? What mechanism do you see reducing V, if not lower short term rates?”
I’ll find the link and send it. I didn’t say there was no correlation. I said it was insignificant. My read of the recent work on this is that it the correlation is small and has fallen over the last 10 or 20 years.
As for a possible mechanism, let’s assume a steady state of spending (both consumption and investment) by businesses and individuals. If those spending plans suddenly change because of some unexpected event (i.e. Fed OMP), then I think it’s possible that businesses and consumers take advantage of the sudden bump in financial asset prices and will liquidate assets somewhat prematurely in advance of the actual expenditures and this will have the effect of slightly increasing their money holdings thus reducing V. I’m speculating here, but this does not seem inconsistent with actual behavior of businesses and individuals.
Again though I would go back to the example of a company that has $4k in money and $40 million in debt. Ask yourself… is a change in real interest rates going to have more impact on the amount of debt they hold or on the amount of money they hold?
8. April 2013 at 19:27
Scott,
“Suppose Bill Gates owned 10% of the world’s gold stock, but each day purchased and sold trivial amounts. Then those daily purchases and sales would have almost no impact on the value of gold.”
So in this scenario:
World 1: Bill Gates loves gold, buys it incrementally from 1980 to 2013 and now owns 10% of all gold.
World 2: Bill Gates is uninterested in gold and never buys any.
All other things being equal, you believe the difference in the price of gold in 2013 in World 1 is only negligibly higher than the price of gold in World 2. Is that correct?
8. April 2013 at 20:20
If I understand you correctly, you argue that the stock market is a good indicator for the current stance of monetary policy. Yet, stock market indices are historically somewhat lousy recession indicators. They indicate too many recessions than actually occured. Could you elaborate a bit more on this and explain this seeming contradiction?
9. April 2013 at 07:37
dtoh, I’m afraid I don’t follow that argument. I look forward to your link, as I’m confident V is highly response to i.
Paul, No, that’s not correct. I think you are missing the point. Economists think at the margin.
Fran, No, I don’t think the stock market is a good indicator of the stance of monetary policy. What might have confused you is that I do think a sudden change in monetary policy affects stock prices. But so do lots of other things.
Expected NGDP growth is the best indicator of the stance of stock prices.
9. April 2013 at 07:59
Scott,
You said:
“…the T-bill market is so big that the direct effects of Fed OMPs can be essentially ignored if rates are positive. That is, the effect on T-bill yields is pretty much the same whether the Fed buys T-bills or Apple stock.”
I said:
“OK so you agree there is a demand effect, but you believe it’s negligible. Currently the Fed owns over 10% of the government debt on issue. So it seems you see 10% of the market as being negligible – is that right?”
You said:
“Paul, No, I don’t consider 10% to be negligible. I was discussing the effects of changes in the monetary base. Changes are usually much smaller than 0.1% of the stock of T-securities.”
I said:
“You were actually discussing the effects of purchases of T-Bills – “It doesn’t occur because the Fed buys T-bills…”, one of which is a change in the monetary base. In any asset market, a participant that has purchased more than 10% of the available stock has had a non-negligible effect on the price of the asset. It seems you disagree with this, is that correct?”
You said:
“The effect would be significant if the amount were purchased all at once, or sold all at once. But ordinary OMOs only affect a tiny percentage of that amount. Suppose Bill Gates owned 10% of the world’s gold stock, but each day purchased and sold trivial amounts. Then those daily purchases and sales would have almost no impact on the value of gold.”
I said:
“So in this scenario: World 1: Bill Gates loves gold, buys it incrementally from 1980 to 2013 and now owns 10% of all gold. World 2: Bill Gates is uninterested in gold and never buys any. All other things being equal, you believe the price of gold in 2013 in World 1 is only negligibly higher than the price of gold in World 2. Is that correct?”
You said:
“Paul, No, that’s not correct. I think you are missing the point. Economists think at the margin.”
OK so you believe that the price of gold in World 1 is significantly higher than World 2. I agree. Thinking at the margin doesn’t affect this plain fact that we both agree on. If something changes incrementally at the margin many times over many years, the “trivial” effect accumulates and becomes significant.
Given that you agree that cumulative daily purchases of gold by Bill Gates over a long period, to reach 10% of the gold stock, would have a significant effect on the price of gold, it seems logical to conclude that you would also agree that cumulative incremental purchases of government bonds by the Fed over a long period, to the point where they now own over 10% of the stock of government bonds, has had a significant demand effect on government bond prices. Why does one not follow from the other? (keeping in mind that you introduced the analogy in order to demonstrate your point).
9. April 2013 at 09:59
Paul, You said;
“If something changes incrementally at the margin many times over many years, the “trivial” effect accumulates and becomes significant.”
I think this is misleading. If the government is steadily issuing more T-securities, and the Fed continues to hold about 15% of the total, as they have for many decades, then I don’t see much effect. In any case, the entire discussion started with my claim that policy initiatives had little direct effect on T-bill yields, I was not arguing that the existence of a monetary system had little effect.
9. April 2013 at 16:18
Scott,
We have agreed that there are 3 effects of T-Bill purchases:
1) Direct demand effect on the asset class purchased
2) Liquidity effect on everything
3) Inflation effect on all USD denominated instruments
You say that 1) is negligible.
You introduced the Bill Gates / Gold thought experiment to try to demonstrate this, but it turns out that in that thought experiment, the direct demand effect is significant.
However you still claim that the direct demand effect is negligible in the case of government debt.
You must at least believe then, on consideration, that the thought experiment is not applicable to the situation we are discussing. Is that fair?
10. April 2013 at 14:49
Scott,
The Fed is currently purchasing MBS at the rate of $40 billion per month. Between 2007 and today the Fed’s holdings of MBS has increased from zero to $1.1 trillion.
Would you agree that the direct demand effect of these purchases on MBS prices has been non-negligible?
11. April 2013 at 06:29
Scott,
You said above:
“If the government is steadily issuing more T-securities, and the Fed continues to hold about 15% of the total, as they have for many decades, then I don’t see much effect.”
To hold 15% of the total they must be purchasing on average 15% of all new supply. If Bill Gates bought 15% of the gold mined every year, don’t you think that would have a significant effect on the price of gold?
12. April 2013 at 05:50
Dr. Sumner:
“Geoff, OK, if the price level doesn’t exit, then I meant no long run impact on NGDP.”
That’s for one-time increases in the money supply, right?
Now suppose there are continuous increases in the money supply. In this case, we are always engaging in economic activity amidst short term effects of monetary policy, aren’t we? The real economy is being affected today by the short run effects of recent central bank activity, right? And the same was true yesterday and the day before, indeed going back 100 years. And it is almost certain that the real economy will be affected tomorrow and the next day, and next year, and maybe even 100 years from now, by the short run effects of central bank activity around those time periods, correct?
Given you agree with all of this, is it not an incomplete story of the economy as it is in the real world, to talk about the theoretical long run effects of a one time central bank action? I mean, we’re not living in such a world. We are living in a world of virtually constant and perpetual short run effects of central bank activity.
Should we not eliminate “long term neutrality of money” from the economics lexigon in a world with perpetual monetary policy that has us living with constant short run effects…over the long run?
Do you think that NGDP can be affected by both central bank activity and real activity that has itself been affected by past central bank activity?
20. April 2013 at 03:01
Slack monetary policy can raise house prices such that households spend say 50% of after tax income on mortgage repayments rather than 10% or whatever. Doesn’t that simply depress the economy? Perhaps with stock prices the effect is more of a transient bubble and crash and as you say long term stock prices stay much the same but to me it just looks like causing mis-allocation and waste rather than building productive capacity and prosperity. With commodity prices it seems even more of a case that slack monetary policy translates purely into increased price volatility. That can be a catastrophe; price signals become totally obscured and we get gluts, famines and mal-investment.