Money/macro needs to go back to basics
Imagine an island with 100,000 people who are all self-employed. They produce 43 commodities, such as food, clothing and shelter, and exchange the commodities with each other. There is no financial system and obviously there is 0% unemployment—how could a self-employed person be unemployed? To avoid the inconvenience of barter, they adopt some form of money—it might be silver coins or it might be a crate of Monopoly money that washed up on the beach.
How do we model the price level? Certainly not with interest rates or a Phillips curve! There are no interest rates and there is no unemployment.
It’s easiest to start with NGDP, and then work backwards to prices. Suppose people prefer to hold 12.5% of their annual output/income in the form of money balances. That 12.5% represents the inverse of velocity (i.e. 1/V). In that case, V will be 8 and NGDP will be 8 times the money supply. Thus if the money supply is $1 billion, then NGDP will be $8 billion, or $80,000 per person. Now let’s model the rate of inflation:
Inflation equals NGDP growth minus RGDP growth
NGDP growth will be growth in the money supply plus growth in velocity. RGDP growth is determined by non-monetary factors. There’s your basic model of inflation in the simple island economy.
Now let me immediately acknowledge that the real world is very complicated, and this makes it hard to model V. Workers are usually not self-employed–they work for companies and have sticky wages. Labor markets don’t always clear. There are also financial markets, and the nominal interest rate can have a big impact on velocity (especially at the zero bound). But no matter how important these extra factors, they are still basically epiphenomena—the core of monetary economics is all about shifts in the supply and demand for money—it has nothing to do with the Phillips Curve or the liquidity effect from interest rate changes. Call the supply and demand transmission mechanism in my simple model, “Mechanism X”. That’s still the core transmission mechanism in our modern economy; it doesn’t go away just because you add sticky wages and interest rates. It’s just harder to see.
Where did modern macro go wrong? Perhaps when they made these liquidity effect/Phillips curve epiphenomena into the center of their models of the transmission mechanism. We don’t need Phillips curves or interest rates to explain why more supply of peaches and/or less demand for peaches reduces the relative value of peaches, nor do we need Phillips Curves or interest rates to explain why more money supply and/or less money demand reduces the relative value of money. We need to go back to basics.
Matthew Klein has a good article in the FT, pointing to the fact that modern macroeconomists are floundering around, unable to explain recent trends in inflation. He begins by quoting Olivier Blanchard, who states the conventional New Keynesian view:
I have absolutely no doubt that if you keep interest rates very low for long enough the unemployment rate will go to 3.5, then 3, then 2.5, and I promise you at some point that you will have the rate of inflation that you want.
-Former International Monetary Fund Chief Economist Olivier Blanchard
Japan has kept rates very low for a very long time, and still has low inflation. Their unemployment rate is only 2.8%. Sorry, but interest rates and the Phillips curve are not reliable models of inflation.
Now of course these elite NKs are very smart guys, and they did not develop these models for no reason at all. In the short run an easy money policy often (not always) leads to lower short-term interest rates. But over longer periods of time it often leads to higher nominal interest rates. The point here is that it’s the easy money policy that matters, not the interest rates. An easy money policy will lead to higher inflation regardless of when whether it causes lower or higher interest rates. The easy money policy of 1965-81 led to both higher interest rates and higher inflation. Switzerland’s tight money policy of January 2015 led to lower inflation and lower interest rates–even in the short run. (Yes, the NeoFisherians are occasionally correct.)
The same is true of the Phillips curve. It worked OK for many years, especially under the gold standard. The Phillips curve still “works” in places like Hong Kong. A low rate of unemployment is indeed often associated with higher inflation. But it did not work during the 1970s in America, when unemployment and inflation rose at the same time, or in the last few years when inflation has stayed low despite unemployment falling to 4.2%. And that’s because it’s not the core transmission mechanism for inflation, the core mechanism is the supply and demand for money. Changes in inflation may or may not be related to interest rates or unemployment, but they are always related to what’s going on with the supply and demand for money.
Unfortunately, this confusion has led Blanchard’s opponents to go even further off base:
Blanchard was prompted to recite his faith in the power of the Phillips Curve by former Fed governor Jeremy Stein, who wondered how central banks were supposed to raise their inflation target to 4 per cent when they are still undershooting the current target of 2 per cent. Blanchard seemed to think the answer was easy: keep rates low, unemployment will fall, and inflation will necessarily accelerate.
Larry Summers — Blanchard’s co-host at the conference and co-author of one of the papers — found this hopelessly inadequate. He pointed to Japan’s long experience with full employment, large government budget deficits, aggressive monetary expansion…and total price stability. If they haven’t managed to get inflation, how could anyone? Blanchard had no answer but to repeat his catechism.
This literally makes me want to pull my hair out. Indeed Stein’s argument is not even logical. Suppose someone were halfway between Baltimore and DC, driving south, and the passenger said “What makes you think you’d be capable of driving this car to New York, when you haven’t even reached Baltimore”. My response would be “Umm, I’m not trying to reach Baltimore. If I wanted to reach New York I’d turn around and drive north. I’m driving south.” My response to Stein would be to point out that if the Fed wanted higher inflation it would not be raising interest rates with the publicly expressed purpose of holding inflation down. Rightly or wrongly, the Fed believes that if it raises interest rates it will achieve 2% inflation, and if it does not raise them then inflation will overshoot 2%. They may be wrong, but this has nothing to do with monetary policy being impotent. It’s a question of whether they are steering in the right direction.
I could have also responded, “I have decades of experience driving cars, I’m pretty sure I’m capable of driving this car to New York.”
I’m not sure if people realize just how radical 2% trend inflation is. If you had told Keynes that central banks could target inflation at 2% in the long run he would have laughed—he would have regard you as a fool. Throughout almost all of human history the long-term trend rate of inflation was either near-zero (commodity money) or wildly gyrating (German hyperinflation, post-Bretton Woods “Great Inflation”, etc.) Then around 1990 the Fed started trying to stabilize inflation at about 2%. Since that time, inflation has averaged about 1.9%, amazingly close to 2%. This isn’t some sort of weird miracle; it’s happened because the Fed controls the long-term trend rate of inflation.
If the Fed wants 4% trend inflation, they’d go back to Volcker’s policy from 1982-90, when inflation averaged 4%. This is not rocket science; other countries have also been able to target inflation.
Japan can’t create inflation? Really? What if they devalued the yen from 112 to the dollar to 600 to the dollar? No inflation? Then what about 6000 yen to the dollar?
Inflation is always and everywhere a money supply and demand phenomenon. (I prefer that to Friedman’s, “Persistent inflation is always and everywhere a money supply phenomenon.” Which is basically what he meant in the quote often attributed to him)
HT: Caroline Baum
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19. October 2017 at 10:05
From an admittedly low base (my PhD was on designing technology prizes) this article has doubled my understanding of current monetary thinking.
19. October 2017 at 11:16
This is a very good post. Very clear.
19. October 2017 at 11:41
“… the core mechanism is the supply and demand for money.”
OK, in situations where supply of money is fixed, excess money supply leads to inflation. But in a situation where central bank provides people with the liquidity they demand, things can’t go this way.
On the other hand, I think Blanchard is correct to say that when the labor market is tight, it must lead to an increase in nominal wage (that’s supply and demand for workers), and that increase in nominal wage makes firms increase their prices.
This couldn’t work for long if money supply was limited, but it’s not.
19. October 2017 at 11:51
+1 on the previous two commenters. The macro equations are gold and somehow not talked about nearly enough.
19. October 2017 at 12:11
“It’s easiest to start with NGDP”
Taking the easy way out doesn’t help anyone. You need to start with individual human action, NOT aggregates, for it misleads and continues to mislead Sumner.
19. October 2017 at 12:13
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>Hillary is demanding to know the truth about Trump and Russia. The truth is that every accusation about Russian ties that Hillary and her associates have hurled at President Trump is really true of the Clintons.
You all have been deceived by the deep state, again.
19. October 2017 at 12:18
Why is there no interest rate in your example? I don’t see how it flows from the assumptions
19. October 2017 at 12:30
Since 1990 we have also had two massive bubbles, a sharp rise in inequality, a sharp fall in productivity, an outbreak of political volatility, etc.
So while we I agree we are able to target inflation to some degree; how we do it, what costs it imposes, and how we respond to those costs, are much more important questions which I rarely see addressed.
The Fed may “target” itself right out of existence if it doesn’t a have a more comprehensive view of inflation-targeting within a society.
19. October 2017 at 15:03
Antoine, No, higher wages do not generally cause higher inflation. Indeed when there is a dramatic change in monetary policy (1920, 1929-30, 1937, 2008, etc) inflation moves before wages.
Mffa, I assume there is no financial sector, no loans.
Effem, I agree that the Fed should not target inflation. I’m just saying they can do so if they wish to.
19. October 2017 at 15:40
This is one of your best posts. Fantastic explanation.
You say “To avoid the inconvenience of barter, they adopt some form of money—it might be silver coins or it might be a crate of Monopoly money that washed up on the beach.”
When you say “they”, do you mean the island government?
Since there is no financial system (no sticky debt contracts) and everyone is self-employed (no sticky wages), would swings in demand for money and the resulting inflation/deflation matter at all?
19. October 2017 at 17:08
I have been waiting for this post, poking at this debate in your comment sections for a while. I like the reasoning from thought experiment.
I’m not sure that I’m entirely satisfied with the answer, although it could be mostly a question of semantics, of small tweaks in use of words when trying to appropriately describe some kind of predictive model of the situation.
It’s true that an absolute “high” or “low” level of interest rate or unemployment doesn’t tell you much. However, this feels like a bit of a straw man. As you often mention yourself, rates relative to an assumed else equal natural rate, or what I think you economists like to call “wicksellian” equilibrium usually allows the use of the word “interest” with a more predictive interpretation. Even when we don’t know the natural rates.
>”the core of monetary economics is all about shifts in the supply and demand for money”
Aren’t interest rates important market indicators of the expected paths of these shifts? How else are you going to quantify them?
It may be difficult to model V, and there is definitely a danger to get into overfitting territory but isn’t it still useful to think of the relative causal importance of different intermediate transmission channels? Sure hot potato effects may encompass all these but it’s difficult to put numbers on the pressures that push and counter-push on M,V,P,Q without looking at interest rates. Markets between financial players, businesses, borrowers, investor, all use them. Why not tap into that data to try to paint a more precise picture? Why not get into the details to try to asses which pressures are more important in which situations, instead of limiting ourselves to a vague image of money burning people’s fingers causing them to throw it away?
I may be missing something but it’s hard for me to see that this intangible “Mechanism X” represents a deeper truth when all these players are using interest rates to quantify things.
19. October 2017 at 17:24
Weill, I agree with this post but…
I wonder if there are times in macroeconomics that structural impediments and institutional imperfections undercut even solid monetary theories so much that…you have to prominently ponder the impediments and imperfections.
If Americans started following a religion that requires six days of prayer in a seven-day week, GDP and NGDP would go down, no matter monetary policy. We might get high inflation or deflation–and monetarists would be screeching about how to fight inflation or deflation
Monetarists would become useless in trying to get real GDP back to where it was. Indeed, most monetarists would call for tighter money, probably making matters worse (but not Scott Sumner or George Selgin).
We may be somewhat in this situation today. There are huge issues with property zoning, offshore banking, criminalization of push-cart vending, international capital flows, and immigration that make a mockery of theories, certainly when it comes to real living standards in many urban areas, including some in the US.
Example: Hong Kong has the world’s least affordable housing. In a tribute to the ossified myopia that is modern macroeconomics, Hong Kong is repeatedly hailed as the world’s freest economy. So we are to believe that free enterprise leads to unaffordable housing, a situation getting worse every year.
Of course, Hong Kong is not free. A propertied-financial class restricts property development.
Hong Kong is pondering tighter money (credit restrictions) to fight property inflation.
If foreign capital (mainland money) flows into Hong Kong, boosting properly values and the stock market, should the Hong Kong Monetary Authority fight asset bubbles?
Market Monetarists are on the right track, but even within this group there seems to be too much concern with inflation, rather than real growth, given the circumstances. Err on the side of growth, dudes.
Final note: Was Milton Friedman right in that, “Persistent inflation is always and everywhere a money supply phenomenon.”
Well, probably not. Suppose a large nation has a growing population but increasingly tight property zoning? It this case you could get inflation as measured for decades upon decades, even with money tight enough to suffocate or slow general growth. Is this “persistent” inflation? Yes. Was this inflation caused by money supply? No, it was caused by tight property zoning.
Structural impediments can make a hash of theories.
19. October 2017 at 18:29
Not that Blanchard is claiming this, but there’s more than one way of thinking of can’t, regarding inflation and monetary policy. Monetary policy can always cause inflation, but does that mean that a specific central bank can set the monetary policy required to cause said inflation? Maybe the market doesn’t find them believable in the long term, or they lack the political stomach to do it.
My son is deathly afraid of butterflies. He could touch a butterfly, or just sit quietly in a butterfly house, if he didn’t have an unwanted emotional response that makes the act impossible for him, no matter how much he might be ashamed of his phobia, and might want to beat it. So from that perspective ‘can’ is not a simple, binary definition.
From the perspective of third parties, including the market, something being physically impossible, and something having a one in a million chances of happening because the will to not do it is unbendable, are not at all different.
When the next crisis happens, and it will, can the US generate 3.5% inflation using monetary policy? I say not, and not because the fed lacks the tools to do it: You might as well ask an Orthodox Jew to cook and eat a porkchop during sabbath.
19. October 2017 at 20:43
I find it odd when you describe Jeremy Stein’s question this way. My interpretation is that he is questioning the validity of Philips Curve without approving the current interest rate policy.
I mean, we all know he is one of the strongest proponent of maintaining large balance sheet of the Fed. True, he is also one of the proponent of using monetary policy to achieve financial stability and this might possibly make him a figure in support for early rate hike.
But I don’t think he is approving the current monetary policy framework. I think he is one of those who think it is best to get an alternative framework that is better than the Philips Curve regime…
19. October 2017 at 23:13
‘No, higher wages do not generally cause higher inflation. Indeed when there is a dramatic change in monetary policy (1920, 1929-30, 1937, 2008, etc) inflation moves before wages.’
You reverse the question here. Wage Setting equations include both inflation and the tightness of labor market. My point is: if 1- unemployment is very low and 2- you are in a framework where fed supplies people with the money they want, then you have low U -> W up -> inflation up
20. October 2017 at 00:30
“The rate of interest – the price of money {sic} – is said to be a key policy tool. Economics has in general emphasised prices. This theoretical bias results from the axiomatic-deductive methodology centring on equilibrium. Without equilibrium, quantity constraints are more important than prices in determining market outcomes. In disequilibrium, interest rates should be far less useful as policy variable, and economics should be more concerned with quantities (including resource constraints). To investigate, we test the received belief that lower interest rates result in higher growth and higher rates result in lower growth. Examining the relationship between 3-month and 10-year benchmark rates and nominal GDP growth over half a century in four of the five largest economies we find that interest rates follow GDP growth and are consistently positively correlated with growth. If policy-makers really aimed at setting rates consistent with a recovery, they would need to raisethem. We conclude that conventional monetary policy as operated by central banks for the past half-century is fundamentally flawed. Policy-makers had better focus on the quantity variables that cause growth.”
http://www.sciencedirect.com/science/article/pii/S0921800916307510
20. October 2017 at 03:05
All this blah-blah about wages is illustrative of how ossified macroeconomics has become.
As Kevin Erdmann has noted the CPI core minus shelter is hardly showing any inflation, less than 1% a year.
Yet house prices are soaring, not just in parts of US but in many global cities. When do the inflation-obsessed become concerned with housing costs—or is that not PC? Housing costs are driving inflation, not wages.
Yet always the foot must be placed on labor, not on the propertied-financial class. Seems a little convenient, no?
Why not lower housing costs though widescale elimination of property zoning?
20. October 2017 at 03:11
Scott,
Inflation is driven by expectations of the balance of supply and demand for goods and services. If there is no expectation of an imbalance, it doesn’t matter how much money there is, you won’t create inflation, you will only reduce velocity.
A lower unemployment rate (U3) used to be a good indicator (and cause) of possible supply shortages presaging an imbalance in the supply and demand for good and services. It’s no longer such a good indicator for a number of reasons.
1. Reduced LFPR
2. Increased competition and available supply of goods and services from foreign suppliers
3. Reduced labor input in total factor productivity.
4. Technological and organizational changes which allow more rapid increases in the production of goods and services.
20. October 2017 at 08:04
Thanks Negation, No, they would not matter very much.
Benoit, You said:
“Aren’t interest rates important market indicators of the expected paths of these shifts? How else are you going to quantify them?”
No, interest rates are not a reliable indicator. NGDP futures prices are far superior.
Bob, Can’t? You could say the same thing about every policy that is not adopted. Policies seem infeasible until they are adopted, then they don’t. Why even read blogs if you are so defeatist?
I could say the exact same thing about your preferred policy.
Cloud, Do you have any evidence that he would have voted against rate increases? I believe he would have voted for them.
I also question the validity of the Phillips curve, but that has nothing to do with the question of whether the Fed can raise inflation to 4% (which Stein thought might be impossible for the Fed to achieve.)
Antoine, I don’t understand your point. Rather than seeing U affecting W, I think W affects U.
dtoh, You said:
“Inflation is driven by expectations of the balance of supply and demand for goods and services. If there is no expectation of an imbalance, it doesn’t matter how much money there is, you won’t create inflation, you will only reduce velocity.”
I disagree. Consider a currency reform. The money supply changes dramatically, the price level changes dramatically, but there is no imbalance between the supply and demand for goods.
In my island economy example there is no product or labor market disequilibrium, and yet more money creates inflation.
20. October 2017 at 09:26
‘“The rate of interest – the price of money….”‘
Talk about getting off on the wrong foot!
20. October 2017 at 12:49
How is the Phillips curve still taught in economics classes? The Phillips is busted. Has been busted for long time. Yet regularly I hear how low unemployment will cause high inflation.
It is past time to dispense with a wrong theory.
20. October 2017 at 21:44
“Throughout almost all of human history the long-term trend rate of inflation was either near-zero (commodity money) or wildly gyrating (German hyperinflation, post-Bretton Woods “Great Inflation”, etc.) Then around 1990 the Fed started trying to stabilize inflation at about 2%. Since that time, inflation has averaged about 1.9%, amazingly close to 2%. ”
Except, of course, the price revolution from the late C15th to mid C17th. Which was caused by the massive increase in silver production accessible to the European/Atlantic economy, first from expanded Central European & Swedish production (due to vacuum pumps lead-silver smelting) and then from the Americas.
In preceding monetary surges, folk tended to hoard (i.e. increase in k, at least in bullion terms) precisely because of the expectation of long run price stability. (Gresham’s law can be thought of as stock-of-bullion maintenance.) But the flow of silver from the mid C15th on so outstripped increases in output (it is estimated that Central European silver production quintupled) that P increased. Though not at high annual rates (actually, less than 2%pa but if that continues for two centuries, then the compound effect is very significant) but very different from the preceding long-run stability. And prices did not increase enough for a straight quantity effect — clearly output also increased, as did alternate uses of silver.
22. October 2017 at 09:02
PART 1 RESPONCE:”And that’s because it’s not the core transmission mechanism for inflation, the core mechanism is the supply and demand for money. ” ””I’m not sure if people realize just how radical 2% trend inflation is. If you had told Keynes that central banks could target inflation at 2% in the long run he would have laughed—he would have regard you as a fool. Throughout almost all of human history the long-term trend rate of inflation was either near-zero (commodity money) or wildly gyrating (German hyperinflation, post-Bretton Woods “Great Inflation”, etc.) Then around 1990 the Fed started trying to stabilize inflation at about 2%. Since that time, inflation has averaged about 1.9%, amazingly close to 2%. This isn’t some sort of weird miracle; it’s happened because the Fed controls the long-term trend rate of inflation.
If the Fed wants 4% trend inflation, they’d go back to Volcker’s policy from 1982-90, when inflation averaged 4%. This is not rocket science; other countries have also been able to target inflation.
Japan can’t create inflation? Really? What if they devalued the yen from 112 to the dollar to 600 to the dollar? No inflation? Then what about 6000 yen to the dollar?
Inflation is always and everywhere a money supply and demand phenomenon. (I prefer that to Friedman’s, “Persistent inflation is always and everywhere a money supply phenomenon.” Which is basically what he meant in the quote often attributed to him)”’ ””It’s easiest to start with NGDP, and then work backwards to prices. Suppose people prefer to hold 12.5% of their annual output/income in the form of money balances. That 12.5% represents the inverse of velocity (i.e. 1/V). In that case, V will be 8 and NGDP will be 8 times the money supply. Thus if the money supply is $1 billion, then NGDP will be $8 billion, or $80,000 per person. Now let’s model the rate of inflation:
Inflation equals NGDP growth minus RGDP growth
NGDP growth will be growth in the money supply plus growth in velocity. RGDP growth is determined by non-monetary factors. There’s your basic model of inflation in the simple island economy.
Now let me immediately acknowledge that the real world is very complicated, and this makes it hard to model V. Workers are usually not self-employed–they work for companies and have sticky wages. Labor markets don’t always clear. There are also financial markets, and the nominal interest rate can have a big impact on velocity (especially at the zero bound). But no matter how important these extra factors, they are still basically epiphenomena—the core of monetary economics is all about shifts in the supply and demand for money—it has nothing to do with the Phillips Curve or the liquidity effect from interest rate changes. Call the supply and demand transmission mechanism in my simple model, “Mechanism X”. That’s still the core transmission mechanism in our modern economy; it doesn’t go away just because you add sticky wages and interest rates. It’s just harder to see.” MANY PROBLEMS WITH THAT POST first off the phillips curve was non linear and it was atrade off with real wages it holded short term to medium term and it was one part of the classical wage curve also your core mechanism for inflation is an empirically incorrect explanation for stagflation look at the following charts https://cdn.discordapp.com/attachments/354440227999186945/371664024309334018/money-supplies-vs-inflation_1.jpg , https://cdn.discordapp.com/attachments/354440227999186945/371664079959490587/C-xPYZsXkAAteo3.jpg , https://cdn.discordapp.com/attachments/354440227999186945/371663926783508480/philkington.png , https://cdn.discordapp.com/attachments/354440227999186945/371664012343115776/yvYa19lr.jpg FISRT OFF empirically most of the cpi during stgflation was decomposed by unit labour costs and oil price meaning cost pus inflation the cpi during that time had no correlation beetwen the monetary aggregates so your cre mechanism just isnt there also inflation directly followed and correlated with capacity utilisation which followed the profit share and profit rate so inflation was mostly a profit squeeze,over capacity phenomenon not a demand pull or monetary inflation phenomenon at all now lets go to the equation ”Inflation equals NGDP growth minus RGDP growth
NGDP growth will be growth in the money supply plus growth in velocity. RGDP growth is determined by non-monetary factors. There’s your basic model of inflation in the simple island economy.”
22. October 2017 at 09:03
PART 2 RESPONCE ”the core of monetary economics is all about shifts in the supply and demand for money—it has nothing to do with the Phillips Curve or the liquidity effect from interest rate changes. Call the supply and demand transmission mechanism in my simple model, “Mechanism X”” its fascinating how these two statements can be contradictory to one another for example What is the limit to the real growth rate is the maximum growth rate the profit rate ala von neumann,L. pasinetti.IS it the natural growth rate which is the growth rate consistent with normal capcity utilisation long term and inflation happens by how actual capcity adjusts to normal capacity longterm.IS it the reserve army of albour cause the wage share rises faster than the profit share and real wages faster than productivity ala goodwin.IS it the modified cambridge equation after the passinetti theorem which is that ”(3.1) shows that the share of profitsin total output depends positively on the natural rate of growth and the capital/output ratio and negatively on the propensity to save of the capitalist class. The second of these relations, (3.2), better known as the “Cambridge equation”, shows that the profit rate is solely determined by the ratio of the natural rate of growth and the propensity to save of capitalists.” but in the short term with a short run stability condition of Sc-Sw>0 and long run Sc>0 where Sc is the propensity of capitalists to save and Sw is the propensity of workers to save .Is it the balance of payments equillibrium growth rate which is the growth rate consistent with balance of payments equillibrium long term ala Thirlwall’s Law. is it the robinsonian stability condition ,the kaleckian stability condition the kaldorian stability condition ect ect in all of these cases THE CORE MECHANISM ISNT THE DEMAND AND SUPPLY OF MONEY PLUS THE EXTERNAL FACTORS in these cases which are far more empirically correct than the monetarist case presented it is the balance of payments,profitability,capcity utilisation,capitalists propensity to save ect ect the core mechanism which determines the limit to the real growth rate is diffrent by the context so you can use the inflationary gap equation which he talks about first presented by keynes btw for litearrly anything infact that equation is consistent even with the phillips curve since full employment is the limit to the real growth rate in that case BTW AS A SIDE NOT THE PHILLIPS CURVE AS PRESENTED BY PHILLIPS WAS NON LINEAR THAT IS IT HOLD SHORT TERM MEDIUM TERM NOT LONG TERM THAT WAS NEVER DISPUTED what friedman disputed was a linear phillips curve witha trade off with money wages in his NAIRU paper so if the phillips curve is just one part of the classical curve then it is empirically correct just not long run https://scontent-mxp1-1.xx.fbcdn.net/v/t34.0-12/22751842_1777133405693131_980190904_n.jpg?oh=6baf04bc4ff2b117bbf68e189adf0214&oe=59EFBB03 . NOW about japan ist obvious that the reason inflation targetting has failed in japan is due to the private debt overhung since the 80s which is BY OFFICIAL OECD DATA NOT THE RANDOM CHARTS ON THE GOGGLE PAGE 270 to 231.06 Aas precenatge of gdp http://stats.oecd.org/index.aspx?queryid=34814 that resulted of course to zombie firms ,stgnation,falling real wages or frozen real wages if you look at the general trend since the 80s ,low investment ,low nominal demand growth japan has also done abenomics and has greatly increased its level of public debt and negative intrest rates ,QE inflation targetting,all of them failed due to the deflationary pressure of the private debt overhung plus the secular declines that larry summers points out in his theory of secular stagnation revised from hansen and stanley fischer.
22. October 2017 at 09:03
PART 3 RESPONCE ALSO ABOUT INFLATION TARGETTING under endogenous money loans create depositss the central bank does not controll the money supply and there fore awlays misses its target ”However, after Brunner “demonstrated” that the central bank could easily offset any
instability of the deposit multiplier (through slightly larger adjustments of aggregate
reserves) in 1968 (and this was later confirmed in Balbach, 1982), the argument that the
government might not be able to control the money supply virtually disappeared from the
literature. Furthermore, rational expectations effectively eliminated any discussion of use
of monetary policy for short run fine-tuning. Thus, by the late 1970s, orthodoxy reached
a consensus that monetary policy should be focused on control of the money supply in
order to control inflation.
This culminated in the disastrous Volcker experiment in the USA (replicated in
the UK) in which the Fed tried to target reserves in order to hit monetary growth rate
targets. (See Fazzari and Minsky 1984) Leaving aside the various (real) economic
problems created by this policy, the most surprising thing for orthodox economists was
that a) any correlation between money growth and inflation disappeared (or, worse,
turned negative), and b) the Fed consistently missed its targets. While Friedman (1984)
wrote an interesting post mortem article claiming that the Fed simply had not tried hard
enough to hit targets, in practice, after the debacle the Fed first tried experimenting with
alternative definitions of money, but by the end of the 1980s simply abandoned any
pretense of targeting monetary aggregates. (Papadimitriou and Wray 1996) More
importantly, orthodox economists reluctantly came to the conclusion that money growth
and inflation are not reliably linked in any manner that allows for policy formulation. The
implication of all this is that during the 1990s monetary policy in much of the world was
shifted away from attempts to control money growth and toward direct control of
inflation. While orthodoxy had no plausible explanation regarding the link between
monetary policy and inflation (indeed, there was little attempt made to explain precisely
which tools government might use to affect inflation), most orthodox economists came to
believe that monetary policy directly sets the inflation rate, without growth of the money
supply playing any intermediary link. ”R.wray this has been also been admitted by fried man himself that targettig a quantity of money and having inflation targetting ala taylor rule is a bad way to go ”This vitiated the use of monetary aggregates as an
instrument of policy control. At the Bank of England Charles Goodhart stated his law: when
you try to use an econometric relationship for purposes of policy control, it changes. Friedman
himself conceded to the Financial Times in 2003: “The use of quantity of money as a target has
not been a success. I’m not sure I would as of today push it as hard as I once did.”james k. galbraith http://utip.lbj.utexas.edu/papers/CollapseofMonetarismdelivered.pdf ”Friedman even recommended replacing the Fed with a computer that would mechanically manage the money supply regardless of the economy’s state. Furthermore, he suggested the Fed aim for a zero nominal interest rate. If the equilibrium real interest rate is three percent, that policy implies steady deflation of three percent.
These monetarist propositions reflect a flawed understanding of money. Money is a form of credit – an IOU. If central banks try to control the narrow money supply, the private sector just moves to create other forms of credit. That is why the Fed was unsuccessful in targeting the money supply, and why predicating economic policy on the relationship between the money supply and economic activity is a will o’ the wisp.”thomas pailley http://www.thomaspalley.com/?p=59 SIDENOTE WHEN I REFER TO ENDOGENOUS MONEY i dont mean intermediattion of lonable funds ala hicksian banking,tobin,gurley and shaw,friedman i refer to endogenosu money as loand creating deposist with looking for resrves late or not looking for reserves at ll since most banks have a very low resrve requiremnt ledning more than they get back in repayments and issuing a deposit on the promise to pay back the lona loans create depsit also banks are not shadow banks which all they do is money market funding of capital market lending that is just financial intemediattion they dont create any money http://eprints.uwe.ac.uk/28552/1/1602.pdf , http://voxeu.org/article/banks-are-not-loanable-funds-intermediaries-macroeconomic-implications , http://www.sciencedirect.com/science/article/pii/S1057521914001434 , http://www.sciencedirect.com/science/article/pii/S1057521914001070 < , http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf , https://www.bundesbank.de/Redaktion/EN/Topics/2017/2017_04_25_how_money_is_created.html
22. October 2017 at 09:15
PART 1 :”And that’s because it’s not the core transmission mechanism for inflation, the core mechanism is the supply and demand for money. ” ””I’m not sure if people realize just how radical 2% trend inflation is. If you had told Keynes that central banks could target inflation at 2% in the long run he would have laughed—he would have regard you as a fool. Throughout almost all of human history the long-term trend rate of inflation was either near-zero (commodity money) or wildly gyrating (German hyperinflation, post-Bretton Woods “Great Inflation”, etc.) Then around 1990 the Fed started trying to stabilize inflation at about 2%. Since that time, inflation has averaged about 1.9%, amazingly close to 2%. This isn’t some sort of weird miracle; it’s happened because the Fed controls the long-term trend rate of inflation.
If the Fed wants 4% trend inflation, they’d go back to Volcker’s policy from 1982-90, when inflation averaged 4%. This is not rocket science; other countries have also been able to target inflation.
Japan can’t create inflation? Really? What if they devalued the yen from 112 to the dollar to 600 to the dollar? No inflation? Then what about 6000 yen to the dollar?
Inflation is always and everywhere a money supply and demand phenomenon. (I prefer that to Friedman’s, “Persistent inflation is always and everywhere a money supply phenomenon.” Which is basically what he meant in the quote often attributed to him)”’ ””It’s easiest to start with NGDP, and then work backwards to prices. Suppose people prefer to hold 12.5% of their annual output/income in the form of money balances. That 12.5% represents the inverse of velocity (i.e. 1/V). In that case, V will be 8 and NGDP will be 8 times the money supply. Thus if the money supply is $1 billion, then NGDP will be $8 billion, or $80,000 per person. Now let’s model the rate of inflation:
Inflation equals NGDP growth minus RGDP growth
NGDP growth will be growth in the money supply plus growth in velocity. RGDP growth is determined by non-monetary factors. There’s your basic model of inflation in the simple island economy.
Now let me immediately acknowledge that the real world is very complicated, and this makes it hard to model V. Workers are usually not self-employed–they work for companies and have sticky wages. Labor markets don’t always clear. There are also financial markets, and the nominal interest rate can have a big impact on velocity (especially at the zero bound). But no matter how important these extra factors, they are still basically epiphenomena—the core of monetary economics is all about shifts in the supply and demand for money—it has nothing to do with the Phillips Curve or the liquidity effect from interest rate changes. Call the supply and demand transmission mechanism in my simple model, “Mechanism X”. That’s still the core transmission mechanism in our modern economy; it doesn’t go away just because you add sticky wages and interest rates. It’s just harder to see.” MANY PROBLEMS WITH THAT POST first off the phillips curve was non linear and it was atrade off with real wages it holded short term to medium term and it was one part of the classical wage curve also your core mechanism for inflation is an empirically incorrect explanation for stagflation look at the following charts https://cdn.discordapp.com/attachments/354440227999186945/371664024309334018/money-supplies-vs-inflation_1.jpg … , https://cdn.discordapp.com/attachments/354440227999186945/371664079959490587/C-xPYZsXkAAteo3.jpg … , https://cdn.discordapp.com/attachments/354440227999186945/371663926783508480/philkington.png … , https://cdn.discordapp.com/attachments/354440227999186945/371664012343115776/yvYa19lr.jpg … FISRT OFF empirically most of the cpi during stgflation was decomposed by unit labour costs and oil price meaning cost pus inflation the cpi during that time had no correlation beetwen the monetary aggregates so your cre mechanism just isnt there also inflation directly followed and correlated with capacity utilisation which followed the profit share and profit rate so inflation was mostly a profit squeeze,over capacity phenomenon not a demand pull or monetary inflation phenomenon at all now lets go to the equation ”Inflation equals NGDP growth minus RGDP growth
NGDP growth will be growth in the money supply plus growth in velocity. RGDP growth is determined by non-monetary factors. There’s your basic model of inflation in the simple island economy.”
23. October 2017 at 08:01
Lorenzo, Good point, although I doubt it had much impact on output.
23. October 2017 at 12:56
But ever since Volcker failed to target monetary aggregrates, markets realized the Fed would always provide the quantity of base money necessary to meet payment needs. Essentially, the supply of money is infinite (or perfectly inelastic?); it’s the price that matters – the price set by the monopoly issuer. An easy money policy is one in which markets expect the price of base money to be lower than the expected return on investment. Flooding banks with excess reserves won’t change a thing either; the expected path of rates is what matters whether there are excess reserves or not.
26. October 2017 at 07:55
Jared, I disagree with everything you. And when you use the term “price of money” you need to define it. I hope to God you don’t mean interest rates, because those are not the price of money.
28. October 2017 at 07:59
Education requested – isn’t the supply of money related to “the liquidity effect from interest rate changes”, I thought interest rate changes affected the supply of money?
I really enjoy your blog!
31. October 2017 at 11:33
I mean the price of renting base money (apologies for using a linguistic shortcut), or that which it costs a bank, expressed as a percentage, to access funds to meet liquidity needs. The FFR rate is the key rental price that happens to influence the rental prices of other sources of funds.
Do you disagree that the Fed would supply (prior to 2008) the amount of reserves demanded by commercial banks? Of course, I’ve never verified this myself, but I recall this was the position of the former head of the Trading Desk at the NY Fed. On a daily basis, they would conduct purchases and sales to add or subtract reserves to ensure just the right amount for clearing and reserve requirement purposes so the FFR would maintain steady at the target rate. If I understand those operations correctly, in the short run, the central bank would supply whatever quantity of reserves the market required. But the CB sets the rental price of those reserves (liquidity effects were minimal at best), which would affect the long run quantity.
What exactly do you disagree with?