A simple model of monetary policy and interest rates

This comment caught my eye:

I think it’s easier for most people (especially laymen) to understand how central banks affect interest rates than it is to understand the mechanics of the money supply and other aspects of monetary policy.

You could probably count on one hand the number of laymen who understand how monetary policy affects interest rates. Suppose you asked an average person how the Fed affects interest rates. What might they say?

Most people would have no idea how to answer this question. Better educated people would attempt an answer, but they would almost certainly be wrong. Consider some plausible explanations:

1. Changing the discount rate? Nope.

2. Changing the interest rate on reserves? OK, but how does that affect market rates? They might cite some sort of arbitrage condition. But from 1913 to 2008 the IOR in America was set at zero, and yet market rates were often well above zero. So that can’t be the entire explanation.

3. Pumping money into the economy? OK, but why would that affect interest rates? They might point to supply and demand. More supply of money means a lower price of money, with the implicit assumption being that interest rates are the price of money. But interest rates are not the price of money; they are the price of credit, and (throughout most of US history) interest rates tend to be higher when money growth rates are higher. Thus money growth sped up in the 1960s and 1970s and interest rates rose sharply. Indeed interest rates rose sharply because money growth sped up (leading to higher inflation.)

Here’s a simple model of money and interest rates:

i = IRG + NRI

That is, market interest rates = interest rate gap + natural rate of interest

The natural rate of interest can be defined in multiple ways, but is usually assumed to represent the risk free short-term interest rate that is consistent with some sort of macroeconomic equilibrium. For simplicity, let’s assume macroeconomic equilibrium occurs when NGDP is consistent with the public’s previous expectations. Even that’s a bit vague, as it raises the question, “Expectations formed at what time?” But it’s a reasonable approximation of what we mean by the concept.

In this model, monetary policy affects interest rates in two ways. Policy affects the natural rate of interest (NRI) and it affects the interest rate gap (IRG). Thus in the long run, a monetary policy that raises the trend rate of NGDP growth from 4%/year to 14%/year will tend to boost the NRI by 10 percentage points. You can call this aspect of policy the “NeoFisherian effect” although it includes both the (real) income and inflation effects.

The other part of policy is the liquidity effect. Because NGDP is slow to respond to changes in the supply and demand for money, policy shocks move the market interest rate away from the natural rate in the short run, producing an interest rate gap.

I cannot emphasize enough that every single monetary policy action influences both the IRG and the NRI; it’s just a question of how much. Furthermore, most actions (not all) push these two rates in the opposite direction. And the liquidity effect has more of an impact on short-term rates, whereas the NeoFisherian effect usually has more impact on medium and longer-term rates.

Imagine asking a layman to explain all this.

Open market purchases raise the supply of base money, creating disequilibrium (excess money supply) at the previous level of interest rates and NGDP. Because NGDP is slow to adjust, short-term interest rates immediately decline to induce the public and banks to hold larger cash balances.

A reduction in IOR reduces the demand for base money, creating disequilibrium (excess money supply) at the previous level of interest rates and NGDP. Because NGDP is slow to adjust, short-term interest rates immediately decline to induce banks to hold existing cash (i.e. reserve) balances.

It is less clear how these actions affect future expected short-term rates; the answer depends on how they influence the future expected path of NGDP, which in turn depends on the impact on the future expected path of policy.

Imagine asking a layman to explain all this!

In general, interest rate gaps move the natural interest rate in the opposite direction. Creating a positive IRG nudges the NRI downward. And in the medium to longer-term, the natural interest rate has more impact on market interest rates than does the interest rate gap. This is what Nick Rowe means when he uses the analogy that monetary policy is like riding a bike where you turn the wheel to the left when you want to go right, and vice versa. If you want lower rates in the long run, you nudge short-term rates higher, and vice versa. Usually.

Imagine asking a layman (or MMTer) to explain all this!!

In some cases (such as Switzerland in January 2015), a cut in the policy rate is associated with the natural interest rate falling, because it is associated with other signals that lead people to expect a more contractionary policy stance going forward. (Signals such as allowing a large upward appreciation in the franc’s exchange rate.)

Imagine asking a layman to explain all this!!!

Before trying to teach students how monetary policy affects interest rates, we should start with something easier, like quantum mechanics.

Treat CPTPP as an opportunity

This caught my eye:

China has applied to join an Asia-Pacific trade pact once pushed by the U.S. as a way to isolate Beijing and solidify American dominance in the region.

The country submitted a formal application letter to join the deal, known officially as the Comprehensive and Progressive Agreement for Trans-Pacific Partnership, according to a statement late Thursday in Beijing.

This is great news. China should be welcomed into the CPTPP if it agrees to adhere to all of their rules (currently it does not.) There should be a provision that no CPTPPP member is allowed to impose economic sanctions on another member in response to any sort of “free speech” in any member country. Today, China retaliates against speech that it opposes in other countries. If China wants to join under those conditions, then let it in. We should encourage any agreement that makes China less nationalistic, less of a rogue nation. (Ditto for the US.)

A number of members of Congress have been calling for the U.S. to either rejoin the CPTPP or to be more active on trade diplomacy in the region. However, the Biden administration hasn’t announced any concrete trade policies for the region, although there are reports it’s discussing a digital trade deal covering Asia-Pacific economies. 

“The future of technology, trade and defense is either going to be led by the Chinese Communist Party or by the United States and our allies,” U.S. Senator Ben Sasse said in response to the news. “If China sees the value in building alliances across the Pacific, why can’t the United States? Let’s get back into a position of leadership instead of retreat.”

Ben Sasse is correct. (He’s one of the few members of the GOP who has not entirely caved in to Trumpism.) And yet I’m not optimistic. I predicted that Biden would be a lousy president, and so far I’ve been right. (Although he’s still 100 times better than Trump.)

BTW, the WaPo has a good article on how our misguided cold war with China is leading to the arrest of lots of Chinese-American scientists on trumped up charges of “spying”.

Did Covid originate in Laos?

Here’s Bloomberg:

Bats dwelling in limestone caves in northern Laos were found to carry coronaviruses that share a key feature with SARS-CoV-2, moving scientists closer to pinpointing the cause of Covid-19.

Researchers at France’s Pasteur Institute and the University of Laos looked for viruses similar to the one that causes Covid among hundreds of horseshoe bats. They found three with closely matched receptor binding domains — the part of the coronavirus’s spike protein used to bind to human ACE-2, the enzyme it targets to cause an infection.

The finding, reported in a paper released Friday that’s under consideration for publication by a Nature journal, shows that viruses closely related to SARS-CoV-2 exist in nature, including in several Rhinolophus, or horseshoe bat, species. The research supports the hypothesis that the pandemic began from a spillover of a bat-borne virus. . . .

The three viruses found in Laos, dubbed BANAL-52, BANAL-103, and BANAL-236, are “the closest ancestors of SARS-CoV-2 known to date,” said Marc Eloit, head of pathogen discovery at the Pasteur Institute in Paris, and co-authors. “These viruses may have contributed to SARS-CoV-2’s origin and may intrinsically pose a future risk of direct transmission to humans.” 

Note that this newly discovered virus is still significantly different from SARS-CoV-2. But the finding is still important, as the receptor binding domains (RBDs) are pretty similar, and some lab leak proponents had argued that the SARS-CoV-2 RBD was suspicious and likely a product of “gain of function” research.

Discount code for my new book

I received this information:

Customers can get a 20% discount (bringing the price to $28 before shipping) when they purchase the book from press.uchicago.edu and enter the code SUMNER20 at checkout. I have that set to run through the end of the year.

Not sure if that’s the best deal, but I thought I’d put it out there.

Also, I did a podcast with Larry White where I discussed the book. It was just released.

I also have a new column at The Hill.

Trevor Chow on machetes and scalpels

Trevor Chow has a long post that provides one of the best summaries of macroeconomics that I have ever read. Highly recommended. Another great post demystifies the money creation process—essential reading for helping people recover from MMT.

Here I’d like to respond to a different Chow post, however, one that looks at the following question:

Can monetary policy control the path of nominal GDP? I have no idea anymore and am wildly confused, so this is an attempt to tell a few just-so stories and see how they land.

Disclaimer: This is wildly wildly wildly speculative, especially story E.

Chow presents 5 options, one of which expresses my preferred view:

Story C

1. The Fed is the monopoly supplier of base money

2.The value of base money is defined as its the purchasing power/exchange rate

3. The Fed can set the value of base money in terms of assets i.e. 1/price of assets

4. The Fed can set the price of assets

5. NGDP depends on the price of assets

6. The Fed can set nGDP

This is a Market Monetarist story and it adds some details to the Old Monetarist hot potato story. Empirically, the entire literature on the Quantity Theory (think McCandless and Weber etc.) suggests that central banks can control nominal quantities.

Then Chow challenges the theory:

But Trevor, central banks don’t actually do this. I have no doubt that if a central bank went about buying everything it could get its hands on by printing money, their prices would get bid up. But the fact that a massive increase in base money would raise nominal quantities does not mean central banks can control nGDP on a meaningful level under its ordinary practices. The ability to wield a machete is no evidence that one can utilise a scalpel.

This is a question I frequently get asked, and I have two related responses:

1. Massive increases in the monetary base (Japan, Switzerland, etc.) are not policies I am trying to get enacted; rather they are policies that I am trying to avoid. The thought experiment about a “whatever it takes” approach to money creation is aimed at convincing skeptics that monetary policy is capable of raising nominal aggregates as high as you like. I hope and believe that my preferred policy would result in less base money creation than actual real world central banks have generated in developed countries.

My claim confuses people because they assume that if we’ve done X% money creation and fallen short of our nominal targets, then we’d have to do more than an X% increase to hit the target. Actually, the demand for base money as a share of GDP is inversely related to the trend rate of NGDP growth. A commitment to do whatever it takes to achieve higher NGDP growth rates actually allows us to do less than otherwise, if credible.

2. Chow would probably say he understands all of that, but still is concerned about the machete/scalpel issue. How do we calibrate the whatever it takes approach? How do we avoid overshooting? How do we make policy a scalpel, not a machete?

The key is to target a variable that responds in real time to monetary policy. That might be an asset price. For instance, the Singapore central bank targets exchange rates. They set the exchange rate at the level expected to lead to macroeconomic equilibrium. No one worries about a zero lower bound for exchange rates. In a perfect world, I’d have the Fed target NGDP futures prices.

In the imperfect world that we live in, I’d have the Fed target its internal forecast of NGDP or the price level, and then construct a real time internal forecast that is a weighted average of asset market prices and model-based forecasts. And that’s roughly what the Fed actually does, at least when policy isn’t hamstrung by an unwillingness to do “whatever it takes”. Fed VP Richard Clarida recently stated that his forecasts combine market and non-market forecasts:

Market- and survey-based estimates of expected inflation are correlated, but, again, when there is divergence between the two, I place at least as much weight on the survey evidence as on the market-derived estimates.

Thus imagine a forecast that is 50% TIPS spreads and 50% model-based inflation forecasts. That hybrid forecast will respond in real time to changes in monetary policy. Do whatever it takes to keep that forecast on target.

PS. If you are having trouble understanding how the Bank of Japan can achieve much higher inflation, it helps to use the following two questions to pinpoint where your skepticism lies:

  1. Do you believe the Bank of Japan would be unable to peg the yen at 1000yen/US$, as compared to the current 110 rate?
  2. Or do you believe that an exchange rate of 1000 yen to the dollar would fail to create lots of inflation?

And if central banks are unable to peg nominal exchange rates, then how did Bretton Woods work?

PPS. Actually, the machete/scalpel issue is a much bigger problem for fiscal policy, which comes in huge discrete chunks despite wide disagreement as to the size (or stability) of the fiscal multiplier.

HT: Basil Halperin


Clarida, Richard.  “Models, Markets, and Monetary Policy.”  In Strategies for Monetary Policy.  Edited by John Cochrane and John Taylor.  2020.  Hoover Institute Press.