Commenter Joseph sent me an excellent set of PP slides by a professor at Harvard named Chris Foote.  He has a very clear derivation of the AD curve from the IS-LM model.  This slide caught my attention.

The “spending hypothesis” obviously cannot explain the Great Depression.  In 1987 we saw an equally big stock market crash, and GDP kept booming.  (And don’t bother trying to concoct excuses about how things were different in 1987—I’ve swatted them all down 100 times.)

An investment backlash? Does that mean people switch from investment goods to consumer goods? If so, why did consumption also fall?  

Hoover actually favored public works projects, so fiscal policy explains nothing until at least 1932, when he raised taxes.   Was there a Great Depression in 2013?  I don’t think so.  And yet we had “savage” austerity in 2013.

OK, so it was tight money.  We’ve known that for 50 years, ever since Friedman and Schwartz. What interests me is the suggestion that the “money hypothesis” is contradicted by various stylized facts. Interest rates fell.  The real quantity of money rose.  In fact, these two stylized facts are exactly what you’d expect from tight money.  The fact that they seem to contradict the tight money hypothesis does not reflect poorly on the tight money hypothesis, but rather the IS-LM model that says tight money leads to a smaller level of real cash balances and a higher level of interest rates.

To see the absurdity of IS-LM, just consider a monetary policy shock that no one could question—hyperinflation.  Wheelbarrows full of billion mark currency notes. Can we all agree that that would be “easy money?”  Good.  We also know that hyperinflation leads to extremely high interest rates and extremely low real cash balances, just the opposite of the prediction of the IS-LM model.  In contrast, Milton Friedman would tell you that really tight money leads to low interest rates and large real cash balances, exactly what we do see.

Note the very last comment on the slide, about the significance of deflation.  The rest of the PP slides develop this idea further, and correctly show that while tight money might raise real interest rates, it could lower nominal rates through the Fisher effect.  Thus it could shift the IS curve.  That helps, but it seems to suggest that the IS-LM model can be rescued by switching the argument from nominal to real interest rates. Alas, that won’t work.  The Fisher effect is only one of the ways that monetary shocks impact interest rates.  Tight money also reduces expected future real GDP, and this also shifts the IS curve.  So it isn’t just nominal interest rates that fall, real rates also fell during the 1930s, as expected future real GDP plunged.  The IS-LM model is useless, and should be discarded.  The fact that it is used to derive the AD curve probably explains why I can’t seem to understand how Keynesians use the concept of AD; they are basing it on ideas that make no sense to me.

Here’s a simpler model.  AD is a hyperbola (a given level of NGDP).  This model does not assume NGDP targeting, just as the current AD model does not assume money supply targeting.  Changes in NGDP are caused by monetary policy.  The P/Y split for changes in NGDP is determined by the slopes of the SRAS and LRAS curves.  The LRAS curve is vertical.  Interest rates?  Yeah, they fluctuate a lot.

BTW, the PP slides end up with an excellent Greg Mankiw post from December 2008.  Mankiw recommends the Fed commit to a price level 30% higher in 10 years time.  Had they done so the recession would certainly have been much milder.

On the other hand if Mankiw had been head of the Fed in December 2008 they would have done almost exactly what they did under Bernanke, not what Mankiw recommended in 2008.  Mankiw’s policy views are pretty similar to Bernanke’s views.  Unfortunately there is also the formidable “FedBorg.” Had Mankiw been in charge, it would have been Bernanke who wrote the blog post suggesting the Fed should commit to a 30% higher price level in 10 years.  We are all just puppets, filling out the roles determined for us by blind fate.

Off topic:  Ramesh Ponnuru is right, I see lots of interest in NGDPLT among conservatives.

I have a post on AD over at Econlog, for those not burned out on the issue.

Just to show you that MMs don’t agree on everything, David Beckworth has a excellent post arguing against the Great Stagnation hypothesis.  Marcus Nunes is also skeptical.  In contrast, I accept the Great Stagnation hypothesis.  Fortunately it doesn’t matter for our monetary policy views, as we all favor targeting NGDP and ignoring RGDP.

What does “aggregate demand” mean?

And why am I asking this question after using the phrase about 1000 times over the past 5 years in this blog?  Shouldn’t I have found out before I started using the term?  Perhaps I was too embarrassed to admit my ignorance.  But now that the esteemed macroeconomist Chris House has admitted a similar uncertainty, I’m less embarrassed:

. . .  I admit that I don’t have a particularly clear definition of what we really mean by “aggregate demand.”  I think often this is meant to capture changes in consumer sentiment, fluctuations in government demand for goods and services or other incentives to purchase market goods – incentives which would include tax subsidies, monetary stimulus, … etc.

I do have a very clear idea as to what I think the profession should mean by AD—nominal GDP. And I’ve seen the AD curve drawn as a rectangular hyperbola in a few textbooks (although the number is gradually diminishing.  But it’s clear that most people don’t agree with me.  So what do they think AD is?

On some occasions people discuss AD as if it’s a real concept.  Changes in the real quantity of goods and services purchased by consumers, investors, governments, and (in net terms) foreigners.  But that can’t be AD, as it would imply that all changes in RGDP were caused by shifts in AD.  After all, all purchases are also sales, so the total aggregate quantity supplied equals the total aggregate quantity demanded.

In the textbooks AD is a downward sloping line in P/Y space, which is not generally assumed to be unit elastic.  That means when AS shifts, NGDP may also change.  But why does NGDP change? What is held constant along a given AD curve?  Presumably a given AD curve is supposed to be holding constant things like monetary and fiscal policy, animal spirits, consumer sentiment, etc.

But that raises another question; what is monetary policy?  If the profession is not too clear about AD, they are completely mixed up about monetary policy.  Indeed even elite macroeconomists have such wildly varying definitions of monetary policy that in any given monetary situation (such as the early 1930s—with ultra-low interest rates and lots of QE), one set of respected macroeconomists will claim policy is ultra-tight (Friedman, Bernanke, Mishkin, etc) while another (even larger) set of economists will claim policy is ultra-accommodative (because interest rates were really low and there was lots of QE.)  So it doesn’t much help to say we are holding monetary policy constant along an AD curve, as no one seems to have a clue as to what the term ‘monetary policy’ actually means.

Hence my bleg.  Can anyone give a short concise definition of AD?  One that I can understand.  Not the definition I’d prefer (a given level of nominal spending), but rather the definition that other economists have in their heads.  I mean other than House and myself, who seem to lack any clear understanding.

PS.  I looked at Wikipedia, but it was no help.  They suggest AD = C + I + G + NX.  But that’s simply GDP.  In that case doesn’t AS also equal GDP?  So how is that definition useful?  Surely AD means more than “GDP?”

Maybe the issue can be resolved by figuring out whether Wikipedia means real GDP or nominal GDP.  Nope:

These four major parts, which can be stated in either ‘nominal’ or ‘real’ terms.

So if a student asks us if AD means RGDP or NGDP we tell them either one is fine?  Even in Zimbabwe, where RGDP plunged by double digits as NGDP rose a zillion-fold?  Wikipedia continues:

Sometimes, especially in textbooks, “aggregate demand” refers to an entire demand curve that looks like that in a typical Marshallian supply and demand diagram. Thus, that we could refer to an “aggregate quantity demanded” (Y^d = C + I_p + G + NX in real or inflation-corrected terms) at any given aggregate average price level (such as the GDP deflator), P.

So not only is it not clear whether AD means real GDP or nominal GDP, it’s not even clear whether it means the entire demand curve or a point along the demand curve.

Now I’m even more confused.  I suppose that people will tell me that it doesn’t matter because when economists like Paul Krugman talk about AD, other economists know what he is talking about.  And yet I suspect Chris House and I are more the rule than the exception.  Even worse, as with the stance of monetary policy, the biggest problem with AD is not that economists don’t have a consensus definition, but that they don’t even realize that they lack a consensus definition.  Thus when I talk about how the Fed’s “tight money” policy caused AD to plunge in 2009, other economists aren’t able to disagree with me, because they don’t even know what I am talking about. “What tight money policy?”

When I watch from the sidelines, it seems like Paul Krugman makes his points in Portuguese, and John Cochrane responds in Norwegian.  Neither understands the other, so they each assume the other side is clueless.

PPS.  And didn’t Krugman once argue that the AD curve might currently be upward sloping?  Now I’m really confused!

Tony Yates has a fairly extensive discussion of his views on market monetarism.  Before dissecting on the specifics, a few general comments:

1.  It’s hard for an outsider to grasp the nuances of any macro framework.  God knows I’ve been criticized for misstating the views of Austrians, MMTers, Keynesians, and many other groups. Yates does better than most.

2.  The views expressed here are my own, and as Nick Rowe indicated in the comment section to Yates’s post, market monetarism is a set of views that share a family resemblance (as is true of Keynesianism, Austrianism, etc.)  Nick’s comments are well worth reading.

So the following will sound more negative than I actually intended.  Let’s go over Yates’s points one at a time.  He starts by listing 10 tenets of market monetarism (these are not his views on policy, but rather his interpretation of our views):

1.  Monetary policy is never ineffective at stabilising inflation or the real economy, even at the zero bound.

Nope.  Monetary policy may be unable to stabilize the economy when there are real shocks. Monetary policy is pretty good at stabilizing the economy when the instability is due to a combination of sticky nominal wages and fluctuating nominal spending.

2.  Fiscal policy is ineffective [at, see above…] always.

Nope.  Fiscal policy can work in many different ways.  If the central bank is targeting inflation (including indirect taxes) then fiscal policy can boost employment if the government reduces VAT taxes, or employer-side payroll taxes.  Under a fixed exchange rate regime the government can boost output with more spending on goods and services.  The US in 1940-41.  My point was that if the central bank is targeting something like “aggregate demand” (as it should), then it’s silly for fiscal policymakers to attempt to influence “aggregate demand.”  That doesn’t mean that certain government projects might not become more desirable at low real interest rates, for standard classical cost/benefit reasons.

3.  Fiscal policy is effective [at…], but not desirable.

I mostly agree, with the caveat of the final sentence in my previous comment.  I do understand that fiscal and monetary policy are not identical, and hence one can construct models with a role for both.  But I don’t find those models persuasive.  To call fiscal policy a “blunt instrument” would be an understatement.

4.  Those New Keynesian models omit to model money, and so don’t capture why monetary policy is effective.

Yes and no.  I happen to think that omitting money makes it harder to see the importance of monetary policy.  However on purely theoretical grounds any story told with changes in the supply and demand for money can also be told with a description of the future path of interest rates relative to the future path of the Wicksellian equilibrium interest rate.  But I could also create models where the key variable was the difference between the actual price of zinc, and the Wicksellian equilibrium price of zinc (where the latter term is defined as the nominal zinc price consistent with 5% NGDP growth.) How do we know of the price of zinc is above the Wicksellian equilibrium price of zinc?  Simple, if NGDP growth is above target.

5.  If you look at New Keynesian models carefully, they show that monetary policy is effective, even at the ZLB, which demonstrates why it, and not fiscal policy, should be used for stabilisation purposes always.

I think it’s more accurate to say that those models allow for the effectiveness of monetary policy at the zero bound.  You can graft onto the NK models something like Krugman’s “promise to be irresponsible.”  Or Lars Svensson’s “foolproof plan” for escaping a liquidity trap.  Of course it’s also possible to construct NK models with expectations traps that do not allow for effective monetary policy.  I don’t accept the assumptions that underlie those pessimistic versions of the model.

6.  Unlike in NK models, monetary policy isn’t just about OMOs, or even buying long dated government securities.  Expansions of the money supply can be used to buy all sorts of assets.

Yes and no.  I certainly don’t believe that developed countries would need to buy non-government securities to hit a reasonable target, such as 4% or 5% NGDP growth, level targeting.  But my deeper objection is that NKs frame the ineffectiveness issue backwards.  They start by asking what the central bank can do at the zero bound, when they should start by asking why we are at the zero bound.  More specifically, imagine a “do whatever it takes” central bank that keeps buying assets until inflation or NGDP growth expectations are on target.  What then?  This reframes the debate in a way that focuses on the real “zero bound” problem, the zero bound on the availability of eligible assets for the central bank to buy.  When framed this way it becomes apparent that the zero bound on interest rates is not the real issue, as a central bank could theoretically run out of eligible assets even at positive rates.

For example, a few years ago the Australian national debt had fallen close to zero.  Nominal interest rates were positive.  Now let’s suppose that the RBA were only allowed to buy Australian government debt.  That constraint would make monetary policy ineffective.  And it would have nothing to do with the zero bound on interest rates, which were (and are) positive in Australia.

Now consider a country at the zero bound like the US.  Suppose that the Fed committed to unlimited “QE” in order to raise NGDP growth expectations up to the old 5% trend line.  They committed to buy T-securities until there were no more, then agency securities until those were exhausted, then Germany, Japanese, Canadian, British, etc., government bonds until those were exhausted, then AAA corporate bonds until those were exhausted, etc., etc.  Is that monetary policy effective?  It’s effective if the Fed can create expectations of sufficiently fast NGDP growth before running out of eligible assets.  Thus the real zero bound problem is not zero interest rates, but the possibility that the Fed might be legally prevented from buying assets that it needed to buy in order to satisfy the public’s demand for base money when NGDP growth is on target.

NKs tend to assume that since the Fed’s balance sheet has ballooned from 6% of GDP to over 20%, a still higher number would be needed if they had adopted a 5% NGDPLT policy in 2008.  Actually just the opposite is true.  With that 5% NGDPLT policy, we never would have hit the zero bound, and hence our monetary base/GDP ratio would be much lower (as is the case in Australia–which never hit the zero bound.)  NKs are monetary policy pessimists because they see interest rates as the lever of policy, whereas it’s more useful to think of them as the outcome of the policy regime.  Yes, NKs are correct that there is a liquidity effect and that easy money today is likely to lead to lower short-term interest rates today.  But as Woodford points out easy money today is not at policy at all; a policy is a change in the expected future path of monetary policy from today to the end of time.  It’s a policy regime.  And an expansionary policy by that criterion may well raise nominal interest rates.

7.  Societies should adopt nominal GDP targeting.

8.  [And/or] It follows from some combination of 1-6 that societies should adopt some form of nominal GDP targeting.

That’s basically right, although I certainly don’t think NGDP targeting is precisely optimal, just a good, pragmatic, easy to understand target that is superior to IT.  I’d prefer something like a nominal total labor compensation target, especially for countries like Kuwait where NGDP can be distorted by commodity price shocks.

9.  The crisis was caused by inflation targeting.  Following a MM perspective, including a nominal GDP target, would have averted it.

Yes and no, there were many causes.  If the Fed had adopted a “target the forecast” approach in their meeting after Lehman failed, monetary policy would have become dramatically more expansionary and the recession would have been significantly milder.  Ditto for replacing an inflation target with a price level target.  But I believe NGDPLT would have been better yet.

10.  Fiscal policy is ineffective away from the ZLB because it prompts an offsetting monetary policy response.

See my response to points 2 and 3.  Note that Yates ignores the “market” part of market monetarism.

A few general remarks:

1.  I accept the fact that it will never be possible to write down a macro model with microfoundations where NGDP targeting is optimal.  However, I also believe that we don’t know enough about the relative importance of price and wage rigidity, or the relative importance of various types of price rigidity, to construct useful models of that sort.

2. It’s a fair criticism of MM to point out that we don’t have much in the way of either sophisticated theoretical models or empirical studies to support our claims.  Like Keynes (1936) we rely heavily on a combination of basic economic models (AS/AD for me, where AD is a hyperbola), stylized facts that are highly suggestive, criticism of alternative approaches, and logic.  If someone bothered to write down the MM model (at least my version of it), the model would be as simplistic as the Keynesian cross.

3.  The real innovation of MM is that we’ve suggested that mainstream economists are thinking about the issues in the wrong way, and we have done so using many concepts that have come from those very same mainstream economists.  I tend to endlessly bore my readers with quotes from famous respected economists who used to claim that low interest rates don’t mean easy money, or that monetary policy remains highly effective at the zero bound.  In late 2008 these mainstream views were abandoned by the profession (including the famous economists I quote), for all the wrong reasons. For example, many economists simply misread the events in Japan (1993-2012) and become pessimistic about monetary policy.  A great deal of MM is simply reminding the profession that if the BOJ does what it did in fact do in 2013, that policy will be effective.  Ditto for the Swiss policy adopted a couple years earlier.

4.  Speaking for myself, I view MM partly as a sort of Deirdre McCloskey-like critique of modern macro methodology.  Milton Friedman (my hero) was famous for not having a well-defined “model.” Or for thinking in partial equilibrium terms.  His best ideas were not his “monetarist” ideas such as the 4% rule, but rather his critique of Keynesianism (low rates aren’t easy money, permanent income hypothesis, natural rate hypothesis, etc.) In my view MM is most effective as a critique of mainstream macro since 2008, and least effective when promoting NGDP targeting.

HT:  Ben Southwood.

There are many theories of why people are willing to hold fiat money without any explicit backing. One theory that I’ve never been very fond of is that the ability to pay taxes with cash is what gives fiat money value.  This caught my attention:

DENVER (AP) — A marijuana business in Colorado has filed a lawsuit against the Internal Revenue Service for assessing a penalty for paying taxes in cash.

The IRS charges a 10 percent penalty on cash payments for federal employee withholding taxes. But many marijuana businesses are forced to pay taxes in cash because of difficulty accessing banking services

Thus it seems like taxes are one of the very few things that you cannot pay for in cash, at least not without a sizable penalty.  

Let´s apply the “Piketty 5% rule” to the City of Detroit.  More specifically, their art wealth:

DETROIT “” A city-commissioned report on Detroit’s fine-art collection released Wednesday pegs its entire value between $2.8 billion and $4.6 billion, a sharp increase over a previous estimate that could create a headache for the city in bankruptcy court.

Some creditors pushing the city to sell or lease its world-class art collection argue that the city previously lowballed the artwork by valuing only a slice of the collection at the Detroit Institute of Arts.

With the comprehensive estimate by Artvest Partners many times the earlier estimate of up to $867 million, the battle over Detroit art could play a big role in a trial on the city’s debt-cutting plan to be held next month.

On Wednesday, Detroit’s emergency manager who represents the city in its municipal bankruptcy case said the report wouldn’t change his support to keep the city-owned collection intact and transfer ownership to a nonprofit separate from the city. His office also noted that selling off the entire collection immediately would only yield a fraction of the overall valuation, according to the report.

“The report makes it abundantly clear that selling art to settle debt will not generate the kind of revenue the City’s creditors claim it will,” Bill Nowling, spokesman for Detroit Emergency Manager Kevyn Orr, said in a statement Wednesday.

Abundantly clear?  Only to people who have already made up their minds. Imagine how much billionaires in places like New York and LA would pay for that collection.  Imagine how much the Getty Foundation would pay.  And 5% of $3.7 billion is $185 million a year, the annual income that (according to Piketty) could be generated by the midpoint of the Detroit art wealth estimate. What else could be done in Detroit for $185 million/year, forever?

When individuals have expensive art collections they are viewed as being “rich.”  When the City of Detroit has a lot of this sort of wealth most pundits let the city get away with pleading poverty.  The paintings suddenly don´t “count.”

Is anyone surprised by this?  Is wealth inequality really about wealth inequality?  Or is it about power and envy?

PS.  Should Detroit be contemplating giving away $3.7 billion in wealth?

PPS.  Detroit could sell a handful of the most valuable paintings for $1 billion and keep the museum mostly intact.

PPPS.  TravisV sent me a good Paul Krugman post on interest rates.  Of course this is also the market monetarist view.