# A short course in monetary theory

[Finally spring break!  I will do the Depression piece this weekend, but I am doing this first, as I hope it will give people a better idea of where I am coming from.  To non-economists, it may seem weird and off-topic at first, to economists it may seem simplistic and off-topic, but bear with me, there is a method to my madness.]

Lesson 1.   Nominal GDP measured in apples:

Before playing tennis, you are supposed to stretch your muscles (although I never do), so this is a mental stretching exercise to help you see monetary theory differently.  Let’s take a good with a roughly unit elastic demand, pretend it is apples.  I want to estimate nominal GDP measured in apple terms, and see what happens to that total after a big harvest.

Now suppose that initially the price of apples is 50 cents a pound, and then after a harvest twice as big as normal the price falls to 25 cents a pound.  In that case if we used apples as our “medium of account,” or what monetary theorists call our “numeraire,” then our \$14 trillion dollar GDP would start at 28 trillion pounds of apples, and then quickly double to 56 trillion pounds of apples.

Now let’s consider how the big apple harvest “caused” nominal GDP in apple terms to soar.  Did it do so by reducing interest rates?  By making consumers more confident?  By boosting the animal spirits of investors?  By spurring banks to lend more?  (Here’s where I have probably lost half my readers already.)  OK, it is a silly example.  I agree.  But it is also useful to think about exactly why it is silly.

Perhaps it is silly because apples are not the medium of exchange.  Money is a medium of exchange, and so I am not doing “monetary theory” here at all.  Maybe I am really doing microeconomics, or “price theory,”  which is the theory of relative prices.  But I don’t agree.   Consider, the antebellum free banking era.  I believe the U.S. was on a metallic standard (whether it was gold, silver or bimetallic, I don’t recall.  But it doesn’t matter.)  Let’s say it was silver.  Make it simple and assume the “dollar” was an ounce of silver.  I also read that the media of exchange were private banknotes of dubious quality, and that shops would post sheets listing the discount on each note based on the perceived soundness of each bank.  (Good to know we’ve moved beyond that era of reckless banking!)

Now I’m sure I’ve oversimplified and that many of the notes traded at par, but what if none had?  The wildcat banking era shows that the media of exchange and the medium of account need not be the same.  And if they weren’t, which one was really “money”?  Many would say the medium of exchange.  But monetary theory says otherwise, all our models of inflation are based on the notion that prices are denominated in a medium of account (which is now Federal Reserve notes, and in 1929 was 1/20.67 oz. of gold.)  Monetary theories are theories of the value of the medium of account.  Thus in my example the price level is going to be exactly the inverse of the value (or purchasing power) of silver, not dodgy banknotes.

Returning to the apple example, where apples are assumed to be the medium of account for the sake of argument, what makes the doubling of the apple supply seem so different from doubling the supply of FR notes?  I think there is really only one plausible answer–nominal rigidity.  There are two types of nominal rigidities that matter:

1.  Nominal debt

2.  Wage and price stickiness

The first is less important, as although it leads to wealth being redistributed under unanticipated inflation, ex post those are sunk costs and benefits and hence normally have little direct impact on output.  The second type of stickiness changes behavior at the margin, and is widely viewed as contributing to the business cycle, especially unemployment fluctuations.

OK, so your intuition that the apple example was fishy is right, but maybe for the wrong reason.  Before we move on, however, we need to consider one more problem.  Wages and prices are not sticky forever, and thus the apple example, believe it or not, is actually a good analogy for the long run effects of monetary policy, for the classical model.  So I wasn’t completely joking with my sarcastic questions about what roles do interest rates and bank lending play in the doubling of NGDP in apple terms.  They play no role.  And I believe they also play no role in the long run effect of monetary policy, although that is more debatable.

Here’s where the mind stretching comes in.  It seems to me that most people approach solutions for the problem of raising our \$14 trillion dollar NGDP up to \$15 trillion, like they are viewing an almost insurmountable task.  Atlas with the world on his shoulders.  The metaphor that I think is actually more apt is a drunk standing next to a pillowbed. How hard is it to just flop down?  That’s the challenge our monetary policymakers normally face if they wish to raise NGDP.  Just debase the currency.

Later we will consider whether, and how much, a liquidity trap makes their job harder.  But unless you have a sense of why it is normally so easy to raise NGDP, even in an economy beset by all sorts of real problems that are unrelated to liquidity traps, then I am afraid we cannot have a meeting of minds, a productive conversation.  Raising NGDP?  What we are talking about is basically just debasing the currency (except NGDP includes both prices and real output.)

So don’t provide me with any argument that an expansionary monetary policy cannot work, that is not somehow tied to the liquidity trap.  Housing market is overextended?  Businesses don’t want to invest because sales are weak?  Exports falling because of a worldwide drop in demand?  Credit market risk spreads are high?  Those are often true in non-liquidity trap recessions, where monetary policymakers are perfectly capable of debasing the currency.

Lesson 2.  Humean Monetary Theory, 1752-1968:

Hume developed much of the macro that we teach to our EC101 students.  Later we will see that there is something interesting about the endpoint of Humean macro, as 1968 is both the date it was replaced by another model, and (not entirely coincidentally) the date it stopped working.

Hume did the obvious thought experiments that many of us do in class; “what if a helicopter suddenly dropped lots of cash on a kingdom, and doubled the money supply.” (Well, without the helicopter.)  I don’t think he needed any data to come up with an answer.  Common sense was enough, and Hume had plenty of that.  (Although since he was a student of history I presume he also got his model through “data mining.”)

But Hume actually went beyond the simple Quantity Theory of Money, and also discussed the transition period (before wages and prices had fully adjusted.)  In doing so, he came up with roughly the version of the Phillips curve used by Irving Fisher in the 1920s and Keynesians in the mid-1960s.  In the short run, a nominal shock (such as an increase in the money supply) will increase both prices and output, but in the long run only prices will rise.  And by the way, I use the term “nominal shock” because Hume’s theory wasn’t just about money, he understood that changes in velocity had the same impact as changes in money (as you saw in the quotation that started my second blog post a month ago.)

How can I be so presumptuous as to dismiss 216 years of steady progress in monetary theory?  Well I am not the only one to do so; Milton Friedman argued that:

“As I see it, we have advanced beyond Hume in two respects only; first, we now have a more secure grasp of the quantitative magnitudes involved; second, we have gone one derivative beyond Hume.”  (1975, p. 177.)

I hope David Laidler is not reading this as he has written several fine books that are sympathetic to the overlooked pre-WWII monetary theorists.  I enjoy reading that stuff, and there are clearly many interesting insights that modern young DSGE theorists would benefit from.  But I still think that most research into monetary economics, which has obviously been focused on the transition period before wages and prices have fully adjusted, has never really resolved anything.  Here are just a few ideas for the transition mechanism:

1.  Nominal interest rates (Keynes)

2.  Market rates relative to the natural interest rate (Wicksell)

3.  Real interest rates (Fisher)

4   Real wages (Pigou)

5.  Relative asset prices and investment (the Austrians?)

6.  Excess cash balances—>spending (lots of people)

And I am sure that there are many more.  But if they have never really resolved anything, then I’m not so sure if we had actually gone much farther than Hume by 1968.

Lesson 3.  Milton Friedman, the prophet of fiat money:

During the 1960s, Friedman developed a model of money that is appropriate to a fiat money regime, not a commodity money regime.  To understand why, we first need to briefly discuss the price level under a commodity money regime.  Note: The following is not exactly true, but is close enough for my argument.  Barsky found that price levels follow a roughly random walk under the classical gold standard.  He argued that the rational expectations estimated rate of inflation was roughly zero, even when, ex post, the eye discerns negative trends (1879-96) or positive trends (1896-14).  I strongly agree with this as a rough approximation of reality, which explains why Keynes refused to accept the idea that the Fisher effect (inflation expectations affect nominal rates) was of practical importance outside of a fiat money regime.

The uptrend of inflation under the last gold standard (1934-68) was mostly a one-time adjustment in the price level to the devaluation of 1934.  After 1968 the free market price of gold rose above \$35/oz. and we were clearly in a fiat money world.  But even before this time Friedman (and Phelps) developed a model that features:

1.  Highly potent monetary policy with an almost unlimited ability to influence the time path of nominal spending.

2.  A Phillips curve that shifts as people change their inflation expectations.

3.  Criticism of old Keynesian theorists for ignoring the Fisher effect.

This is what Friedman meant by the “one derivative beyond Hume” remark.  Friedman saw that Hume only looked at changes in the price level, whereas now we look at changes in the (expected) rate of inflation.  But of course there was really little need for such a model until 1968, when the last vestige of commodity money was abandoned (not 1971 as many believe.)

Lesson 4.  The Rational Expectations Revolution:

immediately after 1968 there was a brief period of speculation about what would happen if you kept raising the inflation rate.  But that silliness could not last long, and by the mid-1970s Lucas and others showed that what really mattered is not actual changes in inflation, but rather (rationally) unanticipated changes in inflation.

The key insight of rational expectations (which should be called consistent expectations) is that if you model the economy in a way where policy X produces result Y, you should not assume the the rest of the public believes policy X produces result Z.  This is especially true of public policies.  It is very unlikely that a policy regime will be effective if it is based on the assumption that the public will respond foolishly to your policy.  They might behave foolishly, but you can’t count on it.

A finance equivalent would be to set up a regulatory structure that assumed the SEC could predict stock prices better than investment banks.  (Many don’t realize that that dubious assumption is implied in arguments that the SEC should have stopped investment banks from buying subprime mortgage securities.)

The rational expectations revolution also showed that:

1.  Today’s AD will be heavily influenced by changes in tomorrow’s expected AD, and thus by changes in the expected future path of monetary policy.

2.  Changes in the expected future path of policy show up immediately in the auction-style commodity, stock, and bond markets.

I think point 2 is under-appreciated, even today.  Point 1 lies at the heart of right wing macro, but also at the heart of modern new Keynesian macro.  The only difference I have with Woodford, et al, is that they look at the future expected path of short term rates (relative to rate consistent with macro equilibrium) and I look at the expected path of the monetary base (relative to the real demand for base money.)  They use the interest rate transmission mechanism, I use the excess cash balance mechanism.

Woodford justifies his approach on the grounds that real world central banks target short term rates.  That is true, but in my view it is a cognitive illusion to assume that this means short term rates transmit the impact of monetary policy.  I see them as merely a symptom of the disequilibrium period associated with sticky wages and prices.  Many people think that interest rate cuts speed the expansionary impact of monetary policy.  They may help it impact real GDP, but they actually slow down the impact on nominal GDP (by depressing velocity.)  If interest rates didn’t change at all, the excess cash balance effect would work almost instantly—raising wages and prices.  But of course the fact that wages and prices are sticky means it cannot work instantly—so short term interest rates move, and appear to be more important than they really are.

My other problem with the interest rate approach is that I find it hard to picture the stance of monetary policy by looking at interest rates.  During the Great Inflation we often saw charts (like the one in Barro’s macro text) that showed the extremely close correlation between the long term average growth rates for money and prices in the high inflation countries.  But what kind of policy data would a Keynesian use in a “monetary history”?  Nominal interest rates are also positively correlated with inflation for those countries, but the causation goes from inflation to interest rates.   So the rates tell us nothing about policy.  Of course this isn’t a flaw in the Woodford model, which allows for the classical result in the long run.  It’s just one reason why I prefer the quantity of money/excess cash balance approach.  It’s easier for me to see what’s going on.

For me the big insight from the rational expectations revolution is that future expected policy affects AD today (which we already saw in the George Warren post.)  Thus if the Fed is expected to increase the money supply 20% next year, and the increase is expected to be permanent, the expected future NGDP three or four years out may rise about 20% (assuming all wages and prices have adjusted by then.)  But that expected increase will sharply boost all sorts of (relative) asset prices today (while wages and prices are still sticky) and dramatically impact AD today.  (I believe this last part is similar to the Austrian view.)

To summarize.  I see monetary policy as follows.  Start with the long run and work backward.  We know the apple example applies in the long run.  Ceteris paribus, long run NGDP will rise one for one with monetary base increases expected to be permanent.  Then work back to get the transmission mechanism.  Real wages, interest rates, asset prices, etc., will be affected in a way we don’t fully understand, but the key is that higher expected future NGDP tends to push up current NGDP, just as in microeconomics expectations of future price changes affect the current price of a single commodity.

Lesson 5.  Short run monetary policy under a gold standard:

Under a gold standard, changes in the price level are exactly (inversely) proportional to changes in the value of money (in terms of purchasing power.)  So it is very simple to model the price level; increases in the supply of gold (from mines) raise the price level.  And increases in the demand for gold (monetary or non-monetary) reduce the price level.  Monetary policy, if it works at all, generally works through changes in the demand for gold.  I titled this lesson “short run policy” as in the long run the price level will be determined by the marginal cost of gold production.  But the short run is very important.

There are different types of gold standards.  Interestingly, under the two extreme cases, full-bodied money 100% backed with gold, or a system with minimal reserves that uses open market operations in T-securities to peg the nominal price of gold, monetary policy is nearly ineffective.  This is because in each case the central bank has almost no impact on gold demand.  (They do have one option under full-bodied money, however, by raising reserve requirements they can increase the demand for base money, and hence the derived demand for gold.)

The interesting case (to be considered tomorrow) is when central banks hold substantial but still fractional reserves of gold, and then adjust that ratio for policy purposes.  This was never more true than in the interwar period.  The basic idea is that if a central bank has a lot of gold (the U.S., France, or even Britain) it can affect the world demand for gold by reducing or increasing its ratio of gold to base money—i.e. by violating the”rules of the game.”

Liquidity traps can occur under a gold standard (as in 1932), but they are not what Keynes thought they were.  They occur when large increases in the demand for gold have produced deflation and near–zero interest rates.  Under these conditions a central bank may not be able to boost the price level without losing all of its gold reserves.  But this is how gold standards are supposed to work, they are supposed to sharply curtail the discretionary power of central banks.  This has nothing to do with the liquidity trap as envisioned by Keynes.  The gold standard limits discretion just as much when interest rates are 5%, as when they are 0%.

Because year to year fluctuations in the (flow) supply of gold and industrial demand are fairly minor, as a practical matter modeling short run movements in the price level under a gold peg becomes a problem of modeling central bank demand, and private hoarding of gold bars, both of which were very unstable.  And central bank demand has two components, the real demand for base money (mostly determined by the public and banks, except for reserve requirements) and monetary policy—changes in the central bank’s gold ratio (the ratio of gold stocks to the base.)

To the extent that PPP holds, small central banks have little power.  To the extent that it doesn’t hold, small central banks can have some control over their price level (as in a closed economy model.)  In practice they didn’t have much power, partly because of rational expectations—investors understood that PPP tends to limit discretion in the long run, and would attack the currencies of central banks behaving recklessly.)

Lesson 6.  Monetary policy under a fiat money regime:

There are many possibilities here.  One is that central banks are not independent, and are forced to monetize the public debt.  Then you have the “fiscal theory of the price level.”  This theory might also apply if money and public debt are perfect substitutes.  If fiat money injections are temporary (as in colonial American during the French and Indian wars) they won’t cause much inflation.  This can be explained with a fiscal theory (Bruce Smith), or with a more conventional monetary theory with rational expectations (me, in 1993, and Krugman, in 1998.)  Or you could  have one fiat currency pegged to another, in which case you would first need to model the monetary policy of the dominant currency.

But let’s focus on the most plausible case for the US; a freely floating currency produced by an independent central bank, where currency injections are often permanent.  We will first consider the case were cash and bonds are not perfect substitutes, then finish up with the case where they are.

This is where the helicopter example is most often used.  You drop some money out of a plane, and per capita holdings double from \$100 to \$200.  At first everyone has more cash than they prefer to carry in their wallets.  So they bring it to their bank.  But even in a recession when no one is borrowing, banks would prefer to hold T-bills earning 3% rather than reserves earning zero percent.  So they shovel the cash out just as fast as they receive it (buy buying interest-bearing assets.)  This game of “hot potato” continues to accelerate velocity as people desperately try to exchange the excess cash balances for goods, services or assets.  AD rises.

Eventually prices double, and people are again content with their cash holdings; what \$100 used to buy, now costs \$200.  So each group gets its way—the Fed determines nominal cash balances, and the public determines real cash balances.  The price level adjusts to make this happen.

Some, will say that the preceding example is really fiscal policy.  I don’t agree, as I haven’t mentioned any government debt, so neither the public nor the government are necessarily any better or worse off in real terms.  But let’s suppose they are right.  It doesn’t matter because as long as interest rates are well above zero, bonds and cash are not close substitutes and OMOs will produce an almost identical outcome as the helicopter drop.  The extra AD generated by having a bit more cash (i.e. disposable income) is trivial compared to the extra AD generate by having the expected future price level double.

So let’s move on to the really interesting case where T-bills earn a zero yield.  In that case if you exchange cash for T-bills nothing may happen to AD.  In a sense, T-bills have become, de facto, part of the monetary base.  So while an open market purchase does raise the official base, it doesn’t budge the more relevant aggregate of “non-interest bearing government paper.”  This is the case that Keynes and Krugman worry about.

And it’s also the problem we face today, (or would be if they stopped paying interest on reserves, and rates fell all the way to zero.)  Here’s my problem with discussions of the liquidity (or expectations) trap.  There is a view that “it all boils down to X.”  You might think from my preceding (highly simplistic) course in monetary economics, that I like boiling a problem down to its essence.  But in the case of liquidity traps I believe great mischief has been done by oversimplifying the problem.  Here are just some of the real world issues:

1.  Can the central bank limit the demand for base money (as I proposed with my interest penalty scheme?)

2.  If the interest penalty on reserves works, are cash held by the public and T-bills really perfect substitutes?  More importantly, are cash and government bonds with positive yields perfect substitutes?  What about other relatively safe bonds?  Some call this option “fiscal policy” as the government might lose money.  But the expected loss is zero if markets are efficient.

3.  Can the central bank influence the public’s expectations of future monetary policy by signaling as follows:

a.  Are massive purchases of government debt (even T-bills) a signal of future policy intentions?  As you have already heard me say, ad nauseum, I think Krugman, et al, drew the wrong implications from the Japanese case, thinking that the BOJ wanted to escape deflation but could not credibly promise to be irresponsible.  I see no evidence that this was the case and lots of evidence that it was not.

b.  Can a central bank signal future policy intentions with an explicit nominal target and a forceful promise to make up for any shortfalls in the future?  The BOJ never made any such commitments.

4.  Can a central bank in a liquidity trap target the price level by pegging the currency to a commodity, and then gradually adjusting the peg to control prices (as Fisher and Warren argued, and FDR showed?)

5.  Can a central bank peg their currency to another currency, and then adjust that peg until the price level target is hit (as McCallum, Svensson, etc, argue is a nearly “foolproof” policy.)

6.  Can a central bank target the price of CPI or NGDP futures contracts (as Sumner, Dowd, Woolsey, et al, have argued.)

I could obviously go on and on.  In a sense, my earlier “multifacted” proposal for monetary stimulus was aimed squarely at this endlessly complex and confusing phenomenon called the liquidity trap.  It doesn’t boil down to any one thing.  Just as AIDS patients do best with a “cocktail” featuring many drugs, the financial markets are desperately crying out for a credible, multifacted policy mix that would address the liquidity trap from all sorts of different angles at once.  Once we scare this ghost away, we’ll see how weak it was all along (as FDR found out in 1933.)

Conclusion:

I keep searching for the perfect metaphor for how I envision monetary policy.  Let me try this one out:  I am an Archimedean.  Archimedes claimed that given a fulcrum and a long enough lever (and a place to stand), he could move the world.  I believe that the Fed is that fulcrum and the control of the supply (and perhaps demand) for base money is the lever.  Give me (or anyone with similar views) control over that policy and we could stop the world’s nominal GDP from falling, and lift it back up.  And do it surprisingly quickly.

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33 Responses to “A short course in monetary theory”

1. Bill Woolsey
7. March 2009 at 09:13

I find all of this very interesting. However:

I suggest you explain monetary theory in the context of a fiat money regime. If some of your explanation is inconsistent with history because they had commodity money schemes, then just mention that in passing. Of course, explaining how things work in commodity money schemes is worthwhile too.

While I finally read you post on Warren, and found that very interesting, rather than refer back to that, I would recommend you do more to explain why current aggregate demand is impacted by expected future aggregate demmand.

Perhaps it is just me, but the process by which an increase in the quantity of money offsets the impact of a decrease in velocity, keeping nominal income from falling below target doesn’t seem obvious from thinking about what would happen if everyone believes the that the quantity of base money will double given velicty and the money mulitliplier.

If the policy fails, and nominal income falls, then getting it back up to target would be a more modest form of the base money doubling story. But how does it work if it works “perfectly?”

I agree with many of the things you say about using interest rates to look at monetary policy. However, it seems to me that the “market” wants to hold lower risk assets and also, shorter term assets. It has to do with uncertainty about the future, at least partly due to real factors. This should change risk premia and term structure of interest rates.

With open market operations involving the Fed issuing very short term and low risk assets for investors and purchasing something else, there is an intermediation here. It would seem to compress the risk and term structure of interest rates. If we consider heroic open market operations, this effect is significant.

I think this is an impact on interest rates that is differnet from transitory liquidity effects.

And again, instead of thinking about a move from a low price to a high price equilibrium, consider maintaining a monetary equilibirum in the face of an increase in the demand for money.

2. Bill Woolsey
7. March 2009 at 09:22

Oh, one other thing…

I don’t agree that nominal contracts are “less important” than sticky prices and wages in the context of falling nominal income. I suppose you were thinking about inflation? While deflation, of course, also just creates sunk costs, etc., default and bankruptcy are pretty disruptive.

3. The Ambrosini Critique » Blog Archive » Sumner on monetary policy
7. March 2009 at 09:56

[…] favorite paragraphs: The key insight of rational expectations (which should be called consistent expectations) is that […]

4. ssumner
7. March 2009 at 11:25

Bill, All good points.

I should probably say that the purpose of the post was mostly to get some of the more practical, real world commenters to see things from the abstract perspective of monetary theorists, and not just a typical monetary theorist, but one far removed from the more “commonsense” interest rate approach to monetary policy.

You are right that the success of a policy to come out of a depression is much less obvious that one that doubles the money supply starting at equilibrium I believe, though, that the key distinction isn’t inflation vs. reflation, but rather liquidity trap vs. non-liquidity trap. In a normal recession when interest rates are positive, velocity doesn’t fall that sharply. Even a 10% 20% 30% fall would be pretty easy to offset with OMOs (we just did 100%!) That’s why I saved the liq1uidity trap for last–I wanted to give them a sense of normal monetary policy first. I’ll try to address your point in another post.

2. Yes, I agree that low interest rates aren’t just due to deflation. The Wicksellian equilibrium real rate is very low due to the financial crisis and low investment (and perhaps a bit from fear of more statist policies, higher taxes, etc.)

3. You may be right about interest rate spreads, but again in a very elementary piece on monetary theory I wanted to stay focused on a few basic principles relating money and NGDP in almost any environment.

4. On your last point in the first reply, offsetting a fall in velocity is much easier if done early in the process (as Bernanke had warned us in the past.) If done aggressively before entering a liquidity trap, I think the Fed could have kept inflation expectations in the 2-3% range, and thus forestall a lot of our current troubles. The transmission mechanism would be the same–an aggressive policy leading markets to expect higher future NGDP through the excess cash balance mechanism. Low rates never should have been the goal. If the Fed had driven the fed funds rate to zero quickly during the October crash (instead of to 1.5% near the end of the crash), it should have been in the hope of boosting longer term rates, as I showed in my earlier Ratex post.

On your second post, I almost did what you suggested. I thought people might think of the current situation, (or the 1930s), which shows how debt-deflation can have devastating real effects. I think I put a word like ‘normal’ in somewhere, as I wanted to indicate that non-devastating financial problems don’t have much impact on incentives at the margin. The 2007 sub-prime crisis had a surprisingly small impact on output for 10 months–as it was mostly sunk losses. Housing construction fell, but manufacturing and services held up pretty well. But I agree, I should have been clearer.

5. JimP
7. March 2009 at 11:52

And how is the petition going? I really do think Bernanke must change – and very soon. There seems to be talk now of actually nationalizing the banks – even from some Fed officials. To do that in a time of deflation would be entirely nutty.

To quote James Saft at Reuters – who was quoting the biggest stock market bear in the universe, Albert Edwards at Societe Generale:

“Banks aren’t the problem, they are a symptom of the problem.”

Saft is now persuaded that we must inflate, as apparently is
Tim Duy. But not Bernanke. It is like a slow motion nightmare.

6. ssumner
7. March 2009 at 14:41

JimP, I totally agree. I am free next week and am really going to push the blog hard. The petition probably won’t work, it’s more a device to get attention for my ideas. But if I push the blog hard enough and get two or three more Tyler Cowen-caliber economists interested, it might create a buzz. I am hoping to get a chance to visit one of the Federal Reserve Banks and do a seminar. I think I might be able to. The key is to get the ideas out there so that people feel its the right thing to do–and that requires more than a petition, and I need some help from my colleagues, or maybe a friendly reporter. I think that gung ho supply-sider on the economics cable show (can’t recall his name) might like my blog.

7. JimP
7. March 2009 at 14:56

You probably meant Kudlow. He can rave. I did send his firm an email on the blog but have not heard back. I have also tried to promote it at The Baseline Scenario – though not with any success. I have also contacted a couple economists I know.

You should contact Tim Duy – here:

8. Jeremy Goodridge
7. March 2009 at 15:07

Can you comment on a few points?

1. It seems to me that the analogy with the helicopter is really where policy people get confused. Because it’s not actually how policy works. Buying something in the market is different than just ‘giving’ people money (which is what the helicopter analogy seems to suggest), and that is particularly true if you are buying something that is in an asset-sense, the ‘same’ as money itself. Why don’t monetary theorists take the helicopter analogy to its fullest logical conclusion? It seems like it would be trivial to add to everyone’s cash balances WITHOUT buying anything. For example, one could just monetize a significant portion of Treasury spending (i.e. buy NEWLY ISSUED treasury debt — and do it in such a way that that debt is NOT issued to the public). I am surprised no one really suggests this. And that approach would work better than ‘open market’ activities in which T-bills are purchased because the people selling those T-bill assets are probably themselves banks who are hoarding even more than typical households.

2. I agree with you that we should eliminate interest on reserves, but I don’t think it would do that much. I think banks are just holding reserves because they need to hoard (not because of the interest rate). And if you imposed a penalty interest, banks would just put money in vaults. In other words, they would redeem their holdings at the federal reserve for hard currency and put the cash in vaults. Or they might use their reserves to buy short-term T-bills (the same thing purchased by the Fed in open market operations…).

3. The real problem with today’s fed policy is not so much that they are charging interest on reserves. It is that they are ONLY buying short-term assets, and these assets are mostly at banks. So, what’s happening is that banks are holding reserves to ensure their OWN ability to pay back those short-term loans. It’s as if the Fed is providing banks with short-term liquidity to stem a bank run — but that is not at all what’s happening (it’s Nominal GDP that’s collapsing). What the fed has to do is ACTUALLY get money into households by buying something that will in fact increase HOUSEHOLD cash balances. Even buying longer-term T-bills will do this, but even better is monetizing Treasury debt (and promising to do so until people start spending).

I would welcome your thoughts on this!!

Thanks for your posts — they are some of the best around. I think the monetary approach is still the one that ultimately will free us from this Depression in the same way that it did get us out of the Great Depression.

Jeremy

9. JimP
7. March 2009 at 15:42

From Bernanke today:
“We will continue to forcefully deploy all the tools at our disposal as long as necessary to support the restoration of financial stability and the resumption of healthy economic growth,”

What I take that as saying is – “we will continue to what we have been doing – which is not working. Too bad for you”

10. JimP
7. March 2009 at 15:54

That was too sarcastic. He is doing what he has support on the board to do. But it is not enough.

The last time he was before Congress he said something like that he expected spending and incomes and economic activity to be slow or below average for some time.

It is not his job to expect things. Statements like that are totally terrible. It is his job to CAUSE things. it is our job to expect them. Why is he so passive?

Now I am ranting. I should go on Kudlow.

11. TGGP
7. March 2009 at 16:08

Steve Keene seems to be arguing that nominal debt is the problem and that we are in a debt-deflation scenario. He seems to be a Post-Keynesian though, and you’ve got enough on your hands trying to deal with one heterodox school (the Austrians).

12. cucaracha
7. March 2009 at 18:27

In the negative side:

If inflationary expectations increase, there is a high probability of non indexed fixed income assets other than Treasuries losing value – so the financial system would be hit again and the increased yield from those instruments could – I said could – offset the decreasing yield of Treasuries.
( Now those instruments stand at more than 100% of the US GDP – It was much less in 1958-59… And probably much less even in 1929-33 );

13. ssendam
7. March 2009 at 18:29

You mention the “excess cash balance mechanism”. Could you explain how this works?

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8. March 2009 at 03:12

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15. ssumner
8. March 2009 at 13:17

JimP, Thanks for the Tim Guy link. He looks very smart, and I will add it to the “Are things going our way?” post this evening. Tomorrow I start marketing this blog much harder, as so far I have spent all my time on some very long posts.
Regarding your other comment, I am just as frustrated as you. It’s Bernanke’s job to control the economy, not predict it. You might look at my “Do we want civil engineers to predict bridge failures?” post back in early February. It makes this point, and I don’t think anyone noticed it.

Jeremy, I use the helicopter because it’s easy to understand, but as I say in my essay, ordinary OMOs are actually not much different during normal times (when interest rates are positive.) That’s because the “income effect” of the helicopter drop is tiny compared to the excess cash balance effect. If I make \$50,000 a year and carry \$200 in my wallet, it doesn’t make that much difference if another \$200 falls on my head. I don’t suddenly feel rich. But I do try to get rid of the money by spending it–and if everyone does this then nominal GDP doubles, and that does make a huge difference.

2. Your point about vault cash and interest is not a problem, as I mentioned in my “proposed petition” explanation, the Fed should just limit interest-free vault cash to roughly 5% of assets, and tell banks they have to pay interest on excess vault cash above 5%. That would limit hoarding, and allow OMOs to get traction. The Fed does have data on vault cash, so they can do this. I am confident that if they make the interest penalty on reserves large enough, it will do the job.

3. I totally agree about buying assets that pay more than a zero interest rate. But I hope you will consider my other ideas as well, as I think a multifaceted approach is most effective–we need to do everything possible to turn around market sentiment.

TGGP, Yes, I do like the Austrians much more than the Post-Keynesians. You are right that I cannot address every group at once.

Cucaracha, I don’t agree. I think that the huge declines in the corporate bond market have occurred exactly because of the big drop in AD. If an expansionary policy sharply boosted AD, it would also sharply reduce debt defaults. FDR’s dollar devaluation policy increased the value of Baa bonds. You are right about inflation hurting T-bond prices, but I am much more hopeful about the corporate debt markets if NGDP growth could be raised up to 5%.

Ssendam, The excess cash balance idea is that if the Fed injects more money into the economy (than people currently want to hold) the public will try to get rid of their “excess cash balances,” thus reducing the value of money. A reduction in the value of money is called inflation. This may not work if the fed simply swaps money for another zero interest asset (like T-bills right now) as they are close substitutes. But if pushed far enough, and the Fed bought unconventional assets, eventually the extra cash would push up inflation. Most people don’t think of it this way, but the same thing occurs in the apple market after a big harvest. Apple dealers have way more inventory that they want, so they try to get rid of excess apples, driving down their value in the marketplace. Inflation is just a fall in the value of cash.

16. smokedgoldeye
8. March 2009 at 15:37

Scott,
I was so pleased to see you start talking about apples as the medium of exchange. Something the government can’t mess with! Alas, you were just using it as an example. You hate big government, you hate statism. But you just love the megalomaniacal idea of wielding a lever big enough to move the world! Speaking of Austrians, I wonder what Freud would say. Expanding the money supply does not expand resources one jot. Monetary interventionism created the boom in the first place…and now you want more. Zero chance or not, serious economists should be pushing to get the government completely out of the money supply business. Fiat money is the statist’s BIGGEST tool. I must conclude that you are insincere about your desire to limit statism. Good luck with your seminar at the Federal Reserve. Hey, maybe they’re hiring.

17. Lorenzo (from downunder)
9. March 2009 at 14:30

I am finding your blog a wonderful course in monetary economics and policy. Which is not to say I pretend to understand all you are saying, but then money seems just a difficult subject. So I keep trying to get back to real basics in order to get more of an understanding. (So please bear with me as I go through my limited grasp.)

The wildcat banking era shows that the media of exchange and the medium of account need not be the same. And if they weren’t, which one was really “money”? Many would say the medium of exchange. But monetary theory says otherwise, all our models of inflation are based on the notion that prices are denominated in a medium of account (which is now Federal Reserve notes, and in 1929 was 1/20.67 oz. of gold.) Monetary theories are theories of the value of the medium of account.

Is not the issue what drives behaviour? Do people act on the basis of money being a unit of account?

Money is the generic trade item. That is why it developed: making it the best single way to reduce transaction costs. We can see how good it is at that by looking at how much people move to barter in extreme hyperinflation situations. (As I understand it, not much.)

All the functions of money — as medium of exchange, unit of account, store of value — come from it being the generic trade item. Now, in hyperinflation, its utility as a store of value is effectively destroyed because people’s expectations about its future value (as a generic trade item) are so low, so people spend it as quickly as possible. In deflation, people’s expectations are that its future value as a generic trade item will continue to increase, so they tend to hang on to it. Which means less transactions.

So that people’s expectations about money are important makes perfect sense to me. That money as a unit of account is a “at any given time” moment makes sense, though it seems to me that would immediately get complex given expectations versus what turns out to happen. What I am not getting is what it means to say monetary theories are about money as a unit of account. Which I suspect is one of those “silly questions” it is really important to get students to ask, because they are basic blocks to understanding.

18. Lorenzo (from downunder)
9. March 2009 at 15:11

smokedgoldeye

A email comment from a former colleague with a PhD in monetary economics seems appropriate:
money is probably the most poorly understood aspect of economics, not least because most modern texts fail to discuss its most important property: it has no market of its own, so excess demand/supply needs to be cleared through other markets (goods, services, assets). This is what makes money potentially so potent in destabilising an economy.

19. smokedgoldeye
9. March 2009 at 16:09

Lorenzo,

“Money has no market of its own”…? Rubbish. You could just as easily say other goods have no market of their own…so excess demand/supply needs to be cleared through trades of money. Tell your PhD to contact me directly and have a try. I’m just a dumb little businessman but I might be able to teach him a thing or two. Money, for example gold, is a good like any other good. It has a supply and it has a demand. This gives it a price in terms of other goods. We used it as a convenient and stable medium of exchange so we don’t have to barter. Money isn’t so stable any more when the Fed decides to radically monkey with the supply in secretive ways. By the way, any supporters of the Fed out there who are aghast at Bloomberg News’ affrontery of filing a FOIA request about who they recently gave \$2 trillion to? Fed claims they’re not a government institution so they don’t have to comply. All you anti-statism supporters of unlimited Fed power…I assume you agree with them here too?

20. ssumner
9. March 2009 at 17:00

Smokedgoldeye, We’ll have to agree to disagree. But a few brief comments. If we’re going to continue to use the move the world metaphor. I believe the Fed’s policy was to move the world at about 5% a year. It went a bit too fast in the housing boom, but not enough to explain all the insanity of bankers. My view of the current situation is that their policy of moving the world at 5% came to a sudden stop. Now a stable world may be fine in the long run (and is what you want) but please don’t suddenly slow down, stop, and go into reverse or we’ll all get whiplash (Ie. recession.) I was offered jobs at the Philly Fed and the NY Fed in the late 1980s, but stayed in academia.

Lorenzo, I was trying to make a theoretical point about which role of money was really key. You said money is generally a “generic trade item.” But in a few cases it was not. Under a silver standard with free banking you might have bank notes from El Dorado Bank and Trust accepted in stores at a 20% discount. So on an item with a \$20 price tag, they’d take your banknote at \$16, and you’d still need another four silver dollars to buy the good. In that situation, it is clear that prices are based on the medium of account (an ounce of silver) not the medium of exchange (or media of exchange as there were many different types of banknotes each with different values.)

Both of you, Can I split the difference in your debate? Money has a sort of market, but it is very different from all other goods. Both fiat money and gold under a gold standard have fixed nominal prices. When there is more fiat money, a dollar is still a dollar, and when there is a big gold discovery, a \$20 gold piece is still a \$20 gold piece. That is the sense that Lorenzo is right. But the value of money can change through changing the price level, i.e. changing the price of all other goods. That is hard to do, and that’s what the person who came up with the “money has no market” was thinking of. Apples have a very specific apple market. The market for money (cash not credit) is basically aggregate demand, that is, all other goods. So each of you is right in a certain sense. Even if you disagree with me, unless you understand the argument of the other side here, you don’t fully understand your own side.

21. smokedgoldeye
9. March 2009 at 17:45

Scott,
That’s not fair to compare fiat money to semi-fiat money (gold standard fixed nominal price \$20 gold coins). Let’s compare true fiat money (what we have now) with true natural money (gold defined only by weight …the government can’t mess with gravity). I think you must agree then, that natural money is indeed a good like any other. It has a demand primarily based on its convience as a medium of exchange. I don’t want a severe recession either. But nor do I want to keep pressing the monetary “snooze button” as Greenspan kept did starting in 2000 to keep postponing the end of the boom. He clearly made this crash a lot worse than if he’s let malinvestments wash out of the system 10 years ago. Now’s the time to bring back natural money. Yes the transition will be painful. But imagine the glorious future!! Imagine selling US products to customers worldwide with one world stable bi-metallic currency. Human prosperity will multiply by 100 times. We’ll have such wealth that we’ve never had in history. All I want is to trade peacefully with my fellow humans. Even the poorest of the poor will be far far more prosperous than they are now or in any previous economic system in history. Tell me why I’m wrong!

22. Jon
9. March 2009 at 19:08

Great primer, especially lesson four. I did find your discussion of the zero-interest rate bound disappointing. As I’ve allude previously, and you’ve gone in for parts, the Fed does not act against short-term interest-rates directly. They observe the overnight-rate and use that to discipline their purchases of multi-year notes.

Money is injected into the bond market directly–via the primary dealers who act as intermediaries: they meet the Fed’s demand by buying from the public and reselling at auction. T-Bill Base Money convertibility is not a meaningful concept given how the Fed usually operates.

The significant regime change into direct auctions to the depository institutions via the TAF and Primary Credit facilities has changed matters (for the worse).

23. ssumner
10. March 2009 at 11:32

Smokedgoldeye, You missed my point, which applies just as much to monetary systems based on weight. Say we swtich to a “gram” system, where the medium of account is a gram of gold. You still have the problem that although, as you say, the relative price of gold change change just like any good, it can only do so through affecting the prices of all other goods. Thus if a gold rush leads to a bit of inflation, it can only occur by raising nominal prices of other goods, not cutting the nominal price of gold. That problem doesn’t go away in even the purist free market system.

Jon, I’m confused here. I assumed that if banks regard T-bills and reserves as perfect substitutes, then any monetary policy that left the sum total of reserves and T-bills unchanged might well be ineffective. Is that wrong? And why does the specific way money gets injected make that wrong?

24. smokedgoldeye
10. March 2009 at 14:06

Scott,
Come on. The inflation of the gold supply is more stable (and lower) than the inflation of fiat money by a factor of a thousand. So what if prices of all other goods in terms of gold nudge up or down a percent or two in response to gold mine mother lodes (up) or consumer saving (down)? You would never have the “insanity” and “mistakes being made” by fractional reserve banks lending out money they didn’t have knowing that the tax payers were on the hook if anything went wrong and their bonuses would be paid no matter what. In my perfect world, lending out money you didn’t have would be fraud. People could even lend their gold holdings to each other with no bank intermediaries perhaps using eBayGold.com. Poorly educated US consumer investors also wouldn’t be forced, as they are today, to buy confusing financial instruments with their savings or else watch fiat inflation slowly take it all away. Scott: all people want to do is to specialize and peacefully trade with each other. We need a stable medium of exchange that politicians can’t mess with. Can’t you at least imagine how glorious that future could be?

25. David Stinson
10. March 2009 at 17:09

Interesting post, Scott.

First, from what reading I have done on the Austrians, their primary transmission mechanism is what you have referred to as the Wicksellian mechanism, i.e., the tendency of monetary policy to create a gap between market interest rates and natural free market rates. As far as I am aware, it doesn’t depend on sticky prices/wages, as you implied above, but rather, at least in the short run, on the following: a) the increased money supply reaches the non-bank public primarily via bank lending and therefore through durable goods purchases (housing bubble anyone?) or investment decisions, b) their views on the nature of knowledge and its dispersal among economic agents implies lots of information asymmetry and heterogeneous expectations, and c) even if all investors were to correctly forecast the likely long-run result of “excess” monetary growth (a la Lucas), a prisoners’ dilemma-type mechanism forces them to take advantage of the monetary stimulus in order to maintain, for example, their competitive position or maximize their wealth prior to the inevitable bursting of the bubble (we’re all doomed anyway). The impact of the lower interest rates raises the net present value of firms and investment projects, with a proportionately greater impact (due to the discounting mechanism) on those investment projects with longer payback period. The investment boom also tends to lead to a commodity price bubble (such as the fabled granite countertop bubble), as necessary factors of production. The bubble can be burst by a tightening of the monetary policy (with an increase in the interest rate) but would in any case “hit the wall” when underlying disequilibria or imbalances in the real economy (and resulting from the interest rate distortions) made their presence known (or something – I haven’t figured that bit out yet).

Second, I am struck by how little of the recent discussion regarding monetary policy, and in particular regarding the Japanese experience or policies necessary to avoid deflation in the US, involves more than a cursory analysis of money demand if it mentions it all. Given that a) the Fed is pumping money like mad, b) everyone knows that they are pumping money like mad, and c) there remains the view that what has been done is not sufficient to stave off deflation, one is forced to conclude (I think) that, notwithstanding the money creation, there is excess demand for money. One would expect to see therefore all sorts of analysis of the factors driving money demand at the moment. Perhaps there is lots of discussion but I just haven’t seen it. There is some discussion regarding the instability of money velocity (or, as I have seen it more helpfully framed, the propensity to hold money) but it tends to be descriptive not explanatory, at least in the context of the very recent behaviour of money demand.

26. Jon
10. March 2009 at 20:45

“I assumed that if banks regard T-bills and reserves as perfect substitutes, then any monetary policy that left the sum total of reserves and T-bills unchanged might well be ineffective.”

Well I cannot argue with “might well be ineffective” but I think that such a weak statement would be true even when the antecedent does not hold.

“And why does the specific way money gets injected make that wrong?”

The core of the Keynesian argument is that the short-rate itself is the operative mechanism. Once rates are zero, there is no price-signal, aka the liquidity trap. But there are many transmission mechanisms of monetization; so it isn’t “wrong” just irrelevant.

Broad money can be expanded irrespective of depository institutions, but depository institutions cannot expand broad money irrespective of base money. i.e., the quantity of base money reflects the Fed’s restraint on depository institutions but not money generally because currency can be held outside of the banks, and banks need not participate in the expansion.

1) Fed -> Monetize bills -> Base expands -> Banks -> Public
2) Fed -> Monetize notes or bonds -> Primary Dealers -> Public

Almost everything about Krugman’s description of how monetary policy works is wrong. 1) manipulating short-rates is not a direct mechanism 2) The Fed monetizes medium term debt not tbills, so the effect on tbill holdings by banks is secondary and the effect on the fed-funds rate is tertiary. 3) The counter-parties to OMO are not banks but primary dealers. primary dealers include banks but in those cases are bank’s trading arms not their depository elements. 4) The OMO deleverages the public therefore either mitigating existing trends or spurring further lending to maintain gearing. This “always works” and can only fail if the Fed’s willingness to deleverage the public is limited.

27. smokedgoldeye
11. March 2009 at 01:40

David,
An excellent eloquent post. Re “or imbalances in the real economy (and resulting from the interest rate distortions) made their presence known (or something – I havent figured that bit out yet).”…due to exhaustion of real economy resources masked by the flood of money? Re: no one is analyzing the causes of excess money demand. I think actually our President recently did. He implored the citizenry “Don’t stuff money in mattresses please.”

28. ssumner
11. March 2009 at 17:41

David, The biggest factor in the high demand for base money was the decision by the Fed last October, for the first time in its 95 year history, to pay interest on reserves. And even worse, at a rate higher than banks could earn on alternative assets like T-bills. The low nominal rates in the economy today also increase the demand for both reserves and cash.
I’m not sure I buy the Austrian prisoner’s dilemma explanation. I want an explanation that would have the banks do the same thing all over again even if they knew then what they know now. I don’t expect anyone to come up with such an explanation, and hence I believe the sub-prime crisis will never be fully understood. But I can’t blame the Austrian for feeling vindicated, on the surface their explanation seems to fit the facts better than the others (I know little about post-Keynesianism, so I’ll defer judgment there.)

Jon, I mostly agree with you, and I suspect you know more than either me or Krugman about the details of Fed policy. I’ll just say one thing here in defense on Krugman. His expectations trap argument is a sophisticated theory that just might be right. I don’t think it is right, but it is not logically wrong. It could even be right if the Fed buys medium term bonds with non-zero yields. I just find the assumptions in the theory too far-fetched to accept. He basically argues that a central bank that sincerely wants to inflate might not be able to, because they lack credibility. I just think there are too many ways that central banks could get around this problem, and I gather so do you. But I just want to emphasize that I do understand (I think) where Krugman is coming from (as some of his supporters read this blog.) And at a superficial level it does seem to explain the Japanese situation–until one delves deeper into the facts. I really appreciate your info on Fed policy, you are making me better informed.

29. Jon
11. March 2009 at 18:50

Well, you have it there. Krugman is a smart man, but his conclusions depends on his model. This argument is older than us. Krugman is a neo-keynesian with a keynesian orientation on the function of short-rates. Whereas, I’m essentially advancing the monetarist position.

Greenspan had a very interesting essay in the WSJ today. His argument runs:
1) short-rates are irrelevant to borrowing costs
2) global integration increased the supply of savings–as if money had been created
3) because of #1, John Taylor is wrong to suggest that Fed caused the housing bubble

An interesting observation about Fed policy since Volcker until mid-2007 is that regardless of whether you’re a monetarist or a keynesian the Fed has done the “right thing”. It lowered interest-rates AND monetized debt counter-cyclically.

If I seem vitriolic, its because I’m convinced that in the last year and a half, the Fed has turned distinctly Keynesian and in the process delivered the “proof” against the Keynesian approach–by following a classically conventional keynesian policy of lowering short-rates while neglecting the supply of circulating money–and drove us into a nasty recession.

30. ssumner
12. March 2009 at 05:24

Jon, I sort of agree, but I think in retrospect I was lulled into to thinking they got it, because as you say, they seemed to be doing well from both a Keynesian and monetarist perspective. In a few days I plan a post on why my earlier naivete is fading away–I suddenly understand that the Fed never really understood what they were doing, they were just fortunate enough to avoid situations where the errors in their model were exposed.

31. é‡‘èžç†è«–ã®çŸ­æœŸè¬›ç¿’ by Scott Sumnerã€€ã€€ – é“è‰
11. January 2011 at 13:31

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32. ã‚¹ã‚³ãƒƒãƒˆãƒ»ã‚µãƒ ãƒŠãƒ¼ã®ãƒžãƒãƒ¼è¦³ã€ãƒžã‚¯ãƒ­è¦³ by Scott Sumner – é“è‰
7. May 2011 at 23:47