I’ve done a number of posts comparing New Keynesian and NeoFisherian views on the relationship between monetary policy and interest rates.  Here I’d like to illustrate the problem with a picture, as people often have trouble understanding this issue.  It’s really hard to not reason from a price change.  It’s hard to stop thinking of interest rate movements as a “policy” rather than an outcome.

These two graphs show the path of the exchange rate (E) over time, under two different monetary policies.  In both cases a higher exchange rate (E rising) reflects domestic currency appreciation.  Importantly, both of these examples are “low interest rate policies”, when the central bank reduces interest rates to a lower level than before.  But case #1 is an easy money policy, whereas case #2 is a tight money policy:

To focus on the essentials, I’d like to assume that a policy change occurs at time = T’, and that the following movement in the exchange rate is anticipated, once policy has shifted.  (The policy move itself was unanticipated beforehand.)

Notice that in both cases, the exchange rate is expected to appreciate after time = T’.  Because of the interest parity theory, this expected appreciation means that interest rates will be lower than before the policy change, when the exchange rate was stable and interest rates were the same as in the other country.  So from the interest parity theory we know that these two cases are both shifts to a lower interest rate policy.

But now let’s look at the long run impact of the two policies on the level of the exchange rate.  In case #1, the exchange rate ends up lower (depreciated) in the long run, despite the near-term expectation of appreciation.  Because of PPP, that means the policy is expected to increase the price level in the long run.  In other words, it’s an expansionary monetary policy.

In case #2, the exchange rate appreciates in the long run, yielding a lower price level.  That’s a contractionary policy.

Because the first case looks so convoluted—a currency that is expected to appreciate over time but still end up lower than before—you might think it represents the “weird and controversial model”.  Just the opposite, the first case is the New Keynesian model of easy money, and more specifically the Dornbusch overshooting version.  The second more straightforward case reflects the weird and controversial NeoFisherian model.  Just looking at the second graph, it’s easy to see how the NeoFisherians are able to get their result from mainstream mathematical models of the economy.

Here’s another way of thinking about the two cases.  In case #1, there is a one-time increase in the money supply (and/or reduction in money demand).  It reduces interest rates (due to the liquidity effect.)  But it also leads to expectations of a higher price level in the long run, due to currency depreciation and PPP.  Because prices are sticky in the short run, the effect of easy money is to initially depreciate the currency, not raise the price level in proportion.

In case #2, there is a permanent decrease in the growth rate of the money supply (and/or increase in money demand growth).  Because of the quantity theory of money, that leads to a permanent decrease in the inflation rate.  And because of the Fisher effect, the lower inflation leads to lower nominal interest rates.  And because of interest parity, lower nominal interest rates lead to an expected appreciation in the currency.  But you don’t even need the interest parity relationship.  By itself, the lower expected inflation combined with PPP leads to the expected appreciation in the currency.

So how does this help us to better understand the New Keynesian/NeoFisherian dispute?  It may be helpful to contrast the “highly visible” with the “highly important”.  The New Keynesians are focused on the highly visible, while the NeoFisherians are focused on the highly important.

The vast majority of specific, short-term decisions by central banks are better viewed as one-time shifts in the money supply, rather than permanent changes in the growth rate of the money supply.  Thus “easy money” announcements often make short-term interest rates fall, even as inflation expectations rise.  At the same time, the truly major moves in interest rates over time largely reflect longer-term changes in the growth rate of the money supply (and money demand—in more recent years).  Thus the low nominal rates in Japan are primarily due to tight money, not easy money.

Both the New Keynesian and the NeoFisherian models are wrong, as both sides engage in reasoning from a price change.  The correct (market monetarist) model says that low rates can reflect easy or tight money, and that one should not draw any inferences about the current stance of monetary policy by looking at interest rates.

If one cannot draw any inferences about the current stance of policy by looking at rates, can one draw any inferences at all?  I see two:

1.  On any given day, a decision by a central bank to cut rates by more than the market expected is usually (not always) expansionary.  It reflects “expansionary intent” and may be viewed as a signal by the central bank of a desire to make policy more expansionary.  This is, of course, consistent with New Keynesianism.  But it does not mean the current stance of policy is expansionary.

2.  When nominal interest rates fall persistently over a long period of time, it is usually (not always) evidence that monetary policy has been contractionary.  (This is more consistent with NeoFisherism).  But it does not mean that the current stance of monetary policy is contractionary.  As usual, Milton Friedman was decades ahead of the rest of the profession:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.  .  .   .

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

In America, monetary policy in 2017 and 2018 became a bit more expansionary, despite higher rates.

Let’s start with an easier question.  In what sense does OPEC control oil prices?

Imagine that OPEC produces 40% of the world’s oil. The cartel also has substantial excess capacity. Now let’s think about its control of global oil prices.

Because both the demand for oil and the supply of non-OPEC oil are relatively inelastic in the short run, OPEC has the ability to double global oil prices, or cut them in half, almost overnight. That’s a lot of control. So let’s assume that OPEC targets global oil prices at $100/barrel, and adjusts output to make the price stick.

There is one problem with this policy; oil supply and demand become far more elastic in the long run. So now let’s assume that the $100 oil price causes a fracking revolution, and non-OPEC supply rises sharply. To keep the price at $100/barrel, OPEC must reduce output to 35% of global production, then to 30%, then to 25%, etc., etc. They can do this for a while, but it’s painful.

OPEC also worries about the long run viability of the oil market, so eventually it decides that it’s no longer wise to keep the price at $100, even though in a technical sense it could continue doing so up until the point where its output fell to zero. OPEC decides that it is in their long run interest to face reality, and allow the fracking boom to reduce oil prices. There are two ways of making this happen

1. OPEC could stop controlling oil prices. They could instruct their members to produce a total of 40 million barrels per day, and let the market set the price.

2. They could keep controlling the price, but gradually reduce the price as needed to keep output at close to 40 million barrels per day (as fracking output rises). Thus they might reduce the price to $95 for a couple months, and then later to $90, and after another 3 months down to $85, etc. Prices would fall in a sort of step function, eventually hitting $45 after a few years. At each step of the way, price would be set at a level expected to keep OPEC output pretty stable, but once at that new price, output would be tweaked each day as needed to keep the price stable. Then after a few more months, another $5 price cut.

So in case #1 OPEC is not controlling global oil prices and in case #2 OPEC is controlling oil prices. But the two cases are actually pretty similar, and as you make the price adjustments smaller, the two cases get even more similar. Thus you could imagine the price being adjusted by $1 at a time, not $5, and the adjustments occurring much more frequently.

At what point do you move from a scenario where OPEC is controlling the global oil price to one where the market is controlling the global oil price?

Now let’s go back and think about the fracking boom, described earlier. Suppose OPEC actually responded to the fracking boom with the step function approach to lowering prices, described in case #2. So for periods of several months at a time, the price would be fixed by OPEC, then a sudden drop of $5/barrel. How would you think about this multi-year price decline, from $100 to $45? Does it make more sense to talk about the fracking boom causing a huge plunge in oil prices? Or should we say that OPEC caused a huge plunge in oil prices?

1.  On the one hand, you could argue that OPEC controlled oil prices all through this period, and hence they caused the decline. They made the periodic adjustments in the official price, and all the time they had the ability to set world prices in a different position.

2. On the other hand, the fracking boom was the big disruptive force in the global marketplace. As fracked oil output soared, it caused global prices to fall. OPEC could have offset that, at least for a while, but they chose not to, keeping OPEC output close to 40 million barrels per day. OPEC did not take concrete steps to prop up oil prices.

Because terms like ‘cause’ are not well defined, there is no right answer. But in this case I think I’d prefer to say that the fracking boom caused the oil price plunge. And I don’t think it’s just me; many economic pundits would view that as a plausible way of describing what caused the big plunge in oil prices.

It turns out that this example is uncannily similar to the plunge in interest rates from July 2007 to May 2008. Before going over that example, recall an important aspect of the previous example. I said that while in the short run OPEC could have continued holding oil prices up at $100 for an even longer period, they also had long term objectives to think about, which made them conclude that it was wise to allow some price decline, so that their long term hold on the oil market would not be completely lost.

Now think about the Fed during 2007-08. Real estate is declining sharply, and there are many fewer mortgages being issued. The lower demand for credit puts downward pressure on interest rates. For the Fed to prevent interest rates from falling, they’d have to continually reduce the monetary base. That sort of tight money would keep rates from falling below 5.25% (via the liquidity effect).

But the Fed realizes that if it did what it took to prevent rates from falling, then this policy would disrupt its long run goals for the economy. Big time! So instead of reducing the monetary base it decides to allow interest rates to fall, while holding the base fairly stable. There are two ways it could do that:

1.  It could hold the base roughly stable at $855 billion (plus or minus 1%), and completely stop targeting interest rates. Let the market set interest rates.

2.  It could instruct the New York Fed to reduce rates by ¼% or ½% every few months, as needed to keep the base fairly stable. On days when the official fed funds target was not being adjusted, the New York Fed would hold rates stable with small adjustments in the base, up and down.

You could also envision intermediate cases, like the official fed funds rate target being adjusted in 5 basis point steps, instead of 25 basis point steps. The smaller the adjustments, the more it would look like the market was setting the rate at a level that resulted in a stable monetary base.

I would argue that case #1 and case #2 are actually pretty similar. But in case one it looks like the market is setting interest rates, and in case two it looks like the Fed is controlling interest rates.

Now let’s return to the weak credit markets, caused by the housing depression. Does it make more sense to talk about weak credit markets depressing interest rates? Or should we say the Fed caused interest rates to fall during 2007-08? And if the latter, exactly how did the Fed cause interest rates to fall? After all, they did not increase the monetary base, which is their usual way of causing interest rates to fall. (This is pre-IOR).

Opinions will differ, but I think it’s more useful to talk about weak credit markets causing a decline in interest rates, and the Fed just sort of getting out in front of the parade by adjusting its official target as the “natural rate of interest” fell during 2007-08. But since the Fed always has the technical ability to move the actual interest rate away from the natural rate, at least for a period of time, others will prefer to say that the Fed caused interest rates to decline. I would not strongly object to that claim. Still, it is interesting that while other pundits would agree with me on the fracking boom example, they’d probably disagree here, insisting it was the Fed that cut rates.

What I would strongly object to is the claim that the Fed caused interest rates to fall during 2007-08 with an easy money policy. I defy anyone to come up with a coherent definition of easy money, which would imply that money was easy during 2007-08 (when nominal rates fell), and also easy during the second half of 2008 (when real rates soared), and was also tight during the Argentine hyperinflation of the 1980s (when the base soared).

I recently gave a talk at Kenyon College, and this post (along with another at Econlog) was motivated by a discussion with Will Luther.  He directed me to an earlier post of his:

I was pleased to see David Henderson call out Bill Poole for claiming the Fed sets the federal funds rate. It doesn’t, of course. Welcome to the Wicksell Club, David! We don’t have ties or t-shirts. But our common cause is worthwhile.

Many of my economist friends get annoyed when I insist they refer to setting the federal funds rate target (as opposed to setting the federal funds rate). They know that the Fed is not literally setting the federal funds rate; that the rate is determined by suppliers and demanders in the overnight market; and that the Fed, as Bernanke has made clear, has a limited influence on even short term rates. But, they maintain, it is a convenient shorthand of little consequence.

I disagree. Perhaps I have spent too much time in a liberal arts environment, but I believe the language we use matters. In this case, the dominant Fed-sets-rate language makes it easy to assume that the federal funds rate is low because the Fed’s target is low. It makes it difficult to even consider the possibility that the Fed’s target is low because the market-clearing federal funds rate is low. Moreover, it suggests the Fed is in a direct and dominant position when, in fact, the Fed plays an indirect role and, at least by my assessment, is subservient to routine market forces. It also seems to perpetuate the all-too-common error of associating low rates with expansionary monetary policy and high rates with contractionary monetary policy. (Scott Sumner is right: Interest rates are not a reliable indicator of monetary policy.)

The Mercatus Center is a good resource for papers that discuss this issue. Check out Jeffrey Hummel’s paper.  A somewhat related paper by Thomas Raffinot is also useful.

Before getting into the main topic of the post, I’d like to point out that Mercatus has recently published a new primer on NGDP targeting, as well as futures targeting, written by Ethan Roberts and myself. I recommend it to people who want a short introduction to the concept:

The first section will clearly define monetary policy, describe the two main methods that central banks have traditionally used to carry out policy, and analyze the weaknesses of these methods. Later sections will articulate what NGDP is and how a policy of NGDP targeting works. Subsequent sections will list the most common criticisms of NGDP targeting and explain why these criticisms are misguided, and they will present arguments in support of the policy. Finally, the primer will provide specific recommendations for how to move from the current system to a system based on NGDP futures targeting.

I have a relatively low opinion of government, so I was very pleasantly surprised to see an outstanding report on monetary policy by the Joint Economic Committee.  You really need to read the entire thing, or at least the entire chapter entitled “Macroeconomic Outlook” from page 51 to 94, but here are a few excerpts:

The Report and Federal Reserve officials find low inflation rates “puzzling,” especially given the low unemployment rates. The “Phillips Curve” theory of price inflation posits that low unemployment rates drive up wages, which leads firms to raise prices to offset rising costs. The Committee Majority explores alternative explanations for below-target inflation. Notably, monetary policy may not have been as “accommodative” as commonly perceived.

The report then began describing policy in 2008, which was aimed at rescuing banks, not the broader economy:

Federal Reserve Bank of Richmond senior economist Robert Hetzel succinctly described the unusual credit policy:

Policies to stimulate aggregate demand by augmenting financial intermediation provided an extraordinary experiment with credit policy as opposed to monetary policy.

The Fed bought financial instruments from particular credit markets segments to direct liquidity toward them, which had the effect of injecting reserves into the banking system. This action alone would incidentally ease monetary conditions, but the Fed then sold Treasury securities from its portfolio to withdraw those reserves from the banking system (called “sterilization”), thereby restricting nominal spending growth.

I also get cited a few times:

Furthermore, despite the low level of the Fed’s fed funds rate target, monetary policy arguably remained relatively tight, as monetary economist Scott Sumner notes in the context of a 2003 Ben Bernanke speech:

Bernanke (2003) was also skeptical of the claim that low interest rates represent easy money:

[Bernanke:] As emphasized by [Milton] Friedman… nominal interest rates are not good indicators of the stance of monetary policy…The real short-term interest rate… 55 is also imperfect…Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation.

Ironically, by this criterion, monetary policy during the 2008-13 was the tightest since Herbert Hoover was President.

Then it discusses why various QE programs had little impact:

The Fed was clear from the outset that it would undo its LSAPs eventually (i.e., remove from circulation the money it created in the future). The temporary nature of the policy discouraged banks from issuing more long-term loans. Alternatively, as economist Tim Duy pointed out during the inception of the Fed’s first LSAP program:

Pay close attention to Bernanke’s insistence that the Fed’s liquidity programs are intended to be unwound. If policymakers truly intend a policy of quantitative easing to boost inflation expectations, these are exactly the wrong words to say. Any successful policy of quantitative easing would depend upon a credible commitment to a permanent increase in the money supply. Bernanke is making the opposite commitment—a commitment to contract the money supply in the future.

Sumner (2010), Beckworth (2017), and Krugman (2018) observe similar issues. Furthermore as Sumner (2010), Feldstein (2013), Beckworth (2017), Selgin (2017), and Ireland (2018) note, payment of IOER at rates competitive with market rates led banks to hoard the reserve, which contributed at least partially to the collapse of the money multiplier (Figure 2-3).

And it wasn’t just right of center economists that objected to IOR:

Regarding IOER, former Federal Reserve Vice Chairman Alan Blinder advised in 2012:

I’ve been urging on the Fed for more than two years: Lower the interest rate paid on excess reserves. The basic idea is simple. If the Fed reduces the reward for holding excess reserves, banks will hold less of them—which means they will have to find something else to do with the money, such as lending it out or putting it in the capital markets.

He later observed in 2013:

If the Fed charged banks rather than paid them, wouldn’t bankers shun excess reserves? Yes, and that’s precisely the point. Excess reserves sitting idle in banks’ accounts at the Fed do nothing to boost the economy. We want banks to use the money.

I suggested negative IOR way back in early 2009.

They also point out that the Fed has ignored the intent of the Congressional authorization of IOR:

The law specifies that IOER be paid at “rates not to exceed the general level of short-term interest rates.” However, from 2009- 2017, the IOER rate exceeded the effective fed funds rate 100 percent of the time, the yield on the 3-month Treasury bills 97.2 percent of the time, and the yield on 3-month nonfinancial commercial paper 82.1 percent of the time (Figure 2-5). The Fed is including its own discount rate (the primary credit rate) in the general level of short-term interest rates to demonstrate compliance with the law.

In connection to IOER, Representative Jeb Hensarling, Chairman of the House Financial Services Committee, stated:

[It] is critical that the Fed stays in their lane. Interest on reserves – especially excess reserves – is not only fueling a much more improvisational monetary policy, but it has fueled a distortionary balance sheet that has clearly allowed the Fed into credit allocation policy where it does not have business.

Credit policies are the purview of Congress, not the Fed. When Congress granted the Fed the power to pay interest on reserves, it was never contemplated or articulated that IOER might be used to supplant FOMC. If the Fed continues to do so, I fear its independence could be eroded.

The following is also an important point—making sure than monetary policy continues to be about money:

Noting that the large quantity of reserves produced by the Fed contributed to the fed funds rate trading at or below the IOER rate, John Taylor of Stanford University’s Hoover Institution said:

[W]e would be better off with a corridor or band with a lower interest rate on deposits [IOER] at the bottom of the band, a higher interest rate on borrowing from the Fed [the discount rate] at the top of the band, and most important, a market determined interest rate above the floor and below the ceiling… We want to create a connect, not a disconnect, between the interest rate that the Fed sets and the amount of reserves or the amount of money that’s in the system. Because the Fed is responsible for the reserves and money, that connection is important. Without that connection, 63 you raise the chances of the Fed being a multipurpose institution.

Most importantly, the government is beginning to recognize that it was tight money that caused the Great Recession:

The preceding observations and alternative views merit consideration. In particular, Hetzel (2009) states:

Restrictive monetary policy rather than the deleveraging in financial markets that had begun in August 2007 offers a more direct explanation of the intensification of the recession that began in the summer of 2008.

When people like Hetzel, Beckworth and I made that claim back in 2008-09, we were laughed at.  Who’s laughing now?

Classical recessions were often caused by shocks that reduced the natural rate of interest.  As market interest rates fell (there was no Fed), the demand for gold increased.  Because gold was the medium of account, this was a negative demand shock.

Modern recessions occurred because the Fed struggled to control inflation, as we gradually moved to a fiat money system after the Depression.  Inflation would rise too high, and this would cause the Fed to tighten.

I recall that Paul Krugman once did a post suggesting that the most recent recessions were not caused by the Fed, but rather were caused by factors such as bubbles and investment/financial instability.  The recessions of 1991, and especially 2001 and 2008, were not preceded by particularly high inflation expectations, which were well anchored by Taylor Rule-type policies. Thus these recent recessions (in his view) were not triggered by tight money policies aimed at reducing inflation, as had been the case in 1982, 1980, 1974, 1970, etc.

I suspect that the post-modern recessions are indeed a bit different, but not quite in the way that Krugman suggests.  Although I don’t think interest rates are a useful way of thinking about monetary policy, I’ll use them in this post.  (If I just talked about slowdowns in NGDP growth it would not convince any Keynesians.)

In the New Keynesian model, a tight money policy occurs when the Fed’s target rate is set above the natural rate of interest. In 1981, that meant the Fed had to raise its interest rate target sharply, to make sure that nominal interest rates rose well above the already high inflation expectations, high enough to sharply reduce aggregate demand.  In contrast, interest rates were cut in 2007, despite a strong economy and low unemployment.  The natural interest rate started falling in 2007 as the real estate sector contracted.

In a deeper sense, however, the post modern recessions are no different than pre-1990 recessions.  They still involve the Fed setting its fed funds target above the natural rate.  The difference is that in recent recessions this has occurred via a fall in the natural rate of interest, whereas in 1981 it occurred through a sharp rise in the market rate of interest.

You might say that we used to have errors of commission, whereas now we have errors of omission.  But that only makes sense if you accept the notion that interest rates represent monetary policy.  But they don’t. Every major macro school of thought suggests that something other than interest rates represent the stance of monetary policy.  Monetarists cite M2, Mundell might cite exchange rates, New Keynesians cite the spread between market rates and the natural rate.  No competent economist believes that market interest rates represent the stance of monetary policy.

Thus in the end, Krugman’s distinction doesn’t really make any sense.  It’s always the same—recessions are triggered by the Fed setting market interest rates above the natural interest rate.  Since 1982, the natural rate of interest (real and nominal) has been trending downwards.  This was an unexpected event that very few people forecast.  (I certainly did not.) The Fed would occasionally end up behind the curve in terms of noticing the decline in the natural rate.  The FOMC would only realize its error when NGDP growth fell well below their desired rate.  Then they’d try to ease policy, but initially they’d underestimate how much they needed to cut rates in order to get the proper amount of stimulus.  The natural rate was lower than they assumed.  Hence slow recoveries.

My hunch is that we are coming to the end of this long downtrend in the natural rate of interest.  That means that future recessions will be caused by some other type of cognitive error.  That’s also why I expect this to be the longest economic expansion in US history.  But that’s not very impressive when you have such a weak recovery.  Much more impressive would be the longest consecutive streak of boom years.  Now that would Make America Great Again!

A commenter named “tpeach” recently asked the following:

My question is, what would have happened if the Fed hadn’t cut rates between Dec 07 and Apr 08? What would have happened to the base and velocity if the fed kept the rate stable while the Wicksellian or market rate plummetted during that time? Would the base shrink? If so, what are the mechanics behind that process? Also, how can the fed adjust the rate without changing the base? And why didn’t velocity drop when they cut rates during this time?

I wasn’t able to provide much of an answer.  Here I’d like to explain why.

At first glance, the obvious counterfactual would seem to be a smaller monetary base and a higher path of interest rates.  But that is a very fragile equilibrium, which could easily spiral off in one direction or another.  For instance, suppose the Fed had reduced the monetary base in late 2007 in order to prevent any fall in the fed funds rate.  What might have happened next?  One possibility is that the economy would have gone into a deep depression in early 2008.  Most likely, the Fed would have responded to that deep depression with a big rate cut and a big increase in the monetary base.  Thus in this case the counterfactual path of the base would have been a bit lower in late 2007, and much higher in early 2008. Indeed what I just described is roughly what did happen between early and late 2008—I am simply contemplating that scenario playing out 6 months earlier.

Monetary equilibrium often has “knife edge” qualities.  Imagine climbing along a mountain ridge with steep drop-offs on both sides.  If you are not at the peak of the ridge, you have the option of walking a bit further up the slope.  But if you go too far, you risk plunging down the other side.  Monetary economics is kind of like that.  Small changes are often “Keynesian” in character, meaning slightly tighter money means slightly higher nominal interest rates.  But larger changes can easily be “Neo-Fisherian” in character, meaning tighter money leads to lower nominal interest rates.  And it’s not just a question of more or less tight money, it’s more about expectations regarding the future path of policy.

Yip Cloud recently pointed me to the latest in his excellent series of interviews of macroeconomists, this one of Atif Mian:

Some people have the 5-year adjustable rate mortgages (ARMs), others have the 7-year ARMs. Let’s say that the mortgages started in 2005. When 2010 comes, in the middle of the slowdown, those with the 5-year ARMs would get the interest rate reduction because the mortgages reset to a lower rate automatically. They get this reduction in the interest rate that the Fed was trying to pass through to the individual households. But those individuals who have a 7-year ARMs still have to wait for 2 additional years before they get a lower interest rate.

By taking advantage of this kind of variation in the cross-section, they can actually show the impact of the reduction in interest rate for the 5-year ARMs owners, by comparing them to the 7-years ARMs owners who didn’t receive the same reduction in interest rate just because they have a different kind of financial contract. What they’ve shown with this kind of analysis is that a reduction interest rate is actually beneficial. It actually allows the lenders to boost their spending and improves local economic outcome, in term of employment and aggregate demand. That’s just one example that actually shows monetary policy can be effective.

At the same time, that same work also shows why the monetary policy was ineffective. If you think about it, you need to be able to pass through the action of the Fed to the ultimate households. However, if people are struck in the 30-year fixed rate mortgages, they would not be able to take advantage of this lower interest rate environment. As a result, monetary policy is not able to pass through to the ultimate households. It is going to be constrained in the effectiveness. That’s a very important insight that has come about because of this kind of work that I emphasized. That’s a very interesting and useful development.

If people have borrowing capacity and willing to borrow, the same monetary policy shock can have more impact on the real economy. When you lower interest rate, for people who are prone to borrow more, they can borrow aggressively against a lower interest rate and that boosts the economy.

But if the same individuals have already borrowed a lot in the down-cycle, you can lower the interest rate but those individuals are underwater. They can’t borrow any more. Then the same reduction in interest rate is not going to have much of an impact on the macroeconomy. This kind of logic also suggests that monetary policy itself is going to be insufficient in dealing with the downturn. You need to focus on something that Sufi and I have to try to emphasize in our book.

I can’t emphasize enough that (as Friedman, Bernanke and Mishkin pointed out) changes in interest rates are not the same as changes in the stance of monetary policy, for standard “never reason from a price change” reasons.  Thus it’s not possible to draw any conclusions about the effectiveness of monetary policy by looking at the impact of changes in interest rates.  To take the most obvious reductio ad absurdum example, a Mexican currency reform exchanging 100 old pesos for one new peso will immediately reduce the price level by 99%, without any significant change in interest rates.