Archive for the Category Quantity Theory of Money


Lower interest rates are contractionary

No, this is not a NeoFisherian post.  I’m not claiming that a Fed policy that depresses interest rates is contractionary, I’m claiming lower interest rates are contractionary, ceteris paribus.  And ceteris paribus in this case means for any given money stock.  For simplicity, we’ll start with a simple model–no IOR— and then bring in IOR later.  And in doing so I’ll answer a question a commenter asked me: Is talking about the effect of IOR an example of reasoning from a price change?

Let’s start with this identity:

M*V = P*Y

Where M is the base and V is base velocity.  Now let’s build a model:

M*V(i) = P*Y

Since V is positively related to i, lower interest rates are contractionary, they reduce V and hence NGDP, AKA aggregate demand.  Larry Summers once wrote an article (with Robert Barsky) pointing this out, but only for the gold standard period.

So why do people not named Summers and Sumner not know this?  There are several reasons:

Sometimes, not always, reductions in interest rates are caused by an increase in the monetary base.  (This was not the case in late 2007 and early 2008, but it is the case on some occasions.)  When there is an expansionary monetary policy, specifically an exogenous increase in M, then when interest rates fall, V tends to fall by less than M rises.  So the policy as a whole causes NGDP to rise, even as the specific impact of lower interest rates is to cause NGDP to fall.

2.  Another problem is the Keynesian model, which hopelessly confuses the transmission mechanism.  Any Keynesian model with currency that says low interest rates are expansionary is flat out wrong.  That’s probably why economists were so confused by 2008.  Many people confuse aggregate demand with consumption.  Thus they think low rates encourage people to “spend” and that this somehow boosts AD and NGDP.  But it doesn’t, at least not in the way they assume.  If by “spend” you mean higher velocity, then yes, spending more boosts NGDP.  But we’ve already seen that lower interest rates don’t boost velocity, rather they lower velocity.

Even worse, some assume that “spending” is the same as consumption, hence if low rates encourage people to save less and consume more, then AD will rise.  This is reasoning from a price change on steroids!  When you don’t spend you save, and saving goes into investment, which is also part of GDP.  Now here’s were amateur Keynesians get hopelessly confused.  They recall reading something about the paradox of thrift, about planned vs. actual saving, about the fact that an attempt to save more might depress NGDP, and that in the end people may fail to save more, and instead NGDP will fall.  This is possible, but even if true it has no bearing on my claim that low rates are contractionary.

To see the problem with this analysis, consider the Keynesian explanations for increases in AD.  One theory is that animal spirits propel businesses to invest more.  Another is that consumer optimism propels consumers to spend more.  Another is that fiscal policy becomes more expansionary, boosting the budget deficit.  What do all three of these shocks have in common?  In all three cases the shock leads to higher interest rates.  (Use the S&I diagram to show this.)  Yes, in all three cases the higher interest rates boost velocity, and hence ceteris paribus (i.e. fixed monetary base) the higher V leads to more NGDP.  But that’s not an example of low rates boosting AD, it’s an example of some factor boosting AD, and also raising interest rates.

Again, I defy you to explain how low rates can boost NGDP, ceteris paribus.  If you think you have an explanation, it’s probably something that confuses consumption with total spending on NGDP.  An explanation that wrongly assumes the public’s desire to spend more on consumption, as a result of lower interest rates, is expansionary for NGDP.  Yes, an exogenous change in M will often cause short term rates to move in the opposite direction, but how often do you see exogenous changes in M?  If we were operating in a normal economy, with say 3% or 4% interest rates, and I told you rates would fall to zero in the next 12 months, would you predict a recession or boom?  Obviously a recession.  Yes, if the Fed perversely cut rates to zero in an otherwise stable economy, via fast growth in the base, that would be expansionary.  But more than 100% of the expansionary impact would come from the rise in the base (hot potato effect), and less than zero from the lower rates.

There is simply no mechanism in macroeconomics where low rates actually CAUSE more NGDP.  None.  Nada.  Lower rates reduce velocity, and that’s contractionary.  It’s not about “spending”, unless by “spending” you mean velocity.  If you mean “spending” vs. saving then you are hopelessly off track.  You aren’t even in the right train station.

Now for the hard part.  The Fed recently raised the fed funds rate, and did so without lowering the base.  So am I claiming that the Fed’s decision was expansionary?  No, but I wouldn’t blame you for seeing a contradiction here, especially if your last name is “Murphy.”

Suppose the Fed had raised the fed funds target, without raising IOR.  What then?  Then they would have had to reduce the monetary base enough to make the rate increase stick.  How much?  Fasten your seatbelts—by almost $3 trillion.  That’s right, without IOR, to even get a measly quarter point increase, they would have had to withdraw almost the entire previous QE (except the part that went into currency held by the public.)

Instead the Fed did something else, they raised IOR.  Even though IOR includes the term ‘interest,’ as part of its acronym, it actually has absolutely nothing to do with market interest rates as I’ve been discussing them so far.  It’s better to think of IOR as a tax/subsidy scheme.

Previously I claimed that higher interest rates are expansionary.  They are.  But higher IOR really is contractionary.  That’s why the New Keynesians love IOR so much.  It helps make their false “non-monetary” models of the economy less false, indeed sort of truish.  It really is true that higher IOR is contractionary.  So why the difference?  Let’s return to the simple model above.  I said that model applied to a world of no IOR.  If IOR exists, then the more general model is:

M*V(i – IOR) = P*Y

That is, velocity is positively related to the difference between the market interest rate and the interest rate on money.  This gap is the opportunity cost of holding reserves.  I wish there were no IOR, if only because it would make monetary analysis so much simpler.

In order to make monetary policy more contractionary, the Fed merely needs to shrink the gap between i and IOR.  That reduces the opportunity cost of holding base money, which causes more demand for base money (as a share of NGDP), which is contractionary.  Consider the weird situation we are in:

1.  Almost everyone assumed higher rates were contractionary, but almost everyone was wrong.

2.  Now IOR comes along, and higher IOR really is contractionary.

Now I fear that it will be even harder to slay the Keynesian dragon; the model now seems superficially even more plausible. If I was a conspiracy nut I’d think it was all a plot to make Woodford’s moneyless models appear more accurate.

To summarize, IOR is not really a market price, it’s a subsidy on base money, and negative IOR is a tax on base money. Just as it’s OK to reason from an increase in excise taxes on gasoline, it’s OK to reason from a change in IOR.  (Of course you also need to consider other changes that are occurring in monetary policy, as is always the case.)

So if lower interest rates are not the reason that monetary stimulus is expansionary, then what is the reason?  Why do more people want to go out and assume car loans when the Fed cuts interest rates via an easy money policy?  Here’s why:

1.  If the Fed lowers rates via an increase in the base, then more base money raises NGDP via the hot potato effect (AKA, laws of supply and demand).  Interest rates play no role, indeed NGDP would rise by even more if rates (and velocity) didn’t fall.

2.  The higher NGDP causes more hours to be worked, due to sticky nominal hourly wages.

3.  More hours worked means more output and more real income.

4.  Say’s Law says supply creates its own demand.  So as workers and capitalists produce more output and earn more income, they go to car dealers to splurge with their sudden newfound wealth.  Interest rates got nuthin to do with it.  Saving (and investment) as a share of GDP actually rises during booms created by monetary stimulus.  It’s not about “spending” (as in consumption), it’s about actual spending on C+I+G+NX, i.e. NGDP.

5.  Of course all this happens simultaneously, as we live in a Ratex world.

PS.  I’m begging you, don’t try to explain what you think is wrong with Say’s Law, unless you want me to be as insulting as possible in response.

Krugman and DeLong mount a chivalrous defense of IS-LM

I’ve posted a bunch of critiques of IS-LM, but naturally Tyler Cowen’s criticism (which I agree with) got more attention.  Brad DeLong had this to say:

The right thing for Tyler to have said, from my perspective at least, would have been that IS-LM does not provide us with enough insights to satisfy us, and here is a slightly more complicated model–a four-good or a three-good two-period model–that actually helps us think coherently about (some of) the issues of nominal versus real interest rates, short-term versus long-term interest rates, safe versus risky interest rates, moral hazard and adverse selection in the bond market, non-interest bearing and interest bearing assets, liquidity and means of payment, flows and stocks, expectations, government reaction functions, and so forth.

Both DeLong and Krugman insist that macro needs to start with simple models.  I agree.  And that those models must at a minimum include money, bonds and output.  Here I don’t entirely agree.  I think a model with money and goods, plus sticky prices, can get at many of the key features of the business cycle.  BTW, I am not envisioning a model with constant velocity; I agree that would be almost entirely useless.  But I’m willing to provisionally go along with the three market minimum for reasons that DeLong lays out here:

But the mechanical quantity theory is simply wrong for us today: the Fed has tripled the monetary base since 2007, and yet the flow of nominal spending has not tripled: not at all. IS-LM at least starts you thinking about the issues around the concept that has been called the “liquidity trap” which the mechanical quantity theory does not.

A quantity theoretic monetary model need not be the mechanical quantity theory.  So I see DeLong making a pragmatic argument here.  He’s saying that thinking in quantity theoretic terms is likely to lead us astray.  We know that V might change, but we are likely to forget that problem when thinking about policy options at the zero bound.  Fair enough.  But this criticism applies equally to IS-LM, which is also likely to lead one astray, especially at the zero bound.

The IS-LM model led economic historians to argue money was easy in 1929-30, because rates fell sharply.  It led modern Keynesians to assume that money was easy in 2008, because rates fell sharply.  And IS-LM proponents underestimated the importance of monetary stimulus in late 2008, because they thought the IS-LM model told them that monetary policy is ineffective at the zero bound.  Brad DeLong himself was one of those IS-LM proponents who underestimated the importance of monetary stimulus in late 2008.  Now he’s bashing the Fed almost every day.

Some IS-LM defenders argue that there is nothing wrong with the IS-LM approach; it’s just that the model is misused by its supporters.  After all, there has to be some sort of general equilibrium in the goods, money, and bond markets.  The markets all interact with each other.  And the IS and LM lines merely depict that general equilibrium.  Yes, but a model that general would be pretty useless.  IS-LM proponents also tend to argue that the IS curve is downward sloping.  Nick Rowe recently argued that it is upward sloping.  I think Nick’s right, at least if we use the yield on T-securities as “the interest rate,” and use a time frame that is relevant for business cycle analysis (a few months or years.)  The problem is that most Keynesians identify changes in monetary policy by changes in interest rates, and hence misidentify monetary shocks.

So has Nick “fixed” the problem with IS-LM?  Not really, because it’s a mistake to think of their being a “true” IS-LM model, untainted by the misuse of its adherents.  Models aren’t out there in some Platonic realm, they are tools created by humans.  The value of any model is instrumental, not intrinsic.  If IS-LM is misused by almost everyone, then ipso facto, it’s not a good model.

Paul Krugman makes an anti-elitist argument in favor of IS-LM:

Here’s the problem: Macro I (that’s 14.451 in MIT lingo) is a quarter course, which is supposed to cover the “workhorse” models of the field – the standard approaches that everyone is supposed to know, the models that underlie discussion at, say, the Fed, Treasury, and the IMF. In particular, it is supposed to provide an overview of such items as the IS-LM model of monetary and fiscal policy, the AS-AD approach to short-run versus long-run analysis, and so on. By the standards of modern macro theory, this is crude and simplistic stuff, so you might think that any trained macroeconomist could teach it. But it turns out that that isn’t true.

.   .   .

Now you might say, if this stuff is so out of fashion, shouldn’t it be dropped from the curriculum? But the funny thing is that while old-fashioned macro has increasingly been pushed out of graduate programs– it takes up only a few pages in either the Blanchard-Fischer or Romer textbooks that I am assigning, and none at all in many other tracts – out there in the real world it continues to be the main basis for serious discussion. After 25 years of rational expectations, equilibrium business cycles, growth and new growth, and so on, when the talk turns to Greenspan’s next move, or the prospects for EMU, or the risks to the Brazilian rescue plan, it is always informed – explicitly or implicitly – by something not too different from the old-fashioned macro that I am supposed to teach in February.

I think Krugman’s right that real world policymakers use IS-LM to frame the issues.  And to me that’s precisely the problem.  The policymakers understand the basic IS-LM model, but not its weaknesses.  They think there is “a” fiscal multiplier, ignoring monetary policy feedback.  They think that low rates mean easy money.  That’s why when I started arguing that money became ultra-contractionary in late 2008 I was regarded as something of a kook.  Policymakers also tend to assume the Fed is out of ammo at zero rates.  Where does this crazy idea come from?  Krugman constantly like to praise Hick’s 1937 model, but in that paper Hicks said that the liquidity trap was the only revolutionary idea in the entire General Theory.  The rest was putting already understood concepts (i.e. money demand depends on interest rates, or wages and prices are sticky) into a different language.  There’s no question that the liquidity trap view comes from IS-LM, even its supporters admit that.  And the liquidity trap view that is out there in the real world is the main reason we are letting central banks off the hook, the reason Obama thinks the Fed has “shot its wad.”

We don’t need policymakers that rely on IS-LM; we need policymakers that rely on cutting edge macro.  Who rely on arguments for why level targeting is an extremely powerful tool at the zero bound.  Those should be the standard model, if we insist on teaching our policymakers a standard model.  We need useful models, not models that fulfill our urge map out a 3 market general equilibrium framework.

Here Krugman trashes Tyler Cowen:

Brad DeLong comes down hard on Tyler Cowen over his attempt to critique the IS-LM model “” but not hard enough.

.  .  .

In macro “” or at least macro that tries to get at monetary and fiscal issues “” what you need, at minimum, is to understand an economy in which there are three goods: money, bonds, and economic output.

.  .  .

There’s something about macro that seems to invite this sort of thing: more even than the rest of economics, macro seems afflicted with people who mistake confusion for insight, who think their own failure to understand basic ideas reflects a failure of those ideas rather than their own limitations.

Tyler shouldn’t feel too bad about this.  After all, Krugman doesn’t identify a single flaw in Tyler’s critique.  The post is just a string of personal insults.  And recall that Michael Woodford creates models without money, so he’s also “confused.”  And of course Milton Friedman was no fan of IS-LM—so he’s another guy who just doesn’t get it.

I favor an ad hoc approach to models–use the simplest model that gets at the issues you are interested in.  Start with a simple economy with money and goods, no bonds.  The supply and demand for money determines the price level and/or NGDP.  That’s most of human history.  Add wage price stickiness and you get demand-side business cycles.  Add interest rates and you get . . . well it’s not clear what you get.  Interest rates almost certainly have an influence on the demand for money.  Do they play a major role in the transmission mechanism between money and aggregate demand?  Hard to say.  Short term Treasury yields probably don’t have much impact.  Other asset prices might, but then there is generally no zero bound for other asset prices.  On the other hand monetary policy often operates through purchase of short term T-securities.  Bottom line, it’s complicated.

Now let’s add another asset, NGDP futures contracts.  Now the modeling process gets much easier.  We model monetary policy as changes in the price of NGDP futures contracts (accomplished through central bank purchases of financial assets in order of safety and liquidity, as much as it takes.)  Then we have a Philips Curve or SRAS curve to translate NGDP shocks in fluctuations in real output.  Since NGDP futures prices are monetary policy, fiscal policy is 100% classical.

Some will object that we don’t have NGDP futures contracts, so we are currently forced to stop at the money/bonds/goods stage of human progress.  Not so, we can construct a pseudo-NGDP futures price by modeling expected NGDP as a function of lots of variables (past NGDP, current asset prices, TIPS spreads, consensus forecast of economists, etc.)  That pseudo-NGDP futures price is available to Fed officials in real time.  They can peg it if they want to.  The policy has flaws related to the circularity problem (which NGDP index futures convertibility does not have), but it’s workable.

Of course you’ve probably noticed that this is also my model.  I think it’s also in the tradition of Milton Friedman, although obviously it differs in certain respects.  Friedman thought it was more useful to take a partial equilibrium approach to macro.  By doing so he was able to avoid the mistakes of those who looked at the Depression from an IS-LM perspective.  He was interested in how monetary policy determined NGDP, and then used a separate Phillips Curve approach with a natural rate to explain output fluctuations, to partition NGDP into RGDP and P.  He viewed interest rate movements as a sort of epiphenomenon.  Monetary policy affected rates in a complex way, which made interest rates an unreliable indicator of the stance of monetary policy.

Of course the indicator Friedman choose, M2, also turned out to be somewhat unreliable, which is why I replaced it with NGDP futures.  Expected NGDP (or something similar that incorporates the Fed’s dual mandate–like the Taylor Rule) is the goal of monetary policy.  There’s quite a bit of slack between changes in M2 and changes in expected NGDP.  In contrast, changes in the price of NGDP futures contracts ought to track changes in expected NGDP (the policy goal) pretty closely.  I find the NGDP perspective to be much more useful than the interest rate perspective.

BTW, I think this might have been what Tyler Cowen had in mind here (first Tyler, then Brad):

“The most important points… one can derive from a… nominal gdp perspective…”

What is this “nominal GDP perspective”? The Google reports that as of this writing the phrase “nominal GDP perspective” appears only once on the internet–in Tyler’s post.

I want all 5000 of my readers to Google “Scott Sumner nominal GDP perspective” 100 times.  Each time, please link to my blog if it appears on the list.

I think DeLong and Krugman need to lighten up a bit.  They are defending the IS-LM model like it’s some sort of bride whose virginity has been challenged.  Models are only valuable if they are useful.  We critics are convinced that other approaches are much more useful.  Contrary to DeLong, there is nothing “tribal” about all this.  I’ve discarded the old monetarist preference for M2 targeting, and accepted the Krugman argument that temporary monetary injections are ineffective at the zero bound.  I’m not tribal, I’m eclectic.  When we see people use models in ways that we think are wrong, indeed that we think helped cause the Great Recession, we are naturally going to be critical of those models.  Especially if we find alternative approaches that seem more fruitful—like viewing monetary policy through the lens of changes in NGDP expectations, and viewing fiscal policy in essentially classical terms (except where a bizarrely perverse central bank allows fiscal decisions to alter its inflation or NGDP target.)

PS.  Yes, I do understand that the strongest criticism of my approach is that we do live in a world with bizarrely perverse central banks.  We’ll fight that issue another day.

A critique of the “credit economy” hypothesis

Tyler Cowen recently linked to a post by Ashwin claiming that the US might now be a credit economy, and that this weakens the old quantity theory of money.  This hypothesis is based on two misconceptions.  Here Ashwin quotes Alex Leijonhufvud:

The situation that Wicksell saw himself as confronting, therefore, was the following. The Quantity Theory was the only monetary theory with any claim to scientific status. But it left out the influence on the price level of credit-financed demand. This omission had become a steadily more serious deficiency with time as the evolution of both “simple” (trade) and “organized” (bank-intermediated) credit practices reduced the role of metallic money in the economy. The issue of small denomination notes had displaced gold coin from circulation and almost all business transactions were settled by check or by giro; the resulting transfers on the books of banks did not involve “money” at all.

If we were moving to a credit economy then the demand for currency and base money would be declining.  But it isn’t, indeed it is higher than in the 1920s.  Admittedly this is partly due to the Fed’s decision to pay interest on reserves.  But even the currency component of the base is larger than in the 1920s, even as a share of GDP!  It is not true that the various forms of electronic money and bank credit are significantly reducing the demand for central bank produced money.

Here Ashwin quotes Claudio Borio and Piti Disyatat:

The amount of cash holdings by the public, one form of outside money, is purely demand-determined; as such, it provides no external anchor. And banks’ reserves with the central bank – the other component of outside money – cannot provide an anchor either: Contrary to what is often believed, they do not constrain the amount of inside credit creation. Indeed, in a number of banking systems under normal conditions they are effectively zero, regardless of the level of the interest rate. Critically, the existence of a demand for banks’ reserves, arising from the need to settle transactions, is essential for the central bank to be able to set interest rates, by exploiting its monopoly over their supply. But that is where their role ends. The ultimate constraint on credit creation is the short-term rate set by the central bank and the reaction function that describes how this institution decides to set policy rates in response to economic developments.

This is a common misconception, especially among Keynesians and MMTers.  It is true that central banks often set a short term interest rate target, and that once this target is set short run changes in the base are endogenous.  But if that’s all they did then the price level would become indeterminate.  Instead, they use their monopoly control over the base to move interest rates around in such a way as to target the price level.  Because money is neutral in the long run, a given change in the monetary base will produce a proportional long run change in the price level and NGDP.  Borio and Disyatat did acknowledge that rates are adjusted to target macro goal variables, but they failed to see the implication of that observation.

This can best be explained with an analogy.  In 1973-74 the OPEC oil cartel decided to increase the price of oil from $3 to $10 a barrel.  At the new price, quantity supplied was completely demand determined, OPEC responded passively to consumer demand at that new price point.  OPEC had no short run control over the supply of oil.  But that’s not at all what economists think is “really going on.”  OPEC was able to raise prices by virtue of its ability to sharply reduce would oil supply.  When we teach this in class, we show a leftward shift in the world oil supply curve.  Or we might show a monopoly diagram with OPEC picking the output point where MR=MC.  In either case, they are only able to control prices by controlling quantity.  Indeed they could have even decided not to set an official price, and instead merely set a sharply reduced output level—the effect would have been the same.

When the Fed eases monetary policy we generally notice them cutting their fed funds target.  But the exact same effect would occur if they simply increased the base, and let the fed funds rate fall in the free market.  Indeed they basically tell their trading desk to adjust the base as need to keep market rates at a desired level.  But it doesn’t have to be that way—they could just as well tell the New York trading desk to adjust the base as needed to keep CPI futures contract prices at a 2% premium over the spot level.  In that case no one would say; “the Fed controls the CPI by controlling the CPI.”  They’d say; “the Fed controls the CPI by adjusting the amount of base money in circulation.”  Today people say; “The Fed controls the CPI by controlling the fed funds rate.”  In fact, they control the CPI by controlling the size of the monetary base in such as way as to produce a monetary base and interest rates that are expected to lead to 2% inflation.

There will probably always be money; a pure credit economy is unthinkable.  Without money there is no price level, because the price level is defined as the average price of goods in terms of money.

PS.  Some might object that a higher proportion of currency is now held overseas.  But nothing in the QTM requires currency to be held in the country where it is produced.  Double the currency stock and the price level will double, ceteris paribus, regardless of where currency is held.

Too literal-minded? A theory of the strange world of the MMTers

I recently did a post trying to figure out whether there are any non-quantity theoretic models of the price level.  It led to one of the most intense debates I’ve ever seen in my comment section, and even other bloggers chimed in with posts.  But no one came forth with a non-quantity theoretic model of the price level.  It is very important that any monetary theory be able to explain why prices aren’t 100 times higher, or 100 times lower.  Thus I’m more inclined than ever to think the QTM is the best starting point for monetary theory (although obviously it’s not literally true that M and NGDP grow at the same percentage rates.)

I wasn’t able to fully grasp how MMTers (“modern monetary theorists”) think about monetary economics (despite a good-faith attempt), but a few things I read shed a bit of light on the subject.  My theory is that they focus too much on the visible, the concrete, the accounting, the institutions, and not enough on the core of monetary economics, which I see as the “hot potato phenomenon.”  This is the idea that the central bank controls the total quantity of money, but each individual controls their own personal “money supply.”  So if the Fed injects more money into the economy, something has to give to equate money supply and demand.  Initially there is too much money in circulation, and people pass the excess balances to one another like a hot potato.  This process drives up NGDP, until the public is willing to hold the new quantity of money.

Importantly, it’s very hard for individual people to see how this process works, as the Fed injection of cash doesn’t make anyone richer.  They swap cash for bonds, at fair market value.  But if no one is richer, why should AD go up?

The easiest way to see the process work is to imagine an economy without banks, where the new money goes right into circulation as currency.  Most people can instinctively grasp that more currency, without any increase in real goods being produced, will lead to inflation.  But when you add a banking system it’s much harder to see the hot potato effect, because now the new money can show up as either cash or bank reserves.  It looks like individuals who didn’t want to hold excess cash, could simply put it in the bank.  But of course the bank usually doesn’t want to hold a lot of excess cash (reserves) either, and so you can still have the hot potato effect.

Now let’s look at an example, first from my perspective, then theirs:

The Fed wants to raise the price level by 10%.  So they decide to suddenly increase the monetary base by 10%, and then continue on with the same money supply growth rate as before.  This should cause a 10% one-time rise in P, and in NGDP, compared to the no-action alternative.  But if they actually did this in a modern economy, it would create a big mess.  NGDP doesn’t change immediately, so it’s be hard to generate demand for that extra cash.  Even so, the Fed can literally force base money into the economy, by selling [I meant buying] bonds.  I believe the MMTers, argue that trying to do this would drive rates to zero.  That may or may not be true; they tend to overlook that the interest rate isn’t just the price of money, it’s also the price of credit.  So a highly expansionary policy can increase interest rates under certain conditions, for certain maturities.  But let’s assume rates did go to zero.  Then AD would rise, and eventually NGDP would increase 10%.  At that point the public is willing to hold the larger cash balances, and the nominal interest rate returns to its original level.

Because this process would be messy, real world central banks would use a much more subtle process, involving signaling.  They will signal the desire for 10% higher NGDP though various mechanisms–a higher inflation target, a lower exchange rate, or most commonly, a lower fed funds target rate.  If credible, this signal will boost AD.  To some that seems like handwaving (the inflation target more so than the interest rate.)  It’s actually an implied commitment to provide 10% more base money at that future date when NGDP is 10% higher.  But in that case the cause of the higher NGDP (more cash in the long run) seems to occur after the effect (higher NGDP growth.)  To many people, that is deeply disturbing.  An observant reader will have noticed that cause doesn’t actually follow effect in this case, the true cause of everything is a sudden expectation that future levels of currency will rise by 10%.  So cause actually does precede effect.

My hunch is that the MMTers are fooled by this process.  They probably have a better understanding of modern central banking than most non-MMTers, certainly better than mine.  They see the central bank targeting rates, and when the target changes, there is often almost no immediate change in the monetary base.  Instead, things like loans may pick up.  To prevent the interest rate from deviating from the target, the central bank is virtually forced to respond to those bank actions by adding more reserves.  This makes the monetary base seem endogenous, and in the extremely short run it is, at least under modern central bank practices.  In the future, the advent of IOR may make central banking resemble the MMTers model even more closely.

Nevertheless, even though money seems endogenous, it actually isn’t.  A permanent peg of the interest rate would leave prices unanchored, or indeterminate.  Thus the central bank moves rates around in a fashion that will eventually move the monetary base around in a fashion that will tend to keep P and NGDP on the target growth path.  So the base is actually doing all the heavy lifting, even though the specific procedure used by central banks makes it seem like the tail of the dog.

That’s why it’s so important to do thought experiments with monetary regimes lacking a banking system.  This allows us to first work out the basic principles of what determines the price level, i.e. what determines the value of money.  Once we’ve done that we can ask whether adding banking actually changes anything fundamental.  I say it doesn’t, but obviously the MMTers disagree.

Still it seems to me that anyone attacking my position first needs to develop a model of the price level (not inflation, but the level of prices.)  I’m convinced that only the QTM can do this, and still explain why Australia and Canada have similar price levels but Canada has more than 5 times as large government liabilities.  My answer is that both countries have similar currency stocks (per capita.)  And it’s the currency stock that matters; not total government liabilities.

The best way to understand modern sophisticated central banking is to study the most primitive monetary system possible–a medieval king debasing his money in a country lacking banks.  The causal chain between debasement and inflation is no different from the causal chain between OMPs of T-securities and inflation, at least in the long run when nominal rates rise above zero.

Are there any non-QTM explanations of the price level?

This is sort of a response to some Keynesian/fiscal theory/Post Keynesian/MMT theories I’ve seen floating around on the internet.  Theories that deny open market purchases are inflationary, because you are just exchanging one form of government debt for another.  But first a few qualifiers:

1.  If the new base money is interest-bearing reserves, I fully agree that OMOs may not be inflationary.  That’s exchanging one type of debt for another.  If it does raise inflation expectations (as QE2 did) it’s probably because it changed expectations of future monetary policy.

2.  If nominal rates are near zero, the situation is complex–I’ll return to that case later.

So let’s start with an economy that has “normal” (i.e. non-zero) interest rates, and non-interest-bearing base money.  How does the price level get determined in that case?  I’m told there are some theories of fiat money that suggest it must evolve from commodity money.  I don’t agree.  I think the quantity theory of money is all we need.  Suppose you dump 300,000 Europeans on an uninhabited island—call it Iceland.  The ship also drops off some crates of Monopoly money, and they’re told to use it as currency.  Assume no growth for simplicity.  Also assume no government and no banking system.  It’s likely that NGDP will end up being roughly 15 to 50 times the value of the stock of currency.  Once you pin down NGDP, then you figure out RGDP using real growth theories, and voila, you’ve got the price level.  At this point you might be thinking; “you consider ’15 to 50 times the currency stock’ to be a precise scientific solution?”  No, but it gets us in the ball park.  It tells us why prices are not 100 times higher than they are, or 1000 times higher.   BTW, prices in Japan are 100 times higher than in the US, and Korean prices are 1000 times higher.  I don’t see how other theories can even get us into the right ball park.

I’m going to illustrate the problem of non-QTM theories of the price level with a comparison of the US  Australia and Canada.  Here are some national debt figures from The Economist:

For simplicity assume Australia’s net debt was zero in 2007.  In Australia NGDP is about 30 times the currency stock.  Canada is similar.  (The US NGDP was only about 18 times the currency stock in 2007, because lots of our currency is hoarded overseas.)  This ratio is determined by the public.  The base also includes reserves, but in normal times like 2007 we can ignore those if we aren’t paying interest on reserves.  The opportunity cost of holding reserves is simply too large for banks to want to hold very much.  So the central bank determines the nominal base, and the public determines the ratio of NGDP to the base (aka velocity.)

Because Australia and Canada are fairly similar countries, I can get a reasonable estimate of each country’s price level as follows:

1.  Notice that their RGDP per capita is similar.

2.  Find the NGDP in one country (say Canada.)

3.   Find the currency stock in each country.

4.  Assume their NGDP/currency ratios are similar (roughly 30.)

Then all I need is Australia’s currency stock to estimate the price level in Australia.   Now suppose it was true that OMOs didn’t matter.  In that case the aggregates that would be important would be the entire stock of government liabilities, currency plus debt.  But as you can see, Canada’s was many times larger than Australia’s.  (Recall that in both countries currency is only about 3% to 4% of NGDP.)  If you looked at total government liabilities you’d get nonsense, you’d estimate Canada’s price level in 2007 to be between 5 and 10 times that of Australia, as its debt was 23.4% of GDP (so debt plus base was about 27% of GDP), vs. about 3% to 4% in Australia.   The base is “high-powered money” and interest-bearing debt isn’t.  Demand for Australian cash is very limited; you just need a little bit to smooth transactions in Australia.  Double it and the value of each note falls in half.  Double the amount of Australian T-bonds, and it’s just a drop in the bucket of a huge global market for interest-bearing debt.  The value of those bonds changes hardly at all.

Now suppose that in 2007 the US monetized the entire net debt, exchanging $6 trillion in non-interest bearing base money for T-securities.  And suppose this action is permanent.  The monetary base would have increased about 8-fold, and the QTM tells us the US NGDP (and price level) would also have increased 8-fold.  In that case our situation will be much like that of Australia; we’d have a monetary base, but no interest-bearing national debt.  So our price level would be determined in the same way Australia’s price level is determined.  NGDP would be some multiple of the base, depending on the public’s preference to hold currency (including foreign holdings of US currency.)   But since our base (and currency stock) went up 8-fold, if the ratio of NGDP to currency remained around 18, then the level of NGDP would also increase 8-fold.  That shows OMOs do matter, at least if I’m right about the public’s demand for currency usually being some fairly predictable share of NGDP.

Here’s my problem with all non-QTM models.  Suppose I’m right that only the QTM can explain the current price level.  Then it stands to reason that only the QTM can explain the price level in 2021.  Then it stands to reason that only the QTM can explain the inflation rate between 2011 and 2021.  Now it is true that a change in the money supply will have certain effects on nominal interest rates, economic slack, etc, depending on whether the monetary injections were expected or not.  And you can try to model the inflation rate using those changes in interest rates, economic slack, inflation expectations, etc.  But that’s really a roundabout way of getting at the problem.  If the QTM says that the price level in 2012 will be 47% higher due to changes in the monetary base, plus changes in the public’s desire to hold currency as a ratio or NGDP, then either the non-QTM approaches also give you the 47% answer, or they are wrong.

Here’s a nautical analogy.  You can estimate how fast a cigarette boat was going by looking at the size of the engine, the throttle setting, and so on.  That’s the direct approach, the engine drives the boat.  Or you can estimate its speed by how big its side effects were (the size of the wake, how loudly seagulls screeched as they got out of the way, etc.)  The engine approach is the QTM.  That’s what drives inflation.  (God I hope at least Nick gets this, otherwise I’ve totally failed.)  The Keynesian approach is to look at epiphenomena (like interest rates and slack) that may occur because wages and prices may be sticky to some unknown extent.  It’s like looking at the wake and trying to estimate what sort of boat went by.

OK, what about at the zero bound, aren’t cash and T-securities perfect substitutes?  Maybe, but if they aren’t expected to be perfect substitutes in 2021, then  a current OMO that is expected to be permanent will have the same impact on the expected long run price level as an OMO occurring when T-bill yields are 4%.

Of course central banks don’t target the base, they adjust the base until short term interest rates are at a level expected to produce the right inflation rate.  It’d be like adjusting the throttle until the wake looks about the right size to hit the target speed.    And in the future they might go even further away from money supply control, if they pay interest on reserves.  In that case they’ll be adjusting rates and the base in a more complicated pattern, both money supply and demand will change.  But the currency stock will still be non-interest bearing for a while, so that relationship will continue to hold.

What would cause a revival of monetarism?  That’s easy.  We just need to return to widely varying trend rates of inflation, as we saw in the 1960-1990 period.  In those decades countries might have 5%, 10%, 20%, 40% or even 80% trend inflation.  As that settles in, and people expect it, the various epiphenomena of unexpected money go away (liquidity effect, slack, etc.)  And everyone goes back to explaining inflation by looking at growth in the non-interest bearing monetary stock.  It’s the only way.  The best example was in the hyperinflationary early 1920s, when even Wicksell and Keynes, the two great proponents of the interest rate approach, became quasi-monetarists.  Needless to say I have very mixed feelings about the prospect of a revival of monetarism.

So here’s my question:  Are there any non-quantity theoretic models of the price level?  Theories that could explain the difference between Australian and Canadian and Japanese and Korean price levels?