Glasner, Keynes, and the Fisher effect

David Glasner has an excellent new post on Keynes’s views on the Fisher effect. I’m going to come at this from a slightly different angle, which I hope will help illuminate Keynes’s thinking.  But I’ll end up in a similar place to David.

Here’s Keynes in the General Theory:

The expectation of a fall in the value of money stimulates investment, and hence employment generally, because it raises the schedule of the marginal efficiency of capital, i.e., the investment demand-schedule; and the expectation of a rise in the value of money is depressing, because it lowers the schedule of the marginal efficiency of capital. This is the truth which lies behind Professor Irving Fisher’s theory of what he originally called “Appreciation and Interest” – the distinction between the money rate of interest and the real rate of interest where the latter is equal to the former after correction for changes in the value of money. It is difficult to make sense of this theory as stated, because it is not clear whether the change in the value of money is or is not assumed to be foreseen. There is no escape from the dilemma that, if it is not foreseen, there will be no effect on current affairs; whilst, if it is foreseen, the prices of exiting goods will be forthwith so adjusted that the advantages of holding money and of holding goods are again equalized, and it will be too late for holders of money to gain or to suffer a change in the rate of interest which will offset the prospective change during the period of the loan in the value of the money lent. For the dilemma is not successfully escaped by Professor Pigou’s expedient of supposing that the prospective change in the value of money is foreseen by one set of people but not foreseen by another. (p. 142)

David talks about how this conflicts with Keynes’s more sophisticated treatment of the Fisher effect in the Tract on Monetary Reform.  In my view that’s because Keynes was (perhaps subconsciously) addressing different monetary regimes in the two books.  The Tract really should have been called “A Tract on Fiat Money Regimes,” as it was written in the wake of the big European hyperinflations and has a real monetarist slant.  The GT should be called “The General Theory of Business Cycles under a Gold Standard and/or Bretton Woods-Type Regime.”  I once published an entire paper arguing that the GT was essentially a gold standard book, as the expected rate of inflation was implicitly assumed to be near zero (which was true of the actual gold standard.)

Here’s the difference.   Under a fiat money regime you can have changes in the trend rate of inflation that are in some sense “equilibrium” cases.  Thus if trend inflation rises from 0% to 10%, then all nominal prices wages and assets prices eventually adjust to that new reality, and nominal interest rates also rise by roughly 10%.  Nothing real changes in the long run, except real cash balances.  In contrast, the trend rate of inflation never really changes (much) under a gold standard, where the price level follows a random walk with near-zero trend.  Thus actual price movements are mostly unexpected, and there’s not much of a Fisher effect.  But that doesn’t fully explain Keynes’s comments; we need to add one more factor.

Under the gold standard there were two very important groups of prices; flexible prices and sticky prices.  (Today sticky prices are more dominant.)  The flexible prices included the prices of commodities (then a far larger share of GDP), real estate, and stocks—which are claims to the ownership of real corporate assets.  A positive monetary shock would immediately raise the prices of the flexible price assets, and that is clearly what Keynes is thinking about in the quote above.  At the same time the CPI inflation will play out gradually over time, and thus there will be some expected inflation at the CPI level.  But in those days most economists focused on the WPI, which was dominated by flexible prices.  Furthermore, and this is a point modern economists sometimes overlook, the Fisher effect applies more to expected flexible price inflation, rather than CPI inflation.  That’s because commodities, real estate, and stocks are closer substitutes to holding money that are toasters and haircuts.

This interpretation makes Keynes’ statements somewhat more understandable, but still not correct.  First Keynes:

The mistake lies in supposing that it is the rate of interest on which prospective changes in the value of money will directly react, instead of the marginal efficiency of a given stock of capital. The prices of existing assets will always adjust themselves to changes in expectation concerning the prospective value of money. The significance of such changes in expectation lies in their effect on the readiness to produce new assets through their reaction on the marginal efficiency of capital. The stimulating effect of the expectation of higher prices is due, not to its raising the rate of interest (that would be a paradoxical way of stimulating output – insofar as the rate of interest rises, the stimulating effect is to that extent offset) but to its raising the marginal efficiency of a given stock of capital. If the rate of interest were to rise pari passu with the marginal efficiency of capital, there would be no stimulating effect from the expectation of rising prices. For the stimulating effect depends on the marginal efficiency of capital rising relatively to the rate of interest. Indeed Professor Fisher’s theory could best be rewritten in terms of a “real rate of interest” defined as being the rate of interest which would have to rule, consequently on change in the state of expectation as to the future value of money, in order that this change should have no effect on current output. (pp. 142-43)

And then Glasner:

Keynes’s mistake lies in supposing that an increase in inflation expectations could not have a stimulating effect except as it raises the marginal efficiency of capital relative to the rate of interest. However, the increase in the value of real assets relative to money will increase the incentive to produce new assets. It is the rise in the value of existing assets relative to money that raises the marginal efficiency of those assets, creating an incentive to produce new assets even if the nominal interest rate were to rise by as much as the rise in expected inflation.

Like Krugman and many other new Keynesians, Keynes insists on thinking of stimulative effects via the transmission mechanism of interest rates.  But as David points out, the rise in existing asset prices is expansionary, in and of itself.  My only suggestion would be to talk about a rise in the value of existing assets relative to nominal wages, not money.  But since nominal wages are sticky in money terms, it amounts to essentially the same thing.  March to July 1933 is a great example.  Asset prices soared, nominal wages were steady, and firms responded by producing lots more commodities and investment goods.

PS.  This analysis may also relate to the following observation by Glasner:

I think that one source of Keynes’s confusion in attacking the Fisher equation was his attempt to force the analysis of a change in inflation expectations, clearly a disequilibrium, into an equilibrium framework. In other words, Keynes is trying to analyze what happens when there has been a change in inflation expectations as if the change had been foreseen.

In my view Keynes saw unexpected shocks leading to unexpected changes in flexible prices, and then subsequently to expected changes in the broader price level.

PPS.  Paul Krugman recently wrote the following:

Just stabilize the money supply, declared Milton Friedman, and we don’t need any of this Keynesian stuff (even though Friedman, when pressured into providing an underlying framework, basically acknowledged that he believed in IS-LM).

Actually Friedman hated IS-LM.  I don’t doubt that one could write down a set of equilibria in the money market and goods market, as a function of interest rates and real output, for almost any model.  But does this sound like a guy who “believed in” the IS-LM model as a useful way of thinking about macro policy?

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

I turns out that IS-LM curves will look very different if one moves away from the interest rate transmission mechanism of the Keynesians.  Again, here’s David:

Before closing, I will just make two side comments. First, my interpretation of Keynes’s take on the Fisher equation is similar to that of Allin Cottrell in his 1994 paper “Keynes and the Keynesians on the Fisher Effect.” Second, I would point out that the Keynesian analysis violates the standard neoclassical assumption that, in a two-factor production function, the factors are complementary, which implies that an increase in employment raises the MEC schedule. The IS curve is not downward-sloping, but upward sloping. This is point, as I have explained previously (here and here), was made a long time ago by Earl Thompson, and it has been made recently by Nick Rowe and Miles Kimball.

I hope in a future post to work out in more detail the relationship between the Keynesian and the Fisherian analyses of real and nominal interest rates.

Please do.  Krugman reads Glasner’s blog, and if David keeps posting on this stuff then Krugman will eventually realize that hearing a few wisecracks from older Keynesians about various non-Keynesian traditions doesn’t make one an expert on the history of monetary thought.



24 Responses to “Glasner, Keynes, and the Fisher effect”

  1. Gravatar of foosion foosion
    28. July 2013 at 09:34

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

    Was MF talking about nominal rates, real rates or both?

  2. Gravatar of Geoff Geoff
    28. July 2013 at 10:56

    There is a fatal defect in the Fisher Effect line of reasoning. Glasner is not going to succeed in establishing a comparative analysis free of logical errors.

    What is the Fisher reasoning? Suppose the “real rate of interest” as imagined by Fisher/Keynes/Glasner/Sumner is 5%. 100 units of money today exchanges for 105 units of money in one year. If the purchasing power of money is expected to fall, then a higher quantity of money should be returned in one year, say 108 units of money. Similarly, if the purchasing power of money is expected to rise, then a lower quantity of money should be returned in one year, say 102 units of money.

    The flaw can be revealed by considering what is called for by the Fisher reasoning, should prices be expected to fall by say 50% next year. In order for the “real” rate of return to remain at 5% as before, lenders must be assumed as having to exchange 100 units of money today for 53 units of money next year. Would anyone do that? Why not? After all, it would preserve a 5% real rate of return.

    Of course, the question that arises is why wouldn’t any would be lender just hold onto their money, and double their real assets as a result of the 50% price fall?

    When Fisher was presented with this devastating blow, he merely hand waved it off and said that the purchasing power premium can never turn interest rates negative. But this invalidates his entire theory! A rigorous theory of interest and real interest rates cannot suddenly drop off a cliff when the going gets tough.

    The flaw in the purchasing power premium idea is due to ignoring the “natural” rate of interest, which is the primary factor for all things interest related. Contra principia negantem non est disputandum I suppose.

    So how does the “natural” interest rate approach fare against an expectation of a halving of prices in one year? A natural interest rate of 5% (simplified) means that 100 units of money are paid today for factors of production, after which output is sold for 105 units of money in one year.

    Now suppose again that purchasing power is expected to double, in that prices are expected to fall by 50% next year. The selling price of output next year will be 53 units of money (which equates to a real return of 5% on 100 units of money spent on factors today).

    So now what? Will investors buy factors for 100 and sell at 53 next year in order to preserve a 5% real return? Of course not. Not unless they did not expect the 50% fall in prices. But to the extent they do expect a fall of 50%, they will hold money rather than buy factors. This will immediately lower factor prices to their expected future values, from 100 to 50.

    What happens to the rate on loans is then trivial. They will simply reflect what has been occurring with the natural rate. Rather than take a monetary loss (100 to 53), even though their real return will be the same, investors will hold back their purchases of factors until factor prices fall immediately to their future low level. But this process of anticipatory price movements do not occur only in the extreme case of a prospective “negative return.” It happens whenever a price change is anticipated, positive or negative.

    Suppose then that investors anticipate that prices will double in a year. The fact of an anticipated rise will lead to an increase in the price level now and an approach immediately toward a doubled price level. Similarly, an anticipated fall will lead to an immediate fall in factor prices. If these changes were anticipated, there would be no room for any purchasing-power component to develop. Prices would simply fall immediately to their future level.

    The purchasing power component, then, is not a consequence, or reflection, of expectations of changes in purchasing power. It is the consequence or reflection of the change itself. If the change were anticipated, the purchasing power would change immediately, and there would be no purchasing power
    component in the nominal rate of interest.

  3. Gravatar of TravisV TravisV
    28. July 2013 at 11:34

    Dear Commenters,

    What are the best articles out there that really illustrate how much stronger Japan’s economy is performing since Abe’s campaign and election increased AD expectations?

  4. Gravatar of TravisV TravisV
    28. July 2013 at 11:36

    Oh, wow!

    “The economy has roared back to life with growth of 4pc over the past two quarters – the best in the G7 bloc this year.”

  5. Gravatar of Geoff Geoff
    28. July 2013 at 12:36

    And just to annoy Dr. Sumner, the bubble predictor hater, (kidding, kind of), I’ll again state here that because of the Fed’s and other central bank’s positive actions (and not “the inflation they failed to bring about”) these past years, they have blown up the biggest financial bubble in the history of mankind.

    This is going to end up as either financial collapse, or war, or both.

    Nothing in the real economy grows at a constant rate year after year after year. Money or spending or prices should not either.

  6. Gravatar of ChargerCarl ChargerCarl
    28. July 2013 at 12:51

    MF according to you the past 100 years of growth is all just one big bubble. Give it a rest already.

  7. Gravatar of Geoff Geoff
    28. July 2013 at 12:55

    Milton Friedman said that? Evidence please.

  8. Gravatar of Geoff Geoff
    28. July 2013 at 12:58

    “The Roman Empire will never fall. You’ve been saying that for 100 years!” – 300 AD.

  9. Gravatar of ssumner ssumner
    28. July 2013 at 13:39

    foosion, Probably nominal

  10. Gravatar of Alex A. Alex A.
    28. July 2013 at 14:17


    New Keynesians do not believe the short-term nominal interest rate is the proper measure of the stance of monetary policy. The short-term *real* interest rate w.r.t the natural real rate is the indicator.

    I’m sure Woodford would agree with your Friedman quote that “low nominal interest rates are usually associated with tight money, [and vice-versa]” But that’s just it–nobody is saying that’s not the case!

    You’re talking past the New Keynesians when you repeat this nominal interest rate stuff over and over–they already agree with you, and they only care about real interest rates relative to the natural rate. Remember Woodford’s Jackson Hole paper?

  11. Gravatar of TravisV TravisV
    28. July 2013 at 18:13

    Prof. Sumner,

    Here is a good question I just thought of:

    Which Fed policy is more damaging and should be eliminated first: the fact that the Fed uses the Fed funds rate (an instrument that becomes “mute” at the zero bound) or the fact that the Fed focuses on the rate of inflation rather than NGDP?

  12. Gravatar of John Papola John Papola
    28. July 2013 at 20:12

    How can “capital”, as Keynes uses the term, have a “marginal efficiency”? My office has a wide variety of different capital. There is no single “marginal efficiency” of the next “unit” of capital we might purchase. This idea seems to be hyper-aggregated to the point of being useless nonsense. I don’t think there can be a “marginal efficiency” of capital in this sense at all. Am I missing something?

  13. Gravatar of ssumner ssumner
    29. July 2013 at 09:03

    Alex, How many NKs said money was tight in late 2008 and early 2009?

    . . . crickets chirping . . .

    John, I don’t really use the concept, but I suppose macro deals with averages, like the average wage rate. So you could talk about the productivity of one more unit of capital on average. Maybe someone else can help—it’s not my area.

  14. Gravatar of flow5 flow5
    29. July 2013 at 12:42

    IS doesn’t equal LM. S never equals I. Debt financed from voluntary savings, which is all debt (except the CB’s & RB’s), provide an outlet for savings. The stimulating effect of this type of debt expansion arises entirely out of the fact that it is the catalyst which changes idle savings into active funds. This is a velocity relationship.

    And only debt growing out of real investment, or consumption, makes an actual direct demand for labor & materials.

    Bernanke destoyed the savings-investment process by destroying the non-banks), or, pre-Great Recession, 82% of the lending market (Z.1 release). Bernanke destroyed the non-banks by intoducing the payment of interest on reserves.

  15. Gravatar of flow5 flow5
    29. July 2013 at 12:50

    Keynes’s liquidity preference curve (demand for money) is a false doctrine. A “liquidity preference” curve is presumed to exist which represents the supply of money. In this system interest is the cost which must be paid, if lenders are to forgo the advantages of liquidity. All of this has little or nothing to do with the real world, a world in which interest is paid on checking accounts.

    Interest is the price of obtaining loan funds, not the price of money. The price of money is the inverse of the price level. If the price of goods & services rises, the “price” of money falls. Interest rates in any given market at any given time are the result of the interaction of all the forces operating through the supply of, & the demand for loan-funds.

    The demand for money is a paradox (see: Cambridge economist Alfred Marshall). All motives which induce larger holding’s, will tend to increase the demand for money, & reduce its velocity.

    In contrast, the demand for loan-funds reflects the advantages of spending borrowed money.

  16. Gravatar of David Glasner David Glasner
    29. July 2013 at 17:08

    Scott, Thanks for this post and for putting my name up there with Keynes and Fisher. As usual we agree on the big picture, but not necessarily on all the details.

    First, about Keynes I agree that Keynes was into fiat money in the Tract on Monetary Reform, and that his argument for flexible exchange rates in the Tract was very powerful. I also agree that his analysis clearly changed in the General Theory, but I am not sure that the difference can be attributed to a shift from fiat money to the gold standard. I think that it has to do more with a shift from the analysis of an open economy to the analysis of a closed economy. I think that the fixed price-level assumption was a simplifying assumption that he felt was justified based on his “proof” that price level changes would not achieve full employment.

    Then, about Friedman, I don’t think he believed in IS-LM, but it’s not as if he had an alternative macromodel. He didn’t have a macromodel, so he was stuck with something like an IS-LM model by default, as was made painfully clear by his attempt to spell out his framework for monetary analysis in the early 1970s. Basically he just tinkered with the IS-LM to allow the price level to be determined, rather than leaving it undetermined as in the original Hicksian formulation. Of course in his policy analysis and historical work he was not constained by any formal macromodel, so he followed his instincts which were often reliable, but sometimes not so.

    So I am afraid that my take may on Friedman may be a little closer to Krugman’s than to yours. But the real point is that IS-LM is just a framework that can be adjusted to suit the purposes of the modeler. For Friedman the important thing was to deny that that there is a liquidity trap, and introduce an explicit money-supply-money-demand relation to determine the absolute price level. It’s not just Krugman who says that, it’s also Don Patinkin and Harry Johnson. Whether Krugman knows the history of thought, I don’t know, but surely Patinkin and Johnson did.

  17. Gravatar of ssumner ssumner
    29. July 2013 at 17:25

    David, I’m afraid I strongly disagree regarding Friedman. The IS-LM “model” is much more than just the IS-LM graph, or even an assumption about the interest elasticity of money demand. For instance, suppose a shift in LM also causes IS to shift. Is that still the IS-LM model? If so, then I’d say it should be called the “IS-LM tautology” as literally anything would be possible.

    When I read Friedman’s work it comes across as a sort of sustained assault on IS-LM type thinking.

    I do agree that Friedman wasn’t good at general equilibrium modeling. But I’m not impressed by the GE models of others.

    I have a paper in Economic Inquiry in the late 1990s that argues the GT is a gold standard model. I don’t see it as a fixed price model, because he discusses inflation in the GT–as during an overheating economy. What’s left out is expected inflation. However I don’t feel as strong about this issue as I do about Friedman. He did not believe in IS-LM.

  18. Gravatar of flow5 flow5
    29. July 2013 at 17:43

    I’m forced to admit that Friedman was actually “way-cool”. He was one of the inspirations for Keynes’ writing the General Theory as he busted some of Keynes’ equations when studying Keynes’ two volume Treatise on Money while attending Chicago in 32-33.

  19. Gravatar of David Glasner David Glasner
    29. July 2013 at 18:08

    Scott, I think that if you look at Friedman’s responses to his critics the volume Milton Friedman’s Monetary Framework: A Debate with his Critics, he said explicitly that he didn’t think that the main differences among Keynesians and Monetarists were about theory, but about empirical estimates of the relevant elasticities. So I think that in this argument Friedman’s on my side. You say that you’re not impressed with the GE models of others. Are you trying to ell me that you’re not impressed with Irving Fisher?

  20. Gravatar of flow5 flow5
    29. July 2013 at 18:16


    Friedman “stopped Viner in his calculus and finally went to the blackboard and worked the whole problem out, which Viner was unable to do”…In Mints’ class “Price and Distribution” Friedman “discovered some of the errors in Keynes’ fundamental equations. Mints wrote Keynes in Friedman’s behalf – & for the class. That Keynes admitted the errors and this gave him, at least in part, the impetus to write the General Theory.”…”Keynes’ subsequent repudiation in the General Theory of those parts of the Treatise on Money grew out of these criticisms.”

  21. Gravatar of ssumner ssumner
    29. July 2013 at 18:27

    David, This would probably be easier if you provided some examples of monetary ideas that are in conflict with IS-LM. Or indeed any ideas that are in conflict with IS-LM. I worry that people are interpreting IS-LM too broadly.

    For instance, do Keynesians “believe” in MV=PY? Obviously yes. Do they think it’s useful? No.

    Everyone agrees there are a set of points where the money market is in equilibrium. People don’t agree on whether easy money raises interest rates or lowers interest rates. In my view the term “believing in IS-LM” implies a belief that easy money lowers rates, which boosts investment, which boosts RGDP. (At least when not at the zero bound.) Friedman may agree that easy money boosts RGDP, but may not agree on the transmission mechanism.

    People used IS-LM to argue against the Friedman and Schwartz view that tight money caused the Depression. They’d say; “How could tight money have caused the Depression? Interest rates fell sharply in 1930?”

    I think that Friedman meant that economists agreed on some of the theoretical building blocks of IS-LM, but not on how the entire picture fit together.

    Oddly, your critique of Keynes reminds me a lot of Friedman’s critiques of Keynes.

    My favorite Fisher models are all similar to Friedman’s models: The Phillips Curve model, the model of money supply and demand, etc. Those where what Fisher used to evaluate the macro issues of the day.

  22. Gravatar of ssumner ssumner
    29. July 2013 at 18:29

    flow5, Interesting stories. Thanks. If I had time now I’d reread the Treatise. I think it has some interesting ideas, but Keynes couldn’t put it all together.

  23. Gravatar of flow5 flow5
    29. July 2013 at 19:03

    Check out Milton Friedman’s Leadenham/Archives:

  24. Gravatar of My Milton Friedman Problem | Uneasy Money My Milton Friedman Problem | Uneasy Money
    1. August 2013 at 14:21

    […] the General Theory in his exposition of own rates of interest and their equilibrium relationship. Scott Sumner honored me with a whole post on his blog which he entitled “Glasner on Keynes and the Fisher […]

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