Josh Hendrickson on the problem with “moneyless” NK models

Josh Hendrickson is sort of like my mirror image; he doesn’t post very often, but almost invariably has something interesting to say.  In a new post he discusses a flaw in one common New Keynesian (NK) model, which looks at monetary policy through the lens of interest rates.  But first, a quick review of interest rates and monetary policy.  The easiest way to see the relationship is with the equation of exchange:

M*V = P*Y

When the Fed raises interest rates, pundits tend to call the policy “contractionary.” That’s misleading for all sorts of reasons, but does contain a grain of truth.  The true part comes from the fact that in the very short run, the Fed engineers interest rate increases by reducing the monetary base. Note that by itself the rate increase is expansionary, as it tends to boost the velocity of circulation, by raising the opportunity cost of holding base money.  But that expansionary effect is more than offset by the direct contractionary impact of the lower monetary base.  Here’s Josh, looking at the opposite case, an increase in the money supply:

Now consider the effects of a change in the money supply. As illustrated in the figure above, the increase in the money supply causes the interest rate to decline. This means that when the money supply increases, velocity declines. However, the interest elasticity of velocity is often estimated to be rather small. The initial effect of the increase in the money supply is that the nominal interest rate to fall and nominal spending to rise. The decline in the nominal interest rate is an effect of the change in the money supply, but note that it is not the cause of the change in nominal spending.

So far so good.  But here’s where NKs get into trouble.  Josh says that their models imply that a higher interest rate is contractionary, even if there is no change in the money supply:

The New Keynesians, however, countered that they didn’t need to use open market operations to target the interest rate. For example, Michael Woodford spends a considerable part of the introduction to his textbook on monetary economics to explaining the channel system for interest rates. If the central bank sets a discount rate for borrowing and promises to have a perfectly elastic supply at that rate and if they promise to pay a rate of interest on deposits, then by choosing a narrow enough channel, they can set their policy rate in this channel. In addition, all they need to do to adjust their policy rate is to adjust the discount rate and the interest rate paid on reserves. The policy rate will then rise or fall in conjunction with the changes in these rates. Thus, the New Keynesians argued that they didn’t need to worry about money in theory or in practice because they could set their policy rate without money and their model showed that they could get a determinate equilibrium by applying the Taylor principle.

Nonetheless, what I would like to argue is that their ignorance of money has led them astray. By ignoring money, the New Keynesians have confused cause and effect. This confusion has led them to believe that they know something about how interest rate policy should work, but they have never stopped to think about how interest rate policy works when the central bank adjusts the nominal interest rates in a channel system versus how interest rate policy works when the central bank adjust the nominal interest rate using open market operations.

Unfortunately the post is hard to excerpt; you really need to read the whole thing.

This does not mean that NK interest rate policies will not “work.”  Rather I would argue that they work for reasons that NKs don’t understand, and when they fail they will fail for reasons NKs don’t understand.  Other economists such as Peter Ireland (who is cited by Josh) have pointed out that even with interest on reserves (IOR) you can never really ignore the quantity of money, and that certain quantity theoretic claims continue to hold true.

For me, the easiest way to understand this issue is to think about (non-interest-bearing) currency. Back in 2007 the base was about $850 billion, with about $800 billion of that being currency.  Now suppose Ben Bernanke had been instructed to use interest rates to double the price level over the next 30 years.  He was not allowed to use the monetary base.  For simplicity, assume he never ran into the zero bound problem.  Even in that case, where positive interest rates allowed him to continually use a Taylor Rule-type approach, it’s easy to see that the policy objective would be impossible to achieve.  There would not be enough base money to match the demand for currency at a price level double its current value.  I think this simple truth sometimes gets overlooked in models that focus on bank reserves and IOR, and/or periods of history where there are plenty of excess reserves.

I said that NK policy might work despite its theoretical weaknesses.  That’s because asset markets would probably (correctly) interpret a rise in the IOR rate as part of a broader Fed strategy to reduce future growth in aggregate demand.  Thus markets would assume that the base would also be adjusted over time in whatever direction was necessary for hitting the central bank’s target. (Surely there must already be a Nick Rowe analogy involving steering wheels and social conventions.) As always, monetary policy is 98% expectations, and 2% concrete steps.  What are those expectations about?  They are about future concrete steps, i.e. future changes in the supply of base money, relative to changes in the demand for base money.

PS.  I have a post criticizing Charles Plosser, and 99% of other economists, over at Econlog.  And also a libertarian rant.



16 Responses to “Josh Hendrickson on the problem with “moneyless” NK models”

  1. Gravatar of Major.Freedom Major.Freedom
    15. November 2014 at 15:49

    “Public choice theory teaches us that small, well-organized special interest groups can often enact legislation that benefits them at the expense of the broader public. The examples are endless; teachers unions, farmers, bankers, taxi companies, auto dealers, lawyers, doctors, etc.”

    I love it when monetarists who talk about public choice theory always conveniently leave out banking.

    Goodness the awkwardness is palpable.

    A small, well-organized special interest group that met on Jekyll Island is why we have central banking, which benefits bankers and politicians at the expense of the broader public. This fact is of course denied by the ideologue monetarists.

    Instead of complaining about the existence of special interest groups affecting legislation that benefits them at the expense of the broader public, why not advise the politicians to enact an aggregate target? Why not NGDPLT, or National Gross Domestic PublicChoice Licentiousness Targeting?

    At least investors will know that each year they’ll be exploited by a stable and expected amount. Lootint habits are after all “sticky.”

    Libertarian rant. Now that’s funny. Krugman called himself a free market Keynesian the other day. It’s like watching Emperor Palpatine saying he loves democracy.

    Oh yeah, let us have individual choice in this and this and this and that. But don’t you dare say individuals should choose their own money! I have a lot invested in what only the perpetuation of special interest groups in banking can prevent in exposing it as malinvestment.

    I’m “getting away with” convincing a lot of people of the immorality and destructiveness of central banking. Of course I am being honest, so a pox to my house and mea culpa!.

  2. Gravatar of Major.Freedom Major.Freedom
    15. November 2014 at 15:50

    At least Sumner included bankers.

    Now if monetarists in general did that.

  3. Gravatar of Gordon Gordon
    15. November 2014 at 18:38

    “There would not be enough base money to match the demand for currency at a price level double its current value.” Scott, I read recently that Sweden has largely become a cashless society. I’m curious, if the US was to emulate Sweden in the scenario you presented, would this negate your objection or would there be other factors that still would increase the demand for base money?

  4. Gravatar of Market Fiscalist Market Fiscalist
    15. November 2014 at 18:39

    I just read the linked to article (which is great, and I will be adding Josh to my feedly feed)

    But I don’t understand:
    “Now consider what happens if the central bank increases the interest rate paid on reserves, holding the money supply constant. According to the expression above nominal spending increases when the interest rate rises. To understand why, consider that the interest rate on excess reserves reduces the demand for currency. Since the supply of currency doesn’t change, individuals increase spending to alleviate attempt to alleviate this excess supply.”

    Why can’t the supply of currency change ? Won’t the CB adjust the amount of notes in circulation on demand and not rely on people increasing spending to bring the price level and currency held into line ?

  5. Gravatar of anon\portly anon\portly
    15. November 2014 at 22:10

    I always thought the (CMP) Econ 1 story was:

    1. Raise FFR target
    2. Sell bonds
    3. Reduce/destroy money and bank reserves
    4. Upward pressure on interest rates (supply of loans left, demand for deposits right, price of bonds down)
    5. Reduction in C and I components of AD, AD shifts left

    Is that completely wrong? Is it just the reduction in money that shifts AD left?

    Time to reread a principles text, I guess….

  6. Gravatar of Rajat Rajat
    16. November 2014 at 03:05

    Very instructive post.

  7. Gravatar of ssumner ssumner
    16. November 2014 at 06:12

    Gordon, I don’t think it would eliminate the problem, but it might be smaller.

    Market Fiscalist, Yes, the supply of currency could change if the central bank wanted it to. Josh is looking at a NK model that claims the money supply doesn’t need to change to make interest rate targeting work.

    anon/portly, The story often involves interest rates, but in my view that’s not what drives changes in AD. Rather changes in AD are caused by expectations of the hot potato effect. Obviously Keynesians don’t agree–they think it is interest rate changes that cause AD to shift. But they also need their story to be explainable in MV=PY terms.

    Thanks Rajat.

  8. Gravatar of Market Fiscalist Market Fiscalist
    16. November 2014 at 06:31

    ” Josh is looking at a NK model that claims the money supply doesn’t need to change to make interest rate targeting work”

    Yes, I can see that is what he is describing – but even if such a mechanism was used to fix the qty of money people would still be able to swap between between currency and bank accounts wouldn’t they ? They wouldn’t need to spend and drive the price level up to get rid of excess currency at the new rate , they could just deposit the excess cash in the bank.

  9. Gravatar of Todd Todd
    16. November 2014 at 09:58

    More help, please. (@DonGeddis?)

    In “Intro To My Views”, post 8, Scott said he hoped to develop an online course. Is that course available, and if so, where can I find it?

    Where can I find a post or a link to a discussion of how Scott’s analysis looks in a post-currency economy? Iceland, for example, has minimal use of currency even now.

    Thanks in advance for the pointers.

  10. Gravatar of Don Geddis Don Geddis
    16. November 2014 at 11:38

    @Todd: Good questions, I have no good answers for you.

    Some folks, looking for a solid introduction to what Sumner is talking about, have had good luck with his National Affairs paper “Re-targeting the Fed“. That paper, and his “Quick intro” on the right here (esp. “short intro course on money”), is as good a recommendation as I have.

  11. Gravatar of Vaidas Urba Vaidas Urba
    16. November 2014 at 13:41

    “Thus markets would assume that the base would also be adjusted over time in whatever direction was necessary for hitting the central bank’s target. ”

    It is possible to construct an example where this is not true. Suppose you have NGDPLT with 5% NGDP growth, where monetary base follows a strict 5% growth rule, and monetary targeting is done solely by adjusting IOR. Central bank could tighten policy by raising IOR and announcing that NGDPLT target path is shifting 1% down, but the path of monetary base is left unchanged. In this case, a shift to tighter money is combined with the shift to higher monetary base / GDP ratio.

  12. Gravatar of ssumner ssumner
    16. November 2014 at 19:17

    Market Fiscalist, He also discusses the likely impact on the money multiplier, and that doesn’t help produce NK results.

    Todd, I’ve been to Iceland and they still use currency. It doesn’t matter how big the currency stock is, just that it is the medium of account.

    Vaidas, Yes, it’s always about adjustments in both the supply and demand for base money. And IOR affects demand, as you say.

  13. Gravatar of Joe Eagar Joe Eagar
    22. November 2014 at 13:39

    Scott, this hasn’t been true in practice, tthough. IIRC, ECB, kiwi central bank and a few others have all tightened policy in the past without ever reducing the money supply. I believe their argument for why this works is (or was) that markets respond to this situation by slowing the growth rate of private money substitutes in response to higher interest rates.

  14. Gravatar of ssumner ssumner
    23. November 2014 at 08:24

    Joe, I’m not sure what you mean by “tightened policy.” Central banks only have two ways of tightening policy, reducing the supply of base money or boosting the demand for base money.

  15. Gravatar of Joe Eagar Joe Eagar
    25. November 2014 at 16:01

    Scott,I mean they raised their discount and IOR rates.

  16. Gravatar of Joe Eagar Joe Eagar
    25. November 2014 at 16:03

    Sorry I should have said “reserves”, not “money supply.”

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