Nick Rowe on monetarism and stability

Nick Rowe has a fascinating new post on monetarism.  It’s fairly long, but I think Nick is saying that throughout history we almost never observe stylized facts that are sharply at variance with monetarist theory.  He also argues that throughout much of history monetary policy was essentially unplanned, thus the correlation between money and prices cannot be due to explicit government policies.  He ends up by arguing that monetarist approaches to the transmission mechanism must be telling us something that is missed in IS-LM models, or else we would observe occasional cases of hyperinflation or hyperdeflation that seemed at variance with monetarism.

I have a lot of sympathy with this post, but would to offer a few suggestions:

1.  I’m not sure what Nick means by “monetarism.”  The old-style monetarism says that the supply of money is the key to modelling inflation.

2.  In my view the market monetarist approach says something closer to “looking the supply and demand for money is the most useful way to model the price level.”   (As compared to looking at interest rates, economic “overheating,” etc.)  Indeed I’d prefer using the term ‘medium of account’ rather than ‘money’ but I’m in the minority.

Consider the following claim by Nick:

Empirically we observe that if you don’t let the money supply explode to infinity the economy won’t explode into hyperinflation either; and if you don’t let the money supply implode to zero the economy won’t implode to zero either. Empirically we know that monetarism is at least roughly true. But theoretically we don’t know why it is true. We don’t understand the strong dark force that makes monetarism at least roughly true.

This makes me a bit uneasy.  Is it really true that all hyperinflations involve huge increases in M?  Maybe, but I could easily imagine one that didn’t.  Suppose the Confederate government was expected to collapse within a few weeks in 1865. Even if they hadn’t printed a lot of money, wouldn’t prices have soared in terms of Confederate money, as the demand for that sort of money plummeted?

At the other extreme, I could imagine the demand for base money soaring during deflation, and leading to a situation where prices rose far less than the money supply.  So I’d emphasize supply and demand.

Here’s how Nick ends up:

Or maybe, just maybe, it’s only hard to understand the strong monetarist dark force if you try to see it in a non-monetarist theoretical framework. Like ISLM, for example, where money only affects AD via its effect on interest rates. Or a neo-Wicksellian/”New Keynesian” framework, which doesn’t appear to have money at all. Maybe the liquidity preference theory of the rate of interest, according to which the rate of interest is (at least proximately) determined in “the money market”, by the demand and supply of money, is theoretically incoherent, because there is no such thing as “the money market”. Because every market is a money market in a monetary exchange economy. And so an “excess supply of money” does not just mean an “excess demand for bonds”.

Or you could stick by your theoretical framework, and ignore the empirical facts. And the historical falsity of the “keynesian” argument from design is one of those empirical facts.

I agree that the Keynesians focus too much on the terms of trade between cash and bonds, and not enough on the terms of trade between cash and stocks, or foreign exchange, or commodities, or real estate.  But more importantly I’d also like to see the Woodfordian “expectations channel” applied to the “hot potato effect.”  If we know that money is neutral in the long run because of the HPE, then expectations of long run money neutrality lead to changes in expected NGDP growth, which is probably the most powerful transmission channel of all.  It’s what Keynes meant by “confidence.”

No one is surprised when a big crop of apples causes NGDP in apple terms to suddenly double.  No one should be surprised when a big crop of currency in Argentina causes NGDP to double in currency terms.  No need to invoke mysterious forces; the transmission mechanism is right out of EC101.

Supply and demand.

PS.  Paul Krugman knew all this years ago; Patrick just sent me the following quote from 1998:

Because the traditional IS-LM framework is a static one, it cannot make any distinction between temporary and permanent policy changes. And partly as a result, it seems to indicate that a liquidity trap is something that can last indefinitely. But the framework here, rudimentary as it is, suggests a quite different view. In the flexible-price version of the model, even when money and bonds turn out to be perfect substitutes in period 1, money is still neutral – that is, an equiproportional increase in the money supply in all periods will still raise prices in the same proportion.

So what would a permanent increase in the money supply do in the case where prices are predetermined in period 1? Even if the economy is in a liquidity trap in the sense that the nominal interest rate is stuck at zero, the monetary expansion would raise the expected future price level P*, and hence reduce the real interest rate. A permanent as opposed to temporary monetary expansion would, in other words, be effective – because it would cause expectations of inflation.

My only quibble would be the central role given to the real interest rate. Expectations of higher future NGDP tend to raise current AD for obvious reasons. That might result in nothing more than inflation. But if wages are sticky you will also get some real growth as NGDP rises.

PPS.  And now I have to write a post taking Krugman’s side in his argument with Nick Rowe.


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26 Responses to “Nick Rowe on monetarism and stability”

  1. Gravatar of Negation of Ideoloy Negation of Ideoloy
    12. August 2013 at 21:04

    Nick says –
    “Empirically we observe that if you don’t let the money supply explode to infinity the economy won’t explode into hyperinflation either; and if you don’t let the money supply implode to zero the economy won’t implode to zero either.”

    And you ask –
    “Is it really true that all hyperinflations involve huge increases in M?”

    Are you sure by “money supply” Nick means M? I assumed he meant M2. I’m not saying for sure he meant that, but wouldn’t that make more sense because Friedman explained the Depression by a drop in M2, not M?

  2. Gravatar of Franky Franky
    13. August 2013 at 03:40

    Scott, I’ve read a lot your blog but I don’t understand what your hot potato effect is. Once rates on bonds reach zero and the special services of money lose their value, money is valued just like any other asset. The terms of trade between money and stocks and other assets are just determined by standard asset pricing arbitrage conditions without any role for supply and demand. This seems to leave no room for a hot potato effect. There can be a wealth effect along the lines of Pigou, but like Nick says that is too weak to have much of an effect. Can you explain precisely what I am missing here?

  3. Gravatar of ssumner ssumner
    13. August 2013 at 04:38

    Negation, Maybe that’s right.

    Franky, They aren’t really perfect substitutes at zero, but close enough. In that case you rely on the expected HPE. The cash is expected to boost NGDP when rates rise above zero.

  4. Gravatar of dtoh dtoh
    13. August 2013 at 04:38

    To paraphrase an earlier comment. Money doesn’t matter (in the short term).

    What matters is that wages and prices (of real goods and services) are sticky in the short term. Real prices of financial assets are not.

    It explains why shocks matter, why monetary policy is necessary and effective, and why Wallace is wrong.

    Once you understand this, you can stop wasting your time talking about convoluted models.

  5. Gravatar of Franky Franky
    13. August 2013 at 05:00

    Scott, how is that any different from the New Keynesian model? You say: when rates rise above zero people won’t want to hold the extra money and they will spend more. New Keynesians say: when rates rise above zero the extra money will keep rates below the natural rate and people will spend more. These two statements seem equivalent to me if money demand and rates pin each other down. Does your view make any predictions that are different from the NK model?

  6. Gravatar of Felipe Felipe
    13. August 2013 at 06:27

    Maybe, but I could easily imagine one that didn’t. Suppose the Confederate government was expected to collapse within a few weeks in 1865.

    I don’t know what happened with the Confederate money, but Japanese Invasion Money did collapse after WW2. Apparently some people tried to sue the US Government for compensation but lost[1].

    [1] http://en.wikipedia.org/wiki/Japanese_invasion_money

  7. Gravatar of Jared Jared
    13. August 2013 at 06:54

    Scott, I’m having the same difficulty understanding the HPE as Franky is. You admit that if the central bank increases IOR (or if the market simply expects the CB will increase IOR), then an increase in the monetary base won’t be inflationary. But once you acknowledge that, aren’t you admitting that it’s the expected PRICE of money that matters, not the quantity? Wouldn’t we have the same HPE if the CB did not conduct QE but just (credibly) promised to keep rates locked at zero until we had several years of inflation above 4%?

    Also, I don’t see how T-bills could rise above zero (or the IOR) if the increase in the monetary base is permanent (i.e. the CB will not drain the excess reserves). See dicussion at David’s Beckworth’s site:

    http://macromarketmusings.blogspot.com/2013/07/abenomics-as-fulfillment-of-milton.html

  8. Gravatar of Philip George Philip George
    14. August 2013 at 06:13

    Your comment on confederate money and inflation was very interesting because I wrote something very like that in a book a year ago:
    “It’s the beginning of May now and everyone is convinced that the world will end on October 31. People therefore move all the funds in their savings deposits into demand deposits and start spending the money. Since in the short run the production of goods and services cannot increase, all that the increase in money does is drive up the prices of goods and services.”

    But the conclusion I draw is quite different. It is that money as a medium of exchange can go up and down independent of the actions of the central bank simply by people converting money as asset into money as medium of exchange.

    The problem is of course to calculate the quantum of money that exists as medium of exchange. I have attempted to do that in the graphs that can be seen at http://www.philipji.com/item/2013-07-03/two-measures-of-money-supply-1981-to-may-2013 show

  9. Gravatar of ssumner ssumner
    14. August 2013 at 06:34

    Franky, I predicted that money was way too tight in late 2008, the NKs did not. They said money was easy. I predict that policies that make wages and prices more flexible will help stabilize the economy, Krugman and Eggertsson say they will tend to destabilize the economy.

    It’s often possible to traslate one model into another. That doesn’t mean the models are equivalent.

    Jared, Yes, I’ve always agreed that the expected future HPE is more powerful than a current HPE. And promising low rates until inflation is high is equivalent to promise a more expansionary future policy. A future HPE.

    But the interest rate and supply of money approach are not equivalent. An increase in the money supply causes a permanent long run increase in the price level and NGDP, but only a temporary affect on interest rates (and it could go either way.) In the long run interest rates return to their original level. It is expectations of the permanent impact of more money that have the greatest impact on current growth in NGDP, by comparison the impact of interest rates on NGDP growth is minor.

    I think your comment also confuses the impact of interest rates on the demand for money, and the impact on NGDP. Higher IOR does increase the demand for money, and hence can produce a powerful negative HPE. But the effect works through changes in the demand for money, not people’s decisions to invest. This means some changes in interest rates (say the 1/4% IOR) may actually be much more powerful than Keynesians assume, but mostly because it raises the demand for ERs, which is deflationary.

    I think Keynesians might find it useful to start off with the question of why when there is no IOR, a 87 fold increase in the base tends to raise NGDP by roughly 87 fold. Once they’ve figured out the transmission mechanism (and obviously interest rates could play at best a trivial role so it has to be HPE) then they need to think about how that non-interest rate mechanism would work its magic at slower rates of money growth. And then how IOR would change things.

    It turns out that at a constant level of IOR, money is still neutral in the long run, the QTM still holds. But if you change the money supply and IOR at the same time, then things get more complicated, as you say. But even that case is still fully consistent with a S&D for money approach, which predicts better than an interest rate approach. If you disagree then please tell me the interest rate models that predict the effect on NGDP of an 87 fold increase in the base, with IOR (but allowing market rates to move.)

    Keynesians (prior to Woodford) see the effects in terms of a series of short runs. I start with the long run expected effect (HPE) and use that to get the short runs by working backwards.

  10. Gravatar of Franky Franky
    14. August 2013 at 11:27

    Scott, everything you said still suggests to me that your model and the basic NK model are one and the same (Eggertsson and Krugman is not the standard NK model, they have nominal debt contracts between two types of consumers, and it’s the distributional effects of deflation that produce their result). You can rewrite the basic NK model so that you have money instead of rates in the Euler equation, and that changes nothing. At the zero bound the demand for money becomes infinitely elastic and changing the supply (in the current period) has no effect on spending. It’s the same model.

    There are differences between you and the NKs, sure. The main one, it seems to me, is that you argue that the commitment problem is a myth (correctly in my opinion). But that doesn’t mean the underlying macro model is any different – all you are saying is that the central bank can credibly implement a policy rule that’s different than 2% inflation targeting. Same goes for arguing whether policy was easy or tight in 2008. In NK terms, that’s a statement about the natural rate, not the actual one. And you could argue either way without contradicting the model.

    We can argue about the transmission mechanism, but in the NK model whether it runs through money or rates is irrelevant, you can read it either way. I have not seen anything in your posts that suggests otherwise.

  11. Gravatar of Jared Jared
    14. August 2013 at 14:29

    That’s a lot to digest! As for the 1-to-1 correlation between the monetary base and NGDP, that should not be too surprising given that prior to IOR (2008) increases to the base FOLLOWED deposit growth. So I think you have the causation reversed. Furthermore, during Japan’s QE in the 2000’s, the BOJ did not pay IOR and NGDP did not grow along with the monetary base, just as it hasn’t during the US QE with IOR. The problem isn’t IOR; it’s that the monetary base is causally inert.

  12. Gravatar of ssumner ssumner
    14. August 2013 at 17:13

    Franky, At that level of generality you may be right. I could have mentioned that I predicted fiscal austerity would not hurt US growth in 2013, and NKs said it would. But then that’s all about monetary offset, and you’d point out that monetary offset is an assumption, not a fundamental part of the model.

    But I also think there is more to models than certain highly technical formal aspects. In some ways this is similar to my ongoing debate about whether Friedman was really a Keynesian.

    In my view if I say “It’s all about the supply and demand for bas emoney, not interest rates (which are an epiphenomenon)” that makes my model different. But I can see how many would see them as being the same. We both believe AD shocks are important. We both believe a credible monetary policy can in principle determine AD. I’d like to add at roughly zero cost, but perhaps some NKs worry about central bank financial losses (I don’t.)

    Jared, The fact that the base sometimes follows deposits is irrelevant in a ratex world. And the base sometimes move first as in 1929-30. And the Japanese base grew faster than NGDP because as rates fall the desired Cambridge k ratio rises. None of that has any bearing at all on anything I said.

  13. Gravatar of Franky Franky
    15. August 2013 at 07:56

    Scott, thanks for the helpful discussion. The irony of that debate for me is that the NK model is much more Friedmanite than Keynesian, but what’s in a label. I think that it is interesting that all sides seem to be relying on a common underlying model. Chicago might argue that prices are not that sticky, you and the NKs might argue about policy rules, commitment and fiscal policy, and central bank losses (I agree with you here too) but everyone sort of speaks the same language.

  14. Gravatar of ssumner ssumner
    15. August 2013 at 10:55

    Franky, I agree that the NK model is slightly more monetarist.

  15. Gravatar of Joe Eagar Joe Eagar
    18. August 2013 at 22:44

    I’m curious. What if one viewed money as an endogenous part of economic systems? After all, most money is created privately in this country, as in most countries around the world.

    I don’t know if the endogenous view of money is correct, but I’ve always thought it fit the facts better than strict monetarism did. Central banks have always seemed to have far greater control over interest rates than the physical supply of monetary assets.a

  16. Gravatar of ssumner ssumner
    18. August 2013 at 23:45

    Joe, Central banks have control over the base—that’s all they need.

  17. Gravatar of W. Peden W. Peden
    19. August 2013 at 02:47

    To add to Scott’s point: all deposits are liabilities to pay cash, so all money is either base money or an asset dependent on the supply of base money. (The banking system can borrow from the central bank when its demand for base money rises, but at a price set by the central bank.) Provided that the supply and demand for base money is in line for stable NGDP growth, deposits vary with the competitiveness of the banking system e.g. bank deposits lost a lot of ground vs. bond funds and mutual funds in the early 1990s, so the velocity of M2 and M3 rose, but the Fed adjusted the base so that NGDP growth after 1992 was very stable.

  18. Gravatar of Joe Eagar Joe Eagar
    19. August 2013 at 02:49

    I agree. Control over the monetary base gives central banks control over interest rates; it allows to inject (and remove) liquidity.

    But strictly speaking, central banks don’t *need* physical control over the base so much as they need control over the short-term money market. Central banks can, and do, manipulate interest rates without altering the supply of base money; that’s why Bernanke convinced Congress to give him the authority to do IOR.

    For hundreds of years, central bankers have thought of themselves as regulating the real rate of interest, not the money supply; don’t forget, many central banks were created in an environment where they were not the sole bank of issue. They had to compete, both in international capital markets and, often enough, in domestic money markets.

    The American shadow banking system of the mid-2000s created an awful lot of money. These institutions were unregulated and, thus, not subject to the money multiplier. The Fed found itself swamped by economic forces beyond its control. Central banks have never been able to control the domestic money supply during balance of payments excesses of the sort we were having; you can read public policy papers on their attempts going back two hundred years.

  19. Gravatar of Joe Eagar Joe Eagar
    19. August 2013 at 03:00

    I guess what I’m saying is that controlling the money supply is very, very difficult, and central banks have not had good experiences doing so. They’ve basically accepted that they cannot control the supply of money (or even measure it); instead, central banks try to make the financial system dependent on the services they provide (base money, discount window loans, deposit services, etc).

    This way, they can exert control over the growth of credit without relying on direct control over the money supply; such control is helpful, but isn’t necessary to the formulation of monetary policy (at least, that’s my understanding of their goals; they don’t always succeed, and sometimes CB’s lose control over both the money supply *and* the real rate of interest; capital inflow bubbles into fixed exchange rate economies come to mind).

  20. Gravatar of W. Peden W. Peden
    19. August 2013 at 04:06

    Joe Eagar,

    Shadow-banking would be a problem for monetary policy if it led to central banks struggling to control short-term interest rates, but that hasn’t happened.

    “These institutions were unregulated and, thus, not subject to the money multiplier.”

    Provided monetary institutions have a demand for base money or depend on intermediaries who have a demand for base money, then you still get a causal connection between changes in the supply of base money and deposits. That’s why central banks like Australia, Canada and Sweden are able to have just as much control over monetary conditions as the Fed despite having no reserve requirements whatsoever.

    “For hundreds of years, central bankers have thought of themselves as regulating the real rate of interest, not the money supply”

    Perhaps they do, but central banks can only control the real rate of interest in the short-run and if they can’t alter the supply or demand of base money to control market interest rates then they can’t even control nominal interest rates.

    “I guess what I’m saying is that controlling the money supply is very, very difficult, and central banks have not had good experiences doing so.”

    It depends what you mean by ‘difficult’. Let’s say a central bank decides that M2 less MMFs and plus large time deposits (i.e. currency plus deposits) is the best measure; it then raises reserve requirements to 100% and targets the monetary base. That would be disastrous for the competitiveness of the US banking industry and have nasty consequences for financial stability, but the Fed would then be able to control M2 with precision. Simply controlling base money would require fewer institutional changes, but have a similar outcome.

    Also, if the Fed can control the price of money (the price level) then it can control the supply of money to the same degree, even without a monetary base control system as described above. I don’t recommend any of these options, of course, but it perhaps illustrates how the Fed can control NGDP, which is the money supply adjusted for its velocity.

  21. Gravatar of Joe Eagar Joe Eagar
    24. August 2013 at 14:13

    “Shadow-banking would be a problem for monetary policy if it led to central banks struggling to control short-term interest rates, but that hasn’t happened.”

    Why the focus on short-term rates? Having control over short-term interest rates doesn’t do you much good if the existence of a shadow banking system fosters a bubble in the capital account. Currency appreciation (and, in some cases, a fall in long-term rates) will offset much of the central bank’s tightening (though I admit, this doesn’t seem to be as big of a problem in floating currency regimes as in fixed).

    “Provided monetary institutions have a demand for base money or depend on intermediaries who have a demand for base money, then you still get a causal connection between changes in the supply of base money and deposits”

    Those institutions often aren’t using the supply of base money to implement monetary policy; instead, they influence money demand through interest paid on reserves, the discount window, loan services, etc. You seem to be acknowledging this. But if money demand is the dominant factor, why should we pay special attention to supply?

    “It depends what you mean by ‘difficult’. Let’s say a central bank decides that M2 less MMFs and plus large time deposits (i.e. currency plus deposits) is the best measure; it then raises reserve requirements to 100% and targets the monetary base.”

    That would work, at least until the shadow banking system came roaring back to life. Don’t forget that money market mutual funds came out of similar restrictions in the 70s.

  22. Gravatar of W. Peden W. Peden
    24. August 2013 at 14:29

    Joe Eagar,

    “Why the focus on short-term rates?”

    Because that is central banks’ short-term target. Provided it can control short-term rates, it can hit just about any nominal target it wants.

    “Currency appreciation (and, in some cases, a fall in long-term rates) will offset much of the central bank’s tightening (though I admit, this doesn’t seem to be as big of a problem in floating currency regimes as in fixed).”

    The proliferation of shadow banking did absolutely nothing to prevent the sharp disinflation of the early 1980s. Shadow banking makes financial regulation difficult, but has no record of limiting monetary policy.

    “Those institutions often aren’t using the supply of base money to implement monetary policy; instead, they influence money demand through interest paid on reserves, the discount window, loan services, etc. You seem to be acknowledging this. But if money demand is the dominant factor, why should we pay special attention to supply?”

    Because it is the control that central banks have over base money that allows all of their price-orientated measures to be effective, except for IOER.

    “That would work, at least until the shadow banking system came roaring back to life. Don’t forget that money market mutual funds came out of similar restrictions in the 70s.”

    If we’re assuming that currency + deposits is the best measure, then shadow banking can produce money substitutes, but not money, and so once again shadow banking has no major implications for monetary policy. MMFs are a good example of money substitutes that are not money.

    Also, the key factor behind the development of money substitutes like MMFs in the 1960s and 1970s was the prohibition of interest rates on demand deposits. That’s a very different kind of restriction from 100% reserve banking.

  23. Gravatar of Joe Eagar Joe Eagar
    25. August 2013 at 02:43

    Why should we assume that currency + deposits is the best measure of money? The relationship between that definition and nominal GDP growth is not exactly stable over time. The market doesn’t care what is or is not “the best measure” of the money supply; it will use whatever forms of money are available.

    “Because it is the control that central banks have over base money that allows all of their price-orientated measures to be effective, except for IOER.”

    This seems like a cop out. IOER is a very powerful tool (for one thing, it makes reserve requirements unnecessary). To raise interest rates, the central bank merely has to pay a higher interest rate on reserves.

    And since IOER affects money demand, the relationship between the money supply and nominal GDP growth becomes even more unstable.

  24. Gravatar of W. Peden W. Peden
    25. August 2013 at 03:46

    Joe Eagar,

    “Why should we assume that currency + deposits is the best measure of money?”

    We shouldn’t: we are just doing so because, in the hypothetical, the Fed has decided that it is so, and we’re asking about whether the Fed can control a measure of the money supply.

    “This seems like a cop out. IOER is a very powerful tool (for one thing, it makes reserve requirements unnecessary). To raise interest rates, the central bank merely has to pay a higher interest rate on reserves.”

    Reserve requirements are always unnecessary.

    I don’t see what I’m copping out of. There are all sorts of things that branches of the government can do to affect demands for base money or other measures of money; no-one has ever denied this.

    “And since IOER affects money demand, the relationship between the money supply and nominal GDP growth becomes even more unstable.”

    Yep. I don’t advocate targeting the money supply even in the absence of IOER.

  25. Gravatar of Joe Eagar Joe Eagar
    29. August 2013 at 20:48

    W Pedan,

    “…and so once again shadow banking has no major implications for monetary policy.”

    “We shouldn’t: we are just doing so because, in the hypothetical, the Fed has decided that it is so, and we’re asking about whether the Fed can control a measure of the money supply.”

    That’s certainly true, but I’m not sure why that is necessary for the formulation of good monetary policy. It doesn’t matter how correlated money is with inflation if we can’t measure it accurately to begin with.

  26. Gravatar of Then How Do You Explain Zimbabwe? Unlearning Econ Looks at Market Monetarism | Last Men and OverMen Then How Do You Explain Zimbabwe? Unlearning Econ Looks at Market Monetarism | Last Men and OverMen
    19. February 2017 at 08:58

    […] of Confederate money, as the demand for that sort of money plummeted?”      https://www.themoneyillusion.com/?p=22964      I’m glad Sumner questioned this because I had the same question. […]

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