No Clean Feed - Stop Internet Censorship in Australia

Easy Guide to Monetary Policy

By Lorenzo

What money is
We use money to transact and the money we use is fiat money, money backed only by government decree. In economic terms, money is a transaction good and all that fiat money is, is a transaction good; the only point in holding such money is to be able to engage in transactions—its expected swap value(s) in exchange is its only value.

The use of money as a transaction good is driven by expectations. People take your money because they expect to use it in future transactions. You offer money in transactions because of that expectation. (Since there is no information from the future, we can only ever act on the basis of expectations; expectations that are derived from existing information.)

Anything that is used in a transaction for its swap value is being used as a medium of exchange. That does not, however, make it money. It is only money if it is also embodies the unit of account. Something that is used as a medium of exchange and embodies the unit of account is a medium of account and so money; something used to both quantify and pay exchange obligations.

(Money is also a store of value, but that is the least distinctive thing about it; many things are stores of value. Money’s role as a store of value comes from its swap value, which takes us back to it being a medium of account. Yes, we use it because of expectations about its future ability to operate as a medium of account, but that is what is distinctive about it, not being a store of value.)

In modern economies, the central bank—the Reserve Bank of Australia (RBA); the Bank of England (BoE); the US Federal Reserve (the Fed); in the Eurozone, the European Central Bank (ECB); the Bank of Japan (BoJ)—is the monopoly provider of local money, the money issued and used in your country. (Or, in the case of the Fed, the monopoly provider of the global reserve money which is also US local money.) The RBA, like the Fed, has a “dual mandate” of keeping inflation down and employment up. Such a mandate is, in effect, a legal obligation imposed on the central bank to neither flood the economy with excess money (causing inflation) nor to starve it of money (causing a fall in transactions from people maintaining their preferred level of money holdings by cutting back on spending and thus transacting). Since—for a given level of prices—the level of transactions determines the level of spending, and thus income (everyone’s money income is someone else’s spending), the latter matters; serious transaction “crashes” are known as recessions and depressions.

Unbalanced credibility
The ECB has price stability as its primary objective, with other objectives being subordinated to it. The BoE has a growth and employment objective, but it is subordinate to price stability. The BoJ just has a price stability objective. The problem with such inflation targeting by the central bank is that the central bank then explicitly promises (or is strongly expected) not to provide excess money but has no such explicit or implicit commitment to provide sufficient money to keep the level of transactions up. The central bank then acquires unbalanced credibility—people believe that their money will retain value but have much less basis for confidence in the future direction of income; unlike expectations about future prices (and so the future value of money), the future direction of income lacks any policy anchor. So, if people increase their holdings of money, and the central bank fails to adjust for this, people then cut back on spending, transactions fall so income falls, so people cut back on spending to maintain their preferred holdings of money, and the downward spiral is on. People (quite rationally) have lowered expectations of income and so engage in less spending, which confirms (and magnifies) the lowered expectations of income.

The level of money provision (and associated expectations) being required to stop actual deflation (which the central bank is expected to do to maintain an inflation target) being less than the level of money provision (and associated expectations) required to have transactions recover (which the inflation targeting central bank is not expected to do), an economy can remain “stuck” in output being well below capacity—the most obvious manifestation of which is unemployment, where labour use is well below labour supply—for a considerable period. (Or, in a milder version, stuck with much lower levels of capacity increase than would have been otherwise possible—Japan has been a manifestation of this as the Bank of Japan has regularly clamped down to maintain its, very low, inflation target; thereby offsetting any stimulatory effect from the amazing run of government budget deficits that have driven Japan’s public debt to the highest in the developed world.)

If an economy has high debt levels, then the level of economic stress from any significant fall in transactions (and so income) is even higher, as people struggle to pay back debts with lowered income. (For an example, see the Eurozone.) If the stress is sufficiently great, the potential for debt defaults—and so significant destruction of financial assets (one agent’s debt being another’s asset)—and consequent threat of major damage to, or even the collapse of, the financial system then further encourages a flight to “safe assets” and away from spending. (Again, see the Eurozone.)

In such a situation, the central bank (as the monopoly provider of local money and so dominant generator of expectations about same) is doing what monopoly providers normally do—it is under-providing its product (in this case, expectations coverage rather than actual currency) to maximise return (in this case, its credibility as an inflation targetter). Once an economy is in this situation, it can be hard for the central bank to change course, because that would have serious reputational effects on the officials running the bank, as it would be an implicit (or explicit) admission that their failure had caused the transaction crash and consequent economic misery in the first place. (For an example, see the Fed.)

As Danske Bank economist Lars Christensen has pointed out in his excellent Market Monetarist blog, failure by the Fed and the ECB to respond to increased demand for dollars and euros in the second half of 2008 is what caused the Great Recession to be The Great Recession—the largest peacetime crash in US money income (i.e. transactions) since 1938 and the largest crash in overall OECD money income since the organisation was founded.

Failed accountability
Both the Fed and the ECB have since behaved as monopoly providers, under-providing (expectations about) money to maximise their credibility as inflation targeters and, in refusing to shift policy, minimising reputation damage from their failure to react to changes in demand for money. The failure of the bulk of the economics profession to call them on it (a constant frustration for Scott Sumner) means that the reputation effect continues to militate against policy change.

Most commentators being unaware of (or simply flatly wrong about) the role of monetary policy in the ongoing economic crisis has greatly helped the Fed and ECB avoid accountability. The obvious political and economic dysfunctions of Greece, in particular, has been a great distractor from the failures of the ECB. Yes, of course the “weakest link” in the Euro chain has had the greatest crisis, but the problems in the Eurozone go way beyond Greece’s dysfunctions. And if it “falls off the edge” of the Eurozone, the next weakest link will simply take its place; a position made all the more precarious from the preceding example of the Greek exit/collapse.  There is nothing like an income crash to make debt problems (private or public) much worse.

Yes, the Fed has massively increased the US monetary base (coins, currency and bank reserves at the Fed), but the Fed has not generated any confidence that it has any commitment to having transactions recover to their pre-Great Recession path. So the increase in monetary base has not had the necessary effect on expectations about future income to generate the necessary increased willingness to spend required to have transactions recover to their pre-Great Recession path. So the US remains stuck with stubbornly high unemployment and it—and, even more, the Eurozone—hovers on the brink of a further downturn, a new crash in transactions.

Money is not just some unified quantity; it can be held, spent or leave the country.* Because of the hold/spend/flight options with money, expectations are crucial and quantities do not speak for themselves.

Monetary flight, manifesting in depleting bank deposits and the money multiplier effect thereof (money deposited in a bank being lent out again), can also result in falling transactions and so falling income. With a floating exchange rate, the result is a falling exchange rate (a fall in the price of that money compared to others due a fall in demand for that money and an increase in demand for other moneys) and increased ability to sell exports. In a fixed exchange rate (or if the exchange rate is otherwise unable to fall sufficiently to compensate), the result is a fall in the money supply and so transactions unless the central bank increases the money supply to compensate. (The history of fixed exchange rates has not been a notably happy one.) All members of the Eurozone have a fixed exchange rate relative to each other and are stuck with a common exchange rate for other moneys, while the ECB has not generated compensating increases in money supply for money flight from the distressed Eurozone economies. On the contrary, it has generated expectations that it will not maintain transaction levels in those economies.

Meanwhile, downunder
Australia stands out in this. [How much so is expressed in a striking series of graphs assembled by economist Tom Conley.] Yes, our public debt levels were much lower than the US’s, or the Eurozone, when the crisis hit but our combined levels of public and private debt were (as a percentage of GDP) at very similar levels. (Japan’s was much higher and the UK’s has since climbed to similar stratospheric levels.) But we sailed through the Global Financial Crisis and the Great Recession without any significant economic downturn. This despite a severe (if temporary) crash in commodity prices which meant our drop in exports (as % of GDP) was worse than the US’s.

It is true that we did not having a housing price crash and Chinese demand for our commodities has been a boon to mining export States, though the resulting high $A exchange rate has been less happy for manufacturing and services exporting States. But it is also true we have not had a recession (defined as two successive quarters of fall in GDP, i.e. output) since 1991 even while our terms of trade (the ratio of prices of what we export to what we buy) continued in what had been their long-term decline (since dramatically reversed).

The reason is very simple; our central bank, the Reserve Bank of Australia (RBA), does not have such unbalanced credibility. On the contrary, it has solid credibility for both keeping inflation down and transaction levels (and thus spending, so income) up. It does have an explicit target (something the Fed lacks)—which is very beneficial for anchoring expectations, as the RBA’s commitment to its target has been highly credible—but it is not a strict inflation target. In the words of the RBA’s website:

The Governor and the Treasurer have agreed that the appropriate target for monetary policy in Australia is to achieve an inflation rate of 2–3 per cent, on average, over the cycle. This is a rate of inflation sufficiently low that it does not materially distort economic decisions in the community. Seeking to achieve this rate, on average, provides discipline for monetary policy decision-making, and serves as an anchor for private-sector inflation expectations.

So the RBA has no temptation to have money supply follow any fall in output down, so as to keep changes in the price level constantly on target. In particular, it does not have to obsess over single quarter results. It is, instead, committed to only maintaining an average level of inflation over the business cycle.

The result is that, if output surges, the RBA tends to tighten monetary policy to minimise inflationary pressures and, if output falls, the RBA tends to loosen monetary policy to minimise effects on income (i.e. any fall in transactions is compensated for by an increase in prices, so keeping money incomes up). People have anchors for their expectations about both the future value of their money and their future income, so we in Australia have not had any of those transaction crashes we call “recessions”.

In particular, major increases in the (domestic) demand for money unmatched by changes in money supply have not occurred so as to lead to crashes in transactions. Having a central bank responsive to both inflationary pressures and shifts in output has successfully anchored expectations, as the RBA has balanced credibility. Since the RBA is accountable for both the value of money and the level of transactions, we have also had beneficial reputation effects operating on our central bank officials. (Which shows up in its statements and actions.)

I used to be a fan of inflation targeting, due to my scepticism about having one instrument—monetary policy—targeting two variables—inflation and unemployment—and concern that the RBA could evade responsibility by pointing to whichever variable was performing better. But the RBA’s actual target is effectively a promise to maintain steady growth in prices and output, which is money income—(in the language of national accounts, nominal GDP; i.e. GDP in money terms not adjusted for inflation; what in macroeconomics is also known as aggregate demand)—making my scepticism ill-founded. (The combination of the ongoing economic crisis and the growth in economic blogging has been a powerful educator in monetary economics.)

So, not only does money supply and demand matter, so do expectations about money. To see how powerful expectations are, consider the ratio of monetary base to GDP in Japan, the US, and Australia over 2011:
Australia:  4.0 %
US:           17.9%
Japan:     23.8%

In Australia, people have anchored money income expectations, so have much lower demand for money. In the US and Japan (and the Eurozone), people have strongly anchored inflation expectations but no such anchor for money income expectations, so the demand for money is high and willingness to spend is low. These expectations are entirely rational and have major economic consequences, as we can see on the figures for nominal GDP (i.e. aggregate money income) growth over the past five years:
Australia: 41.3 %
US:            12.8%
Japan:      -8.3%

Of course, the Fed and the Bank of Japan (and the ECB) could change these expectations with a press release, which would be a lot cheaper (and far less wasteful) than surges in public debt from fiscal stimulus. Especially as the effect of any fiscal stimulus is entirely dependant on the central bank accommodating it, otherwise any flow-on increase in transactions is simply neutered by monetary tightening. Just as the central bank can counteract any restrictive effect from falling government deficits, or even government surpluses, by engaging in monetary easing—the austerity that is devastating the Eurozone is not fiscal austerity (the level of which, at least in terms of spending reductions, is generally much exaggerated) but monetary austerity generated by the ECB.

To see how much Germany and other parts of the Eurozone are in different economic worlds, consider the two graphs of NGDP in Germany and the rest of the Eurozone in this post. While the US and UK are in similar places of demand shortfall misery. And lack of demand is lack of spending is lack of income is lack of jobs. We can even see where the Fed “lost the plot” in its NGDP forecasts. The same place where poor sales surged ahead of taxes, regulation and labour quality as the prime concern of small business in the US.

(As an aside, her opposition to the euro triggered the end of Margaret Thatcher’s Premiership; yet her analysis of the fundamental problem of the proposed euro has proved to be correct. I wonder if any of those Great and Good who publicly sneered at her opposition to the next great project of European Union have had the grace to apologise?)

Too much talk about interest rates
Notice that I have discussed monetary policy without mentioning interest rates once. First, as the above indicates, it is perfectly possible to usefully discuss monetary policy without mentioning interest rates. Second, the role of interest rates in monetary policy is primarily as a signalling device. Lowering the base rate lowers the price of credit (so is usually stimulatory for activity) and indicates the central bank sees inflationary pressures as weakening; raising the base rates raises the price of credit (so is usually restrictive of activity) and indicates the central bank sees inflationary pressures as strengthening. But that signalling role is itself embedded in a framework of expectations about central bank policy (or its reaction function, if its policy target is inferred, as in the case of the Fed, rather than explicit, as in the case of the ECB and the RBA). If the bank has unbalanced credibility, the signal will “work” for inflation expectations but not for income (transaction levels) expectations. If, as in the case of the RBA, it has balanced credibility, it will work for both.

A recent, dramatic, example of the power of credible central bank action was the Swiss central bank acting to stop the appreciation of the Swiss franc by announcing it would defend an exchange rate of 1.2 to 1 on the euro; since the Swiss central bank can print any number of Swiss francs it can obviously swamp any speculative pressure, so its decision was highly credible and the surging appreciation of the Swiss franc simply stopped. Without endorsing the rest of the monetary policy of the Swiss central bank (such as why the Swiss franc was appreciating so strongly in the first place), it was an excellent example of the power of expectations, as all the Swiss central bank actually did was issue a press release. But it was a highly credible press release. (Which, one might note, had nothing to do with jiggling interest rates.) An example of the Chuck Norris effect. Or central banking as Jedi mind trick.

One of the problems which has helped central banks evade accountability is obsessive focus on interest rates. Particularly the delusions that (1) low interest rates indicate that money is loose and (2) that a liquidity trap, or Zero Bound, renders monetary policy impotent. Think about money and monetary policy in supply, demand and expectations terms, and the so-called “zero bound” looks like nothing more than a policy phantasm from over-relying on a specific signalling device.

Especially as central banks just announce the base rate, they don’t actually do anything to underpin it, as (provided it is within whatever other constraints are operative) markets are not so silly as to bet against someone who always has more (local) money than you because they make the stuff and can produce any amount of it (the cost of production of paper or plastic notes and electronic data entries is, well, not a constraint).

As for the first delusion, interest rates are the price, not of money, but of credit (of renting money; so interest rates are no more the price of money than rents are the price of houses). As Milton Friedman pointed out, low interest rates are generally an indicator that money is tight (for use in transactions), not loose. Again, we can see this from looking at the 5 year Government bond yield over the last five years:

Australia: 3.69 %
US:            0.90%
Japan:      0.31%

In Japan and the US, there is lots of money available for safe assets, so of course their rental rate [price] is low (remembering that bonds are a form of credit). It is money for transactions that Japan and the US (and the Eurozone) are starved of. Milton Friedman’s words have a certain haunting quality now:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy. … After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

Sadly, apparently they do not. That a central bank lowering interest rates is taken as monetary easing, raising it as monetary tightening, probably helps keep the fallacy alive. But the price of credit is not the price of money and is certainly not a positive indicator of the availability of money for transactions. Monetary easing, after all, is about making more money available for transactions and monetary tightening is about making less money available for transactions.

To put it another way; lowering the cost of credit encourages spending while raising the cost of credit discourages spending. But that is always a “from where we are now” move, it is not an absolute indicator.  High interest rates suggest high money risk (i.e. money is expected to lose value at a significant rate) which suggests high levels of spending compared to actual output (i.e. that money is loose). Low interest rates suggest low money risk (i.e. money is not expected to lose value at a significant rate) which suggests low levels of spending compared to output (i.e. that money is tight).

About capital, assets and money
Since capital is the produced means of production, it represents resources withheld from present consumption for future (productive) use or which cannot be used for consumption. The cost of deferring resource use or acquiring resources purely for productive use incorporates the risk of failure (such as misallocation or accident), the risk of adverse shifts in the value of the resources used and the base risk in not having immediate access to the resources. Which replicates the elements in interest rates (asset risk, money risk, base cost). Capital is often bought via credit, but opportunity cost is enough to make interest rates the cost of capital, given these are all alternate uses of money not used for consumption. Asset prices are inter-connected, because the same deferral considerations operate across all of them, creating a continuum of opportunity costs according to level of expected risk. (Their prices will also take into account expected income and strength as a store of value.)

This again points to the limitations of interest rates as the central transmission mechanism in monetary policy. If there was no credit, there would still be money and questions for monetary policy. Even with the existence of credit, interest rates are not somehow quarantined from other asset prices.

Assets range from gold—a pure store of value that provides no income—to bonds—whose role as a store of value is entirely determined by their value (including attendant risks) as sources of income. Betwixt and between these poles, there are assets who provide income (either explicitly by being rented out or implicitly by being used by the owner) but can also be priced as stores of value beyond their current expected value as an income source. Housing land during housing booms is notoriously an example of this (houses are large decaying physical objects, it is the land the houses are on that jumps around in price).

Asset prices are fundamentally based on assessments of risk. The easiest way for asset prices to go on a trajectory that proves unsustainable is through distorted or unsustained assessments of risk. (Hence arguments about the contemporary destruction of prudence.) Obviously, shifts in income expectations matter too, but they tend to flow from current income, so have a more specific grounding in information.

Economists draw a distinction between risk (which can be calculated) and uncertainty (which can not). What Keynes called “animal spirits” is how people are currently framing uncertainty. Since uncertainty represents a lack of sufficient information to infer calculation of risk, any framing of uncertainty is unstable—easily shifted (or even reversed) by new information. There is a large area of uncertainty from new technology, which can create asset price instability. Strong expectations about income will tend to encourage positive framings of uncertainty; poor expectations about income will tend to encourage negative framings of uncertainty.

Monetary policy can affect asset prices through its effects on income and price expectations. The former through effect on expected income from assets, the latter through the level of money risk (expectations about money as a store of value). The mere availability of money is not sufficient to drive asset prices (otherwise US and Japanese asset prices would be rather higher than they currently are); it is (interrelated) assessments of risk, expected income and reliability as a store of value that drive asset prices. Public policy is far more likely to affect prices of assets through its effect on levels of risk or by distorting risk assessment (including through constraining supply) than the mere availability of money. For money is not just some unified quantity; it can be held, spent on consumption or assets or leave the country.* Because of the hold/spend on assets or consumption/flight options with money, expectations are crucial and quantities do not speak for themselves.

Reputations protected over the misery of millions
Meanwhile, Japan, the UK, the US and the Eurozone remain starved of money for transactions, utterly unnecessarily; as is the unemployment and economic stress that flows from that. The story of the central bank failures of our time is the story of unbalanced central bank credibility resulting in massively mismanaged expectations all flowing from a dramatic lack of accountability. Officials valuing their reputations as much more important than any amount of utterly unnecessary economic misery and not being effectively called on it.

Monetary policy matters; it really matters. And people need to understand how and why it matters if the institutions and officials that run it are to be held to account.

* If a currency only has purchasing power within a single country, this will require “swapping out” to a different currency. Either way, what is known as “capital flight” generally has negative impacts on the level of transactions.

[UPDATE: In the light of some of the discussion below.

Note for non-economist readers:
NGDP = aggregate demand = Price level (P) times output (y) = Py.]

ADDENDA  Lars Christenson has a post on Australia as a case of the export price norm (follow up here).

Yichuan Wang has a great pithy post on NGDP targeting and credibility.

36 Comments

  1. derrida derider
    Posted June 8, 2012 at 12:31 pm | Permalink

    Well, LE, inflation targeting and independent central banks were both supposedly introduced for precisely the reason you said.

    It was originally down to Milton Friedman, though of course he held the rule to be that the bank should target the quantity of money rather than the inflation rate. Milton’s scheme fell foul of Goodhart’s Law, disastrously so in fact (look at the UK in the late 70s and 1980s). As soon as you controlled the money supply, however you defined it, you gave people an incentive to substitute other forms of “money” outside your definition for their transactions.

    So following Lucas’ Critique ( a generalisation really of Goodhart’s Law) people decided markets will always outsmart any policymakers, including central bankers, and said bankers should therefore target something markets couldn’t game so easily – ie inflation.

    Like Lorenzo, I think the events of the past few years have made it clear that inflation targeting leaves you nowhere to go in a liquidity crisis (we really, really should have learned this from the Japnese experience), and that a natural alternative that has good theoretic backing (see the bulk of Lorenzo’s post) is NGDP. Lorenzo doesn’t mention, though, that NGDP has some problems of its own.

    In particular it is unclear what to do when you are faced with a totally exogenous supply-side shock of indeterminate size that changes the expected balanced growth path of real GDP. You don’t have to be into RBC to see that this can sometimes happen (eg the oil shocks of the 70s and 80s), even if (unlike the RBC fanatics) you don’t think such shocks are the only type of shock we face. That’s not a problem today, where the shocks are clearly neither exogenous nor supply-side (RBCers like Cochrane and Fama have made great fool of themselves desperately trying to pretend otherwise), but it could certianly be one in the future.

  2. Mel
    Posted June 8, 2012 at 1:38 pm | Permalink

    Meanwhile over at Catallaxy, Australia’s leading right wing blog, we’re being told to learn the lessons of the Estonian miracle …. Any thoughts, Lorenzo?

  3. Posted June 8, 2012 at 2:26 pm | Permalink

    LE@1 Thanks. Which raises the question of how one changes the incentives so they behave better. Scott Sumner’s strategy is to try and change the views of the “median economist” so that the balance of reputational effect shifts.

    Adopting the Australian system so that you have a target agreed between Bank and Treasurer could work too. (Particularly in the UK, where the Government could just tell the Bank its new objective.)

    DD@2 The case of

    totally exogenous supply-side shock of indeterminate size that changes the expected balanced growth path of real GDP

    is sufficiently removed from current problems that I believe it falls into the principle of “sufficient unto the day are the evils thereof”.

    One of the virtues of NGDP targeting is that it can cope with fluctuations in P and y. But if the underlying growth rate of y changed significantly, there could be an issue, as you say.

    In which case, NGDP targeting can be conceived as having two parts
    (1) The central bank will have a NGDP target (Scott Sumner specifically advocates “targeting the forecast“.)
    (2) The target will be X.

    If you had an appropriate procedure for changing X, the approach would cope with the economy shifting onto a new path.

  4. Posted June 8, 2012 at 4:56 pm | Permalink

    I think its dangerous to abandon inflation targeting. The idea of NGDP targeting seems to me to be based on the same sort of reasoning that lead to the high inflation during the 70′s & 80′s. That is I think by advocating for NGDP targeting you’re failing the Lucas’ Critque/Goodhart’s law test.

    Specifically once you’re targeting NGDP there’s nothing left to govern the balance between P and y, meaning the whole economy becomes unstable. As soon as there’s a decrease in y, the central bank will pump money into the economy until Py recovers. If there’s already a bound on y then that means P goes up. A rapid change in P would have impacts in the real economy thus forcing y down further. In essence you’re setting up the economy to go into an inflation spiral and economic crash at the slightest disruption.

    The second point I’d make is that while the monetary impact of the GFC was significant (unwinding debt sucks a huge amount of money out of the system), it wasn’t the only (or even really the key) issue and proposing a monetary solution without resolving the other issues just won’t get the economy back on track. I’m yet to be convinced that a different monetary policy could have done anything to prevent or even significantly reduce the impact of the GFC.

  5. Posted June 8, 2012 at 4:58 pm | Permalink

    That said, if you kept an inflation target band, targeting NGDP might give you a more specific target within that band.

  6. Posted June 9, 2012 at 4:47 am | Permalink

    M@3 Estonia, stuck with the euro, probably has done as well as could be expected in the circumstances. It has a tiny level of public debt (6% of GDP in 2011), likely fairly flexible markets (the tax system is very simple, for example) so probably not much of an example for countries in very different situations.

    So, I would not participate in Catallaxy crowing over Keynesianism. The ability to adjust is likely much greater than just about any other Eurozone country. [UPDATE: The more flexible the economy the more "classical" the response.]

    But, as this post indicates, Krugman has not exactly covered himself in glory either.

  7. Posted June 9, 2012 at 4:51 am | Permalink

    D@5

    I’m yet to be convinced that a different monetary policy could have done anything to prevent or even significantly reduce the impact of the GFC.

    Prevent, probably not, as Scott Sumner discusses here. Significantly reduce, absolutely. It is not hard to see that (greatly) increased demand to hold money not compensated for by increased money supply will lead to a transactions crash. The more money supply compensates, the less of a transaction crash there would be.

  8. Posted June 9, 2012 at 5:06 am | Permalink

    D@5

    The idea of NGDP targeting seems to me to be based on the same sort of reasoning that lead to the high inflation during the 70′s & 80′s. That is I think by advocating for NGDP targeting you’re failing the Lucas’ Critque/Goodhart’s law test.

    What fell prey to the Lucas’ Critque/Goodhart’s law was targeting specific monetary quantities. NGDP is simply not subject to manipulation in the same way. On the contrary, it makes expectations work for you not against you. And NGDPLT (NGDP Level Targeting) would have run much tighter monetary policies than were run pre-Volker.

    NGDP there’s nothing left to govern the balance between P and y, meaning the whole economy becomes unstable. As soon as there’s a decrease in y, the central bank will pump money into the economy until Py recovers. If there’s already a bound on y then that means P goes up. A rapid change in P would have impacts in the real economy thus forcing y down further. In essence you’re setting up the economy to go into an inflation spiral and economic crash at the slightest disruption.

    If you are targeting Py, then that is stabilising, not destabilising because you are using P to lean against changes in y.

    This is not mere theoretical assertion, you can see it in the evidence. Not merely in the success of the RBA (it is not absolutely doing that, but it is doing much closer to that than any other central bank) but also in the Great Moderation (which in Australia has kept going because our central bank …). The role of de facto NGDP targeting in the Great Moderation is discussed in this post.

    Whatever else, we are surrounded by the evidence of the destabilising effects of inflation targeting in a liquidity crisis where unbalanced credibility suddenly really matters.

  9. Aaron W.
    Posted June 9, 2012 at 5:40 am | Permalink

    @5: “The idea of NGDP targeting seems to me to be based on the same sort of reasoning that lead to the high inflation during the 70′s & 80′s. ”

    The period during the 70′s and 80′s that had high inflation was also a period with unanchored NGDP expectations, where both inflation AND NGDP soared. Compare both series with the period from 1970 to 2000 for the US, for example:
    Nominal GDP: Nominal GDP in the US From 1970 to 2000

    Core inflation:
    Core inflation (inflation minus food and energy) from 1970 to 2000

    The period during the 70′s and early 80′s has especially unstable inflation and NGDP, which led to especially unstable RGDP:
    RGDP growth in the US from 1970 to 2000

    In any case, from this data from the US, it’s not exactly clear how NGDP level targeting would necessarily lead to an inflationary spiral since during an inflationary spiral NGDP growth is also spiraling out of control.

    “Once you’re targeting NGDP there’s nothing left to govern the balance between P and y”
    It is true that the central bank can do nothing to govern the balance between P and y under an NGDP targeting regime. If there was some kind of oil shock it could potentially lead to some stagflation where P is say 7% and y is -2%. But what if in response to the same shock, the central bank tried to keep P at 2%, while Py went to -9% and y became -7%. Is that actually a better outcome? Even if you disagree, here’s a real life example of that actually happening from Israel. NGDP targeting hasn’t eliminated a recession, but it did make it much milder than the comparable recessions in the US or EU.

    In any case, even though the central bank can’t control the mix of P and y, the policies of the other branches of the government certainly can. If the legislative body decides to reform unnecessary labor market laws, this would almost certainly benefit the mix of P and y absent any other shocks. In fact, I would suggest that this would be a great indicator of supply side problems in a particular economy if the mix of P and y went more towards P.

  10. Posted June 9, 2012 at 5:54 am | Permalink

    M@3 Estonia is a very strong outlier, which reinforces my belief that its markets are more flexible than the Euro-norm (a low benchmark, I concede).

    If prices and wages are fully flexible, then you get “classical” economic responses. The more flexible they are, the closer to a “classical” economic response you get.

    If, however, you have “sticky” wages and prices, you do not get a “classical” response and the “stickier” wages and prices, the less “classical” the response is.

    All of which Keynes would have entirely agreed with. So, Estonia is not a rebuttal of Keynesian analysis. Keynesianism is all about given sticky wages and prices, then

    The data in that same post is much more of an issue for Keynesianism as (if you stop playing games with outliers) it implies change in government spending has very little to do with change in GDP. Though, even then, it is hardly a clincher since any sensible Keynesian is going to (entirely reasonably) ask “and what about revenues?” Given spending is only half the fiscal stimulus story.

    So, I am really not going to go along with Estonia as some stick against Keynesianism.

  11. Posted June 9, 2012 at 10:24 am | Permalink

    But what if in response to the same shock, the central bank tried to keep P at 2%, while Py went to -9% and y became -7%.

    It’s not clear to me why you think the central bank restricting the money supply to lower P would result in a lower y. I’d argue that lowering (stabilising) P would, if anything, result in a higher y. In terms of NGDP targeting, I don’t see how a stable Py is more important than a stable P. If anything stable P helps cause a stable y and as a result a stable Py. However targeting Py directly is putting the cart before the horse. If there’s a non-monetary disturbance to y (up or down), you’re going to be deliberately destabilising P which will further destabilise y.

    If we take your scenario of P at 7% and y at -2% then that results in a Py of ~5%. The average NGDP on that graph for that time period would have been ~10%. Would pumping money into the economy to try to push P up to 12% to get Py to ~10% be a good outcome?

    Now I’d accept that stabilising Py will also help stabilise y, however I can’t see the impact as being as significant as a stable P. Hence my comments about targeting Py within an inflation target band. Sacrificing a little bit of stability in P may be worth stabilising Py, however the primary concern needs to be having a stable P.

  12. Mel
    Posted June 9, 2012 at 11:28 am | Permalink

    Lorenzo,

    Estonia has also got a couple of billion euros in EU assistance.

    Thanks for providing an informative perspective with a minimum of barracking.

    I must admit I have few strongly held opinions on economics. It’s too bloody complicated!

  13. Posted June 9, 2012 at 1:41 pm | Permalink

    M@13 Some economics is more complicated than other bits, but yes. (Also, the EU assistance to Estonia would count as government spending and it is not the only recipient of such spending.)

  14. Posted June 9, 2012 at 2:01 pm | Permalink

    D@12

    If anything stable P helps cause a stable y and as a result a stable Py.

    Clearly, it doesn’t, as recent events in the US, UK and Eurozone have demonstrated.

    Note for non-economist readers: NGDP = aggregate demand = Price level (P) times output (y) = Py.

    however the primary concern needs to be having a stable P.

    Ask people which is more important, stable prices or reliable income and I can tell you which they prefer.

    Py matters because it is about people’s incomes; whether they can get jobs, whether they can pay their debts. The Eurozone and the US have very stable prices (and very low inflation expectations) and millions of people absolutely unnecessarily unemployed.

    So, no, stabilising P is not the most important thing.

    the central bank restricting the money supply to lower P would result in a lower y

    If incomes follow output down, then the effect of the fall in output is magnified. (Of course, if all prices and wages were fully flexible, then price and wage changes would do all the work; they are not, so they cannot.)

    If you lower the money supply then people will transact less to maintain their preferred level of money holdings. Indeed, their preferred level of money holdings is likely to go up if output is falling–especially if they have no confidence on incomes but are confident about their money retaining value. If people transact less, output (y) falls further.

    The central bank cannot directly control output but it can profoundly affect people’s willingness to transact, which has effects on output.

  15. Posted June 9, 2012 at 3:13 pm | Permalink

    Clearly, it doesn’t, as recent events in the US, UK and Eurozone have demonstrated.

    The ills of the GFC weren’t caused by a monetary problem, therefore they cannot (in isolation) be used to illustrate the failure (or success) of a given monetary policy.

    Ask people which is more important, stable prices or reliable income and I can tell you which they prefer.

    My arguments aren’t about what people would prefer, they’re about what is possible to achieve with monetary policy.

    If you lower the money supply then people will transact less to maintain their preferred level of money holdings. Indeed, their preferred level of money holdings is likely to go up if output is falling–especially if they have no confidence on incomes but are confident about their money retaining value. If people transact less, output (y) falls further.

    The flip side to that issue is if you destabilise price levels then people’s preferred level of money holdings goes up. Destabilised prices also make (longer term) transactions more uncertain and therefore more costly. Both of which have a negative effect on the amount of transactions and therefore output.

    The central bank cannot directly control output but it can profoundly affect people’s willingness to transact, which has effects on output.

    That has been tried. Raise inflation to get people to spend more gaining greater employment (i.e greater output). It didn’t work. It led to stagflation.

  16. kvd
    Posted June 9, 2012 at 3:33 pm | Permalink

    Lorenzo, like Mel@13 I tend to think economics is way too complicated – therefore I disagreed with the title of this post; was completely confused by the maths in Aaron@10’s “what if “scenario – and desipis’ follow up – and was very pleased to see your bolded bit in comment 15 ;)

    But my continuing confusion comes from two comments you made, when compared to your quote of Milton Friedman: (I’ve italicised some bits)

    Lorenzo:
    The result is that, if output surges, the RBA tends to tighten monetary policy to minimise inflationary pressures and, if output falls, the RBA tends to loosen monetary policy to minimise effects on income (i.e. any fall in transactions is compensated for by an increase in prices, so keeping money incomes up).

    Lorenzo:
    Second, the role of interest rates in monetary policy is primarily as a signalling device. Lowering the base rate lowers the price of credit (so is usually stimulatory for activity) and indicates the central bank sees inflationary pressures as weakening; raising the base rates raises the price of credit (so is usually restrictive of activity) and indicates the central bank sees inflationary pressures as strengthening.

    Milton Friedman:
    I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead.

    Lorenzo, I cannot reconcile your comments with Friedman’s throwaway line?

  17. Posted June 9, 2012 at 5:31 pm | Permalink

    kvd@17 A good question (and I am glad my bolded bit was helpful).

    The answer relies on the difference between level and direction of movement and the components of interest rates.

    Interest rates consist of three basic components:
    (1) “the risk free cost of capital“.
    (2) the risks specific to the asset in question. (Rated at 0 for government bonds for which there is no expected default risk.)
    (3) expected inflation.

    If expected inflation is high, interest rates will be high. If expected inflation is low, interest rates will be low. (If weird things are happening with the other two components, that would not necessarily be true, but we can ignore that.)

    High inflation is loose money (lots of money being spent for a given level of output) and low inflation is tight money (not so much money being spent for a given level of output). Hence Milton Friedman’s comment.

    But interest rates are the cost of credit. If people borrow more, they spend more (in particular, they invest more); hence lowering interest rates is deemed to be stimulatory (encouraging more borrowing and investing) and raising interest rates is deemed to be restrictive (discouraging borrowing and investing).

    If people have loans with floating interest rates, then lowering rates frees up some of their income (encouraging spending), raising rates absorbs more of their income (discouraging spending).

    Increased spending will raise output or prices (depending on what supply-side [i.e. capacity] constraints are operating).

    But the central bank changing the base interest rate is movement from a given spot (i.e. it is a directional movement at a given level). It can only change the overall looseness or tightness of money if it changes inflationary expectations. (And the impact of the interest rate change will vary depending on how inflationary expectations are running; so keeping interest rates unchanged as inflationary expectations drop is contractionary, as the non-inflationary cost of credit will rise.)

    If you are already in your target inflation range, the ideal outcome is you encourage output without significantly changing the general trend of money “tightness”.

    In other words, it is the movement of money into or out of spending, and the consequent effect on output, which matters. So, somewhat paradoxically, low interest rates are a sign of monetary tightness but lowering interest rates are a signal for monetary easing.

    Hence, and this is where the two collide, the concern about the Zero Bound or liquidity trap; when you cannot cut interest rates any further (you are at 0%p.a.) but folk still aren’t spending. The infamous “pushing at a string”.

    Which is where the fallacy comes from, I suspect. People know that cutting interest rates is intended to be stimulatory, so it is “obvious” that low interest rates mean loose money.

    Yes, cutting interest rates is intended to be stimulatory but, no, low interest rates are not a sign of loose money but its opposite. Because interest rates are the price of credit, a price which incorporates inflationary expectations, and the tightness or looseness of money depends on the level of spending for a given level of output.

  18. Posted June 9, 2012 at 6:09 pm | Permalink

    D@16

    The ills of the GFC weren’t caused by a monetary problem, therefore they cannot (in isolation) be used to illustrate the failure (or success) of a given monetary policy.

    The GFC and the Great Recession are two different things (related but different). So, yes, the Great Recession can be used to illustrate the impact of monetary policy. Just like the Great Depression can (and is separate from the Great Crash).

    if you destabilise price levels then people’s preferred level of money holdings goes up

    What do you mean by “destabilise”? No one is talking about double-digit inflation here. Indeed, NGDPLT targeting would have often meant tighter monetary policy over the postwar period.

    It is destabilising people’s income expectations while having very “stable” price expectations which is disastrous. As we found in the Great Depression and are finding out all over again in the Great Recession.

    In the 1930s, as soon as FDR took the US off the gold standard and committed to a higher price level (which was also a higher money income level), spending boomed. Alas, he then choked it off again with NIRA, but spending (and output) recovered when the Supreme Court ruled NIRA unconstitutional until the Fed screwed up again–the link in my comment@7 has the goods.

    That has been tried. Raise inflation to get people to spend more gaining greater employment (i.e greater output). It didn’t work. It led to stagflation.

    The 1970s policy, which anchored neither P nor Py expectations, was not remotely NGDPLT. The policy is not a blanket “raise inflation”, it is to provide an anchor for income expectations.

    During the Great Depression people blathered on about the evils of inflation too. It was just as disastrously wrong-headed then as it is now. Particularly with inflationary expectations being as low (indeed falling) as they are currently.

  19. Posted June 9, 2012 at 6:22 pm | Permalink

    D@16 This post makes it obvious how tight money has been in the US and Eurozone (outside Germany).

  20. Posted June 10, 2012 at 1:00 am | Permalink

    D@16 This paper (pdf) takes us through what happened in the 1930s in the UK. It is a pity Cameron or Osbourne (or their advisors or whoever) apparently don’t know their economic history. If they just told the Bank of England to accommodate all the fiscal consolidation and then some, things would be much better.

  21. kvd
    Posted June 10, 2012 at 3:21 am | Permalink

    L@18 that is a very clear explanation. Thanks for taking the time to set it out so well.

  22. Posted June 10, 2012 at 3:45 am | Permalink

    kvd@22 My pleasure. I am glad it was clear, because it was helpful to me to set it out.

  23. Posted June 10, 2012 at 4:17 am | Permalink

    D@16 This post goes through the stabilising effects of NGDPLT quite well.

  24. Postkey
    Posted June 12, 2012 at 6:07 pm | Permalink

    “For money . . . or leave the country.”

    With a fully floating exchange rate regime, money does not ‘leave the country’.

  25. Posted June 12, 2012 at 6:20 pm | Permalink

    PK@25 Mostly true (if your currency is a major global reserve country, it can still leave the country), but floating exchanges rates are not the only inter-country arrangement. Ask the Greeks.

    But, even in a fully-floating exchange rate, there will be consequences from one-sided swapping out of one currency into others.

  26. kpm
    Posted June 14, 2012 at 10:17 pm | Permalink

    Lorenzo,

    Just so I am clear on your points, can you clarify something? You are saying that even though the Fed cannot really lower rates much more that they are not out of bullets. Those bullets are announcing a higher inflation target or, preferably, an NGDP target. The market will believe that the Fed will print as much money as needed in order to hit the inflation or NGDP target…but do they need to believe that there is an actual mechanism to get the money into the economy (and not just sitting at the banks)? Or is it just the idea that they will come up with something…buying other assets, whatever it is…am I summarizing your thoughts correctly or am I missing something?

  27. Posted June 15, 2012 at 2:07 pm | Permalink

    kpm@27 The short answer is yes. This paper (pdf) by Lars E. O. Svensson (Deputy Governor of the Riksbank, the Swedish central bank) indicates the sort of thing that can (and should) be done.

    The Riksbank has gone so far as to have a negative base interest rate (in July 2009), the first central bank to do so.

  28. Postkey
    Posted June 15, 2012 at 3:47 pm | Permalink

    If you have not seen it you may be interested in this article?
    “Ex ante, an expected negative real interest rate would mean that the anticipated rate of inflation is greater than the nominal interest rate. In principle, the central bank can stimulate the economy by holding its interest rate down while encouraging people to expect inflation. Indeed, this is the classic recipe for escaping the so-called ‘liquidity trap’, much discussed in the context of Japan’s ‘lost decade’ of the 1990s. Reductions in the real interest rate sustained over a period of time have the potential to act as an expansionary policy so monetary policy is not impotent after all even when interest rates hit the zero lower bound.”
    http://www.centreforum.org/assets/pubs/delivering-growth-while-reducing-deficits.pdf

  29. Postkey
    Posted June 15, 2012 at 5:43 pm | Permalink

    Sorry. Missed your 21.

  30. Posted June 15, 2012 at 10:02 pm | Permalink

    Pk@29,30 Well, at least you were correct, i was interested :)

  31. Posted June 16, 2012 at 12:08 am | Permalink

    A nice piece on why Keynesianism is better in theory than practice.

  32. Mel
    Posted June 16, 2012 at 11:46 am | Permalink

    Krugman as well as other prominent Keynesians declared Obama’s stimulus package way too small from the outset. If you give a patient half the necessary does of antibiotics, the patient doesn’t recover- nothing surprising or interesting about that.

    Sanandaji’s article doesn’t land any killer blows, indeed I think it hardly lays a glove on Keynes. Fail.

    An interesting article on Friedman, Hayek and Pinochet. Eek!

  33. Posted June 16, 2012 at 2:07 pm | Permalink

    M@33 As Milton Friedman said, he also went to China and offered political advice to the Chinese Communist government; he would provide advice on how to improve things for ordinary folk to any government that might listen. The “Pinochet was so much worse than Mao” line never does it for me.

    On Sanandaji’s article, as he points out, the wider evidence on fiscal stimulus is not exactly encouraging. There is the counter argument on the US that it was not the right sort of spending and that the actual stimulus bit in the enormous increase in the US federal deficit was not all that remarkable, Daniel Kuehn makes it here.

    Even if you accept what Krugman and co have to say about US spending (and ignore all the other evidence), a policy that apparently Congress is not actually competent to do is not much of an option.

    More to the point, if the Fed just moves in and tightens so as to stop inflation increasing, then all the fiscal stimulus in the world is not going to get you anywhere. (This is what happened in Japan.)

  34. Mel
    Posted June 16, 2012 at 9:39 pm | Permalink

    L@33:

    “The “Pinochet was so much worse than Mao” line never does it for me.”

    Doesn’t do it for me either. But that isn’t the point.

    “Even if you accept what Krugman and co have to say about US spending (and ignore all the other evidence) … ”

    AS far as I can tell the jury is still out on the efficacy of fiscal stimulus. I rather suspect you’ve read mostly only one side of the argument as Keynes has most libertarians reaching for wooden stakes and cloves of garlic.

    “More to the point, if the Fed just moves in and tightens so as to stop inflation increasing, then all the fiscal stimulus in the world is not going to get you anywhere. ”

    Probably true and I doubt Quiggin, Krugman etc would deny that the two must work in tandem.

  35. Posted June 17, 2012 at 1:12 am | Permalink

    M@35. Chile is now a stable democracy and one of the most prosperous states in Latin America, so I guess it is a case of all’s well that ends well.

    While the US conservative angst over Keynes is way overdone (they should listen to what Friedman had to say; but that applies more widely than just Keynes, Friedman would have had no patience for the current mindless hawkishness on inflation), the poor evidence on the efficacy of fiscal stimulus was why fiscal stimulus was losing traction among macroeconomists generally before the present crisis. One of the surprising results of the crisis is how economists relapsed into the comforting narrative of fiscal stimulus.

8 Trackbacks

  1. [...] Maybe our New Lords of Finance should read this Easy Guide to Monetary Policy. Share this:EmailLike this:LikeBe the first to like this post. 2 Comments by Lars Christensen on [...]

  2. [...] Any Chicago students reading this blog are encouraged to supplement your studies with this excellent essay on monetary economics by frequent commenter [...]

  3. [...] for their grotesque refusal to take responsibility for ensuring that there is sufficient money, and associated expectations, to keep the level of transactions on a stable [...]

  4. [...] I am not talking here about debates over monetary base (coins, notes and bank reserves with the central bank) and the various monetary aggregates (M1, M2, M3 etc). These debates are even less interesting than they appear, not least because expectations matter so much. [...]

  5. By Skepticlawyer » Broken by the fix on July 30, 2012 at 12:01 pm

    [...] seriously contractionary, even without significant continuing effects on the price level. Indeed, unbalanced credibility–where confidence in the value of money is high (i.e. there is a nominal anchor for price [...]

  6. By Skepticlawyer » They did it again on September 19, 2012 at 10:32 am

    [...] stability and the financial system to the sacred doctrine of gold. It is as if money stops being a tool for transactions and becomes some sacred principle to which all else must be sacrificed at whatever [...]

  7. By Skepticlawyer » Time enough for success on November 2, 2012 at 11:38 pm

    [...] other market monetarists, I attribute the Australian success in avoiding those transaction crashes we call “recessions” to the Reserve Bank of Australia’s (RBA) monetary policy.  [...]

  8. By Skepticlawyer » Value and ambit on February 9, 2013 at 12:45 am

    [...] with inflation targeting show that anchoring expectations about money as a store of value is not the same as anchoring expectations about the future level of transactions (i.e. expectations about [...]

Post a Comment

Your email is never published nor shared. Required fields are marked *

*
*