Does Market Monetarism Forsake Modern Theory?

A recent post by Arash Molavi Vasséi seems to suggest that the arguments put forth my Scott Sumner, David Beckworth, Nick Rowe, Bill Woolsey, and others (referred to by Lars Christensen as “Market Monetarists”) forsakes modern macroeconomic theory. For example, Arash writes:

In defining an economic school, Christensen is in need for a unifying framework that he defines in opposition to the general trend described above. He claims that “Market Monetarists generally describe recessions within a Monetary Disequilibrium Theory framework” and, thereby, suggests that MM rests on a relapse to pre-DSGE analysis. Accordingly, Christensen argues that “Market Monetarists are critical of the ‘equilibrium always’ views of money held by both New Keynesians and New Classical economists”. He provides plenty of evidence showing that most MM advocates do favor such theory choice. Nick Rowe’s plea for monetary disequilibrium analysis, especially his revival of the proposition that only monetary disequilibria can account for AD-constrained output, figures most prominently in Christensen’s account.

Yet, none of defining characteristics of MM depend on disequilibrium analysis. They rather fit the “equilibrium always” views of money (that rely on money as a unit of account rather than a medium of exchange). In fact, some of the characteristics fundamentally depend on equilibrium reasoning.

The thrust of the post is that Market Monetarists emphasize a disequilibrium analysis thereby forsaking modern work on monetary theory and central banking. The point made by Arash is that,

Without a disequilibrium model that reproduces such REE predictions, MM advocates as described by Christensen cannot compete with the mainstream view that still favors some form of inflation targeting. They give up a suitable high-end toolset that allows them to communicate their important message in the language of those whom they want to convince. And MM advocates get nothing in return. The history of economics witnessed many attempts to approach real-world phenomena by means of disequilibrium analysis. All of them proved to be futile in some sense. In short, they follow a poor strategy. This said, MM advocates should be cautious not to be regarded as a distinct economic school. [Emphasis in the original.]

Since I am mentioned by name in the post, I have three points that I would like to make regarding this post and Market Monetarism. My views may differ from others identified in the post. The three points are described in turn below.

1. The concept of monetary disequilibrium does not preclude equilibrium reasoning or modeling.

Market Monetarists, especially myself, often refer to the concept of monetary disequilibrium. When I refer to monetary disequilibrium, I am referencing a divergence between desired and actual money balances. If there is a ceteris paribus increase in desired money balances, for example, this will result in excess money demand and ultimately lower nominal spending. The importance of this concept is the role of money as medium of exchange and the implications for monetary policy; it is NOT the concept of disequilibrium or the development of a disequilibrium framework. I am completely in agreement with Arash that what we refer to as monetary disequilibria is capable of being explained in an equilibrium framework. I disagree to some extent regarding the New Keynesian model, however, which is the subject of my next point.

2. The New Keynesian model is capable of explaining AD-constrained output, as Arash notes. However, I am not interested in explaining AD-constrained output for the sake of AD-constrained output. I am interested in explaining the importance of money as medium of exchange.

Arash is completely correct that the New Keynesian model can explain AD-constrained output in an equilibrium framework. However, as noted above, it does not explain the main characteristic of monetary disequilibrium. Money is useless in the model except as unit of account. It therefore abstracts from the most important concept of monetary disequilibrium — money’s role as medium of exchange.

An example of equilibrium theory that can explain the concept of monetary disequilibrium can be found in Stephen Williamson’s New Monetarist framework. What I like about that framework is that it makes explicit use of the role of money as medium of exchange and is able to describe different equilibria that exist in which certain liquid assets are scarce. Thus, it is an equilibrium framework capable of describing the disequilibrium concept described above. What I don’t like about this model is that it implies that under certain conditions, open market operations have no effect — and does so by assumption. For example, in the “liquidity trap equilibrium”, the central bank can be effective by increasing the size of its balance sheet, but since the government is described by a consolidated budget constraint, the exchange of money for bonds does not alter size and therefore is irrelevant. It is possible, however, that open market operations could work through distributional effects (call it a real balance effect if you like), but such effects are assumed to be non-existent due to the existence of quasi-linear preferences of the agents in the model. (Amending the model to have limited participation a la Lucas and Fuerst would change this — and would be a step in the right direction in my view as it would incorporate a portfolio balance channel of monetary transmission.) Nonetheless, despite my quarrels, this is a step in the right direction.

3. I’m not forsaking the language of those I want to convince, but actively use it in my ongoing research.

Arash notes that Market Monetarists should try to communicate their views in terms of language of those we would like to convince. I am actively engaged in doing so. For example, the conventional wisdom among those who believe that monetary policy contributed to the Great Moderation is that the Federal Reserve increased its responsiveness to inflation post-1979. This is a quintessential New Keynesian story. The parameter on inflation in the Taylor rule rose above unity after 1979 thereby satisfying the Taylor principle. Embed the changed rule in a New Keynesian model and you find that this change in policy reduces the volatility of inflation and output — just like we observe in the data.

I disagree with this assessment on a number of grounds. For example, empirical evidence using real-time data rather than ex post, revised data suggests that the parameter on inflation was above unity in both periods. Taken together with identification issues, I think the Taylor story is hardly convincing. As a result, I currently have a paper under review in which I argue that the change in monetary policy post-1979 was an implicit commitment to low, stable rates of nominal income growth. Specifically, beginning under Paul Volcker there was a shift in policy at the Federal Reserve to control inflation expectations and there was a clear recognition that the Fed creates inflation, it doesn’t merely fight inflation. The implicit commitment henceforth was to commit to low, stable rates of nominal income growth to anchor inflation expectations and allow the price system to determine output and employment consistent with the natural rate hypothesis. How do I communicate this point? I estimate Fed reaction functions with respect to Greenbook forecasts of nominal income growth pre- and post-1979 and then embed these in a standard New Keynesian model and a P-bar model to determine the implications for the variability of output and inflation. A quintessentially Market Monetarist story in the language of modern macro!!

The reason that I bring up this paper is not to promote my own research (okay, yes it is), but rather to emphasize the point that there is a distinct difference between blogging and research. The research agenda that I am working on — and David Beckworth, for example, is working on — is consistent with modern monetary theory. However, the communication medium of blogging — where Market Monetarism has gotten the most attention — is not the medium in which to present simulations, etc. I will gladly summarize projects I am working on and publications, but comments that I make about the importance of monetary disequilibrium while blogging can be communicated in non-technical fashion with only references to the intuition that applies to the implicit framework that I have in my head.

In short, with regards to the points Arash makes in the post:

a. I believe that the concept of monetary disequilibrium is an important one. I similarly believe that it does not require disequilibrium modeling techniques.

b. I do not believe that the New Keynesian model gets to the heart of what Market Monetarists are saying. Nonetheless, I do believe that it can be a useful communicating device.

c. Monetary theory needs to go in the direction of taking seriously the role of money as medium of exchange. Search models do this to some extent, but I have some quarrels about certain aspects of the model. Nonetheless, search models present more potential than the New Keynesian framework.

Other Market Monetarists may disagree.