Arnold Kling has been developing a macroeconomic theory that he refers to as “Recalculation”. It is somewhat of a takeoff of real business cycle theory (Kling himself has referred to this as “not your father’s real business cycle theory). David Beckworth highlights three main features of Kling’s analysis:
(1) Monetary policy has no effect on expectations in the short-run.
(2) Monetary policy has no effect on nominal economic activity in the short run.
(3) Monetary policy has no effect on real economic activity in the short run.
What is perhaps most ironic about Kling’s theory is that he has largely taken a position on monetary policy that is consistent with real business cycle theorists, but rather than doing so by assuming rational expectations (as the New Classicals did), he does so by assuming strong habit formation:
Like most economists, I view real GDP in the long run as determined by real factors, such as the supply of factors of production, the state of technology, and the nature of economic and cultural institutions. However, I view average prices in monetary units as reflecting habits. The government can change people’s habitual price behavior only by making significant, long-lasting changes in the amount of deficit that it finances by printing money. On the other hand, changes in money-printing that are modest and short-term have essentially no effect.
Regardless, the points summarized by David Beckworth present testable hypotheses. Luckily, there is a voluminous literature on money and business cycles. Beckworth himself takes up the challenge on his blog and presents evidence against Kling’s theory. (UPDATE: Bill Woolsey shows that Kling’s theory would hold if money demand was not dependent on income. Of course, a large body of empirical evidence shows that it is dependent on income. Also, as Bill notes, it doesn’t make sense when carried to its logical conclusion either.) As a complement to Beckworth’s post, I would like to review some empirical evidence.
There is an abundance of evidence that suggests that Kling is wrong. Let’s begin with point number 2 as it is the easiest to refute. Kling argues that monetary policy cannot affect nominal variables (i.e. the price level) in the short run:
Another way to express my view is that there is a probability distribution for nominal GDP growth. By printing money much faster starting today and persisting for several years, the government can raise both the mean and the variance of the distribution of nominal GDP growth many years from now. However, in the short run, both the mean and the variance are determined by things that have happened in the past, including past monetary policy but also including Recalculations and other factors that affect real GDP as well as past habits of price-setting.
I suppose that this depends on one’s definition of the short-run. We know from the literature using vector autoregressive models that contractionary monetary policy does not affect the overall price level, initially, because prices are sticky. After about a year and half, the GDP deflator persistently declines. Consumer prices do, however, result in a reverse hump-shaped response that begins one quarter after the monetary shock. (For a summary of this literature, see Christiano, Eichenbaum and Evans, 1999.) It is also important to note that in the VAR literature, what one is measuring is a monetary policy shock and not the effect of systematic monetary policy. This evidence thus casts doubt not only on Kling’s hypothesis that monetary policy doesn’t effect nominal variables, but also that a regime shift is necessary to influence price behavior and therefore inflation as these “shocks” are enough to generate the behavior denied by Kling’s model.
The second point in question is whether or not monetary policy effects real variables in the short run. Kling argues that it does not:
So, the question is whether there is a medium run in which M affects Y. My bizarre monetary hypothesis is that the answer is “no.” That is, I believe that the medium run usually looks like the short run, in which changes in M show up as changes in V. The medium run only looks different if the central bank is engaging in a regime shift, changing the long-term trend of M and P.
There is an abundance of evidence, however, that money does affect real output in the short run. The pioneer monetarist, Clark Warburton, published a collection of work that demonstrated that causation flowed from money to output to prices and then to velocity, thereby both demonstrating that monetary policy has short term real effects and that changes in M are not offset by changes in V as Kling suggests. Friedman and Schwartz’s A Monetary History of the United States and Monetary Trends in the United States and the United Kingdom as well as the work of David and Christina Romer (here and here) are also particularly of interest here. What’s more the work on monetary policy shocks shows that a contractionary monetary policy shock results in a reverse hump-shaped response to real output that peaks 4 quarters after the shock. In Allan Meltzer’s paper in the JME in 1986, he uses a multi-state Kalman filter to compare direct and reverse causation of money and output and finds that the evidence is greater for direct causation of money to output. Edward Nelson recently published in the JME in 2002 a paper that demonstrated that changes in the real monetary base are an important and independent factor effecting changes in output. This corresponds with the previous literature of Meltzer and Evan Koenig that changes in the monetary base cause statistically significant changes in consumption (independent of a significant interest rate effect).
There is an overwhelming body of empirical evidence that suggests that Kling is incorrect about monetary policy. Nonetheless, I felt the need to respond to his posts because I think that recalculation is important. However, I think that Kling has taken the argument too far in terms of his discussion of monetary theory and policy. One could argue that monetary policy (and indeed fiscal policy as well) are limited in their ability to correct for unemployment when resources are being reallocated without making the claim that monetary policy is unimportant. Monetary policy clearly has effects on output and prices in the short run. Denying this leaves Kling’s theory precariously in contradiction to the facts.