There seems to be a lot of debate in the blogosphere about how to evaluate whether monetary policy is too tight. Specifically, Arnold Kling notes:
According to Sumner, we know that the Fed tightened because we know that real interest rates on TIPS rose. The real rate is the nominal rate minus the expected rate of inflation. Because the nominal rate did not rise, the increase in the real rate came from a big drop in expected inflation. So we know that the Fed tightened because expectation inflation dropped, and we know that expected inflation dropped because the Fed tightened. That’s too circular for my taste.
Scott and I hold somewhat similar views, but I don’t want to focus on whether Scott’s logic is correct; rather I want to focus on the first sentence of Arnold’s comment. Specifically, I want to isolate the phrase “we know that the Fed tightened”. The phrase is important because it asks whether the relative tightness of monetary policy requires that the Fed’s behavior has changed. I intend to argue that monetary policy can be too tight even if the Fed does nothing.
Recall the equation of exchange:
MV = Py
where M is the money supply, V is velocity, P is the price level, and y is real output. Now, let’s make the modification that I like to use by viewing the money supply as the product of the monetary base (B) and the money multiplier (m):
mBV = Py
Now let’s suppose that the Federal Reserve is targeting nominal income. Assuming that the money multiplier and velocity are constant, the Fed can adjust the monetary base to target nominal income. Another way of thinking about this is that movements in the money supply offset corresponding movements in velocity such that nominal income remains stable. Thus, the policy can be seen as one that seeks to achieve monetary equilibrium (reductions in velocity — increases in money demand — are offset by increases in the money supply). Given the severe informational problems with predicting the behavior of velocity and the money multiplier, the nominal income target serves as a measuring stick to which monetary equilibrium is being maintained.
Given this framework, consider what happens to the money multiplier and to velocity when Lehman Brothers fails and Paulson and Bernanke testify to Congress that the situation is dire. Individuals restrain from consumption and thus velocity falls. In addition, fears about the banking system cause banks to increase their demand for reserves and individuals to increase their demand for currency relative to deposits; each of which reduce the money multiplier. In this case, with m and V falling, nominal income will fall as a result of falling velocity and multiple deposit destruction (thereby maintaining the equality).
Note that the Fed has really done nothing in this instance. However, I would consider monetary policy to be tight because the Fed could (should) increase the monetary base to offset the changes in velocity and the money multiplier thereby stabilizing nominal income. In other words, the Fed could increase currency and bank reserves into the system to meet the corresponding increase in demand.
In actuality, this is precisely what happened beginning in September 2008 when Lehman collapsed and Paulson and Bernanke gave their testimony. David Beckworth’s excellent graph shows that the sudden drop off in the money multiplier and velocity corresponding to this period.
Thus, it would seem that monetary policy became tight without the Fed doing anything. (Of course, not to be outdone by secular forces, the Fed did start paying interest on bank reserves — thereby increasing the demand for bank reserves and reducing the money multiplier — in October).
Critics of my view would argue that the monetary base increased significantly in the aftermath of September 2008. However, as I wrote back in July:
Ultimately, the money multiplier (M1) has fallen from around 1.6 prior to the recession to .93 as of June 17. At the beginning of January 2008, the monetary base was roughly $848 billion. Given that money multiplier, this would suggest that M1 was around $1.356 trillion. Thus, given the current money multiplier, this would suggest that the monetary base would have to be about $1.458 trillion today to maintain the same money supply — an increase of roughly 72%.
Of course, the 72% increase would only be sufficient keep the money supply constant and would not offset any change in velocity. In actuality, we would want the money supply to grow to increase nominal income (even if we were targeting a rate of deflation consistent with productivity growth).
Ultimately, targeting nominal income is an attempt to maintain monetary equilibrium. In this view, nominal income is the metric by which to measure whether monetary policy is too tight (or loose). What’s more, this view suggests that monetary policy can be too tight even if the Fed doesn’t “tighten.” Given the utter collapse of nominal income that characterized the crisis (nominal income growth actually became negative), I would argue that monetary policy was/is too tight and that this claim is consistent with the view outlined above.
[NOTE: For more on this view, see my earlier post.]