Monthly Archives: November 2010

Blinder on QE2

Alan Blinder and I often do not agree on policy, but he has written a good op-ed in the WSJ today on quantitative easing. My favorite passage:

Here’s the first Economics 101 question: When central banks seek to stimulate their economies, how do they normally do it? If you answered, “by lowering short-term interest rates,” you get half credit. For full credit, you must explain how: They create new bank reserves to purchase short-term government securities (in the U.S., that’s mostly Treasury bills). Yes, they print money.

But short-term rates are practically zero in the U.S. now, so the Fed wants to push down medium- and long-term interest rates instead. How? You guessed it: by creating new bank reserves to purchase medium- and long-term government securities.

That sounds pretty similar to garden-variety monetary policy. Yet critics are branding QE2 a radical departure from past practices and a dangerous experiment.

This is precisely the point I made last week (see here and here.)

Nominal Income Targeting

Nominal income targeting gets some attention from Ramesh Ponnuru over at National Review Online:

There may be a way to avoid the worst fears of both camps. Economists Scott Sumner of Bentley University and David Beckworth of Texas State University are among those who have suggested that the Fed should move gradually toward a new, more rule-bound and predictable monetary policy. The first step would be to signal to the markets that the Fed is willing to do whatever it takes to reach 2 percent average inflation. Over time the Fed would move to stabilize and then slow the growth of nominal GDP, which is the size of the economy as measured in a given year’s dollars. If the nominal GDP target was for 3 percent growth and the economy grew by 2 percent, there would be 1 percent inflation.

That policy would bind the Fed to a rule, thus reducing the uncertainty that recent policy has generated, including the risk that we will get galloping inflation at some point in the future. But it is superior to simply targeting the inflation rate, Beckworth argues, because it incorporates two worthwhile types of flexibility. It allows the price level to move in response to supply shocks: An oil embargo would cause prices to rise, a technological advance would have the opposite effect. And it allows the money supply to move up and down in response to the demand for cash: In periods such as late 2008, when people were holding on to their money, the Fed would have loosened more than it did. But since the rule would have required tighter money during the boom years, the financial crisis might not have been as severe in the first place.

This policy would, in the short run, increase inflation, but to a low rate; we have averaged higher than 2 percent inflation for each of the last five decades. Eventually it would yield a gentle, long-term deflation: Prices would fall during periods of productivity growth. (George Selgin, an economist at the University of Georgia, has made an elegant case that productivity-driven deflation is not dangerous.) Beckworth cites evidence that both Milton Friedman and Friedrich Hayek favored something like this approach of stabilizing nominal spending.

Read the whole thing.

Alan Reynolds and the Straw Man

Alan Reynolds writes in the WSJ this morning:

Federal Reserve Chairman Ben Bernanke may be an excellent economist, but he is not a very good bond salesman. Since his Aug. 27 speech at an annual Fed symposium in Jackson Hole, Wyo., he’s been telling us that he thinks inflation is too low and long-term interest rates are too high. In a quixotic effort to “maximize employment,” he’s begun purchasing up to $600 billion worth of long-term Treasury obligations to push inflation up and bond yields down.

If it worked as planned, this would flatten the yield curve, meaning it would narrow the spread between short-term and long-term interest rates. Since banks make money by borrowing short and lending long, the effect would be to discourage bank lending. That seems an unpromising way to stimulate the economy. But the whole notion of simultaneously raising inflation and lowering bond yields presumes bond buyers are docile fools.

Indeed. Of course, Reynolds is attacking a straw man.

As I wrote in a previous post, the purpose of quantitative easing is not lower long-term interest rates, but rather to restore monetary equilibrium. (If lowering interest rates was the objective, we would be in big trouble. For heaven’s sake, Chirinko taught us that interest rates aren’t all that important for investment.)

To understand the purpose of QE, let’s consider a simple framework for analysis, the equation of exchange:


where M is money, V is velocity, P is the price level, and Y is output. Re-writing this in terms of growth rates yields:

dM + dV = dP + dY

Suppose for simplicity that we assume that the central bank cannot have any real effects — I’m trying to put a New Classical spin on this. Now suppose that the Federal Reserve has a target for inflation (dP) of 2%. It follows that if inflation is less than 2%, monetary policy should be interpreted as too tight.

Now suppose that monetary policy is too tight and the federal funds rate is at zero. In addition, let’s suppose that M is defined as a broad monetary aggregate like M2 or MZM. With inflation below its target, the Fed wants to become expansionary. Typically, they would conduct an open market purchase of T-bills. However, since T-bills and reserves are essentially perfect substitutes at the moment, this would have no effect other than to increase reserve balances and the monetary base. There would be no effect on the broad monetary aggregate and thus no effect on inflation. In order for the Fed to be successful, they must purchase assets other than the short-term bonds.

In other words, the Fed is trying to increase inflation not for the sake of inflation, but because of the fact that inflation is below its target, which is a signal of monetary disequilibrium.

Reynolds has every right to oppose QE and to dismantle the concept of monetary disequilibrium as a framework for monetary policy analysis. However, to claim that the Fed is only buying long term bonds to lower their yields is simply beating up on a straw man.

The Monetary Base, Part II

As I stated in my previous post, there are those who interpret the recent expansion of the monetary base as a sign of rising future inflation. In addition, there are those who interpret the failure of that surge in the monetary base to have real effects as evidence of a liquidity trap.

With the Fed paying interest on reserves, open market operations literally entails the Fed exchanging debt for debt — specifically, Federal Reserve debt for Treasury debt. Commenter ‘The Money Demand Blog’ points out that this distinction is irrelevant as without interest on reserves the T-bill rate would fall to zero would therefore remain perfect substitutes for reserves. This might be so, but it is not necessarily the case that it would go all the way to zero and there is a difference between near-zero rates and a zero rate (see this post by Tyler Cowen). Nonetheless, by paying interest on reserves, the Fed has rendered any such distinction moot.

Regardless, when thinking about monetary policy in terms of open market operations, it should be clear that the Fed is not being expansionary when it exchanges debt for debt. Nonetheless, this is not the same thing as saying that the Fed cannot be expansionary.

Brunner and Meltzer (1968) demonstrated some time ago that the existence of a liquidity trap is not possible when the model consists of a spectrum of interest rates rather than “the” interest rate — as is typical in the majority of macroeconomic models. To understand why, one needs a grasp of the monetarist transmission mechanism.

Monetarists emphasize the role of monetary policy on relative prices and a variety of asset substitutions. For example, an open market purchase is likely raises the price of bonds and reduces the yield. Following the open market purchase, the seller(s) will seek to re-balance their portfolio(s), most likely by trying to buy other financial assets. This process bids up the price of financial assets relative to non-financial assets, like capital, which increases the demand for the latter. Initially, the lower relative price leads to an increase in the demand for existing non-financial assets. However, as the price of existing non-financial assets gets bid up, this increases the demand for newly produced non-financial assets and leads to increased capital accumulation. In addition, these higher asset prices boost wealth, which increases the demand for consumption. These asset substitutions generate real effects and ultimately the price level will rise to bring real money balances in line with desired money balances.

It follows that the central bank’s ability to affect the price and corresponding yield of financial assets through open market operations is essential to understanding the effects of monetary policy. This is where quantitative easing comes in. Some commentators have assumed that the sole effect of quantitative easing is to reduce long-term interest rates and stimulate investment. This is wrong-headed and demonstrates — or at least after reading this post, I hope will demonstrate — why obsessions with the interest rate effect are misguided. The point of quantitative easing is not to reduce the long-term interest rate, but rather to resolve monetary disequilibrium.

Suppose that there is an excess demand for money. Since money is the medium of exchange and is traded on all markets, this necessarily causes an excess supply of goods and services. The central bank can eliminate the excess demand for money by increasing the money supply. However, as has been discussed above, if the central bank is exchanging interest-bearing reserves for interest-bearing debt, it is essentially exchanging perfect substitutes. If this is the case, traditional open market operations will not resolve the excess demand for money. Rather, the central bank needs to exchange the interest-bearing reserves for something that is not a perfect substitute. Potential assets that satisfy this criteria could be anything from long-term bonds to a portfolio of stocks. The central bank purchases these assets in order to increase the money supply and resolved monetary disequilibrium.

In addition, these asset purchases will have real effects as well. As the monetarist transmission mechanism highlights, open market purchases can resolve monetary disequilibrium, but also lead to real effects through capital accumulation and wealth effects. As Nick Rowe recently highlighted, rising stock and bond prices that result, directly or indirectly, from open market purchases can lead to increased investment due to the effect on Tobin’s Q.

So what is the point of all of this? The point is that much of the focus on quantitative easing is misguided. The purpose of QE is to resolve monetary disequilibrium. Given that the Fed is paying interest on reserves, traditional open market operations will not suffice. An exchange of interest-bearing reserves for interest-bearing government debt is unlikely to lead to portfolio re-balancing and therefore the increase in the monetary base is unlikely to resolve the excess demand for money. A shift toward other types of asset purchases is much more likely get the increase in the monetary base circulating the resolve monetary disequilibrium.

Quick Update

I successfully defended my dissertation today.

I apologize if I have been behind on responding to emails and/or comments as I have obviously been a bit preoccupied.

Milton Friedman and the Fed

David Beckworth and William Ruger had an op-ed in the Investor’s Business Daily last week on what Milton Friedman might say about monetary policy. I am not going to weigh in on what Friedman might or might not have said if he had lived to see the Great Recession. However, I do want to address one point. One of the criticisms of Beckworth and Ruger’s op-ed that many Friedman supporters have levied is that Friedman advocated stable money growth and therefore would not support quantitative easing. So let’s look at Friedman’s favorite monetary aggregate, M2:

Graph source here.

Does this look like stable money growth? It looks to me like the growth rate of M2 has slowed substantially.

The Monetary Base: Context Matters

Take a look at the monetary base:

In 2008, the monetary base started increasing dramatically. Today, there are two major views on monetary policy that view this increase as supporting evidence. The first view, typically advocated by hawkish, right-wing monetarist-types is that the dramatic increase in the monetary base suggests that the United States is headed for high inflation. The second view, typically advocated by left-wing, Keynesian types, is that the United States is currently in a liquidity trap. The first group sees the substantial increase in the monetary policy as a predictor of inflation on quantity-theoretic grounds. The second group thinks that the fact that the base has increased so substantially without promoting recovery provides support for the hypothesis of a liquidity trap, whereby monetary policy is impotent.

I would like to suggest a third view.

A consistent concept throughout monetary theory is that of monetary disequilibrium. Central to monetary disequilibrium theory is the understanding that money is the medium of exchange. Since this means that money is traded in all markets, it follows from Walras’ Law that when there is an excess supply of money, excess demand will exist in all other markets. Similarly, this means that if there is an excess demand for money, an excess supply will exist in all other markets. Since money trades in all markets, the price level must adjust. If prices do not adjust instantaneously, this will also result in changes in production.

A simple way of looking at this theory is through the equation of exchange:


where M is money, V is velocity, P is the price level, and Y is output. For simplicity, M will be defined as the monetary base. Velocity reflects changes in the demand for the monetary base.

An excess supply of money occurs when the monetary base increases or the demand for the monetary base declines (V increases), ceteris paribus. An excess demand for money occurs when the monetary base decreases or the demand for the monetary base increases (V falls), ceteris paribus. It follows from the equation of exchange that an excess supply of money leads to an increase in nominal income (PY) and an excess demand for money leads to a decline in nominal income.

The first view articulated above sees the expansion in the monetary base as reflecting an excess supply of money and therefore anticipates higher inflation. The poor performance of nominal income over the last two years would seem to call into question this view. However, advocates typically point out that there are long and variable lags associated with monetary change or that current increases in money demand won’t last forever and when they subside, inflation will emerge.

The second view sees the combination of the expansion of the monetary base and the poor performance of nominal income as evidence of a liquidity trap. Under this view increases in the supply of money are offset by increasing in the demand for money and have no influence on the economy.

I believe that both of these views are wrong. A careful discussion of how monetary policy works will elucidate my point.

Monetary policy is typically conducted through open market operations, in which the central bank buys and sells short-term government bonds. The central bank credits or debits a bank’s reserve account depending on the transaction. Suppose that the central bank conducts an open market purchase. In this scenario, bank reserves increase and therefore the monetary base increases.

In the typical monetarist-type view, the exchange of money for bonds generates a disequilibrium in the bank’s portfolio. The bank will then seek to re-align their portfolio through a series of asset substitutions. This results, initially, in changes in output and, ultimately, prices.

In the Keynesian view, when interest rates are zero, money and bonds become perfect substitutes. As a result, an open market purchase just leads to a reduction in velocity and no change in output or prices.

The problem with using either of these methods to evaluate monetary policy in the present context is because the Federal Reserve is not issuing new base money. The Fed has been issuing debt.

In October 2008, the Federal Reserve started paying interest on reserves and therefore effectively issuing debt. As a result, open market operations have not entailed exchanging base money with government debt, but rather Federal Reserve debt with government debt. Given that the yield on a 90-day T-bill is roughly equivalent to the interest payments on excess reserves, the Federal Reserve is literally exchanging perfect substitutes, but it has nothing to do with a liquidity trap. Thus, the effective monetary base is not changing all that much despite the evidence from the graph above.

This has important implications for quantitative easing. More later…