Monthly Archives: September 2011

Expectations and Policy

I wrote in my previous post that expectations matter. This is something that cannot go understated and is often disregarded when talking about the effects of policy. For example, David Wessel writes:

In our time, says Mr. Ahamed, “I don’t think Keynesians or even monetarists ever realized that the numbers to make their policies work are so gigantic. Everyone had sticker shock.” The Obama stimulus seemed huge and the Fed’s quantitative easing—printing money to buy bonds—looked massive, but in retrospect perhaps they weren’t sufficiently large.

I continue to hear that the problem with fiscal and monetary stimulus in recent years has been one of magnitude. Monetary and fiscal policy have failed because they simply were not large enough. This is the argument prominent in the quote above. When I hear this, however, I cannot help but to think that we have failed to learn the lesson of the Lucas Critique.

I am fond of using the equation of exchange to communicate points about monetary disequilibrium. The modified equation of exchange that David Beckworth and I often use is:

mBV = PY

where m is the money multiplier, B is the monetary base, V is velocity, and PY is nominal income. This is essentially a reduced form equation that captures the determination of nominal income. Personally, I find this as a useful guide for explaining what happens when there are deviations of desired from actual balances. It is, of course, possible to explain this within other models (both simple and complex), but this seems to be a useful device for organizing one’s thinking on the topic and especially for communicating the concept through blogging.

With that being said, I do not under any circumstances see the equation of exchange as representing a menu of policy options. Why? Because expectations matter.

The (simplified version of the) lesson of the Lucas Critique for econometric policy evaluation is that we cannot simply plug in the size of a policy to some “structural” model of the economy and expect it to tells us the size of the effect of the policy. The reason is because when policy changes, this can effect expectations and therefore the marginal effect of a policy. In other words expectations matter.

One way to think about this is in terms of my original critique of the fiscal stimulus package. In that post I outlined the importance of Ricardian equivalence — the idea that government debt is not net wealth. (While there are many reasons to doubt that Ricardian equivalence holds, it does seem to be a close approximation to reality based upon empirical evidence.) To understand this concept, consider a simple scenario. Suppose that the only way to save is by purchasing government-issued bonds. Now consider the effects of a temporary tax rebate financed through deficit spending. In this scenario, the government issues a bond in the amount of the rebate and promises to pay the buyer back with interest. The government then uses the proceeds of the sale to give a tax rebate. If the individual receiving the tax rebate (correctly) perceives that they will have to pay back the amount of the tax rebate plus interest in the future, they would simply use the proceeds of the tax rebate to purchase the bond. In other words, there is no effect. Government bonds are not net wealth.

The lesson from this example is that expectations matter. The tax rebate does not alter the individual’s tax liability. Thus, the individual uses the rebate to increase saving in order to pay future taxes. Similarly, a permanent increase in government spending increases an individual’s future tax liability thereby producing a similar result. The increase in government spending is thereby offset by a corresponding reduction in consumption. Thus, when one looks at the effects of such a policy in its aftermath, one could either conclude that the policy was ineffectual or that the policy simply wasn’t big enough.

This brings me back to the discussion of monetary policy. The equation of exchange, as articulated above, is an organizing relationship that helps to understand the concept of monetary disequilibrium. However, the same logic applies to the role of expectations for monetary policy. For example, suppose that we observe a sharp reduction in the money multiplier (an increase in the demand for base money) and a corresponding reduction in nominal income. If monetary equilibrium is the policy goal (which I am assuming it is), then monetary policy needs to adjust to promote stability in nominal income by increasing the monetary base. I DO NOT, HOWEVER, pretend to know the magnitude by which the monetary base should increase nor is there any model in existence that can tell us with any degree of accuracy by how much the base should increase. In addition, it is undoubtedly true that the answer is not that which exactly offsets the decline in m that was observed. Why? Because expectations matter.

Just like with the example of fiscal policy, we can draw important lessons for monetary policy. The question is whether monetary base injections are perceived as net wealth. If the Federal Reserve were, for example, to announce that they were going to temporarily increase the monetary base because of the decline in m, this has an impact on the expectations of individuals in the market. If any introduction of new base money is expected to be pulled back out of circulation after a short period of time, money (like bonds in the previous example) will not be seen as net wealth and will simply be held. In the aftermath of such a policy, one could either conclude that the magnitude of open market operations wasn’t large enough or that the policy was ineffectual.

This does not, however, mean that monetary policy is impotent. It means that expectations are important. In fact, monetary policy can be successful if it partners the monetary injection with an explicit account of expectations. If monetary policy was conducted by announcing that the central bank would increase the monetary base until it met its target for a particular variable — say the price level or nominal income — this would help to shape expectations and help policy to be successful as the increase in the monetary base would have distributional effects.

The Federal Reserve’s focus on the size of its asset purchases represents a grave mistake. There is no model that tells us the precise size increase in the central bank balance sheet will get us to a desired level of nominal income. Those who continue to claim that the magnitude of monetary and fiscal policy haven’t been large enough fail to recognize this point. This is the lesson of the Lucas Critique. Expectations matter.

Operation Twist: Doing Nothing While Looking Busy

I once read that Carl Icahn took over a particular company, brought his team in to assess the inner workings of the firm, and found an entire floor of workers who looked busy, but whose purpose in the firm couldn’t be identified. As a result, they fired everyone on the floor. Nothing changed. Now this story could be a complete fabrication, but I don’t care whether its true. I bring it up because Operation Twist 2.0 is the embodiment of that floor of workers. There is an illusion that something is being done, but in reality, things would be no different if the policy didn’t exist.

Bill Woolsey provides conditional support for Operation Twist based on monetary disequilibrium logic. Here is a brief summary of his argument:

In 1956, Leland Yeager explained the “monetary disequilibrium” approach to the liquidity trap. One core principle of his view is that any general glut of goods, in particular, any drop in the flow of money expenditures on output, must be matched by an excess demand for money. People are trying to accumulate and hold more money than exists.

If we think about the possibility of people trying to sell current output and accumulate some other nonreproducible good, like “old masters” or land, and the result is a shortage, then we must ask what the frustrated buyers do. If they purchase some other reproducible good or service, then there is no general glut of output and nominal expenditure on output is maintained. If, on the other hand, they simply hold money, then the result will be a shortage of money and a general glut of goods. Nick Rowe often writes on this issue.

Suppose the good that people want to accumulate are short and safe financial assets. Suppose people are trying to accumulate T-bills. Yeager pointed out that once the interest rate on those bonds become so low that it isn’t worth the bother of buying them rather than just hold money, then the shortage of them is leaking over into a shortage of money. It is very much like the frustrated buyers of “old masters” choosing to hold money rather than buy something else.

These days, the liquidity trap is identified with the zero nominal bound on nominal interest rates. So rather than this shifting of a shortage of bonds to a shortage of money at a very low positive interest rate, the leakage supposedly happens at zero. The way I would describe the problem is that if the market clearing interest rate on these bonds is negative, and greater than the cost of storing currency, then of course, the shortage of these bonds is going to shift over to a shortage of money.


What does that imply regarding “operation twist?” By having the Fed sell off its holdings of short term government bonds, the Fed will relieve that underlying excess demand for those securities and lessen any shift of that excess demand to an excess demand for money. It should help relieve the monetary disequilibrium. Of course, if the Fed reduced the quantity of base money, as would be the usual consequence of an open market sale, then any decrease in money demand would be offset by a decrease in the quantity of money. However, by purchasing long term bonds, the Fed sterilizes the impact of the sale of short term bonds on the quantity of base money.

The other way to look at the issue is that with nominal interest rates on T-bills (nearly) at zero, they are perfect substitutes for money. By selling T-bills and purchasing long term government bonds so that base money does not decrease, the total quantity of money, T-bills held by households and firms and base money, increases. This will tend to relieve the excess demand for money.

While Bill is correct in his discussion of Yeager and monetary disequilibrium, I think that he is wrong in the assessing the efficacy of the program. In theory, Operation Twist could potentially relieve monetary disequilibrium by expanding the supply of short term safe assets. However, since the Federal Reserve is paying interest on reserves, they have effectively placed a ceiling on short term yields.

To understand why this is important, consider the effects of Operation Twist conditional on the assumptions Bill makes: (1) there is an excess demand for safe assets; (2) the excess demand leaks into money demand; (3) the increase in money demand leads to a reduction in spending and therefore nominal income. Now suppose that the Federal Reserve sells $X of T-bills uses the proceeds to buy $X of long term bonds. In doing so, the price of T-bills fall and the yield correspondingly rises. However, this generates an arbitrage opportunity for banks, which will use excess reserves (now paying a lower rate of interest than T-bills) to buy T-bills. They will continue to do this until the price of T-bills is bid up such that the yield on T-bills is equal to the interest rate on reserves. The degree to which the new reserves created by the sale of T-bills are used to purchase T-bills will be determined by the price elasticity of demand.

The transmission of monetary policy works through changes in relative asset prices. The relative price effect generated by this policy is minuscule. One can always argue that the sale of T-bills increase the supply of short-term safe assets by $X, but the only effect is a pure arbitrage opportunity that ultimately changes the distribution of T-bills and reserves, but leaves the total relatively unchanged.

This is not to say that Operation Twist 2.0 can’t or won’t have any effect. However, for it to be successful, it would have to relieve the excess demand for safe assets. The Fed has committed to a specific value of purchases. Is there any reason to believe that the magnitude of purchases announced by the Fed is enough to relieve that excess demand? Who knows? Therein lies the problem.

The biggest problem with current Federal Reserve policy is that it lacks any coherent direction or policy goal. Expectations matter. (Read Woodford, for heaven’s sake! This is supposed to be mainstream monetary theory.) For Fed policy to be successful, they need to outline an explicit goal for policy in the form of a target for nominal income and the price level and commit to using the tools at their disposal to achieve that goal. Random announcements of specific quantities of asset purchases provide no guidance and will not be effective. Temporary monetary injections are not successful for much the same reason that temporary tax cuts are not successful (see Weil, “Is Money Net Wealth?”, 1991). Without a coherent goal or strategy, monetary policy with all its fits and starts will continue to fail.

Quote of the Day

“Some articles point out one “bright spot” in this dismal day—the Fed succeeded in lowering long term yields. They also raised short term yields, making the yield curve flatter. You might want to get out your money textbook to find out what type of monetary policy causes a flatter yield curve.”

Scott Sumner

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.

If the FOMC was on the Titanic…

…they would have suggested re-arranging the deck chairs to prevent the sinking of the ship.

Monetary Policy and Politics

I wrote a piece for NRO that is up this morning describing why potential Republican presidential candidates should push for a monetary policy rule for the Federal Reserve.

For those NRO readers venturing to the blog, I would recommend these posts (in no particular order):

A Juxtaposition

From the WSJ:

“I think he’s been the most inflationary, dangerous, and power-centered chairman of the Fed in the history of the Fed,” Mr. Gingrich, a former House Speaker, said Wednesday.

Now we can debate whether he is the most dangerous or power-centered chairman of the Fed, but let’s consider the first claim regarding inflation.

Inflation, as measured by the GDP deflator since Bernanke was appointed on February 1, 2006:

Inflation, as measured by the GDP deflator during Arthur Burns’ term as Federal Reserve chairman (February 1, 1970 – March 8, 1978):

Note that the highest rate of inflation during Ben Bernanke’s tenure is below the lowest inflation rate observed during the tenure of Arthur Burns.

Has the WSJ Embraced Monetary Equilibrium?

Over the past few years, David Beckworth and I have stressed the importance of the concept of monetary equilibrium. When actual money balances differ from desired money balances, this causes fluctuations in spending and as a result nominal income. This is significant because in the short run, such fluctuations also have real effects. The implication is that increases in the demand for money should be offset with increases in the supply of money from the central bank.

This morning the Wall Street Journal editorial board embraced this concept (for Switzerland):

The Swiss National Bank’s announcement Tuesday that it would buy “unlimited quantities” of euros to keep the franc-euro exchange rate above 1.20 is a dramatic and helpful move amid the continuing euro crisis.

Switzerland is a small economy, but since 2008 its franc has become the shelter currency of choice for skittish investors. With debt crises on both sides of the Atlantic and Japan on its sixth prime minister in five years, Switzerland looks like the last sane man in the room.

But such popularity has driven up the purchasing power of the franc abroad while making Swiss exports more expensive. Exporters in particular have been howling about the franc’s appreciation. The Swiss central bank clearly had these pressures in mind in deciding to impose the exchange-rate ceiling.


But throwing a bone to exporters is not the most important reason for the central bank to intervene. Central banks are the monopoly suppliers of the commodity known as money. When a currency like the Swiss franc appreciates rapidly, the market is sending a signal that not enough francs are being printed to meet demand.

The modern central banker’s weapon of choice for combatting a currency’s rapid rise in value is a “sterilized” intervention—in which a bank sells its currency against another, but then sells bonds or other instruments so the amount of money in circulation doesn’t change. This may have a psychological effect on speculators but does nothing to change the supply-demand imbalance.

The Swiss National Bank, by contrast, seems to be buying euros with francs without offsetting the purchases elsewhere. In other words, it seems prepared at last to meet the increased demand with additional supply. This need not be inflationary for Switzerland. Should demand for francs recede in the future, the central bank can easily mop up the additional money it’s creating now by selling the foreign-exchange it’s currently buying to keep the franc steady.

I have previously written about these concepts here and here. It is nice to see the WSJ editorial board coming around.