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.