# Monthly Archives: January 2012

## Here We Go Again: How Much is Too Much?

This comment is going to leave me subject to a lot of criticism because it (a) defies conventional wisdom, and (b) currently evokes strong feelings in a specific direction. Nonetheless, I am going to proceed anyway. Tyler Cowen writes:

I see two big and very real problems: slow income growth for many income classes and a problem with excessively high returns to finance at the very top.

This isn’t really about Tyler, but rather about the fact that he is among a group of individuals who are so self-assured about this point. Once more I would like to ask, “what are the optimal returns to finance?” The conventional wisdom is that the financial crisis proved that we had invested too heavily in finance, those who worked in finance were overpaid, etc. But how do we know how much is too much? The conventional wisdom seems to suggest that we can define “too much” in the same terms as pornography — we know it when we see it. But this is ludicrous. Even if one is willing to concede that it is somehow obvious that the returns to finance were excessive, it is still necessary to understand at what point these returns exceed optimality. Unfortunately, those who are most self-assured that the returns to finance were too large have offered no criteria for such an assessment. The financial crisis in and of itself is purportedly evidence.

A serious analysis would begin by understanding what is actually being done in finance. A popular view that I hear in the punditry is that we invested too much in finance and not enough into actually making things — whatever that means. As I have talked about before, financial intermediaries do create things. They transform illiquid assets into liquid liabilities. To the extent to which these liabilities are information-insensitive (Gary Gorton’s term), these liabilities can be considered “safe.” Ricardo Caballero has made the case that the world has a shortage of safe assets. If Caballero is correct, then the world of finance could play a significant role it mitigating that shortage and potentially create large welfare gains.

If one wants to talk about the optimal returns to finance, it is first necessary to understand the size and the scope of welfare gains created by financial innovation. Doing so requires an understanding of the purpose and the role of financial intermediaries and an explicit framework for determining optimality. Once that is done perhaps Tyler and the others will be proven correct that we need a smaller financial sector. Perhaps not. Until then, however, let’s have a moratorium on declaring something to be “too much” without having an explicit objective measure as to what is optimal.

## Politics

Everything that is wrong with politics can be found here.

## TED Talk: Art Rolnick

Art Rolnick on early childhood education.

## Bullard’s “Death of a Theory”

St. Louis Fed President James Bullard has released a paper entitled, “Death of a Theory”. Overall, I think that the paper is a useful overview of the issues surrounding the use of monetary and fiscal policy in the context of the New Keynesian model and in recent experience.

The basic argument made by Bullard is as follows:

1. The conventional wisdom prior to the crisis was the fiscal policy was largely ineffective as a stabilization tool and therefore stabilization should be left to monetary policy.

2. The New Keynesian model suggests that monetary policy is ineffective at the zero lower bound.

3. The effectiveness of fiscal policy is dependent on the role of monetary policy. Given the ineffectiveness of monetary policy at the zero lower bound, there is a potential role for fiscal stabilization policy.

4. There are three problems with this viewpoint:

i.) The political process in the United States is ill-equipped to make timely and effective decisions on fiscal policy.

ii.) Monetary policy over the last few years has shown that monetary policy is not ineffective at the zero lower bound.

iii.) “The actual fiscal stabilization policy experiment did not involve funding increased government spending with lump-sum taxes, as contemplated in the theory, but instead involved heavy borrowing on international markets. In models, the borrowing would be interpreted as promised future distortionary taxes, but it is exactly the shifting of distortionary taxes into the future beyond the period of the binding zero lower bound and financial market turbulence that can undo most or all of the benefits that might otherwise come from the fiscal stabilization program.”

Some useful quotes can be found after the jump.

## Varieties of Phillips Curves

As one might have guessed from my previous post, I am skeptical of the use of the Phillips curve for generating predictions. One reason that I am skeptical is because I’m not entirely sure about the direction of causality between output and inflation. (The original Phillips curve was concerned with the relationship between unemployment and wage inflation. The present discussion of Phillips curves follows the contemporary literature in referencing the relationship between output and inflation.) Once again, the source of disagreement can be found in the differences between the New Keynesian and Monetarist literature.

The New Keynesian Phillips Curve

As discussed previously the New Keynesian Phillips curve is derived based on the assumption that prices are sticky. Specifically, one of two assumptions is made. First, it is assumed that only a subset of firms are capable of adjusting their prices in any given period (literally, assuming the can opener). The second alternative assumption is that it is costly to adjust prices. Based on these types of assumptions, the NK Phillips curve is given by:

$\pi_t = \beta E_t \pi_{t + 1} + by_t$

where $\pi$ is the rate of inflation, $\beta$ is the discount factor, $E$ is the expectations operator, $y$ is the output gap, and $b$ is a parameter.

The NK Phillips curve essentially implies that inflation is determined by “excess capacity.” When output is below potential, this exerts negative influence on the inflation rate. (This is why you often even commentators on financial news networks say that they don’t anticipate inflation given the excess capacity in the economy.) However, when output is above potential there is upward pressure on inflation. Regardless, the causation in the NK Phillips curve runs from output to inflation.

The Monetarist Phillips Curve

Long before A.W. Phillips plotted his curve, Irving Fisher had discovered the statistical relationship between employment and inflation (International Labour Review, 1926). Fisher identified the statistical relationship and made the following claim regarding causation:

“But as the economic analysis already cited certainly indicates a causal relationship between inflation and employment or deflation and unemployment, it seems reasonable to conclude that what the charts show is largely, if not mostly, a genuine and straightforward causal relationship; that the ups and downs of employment are the effects, in large measure, of the rises and falls of prices, due in turn to the inflation and deflation of money and credit.”

In other words, Fisher saw the direction of causation as going in the opposite direction as New Keynesians; inflation was causing fluctuations in employment.

This Fisherian view of the Phillips curve was embraced by Milton Friedman and fellow Old Monetarists under the accelerationist hypothesis. In Friedman’s 1967 address to the American Economic Association, he details a relationship between the unemployment and inflation with causation running from the latter to the former. Friedman hypothesized that the only way that a central bank would be able to achieve an unemployment target below the “natural rate of unemployment” was through accelerated increases in the rate of inflation. Again, this is in contrast to the NK Phillips curve.

New Monetarists have much the same view as Old Monetarists, however, the conclusions depend on the level of information and monetary policy. For example, suppose that there are two type of individuals, buyers and sellers. Assume that money growth is stochastic. For simplicity assume that money growth is either “high” or “low”. There are two periods of analysis. Increases in the money supply take place in the second period. Now suppose that buyers know in the first period if money growth will be high or low. Sellers do not have this knowledge. In addition, define the value of money as:

$\phi_t = {{\phi_{t - 1}}\over{\mu_t}}$

where $\mu$ is the rate of money growth and $\phi_t$ is the value of money. It follows that when money growth is high the value of money is lower than when money growth is low. Thus, since buyers know about the state of money growth prior to the sellers, they will seek to spend more of their money balances when money growth is high than when it is low. Put differently, increases in money growth causes higher rates of inflation and a higher level of production. This is the basic Fisherian view of the Phillips curve.

The central bank could remove the uncertainty surrounding money growth by simply announcing and committing to a money growth target. However, since buyers no longer have the informational advantage, the positive correlation between inflation and output disappears. In fact, the higher rate of money growth implies that the cost associated with holding money rises thereby causing buyers to economize on money balances and reducing consumption. (This is the insight of the Friedman rule and the discussion of the optimal quantity of money.) Thus, when money growth is known with certainty, there is a negative relationship between inflation and output.

So Why Do We Care?

The reason that we care about the varieties of Phillips curves is because they provide vastly different implications. The New Keynesian Phillips curve implies that inflation is, in part, caused by the relationship between output and potential. So long as output is below potential, this exerts negative pressure on inflation.

The Monetarist view is in direct contrast to NK Phillips curve. Rather than output exerting a causal influence on inflation, the causation is reversed. However, even this conclusion has been shown in recent years to be dependent upon the structure of information available to different economic agents about monetary policy. If all agents are perfectly informed as to policy, the relationship between inflation and output is negative.

These views provide non-trivial differences in prescriptions for policy.

## Conflicting Views of Inflation

What causes inflation?

One might think that this issue is fairly resolved in modern macroeconomics, but it is not. There are largely two competing visions of inflation circulating, the New Keynesian view and the Monetarist (Old and New) view.

The New Keynesian View

The basic New Keynesian model can be represented by the following three equations:

$y_t = E_t y_{t+1} - a(R_t - E_t \pi_{t+1}) + e^{IS}_t$

$\pi_t = \beta E_t \pi_{t+1} + by_t + e^{PC}_t$

$R_t = R + \phi_{\pi} \pi_t + \phi_y y_t + e^{R}_t$

where y is the output gap, R is the nominal interest rate, $\pi$ is the inflation rate, E is the mathematical expectations operator, $e^{IS}$, $e^{PC}$, and $e^{R}$ are stochastic shocks with mean zero and finite variance, and a, b, $\phi_{\pi}$, $\phi_y$ are parameters. The first equation is the dynamic IS equation, the second is the New Keynesian Phillips curve, and the final equation is the Taylor Rule that governs monetary policy.

Within the New Keynesian framework, the central bank is an inflation fighter. What I mean by this is that the central bank adjusts the short term nominal interest rate, R, in response to realized inflation. The higher the value of $\phi_{\pi}$, the greater the responsiveness of the central bank. Inflation, within this framework, is pinned down by the Taylor principle ($\phi_{\pi} > 1$). To illustrate this suppose that there is some cost-push shock in the economy ($e^{PI}_t$ is positive). The cost-push shock causes an increase in realized inflation. However, if the central bank adheres to the Taylor principle, the central bank will raise the short term interest rate by more than the increase in inflation. With sticky prices, this leads to an increase in the real rate of interest and therefore a reduction in “aggregate demand” and thereby the output gap. The reduction in the output gap reduces inflation (see the New Keynesian Phillips curve).

So what determines inflation in the New Keynesian model? In short, inflation is determined by the central bank target of inflation. Deviations from this target are caused by shocks to supply ($e^{PC}$) and demand ($e^{IS}$). The demand shock is (given the derivation of the model) a household preference shock (e.g. households wake up one morning and decide that they prefer current to future consumption). The supply shock is a shock to marginal costs, which causes firms to increase their prices. So long as the central bank adheres to the Taylor principle, the inflation rate can be uniquely determined.

A separate, but related question is what causes inflation in the New Keynesian model? Conceivably, it is the shocks to supply and demand. The central bank doesn’t create inflation, it prevents it through the Taylor principle.

The Monetarist View

The New Keynesian View is in stark contrast to the Monetarist View. In the Monetarist View, the central bank is not an inflation fighter, but rather an inflation creator. To understand why, let’s consider this from a New Monetarist perspective.

The New Monetarist framework is interested in examining money, monetary arrangements, intermediation, monetary policy, etc. from a perspective in which (*gasp*) money is actually important. You will note that in the New Keynesian framework above, money was never mentioned. This is because money is inconsequential for analysis within the NK model. The main reason why money is unimportant in NK models, however, is by assumption. Money, if it is introduced, is done through reduced form methods like putting money in the utility function or requiring that individuals must buy goods with money. These reduced form approaches, however, fail to capture the characteristics of money that make it important and therefore it is not surprising that they fail to identify that money isn’t important.

New Monetarist economics, in contrast, concerns itself with environments in which money is essential. It is therefore not surprising that one gets substantially different results. In NM models, the goods price of money is an endogenous determined. Put differently, the value of money is determined within the model rather assumed. If the goods price of money is zero, this means that money has no value and therefore a monetary equilibrium doesn’t exist (money is not simply assumed to be unimportant).

In equilibrium the goods price of money is determined as follows:

$\phi_t = {{z(q_t)}\over{M}}$

where $\phi_t$ is the goods price of money, $z(q)$ is the quantity of real money balances demanded given the quantity of consumption $q$, and $M$ is the aggregate supply of money. If we think of the goods price of money as the inverse of the price level, this implies that the price level is determined by the following equilibrium condition:

$P_t = {{M}\over{z(q_t)}}$

In other words, the price level is pinned down by the ratio of the money supply and money demand. It is deviations between the money supply and money demand that cause fluctuations in the price level. It follows that the central bank in this type of framework is an inflation creator. Money growth causes inflation.

So why does this distinction matter?

It matters because it is an often overlooked aspect of inflation targeting. When forecasts are being conducted on inflation, care needs to be taken as to how inflation should be forecast. The NK approach would have inflation forecasts based on the NK Phillips curve. The NM approach would have inflation forecasts based on money growth.

Unfortunately, simply taking these models to the data doesn’t resolve this issue. For example, NK advocates would argue that money growth doesn’t do a good job predicting inflation and therefore the NK approach is better. However, the empirical evidence upon which these claims are made rely on simple sum measures of the money supply, which are severely flawed (more on this later). In addition, from the NM side, one could easily point to the failure of the NK Phillips curve in fitting the data. While New Keynesians like to point out that the fit improves by incorporating lagged terms of inflation, it also undercuts the notion of microfounded macroeconomic models and suggests a circularity between fitted the data to the model and the model to the data.

In short, the differences between the New Keynesian view on inflation and Monetarist view on inflation are stark. In the NK view, the central bank acts as an inflation fighter using the nominal interest rate to mitigate and control inflationary pressures. In the NM view, the central bank is an inflation creator. The price level is determined by the relationship between the money supply and money demand. This distinction is not minor.

(Note: The inflation fighter vs. inflation creator terminology comes from the work of Robert Hetzel.)