Some Thoughts on Liquidity

The quantity theory relates not so much to money as to the whole array of financial assets exogenously supplied by the government. If the government debt is doubled in the absence of a government-determined monetary base the price level doubles just as well as in the case of a doubling of the monetary base in the absence of government debt. — Jurg Niehans, 1982

Seemingly lost in the discussion of monetary policies various QEs is a meaningful resolution of our understanding of the monetary transmission mechanism.  Sure, New Keynesians argue that forward guidance about the time path of the short term nominal interest rate is the mechanism, Bernanke argues that long term interest rates are the mechanism, and skeptics of the effectiveness of QE argue that it is the interest rate on excess reserves that is the mechanism.  I actually think that these are not the correct way to think about monetary policy.  For example, there are an infinite number of paths for the money supply consistent with a zero lower bound on interest rates.  Even in the New Keynesian model, which purportedly recuses money from monetary policy, the rate of inflation is pinned down by the rate of money growth (see Ed Nelson’s paper on this).  It follows that it is the path of the money supply that is more important to the central bank’s intermediate- and long-term goals.  In addition, it must be the case that the time path of the interest rate outlined by the central bank is consistent with expectations about the future time path of interest rates.  The mechanism advocated by Bernanke is also flawed because the empirical evidence suggests that long term interest rates just don’t matter all that much for investment.

The fact that I see the monetary transmission mechanism differently is because you could consider me an Old Monetarist dressed in New Monetarist clothes with Market Monetarist policy leanings (see why labels are hard in macro).  Given my Old Monetarist sympathies it shouldn’t be surprising that I think the aforementioned mechanisms are not very important.  Old Monetarists long favored quantity targets rather than price targets (i.e. the money supply rather than the interest rate).  I remain convinced that the quantity of money is a much better indicators of the stance of monetary policy.  The reason is not based on conjecture, but actual empirical work that I have done.  For example, in my forthcoming paper in Macroeconomic Dynamics, I show that many of the supposed problems with using money as an indicator of the stance of monetary policy are the result of researchers using simple sum aggregates.  I show that if one uses the Divisia monetary aggregates, monetary variables turn out to be a good indicator of policy.  In addition, changes in real money balances are a good predictor of the output gap (interestingly enough, when you use real balances as an indicator variable, the real interest rate — the favored mechanism of New Keynesians — is statistically insignificant).

Where my New Monetarist sympathies arise is from the explicit nature in which New Monetarism discusses and analyzes the role of money, collateral, bonds, and other assets.  This literature asks important macroeconomic questions using rich microfoundations (as an aside, many of the critics of the microfoundations of modern macro are either not reading the correct literature or aren’t reading the literature at all).  Why do people hold money?  Why do people hold money when other assets that are useful in transactions have a higher yield?  Using frameworks that explicitly provide answers to these questions, New Monetarists then ask bigger questions. What is the cost associated with inflation? What is the optimal monetary policy? How do open market operations work?  The importance of the strong microfoundations is that one is able to answer these latter questions by being explicit about the microeconomic assumptions.  Thus, it is possible to make predictions about policy with an explicit understanding of the underlying mechanisms.

An additional insight of the New Monetarist literature is that the way in which we define “money” has changed substantially over time.  A number of assets such as bonds, mortgage-backed securities, and agency securities are effectively money because of the shadow banking system and the corresponding prevalence of repurchase agreements.  As a result, if one cares about quantitative targets, then one must expand the definition of money.  David Beckworth and I have been working on this issue in various projects.  In our paper on transaction assets shortages, we suggest that the definition of transaction assets needs to be expanded to include Treasuries and privately produced assets that serve as collateral in repurchase agreements.  In addition, we show that the haircuts of private assets significantly reduced the supply of transaction assets and that this decline in transaction assets explains a significant portion of the decline in both nominal and real GDP observed over the most recent recession.

The reason that I bring this up is because this framework allows us not only to suggest a mechanism through which transaction assets shortages emerge and to examine the role of these shortages in the context of the most recent recession, but also because the theoretical framework can provide some insight into how monetary policy works.  So briefly I’d like to explain how monetary policy would work in our model and then discuss how my view of this mechanism is beginning to evolve and what the implications are for policy.

A standard New Monetarist model employs the monetary search framework of Lagos and Wright (2005).  In this framework, economic agents interact in two different markets — a decentralized market and a centralized market.  The terms of trade negotiated in the decentralized market can illustrate the effect of monetary policy on the price level. (I am going to focus my analysis on nominal variables for the time being.  If you want to imagine these policy changes having real effects, just imagine that there is market segmentation between the decentralized market and centralized market such that there are real balance effects from changes in policy.)  In particular the equilibrium condition can be written quite generally as:

P = (M+B)/z(q)

where P is the price level, M is the money supply, B is the supply of bonds, and z is money demand as a function of consumption q.  I am abstracting from the existence of private assets, but the implications are similar to those of bonds.  There are a couple of important things to note here.  First, it is the interaction of the supply and demand for money that determines the price level.  Second, it is the total supply of transaction assets that determines the price level.  This is true regardless of how money is defined.  Third, note that as this equation is presented it is only the total supply of transaction assets that determine the price level and not the composition of those assets.  In other words, as presented above, an exchange of money for bonds does not change the price level.  Open market operations are irrelevant.  However, this point deserves further comment.  While I am not going to derive the conditions in a blog post, the equilibrium terms of trade in the decentralized market will only include the total stock of bonds in the event that all bonds are held for transaction purposes.  In other words, if someone is holding bonds, they are only doing so to finance a transaction.  In this case, money and bonds are perfect substitutes for liquidity.  This implication, however, implies that bonds cannot yield interest.  If bonds yield interest and are just as liquid as money, why would anyone hold money? New Monetarists have a variety of reasons why this might not be the case.  For example, it is possible that bonds are imperfectly recognizable (i.e. they could be counterfeit at a low cost). Alternatively, there might simply be legal restrictions that prevent bonds from being used in particular transactions or since bonds are book-entry items, they might not as easily circulate.  And there are many other explanations as well.  Any of these reasons will suffice for our purposes, so let’s assume that that is a fixed fraction v of bonds that can be used in transactions.  The equilibrium condition from the terms of trade can now be re-written:

P = (M + vB)/z(q)

It now remains true that the total stock of transaction assets (holding money demand constant) determines the price level.  It is now also true that open market operations are effective in influencing the price level.  To summarize, in order for money to circulate alongside interest-bearing government debt (or any other asset for that matter) that can be used in transactions, it must be the case that money yields more liquidity services than bonds.  The difference in the liquidity of the two assets, however, make them imperfect substitutes and imply that open market operations are effective.  It is similarly important to note that nothing has been said about the role of the interest rate.  Money and bonds are not necessarily perfect substitutes even when the nominal interest on bonds is close to zero. Thus, open market operations can be effective for the central bank even if the short term interest rate is arbitrarily close to zero.  In addition, this doesn’t require any assumption about expectations.

The ability of the central bank to hit its nominal target is an important point, but it is also important to examine the implications of alternative nominal targets.  Old Monetarists wanted to target the money supply.  While I’m not opposed to the central bank using money as an intermediate target, I think that there are much better policy targets.  Most central banks target the inflation rate.  Recently, some have advocated targeting the price level and, of course, advocacy for nominal income targeting has similarly been growing.  As I indicated above, my policy leanings are more in line with the Market Monetarist approach, which is to target nominal GDP (preferable the level rather than the growth rate).  The reason that I advocate nominal income targeting, however, differs from some of the traditional arguments.

We live in a world of imperfect information and imperfect markets. As a result, some people face borrowing constraints.  Often these borrowing constraints mean that individuals have to have collateral.  In addition, lending is often constrained by expected income over the course of the loan.  The fact that we have imperfect information, imperfect markets, and subjective preferences means that these debt contracts are often in nominal terms and that the relevant measure of income used in screening for loans is nominal income.  A monetary policy that targets nominal income can potentially play an important role in two ways.  First, a significant decline in nominal income can be potentially harmful in the aggregate.  While there are often claims that households have “too much debt” a collapse in nominal income can actually cause a significant increase and defaults and household deleveraging that reduces output in the short run.  Second, because banks have a dual role in intermediation and money creation, default and deleveraging can reduce the stock of transaction assets.  This is especially problematic in the event of a financial crisis in which the demand for such assets is rising.  Targeting nominal income would therefore potentially prevent widespread default and develeraging (holding other factors constant) as well as allow for the corresponding stability in the stock of privately-produced transaction assets.

Postscript:  Overall, this represents my view on money and monetary policy.  However, recently I have begun to think about the role and the effectiveness of monetary policy more deeply, particularly with regards to the recent recession.  In the example given above, it is assumed that the people using money and bonds for transactions are the same people.  In reality, this isn’t strictly the case.  Bonds are predominantly used in transactions by banks and other firms whereas money is used to some extent by firms, but its use is more prevalent among households.  David Beckworth and I have shown in some of our work together that significant recessions associated with declines in nominal income can be largely explained through monetary factors.  However, in our most recent work, it seems that this particular recession is unique.  Previous monetary explanations can largely be thought of as currency shortages in which households seek to turn deposits into currency and banks seek to build reserves.  The most recent recession seems to be better characterized as a collateral shortage, in particular with respect to privately produced assets.  If that is the case, this calls into question the use of traditional open market operations.  While I don’t doubt the usefulness of these traditional measures, the effects of such operations might be reduced in the present environment since OMOs effectively remove collateral from the system.  It would seem to me that the policy implications are potentially different.  Regardless, I think this is an important point and one worth thinking about.

QE3 and the Optimality of Nominal GDP Targeting

The Fed’s announcement last week that they intend to conduct open-ended open market purchases has been seen as a victory for advocates of nominal GDP level targeting, especially market monetarists. Scott Sumner has received praise from a number of publications for leading the charge (see here and here). Scott has long advocated nominal GDP level targeting and was criticizing tight monetary policy from the beginning of the recession. The shift toward open-ended open market purchases is therefore certainly a change in the direction of policy and one that is much more in line with a level target. Nonetheless, I don’t think that this is as much of a victory for level targeters as is being claimed. Thus, I would like to take this post to describe my differing view and also the recent discussion of optimal monetary policy.

The intuition of a level target runs as follows. The purpose of the level target is to anchor long run expectations. Thus, suppose that the central bank announces that their objective is to target 5% trend growth in nominal GDP consistent with the trend from essentially 1983 – 2008. This policy announcement suggests that the central bank would like to create nominal GDP growth in the short term that is higher than 5% (since we have been below that trend since 2008), but once nominal GDP returns to trend, growth will return to 5%. So long as the central bank has a good degree of credibility in committing to these actions, this should help to anchor expectations.

Thus, if nominal GDP is significantly below the long run trend, the policy suggested by this intuition is for the central bank to announce its intention to conduct open market purchases sufficient to achieve its target. In other words, the central bank announces a plan to conduct open-ended open market purchases (i.e. whatever it takes to hit its target).

The recent Fed statement represents a stark change from previous policies specifically as it pertains to its efforts at quantitative easing. Specifically, rather than announcing particular dollar values of assets that they intends to purchase, the Fed has changed their statement to reflect their desire to “increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month.” That’s clearly open-ended. However, advocates of a nominal GDP level target and similar objectives should NOT see this a clear victory.

As the description of the intuition behind level targeting makes clear, the use of open-ended open market purchases should be coupled with an explicit objective for policy. There is no such objective in the Fed’s statement. The duration of policy is not defined in terms of objectives, but rather time:

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low level ofs for the federal funds rate are likely to be warranted at least through mid-2015.

The federal funds rate is not the objective of monetary policy, it is the intermediate target. In addition, and perhaps more importantly, we need the Fed to define what they mean by “after the economic recovery strengthens.”

The closest the FOMC statement comes to an objective is the following statement:

The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases. [Emphasis added.]

This is hardly an explicit objective for policy. In addition, not only does the statement leave out an explicit objective, its one mention of a criteria for adjusting policy is a reference to the labor market. Does the Fed now believe that they can target employment? So some less skeptical of the Fed, this question might seem facetious. However, the Fed explicitly put in the statement that they will judge policy in accordance with fluctuations in the labor market. What is an acceptable amount of unemployment to the Fed? To what extent do they think that they can reduce unemployment?

Note here the important difference between the nominal GDP targeting example given above and the actual policy that is being implemented. The adoption of a nominal GDP level target would lead to higher nominal GDP growth in the short run which, given non-neutralities, would lead to a corresponding short run increase in real GDP thereby reducing unemployment. Thus, the objective of the policy would be to increase nominal GDP growth. The result of the policy (assuming that it is successful) would be to reduce unemployment. The actual policy of the Fed, however, seems to be to use unemployment as their objective. This is not the same thing.

This brings me to my final point. Throughout the discussion above, I was comparing the difference between actual Fed policy and a hypothetical nominal GDP target. This latter type of policy has become substantially more popular in the public conversation thanks to Scott Sumner. Its popularity in the economic literature has been somewhat lagging, but once had the support of Ben McCallum, Greg Mankiw, and others. More recently, Michael Woodford quasi-embraced nominal GDP targeting in his recent talk in Jackson Hole. However, Woodford also stated that he doesn’t see nominal GDP targeting as optimal policy. Rather, flexible inflation targeting in which the central bank targets inflation, but gives some weight to the output gap is optimal within the New Keynesian framework.

On this last point, Woodford is clearly correct — he wrote the book on optimal monetary policy in New Keynesian models, literally. Nominal GDP targeting can be consistent with optimal monetary policy in these models, but it depends on the particular characteristics of the model and the value of the parameters. Nonetheless, it is in the New Keynesian framework that nominal GDP targeting should find much of its support. Optimal monetary policy within these frameworks is defined as the policy that minimizes fluctuations in utility around the steady state. By performing a second-order Taylor series expansion of the utility function around the steady state and some mathematical manipulation, it can be shown that the optimal monetary policy is one that minimizes the weighted average of deviations of inflation from its target and output from its “natural” level. (This, by the way, is contrary to the assertions by Scott Sumner and George Selgin that the welfare criteria in these models is ad hoc.) Woodford is obviously correct that in this context that flexible inflation targeting is the optimal monetary policy. However, how should one use this criteria to practically guide monetary policy? I would argue that New Keynesians should advocate nominal GDP targeting because flexible inflation targeting places a large knowledge burden on central bankers as it requires that they know what natural (or potential) output is an any given point in time. In fact, we have very poor estimates of the output gap in real time — a point highlighted in work by Athanasios Orphanides.

Regardless of what policy is optimal, however, recent Fed policy is only a minor step in the direction of the desired policy of advocates of more expansionary monetary policy.

Nominal Income and the Great Moderation

The period from 1984 through 2007 was one that exhibited a marked decline in macroeconomic volatility. As such, it is commonly referred to as the Great Moderation. This period has potentially important implications for policy. If, for example, the reduction in volatility was the result of smaller “exogenous shocks” to the economy, then we can largely view the period as one of good luck. However, if the reduction in volatility can be linked to a change in policy, then this period can potentially provide guidance as to how policy should be conducted in the future.

A subset of the literature on the Great Moderation suggests that the reduction in volatility can be explained by a change in monetary policy. In particular, this research largely suggests that the change in monetary policy during the Great Moderation was the Federal Reserve’s commitment to the Taylor principle. Put succinctly, the Taylor principle refers to the idea in which the central bank raises the nominal interest rate more than one-for-one with realized inflation. In other words, the central bank increases the real interest in response to higher realized inflation.

In a new paper, which is forthcoming in the Journal of Macroeconomics, I argue that monetary policy was in fact an important factor in reducing macroeconomic volatility. However, I present an alternative view of the behavior or monetary policy and explicitly reject what I call the “Taylor view.” Specifically, in the paper I make the following argument:

An alternative view of the change in monetary policy from the Great Inflation to the Great Moderation is that there was an overhaul of Federal Reserve doctrine. The radical change in monetary policy was that the Federal Reserve placed emphasis on the role of inflation expectations, knowing that if inflation expectations were stabilized, the price system would restore full employment. The mechanism through which the Federal Reserve sought to achieve this goal was in maintaining low, stable rates of nominal income growth. The commitment to a low, stable rate of nominal income growth regardless of fluctuations in output and employment would give the central bank credibility and therefore stabilize inflation expectations. Full employment was left to the price system.

This understanding of the change in policy is in sharp contrast to the Taylor view. As I argue in the paper, during the Great Inflation period of the 1970s, members of the FOMC regularly asserted that the process of inflation determination had changed. Relying on public statements and personal diary entries from Arthur Burns, I demonstrate that there is little evidence that the Federal Reserve was less concerned with inflation during the 1970s. Rather, the view of Burns and others was that inflation was largely a cost-push phenomenon. Burns thought that incomes policies were necessary to restore price stability and stated that “monetary and fiscal tools are inadequate for dealing with sources of price inflation that are plaguing us now.”

The shift in policy, beginning with Paul Volcker, was an explicit attempt to stabilize inflation expectations and this was done deliberately at first through monetary targeting and ultimately through the stabilization of nominal income growth. Gone were notions of cost-push versus demand-pull inflation. The Fed simply assumed accountability as the creator of inflation.

In addition to examining public statements, I empirically test the hypothesis that the Federal Reserve became more responsive to their forecasts of nominal GDP growth beginning with Paul Volcker. In addition, using simulations (based on simple, conventional sticky-price models), I demonstrate that a monetary policy rule based on the estimated response to these forecasts can potentially explain the reduction in macroeconomic volatility observed during the Great Moderation.

For those interested, a link to the working paper version of the paper can be found here. (The link is a viewable link. To download the paper, go here.)

Money, the Money Multiplier, and Monetary Theory

John Williams recently gave a speech on teaching about monetary theory and policy after the financial crisis. Here is the basic thesis:

When I was an undergraduate at Berkeley in the early 1980s, much of the monetary economics that I learned was based on theories from the 1950s or even earlier. These included the quantity theory of money, Keynes’s LM curve, Milton Friedman’s monetarism, and the Baumol-Tobin theory of money demand, to name a few examples. Now, there’s no question that Keynes, Friedman, and Tobin were among the greatest monetary theorists of all time. Their theories are elegant statements of fundamental economic principles. As such, they deserve to be taught for a long time to come. But viewing them as definitive in today’s world is like thinking that rock and roll stopped with Elvis Presley. The evolution of money and banking since the 1950s is at least as dramatic as what’s happened with popular music—not that I want to compare the Fed with Lady Gaga. The theories of that era need to be adapted to the brave new world in which we now live.

I am not sure what this means, however, given the remainder of the speech. Despite the fact that Williams claims that the work of Friedman, Tobin, and Keynes represent “elegant statements of fundamental economic principles”, he subsequently goes on in the speech to largely disparage this work; in particular, the quantity theory of money and the Baumol-Tobin inventory-theoretic model of money demand. While I share Williams view that we need to understand modern innovations in economic thinking, I also think that it is important to understand and appreciate contributions of the likes of Friedman, Tobin, Keynes, and others. There is much that we can learn from the history of economic thought and, in this respect, it is important to read primary sources of the literature and not second-hand accounts (note: this is a general statement, not a knock against Williams). Thus, while I share Williams’ view that we need to appreciate recent contributions, I think that it is important to give fair treatment to earlier important contributions as well. I will elucidate this point below.

Williams seems to disparage the quantity theory of money by pointing to a fairly standard objection:

There have been a number of attempts to find a broader measure of “money” that has a stable relationship with nominal spending — that is, a constant velocity.

He then proceeds to detail differences in different monetary aggregates and their growth rates during the crisis. Differing growth rates and changes in velocity over the past few decades are then cited as evidence that using using the money supply to forecast nominal spending or inflation is a fool’s errand. This reasoning is flawed for two reasons. First, constant velocity is a straw man as Thomas Sowell details in On Classical Economics:

The idea that the price level is rigidly linked to the quantity of money by a velocity of circulation which remains constant through all transitional adjustment processes cannot be found in any classical, neoclassical, or modern proponent of the quantity theory of money. Changes in the velocity of circulation — short run and/or long run — were analyzed by David Hume, Adam Smith, Henry Thornton, T.R. Malthus, David Ricardo, Nassau Senior, John Stuart Mill, Alfred Marshall, Knut Wicksell, Irving Fisher, and Milton Friedman.

As I have illustrated before, velocity is not constant, but appears to be a stable function of the interest rate. (See Allan Meltzer’s graph.)

The second flaw in the analysis is that Williams is relying on simple sum aggregates, which are theoretically flawed and often produce puzzling empirical results. The question surrounding the quantity theory of money is essentially whether or not money can forecast inflation and nominal income growth and the answer is yes especially using longer time horizons and low frequency data.

Williams similarly caricatures analysis of the money multiplier:

The breakdown of the standard money multiplier has been especially pronounced during the crisis and recession. Banks typically have a very large incentive to put excess reserves to work by lending them out.

I assume that what Williams means by “the standard money multiplier” is the framework put forward in Phillips’ (1920) Bank Credit in which the money multiplier is a parameter. This view of the multiplier might be taught in principles, but I don’t think that it is used beyond that point. Even in Mishkin’s Money and Banking text, which does include analysis of the multiplier, there are explicit references to changes in the underlying factors that determine such a multiplier. Indeed, the literature on monetary theory has long recognized that the money multiplier could not be viewed as fixed coefficient. In the post-war era, this view was recognized by Gurley and Shaw (1960) and Tobin (1963). In addition, Brunner and Meltzer (e.g. JPE, 1968; JPE, 1972) explicitly modeled the money multiplier as a function of interest rates.

Jurg Niehans (1978: 274) elaborates on the points above:

While this fixed-coefficient approach, though perhaps pedestrian, is often useful and , for certain purposed, illuminating, it is also subject to serious limitations. Taken at face value it seems to say that money is very different from other things, inasmuch as demand has no influence on the quantity available; the quantity seems to be purely supply-determined. However, this is a superficial impression. It is well recognized that the coefficients appearing in the multiplier are not, in fact, technological constants, but depend, in turn, on interest rates (Brunner and Meltzer, 1968).

In addition, as Niehans (1978: 274) details, the general equilibrium approach in which interest rates are jointly determined with the money supply was developed by Tobin (1963), but actually has “its long ancestry in the pre-Phillips tradition of money supply theory.” Those who have used the money multiplier in discussions of the crisis have, by and large, recognized these points as well.

Like Williams, I agree that the financial crisis and the broader recession pose important questions for monetary theorists and teachers. However, I believe that there is much to be learned in both the present literature and the past literature on issues of monetary analysis and central banking (see Perry Mehrling’s The New Lombard Street, for example). And I wish that Tobin and Friedman would have received fairer treatment from Williams.

Thinking About Monetary Policy

Nick Rowe and Bill Woolsey bring up some interesting points in their recent posts. These points are often neglected, but are of the utmost importance for monetary policy. Below, I will explore what is meant by a monetary policy tool, target, and goal and why it is important to understand the distinct characteristics of each.

Often times, we are told that monetary policy is tight (or loose) by observing the interest rate. In a recent post, I made the case that the real interest rate isn’t a good predictor of the output gap. In a standard New Keynesian framework, if the real rate doesn’t predict the output gap, it will not help to predict inflation either. Thus, the real interest rate does not appear to be a good indicator of policy. In that same post I argued that the growth of the Divisia monetary aggregates do help to predict the output gap. So does this mean that these aggregates are a good indicator of the stance of policy? Potentially, but not necessarily.

To motivate the discussion, consider a simple monetary equilibrium framework captured by the equation of exchange:

mBV = Py

where m is the money multiplier, B is the monetary base, V is the velocity of the monetary aggregate, P is the price level and y is real output. The monetary base, B, is the tool of monetary policy because it is under more or less direct control by the Federal Reserve. The Fed’s job is to adjust to base in order to achieve a particular policy goal.

Other important factors in the equation of exchange are the money multiplier, m, and the velocity of circulation, V. These are important because V will reflect changes in the demand for the monetary aggregate whereas m will reflect changes in the demand for the components of the monetary base.

Now suppose that the Federal Reserve’s goal is to maintain monetary equilibrium. In other words, the Fed wants to ensure that the supply of money is equal to the corresponding demand for money. In the language of the equation of exchange, this would require that mBV is constant. Or, in other words, that changes in m and V are offset by changes in B.

This goal would certainly make sense because an excess supply of money ultimately leads to higher inflation whereas an excess demand for money results in — initially — a reduction in output. Unfortunately, this is a difficult task because it is difficult to observe shifts in m and V in real time. Nonetheless, there is an alternative way to ensure that monetary equilibrium is maintained. For example, in the equation of exchange, a constant mBV implies a constant Py. Thus, if the central bank wants to maintain monetary equilibrium, they can establish the path of nominal income as their policy goal.

Thus far, the framework we have employed has outlined two aspects of monetary policy. First, the monetary policy tool (or instrument) is the monetary base. This is considered a policy instrument because it is directly controlled by the Fed. Second, the goal of monetary policy is to target a desired path for nominal income. This goal is considered desirable because it maintains monetary equilibrium. Even with the instrument and goal in place, the analysis is not complete. The central bank needs an intermediate target.

The intermediate target of monetary policy can be anything that has a strong statistical relationship with the goal variable. In addition, it must be available at higher frequencies than the goal variable. This intermediate target can be a measure of the money supply, the federal funds rate, or even the forecast of the goal variable. (It is important to note that the federal funds rate is NOT the instrument of monetary policy despite the frequent usage of this term.)

Returning to the equation of exchange, a natural choice for an intermediate variable (so long as there exists a strong statistical relationship) is a monetary aggregate. Re-writing the equation of exchange, we have the more familiar form:

MV = Py

where M is the monetary aggregate used as the intermediate target.

The behavior of monetary policy is characterized as follows. The central bank chooses the monetary base with the intent of guiding the path of nominal expenditures. However, the control of the monetary base in and of itself is not always enough to ensure that the policy goal is met. This is because changes in the demand for the monetary base will result in changes in the money multiplier and, as a result, a different relationship between the monetary base and nominal expenditure. In order to ensure that the monetary base is being adjusted enough to maintain the desired path of nominal expenditures, the central bank uses the monetary aggregate as the intermediate target. In other words, the central bank chooses B so as to ensure that:

mB = M*

where M* is the desired level of the monetary aggregate. What’s more, this desired level of the monetary aggregate is chosen such that it maintains the desired level of nominal expenditure.

The most important question that I want to address is in regards to the “best” measure of the stance of monetary policy. In our example, the monetary base serves to demonstrate the actual adjustments made by the monetary authority. However, it does not necessarily demonstrate the stance of monetary policy (i.e. if policy is loose or tight). For example, if there is a change in the demand for the components of the monetary base, the money multiplier will change and, depending on the direction of the change, the monetary base might suggest that monetary policy has been expansionary or contractionary even when M and Py remain correspondingly constant.

The same problem exists for M. The central bank adjusts the monetary base to target the intermediate variable, M. The target of M is meant to generate the desired path for Py. Like the monetary base, however, movements in M will not be sufficient to produce the desired path of nominal expenditure if the demand for M — reflected in V — changes. Relying on M to discover the stance of monetary policy is potentially misleading as well in that higher than expected changes in M might merely reflect declines in V.

So what is the best way to determine the stance of monetary policy?

The answer is quite simple. If the goal is to achieve a certain level of nominal expenditure, (Py)*, then the stance of monetary policy is best determined by deviation of the goal variable from its target:

Py – (Py)*

If this value is positive, it suggests that policy has been overly expansionary. If this value is negative, it suggests that policy has been overly contractionary. This point seems to be missed by many within the United States, but is widely accepted elsewhere. For example, the Bank of England has an explicit inflation target. If their target is 2% and inflation comes in at 3%, there would be little doubt that the policy was over-expansionary regardless of the level of the nominal interest rate or the behavior of monetary aggregates. The problem in the United States seems to center around the fact that the Fed has no explicit goal for monetary policy. Rather the Fed is to promote full employment and low inflation. As a result, we tend to rely on the behavior of the intermediate targets like the federal funds rate and monetary aggregates to gauge the stance of policy when, in fact, these variables can potentially be misleading.

The Bernanke Speech

Bernanke gave a speech at the AEA meetings defending the actions of the Federal Reserve in the early part of the decade. Scott Sumner makes a keen observation:

Bernanke’s explanation for the Fed’s actions in 2002 show exactly how monetary policy failed in 2008. In particular, Bernanke made the following three observations regarding 2002:

1. Monetary policy needs to focus on the macroeconomy, not specific sectors.

2. Monetary policy must be forward-looking, must target the forecast.

3. Monetary policy must be especially aggressive when there is risk of liquidity trap (which would render conventional policy ineffective.)

In 2008 the Fed did exactly the opposite. Between September and December 2008 the Fed focused on banking, not the macroeconomy, they adopted a backward-looking Taylor Rule, and they were extremely passive when the threat of a liquidity trap was already obvious.

BTW, the quote of the day comes from Sumner’s post as well:

Unlike [Arnold] Kling, the stock market does believe monetary policy has a near-term impact on the economy.

UPDATE: David Beckworth on why we should doubt the claims put forth in the speech.

What Super-neutrality Really Isn’t

Our friend Nick Rowe pays homage to Milton Friedman in one of his latest posts on what monetary policy cannot do. Indeed, Friedman’s speech to the AEA in 1967 should be required reading for any who wish to learn about monetary policy (it is indeed required reading for my Money and Banking students). The purpose of this homage is to absolve monetary policy of any wrong-doing in the current recession and preceding housing boom. Specifically, he argues:

It was in that paper that Friedman introduced the concept of the natural rate of unemployment. Prior to Friedman, most economists thought there was a downward-sloping Phillips curve, and that monetary policy could keep unemployment low provided we were willing to accept higher inflation. Friedman argued that this was true in the short run only, and that in the long run, when expected inflation equaled actual inflation, the Phillips curve was vertical. Monetary policy could target any rate of inflation, but the result would be the same long run equilibrium rate of unemployment.

Friedman needed a name for that long run equilibrium rate of unemployment, and he chose to call it the “natural rate of unemployment”. He chose that name to draw a parallel to Wicksell’s concept of the natural rate of interest.

[…]

There is nothing special about unemployment or interest rates in Friedman’s argument. Everything he says about them applies equally well to any real variable. Just as there is a natural rate of unemployment, and natural rate of interest, so there is a natural rate of output, employment, real wages, relative price of houses, or relative price of sardines. The underlying vision is one of the long-run super-neutrality of money.

Monetary policy has real effects in the short run, because it takes time for prices and expectations to adjust to a change in monetary policy. But if we compare alternative worlds where prices and expectations have adjusted to alternative monetary policies with different average money growth rates and average inflation rates, real variables should not be affected. They are pinned down at their natural rates by real, not monetary forces.

I am in agreement with Nick on nearly every point of this argument. Nevertheless, I am puzzled regarding his conclusion about relative prices. When discussing long-run superneutrality of money, he is referencing the idea that a change in money growth will only cause a change in the rate of inflation in the long run and thus have no effect on real variables. However, even accepting long run money neutrality, isn’t it possible (and in all likelihood probable) that relative prices have changed? In fact, this was Hayek’s main point in extending Wicksell’s idea of a natural rate of interest. In Prices and Production, for example, he writes:

. . . it seems obvious as soon as one once begins to think about it that almost any change in the amount of money, whether it does influence the price level or not, must always influence relative prices. And, as there can be no doubt that it is relative prices which determine the amount and the direction of production, almost any change in the amount of money must necessarily also influence production.

The appropriate question is thus whether superneutrality of money not only implies that the change in the rate of inflation is proportionate to the change in the rate of money growth, but also that individual price changes are equiproportional. Nick seems to believe that it is the case, whereas I find this conclusion wanting.

There is no greater illustration of our opposing views than the idea of inflation targeting. Nick argues that monetary policy did not play a role in the Canadian housing boom:

Did a change in monetary policy cause the house price bubble? In Canada, absolutely not. There was no change in monetary policy in Canada. As I argued in my previous post, The Bank of Canada hit its inflation target almost exactly on average over the period when Canadian house prices were rising. With actual CPI inflation at the 2% target, and expected CPI inflation presumably at the same 2% target, there was no sign of the unexpected inflation that is the signature of the short run effects of a change in monetary policy.

The inflation target was 2% and actual inflation was 2%. Nick views as suggesting that monetary policy could not possibly be to blame for rising house prices. I do not find this evidence convincing in the least. What an inflation target does is establish transparency and accountability for the central bank. If the central bank hits its target, all this tells us is that they have hit their goal. It does not tell us about the desirability of the outcome.

It is entirely possible (if not probable) that monetary policy has an influence on relative prices and the allocation of resources without the aggregate level (growth) of money having an effect on the aggregate level (growth) of output. Indeed, the fact that housing prices rose 85% in Canada while the inflation rate was 2% poses interesting questions. Does the price index targeted by the Bank of Canada underweight housing? Is housing measured properly in the price indices? Doesn’t the rise in housing prices suggest that relative prices have changed (in real terms)?

I think that this is the fundamental point surrounding inflation targeting. If one focuses exclusively on the overall rate of inflation and monetary policy affects relative prices, then monetary policy directed in this manner has the potential to create asset price bubbles, resource misallocations (or simply reallocations), and boom-bust scenarios — even if super-neutrality holds.

Inflation is a Monetary Phenomenon, But This Isn’t Inflation

There has been much talk recently about the potential inflation on the horizon given the unprecedented movement of the Federal Reserve of increasing the monetary base through quantitative easing. The talk has predominantly surrounded the substantial increase in the monetary base. However, increases in the monetary base are not sufficient to cause inflation. Like discussion of other markets, we must consider both supply and demand conditions.

Milton Friedman famously quipped, “inflation is always and everywhere a monetary phenomenon.” Friedman was undoubtedly correct. However, recently a few seem to have taken this claim to mean something different entirely. Namely, that any increase in the money supply necessarily causes inflation. This is something that Friedman himself did not believe.

In his restatement of the quantity theory of money, Friedman pointed out that the quantity theory is primarily a theory of money demand. Specifically, quantity theorists view the level of real money balances as more important than the nominal quantity of money. Thus, if at any point in time people have chosen to hold some level of real money balances that they deem optimal, an increase in the nominal money supply will leave these individuals with a larger level of real money balances than they wish to hold. These individuals will then necessarily try to reduce their holdings of nominal money balances such that their real money balances fall back to their optimal level (perhaps by increasing spending). Unfortunately, as a group, they will not be able to do so because every person’s spending is another person’s receipt (or income). Initially output will increase and gradually prices will rise until the level of real balances falls back to the optimal level.

Given this discussion, it should not be difficult to understand why I prefer a monetary equilibrium framework. What’s more, it should be apparent that what causes inflation is not an increase in the money supply, but rather an excess supply of money.

Ultimately, the question at hand is whether the current increases in the monetary base imply that there is an excess supply for money. If so, inflation is on the horizon. If not, we need not fear inflation.

Personally, I do not believe that the recent increases in base money imply that there is an excess supply of money. There are a couple reasons for this belief. First, it has been well-known — at least among monetarists — since Clark Warburton’s influential work that the peaks in the time series variables important for quantity theorists follow this order: (1) money, (2) output, and (3) velocity. The implication here is that declines in velocity (increases in the demand for money) are an accentuating feature of the business cycle. In other words, after output begins to fall, the demand for money increases. As our previous discussion of monetary equilibrium implies, this creates an excess demand for money, which results in falling output and prices — thereby exacerbating the previous decline in output.

Second, the money multiplier has declined drastically. In fact, the money multiplier for M1 remains below 1. This means that for every increase of $1 in base money, the money supply (as measured by M1) increases by less than $1. In order to determine the cause of the decline in the M1 multiplier, we should first discuss its components. The money multiplier for M1 consists of the currency-to-deposit ratio, the required reserve-to-deposit ratio, and the excess reserve-to-deposit ratio. An increase in any of these ratios implies that the money multiplier will fall. The required reserve ratio is set by the Federal Reserve and has not changed. Thus, the decline in the M1 multiplier must be the result of changes in the currency-to-deposit ratio and the excess reserve ratio. As previously mentioned, the demand for money often increases during the downturn in the business cycle. What’s more, financial crises often induce a flight to quality in which individuals abandon risky investments for safe investments such as bonds or cash. The increase in cash balances increases the currency-to-deposit ratio.

The largest cause of the decline in the money multiplier, however, is the result of the increase in the level of excess reserves. What’s more, this increase in excess reserves can be directly attributed to the fact that the Federal Reserve started paying interest on excess reserves late last year. In doing so, the Fed essentially reduced the opportunity cost of holding excess reserves thereby giving banks the incentive to hold more reserves on their balance sheets. This is why our friend Scott Sumner not only supports eliminating the interest payments on excess reserves, but prefers that the Fed impose a penalty on those who hold reserves above the required level.

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%. Given that we are currently in a recession, this suggests that the Fed wants to increase the money supply rather than simply maintain the earlier level. Given that the monetary base is about 90% higher than it was at this time last year, this would suggest that the Fed is expansionary, but hardly over-expansionary given the circumstances surrounding money demand.

With that being said, the Fed must be careful and begin pulling money out of the economy when this demand for base money subsides and the money multiplier begins to rise again. A failure to do so would result in a substantial period of inflation. However, at the current time, the evidence suggests that the massive increase in the monetary base is justified by the increase in the demand for base money. Thus, the increase is in the monetary base doesn’t suggest that massive inflation is on the horizon … yet.

(In the future, I hope to post on how the Fed can prevent finding itself in such a precarious situation in the future, but this is clearly enough for now.)

Should We Fear Rising Bond Yields?

There seems to be some concern as to the rising yields on long-term bonds. Our friend Jimmy P. (now of Reuters) quotes Scott Grannis, who writes:

The Fed is trying to fight a force of nature—the bond market—and they are bound to lose. Purchasing long-maturity Treasuries, mortgage-backed securities or corporate bonds in an to keep their yields low is a self-defeating strategy … Ultimately, inflation and inflation expectations are what drive bond yields. If the Fed buys too many bonds, rising inflation expectations will kill the world’s demand to own bonds, and yields will rise. … So far this year, the yield on 10-year Treasuries has risen from 2.05% to 3.4%, and that is just a down payment on the eventual rise.

This presents two interesting questions:

1. Is the Fed trying to lower long-term rates?

2. Are rising long-term rates a bad thing?

I think that the answer to (1) is ‘no’. Counter to what seems to be the conventional wisdom, I believe that the Fed is buying long-term bonds because because short-term bonds and cash having largely been near perfect substitutes for quite some time. Thus replacing an asset that banks are gladly holding at near zero yield for an asset that earns zero yield isn’t likely to create the proper incentive to expand the money supply and stimulate economic activity. Buying the longer term debt, on the other hand, serves the purpose of creating the incentive to replace said debt with something that earns a return, thereby promoting lending and monetary expansion. What’s more this monetary expansion, if successful (or, more appropriately, credible) will begin to create an increase in inflation expectations, reduce the real interest, and therefore create demand for investment.

This latter point brings us to question number 2.

I similarly think that the answer to (2) is ‘no’ as well (or at least ‘not yet’). The creation of inflation expectations will temporarily lower the real interest rate, but as these expectations become more widespread the nominal interest rates will start to creep up. The recent increase in nominal rates is seen by some (including Scott Grannis, above) to be a sign that investors are worried about inflation. I am not convinced that this is the case for two reasons.

First, the nominal rates on bonds have been at historically low levels for some time. These low rates are largely the result of expectations of deflation and, more importantly, the flight to quality. Given this diagnosis, it is not surprising that these longer term bond yields have started to rise. Indeed, Martin Wolf (HT: David Beckworth) notes:

The jump in bond rates is a desirable normalisation after a panic. Investors rushed into the dollar and government bonds. Now they are rushing out again. Welcome to the giddy world of financial markets.

At the end of December 2008, US 10-year Treasury yields fell to the frighteningly low level of 2.1 per cent from close to 4 per cent in October (see chart). Partly as a result of this fall and partly because of a surprising rise in the yield on inflation-protected bonds (Tips), implied expected inflation reached a low of close to zero. The deflation scare had become all too real.

What has happened is a sudden return to normality: after some turmoil, the yield on conventional US government bonds closed at 3.5 per cent last week, while the yield on Tips fell to 1.9 per cent. So expected inflation went to a level in keeping with Federal Reserve objectives, at close to 1.6 per cent. Much the same has happened in the UK, with a rise in expected inflation from a low of 1.3 per cent in March to 2.3 per cent. Fear of deflationary meltdown has gone.

The most important point to take away from this is that inflation expectations are in line with rates in which the Federal Reserve is quite comfortable. Thus, I am not trying to argue that rising inflation expectations have played no role in the rising bond yields, but rather than these increases are the result of a return to normal conditions (hence my reason for offering the qualification ‘not yet’).

The second reason that I remain unconcerned about the rising yields is that the phenomenon is not unique to the United States. One of the main points underlying the inflation expectation concerns is that the Federal Reserve will monetize some of the growing debt (or similarly about the risk of default). However, if increases in bond yields were the result of the growing budget deficit and debt, then one would expect to see such increases in the United States, but not countries with relatively small deficits. With that being said, Stephen Gordon’s recent comparison of the yields on Canadian and U.S. bonds throws a wet blanket on this hypothesis. He notes:

As we all know, Canada’s deficit and debt picture resembles in no way that of the US. But a US recovery is a sufficient (although perhaps not necessary) condition for a Canadian recovery.

If investors were suddenly concerned about default, it’s hard to see why Canadian bond yields should be affected in the same way that US yields would be. But if investors are anticipating a US recovery that would spill over to Canada, then we would expect long-term interest rates in both countries to increase.

Thus, like Gordon, I would argue that the rising yields are a good thing as they seem to indicate a return to normalcy rather than runaway inflation expectations. This is also a sign that the Fed’s policy of quantitative easing is working (at least in terms of what I believe to be the Fed’s goals).

In Search of Monetary Stability

I have been discussing a multitude of issues including quantitative easing, Ricardian Equivalence, and the current state of monetary policy with Scott Sumner over the in comments of his excellent blog and it has given me the inspiration to provide a more thorough outline of my thinking.

I think that the best way to think about money is, as Leland Yeager might say, in terms of monetary equilibrium. In other words, if we view money as being just one other good in a Walrasian general equilibrium model, then an excess demand (supply) of money is accompanied by an excess supply (demand) of goods and services. Thus, maintaining monetary equilibrium is essential to achieving economic stability. What’s more, the particular problem with an excess demand (or supply) of money is that money has no market of its own. Or as Keynes would say, labor cannot be shifted away from the production of goods where there is an excess supply to the manufacture of money. Further, the fact that money does not have a market of its own implies that an excess demand (supply) of money will have an impact on all markets because money is a medium of exchange.

My view here is not unique. In fact, Nick Rowe recently wrote an excellent post on this very topic that rightfully referenced the work of Robert Clower. The central point is that individuals have notional demands for money, goods, and services. Notional demand is understood as the intended demand. Thus, suppose for example that everyone arrives at some centralized market with their own plans for consumption and ultimate real money balances. If there is an excess demand for say lemonade, individuals can bid up the price of lemonade and the market will clear. If the excess demand is for money, however, there exists no price to adjust to clear the market and the effective demand for goods and services will fall short of supply.

A very simple way to think about monetary equilibrium is in the context of the equation of exchange:

MV = PY

where M is money, V is velocity, P is the price level, and Y is real output. Thus, M is the supply of money and V can be seen as the demand for money. (A particular note: velocity is understood as the number of times that the average dollar — or other medium of account* — is turned over. Thus an decrease in velocity reflects an increase in the demand for money.) Monetary equilibrium therefore implies that the product MV should be constant (and thus so should nominal GDP, or PY. Keep in mind that this is a static analysis).

The maintenance of monetary equilibrium essentially implies that monetary policy should be aimed at satisfying money demand (or nominal income) rather than the price level (as is currently the case). Thus, in a growing economy, the price level should actually be falling as increases in real output and productivity put downward pressure on prices. This type of thinking loosely forms the basis for what George Selgin calls the productivity norm. Such a maintenance of monetary equilibrium has a rich history in the course of economic thought (see Selgin, 1995).

So how does this framework relate to the current situation? Scott Sumner believes that the current recession could have been avoided using a nominal income target (more specifically, using nominal income futures targeting). I am not sure that I agree with this assertion, but it does fit with this framework. Allow me to explain.

If Sumner is correct, then (using our simple equation of exchange model) anticipations of lower nominal income would be reflected in an increase in the demand for money or a decrease in spending (a fall in V). (Alternatively, it is possible that the increase in the demand for money could be an exogenous event such as described by Keynes when there is an increase in uncertainty.) If the central bank was targeting nominal income, they would respond by increasing the money supply to offset the fall in velocity such that nominal income remains at the target level.

Sumner, however, likes to view this phenomenon through the lens of nominal income and expectations rather than through a monetary equilibrium framework (or at least that is my impression). Thus, in his mind, the nominal income target signals to economic agents that the Federal Reserve will do everything that it can to make sure that nominal income does not fall. If the Fed is credible on this point, then nominal income will not fall because people expect the Fed to follow through on this promise. I actually think that my view of monetary equilibrium is consistent with this view, but that Sumner simply has a different way of describing the policy.

In any event, Sumner has recently expressed his concern with the productivity norm view because (as I understand it) he is concerned with nominal wage rigidity. Thus, the falling prices implied by the productivity norm might actually produce malign effects. He would prefer a broader idea of a nominal income target. He might be correct, but I do not share this concern about wage rigidity. The reason is because wage rigidity should only be a concern when prices are falling due to adverse aggregate demand shocks. Falling prices due to productivity advances should have no effect on the nominal wage. In fact, rising productivity should be consistent with higher real wages (in this case due to falling prices). In any event, one need not worry about this problem under the current circumstances because the decline in nominal income is the result of a severe adverse aggregate demand shock.

I am inclined to think that nominal income targeting is certainly more desirable than the current regime. However, the ultimate question is whether or not the current situation could have been avoided under a nominal income targeting regime. Scott Sumner believes that we could have avoided the recession and simply experienced a burst of the housing bubble had we followed a nominal income target. I actually think that we might not have even had a housing bubble if we had a nominal income target (that allows for falling prices). In any event, the current situation has raised interesting questions about the state of monetary policy and monetary stability. Hopefully, we will also stumble upon some of the answers.

* “Money is here called a medium and not, as customary, a unit of account because, clearly, money itself is not a unit, but the good whose unit is used as the unit of account” Niehans (1978).