Cryptic Note to Self: I Will Never Understand Chicago Today...
6/17/09 9:30 PM
Grasping Reality with Both Hands The Semi-Daily Journal of Economist Brad DeLong: A Fair, Balanced, Reality-Based, and More than Two-Handed Look at the World J. Bradford DeLong, Department of Economics, U.C. Berkeley #3880, Berkeley, CA 94720-3880; 925 708 0467; delong@econ.berkeley.edu.
About This Website | About Brad DeLong | This Weblog | Weblog RSS feed | Brad DeLong's Egregious Moderation | Order of the Shrill | Office Hours: Evans 601, W10-12, 2-3, and by appointment, email delong@econ.berkeley.edu | Macroeconomic Policy Lectures | Economic History Lectures | Academic C.V. | John Yoo and the Torture Memo | Audio and Video Read the comment policy: no drive-bys, and if you bring information and humor you will be fine... Expert Economic Analysis Ctr for Forensic Economic Studies Contact us to discuss your case. www.cfes.com
Find Stimulus Contracts Free Report: Top Federal Agency Stimulus Spending Initiatives. www.INPUT.com/StimulusReport
Stimulus Financial Aid Take Advantage of Stimulus Bill Aid for Education. Find a School Here! FinancialAid.Search-Schools.com
Litigation Economics Expert Testimony Litigation Support Lost Profits, Valuation, Damages www.AndersonEconomicGroup.com
Weblog Home Page Weblog Archives Subscribe to RSS Brad DeLong's Home Page Berkeley Economics Department NBER Brad DeLong's Egregious Moderation May 05, 2009
Cryptic Note to Self: I Will Never Understand Chicago Today... "But monetary policy can still be very effective: you just have to buy things other than Treasury bonds in your open-market operations..."
http://delong.typepad.com/sdj/2009/05/i-will-never-understand-chicago-today.html
Page 1 of 11
Cryptic Note to Self: I Will Never Understand Chicago Today...
6/17/09 9:30 PM
So you grow the money stock: what does that do? Unless your expansionary monetary policy raises short-term interest rates--in which case it is not what I at least think of as expansionary monetary policy--it moves you by the little red line-and it creates a huge excess demand-inflation problem whenever interest rates return to their normal (black) levels as shown by the big black arrow. By contrast, fiscal policy--or perhaps flow-of-funds policy: fiscal and banking policy--that sops up the flow of savings and raises short-term safe nominal interest rates gets you quickly to the blue arrow--with no long-run monetary-overhang problem to produce a big burst of inflation later. More to follow... rated 3.56 by 16 people [? ] You might like:
Technological Regress in the Thinking of William Poole (@this site) Israel Central Banker to Push Expasionary Monetary Policy (@WSJ.com: Real Time Economics) 2 more recommended posts Âť Brad DeLong on May 05, 2009 at 09:33 AM in Economics, Economics: Economists, Economics: Federal Reserve, Economics: Finance, Economics: Fiscal Policy, Economics: History, Economics: Macro | Permalink TrackBack TrackBack URL for this entry: http://www.typepad.com/services/trackback/6a00e551f0800388340115706fa46e970b Listed below are links to weblogs that reference Cryptic Note to Self: I Will Never Understand Chicago Today...:
http://delong.typepad.com/sdj/2009/05/i-will-never-understand-chicago-today.html
Page 2 of 11
Cryptic Note to Self: I Will Never Understand Chicago Today...
6/17/09 9:30 PM
Comments The trouble appears to be that the monetarists think that the problem is an excess demand for money. That's just not right. The problem is an excess demand for REAL SAVINGS over the demand for REAL INVESTMENT. In a sense the demand for real investment is like the supply of real saving opportunities. Fundamentaly saving is an attempted substitution of less consumption today for more consumption tomorrow. SAVING ONLY ADDS TO AN AGENT'S HOLDING OF MONEY WHEN THERE IS NO REAL INVESTMENT DEMAND TO ABSORB IT. The fact that right now it seems as though people are saving by hoarding money is a symptom of the excess demand of saving over demand for investment. It is not the cause of anything. Posted by: Adam P | May 05, 2009 at 11:33 AM I have recently had the impression that I understand Chicago today (and I stress I used no chemical assistance). I think the key is something like "If the Fed does it then it's monetary policy" (something like if the President does it then it's not a crime). Thus Monetary policy might work if instead of T-bills, the Fed bought newly built bridges and highways (or pace Atrios supertrains). Or maybe bought newly issued Citibank common stock. As soon as you get over the old fashioned lefty pinko idea that "monetary policy" has something to do with the supply of and demand for money, then it all makes sense. Posted by: Robert Waldmann | May 05, 2009 at 01:00 PM What "end" are these people working towards, anyway? You can't just treat analysts as "analysts", they have some dog in the fight ... And like Obama saying that SCOTUS Judges should consider the effect of Law on real people, so should those both handling and theorizing about money. Posted by: Neil B â˜ş | May 05, 2009 at 01:44 PM Indeed, at current interest rates any money you print and just throw into the economy becomes mattress money. Not literally, for the most part -- but even virtual mattress money sitting in a Federal Reserve fault or at 0% in money market accounts at banks that literally are refusing to lend is still mattress money, doing nothing at all to create economic activity. And once interest rates rise and pull all that money out from under mattresses, you have an enormous inflation problem... The only way to print money and *not* have it become mattress money is to give the money out with strings attached. Like, we'll print this money but instead of dropping it over Chicago via a Friedman/Bernanke style "helicopter drop" (at which point it would promptly disappear under [possibly-virtual] mattresses because people would judge the future value of the money as being higher than its current value in a potentially deflationary environment), we'll give it out in exchange for you building a bridge for us. Or a highway. Or a high-speed electric train. Something that requires the money to move through the economy because the contractor building the highway has to buy concrete, the person providing the concrete has to buy cement and gravel, the person providing the gravel has to buy fuel and maintenance supplies for his bulldozers and pay his truck driver and pay for maintenance on his trucks, and so on and so forth. But we don't call this last paragraph monetary policy. We call it fiscal policy. Unless, apparently, you are a Chicago theorist (?)... Posted by: Badtux | May 05, 2009 at 02:17 PM At this point, I think that Libertarianism needs an entry in the DSM IV. Posted by: DrDick | May 05, 2009 at 02:32 PM The demand for government goods and services is down about 20%, if we use the revenue numbers for supply and demand. Supply and demand must work for government. Yet the demand for government bonds is unabated, their prices have risen. This is not a paradox, but rather an artifact of the conglomerate nature of government. We have no mechanism to invest in just the public goods that caused the mini-depression, we can only invest in the broad portfolio of public goods. That leaves us with the election cycle, hence the conclusion: The federal government has the longest equilibrium time in the economy. It is going to take years for government to find and correct the constrained public goods.
http://delong.typepad.com/sdj/2009/05/i-will-never-understand-chicago-today.html
Page 3 of 11
Cryptic Note to Self: I Will Never Understand Chicago Today...
6/17/09 9:30 PM
Posted by: Mattyoung | May 05, 2009 at 02:50 PM I read that as reducing credit spreads on corporate and private borrowing, which the Fed is already doing. That has more punch than treasuries, especially for the corporate and private borrowers. One would expect those rates to remain stable or fall as conditions return to normal. Posted by: Lord | May 05, 2009 at 04:15 PM Well, "Lord", I assume you're referring to the Fed's open market operations where they are purchasing Fortune 500 bonds on the open market with freshly printed money. The problem is that what's happening is that the investors who held the bonds are just shoving the freshly printed money under their (virtual) mattresses too. Or if they're buying fresh issue debt from the Fortune 500, again, the Fortune 500 is just using that fresh issue debt to roll over old debt, so the money goes right back out to those investors who then shove it under their (virtual) mattresses again. I reiterate that the only way for this freshly printed money will actually create economic activity in an environment of deflationary expectations is to hand it out with strings attached requiring it to be spent on something which actually produces economic activity, such as road construction or food stamps. Buying corporate bonds will *not* work here, because the corporations are just rolling it over to pay off the investors who previously owned that debt who are promptly shoving the slightly-rinsed Fed money under mattresses real or virtual (since they view the future value of this money if stashed away and lent or spent later to be higher than their current value received if lent or spent today). You're just increasing the possibility of an inflation whiplash once that cash comes out from under mattresses via any kind of open market operations right now, whether you're conducting open market operations by buying Treasuries or by buying corporate bonds is irrelevant. (Other than that buying Treasuries at the same time that the government is then taking the freshly printed money and handing it out with strings attached -- i.e., fiscal policy -- allows the government to do fiscal policy without raising taxes or driving up its borrowing expenses). In short, fiscal policy is the only thing that can, or will, work when you've hit the zero boundary and deflationary expectations are the norm. Posted by: Badtux | May 05, 2009 at 05:33 PM but there's more than one interest rate that affects investment, which the IS-LM model obscures... Posted by: js | May 05, 2009 at 08:47 PM "At this point, I think that Libertarianism needs an entry in the DSM IV." Already got one: "A personality disorder is a pattern of deviant or abnormal behavior that the person doesn't change even though it causes emotional upsets and trouble with other people at work and in personal relationships. It is not limited to episodes of mental illness, and it is not caused by drug or alcohol use, head injury, or illness. Narcissistic Personality Disorder While grandiosity is the diagnostic hallmark of pathological narcissism, there is research evidence that pathological narcissism occurs in two forms, (a) a grandiose state of mind in young adults that can be corrected by life experiences, and (b) the stable disorder described in DSM-IV, which is defined less by grandiosity than by severely disturbed interpersonal relations." etc. From http://www.halcyon.com/jmashmun/npd/dsm-iv.html Posted by: albrt | May 05, 2009 at 09:32 PM Many empirical studies on money demand have found that it is sensative to long bond rates as well as short interest rates (as Milton Friedman predicted). You need a 3d diagram, with surfaces instead of lines, to represent this graphically. The key point is that even when money demand has become infinitely elastic with respect t the short rate (analogous to the flat part of the red line in Brad's diagram; in 3d terms the money demand goes flat orthogonal to the shor rate dimension), the surface can still be negatively sloped in the long rate dimension (a situation I think we are in now). Under these circumstances, money injected into the long bond market by quantitative easing is emphatically not left standing idle, although the velocity of circulation will fall a bit.
http://delong.typepad.com/sdj/2009/05/i-will-never-understand-chicago-today.html
Page 4 of 11
Cryptic Note to Self: I Will Never Understand Chicago Today...
6/17/09 9:30 PM
Bear in mind that Friedman & Swhwartz, and more recently Romer, have analysed the recovery from the great depression and concluded that it was quantitative easing, and not fiscal policy (which consisted of a structural budget deficit roughly in balance) that caused the economy to recover. Also, recovery in Japan happened after quantitative easing, and not after the huge structural deficits! I think fiscal policy has a supporting role to play in the recovery from this recession. It is especially useful because it works with shorter time lags than monetary policy. These lags for monetary policy (in normal times 12 months) have to be taken into account in assesing the effects of the Feds quantitative easing (from late October 1998). - Tim Posted by: Tim Peterson | May 06, 2009 at 12:32 AM The wealthy special interests have been fighting a class warfare since FDR to limit fiscal spending on social programs and infrastructure. A huge fiscal response to the current crisis would mean that they lose the class war. The wealthy special interests don't think they can beat back spending and new programs once they are enacted. Therefore they favor monetary solutions however convoluted. Fiscal stimulus is not on their table. Posted by: bakho | May 06, 2009 at 03:51 AM Some comments here seem to get Chicago right. (1) There are a multitude of interest rates out there, each of which has an impact on particular types of investment. So, if the Fed starts buying Ford's bonds, then Ford will invest more, as its interest rate has declined. We don't have to worry about the money not being spent - the point is that the fall in interest rates will lead Ford to issue more NEW bonds, and invest that money. (2) Monetary policy, from the Chicago view, is based in, well, money... Not necessarily interest rates. So, if the Fed prints a bunch of money and buys roads and bridges, it still counts as monetary policy - though it would have an impact far more like fiscal policy in the traditional IS-LM setup. As far as libertarianism needing to be in DSM... I don't think libertarianism relates at all to this. The Fed is a quasi-government institution that isn't "libertarian" at all. Have you ever heard Ron Paul say a GOOD thing about the Fed? Posted by: Lucas M. Engelhardt | May 06, 2009 at 07:47 AM LME's Assumption #1 assumes that Ford will issue a larger volume of new bonds than the debt that it is rolling over. The reality is that Ford is sales-constrained. They will invest what is necessary to meet their current sales demand (which is 50% lower this April than it was in April of two years ago), as well as continue their current investments towards future product introductions. The chances of Ford significantly increasing their economic activity in response to lower bond rates are absolutely zero. Businesses simply do not operate that way. They will be happy to have lower bond rates, because it reduces their expenses, but they will not increase economic activity because of it, because economic activity for Ford is determined by demand and by their long-term product plans, not by bond rates. In short, all the Fed manages by printing money to buy Ford bonds is insure that there is a market for Ford bonds, i.e., serve as a lender of last resort when the private marketplace for some reason decides to no longer roll over Ford's debt. Which is an important role, but has no significant influence on the circulating money supply in an era of deflationary expectations where the money being printed basically just disappears under mattresses (virtual ones in the case, but same effect) at which point it ceases to contribute to economic activity. 2. If the Fed prints money and buys roads and bridges, they are no longer serving as a bank, because banks do not perform that sort of activity, banks accept deposits and make loans. That's sort of the definition of a bank. If they buy roads and bridges (rather than loan money to construct roads and bridges) they are performing a government function and it is proper to call it fiscal policy rather than monetary policy, albeit monetary policy is certainly involved here due to the fact that money is being printed to finance this fiscal policy. 3. Regarding the relative monetary vs. fiscal inputs into the end of the Great Depression, these analyses tend to be strictly conducted in order to prove the point that the person doing the analysis wants to prove, rather than with any attention to little things like truth. In particular, these analyses typically ignore the huge, gigantic, tremendous fiscal stimulus of WWII, instead apparently ending their analysis on December 7, 1941. It took WWII to mobilize the slack resources in the economy and end pervasive and persistent http://delong.typepad.com/sdj/2009/05/i-will-never-understand-chicago-today.html
Page 5 of 11
Cryptic Note to Self: I Will Never Understand Chicago Today...
6/17/09 9:30 PM
analysis on December 7, 1941. It took WWII to mobilize the slack resources in the economy and end pervasive and persistent unemployment and put Americans back to work, and WWII was a fiscal event, even though monetary policy certainly took place at the same time. In short, it is clear from a historical point of view that fiscal policy, and specifically the huge fiscal event called "WWII", ended the Great Depression. Historical revisionism which claims that the Great Depression ended at some point before this gigantic fiscal stimulus ignores the "facts on the ground", which was that prior to this fiscal stimulus huge numbers of people were still suffering in dire poverty unemployed and reliant upon government assistance for their very survival. Granted, the Chicago School doesn't care about such things except insofar as it affects industrial output and the money supply, but for the people suffering, they certainly believed they were still in the Great Depression even if the Chicago School wishes to insist that they weren't. Posted by: Badtux | May 06, 2009 at 11:00 AM Correction: I meant to say that the 3d LM surface is upward sloping in the long interest rate dimension, even where it is flat (ie in a liquidity trap) in the short interest rate dimension. As far as the badtux's points go: 1) Firms that are imperfect competitors (ie sales constrained) may still undertake capital deepening (eg productivity enhancing, cost cutting) investments even when there is spare capacity. They are likely to do so in response to a fall in long term interest rates. 2) Wealth created by higher long bond prices has a (admittedly small) effect on consumption expenditures 3) The economy in the 1930's started to recover when the US went off the gold standard (see Brad's graph!) and the Fed (and interestingly enough, the treasury) undertook a big expansion in the money supply. Growth rates were impressive, but not enough to restore the pre-stockmarket crash trend. 4) I think it could be argued that the eonomy had 'recovered' by 1937, inspite of being below trend, in the sense that the output gap was negligible. This is because potential output had taken a truly humungous slug from very high union driven real wage increases and Hoover/Roosevelt orchastrated cartelization of American industry. These things dragged the NAIRU up into low double digits. If you doubt that NAIRUs can get that high, look at Europe in the 1980s! It should also be added that this might have been helpful in the early to mid stages of recovery, as the smaller output gaps consistent with the higher NAIRU steered the economy away from the deflationary-spiral precipice. 5) WWII wasn't just fiscal stimulus, but also measures that reduced the bargaining power of unions, directly restrained wages, and dragged the NAIRU back down to 5-6% or so (difficult to tell exactly what it was because of the wage/price controls). As for DSM-IV and liberterians, I think Albrt is playing with the Milton Bradley DSM-IV party pack edition; its like Trivial Persuit, only you diagnose the percieved pathologies of your friends in a party setting :-) - Tim - Tim Posted by: Tim Peterson | May 06, 2009 at 08:27 PM Adam P. I think you must have been half-asleep when you wrote that. It doesn't make the slightest bit of sense. In particular this: SAVING ONLY ADDS TO AN AGENT'S HOLDING OF MONEY WHEN THERE IS NO REAL INVESTMENT DEMAND TO ABSORB IT Can only be true for strange definitions of savings. If savings means income that is not spent then it must always add to holdings of money. If what you are trying to say is that individuals who are saving prefer to buy investments rather than hold more money - well surely that depends on a number of factors. But individuals can hold more money at the same time that firms invest more - that is what banks are for. Posted by: reason | May 07, 2009 at 05:30 AM Reason, I did have in mind a certain context from the WCI blog so maybe it wasn't clear. However, you seem to forget that firms are people too. (Or at least collections of people.) If I save $100 and deposit it in the bank and you borrow the $100 to fund real investment we have $100 of saving, $100 of investment and $100 - $100 = 0 addition to net money demand. That's what banks do, they channel funds from savers to investors. http://delong.typepad.com/sdj/2009/05/i-will-never-understand-chicago-today.html
Page 6 of 11
Cryptic Note to Self: I Will Never Understand Chicago Today...
6/17/09 9:30 PM
investment and $100 - $100 = 0 addition to net money demand. That's what banks do, they channel funds from savers to investors. Right now it only appears that savers "demand" high money holdings because isn't enough demand on the other side to borrow the money and invest. Posted by: Adam P | May 07, 2009 at 10:44 AM Sorry, should that should have been: "addition to net money holdings". Posted by: Adam P | May 07, 2009 at 10:46 AM Adam P. But you included the word "AGENT" - if you mean to talk about aggregate effects, you should leave it out. Posted by: reason | May 08, 2009 at 03:45 AM reason, yes you're quite correct. In fact it's worse than that since I said "an agent's". My mistake. Posted by: Adam P | May 08, 2009 at 10:36 AM Adam P: Money (ie monetary aggregates) is taken to include bank deposits. Quoted measures like M1 and M2 include demand (immediately withdrawable) deposits, and the discontinued M3 measure included time deposits as well. So if I take $100 in cash and deposit it in a bank, demand for the monetary aggregate M2 is unchanged. Also bear in mind that banks have reserve requirements. This gets back to a measure of money more like the one you have in mind: the monetary base (cash plus bank deposits at the Federal Reserve). When $100 in cash is deposited at a bank, they only re-lend about $90 of it; they hold on to some cash in their vaults and deposit the rest with the Fed (where they can withdraw it any weekday). These reserves are needed to cover withdrawals and to a lesser extent transfers to other banks through the cheque/electronic funds transfer/direct debit clearing system, as well as providing a 100% safe asset in troubled times. The interesting thing is that most of the money lent out will be redeposited (or transfered to another bank account by cheque or order). These new deposits are, in turn, lent out again and redeposited again. This process is called the money multiplier; it goes on adding to the aggregate money supply until banks have just sufficient reserves to cover their deposits. If the money multiplier has run its course, and I save a cheque by depositing it in a bank account, this is according to basic monetary theory equivalent to stuffing cash into a matress - it takes the money out of circulation. In other words the bank has already lent out as much as it can in relation to the deposit, and will lend no more or less wether I keep the money in the account or write another cheque to spend it. A caveat here is that, as pointed out by Brad in an earlier post, the ratio of reserves to deposits, and hence the value of the money multiplier can vary through time (although there is a statutory minimum reserve ratio that sets limits to this process). If I save the cheque rather than spending it, the bank can be induced to part with some of its reserves and lend them out (although the mechanism by which it is induced to do so is a bit complex and I wont go into it here). Banking theory asside, your basic point is right. A guy called Patinkin related money demand to inbalances between planned saving and investment (there is a great writeup of this in one of the articles in the 1980 Brittanica). I say planned, because actual savings and investment must by definition always coincide; this is brought about in the face of a planned imbalance by movements in income (in Patinkin's version, induced by the corresponding imbalances between money demand and supply; Keynes' version was simpler). I can explain in more detail if anyone here is interested. - Tim Posted by: Tim Peterson | May 09, 2009 at 09:08 PM Actually, Reason is right in usual economic times (I missed the unconditionality in AdamP's statement about savings/investment and money demand). People can save more by holding more money (typically bank deposits), with this additional money created by the banking system, and these funds (on the asset side of the balance sheet) put into investment expenditures. This works smoothly most of the time under an endogenous money supply (the Feds policy in good times; its not quite so clear exactly what it is right now). I think the basic point that Brad was making is that, at the minimum possible (*) level of interest, Treasury bills and money become perfect substitutes (J.M Keynes' liquidity trap). http://delong.typepad.com/sdj/2009/05/i-will-never-understand-chicago-today.html
Page 7 of 11
Cryptic Note to Self: I Will Never Understand Chicago Today...
6/17/09 9:30 PM
perfect substitutes (J.M Keynes' liquidity trap). Under these circumstances (depicted by Brad as the flat part of his LM curve, for those familiar with IS-LM analysis) saving directly lowers income for a given level of investment. Even if more money were printed to try to allow people to build up money balances with their new higher savings rate, the corresponding financing of investment by the higher money balances does not occur. This is because the level of (short) interest rate that would generate enough investment to absorb the savings is now below the minimum level of (short) interest rates (eg in the current situation, this would involve negative interest rates!). This doesn't quite nail AdamP's point about cash demand. The answer is quite complex, and I will try and outline the details, and also explain why trying to facilitate the desire for more money by money creation does not work in a liquidity trap. Consider an economy that is starts out at full employment at exactly the minimum rate of interest, and where there are two assets, bonds and money. Money is used for two purposes: as an asset to accumulate (which in this liquidity trap case is a perfect substitude for bonds) and as a means to fund consumption. People get payed in arrears every two weeks, consume a constant proportion of last forthnights paycheck, and hold transactions average transactions balances of one weeks worth of consumption. Investment is financed by selling bonds. Suddenly one fortnight, people permanently try and save a larger proportion of last weeks pay check. Interest rates cannot fall, so no more investment is forthcoming. In classic Keynesian style, income falls but the national saings rate, defined in terms of _this_ weeks income, does not rise (GDP=Consumption+Investment, and National Savings=GDP-Consumption, assuming away international trade). However, people still have last weeks paycheck in the bank at the start of the week. They want to save say, an additional trillion dollars, but since investment has not gone up, there isn't an additional trillion dollars worth of bonds for them to purchase. But as bonds and money are perfect substitutes, they increase their money holdings directly by a trillion dollars instead; this money will then stand idle. A tricky situation applies in the special case where transaction balances are bigger than the savings rate. If we assume that everyone gets payed on different days, then the reduction in consumption will free up half a trilion dollars worth of money , divided by 14, per day, that was previously used to finance consumption. This money will redux from the bond market like the first lot of money, and also be accumulated and stand idle. Next fortnight, people still try and save the same higher proportion of their previous fortnights income, but save a bit less as income has been reduced by the outcomes of the first fortnight. They still want to save more than the investment level, so essentially the same thing happens as before: income falls again, investment (and hence savings) is unchanged, the excess of attempted savings over investment gets accumulated as money, and the average amount of money used to fund transactions shrinks. This process goes on and on until income is so small that a constant savings rate (out of last fortnights income) exactly covers investment, and income falls no more. Throughout, money is shifted out of circulation and into idle balances; no money on net (asset balances plus transactions balances) gets accumulated. This is a counterintuitive result, as it looks to the people at the time as though they are building up money balances right until the process has played out, but the reduction in income with which to hoard money is the dominant factor at work here. Also note that we can't fix the situation by injecting money into circulation at the first moment that people try and save more. This would have to proceed (in this simple model) by having the central bank buy up bonds. This would reduce the supply of bonds and put us back to square zero (although people would then actually accumulate more money holdings in place of the smaller supply of bonds). The above is an integration of money into a standard Keynesian multiplier analysis; unpicking the IS-LM model in liduidity trap case if you will. It is more complex than, but compements, the case of money injection into a liquidity trap. A Chicago school person would criticise it for having too simplistic a model of money demand and the bond markets, and for being too static; but essentially I think it gets the story of what happens to money in an underemployment/two asset liquidity trap situation about right... Phew! That involved a bit of thought, and more detailed paleo Keynesian economics than I learned in my undergraduate degree (at very, very paleo/post Keynesian Sydney University, although I learned a of of my Economics from Edward Nelson, a fellow http://delong.typepad.com/sdj/2009/05/i-will-never-understand-chicago-today.html
Page 8 of 11
Cryptic Note to Self: I Will Never Understand Chicago Today...
6/17/09 9:30 PM
very, very paleo/post Keynesian Sydney University, although I learned a of of my Economics from Edward Nelson, a fellow undergraduate at the time and very Friedmanite/New Keynesian). - Tim (*) Keynes put the minimum possible level of interest on T-Bills above zero, on account of possible capital losses if interest rates increased. Its interesting to note, though, that at one stage last year 3 month T-Bills were trading _above_ par (eg a negative interest rate). But everyone agrees that there is some interest rate below which they cannot go. Posted by: Tim Peterson | May 10, 2009 at 01:39 AM Tim, I couldn't quite tell if you were agreeing with me or not but in any event I think my point was a bit simpler and independent of the details of what constitutes M1 or M2. You hear a lot of people saying that the issue is "an excess demand for money" which certainly sounds as if it can be soved by simply supplying more money. My point is that this is not true, what is actually being demanded is real savings. The problem is that the demand for real savings exceeds the demand for real investment. The story goes something like this: Start on the full employment consumption path and suppose that in aggregate we are attempting to substitute less consumption today for more consumption tomorrow. Absent an unexpected increase in productivity this is only physically possible if the savings are used to expand the capital stock. In normal times when demand for real savings increases it drives down the real interest rate, this accomplishes two things: 1) future consumption gets more expensive relative to current consumption and so people start subtituting away from future consumption and towards current consumption (savings demand falls). 2) required return on real investment falls and so demand for real investment increases (via firms trying to have the marginal product of capital equal the real rate). Thus the falling real interest rate re-equates savings and investment demand. So far in the story money has nothing to do with anything. Now, suppose the real interest rate required to equate real saving demand to real investment demand is negative and for some reason the actual real rate is stuck on zero (this is the liquidity trap which in fact has little to do with liquidity). Now we have a shortfall of aggregate demand and so output falls. So far this can all happen in a world without money and the only solution is to change the real interst rate, make it less than zero, to reduce real saving and increase real investment. Now, in a world that has money the difference ends up held as "money" but in this case that just means units of account. It's not money or liquidity that people want, what we want is to substitute more consumption tomorrow for less today. So, suppose that we do increase the money supply, say by dropping money from a helicopter. However, it is understood that the extra money supply will be withdrawn tomorrow so that this doesn't generate any increase in expected inflation. Now, remember that at full employment (with the zero real interest rate) we both want to trade less consumption today for more tomorrow but because of the lack of investment opportunities it's not possilbe. Now the helicopter money comes, suppose I spend my share and you save yours. I get extra consumption today (equal to the amount you sacrifice) and you get extra consumption tomorrow. The result is that you've accomplished what you wanted but I've done the opposite. So I also want to save my money today just to keep up with you. Of course if the extra money is permanent then we expect thta tomorrow we'll get inflation which lowers the real rate today... But extra money today solves nothing. Posted by: Adam P | May 10, 2009 at 04:45 AM AdamP: You seem to grasp the basics of macroeconomic theory pretty well, but you get a few points wrong. Firstly, it is not necessary to expand the capital stock to substitute consumption tomorow for consumption today. If I spend $100 less now, buy 40 tins of heinz tomato soup and store them for a year, I can consume said soup at that time. http://delong.typepad.com/sdj/2009/05/i-will-never-understand-chicago-today.html
Page 9 of 11
Cryptic Note to Self: I Will Never Understand Chicago Today...
6/17/09 9:30 PM
now, buy 40 tins of heinz tomato soup and store them for a year, I can consume said soup at that time. I can also hoard money for the year then spend it. Consumption and GDP would go down and then up again if everyone did that and there was no corresponding change in the money supply. If there was, the government bond purchases/sales used to implement the money supply change would have ripple through effects and produce changes in investment that corresponded to the changes in savings. The definition of M1 & M2 matters because money, esspecially under the bank account definition, is an asset that is used in peoples portfolios along with stocks, bonds and businesses. In the limit, where the banking system is nonfunctional, people save by accumulating money in safes and safety deposit boxes. Slightly more advanced macro theory, developed by Keynes and refined by Hicks (IS-LM analysis) and Friedman, shows how the accumulation of money as an asset depends negatively upon the difference between the rate of interest that the money pays and the rate on alternative assets. Going back to your savings increase example, as interest rates fell in response to the attempted substitution of future for current consumption, people would want to hold an increased proportion of their wealth in the form of money. They would try and build up their bank balances instead of buying bonds, and even sell bonds & deposit the money. Unless enough money was created and injected into the economy with a bond purchase (ie an open market operation), this reduced demand and increased supply for bonds would work against the initial fall in interest rates, specifically preventing interest rates from falling enough to generate an increase in investment that balances the higher savings rate. Keynes' analysis ends here. Because of variable demand for money as an asset, interest rate movements are not large enough to equilibrate savings and investment at full employment, and an underemployment equilibrium results from the increased savings rate. Friedman agreed with this as a short run analysis. But he traced the process a stage further. The unemployment resulting from the above situation would put downward pressure on wages and prices. The lower price level would increase the real value of the money stock. People would now have more money than they wanted in the bank, and be inclined to shift their portfolio back into bonds. This shift would push interest rates down to the level needed to restore full employment. Now for the liquidity trap. Keynes identified the role of liquidity in the minimum interest rate situation, because people are indifferent between holding bonds and money in this case; they just don't care what proportion of their portfolio is in bonds, and what proportion in money. A fall in the price level thus doesn't make people want to hold any more bonds, and in any case it is not possible for interest rates to fall any further. As I explained earlier, an increase in savings will simply transfer money from circulation to idle balances until the fall in activity has played out. Also Friedman's candidate equilibrating mechanism doesn't appear to work; people don't want to hold more bonds as the price level falls. I say doesn't appear to work, because Friedman insisted on distinguishing between different types of bonds; specifically between short bonds like 3 month treasury bills and long bonds like 30 year treasury bonds. It is possible for short rates to be at their minimum while long rates are way above their minimum (the situation in the US at the moment!). The long bonds are most definitely not perfect substututes for money in this case. Beause of this, an increase in the real money supply (wether due to the Fed or a fall in the price level) will cause peole to buy long bonds. This will drive down the interest rate on long bonds and stimulate expenditures in the economy (expenditures are more sensitive to long term interest rates than short term interest rates). This analysis suggests that the economy would be self correting if given enough time (just wait for mild deflation to set in and hold the nominal money supply constant). It should be pointed out, though, that the suffering in the short run is very, very real, and we should strive to end it as soon as possible. One last note: in your analsysis of the liquidity trap you consider a situation where the money supply is permenantly increased and inflation expectations go up. Two points: 1) You have to assume a mechanism like Friedman's (or a theoretical curiousity like the Pigou effect) for this increase to be inflationary. Otherwise, the increased money just sits idle. Since money and bonds are perfect substitites, people lazily sit around and http://delong.typepad.com/sdj/2009/05/i-will-never-understand-chicago-today.html
Page 10 of 11
Cryptic Note to Self: I Will Never Understand Chicago Today...
6/17/09 9:30 PM
inflationary. Otherwise, the increased money just sits idle. Since money and bonds are perfect substitites, people lazily sit around and let the government swap money for bonds without doing anything at all in response. No fall in interest rates, no increase in demand, no inflation and no reason to expect inflation. 2) If the Friedman analysis holds (which I think it does), then the lower real interest rate can restore full employment. - Tim Posted by: Tim Peterson | May 10, 2009 at 11:08 PM Tim: "Firstly, it is not necessary to expand the capital stock to substitute consumption tomorow for consumption today. If I spend $100 less now, buy 40 tins of heinz tomato soup and store them for a year, I can consume said soup at that time. I'm assuming the 40 tins cost some money, say $100. Tim again: " can also hoard money for the year then spend it. Consumption and GDP would go down and then up again " Here you're just wrong (or perhaps misundersood what I'm saying). I said that on the full employment consumption path we want to subtitute more consumption tomorrow for less today. You're hoarding money example does mean we consume less today, however without more productive capacity our consumption tomorrow is no higher than it would otherwise have been. (It is higher than our artificially reduced first period consumption but that's not the trade we wanted. What we wanted to do was increase consumption tomorrow relative to its original full-employmnet level.) Posted by: Adam P | May 11, 2009 at 10:43 AM Tim you are correct that I was implicitly assuming that consumption is non-storable though. Posted by: Adam P | May 11, 2009 at 10:45 AM AdamP: You are right: I miunderstood the point you were making about raising consumption relative to what it would have been. - Tim Posted by: Tim Peterson | May 11, 2009 at 10:03 PM
The comments to this entry are closed. Me: Economists: Juicebox Mafia: Moral Paul Krugman Ezra Klein Philosophers: Mark Thoma Matthew Yglesias Hilzoy and Cowen and Spencer Friends Tabarrok Ackerman Crooked Timber Chinn and Dana Goldstein of Humanity Hamilton Mark Kleiman and Friends Eric Rauchway and Friends
http://delong.typepad.com/sdj/2009/05/i-will-never-understand-chicago-today.html
Page 11 of 11