Arnold Kling  

I Hate Monetary Theory

What Responds to Interest Rate... Challenge to Cowen and Gilbert...

Bryan writes,

People adjust their borrowing to interest rates all the time. But cash balances? That's hard to believe.

Who cares? In practice, the Fed has its famous three tools--the discount rate, the reserve requirement(s), and open market operations. In the latter, it fiddles in the repo market.

When the Fed fiddles in the repo market, Bryan says that he does not adjust how much cash he carries in his wallet. Neither do I. But that just means that there is a loose relationship between Fed fiddling and measures of the money supply.

But there is a very tight relationship between Fed fiddling and one measure of the money supply--H, or high-powered money. H is equal to the liabilities on the Fed's balance sheet. The Fed does control that.

There is slack in the relationship between H and cash held by the public. There is slack in the relationship between H and M1, the traditional measure of cash plus checking accounts. There is slack in the relationship between H and M2, which is M1 plus some savings accounts, and is Milton Friedman's favorite definition of "M."

The slack does not stop there, by any means. There is slack between any of the M's and nominal GDP. There is slack between the repo rate (where the Fed does its fiddling) and every other interest rate in the economy. There have been plenty of times where the Fed leaned one way on interest rates and bond market vigilantes, who affect mortgage rates and corporate bond rates, sent rates in the other direction.

If Bryan wants to fight like heck for his theory of the inelastic money demand function, let him. I think it's pointless. In going from textbook monetary theory to reality, there are plenty of more important problems to worry about. Because there are so many problems, my guess is that a good case can be made for all sorts of values for the interest elasticity of money demand, including very low values.

It's a stupid fight to get into. My initial instinct was to stay out of it, and I wish I'd stuck with my initial instinct.

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CATEGORIES: Macroeconomics

COMMENTS (4 to date)
Fritz writes:

During Christmas, the demand for pocket cash rises dramatically, to offset this seasonal phenomena the Fed prevents Byran and the public from noticing interest rates. If the Fed didn't intervene, Banks would be offering 2 week saving certificates at 20% and a service charge to withdrawal cash. The volatility of over-night money markets during this period is dramatic. Yes, I was a Repo Trader. Arnold, the Fed also does bill and coupon passes, some directed at the yield curve.

Lawrance George Lux writes:

You would hate Monetary Theory even worse, if you came to understand the Theory is basically hot air. Government only secures the financial documentation, financial markets create the necessary level of M1, M2, and Bond issuances; the Government simply attempts to assure their redeemibility.

There has only been about three national Recessions because of Bad Paper, all of which did not extend much beyond national borders. Crackpot Monetary theorists, though, have damaged most Economies who utilized the Theory and them. lgl

Matt writes:

Raising interest rates takes cash out of circulation because cash loaned out has a higher return than current consumption? Some of that cash leaving circulation ends up in the fed.

Sounds about rght to me.

Diego writes:

Let me get this strait: Bryan doubts that fiscal policy has any effect on aggregate demand because he claims that money demand (cash balances) are inelastic with respect to interest rates. As evidence that people do not adjust their cash balances in response to changes in interest rates, he offers introspective insights and other people's comments saying they do not adjust in response to changes in interest rates.

Am I missing something?

I bet that if you ask non-economists (and to a lesser extent economists), most would say that they do not adjust their behavior to (unexpected) changes in mandated seat belt laws, lifetime earnings, etc. Yet, research suggests people do. They probably do not do it consciously, but the evidence suggests that on an aggregate level, they do.

Now I have a question: Is it possible that the interest rate elasticity of money demand comes more from changes in the velocity (V) part of the equation?

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