Bryan Caplan  

Mankiw on Fiscal vs. Monetary Policy

Economic Dynamism... Net Neutrality?...

The noble Mankiw has a thoughtful reply to a question from me about the effect of fiscal and monetary policy on nominal GDP. (The question is based on one of my old posts):

How far off is the vertical LM case as a practical matter? One way to answer this question is to look at the fiscal-policy multiplier. In chapter 11 of my intermediate macro text, I give the government-purchases multiplier from one mainstream econometric model. If the nominal interest rate is held constant, the multiplier is 1.93. If the money supply is held constant, the multiplier is 0.60. If the LM curve were completely vertical, the second number would be zero. To return to Bryan's WWII example, taking these estimates literally, if the Fed had held the money supply constant rather than keeping interest rates low, the WWII boom would about been about 1/3 as large as it was.

Where does Mankiw think I go wrong?

I disagree with Bryan's suggestion that the LM curve is vertical, however. Introspection is not a particularly reliable way to measure elasticities. There is a substantial empirical literature on money demand that demonstrates that it is interest-elastic.

I agree that introspection is far from perfect. But in practice, economists form their beliefs based on a weighed average of introspection and econometrics. And we should, becase econometrics is far from perfect too. Even if econometricians agreed, for example, that prime-age male labor force participation was highly responsive to wages, I would still think "I've never heard of a prime-age male who dropped out of the labor market because wages were too low. How can that be?"

From another angle: What happens when econometricians reach counter-intuitive conclusions about elasticities? Example: There was a long period in macro when researchers kept finding that money supply shocks increased interest rates (the "interest rate puzzle"). The main result was that econometricians kept trying different approaches until they finally got the "right sign."

Perhaps the econometrics that was consistent with introspection was of vastly higher quality than all the other approaches. But I doubt it. If we didn't rely on introspection, we'd probably still be saying that "the balance of evidence shows that monetary shocks raise interest rates."

None of this means that were should ignore econometric evidence. But when econometrics and introspection conflict, we should think harder about both - not give econometrics veto power.

P.S. One of Mankiw's commenters writes: "If I didn’t know better, I’d have to conclude that Bryan Caplan was too young to have a bank account in the early 80s."

Guilty, as charged. I'm willing to admit that money demand would respond to large changes in interest rates. But that's still consistent with the LM curve being roughly vertical over the ranges that are relevant today.

Readers' Query: Do you change your cash holdings when nominal interest rates change? Anyone you know?

Comments and Sharing

COMMENTS (10 to date)
Do you change your cash holdings when nominal interest rates change? Anyone you know?

I personally do not, but if you read personal finance blogs you can find many people who would. Without accounting for inflation, many personal finance bloggers compare the interest rates they could get in online savings accounts with historical stock returns to decide how much money to keep as cash and how much to invest.

There is a pretty definitive list of personal finance blogs at

liberty writes:

The rate I get in my savings account determines how much I keep there and how much I invest.

knzn writes:

“Guilty, as charged” … as I now see from your CV, which includes (Is this standard practice?) a birthdate. (I think I had you confused with someone older with a similar name…which explains why you looked so well-preserved.)

Maybe this degenerates into a debate over “how big is big,” but it seems to me that, since your 18th birthday, with the exception of the 2002-2004 period, the nominal interest rate can (for these purposes) almost be reasonably approximated by a constant. Throw in behavioral lags, and it doesn’t surprise me that, given a random sample of your cohort, none can remember adjusting balances in response to nominal interest rates.

But the phrase “adjusted my cash balances” is misleading. Few people would hurry to the ATM after each Fed meeting announcement. But I expect that anyone who had money piling up in his checking account in 2003 didn’t feel much pressure to do anything with it. (Unfortunately I wasn’t such a person, but, based on introspection, I can guess I would have let the money sit there.) Today, though, it’s like, “Damn it, honey, we’ve gotta call Vanguard!”

In the 1970s any interest you earned was well below the inflation rate. So, I learned to borrow money and invest it, in real estate.

I called it selling money short.

James A. Donald writes:

Sure, I am extremely sensitive to interest rates. I take interest rates strongly into account when deciding how long to go on housing and shares, and how long to go on cash.

A small change in interest rates frequently results in very large changes in my investment program.

Robert Book writes:

I know a few "prime-age males" who've dropped out of the labor force because the wage rate (for them at least) was too low. One became a stay-at-home Dad. One laid-off engineer, as far as I could tell, got some binoculars and did a lot of bird-watching and not much else (literally -- he knew a heckuva lot about birds!).

Another dropped out of the "legal" workforce, and does odd jobs like yardwork, painting, and giving rides to the airport (not licensed as taxi or other a passenger carrier). I supposed technically this is not dropping out of the labor force entirely, but if taxes were lower, I'm sure he'd rather take a normal job. He has a college degree.

aaron writes:

Can it be as simple as supply shocks increase volatility and thusly a higher return is demanded?

Mark Horn writes:

I don't know the balance between econometrics and introspection, but as far as your questions are concerned:

  • When I was in college, I knew plenty of people who had no money and refused to work at McDonald's. For the most part, they spent their efforts trying to leach off of their friends. And it worked for a bit. It was a richer experience for them. Not only did they get to eat, they got to hang out with their friends.
  • I don't change the amount of money in my savings account, because what's there is the emergency fund. I don't care about the interest rate for that account. But I do change the relative holdings of my portfolio to try and maximize my return for the risk. The amount that goes from bonds into interest rate fluctuates as the trend of interest rates.

  • I don't know if this counts as support of econometrics, but it's not hard to imagine/remember specific examples in support of the data.

    Roger M writes:

    It seems to me that there would be a lot of noise in the equations that have interest rates determining cash holding. As the Austrians say, time preference is a big factor. Other factors include age, marital status, income, how fast prices are rising. I have to keep more cash now that the price of gas has gone up. One problem with econometrics is that it assumes people are far less complex than they really are.

    Fabio Rojas writes:

    On the issue of cash holding, the issue seems to be tied to your income:

    People only the lower end of the income curve have little in cash savings so the issue is moot (there is no cash to shift to investment - it's all spent on living expenses).

    People in the middle vary. The key variable is probably knowledge of financial investment, which in the Bryan world is essentially IQ. Maybe the right way to say it is that the average person doesn't shift cash, but there is huge variation around this mean.

    At the higher end of the income curve, people are either knowledgable about finance or can hire professional money managers. For the wealthy, we can probably expect fast responses.

    The overall question is empirical - are overall cash balances driven by the wealthy and knowledgeble, or by the middle class investor with their savings accounts? I don't know the answer.

    Comments for this entry have been closed
    Return to top