Bryan Caplan  

Fama and Fiscal Policy

Boo, Eugene Fama... What If Fama Was a Protectioni...
I disagree with both Fama and Arnold's critique of Fama.  Fama's strangely trying to use an accounting identity to make inferences about causation.  No can do.  But Arnold seems to say that fiscal policy matters as long as there are unemployed resources:

Basically, Fama says that national savings equals national investment. So, if the government deficit goes up and private saving is unchanged, then investment must go down. Therefore, the argument runs, a government deficit crowds out private investment and does not raise output.

That story holds for an economy that is always at full employment. However, if the economy were always at full employment, then hardly anyone would have heard of a fellow named John Maynard Keynes, and we would not be talking about the issue of an economic stimulus.

That's wrong too.  Even in a word of unemployed resources, fiscal policy is impotent if money demand elasticity is zero.  In intermediate Keynesian terms, if the LM curve is vertical, fiscal policy has no effect even if the AS curve is horizontal. 

Who cares?  Well, I've previously argued that this "special case" is probably close to the truth.  The Keynesian view that money demand has appreciable interest elasticity is almost as fanciful as the Real Business Cycle view that labor supply has appreciable interest elasticity.  Maybe I'm wrong about this; Mankiw says so (though here's my reply).  But in any case, this abstruse issue of the interest elasticity of money demand is what economists should be debating - not the silly question of "whether unemployed are possible."

Comments and Sharing

COMMENTS (9 to date)
dw writes:

you pasted the quote as a link there.

might want to review and edit this.

dearieme writes:

I hope that Mr Henderson will weigh in on this.

P.S. although I'm delighted that there are now three Econbloggers, is that portrait entirely wise? Larry, Curly and Moe, some might think.

Barkley Rosserr writes:

And you became a fan of ISLM when, Bryan?

I still don't understand why using an identity to explain the world is the wrong thing to do. I sat in a price theory course with Gary Becker and Kevin Murphy and they always ask rediculous questions about what some random equation means for society.

Bill Woolsey writes:

If you think about negative nominal interest rates, and the reason why they are "impossible" you get an perfectly elastic demand for zero interest currency at an interest rate near zero.

The actual interest rate on bonds is near zero, but an increase in the supply of bonds just reduces the demand for currency--in this special situation.

More generally, the interest elasticity of the demand for money makes sense for a measure of money that has sticky interest rates, and then only in the short run--the run over which the
interest rates on the money are sticky. Regulations, of course, might make this short run
quite long.

If you start expanding the measure of the money
supply to include assets that have flexible interest rates, then any shifts would be between
parts of the money supply.

Caplan's "intuition," is really a matter of his experience. He has never found it worthwhile to actively trade something counted as money for something not counted as money based on differentials in interest rates in order to make sure his checks clear.

If you are a corporate treasurer, how much should be keep in your checking account? Your checks need to clear. Should you buy eurodollars?
How about some overnight corporate paper? T-bills? The corporate treasures call it all "cash." But we economists call only some of it "money."

Perhaps Tobin's formula is a little simplistic,
but transactions costs and the opportunity cost
of holding money should impact "optimal" money
blanances. Just because Caplan (and I) are deep
in the corner where we just hold money doesn't
mean everyone is. Their demand for money depends on interest rates. Ours doesn't. Add
together and the total does.

I have excess money, and I go out to eat. I never
"park" the money by calling some kind of security
dealer. But the money I spend goes to someone else, giving them excess balances. They spend it.
Eventually, we get to someone who buys securities with excess money. This tends to lower interest rates. Generally, interest rates don't fall to zero. Why not?

When I am short of money, I tell my wife to spend less, and I buy cheaper things at my daily trip to Piggly Wiggly. I don't have a portfoilio of
liquid securities to sell. I just spend less.

But if I spend less, that means that Piggly Wiggly has less money. Now, I think that Piggly Wiggly actually does hold securities to sell to make sure they have enough money to make payments.

But when they sell them, the buyers have less money.

And on, and on.

Some people sell securities to come up with the money, and interest rates rise. Do they rise to
infinity? No, they rise until some people are willing to hold the securities rather than money. Until money demand falls to meet the supply.

If the interest rate elasticity of the demand for money is very low, then huge changes in the interest rate must be necessary to cause money demand to adjust to money supply. Or else, the price level (really the prices of things other than securities) adjusts. Or total production adjusts.

And, of course, the econometrics is about trying to sort all of this out.

I have never had a problem with accepting that there are a bunch of corporate treaurers out there who adjust the demand for some kind of money to the supply in response to changes in interest rates.

Perhaps I am wrong.


Fama and Caplan should have mentioned that in reality, the Federal Reserve is going to increase the money supply to finance the additional government spending. The LM curve is going to shift to the right. The concept here is that both with shift to the right, meeting at the horizontal axis. Monetary policy won't work now because the US is where the IS curve crosses the horizontal axis.

mk writes:

Why does new government debt crowd out investment at a 100% rate? Government debt is not a perfect substitute for equity or corporate bonds due to its different risk profile. So if government debt becomes more lucrative to hold, it still won't necessarily reduce my holdings of other assets. Am I missing something?

Bill Woolsey writes:

Government debt isn't exactly the same as equity or other assets. True. But where do you get the money to hold the additional debt?

It is a budget constraint argument, not a perfect substitution argument.

John Seater writes:

ISLM actually is a perfectly good tool, *provided* it is augmented by the aggregate supply curve (call it AS), which is essentially the aggregate production function. Once that is done, it becomes apparent that in response to movements in AD (e.g., fiscal stimulus), the interest rate moves to the intersection of AS and AD. That determines GDP and also the distribution of GDP among C, I, and G. The price level then changes to move the LM curve to the intersection of AS and AD. The slope of the LM curve is irrelevant to real side behavior, determining only the size of the price adjustment necessary to restore general equilibrium. We can augment this story to include expectational errors and temporary deviations from long run equilibrium, which would allow transitory real effects of monetary surprises, that is, by fooling people, which almost by definition is suboptimal. All this stuff was discussed literally decades ago in Mansfield's 3rd edition of his macro text.

The main thing to note is that output is determined by the intersection of AS and AD. If AS is nearly vertical, even large changes in the interest rate have little effect on output, and fiscal policy has almost no effect on the volume of output, only on its composition. If AS is nearly flat, small changes in the interest rate elicit large changes in output, and fiscal policy is potent. Capital is fixed in the short run, so its interest elasticity is zero. The evidence seems to be that labor's interest elasticity is positive, statistically significant, but small in magnitude. All this suggests a very steep AS curve and thus impotent fiscal policy. The slope of LM is irrelevant.

Barkley Rosser writes:

Bill Woolsey,

But negative nominal interest rates are not impossible. They happened several times this fall. Also, they happened periodically in the repo market during August-November, 2003 as reported in an NYFRB paper. And they occurred in Japan off and on in the late 1990s (that was a period of deflation). Probably the first time they ever occurred was during the day for the federal funds rate on December 31, 1986, although that was never reported in any official documents.

Comments for this entry have been closed
Return to top