Arnold Kling  

Tyler Cowen on Macro (and me on Bizarre Monetary Theory)

Attention, Twits... Why Not Restore Glass-Steagall...

Read the whole thing.

He likes the Recalculation story, which he points out he articulated last December.

But he doesn't really buy my bizarre monetary theory. He writes, "I see the Fed as controlling nominal gdp but not always real gdp."

Let me start this way. There is a short run in which monetary policy cannot control nominal GDP, and there is a long run in which monetary policy cannot control real GDP. That is, there is a short run in which M affects only V and a long run in which M affects only P.

Suppose we measured GDP on a weekly basis. What can the Fed do this week that would affect nominal GDP next week? I say "nothing." Maybe Scott Sumner wants to say, "the Fed can change expectations," in which case we can start our argument there. I don't think that the expectations that matter for next week's nominal GDP are expectations that can be changed quickly. Or maybe Sumner will concede that next week's nominal GDP is given, so that for next week any big increase in M will result arithmetically in a big decrease in V.

In the long run, the neutrality of money says that M affects P, not Y. We can go with that long-run neutrality, although V changes a lot over time due to new methods for processing transactions.

So, the question is whether there is a medium run in which M affects Y. My bizarre monetary hypothesis is that the answer is "no." That is, I believe that the medium run usually looks like the short run, in which changes in M show up as changes in V. The medium run only looks different if the central bank is engaging in a regime shift, changing the long-term trend of M and P.

The long-run trend of M affects the long-run trend of P. If people get used to low inflation, there will be low inflation. If people get used to high inflation, there will be high inflation. It takes a long time to change what people are used to.

In my hypothesis, the central bank can only change behavior by undertaking a long term regime change. This necessarily involves a long lag, since people only internalize regime changes by observing the outcomes over a period of years. It is unlikely that the central bank can fight a short-term cyclical downturn with a regime change that requires several years to take hold.

In short, the bizarre monetary hypothesis that I am proposing is that monetary policy only affects nominal expenditure in the long run, and in the long run monetary policy affects inflation rather than real output.

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COMMENTS (6 to date)
Tyler Cowen writes:

Fischer Black argued for your view. He pointed out that if M goes up, banks can use that money to repay the Fed or perhaps send that money outside of the banking system. Whether they will is one question, another is whether that response can hold at all relevant margins. Still, I feel that Black's argument has never been taken seriously enough.

winterspeak writes:

ARNOLD: You are correct, the Federal Reserve bank can do nothing to impact nominal GDP in the short run. All it does is shuffle assets within the Fed around, which effect interest rates (price) but not savings (quantity).

Fiscal policy can, of course, impact nominal GDP immediately.

There is a medium run M which impacts Y. V changes not because of "transaction technologies" buy because private sector savings desire changes. Right now it is low. 3 years ago it was high. Different animal spirits, different V, same technology. Therefore, in periods where V is low, so low it reduces employment (and thus makes Y fall), higher M can increase aggregate demand again by raising employment, raising Y, and not having P become inflationary large (although you have prevented it from becoming deflationarily small).

Higher M can happen through industrial policy, or through tax cuts, but it really cannot happen through increasing reserves at banks or through interest rates (certainly not in the short term). Bank lending is not reserve constrained. There is no such thing as the "money multiplier".

TYLER: I'm more aware of Fisher Black's debt deflation work than his arguments over M. Remember though, his work was done while the US was still on a gold standard, and we are no longer in that regime today. Banks are not reserve constrained in their lending.

thruth writes:

Suppose we measured GDP on a weekly basis. What can the Fed do this week that would affect nominal GDP next week? I say "nothing."

What if you go the other way? Say the Fed credibly commits tonight to raise short rates to 5% for the foreseeable future. Do you think velocity will spring back to life?

Richard A. writes:

"Suppose we measured GDP on a weekly basis. What can the Fed do this week that would affect nominal GDP next week?"

What GDPn does next week is not determined by what the Fed does this week. It's determined by what the Fed has been doing for the past couple of years including what the Fed does this week.

One way to look at it is that weekly GDPn is determined by a weighted moving average of M1 (or some other definition of the money supply)over the past couple of years.

fundamentalist writes:

The ngdp is a quarterly report. The Feds need at least two quarters of data in order to begin to see a trend. Once the feds implement a policy, the lag time to max effect is 4.5 years according to some econometric analyses. So the feds are behind the data by six months and it takes another 4.5 years for the policy to have max effect; you're looking at close to 5 years from the beginning of a problem until monetary policy has an effect. So where do these guys get the idea that the feds can turn ngdp around on a dime? I thought these guys were economists!

Lord writes:

I think it really does matter how the Fed acts and what actions it undertakes to increase M that affect whether it results in a change in V, P, or Y. Printing money and burying it in bank vaults won't do much at all. Buying assets will increase the price of those assets but will take time to diffuse over general prices. Lowering borrowing costs for the indebted can translate quite directly into income. A credit crisis makes all this more difficult as assets lose their value, borrowers their creditworthiness, earners their incomes, and the Fed could well use more direct means of increasing incomes (Fed debit cards), but none of these become totally ineffective.

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