Arnold Kling  

Bryan: Define Money

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Bryan writes,

Out of all of Arnold's macroeconomic views, only one strikes me as truly absurd: His skepticism about the ability of central banks to affect nominal GDP and other nominal variables.

Here is my problem. Nominal GDP is measured in a way that uses money as a unit of account. The central bank affects the quantity of some physical monetary aggregate. Those are not necessarily the same.

For example, suppose that the Fed swaps dimes and pennies for nickels, cutting the supply of nickels in half. I contend that nominal GDP, measured in dollars, will stay unchanged. Scott Sumner is prepared to argue differently, but I find that odd on all sorts of counts. If you think of currency as the key nominal aggregate, exchanging dimes and pennies for nickels does not change the total amount of currency outstanding, so why should it change nominal GDP, even if you believe the quantity theory of money?

So, if you are with me so far, then you agree that the Fed cannot just engage in any old open market operation and change nominal GDP. It has to increase an M that "matters" for nominal GDP. What I want you to do is choose a definition of M, stick to it, and then tell the empirical story.

If you choose the monetary base, you will have a big problem with the fall 2008 episode, when the Fed pretty much doubled the monetary base and nominal GDP did not even rise, much less double. If you choose a broader definition of money, then you are choosing an aggregate that the Fed does not exactly control.

We know that a country can debase its currency if it really is determined to do so--which is what happens under hyperinflation. This occurs when a country whose budget deficit far exceeds the amount it can borrow, and it just prints money to cover the shortfall.

I think that the Fed could debase our currency, too, if it were really determined and followed pretty drastic policies for quite a long time. However, within the range of realistic policy moves, there is only a loose relationship between the monetary aggregate that the Fed controls and any monetary aggregate that will correlate closely with nominal GDP. Hence, the relationship between what the Fed does and nominal GDP is going to be a loose one.

So my challenge for Bryan (and for the rest of the profession, because I am the one who is out on a limb on this) is to come up with a definition of money that satisfies two criteria. First, your monetary aggregate is correlated with nominal GDP in a reliable way (with "reliable" including that if you were to target it, the relationship would not fall apart). Second, the Fed controls that monetary aggregate reasonably closely.

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CATEGORIES: Macroeconomics , Money

COMMENTS (16 to date)
ionides writes:

Totally coherent except for the dimes and pennies story. I can't make, well, heads or tails of it.

Eelco Hoogendoorn writes:

I think what is being ignored here is that even though the monetary base might represent only a small fraction of monetary instruments, and therefore inflating it does not change the overall money supply radically, the fiat currency does have a special position in the sense that it has a preferred role as a unit of accounting: the vast majority of long term contracts are denominated in terms of some fiat currency, not in terms of an arguably more sane and less easily manipulated monetary unit.

Thats where the power of the FED to pander to political interests, and disrupt the economy comes from. Doubling the amount of dollars makes me a happy debtor, if I have a debt in dollars (that is, assuming I wasnt so painfully aware of the distortion rendered upon our economies). That effect is very real.

As for the nonlinearity you suggest (small changes have no effect, large changes have large effects): im not seeing the mechanism responsible for such a type of effect. If your theory holds, then why doesnt it hold 'all the way'?

Adam writes:

The reason that the monetary base doubled but nominal GDP shrank was because that money never left banks' reserves. And that wasn't just because the banks didn't feel like taking it out--the Fed paid interest on those reserves in order to discourage putting that money out into the economy. The Fed could increase any definition of the money supply today if it stopped paying interest on reserves--or if it started charging a penalty on excess reserves.

Richard A. writes:

The Fed doesn't just control the monetary base, it also controls the M1 money multiplier (mm). In the past mm was controlled by setting reserve requirements. Since 2008 what the Fed pays banks on reserves also determines mm.

mlb writes:

It is true that the Fed paid interest on reserves but what the banks do with those reserves is still the main driver of GDP. If the Fed suddenly stopped paying interest on reserves and banks decided to put all their reserves in gold instead of at the Fed, NGDP wouldn't budge (the impact from the gold mining industry would be tiny).

jsalvati writes:

More importantly, the Fed has always maintained that the monetary injection is temporary. They always mention that they will soon need to withdraw money from the economy.


Is it really that hard to understand that expectations of the future money supply are important?

Joe in Morgantown writes:

M1 is clearly in the category of "too narrow to be useful".

Any measure of money that doesn't include money markets is a measure for some other century. Any that doesn't include lines of credit is dubious.

Zdeno writes:

If you accept that a government can create hyperinflation, just imagine the same policies being pursued in a less extreme form. Mugabe was "successful" at creating inflation because he credibly committed, as it were, to not reducing the money supply at some future time period.

As for your challenge, I say M1 is fine as long as you include expectations. Debt and reserve ratios enter the picture, but all monetary policy variables cower before the current and expected future growth path of M1.

Richard A. writes:

If the Fed did not pay interest on reserves the banks would have to charge a fee or negative interest on deposits to cover operating costs.

Guess what would happen to bank deposits.

David Pearson writes:


Expectations are driven by narratives. Narratives, in turn, describe mechanisms. What is the mechanism through which the Fed affects future expectations of the money supply that matters? Kling proposes two: currency devalutation and deficit monetization. These have long and convincing track records as levers that a central bank can pull to influence nominal gdp. In countries like Brazil, for the central bank to manufacture inflation, all it takes is the announcement that the government is increasing public sector salaries--it was a given that the central bank would pay for the increase. So what Kling is asking, I think, is what is your mechanism for impacting expectations? A press release from the Fed? Or some narrative about how inflation will actually occur.

Curt writes:

If I follow this correctly, it seems like Arnold is arguing that there are practical limits on what a responsible Fed can actually influence.

I can't help feeling that I'm missing something around money supply and credit. It seems clear that GDP was pushed upward in the housing bubble years by the creation of more and more money through mortgages and equity lines (perhaps just continuing a trend that got started with credit card debt expansion). When those sources of 'money' dried up in 2007-08, it seems inevitable that consumer spending drops, and thus GDP. And what can the Fed do about that, short of actually cutting checks to consumers to spend?

Making sure the banks have reserves helps prevent runs on banks, but does not put that money into circulation unless, as mentioned, the banks loan it out at the same pace as before.

JFox writes:

Very tough assignment. I would suggest removing the requirement that the Fed affect what we are defining as "money" since I think there are many instruments that are money-like that the Fed doesn't control.

I think you also need to determine what you mean conceptually by "money". Are you talking about money only insofar as it can affect a transaction, or more broadly as a store of wealth, or some combination of the 2.

I think you have a very complex issue here. I would suggest probably at least one chapter in your textbook on different concepts and definitions of "money". Personally I find many of the central bank and economists definitions of "money" to be pretty bad. I think this is an area of economics that is neglected, at least as far as I know. I'm not in academia so perhaps I'm wrong.

fundamentalist writes:

I have to go along with Dr Kling on this one. As Hayek and Mises emphasized, the monetary theory isn't mechanical. It's a general tendency with a lot of exceptions. I think Fed monkeying with interest rates and open market operations affects assets. That will eventually filter down to the real economy, but it takes years. Asset bubbles result from Fed credit creation but the real economy pops them. The Fed giveth, but the real economy taketh away.

And as Dr Kling wrote, price inflation only happens when the guv does the borrowing. Of course, the Fed must goose credit so that the guv can borrow, but then the guv spends his money on goods and services and salaries and then we enjoy hyperinflation.

Philo writes:

"First, your monetary aggregate is correlated with nominal GDP in a reliable way (with "reliable" including that if you were to target it, the relationship would not fall apart)." I think you are slightly misconceiving Sumner's program. He does not claim that there is a simple functional relationship between M and NGDP; all sorts of factors besides M influence NGDP. But M is *one important factor*, and if you knew what all the others were (so long as they were within a fairly normal range) and what the functional relationship was, you could determine NGDP by manipulating M. Now, even though the Fed doesn't control all the other causal factors--and probably doesn't even know what all of them are--and even though it doesn't know what is the functional relationship between them and NGDP, a *futures market* in NGDP would show the Fed how to manipulate M so as to hit its NGDP target.

Jeff writes:

I think you're missing Sumner's point. He's repeatedly said that the best measure of the stance of monetary policy is expected nominal GDP. He doesn't care about M1, M2, the monetary base or the federal funds rate. Sumner's policy prescription is simple: the Fed announces a target for expected NGDP and a way to measure it, presumably through NGDP futures. Then the Fed engages in open market operations until its measure of expected NGDP is close to the target.

Since this is a feedback system, you don't need to know which aggregate is the "correct" one, nor do you need to have an accurate model of the economy. When you drive your car, you don't calculate precisely how much accelerator pressure you need to maintain a particular speed. You just apply enough pressure to accelerate, and when you get to the desired speed you back off.

Noah Yetter writes:
First, your monetary aggregate is correlated with nominal GDP in a reliable way (with "reliable" including that if you were to target it, the relationship would not fall apart).

Impossible. Goodhart's Law.

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