Bryan Caplan  

Noisy Monetarism: An Answer to Arnold's Challenge

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In response to my criticism, Arnold writes:
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.
I think Arnold's Criteria #1 conflates two distinct positions:

Variant A: Increasing/decreasing some measure of the money supply reliably increases/decreases Nominal GDP.

Variant B: Nominal GDP only increases/decreases when some measure of the money supply increases/decreases.

Arnold's implicitly assuming Variant B.  On this assumption, I can't meet Arnold's challenge.

However, my position (and I think the position of most economists, at least pre-2008) is Variant A.  And under Variant A, my answer to Arnold's challenge is simply the monetary base.

Think of my position as "noisy monetarism."  NGDP fluctuates for lots of reasons, but changing the monetary base still reliably changes NGDP relative to what it would have been.  Arnold's correct to observe that the Fed massively increased the base in 2008 as NGDP fell.  But if the Fed hadn't massively increased the base in 2008, I say that Nominal GDP would have fallen vastly more than it did.  There was a huge increase in money demand in 2008, and the Fed only partly accomodated it.

I can see why Arnold might find my position dogmatic, but I think it's the most reasonable position.  As I I explained in my original post, the quantity theory isn't just intuitive; it also passes the clear-cut tests - historical episodes of high inflations and high deflations.  The rest of the time, the world is too noisy to convincingly confirm or falsify the quantity theory.  And if intuition and the most probative tests support a position, so should we.

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COMMENTS (13 to date)
roversaurus writes:
There was a huge increase in money demand in 2008, and the Fed only partly accomodated it.

After years of looking at the Fed I still don't understand what the heck it is doing. I don't really understand the above sentence.

What do you mean an increase in money demand???
To be simplistic isn't the demand for "money" infinite? If money represents the "ability to get more stuff" and human wants are unlimited then I always want more money.

Do you mean people wanted more physical bills and they weren't available? For example if everyone converted their mutual funds and savings accounts into actual cash in their wallet there would not be enough physical dollar bills to satisfy it?

I don't think that is what you mean.

So what in the world does your sentence mean? Please assume that I am an idiot in this matter.

Doc Merlin writes:

Now that reserves pay interests, I don't think you are correct. Its also not a falsify able position that you take.

Rebecca Burlingame writes:

This is where it gets crazy for me, in that money demand presently originates not in our individual productive capacity, but our capacity to want yet another loan. (Whether we meet loans with our skills is still beside the point, does the loan originator care if we rob banks to pay?) And if I am reading this correctly, the increase in money demand says we want more loans. What if we just wanted the ability to match our skills with money a bit better and not in the sense of needing a loan?! Perhaps someone can enlighten me.

Mike Sproul writes:

Every episode where the money supply rose relative to real output was also an episode where the money supply rose relative to the assets backing that money. The quantity theory and the backing theory are observationally equivalent. The few studies that have addressed this point (Sargent, Cunningham, B. Smith, Calomiris, Siklos, Bomberger, Makinen, etc.) have found that the backing theory fits the data better than the quantity theory.

Richard A. writes:

Let's not forget that the massive expansion of the monetary base was accompanied by the collapse of the money multiplier as a result of the Fed paying interest on reserves. The Fed needed money to buy MBSs, but at the same time they did not want a massive expansion M1. Their solution -- drive down the money multiplier.

Lord writes:

Let's not forget the significant difference between now and the 30s, while asset prices have fallen, the price level hasn't dropped. The Fed's problem is it cares more about its constituents the banks than the country so they consider that enough.

Lee Kelly writes:

I am surprised that Kling misunderstood your position the first time. It has me wondering how often you all have been talking past one another.

Arnold Kling writes:

What is your explanation for the fact that the monetary base exploded late in 2008 and the price level stayed flat?

If you are going to argue that the demand for base money fell precipitously, then how can I possibly respond? Obviously, any variation in the ratio of PY to M can be "explained" as a shift in V. In this case, I just don't find that explanation terribly satisfying. If the change in the monetary base in 2008 was not large enough to affect PY, then what does it take?

Scott Sumner's explanation is that the Fed started to pay interest on reserves. That has the advantage of being a plausible story. It has the disadvantage of discrediting the monetary base as a reliable indicator of monetary policy.

Lee Kelly writes:

Arnold said: "What is your explanation for the fact that the monetary base exploded late in 2008 and the price level stayed flat?"

Surely this question has already been answered by Bryan: "But if the Fed hadn't massively increased the base in 2008, I say that Nominal GDP would have fallen vastly more than it did. There was a huge increase in money demand in 2008, and the Fed only partly accommodated it."

rjw writes:

I commented on Arnold's original post, arguing that the QT should be rejected for three reasons, which I will quickly repeat, as they remain valid

- reverse causality
- unstable velocity
- output isn't fixed

But rather than flog those again, I'd like to pose a question.

Monetarists often present their world view as intuitive ... .. more money chasing goods, so prices go up. The problem with this, it seems to me, is that monetarists generally don't really give any reason why 'excess' money balances chase GOODS.

If people hold 'excess' money, why not make a portfolio shift into other assets ? Or use 'excess' money to extinguish debt ? Why does 'excess' money mean people spend more on goods, as opposed to making a portfolio shift into other monetary assets ?

Now, clearly not everyone can shift out of money, so the net effect would be to change relative prices of monetary assets such that people now willingly hold the excess balances. But I don't really see why 'excess' money balances should necessary lead to proportional extra demand for goods.

Lord writes:

It needn't and that is why it is only approximate. Money may flow into assets, or debt liquidation, but keep pouring until satiated and it will flow into prices. At some point people will say they are wealthy enough, their debt is low enough, their income is enough they can revert to fulfilling their desires, after all, that is what money is for.

rjw writes:

Lord, if we were talking about money dropped out of helicopters I could agree. Drop enough and people will spend some of it. The closest parallel I can think of is the spanish looting south america and shipping the gold back to europe. That was pretty close to helicopter money, and had similar effects. But in a modern monetary economy money does not enter the system that way and never has. That's why the helicopter money analogy is generally not accepted by critics of monetarism, who point out that it assumes away exactly what is important: ie the mechanics of how money is actually created.

Lord writes:

I have to agree with you there. The Fed can lower borrowing costs or increase asset prices or buy government debt and it would work but may need too great a scale to be acceptable while providing another means could be immensely more efficient.

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