Arnold Kling  

Two Basic Macro Questions

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1. Does the Fed matter? Vincent and Carmen Reinhart write,


First, spending and pricing decisions are assumed to be based on long-term assessments of real income and real rates of return. Second, changes in monetary policy can only change real interest rates temporarily. Ultimately, the forces of productivity and thrift determine them, not changes in nominal magnitudes on the central bank balance sheet. Combining the two propositions implies that the Federal Reserve's interest rate policy, as long as it stays within the narrow range of experience, would not be expected to have a significant or long-lasting imprint on markets or activity.

I have expressed this view before. The difference is that I never tried to demonstrate it empirically. The point of the Reinhart and Reinhart paper is to demonstrate empirically that central bankers can only make a big difference if they make really big policy changes. I believe that there is a very large Fed attribution error--people attribute to monetary policy far too much power. This puts me at odds with Scott Sumner and John Taylor, among many others.

Speaking of Sumner, he resurrects a debate about the Phillips Curve that was conducted in the 1970's.


My approach to macro has always been "nominal shocks have real effects." As a result, I've never cared for the Keynesian view that inflation was caused by an overheating economy, and disinflation was caused by economic "slack." If that were true, then it would be the case that "real shocks have nominal effects." I.e. changes in real GDP affect inflation. And that just didn't seem right.

When we called it the Phillips Curve, there was the question of whether unemployment was the causal variable (the original interpretation) or inflation was the causal variable (the Friedman-Phelps interpretation).

When the Phillips Curve morphed into Aggregate Supply and Demand, this question was finessed. You do not ask whether price causes quantity or quantity causes price. You talk about supply shocks (a shift to the right lowers P and raises Q) or demand shocks (a shift to the right raises both P and Q).

In the current setting, it appears that economic activity is expanding and inflation is higher than it had been. One may choose to interpret this as resulting from the Fed's quantitative easing. However, I am not signing onto that one. I recall reading recently that QE 2 was basically canceled out by offsetting changes in Treasury funding operations. That is, as the Fed bought more long-term bonds, the Treasury issued more long-term bonds relative to short-term securities. So we are left with the channel that the Fed announced a higher intended path for nominal GDP, and this was self-fulfilling. Strikes me as a very difficult proposition to prove or disprove.


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COMMENTS (9 to date)
Noah Yetter writes:
If that were true, then it would be the case that "real shocks have nominal effects." I.e. changes in real GDP affect inflation. And that just didn't seem right.

Of course changes in real GDP affect "inflation" (when inflation is improperly defined as an increase in the price level, rather than an increase in the money stock).

1. start with a fixed money stock (or even just relatively stable)
2. add GDP growth
3. money prices will decline, as the same amount of money chases more goods

I lose more respect for Sumner every time he opens his mouth. The above is essentially what happened in the USA prior to the founding of the Federal Reserve. I would have assumed he was familiar with this very important chapter in monetary history.

Philo writes:

Contrary to the Reinharts, spending and pricing decisions are not based exclusively on long-term assessments: short-term assessments matter, too. Monetary policy can affect important real variables, even if not in the long run. *Ultimately* monetary policy doesn't matter, but ultimately we're all dead. Besides, a succession of monetary policy mistakes, each producing a short-run negative effect, can produce a very prolonged depression.

Philo writes:

Re the debate whether "real shocks have nominal effects":

To defend Sumner against Noah Yetter's complaint, one might say that (a) Sumner was assuming a fiat currency, not the gold standard that existed during the deflation of the late 19th and early 20th centuries, and (b) the fiat-monetary authority has the power to maintain the important real variable (variables?) on a steady path, and this should be its routine policy, so any departure of said variable from its proper path must be due to a departure by the authority from the correct policy--a "nominal shock."

Is this defense adequate, or does it reflect an inadequate conception of "nominal shock"? I do not know; my own conception of the real/nominal distinction is too fuzzy.

AMW writes:

1. Does the Fed matter?

What's the second basic macro question?

david writes:

@Noah Yetter

Don't start with a fixed money stock; the money stock isn't fixed. Start with a fixed interest rate.

Doc Merlin writes:

@Noah Yetter:

But the money stock isn't fixed, nominal rates are. The fed can't really change real rates for very long, but it can change nominal rates, and debt contracts provide nominal stickiness over very long term, but only in the direction of rate raises (because refi allows rate drops to not be sticky.) Furthermore since nominal contracts can be very long term (housing loans for example), the stickiness can be very long term.

Doc Merlin writes:

I forgot to add, yes, this means that positive effects of monetary policy are short term and illusory and followed by badness, and that the fed can /only/ make things (sometimes through inaction, sometimes though action) worse not better. It seems that the Reinhardts are also saying the fed can't make things better, something I agree with.

Yancey Ward writes:

So, can one assume that position is that central banks don't matter unless they blunder? I feel so much better.

Doc Merlin writes:

@Yancey Ward:

As far as I can tell, that isn't said in the paper, but is consistent with their analysis.

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