In times of trouble, I often turn for comfort to the Cagan
money demand model. Philip Cagan, who passed
away in June of this year, was a monetarist who moved the ball down the
court. Back in the 50's, he gave us a new
and better set of reasons for thinking that future monetary policy impacts
Here's his story: Today's demand for real, liquid buying
power (the money supply divided by the level of prices, M/P) depends partly on
inflation in the near future. If
inflation's high, you want to hold less money--you'd rather hold real assets
that won't lose value in an inflation.
Sure, you as one person can dump your money holdings by
selling (!) them to someone else. But
for the economy as a whole, the money supply is pinned down by government (and
some other stuff I'm leaving out--remember, you never
want to see everything in perspective). So if there's inflation in the future, the only way people can reduce their real buying
power today is for the price level to
rise. Future inflation causes a price increase today.
But here's the thing: Cagan doesn't just assume that inflation is caused by money
growth---he proves it. There's a little
arithmetic to it, but the story is this: Today's price level depends partly
on today's money supply, and partly on tomorrow's price level.
price level depends on both tomorrow's money supply and the price level in the even
more distant future, which depends partly on money in the still more distant
future. And so onward, forever.
The result? Today's price level depends mostly on the future supply of money.
So if word gets out that the money supply will be higher than
expected two years from now, in Cagan's story that pushes up prices today.
And longer-lasting increases in future money have a bigger impact on
prices than one-off increases (like the burst
of money printed around Y2K).
Economists have a lot of stories about why expectations
matter, how beliefs about future government policy influence things today. But Cagan's money demand model did more than
that: It gave us a new reason to think that a credible Federal Reserve---one
that makes their future intentions clear, and sticks to those plans--creates macro
Implication: Countries that seriously
debate big changes in their monetary policy--even for the better--create macro
instability right now.
And the Cagan model is a great starting point for thinking
about why the Fed's new
monetary policy rule will start pushing up nominal GDP fairly soon...even if it
takes years for the mortgage purchases to add up to much of anything. Expected money matters today.
Congratulations to Scott Sumner on his deserved and underacknowledged victory.