Tuesday, November 13, 2012

ECO 302: Big Bag of Market Monetarism

We're doing market monetarism in my intermediate macro class tomorrow morning. Here are the handout notes, minus some explanatory material. These are just a few of the things written in the last 45 days on the subject - making the class CURRENT, baby! - without themselves being an attempt to define and explain everything about market monetarism. The main topic is why current inflation rate and interest rate targeting is ineffective, supporting the MM view that we should target the forecast of nGDP growth.

Low interest rates aregenerally a sign that money has been tight, as in Japan; high interest rates, that money has been easy. .   .   . After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

DW here: Notice the verb tenses. Low rates are a sign that money HAS BEEN tight. The claim is not that tightening monetary policy will lower interest rates in the short run, but that if monetary policy has been excessively tight, aggregate demand will decrease (recession) and that will lower interest rates. I had an argument with a colleague here about that one when I tried explaining it to him.

Then:  In the 1971-81 period NGDP grew at 11%, causing high inflation.  I favored much lower NGDP growth, and thought easy money was to blame.  The vast majority of economists disagreed with me and the other monetarists.  ”Only those crazy Chicago economists think monetary policy determines inflation.”  Inflation is caused by unions, and deficit spending, and low productivity growth in services, and crop failures and oil shocks.  In any case, interest rates are high so it can’t be loose money.  
Now:  Over the last 4 years NGDP growth has averaged 2%, lowest since the early 1930s.  I favor much faster NGDP growth, and blame tight money.  The vast majority of economists disagree with me.  ”Only those crazy market monetarists think monetary policy explains the 2% NGDP growth since 2008.”  It’s the collapse in housing, the tighter lending standards, the hoarding of ERs, the cutbacks in state and local spending, fear of Obamacare tax increases.  In any case interest rates are low so it can’t be tight money.
If the Fed had been able to cut rates below zero, markets would have had confidence that any economic weakness would be temporary, and that we’d quickly return to a healthy level of NGDP, as in Australia. This would have supported asset prices, and prevented the big “shock” to NGDP from occurring in the first place.  The irony is that if the Fed had been able to push the fed funds rate negative, it might not have had to do so, or perhaps it might have only required a negative 1% or 2% target.
This example perfectly illustrates why interest rate targeting must be ended.
the appropriate policy is not “Keynesian.” The appropriate policy is to get out of the Keynesian world. … NGDP growth dropped to 2.77% in the second quarter, and it seems like the Fed wants to get it back up over 4%.  Eventually they’ll succeed, but it will be a limited “success.”  We’ll still be in a Keynesian world for many years.  And we’ll react to that fact not by getting out of the Keynesian world, as we should, but rather by continuing to run big deficits and bailing out firms that are failing.

Interest rate targeting had a good run because everyone understood the convention, but the combination of low inflation and population aging means that negative demand shocks are now going to regularly put us at-or-near the zero bound. That means we'd be well-served to find some other monetary routine to appeal to.

We have to assess monetary policy by comparing the economy’s performance relative to the FOMC’s goals of price stability and maximum employment. In particular, if the FOMC’s policy is too accommodative, that should manifest itself in inflation above the Fed’s target of 2 percent. This has not been true over the past year: Personal consumption expenditure inflation—including food and energy—is running closer to 1.5 percent than the Fed’s target of 2 percent. But this comparison using inflation over the past year is at best incomplete. Current monetary policy is typically thought to affect inflation with a one- to two-year lag. This means that we should always judge the appropriateness of current monetary policy using our best possible forecast of inflation, not current inflation. Along those lines, most FOMC participants expect that inflation will remain at or below 2 percent over the next one to two years. Given how high unemployment is expected to remain over the next few years, these inflation forecasts suggest that monetary policy is, if anything, too tight, not too easy. (my source)

Sumner on relative ability of fiscal and monetary policy to do anything. Sumner’s answer:
It is true that an expansionary fiscal policy can boost velocity, but it quickly runs up against a huge problem (which is nicely explained in Mishkin’s text.)  You don’t just need big deficits to raise velocity at 6% per year; you need rapidly rising deficits.  Thus a deficit of say 8% of GDP, maintained year after year after year, will only provide a one-time boost to velocity.  In that case you need a deficit of 16% of GDP the second year, then 24% the third.  (Those numbers are illustrative; I don’t know how large the deficit would have to be.) But without help from the monetary authority, fiscal policy is far too weak to target inflation at 4%/year, or indeed even 2%/year. In contrast, as long as the central bank is independent, and not forced to monetize the debt, it can target many different inflation rates and pretty much ignore what Congress is doing.

[Remember] Denmark's misguided policy of pegging its currency to the euro. Sweden, which … lets its currency float, depreciated substantially during the crisis and then its currency bounced back during the recovery and is now higher relative to the euro than it was before the crisis. Denmark, by contrast, has stuck with the flat peg and continues to see a sluggish job market.
The fact that Danish interest rates are incredibly low right now is just another example of how misleading it can be to rely on interest rates as your way of understanding the stance of monetary policy. Exchange rate dynamics are incredibly important. Denmark's commitment to the euro peg means that when the eurozone's nominal growth path started slowing sharply, Denmarks was brought down with it.
And for a bonus, here is information on hyperinflation in Iran right now: 70% inflation per month as of October.
Our textbooks teach macro in a very strange way.  We often start off the core material with a chapter that discusses the “classical dichotomy.”  We try to convince students that if you double the money supply then all you’ll do in the long run is double the price level.  But we also explain that nominal shocks can have real effects in the short run, as wages and prices are sticky.  We often present the equation of exchange and the quantity theory of money. 
And then we proceed to entirely ignore this framework for the rest of the textbook.  The QTM is treated like a crazy aunt that has to be hidden away in the attic.  Time for more serious stuff!  On to the AS/AD model, and the various components of GDP.  Of course economists understand the linkages between these two approaches; they understand that real shocks are sort of like supply shocks and nominal shocks are sort of like demand shocks.  But not exactly. 
Unfortunately students don’t see this at all.  And why should they?  It’s like we started teaching the course in one language they don’t understand (say ancient Greek) and half way through switch over to another language they don’t understand (Latin.) 
I have a modest proposal.  If we are going to start the course in Greek, why not continue in that language all the way through?  Why not do inflation and business cycles using the language of nominal and real shocks, instead of AS/AD shocks?  After all all definitions of AD are arbitrary.  So why not pick the one that corresponds to “nominal shocks,” i.e. to changes in M*V? 
So our AS/AD models starts out as a LRRO/NS model (that’s long run real output and nominal spending.)  The LRRO line is obviously vertical, and is obviously identical to the LRAS line.  The NS line is a rectangular hyperbola representing a given level of P*Y.  AD shocks (M or V) move the NS line.  We use this model to explain why poor countries can’t get rich by printing money.Then we move on to business cycle chapters, and bring in sticky wages and prices.  Now we add the SRRO line, which is identical to the SRAS line.  Now we can explain why nominal shocks have real effects in the short run.  We tell students that the SRRO line partitions changes in nominal spending (M*V) into real growth and inflation (P and Y.)This approach is also a far better way of teaching fiscal and monetary policy.  Both monetary and fiscal policy can, ceteris paribus, impact the NS line.  Some types of fiscal policy also may also be able to impact the LRRO and SRRO lines.

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