Sunday, March 1, 2015

Yates on Lags and a Balanced Budget

Well they are all a twitter.

Yates reports that Wiesenthal of Bloomberg asked what MaMos would think of a balanced budget rule.

He then added how Noah Smith twitted a link to a Scott Sumner post claiming that long and variable lags are a myth.

Yates then writes a blog post discussing how Sumner must be wrong--referring to characteristics of new Keynesian models.

Under current conditions, I believe the U.S government should run a surplus under "normal" conditions.   Government spending should be kept to a minimum and tax rates set to generate slightly more revenue.   It should then gradually pay down the national debt.

If the economy does poorly, then the government will collect less tax revenue.  I would strongly oppose having the government raise tax rates to balance the budget.   The budget surplus would, and should, decrease.   Now, if the problem is so severe that the result is a deficit, I do think the government should borrow and add to the national debt.   However, I favor a constitutional debt limit, and one reason why running a surplus under normal conditions is to reduce the national debt below the debt limit so that borrowing would be possible.  

I am not too worried about the national debt being paid off, but if that did happen a balanced budget is appropriate and in that scenario, a temporary reduction in tax revenue should allow for a budget deficit and at temporary national debt.   Then a surplus when the economy returns to normal.

A permanent contraction in real output, on the other hand, should result in less government spending and a reduction in the provision of public goods.

I have no interest in using discretionary fiscal policy, including tax cuts, to return spending on output to a target growth path.   Even less do I favor introducing special government spending projects for the purpose of creating jobs.

Note that I don't worry much about the impact of taxes and spending on spending on output.

Yates apparently hasn't heard, but Market Monetarists favor targeting nominal GDP in the future.   We do not favor adjusting a target interest rate according to the past deviation of nominal GDP from a target level.

Now, for long and variable lags.

For Milton Friedman, the thought experiment was always a change in the growth rate of the money supply.   We are in equilibrium at one growth rate of the money supply   Suppose we shift to a higher growth rate?   How long will it be before the economy returns to long run equilibrium?   That is, a higher inflation rate, higher nominal nominal interest rate, with real interest rates, real output, and employment all back to their natural, long run equilibrium values?   Well, the lag between the new growth rate of the money supply and that final long run equilibrium is long.   And further, it appears to take longer sometimes than other times.

However, one problem with the use of empirical evidence to evaluate Friedman's claim is that there has never been a monetary regime that targets the growth rate of the money supply, much less one that has tried out various growth rates and allow adjustments to the new equilibrium.   Friedman tested this thought experiment in worlds with quite different monetary regimes.

Most importantly, with a gold standard, changes in the quantity of paper money and deposits (both demand and time) are unlikely to be new, persistent increases in the growth rate of the quantity of money.    Frequently they will be accommodating a temporary or even permanent change in the demand to hold money, and even if they are truly an excess demand for or supply of money given the existing trajectory of nominal income, there is a very good reason to expect they will be temporary.

This same reasoning applies to price level target.

Market Monetarists don't favor changing the growth rate of the money supply and letting the economy settle down to a new equilibrium,  How long it would take for a change in the quantity of money to have its full effect on inflation is of little concern.

What is of more concern is the lag between current monetary conditions and spending on output.   How changes in spending on output would be split between changes in prices and output is of less concern.   We are not concerned about inflation per se, but neither is the goal to goose demand to create output and employment.  Nominal GDP level targeting means that the goal is to get spending on output on target.

Years ago, Sumner advocated targeting the price level one month in the future.   But for the last decade or so he has advocated targeting nominal GDP one or even two years in the future.  The stabilization of current spending on output would largely be generated by the expectation that spending on output will be on target in the future.    And further, the reason that nominal GDP will be expected to be on target in the future will mostly be the expectation that future monetary conditions will be consistent with nominal GDP being on target in the future.

Milton Friedman and the old monetarists typically assumed that all changes in the quantity of money are permanent.   How long will it take for that permanent change to have its full impact on the price level?   How long will the transitory changes in real interest rates and real output and employment last?

But that tells us little about what happens if the quantity of money were to rise and then fall.   Should the analysis of a permanent increase in the quantity of money be transitioned over to a temporary increase in the quantity of money?   Suppose the quantity of money rises by $50 billion this quarter and then falls by 100 billion the following quarter.  Do we really expect that a year later there will be a quarter of higher real output growth followed by a quarter of lower real output growth?   And then a year after that a quarter of a higher price level followed by a quarter with a lower price level?    What possible market process would allow for such a result?

What firm would raise prices because of a boom in demand a year ago, especially when it was followed by a recession nine months ago?

Under a gold standard, the inflation rate depends on the supply and demand for gold.   Maybe projecting past experience into the future was a good enough rule of thumb    Current changes in the price level are likely to be reversed with long run stability.   Looking at what happens to various measures of the quantity of money says little.

Looking at data from a period where the central bank uses a smoothed interest rate target to keep inflation and unemployment from rising too high will provide little information as to how a regime that targets a growth path for spending on output.

Market Monetarists believe that the central bank should make no commitment regarding the future path of money market interest rates or the quantity of any measure of the quantity of money.   We certainly anticipate that nominal GDP will deviate from target.   The only commitment is that the quantity of money and interest rates will be at the level expected to keep future spending on output--future nominal GDP--on target.

Nominal GDP Stability and Coordination

A nominal GDP level target requires changes in the demand to hold money be accommodated by changes in the nominal quantity of money.   In my previous post in response to the Wagner and Viteel paper, I argued that there is no presumption that these changes in the quantity of money occur with no impact on the flow of expenditure through the economy or the allocation of resources.   Rather, the argument is that such changes are entirely appropriate and coordinating as long as the quantity of money increases such that it matches increases in the demand to hold money.   Rather than imagining some kind of perfect neutrality, the proper comparison is to an increase in the demand to hold some other type of financial asset.    Given that changes in the quantity of money, even if accommodating changes in the demand to hold money, involve some change in the pattern of expenditures and allocation of resources, why is it desirable to keep nominal GDP stable?

First, I would point out that there are some changes in the demand for money where the needed change in the allocation of resources is small.   The thought experiment of a reduction in consumption and increase in the demand to hold money, matched by an increase in the quantity of money that is used to fund additional investment involves a major shift in the pattern of expenditure and allocation of resources.   Suppose instead that households sell off financial assets to increase money balances and this is accommodated by a bank (commercial or central) making open market purchases, creating money by purchasing financial assets.   It is possible that the issuer of money would purchase the exact financial assets sold, resulting in no change in the flow of expenditure or the allocation of resources.   Of course, if a private bank purchases some other sort of financial asset (or makes a commercial bank loan,) the pattern of finance would be changed somewhat.   Only with stringent and unrealistic assumptions (which are not uncommonly made in finance theory,) would this have no impact on what particular investment projects are ultimately financed.     In my view, it is at least roughly similar to a household's choice to sell off bonds issued by corporation A with one more year to run to maturity, and purchasing bonds issued by corporation B with five more years to maturity.   Perfectly neutral, not likely.   But how neutral would be a deflation in prices and nominal incomes in response to a sale of financial assets to fund increased money balances?

Rather than continuing on to consider various scenarios regarding shifts in the demand and supply of money, I will use a different approach to explaining why stable spending on output is desirable.   First, consider a two consumer good economy.   A change in preference results in an increase in the demand for apples and a reduction in the demand for oranges.   I must admit that I find it most natural to consider this scenario as an increase in spending on apples and a reduction in spending on oranges.   Perhaps this is based upon a simplistic transfer of the reasoning of a single household with a budget constraint constructed from a given nominal income.   The household remains on the budget constraint and so shifting along it involves less spending on one good and more spending on the other.   Less spending on oranges and more spending on apples.

 Regardless, I would construct the market experiment as the demand curve for apples shifts to the right while the demand for oranges shifts to the left.   The price and quantity of apples rise.   The higher price of apples results in a move up the supply curve of apples.  Resources are pulled into apple production by higher prices and profits.   Meanwhile, the price and quantity of oranges fall.  The lower price of oranges results in a move down the supply curve of oranges.   Resources are pushed out of the orange industry by lower prices and profits, and perhaps even losses.

If, as is usual, the long run supply elasticity is greater than the short run elasticity, profits and prices will fall in the apple industry, with profits returning to normal and any long run increase in price reflecting higher rent on resources specific to apple production.   Similarly, any losses in orange production must disappear and prices will recover.  Any long run reduction in prices will reflect lower rents to resources specific to orange production.   These shifts from short run to long run supply can be represented by short run supply curves shifting--to the right for the apple industry and to the left for the orange industry.

Perhaps this is just my naive microeconomist thinking, but surely this is the way the market process is supposed to work?

However, it is clear that the same reallocation of resources and production would be possible if the demand for oranges fell, and the demand for apples stayed the same.   In this simple two good world, it might seem to make no difference..   The demand for oranges falls.   The price and quantity of oranges fall.  The lower price results in a shift down the supply curve for oranges.   Lower prices and profits, perhaps even losses, push resources out of the orange industry.   Where do the resources go?   To the apple industry.   The supply curve for apples shifts to the right.   The result is a shift down the apple demand curve, with the result being a lower price and higher quantity of apples.   The long run adjustment from the less elastic short run supply to the more elastic long run supply can be represented by further shifts in short run supply.   The short run supply of oranges shifts to the left and the short run supply of apples shifts further to the right.

So far, there has been no specific discussion of markets for resources, such as labor.  In the first scenario, the increase in the demand for apples results in a nigher imputed demand for labor while the reduction in the demand for oranges results in a lower demand for labor   While there is no guarantee that the two effects are exactly offsetting, there is some offset.   At least some of those workers pushed out of the orange industry can find new jobs in the apple industry.   Leaving aside a substitution from labor to leisure, all of the labor must shift from oranges to apples.  (That is my usual assumption, of course, real business cycle theory emphasized just this substitution to leisure that I usually ignore.)

On the other hand, in the second scenario, one key reason the supply of apples increases is because lower resource prices, including wages, results in a lower cost of production for apples.   The process requires a surplus of labor.   Both the apple and orange industry must cut the wages of all of their workers for there to be a return to equilibrium.   Compared to the shift in demand in product markets, the market process in the second scenario puts an additional burden of adjustment on resource markets, including labor markets.  In the end, just as in the first scenario, the workers are all shifting from the orange industry to the apple industry.

More importantly, if apples and oranges are but two products in an economy made up of thousands of products then the adjustment  process will inevitably impact other markets.   Substitutes and complements in production and consumption will be impacted, as well as the outputs of apples and oranges.   Still, in the second scenario, the reduction in wages and lower costs will impact all markets, raising their supplies and tending to result in lower prices and higher quantities too.   If their relative prices are to remain unchanged, the demands for each and every good in the economy must fall at least a little.   At least, they must do so if the entire adjustment is to be made with no increase in the demand for apples.

Now, back to the two good scenario.   It would be possible for the reallocation of resources to occur solely through an increase in the demand for apples, with the demand for oranges remaining constant.   The production of oranges would be curtailed by a decrease in the supply of oranges as resources are pulled into apple production.   With labor markets, this would involve a shortage of labor and higher wages.  The higher cost of production is what would cause the lower supply of oranges.   In a many good world, the result would be decreases in the supplies of all goods and at least slight increases in the demands for everything other than apples.  Worse, outside of the world of the Walrasian auctioneer, there might well be some overshooting of apple demand.

Wagner-Viteel seem to argue that increases in the demand for money should not be accommodated by increases in the quantity of money because it is better to coordinate a shift in demand solely by pushing resources out of firms with reduced demand, while surpluses of resources lower resource prices and so costs and thereby increase the supplies of other goods.   As explained above, it could happen that way, but why is it better to require these adjustments in prices and wages in all product and resource markets?

The Mises problem is directly a need to contract the production of capital goods and expand the production on consumer goods.    Why shouldn't this be accomplished by a simultaneous increase in spending on consumer goods (apples,) pulling resources in that direction, along with a push of resources out of capital goods (oranges?)     Why would it somehow be better for this reallocation to occur solely by pushing resources out of the production of capital goods so that surpluses of resources push down costs and so increase the supplies of consumer goods?

The Schumpeter problem has two parts.   Consider the introduction of a new product.   Why shouldn't the demand for the new product rise (apples) and the demand for the old, heading-to-obsolescence product (oranges) fall?  Why not have resources pulled to the innovative product and pushed out of the obsolete product?   While it would be possible to coordinate this solely by a reduction in demand for obsolete products.....

Well, it is actually hard to imagine how that would be possible.   The shift in expenditure would seem pretty much essential.   And, of course, Schumpeter's recession occurs when there are few (or no) innovations.   Given this simple thought experiment, what is the problem?   While there might sometimes be no added demand for new products, neither would there any decreases in demand for existing products due to their becoming obsolete.  

What about the other element of creative destruction?   Improved efficiency for producing existing goods    Suppose there is improved efficiency in producing apples.   There is little doubt that this should be associated with more apple production.   However, the direct effect is an increase in the supply of apples, shifting the supply curve to the right.   Output and profits rise, prices fall.

What happens to spending on apples depends on the elasticity of demand.   If demand happens to be unit elastic, then spending on apples remains the same.   If total income and expenditure is held constant, then the demand for oranges remain the same.

If the demand for apples is inelastic, then spending on apples fall.   Some of those involved in the apple industry must earn lower nominal incomes.   However, what this means is that some of those buying apples want to use part of their added real incomes to purchase other goods.  In a two good scenario, that is a higher demand for oranges.  Prices and profits rise in the orange industry as does the production of oranges.  Where do the resources come from?   Out of the apple industry.   Demand rises in the various industries where people want to buy more.  While "demand" remains the same in apple industry, spending falls.   Isn't that exactly what provides the proper signal and incentives?

On the other hand, if the demand for apples were elastic, then the increase in supply of apples results in more spending on apples.   That means that the lower price of apples motivates some of those purchasing other goods to spend more on apples.   In the two good scenario, that is less spending on oranges.  Prices, profits, and production fall in the orange industry.   This pushes resources out of the orange industry into the apple industry, where total spending and incomes are rising.

At least qualitatively, these adjustments appear appropriate.   Again, there is no guarantee that there would be no net change in the demands for resources, such as labor, there would surely be at least some offset.

And, of course, this is exactly how nominal GDP targeting works.

(Schumpeter's theory of the business cycle very much depends on credit demand and the quantity of money being driven by innovation.   More innovation results in more credit demand, an increase in the quantity of money and so nominal GDP.   The "problem" of recession occurs when innovation slows or stops.  Whether this could occur with a constant quantity of base money or even some broader measure of money hardly matters to Market Monetarists.   Our approach constrains the process of creative destruction to operate in an environment of stable nominal GDP.)

Anyway, we had nearly a half-century of Hayek and Mises, and their followers arguing that trying to generate "full employment" by increasing the quantity of money is a bad idea.   If there is a need to reallocate resources from capital goods production to consumer goods production, then trying to keep employment unchanged in capital goods industries is a bad idea.   Similarly, trying to maintain employment in industries producing obsolete product is a bad idea.   Trying to maintain employment in industries where productivity has increased and demand is inelastic is a bad idea.

Targeting total employment or unemployment is a bad idea.

Similarly, trying to maintain the real output of capital goods or obsolete products or import competing industries or housing or.... anything, is a bad idea.     If bottle necks limits expansion in some industries while decreases in output occur rapidly in shrinking industries, then real output will fall.   Nominal GDP level targeting does not try to keep aggregate real output from falling in that circumstance or any circumstance.   In particular, it does not propose increasing the quantity of money and nominal GDP to reach some target for real GDP.

Targeting real GDP is a bad idea.

 Nominal GDP level targeting is not the unemployment rate targeting.  Nominal GDP is not real GDP targeting.   Isn't that obvious?

Of course,  I don't favor keeping nominal GDP constant in a progressive, growing economy. (I don't favor Hayek's "ideal" policy.)  I favor a stable growth path for nominal GDP, with the growth rate based upon the estimated growth of potential output.   At any point in time, the level of nominal GDP is given and the above analysis applies.

I need to explain why this growing trend for nominal GDP is not especially disruptive, and more importantly, not more disruptive relative to the alternatives--including constant nominal GDP.  I'll get to that.

Returning to Wagner and Veetil, I need to explain why accumulating money balances due to uncertainty is saving and as such, implies a reduction in the natural interest rate.   In other words, it is appropriately coordinated with other households and firms by an adjustment in market interest rates.    There is nothing about a temporary increase in the demand for money due to uncertainty that makes reduced nominal GDP somehow coordinating and an expansion in the nominal quantity of  money discoordinating.

Tuesday, February 17, 2015

More Basic Macro

David Glasner again argues against the identity between saving and investment.    He finds some quote by Scott Sumner where it sounds like Sumner claims that the profession has just decided to define saving so that it means the same thing as investment.   I don't really think that is true.

I certainly see saving and investment as quite different things.   Saving is that part of income not spent on consumer goods.   Investment is spending on capital goods.   They aren't anything like the same sort of thing.   That they must always be equal as a matter of arithmetic is a bit remarkable.   But it is true.

In my opinion, there was a tendency by Keynes and some of his followers to confuse the identity with an equilibrium process by which a change in planned saving or investment causes output to change until planned saving again equals planned investment.    Worse, very poor arguments were sometimes made against the orthodox view that interest rates adjust to bring saving and investment into equilibrium on the grounds that saving and investment are always equal.  

Planned saving doesn't have to equal planned investment.    It is certainly possible that interest rates might change to bring planned saving and planned investment into equilibrium.   It is even possible that output and income might adjust to bring planned saving and planned investment into equilibrium.

Purchases and sales are equal by definition.   But quantity supplied and quantity demanded can be different.   Quantity supplied is planned sales and quantity demanded is planned purchases.   They don't have to be equal, but the price can adjust to bring them into equilibrium.   It would be a very poor argument to say that the price cannot adjust to bring quantity supplied and quantity demand into equilibrium because purchases and sales are always equal by definition.   And then to insist that the quantity will adjust to the amount purchased at a given price and call that equilibrium.   That might be what would happen, but it is what we call "surplus."

Suppose there is an all service economy.   Further, everyone is an independent businessman.   Everyone's income is someone else's expenditure.    Everyone's expenditure is someone else's income.

The barber's expenditure on massages is the income of the masseuse.   The expenditure of the masseuse on haircuts is the income of the barber.   The expenditures of the barber and masseuse on musical performances is the income of the musician.

And, further, the expenditure of the musician on music lessons is the income of the teacher of music.

Income and expenditures are equal.   It is like receipts from sales are equal to spending on purchases.  No, it is exactly the same thing as receipts from sales are equal to spending on purchases.

Now, that part of income not spent on services that start with the letters A to M must equal spending on services that start with letters N to Z.    It isn't that anyone must spend some particular amount on any particular service, it is rather that the economist is partitioning income and expenditure.

And really, it is just a partition of expenditure.   To say "that the part of income not spent on services that start with the letters A to M" is the same thing as saying "that part of expenditure that is not expenditure on services that start with the letters A to M."   The other part of expenditure must be expenditure on services that start with the letters N to Z.

If we define that part of income not spent on services that start with letters A to M as saving and spending on services that start with N to Z as investment, then saving and investment must be equal by definition.

Further, in a four service economy, that part of income not spent on haircuts, massages, or musical performances must be equal to the amount spent on music lessons.   That part of income not spent on haircuts, massages, or musical performances is saving.   Spending on music lessons is investment.   Saving equals investment.

Does adding entrepreneurs hiring workers to produce the services make a difference?   No.   Because the revenues of the firms will equal wages plus profits--income to the employees plus income to the entrepreneurs.

Does the production of goods make a difference?   Well, there is the possibility that goods will be produced and not sold.    But that doesn't really matter either.   What is in fact done is that unsold goods are counted as purchased by the producer, and included as inventory investment.   What this implies is what is actually produced results in a matching income and as well as matching expenditures.   Income equals output and output equals expenditures, so income equals expenditures.   But consideration of the all service economy where unsold output isn't an issue shows that income equals expenditure anyway.

Nothing in this argument says that expenditure equals potential output--which is more or less the same thing as saying quantity demanded equals quantity supplied.   The prices need to be right for that to happen.   The interest rate has to be right for planned saving to equal planned investment while expenditure equals potential output.   Again, this is the same thing as the prices have to be right so that quantity supplied equals quantity demanded.   And finally, the nominal quantity of money very much impacts which money prices and wages are the ones that keep quantity supplied and demanded equal.














Saturday, February 14, 2015

Sumner and Glasner on Identities

Sumner has repeated his claim that saving and investment are always equal as a matter of definition.   Glasner has taken him to task.  As always, I disagree with both of them.

Sumner is correct, but makes the same error as Keynes in giving these identities much significance.

I think Glasner is pretty much in error about the identities, but is correct that the equilibrium conditions are all that matter.

In my teaching, I have long emphasized what I was told is the "basic identify of macroeconomics."   This identity is income equals output.

The reason that it is true, and true by definition is that profit is both defined to be a part of income and also as the value of output minus the other sorts of incomes--wages, interest and rents.   Wages, interest, and rents usually involve some flow of funds from the firms, though they can just be an accrued cost.   And the value of output usually represents a flow of funds to firms, but output that is unsold or else sold with no funds collected still counts.

Anyway, with profit being output minus other sorts of income, then by the definition of addition and subtraction, output must equal profit plus other sorts of income.  Since profit plus other sorts of income is income (in total,) then income equals output.

That output equals expenditure is also an identity.   That is because all output is counted as having been purchased by someone.   And while most output is sold and purchased by some buyer, that part of output that is not purchased by anyone counts as inventory investment.   The firm that produced it and did not sell it is counted as having purchased it.

Now, with expenditure equal to output due to inventory investment, and output equal to income because of the definition of profit, then by a matter of the definition, income equals expenditure.

The big fudge factor here is the profit on inventory investment.   If firms produce something with the intention that they will sell it to someone else, and they don't, the payments they would have received as profit if they had sold it is counted as part of profit and so income.   What kind of income is that?  It is hardly something you can spend.

The equilibrium condition that Glasner emphasizes is that firms will not produce output to obtain these pseudo-profits, and so will adjust output to sales plus desired inventory investment.   In other words, firms will adjust production to avoid unplanned inventory investment.

I am embarrassed to admit that it was just over the last few years after reading Nick Rowe it became obvious to me that much of this is irrelevant for the service sector--not a small consideration.   The actual output of the services necessarily equals the expenditures on services.    And so expenditures on services must then always equal income from services (including profit or loss.)

As I have pointed out before, this is equivalent to pointing out that purchases and sales for some good are equal.   Spending by buyers matches receipts to sellers.  

But, of course, in microeconomics, we are concerned with quantity supplied equaling quantity demanded, which involves planned purchases and sales--an equilibrium condition.

And so, while income equals output equals expenditure is true enough, and I can never understand why Glasner says they are not, I don't think it matters much.   And so when Sumner seems to think it does matter, I find it puzzling.

In a closed private economy, saving must equal investment.   This is a matter of definition.  Saving is defined as income less consumption.   All output is defined as either being consumer goods or capital goods.   Consumption is spending on consumer goods and investment is spending on capital goods.   All expenditure is either on consumer goods or capital goods.   Since income equals expenditure, and consumption is itself, then income less consumption must equal expenditure less consumption.  By the definition of saving and investment, saving and investment are always equal.

I guess someone might think that is all insightful, but it comes down to saying that purchases equals sales.

To say that at the natural interest rate saving equals investment is like saying at the equilibrium price quantity supplied equals quantity demanded.   To say that savings always equals investment is like saying that purchases always equals sales by definition.

What about Sumner's argument?   Suppose nominal (and real) income falls.   Households don't want to cut consumption and so reduce saving.   That makes sense.  It is based upon what households choose to do.

Now, investment must equal saving by definition, so investment must fall more than in proportion to nominal income?

Well, no.   What causes firms to choose to spend less on capital goods?    It isn't that the definitions make them do it.   Real firms have to choose not to order up capital goods.   Now, if they didn't cut back their capital spending, then perhaps nominal income wouldn't have decreased as much after all.

Consider the expectation that nominal income will fall.   Households respond by cutting consumption now, but just a little because of consumption smoothing.  Firms cut planned investment a lot.   But it is because the reduction in expected sales causes them to want to cut investment a lot, and it is that actual decision by firms that causes current nominal income to fall more than in proportion to the decrease in consumption.   It isn't that there is a given decrease in nominal income and because consumption falls less than in proportion to the decrease in nominal income, investment must fall more than in proportion to the decrease in nominal income.   The decrease in velocity (or increase in money demand) or even the decrease in the quantity of money due to the expectation of lower future nominal income depends on the decisions of the firms and households.

Friday, February 13, 2015

What do Central Bankers Want?

Scott Sumner asks if central bankers are more concerned with the bond market than the labor market.

My theory of central banker behavior is to minimize the increase in short term interest rates subject to the constraint that neither unemployment or inflation rise to high.

So, that is different from being worried that long term interest rates will rise,  creating capital losses in bond markets.   A series of small increases in short term rates should immediately depress long term bond prices if anticipated.  

In the old days, a liquidity crunch would cause a spike in short run interest rates.   This would be really bad for money center commercial banks (who borrow "hot" money,) as well as investment banks borrowing short to fund their inventories of securities that they have underwritten and not yet sold.

Central banks have not forgotten.   Avoiding spikes in short term rates is their key mission.

Now, they have learned that never increasing short term rates can be a disaster in some circumstances.   Inflation might rise too high.   While this is bad because of voters and politicians don't like high and especially higher inflation, it is also true that when they are finally forced to respond to the inflation, they must hike short term rates.   A series of small and modest interest rate increases now is better than much larger increases later.

And, of course, they have learned that when they finally act to choke of the inflation, unemployment will rise and voters and politicians hate that as well.

So, raise interest rates a smaller amount now each month and keep it up.   While that is "bad" compared to leaving interest rates the same, which is ideal, waiting until inflation picks up and interest rates must rise alot and unemployment will rise--so much the worse.

While this theory provides no explanation of why central bankers don't like lower short term rates, I think there the problem is almost entirely a worry that they will be forced to raise them latter.

They don't mind lower interest rates, but they don't really see it as a  good thing, but if they must raise them latter, that is really bad.

Of course, presumably they understand that failure to lower interest rates when needed can lead to rising unemployment, which voters and politicians hate.   And so, they do need to lower interest rates sometime.

Basically, the ideal is for short term interest rates to stay constant.   And when that troublesome economy forces them to adjust them to avoid unemployment or inflation, they will do so.   And a series of modest changes is better than sudden changes.

Tuesday, February 10, 2015

Richard Wagner's Critique of Market Monetarism

Writing with Vipen Veetil, Richard Wagner of George Mason University has criticized Market Monetarism and particularly nominal GDP level targeting as chasing a mirage.   (Wagner was my public finance professor at Virginia Tech in the late seventies.)

Some of their arguments are mistaken characterizations of market monetarism.   They make an implicit claim of "all" when a more appropriate statement would be "some."   While Scott Sumner's approach to macroeconomic theory is sometimes a bit baffling to me, and I have no problem with them citing the Nunes-Cole monograph, their criticism of Leland Yeager's monetary disequilibrium approach is far off the mark.   Leland Yeager did not use representative agent models, and to transition from claiming that market monetarists are implicitly using a representative agent model to to claiming that they do use such models is an error.

The monetary disequilibrium approach to recession is not based upon the assumption that all increases in the demand for money are proportional for each and every individual demanding more money.   This is no more implicit in the analysis of the supply and demand for money than it is in the analysis of the supply and demand for apples.   An increase in the market demand for apples might well involve some households planning to purchase more apples and others planning to purchase the same amount of apples and even some purchasing  fewer apples.    All the same, there is a shortage of apples at the current market price.   If the market demand were unchanged, despite some households purchasing more and others purchasing less, there would be no market disequilibrium.   And perhaps I am wrong, but I am pretty sure that those who plan to purchase more could complete their plans by purchasing those apples that would have been sold to those households who chose to purchase less.

In the case of money, when those demanding more money restrict expenditures out of current income, this does necessarily impact those who would have otherwise sold them products    And if this is matched by others demanding less money and so spending more on goods and services, then that will also impact those that have increased sales.   In aggregate, total spending, sales, and income are unchanged.   It is conceivable that the person demanding more money would reduce expenditure on the very same product that those demanding less money choose to purchase.   In a one good economy, that is necessarily true.   However, more generally, this shift in the demand for money among different individuals will impact the composition of the demand for output.

There is nothing unique about money.   Suppose rather than accumulating money, an individual saves by purchasing bonds.   At the same time, someone else dissaves by selling bonds.   If we had a single consumer good, then the decrease in demand for the consumer good by the saver would be exactly offset by the increase in the demand for the consumer good by the dissaver.   However, more generally, there will be a change in the composition of demand for consumer goods--less on the particular goods the saver refrains from buying and more demand for the particular goods the dissaver chooses to buy.

Rather than dissaving, a firm might sell bonds that were previously held as retained earnings or perhaps issue new bonds.   In that situation, there is a decrease in spending on some particular consumer goods favored by the households that are saving and an expansion in spending on some particular capital goods that the firms selling the bonds believe can be profitably employed.   This reduced spending would impact those who would have sold the consumer goods and the increased spending would impact those selling additional capital goods.   This would be no different than if the household had saved by accumulating money, while the firm had reduced money holdings and used it to fund the purchase of capital goods. Further, if the firm purchasing capital goods was in a position to fund them by issuing new money, the effects on the sellers of the capital goods and those who in turn sell to them would be the exact same.    

Back to the apples.   If the market demand for apples increased, then at the existing price there is a shortage.   Superficially, the solution is a higher market price for apples.   If the quantity of apples is fixed, then the higher price simply rations the apples to those households that value them most.   There is no assumption that all households end up with the same amount of apples as before.   As the price increases, the quantity of apples demanded would decrease.   The most likely pattern is that those households that did not initially demand more apples would end up purchasing fewer apples and those households that did demand more apples, while purchasing less than they would have liked at the old market price, will end up purchasing and consuming more.   The apples would be redistributed from those with unchanging demand to those demanding more.   And if there had been some households who happened to be demanding less anyway, the higher price would reinforce that reduction further reducing their purchases by more than they had planned.

However, if the supply of apples is not perfectly inelastic, then the sellers of applies will produce more--quantity supplied will increase.  Now, is there an assumption that all apple producers increase quantity supplied in proportion?   Not at all.   Market clearing just requires that the quantity supplied match the quantity demanded by the market.   There could easily be a shift in market shares among apple producers along with the shift in the distribution of apple consumption among households.

If the supply of apples were perfectly elastic, then the shortage of apples would be cleared up by an increase in the quantity of apples at an unchanged price.    Those households demanding less apples would get less, those demanding the same would get the same, and those demanding more would get more.

Now, would it be bad for the supply of apples to be perfectly elastic?   If apples could be produced at constant cost, would it be socially desirable to make sure that the quantity of apples did not increase so that the increase in demand were entirely choked off by a higher price?

I think not, and in fact, there is a sense in which I would think that it would be desirable if the supply of apples were perfectly elastic, so that the quantity could adjust with demand.   Of course, if that isn't the cost structure of the industry, then trying to make the supply of apples perfectly elastic would likely do more harm  than good.

The monetary disequilibrium approach suggests that it is quite possible for the supply of money to be perfectly elastic.   And that there is no problem with the quantity of money adjusting to changes in the demand to hold money.   There is nothing in the approach that suggests  that these shifts in the demand for money accommodated by changes in the quantity of money would have no impact on the the pattern of expenditures in the economy.   In a world with many firms and households and many goods and services, in general, the pattern of expenditures would and should change.

Wagner and Veetil make the same error as Hayek.   They dwell on some bizarre notion of perfectly neutral money, and fail to see that a reallocation of expenditure in the economy is generally appropriate and coordinating when the quantity of money adjusts to meet the demand to hold money.   Imagining that the "proper" way for new money to enter the economy is as a free gift to those demanding more money so that they continue to spend as before, is just groundless.

For example, if households choose to save by spending less on consumer goods and services out of income--refraining from writing checks to purchase consumer goods while continuing to have income payments credited to their checking accounts, then this is going to impact those selling the consumer goods they would have bought.  Those sellers will in turn have to restrain expenditure and so on.    That the banks extend new loans to firms wanting to purchase capital goods will certainly result in those selling capital goods having greater receipts, and they will spend more and so on.   This change in the pattern of expenditure is exactly what would have happened if the households had saved by purchasing bonds newly issued by the firms who wanted to invest.  An increase in saving matched by an increase in investment is exactly the appropriate reallocation of expenditure in the economy.

But what if the banks had to lower interest rates to generate more loan demand?  Is this some kind of distortion of interest rates?   No.   If the households had purchased bonds, the prices of the bonds would have increased and the interest rates would have fallen, which would motivate the firms to issue new bonds and buy capital goods.    This is exactly what should happen.

I am a market monetarist.   I am pretty much a "charter member" of the club.   I hope that this brief analysis shows that at least some market monetarists are well aware of microeconomics (the supply and demand for apples) and do not assume that changes in the demand for money are necessarily proportional and further, do not ignore the impact of shifts in money demand on the composition of spending on output and the allocation of resources.

Personally, I find analogies using the supply and demand for apples much more useful than highly abstract discussions of plan coordination, number matching games, or airplane piloting.

And nothing is a substitute for actually thinking about what happens when households and firms choose to change their money balances along with the money supply process.   And, of course, what happens when there are other changes in the pattern of demands, including changes in saving and investment coordinated by the purchase and sale of nonmonetary financial instruments.

In this post I have focused on Wagner and Veetil's mistaken claims about monetary equilibrium and disequilbrium theory and particular their claim that market monetarists necessarily assume that aggregates directly impact one another or shifts in the demand for money or changes in velocity must be proportional or that there is an implicit or explicit assumption of representative agents.

I will later briefly review why needed reallocations of resources are best coordinated in an environment of stable aggregate expenditure rather than having total expenditure shift.   This includes all sorts of changes, but including especially some need to shift from the production of capital goods to consumer goods (the Mises problem) or with the introduction of new products or more efficient production processes (the Schumpeter problem.)

And finally, I will discuss the theory that an increase in the demand to hold money because plans are not coordinated should not be accommodated by an increase in the quantity of money because it would interfere with the supposedly desirable situation of resources waiting patiently to be utilized in entrepreneurial plans.   In my view, while entrepreneurship and plan coordination are important in economics, it is important not to ignore some fundamental microeconomic concepts such as scarcity.
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Monday, February 9, 2015

Renewing the Search for a Monetary Constitution


The book from the Liberty Fund Conference is finally out.   I have a chapter about nominal GDP level targeting and free banking.

There is a Cato Event with editor Larry White about the book.   It will be in the D.C. area on February 25.   Here is the information.   You can watch it live online.