Eggertsson on the Liquidity Trap (Does Palgrave make it official?)

I found Eggertsson's version of the Liquidity Trap in New Palgrave Dictionary of Economics.

According to Eggertsson, monetary policy is setting short term interest rates. The variable representing the nominal interest rate has a side constraint--greater than or equal to zero.

Eggertsson shows that aggregate demand doesn't simply depend on the current value of the interest rate, but rather on its expected future value. He claims that this means that demand depends on long term interest rates. However, he manages this with a model that only has "the" short term interest rate. It turns out to be crucial, because long term interest rates don't show up as the yields on long term bonds, but rather are all about expectations of future monetary policy.

Eggertsson also notes that there is an implication for the quantity of money in all this. He gives a money demand function, which presumably determines the quantity of money. He explains that the quantity of money is indeterminate at the zero nominal bound because zero-interest government bonds and money are perfect substitutes. (I never fully trusted the figures provided by the Federal Reserve, but I feel sorry for the statisticians, having to calculate something that cannot even be determined!)

Monetary policy, (setting the short term interest rate,) is assumed to be aimed at avoiding output gaps or deviations of inflation from target. The "modern" liquidity trap exists because the central bank cannot credibly promise to keep interest rates at a low level after a deflationary shock passes and generate an inflationary boom. Real output collapses and price deflation results because no one believes that the central bank will allow real output to rise above target and prices to rise faster than the long run trend during future periods.

It all becomes clear. The Fed is doing its job. It promises to keep the federal funds rate low for a good long time. If people have faith in the Fed, this will bring recovery. But this is faith in the Fed generating an inflationary boom at some future time. Maybe that future Fed will instead revert to its 2% inflation target. And so the Great Recession.

According to Eggertsson, aggregate supply is driven by changes in inflation. I guess this means that if aggregate demand falls, and prices fall, this creates deflation, and leads to an output gap--a recession. If aggregate demand rises, and prices rise again, then this leads to inflation and a boom.

I don't think so. Suppose prices aren't just sticky, but stuck. Falling demand results in lower output, and the current price level is above its now lower equilibrium value. If aggregate demand increases, then output rises again, the economy recovers, and the equilibrium price level rises back up to its existing level.

Suppose some prices are flexible. Those prices fall with aggregate demand. And if aggregate demand recovers, those prices rise again. It isn't that the deflation caused output to fall, and reversing the deflation isn't going to cause an inflationary boom. While real output may grow more quickly than usual, it is just returning to his natural level in a prompt fashion.

In my view, a scenario of falling nominal expenditure (like 4th quarter 2008 and 1st quarter 2009) has this sort of effect. Modeling in terms of inflation and expected inflation may be best when trying to explain a boom due to more rapid growth of demand, or even a recession due to slower growth of aggregate demand. But aggregate demand falling and then, hopefully, rising back to where it should have been?

These models fail. Or maybe they describe the behavior of a blind and foolish central bank.

Suppose that the central bank targets a growth path of nominal expenditure. There are implications for the output gap and inflation, of course. But with that goal, there is no reason for the central bank to prevent whatever inflation that results from a return of nominal expenditure to its targeted growth path.

The liquidity trap described by Eggertsson, (as best I can tell) is that the assumed deflationary shocks push the price level down. For some reason, the central bank wants the price level to grow from that low level at a targeted rate. Why?

Further, the central bank manipulates long term interest rates by making promises about future short term interest rates. What about purchasing long term bonds? Why can't the central bank manipulate long term rates directly buy purchasing long term bonds? Does demand depend on the short term interest rates set by monetary authority in the future? Or do decreases in long term interest rates in the present, rates that are not at the zero bound, impact demand directly? In my view, quantitative easing is about purchasing long term bonds if necessary, not about making promises to keep short term interest rates low in the future to generate inflation in the future.

What is the supposed arbitrage that keeps short term rates above zero? Obviously, it is arbitrage between zero interest currency and bonds, but there is no explicit discussion of currency at all. Money is identified with currency, even though most of it takes the form of deposits that pay interest. Why nothing about this? Well, it is easy with money is thrown in as an afterthought.

In my view, Eggertsson's version of the liquidity trap is really a story about a model--a class of models. Did we suffer a Great Recession because central bankers pay too much attention to these models?

The Liquidity Trap

That bear speculators could keep interest rates from falling enough to clear saving and investment always seemed implausible to me. On the other hand, that there is a zero nominal bound on interest rates has seemed plausible enough. How does this relate to monetary disequilibrium?

Suppose there is an increase in the demand for T-bills. Their prices rise, and their yields fall, clearing the market. However, suppose the increase in demand is so great that that market clearing yield is negative. What happens when T-bills hit the zero nominal bound?

If the zero nominal bound were a ceiling on the prices of the T-bills at their face values, then the result would be a shortage of T-bills. What do the frustrated T-bill buyers do with the funds they had planned to use to purchase the T-bills? If they just choose to hold the money, the indirect consequence of this "price ceiling" on T-bills is to create an excess demand for money. The excess demand for T-bills has spilled over to money and has become an excess demand for money.

However, the zero-nominal bound on T-bills or any other nonmonetary asset isn't like a price ceiling at all. While mathematical economists might see it as a side constraint (R greater than or equal to zero,) everyone else says, "if the interest rate is zero, why not just stuff money under the mattress?" The entire rationale for the zero nominal bound is that rather than lend by holding assets with a negative nominal yield, people will just hold money. The zero nominal bound exists because an excess demand for a nonmonetary asset at a yield of zero will shift to an excess demand for money.

But doesn't an excess demand for money lead to lines at the money store? No it won't, because money is the medium of exchange. People regularly receive money in payment for goods and resources and can build money holdings by refraining from spending. The result is an inability to complete habitual sales of goods and services. An excess demand for money creates the illusion that everyone doesn't want to purchase as many goods and services. Or worse, the illusion that too many goods and services have been produced.

If those frustrated by an inability to sell reduce production, the lower output results in a lower real income. Money being a normal good, the demand to hold money falls to meet the given supply. The excess demand for T-bills at the zero nominal bound leads to a decrease in real income and output.

Why is monetary policy ineffective at the zero nominal bound?

What does monetary policy mean?

If monetary policy means open market operations using T-bills, and T-bills are at the zero nominal bound, then purchasing T-bills with newly created money will not directly clear up the excess demand for money. The nominal yield on T-bills is at zero and the excess demand for T-bills has shifted to an excess demand for money. The central bank buys T-bills, increasing the demand for them and creating a new excess demand for T-bills. This excess demand for T-bills will be shifted into an excess demand for money. The central bank has created new money to purchase the T-bills, and so this increased quantity of money accommodates the excess demand for money. However, the net result of the open market operations is an increase in the demand for money that is matched by an increase in the quantity of money.

If this occurs before real income falls, the initial excess demand for money remains. If it occurs after real income falls, no excess supply of money is generated. Real income remains depressed. There appears to be some kind of trap.

If monetary policy isn't defined in terms of open market operations in terms of one particular asset, then monetary policy isn't ineffective when T-bills have a nominal interest rate of zero. The reason for ineffective monetary policy is simple. If there is an excess demand for some asset, and it is shifted into an excess demand for money, then if the central bank attempts to accommodate the increased demand for money using open market purchases of the particular asset that was in excess demand to start with, the policy will be ineffective.

The central bank simply needs to increase the quantity of money by purchasing some asset that is not in excess demand. In other words, it must purchase some asset whose yield is not at the zero nominal bound. If the central bank generally buys T-bills, and the yield on one maturity is driven to zero, then buying more of that maturity is pointless. The central bank should switch to another maturity. Presumably, the central bank will need to purchase bonds of progressively greater terms to maturity or progressively greater credit risk until the quantity of money rises to meet the demand to hold money. If real income has already been depressed by reduced expenditures due to the excess demand for money, the central bank must increase the quantity of money enough to match how much money would be demanded if real income were equal to potential income.

Suppose monetary policy is implemented using "helicopter drop," with money being created and given away. The liquidity trap no longer applies even if T-bills are at the zero nominal bound. The excess demand for money may still exist because an excess demand for T-bills spilled over to an excess demand for money. But when new money is created, the central bank is no longer demanding more T-bills, creating a greater excess demand for T-bills, spilling over to a greater demand for money, matching the added quantity of money. The newly created money can accommodate the added demand to hold money.

Further, if real income has already been depressed, reducing the demand for money to match the existing quantity of money, there is no reason to assume that the additional money will not be spent on current output. If the additional money were all spent on T-bills, then this would create an excess demand for T-bills. Given that they are at the zero negative bound, it would spill over to a demand for money, and the demand for money would rise to match additional quantity of money. However, with the helicopter drop scenario, the notion that people will spend all of the new money they have been given on zero-yield T-bills seems strained.

Rather than a helicopter drop, suppose the real quantity of money increases through a proportional decrease in all prices, including the prices of resources, like labor. Does the liquidity trap apply? Again, suppose the initial problem is caused by an excess demand for T-bills. The nominal yield hits zero, and any remaining excess demand for T-bills spills over into an excess demand for money. Prices (including wages) all drop to a level so that the real quantity of money matches this additional demand. There is no longer an excess demand for money.

Why no liquidity trap? The central bank has not purchased T-bills, increasing the demand for them, causing a further spillover into the demand for money, and so matching the increase in the real quantity of money with an increase in the demand for money. On the contrary, the decrease in all prices and wages raises the real quantity of T-bills. (As well as the real tax burden of paying the debt.)

Having bonds, such as T-bills, hit the zero nominal bound can easily lead to an excess demand for money and depressed output, employment, and real income. Open market operations using the very T-bills in excess demand at a zero nominal yield will not fix the problem. However, open market operations using other assets, even government bonds, that are not at the zero nominal bound can still be effective, as can helicopter drops of money or an increase in the real quantity of money created by a lower price level.

Merry Christmas from Charleston

As you can see from my James Island hoody, it is a bit chilly in Charleston. No freezes yet, but the oranges looked ready.

P.S. Today, I am in Lynchburg, Virginia, with a sore back after shoveling snow off my mother-in-law's driveway. I want to go home!

Money and Credit Still Confused at the Cleveland Fed?

A new commentary from the Cleveland Fed by Charles Carlstrom and Andrea Pescatori received some attention from Mark Thoma and Scott Sumner. On the bright side, they recognize that "level targeting" is desirable when short term nominal interest rates reach the zero nominal bound. They also understand that the Fed must be willing to purchase something other than T-bills if their yields have reached the zero bound.

However, I was surprised by what I believe were some errors in their analysis. Most importantly, they confuse money and credit. They argue that if the interest rate on T-bills is zero, and the Fed makes open market purchases of T-bills, then because those T-bills are perfect substitutes for the banks' cash reserves, the banks will not increase lending.

While this argument is plausible enough if the Fed purchases the T-bills from banks, if the Fed purchases T-bills from someone other than banks, then the quantity of money increases when the seller's bank credits the seller's deposit. Even if the banks are willing to hold the increased reserves, rather than purchase some other assets, the quantity of money has increased.

By definition, open market purchases involve the Fed purchasing assets from whoever is willing to sell. If the Fed is buying T-bills, it may buy some from banks, but eventually the banks will run out, and then any further purchases come from someone other than banks, leading to increases in the quantity of money regardless of whether or not banks want to expand lending.

Unfortunately, Carlstrom and Pescatori seem focused on what happens to bank lending, rather than on the quantity of money created by the Fed and the banks. A zero nominal bound, however, isn't a problem of an inadequate supply of credit. Low interest rates are a sign of an adequate supply of credit. The problem is an excess demand for money. The quantity of money is less than the amount people want to hold at a level of real income equal to the productive capacity of the economy. As long as the open market operations increase the quantity of money, they help clear up the excess demand for money.

Carlstrom and Pescatori then describe the alternative of open market purchases of long term securities. They correctly explain that by purchasing them, the Fed will raise their demands and prices, and so lower their yields. I think the key point here is that the entire notion that the economy was at the zero nominal bound is just a strange illusion. The interest rates that the Fed traditionally targets are near zero, but there are many interest rates. Most of them are nowhere near zero. Macroeconomists are in the habit of modeling the economy with a single interest rate. For many purposes, this may be a useful abstraction. However, treating a situation where some nominal interest rates are zero as being the same as "the" interest rates is zero, confuses models with reality.

Carlestrom and Pescatori discuss how purchasing longer term securities will be effective because banks will not treat these securities as perfect substitutes for their cash reserves. The banks will be motivated to expand lending when they receive additional reserves in place of long term securities. Again, they are assuming that the Fed purchases securities directly from banks and their focus is on getting banks to expand lending. The Fed might purchase long term securities from banks, and regardless from whom the Fed purchases securities, bank lending would certainly be helpful in multiplying the impact of the open market purchase on the quantity of money, but this isn't necessary. When the Fed purchases long term securities from someone other than banks, the quantity of money expands. The problem isn't that banks aren't lending, it is rather than the quantity of money is less than the demand to hold money and expanding the quantity of money helps solve the problem.

Perhaps the core idea of monetary disequilibrium theory is that undesirable changes in nominal expenditure must be due to an imbalance between the quantity of money and the demand to hold money. The response to this strong claim is usually some particular scenario where someone spends less on final goods and services. The rejoinder is always, what do they do with the money instead? Hold it? There is the problem. Spend it? Then what does the recipient do? Hold it? See, excess demand for money.

Yeager has always emphasized that if there is a shortage of some nonmonetary asset, the only way this could generate a general glut of goods--an excess supply of current output--is if the excess demand for the nonmonetary goods spills over into an excess demand for money. For example, people want to produce and sell apples, and then use the income earned from the apples to purchase "old masters." No new old masters can be produced, so wouldn't this cause a general glut of goods?

Of course, there is no reason why the prices of old masters cannot rise, closing off the shortage for them and at the same time ending the surplus of currently produced goods. But suppose that is impossible. Suppose there is a price ceiling on old masters. Is there a perpetual excess supply of goods matching the shortage of old masters? As Nick Rowe frequently explains, the frustrated buyers either purchase something else or maybe even no longer want to produce and sell products if there is nothing they want to buy. No general glut of goods results from even a persistent shortage of nonmonetary assets.

The problem develops if the shortage of nonmonetary assets spills over into an increased demand for money. There is a shortage of some nonmonetary asset, and the frustrated buyers simply hold onto money. The individual can produce and sell goods, and being unable to find the desired nonmonetary asset, just holds onto increased money balances. Of course, given the quantity of money, this cannot be done by everyone at once. The result is an inability to sell--a general glut of goods.

And that is how the zero nominal bound on interest rates impacts nominal expenditure and why it is relevant for the type of assets purchased by the Fed. Suppose there is a flight to safety and an increase in the demand for short and safe assets. The increased demand for these assets raises their prices, and lowers their yields. When the yields on those assets hits zero, and an excess demand remains, a shift of that excess demand to an increased demand for money not only is possible, it is likely. In the final analysis, zero-interest currency provides a prefectly liquid and safe haven.

If there is an excess demand for money due to a spillover from an excess demand for short and safe nonmonetary assets, and the Fed responds by purchasing safe and short nonmonetary assets, it will fail to solve the problem. While the increase in the quantity of money will help meet the excess demand as usual, the Fed's purchases of the nonmonetary assets increases the demand for them, and as that excess demand is shifted to an increased demand for money, the Fed is left where it started.

What is the solution? The Fed needs to purchase nonmonetary assets than aren't in excess demand. That is, monmonetary assets that are not at the zero nominal bound. This will increase the quantity of money without exacerbating the excess demand for safe and short assets at the zero nominal bound. Like usual, the process will increase the reserves of banks, and if banks choose to purchase assets, then the direct impact of open market operations by the Fed on the quantity of money will be multiplied. However, to identify the increase in bank lending with the increase in the quantity of money is--money and credit, still confused.

P.S. Carlstom and Pescatori point out that targeting the price level implies that the Fed will reverse any deflation that occurs. As deflation lowers the price level, the expectation will be ever faster (or more lengthy) inflation to return the price level to target. A lower price level, then, implies higher expected inflation, and lowers the real interest rate consistent with any given nominal interest rate, particularly one at zero. They then point out that targeting the price level requires that the central bank offset productivity shocks, which would be disruptive.

What is the answer?

Target a growth path for nominal expenditure! How about 3 percent?

The Macro Effects of a Lower Minimum Wage

What is the macroeconomic effect of a lower minimum wage?

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Next to nothing.

However, I oppose the existence of the minimum wage, and consider reversing the 40% increase from $5.15 to $7.25 a good first step.

Aproximately 2% of workers in the U.S. earn the minimum wage or less. Even if they all worked full time (and they don't) and they all earned the minimum wage (and they don't,) and all of them had their wage rate cut back to the 2006 level (and they wouldn't) then reversing the increase in the minimum wage would decrease their income by .1% of GDP. If the cost savings were all passed on in the form of lower prices, that same .1% is about how much the price level would decrease.

Krugman's approach of switching the subject to an across the board cut in wage rates is absurd. If all wages dropped nearly 30%, that would be 20% of GDP, and probably the best estimate of the direct impact on the price level would be a 20% decrease. There would be large macroeconomic effects. The impact on real money balances--currency and reserves--the real national debt, shifts in the burden of private debt, and expectations about future prices, would all be the key concerns.

Is the simple quantity theory approach correct? Nominal expenditure would remain unchanged? Would a 7% decrease in the price level, including resource prices like wages, reverse the decrease in real output and return it roughly to capacity? Or would the real demand for money rise, resulting in a further decrease in nominal expenditure?

Would a 30% decrease in wages be vastly excessive? Could it actually be inadequate? Regardless, the impact of a substantial decrease in the minimum wage on these things is trivial--lost in the noise.

Evidence suggests that the demand for minimum wage labor is inelastic. That doesn't mean that decreases in wages have no impact on employment. It rather means that a 30% decrease in the minimum wage would result in a less than 30% increase in employment. Suppose there is only a 10% increase in the employment of minimum wage workers. That would be an increase in employment of maybe 276,000. That would be about 2% of those currently unemployed and would reverse about 3.5% of the loss in employment during the recession.

If the demand for unskilled labor really is so inelastic, the total income of those earning the minimum wage drops by roughly 20%. The existing workers earn 30% less and the 10% additional workers earn more, and the net effect is a 20% decrease. But because their total earnings is so small compared to total income, this a tiny fraction of one percent of GDP. The notion that this loss in income would result in a significant decrease in consumption expenditure, sales, and production is just absurd.

The most likely effect of a decrease in the minimum wage is that more unskilled workers are hired and they produce more output. Those selling the products of unskilled labor lower the prices of those products to sell the extra output.

The increase in the actual production of goods and services represents an increase in aggregate real output and aggregate real income. The increase in real income isn't received by the unskilled workers or their employers. It is received by the more than 99% of the population that aren't minimum wage workers in the form of lower prices for the products of unskilled labor.

The reason the demand for minimum wage labor is inelastic is almost certainly because the demand for their products is inelastic. The prices of those products fall, and the total amount of revenue earned by firms using minimum wage labor decreases. But that that means is that the 99% of the public who are not minimum wage workers receive more of those products while using less income. And that leaves them with more income to spend on other things.

If the demand for the products of minimum wage workers were unit elastic, then the total revenue of that sector would be unchanged. More output would be purchased with the same amount of expenditure. And that would leave the same expenditure for other products.

If the demand for the products of minimum wage workers were elastic, then total revenues in that sector would expand due to the lower prices. Less would be spent on other products.

Does a decrease in the minimum wage have no macroeconomic impact? Of course not. The increase in the output of minimum wage workers is an increase in aggregate output and real income. Money is normal good. The increase in real income increases the demand for money. The real quantity of money must increase--at tiny bit. Fortunately, the decrease in the prices od the products of minimum wage workers decreases the price level a tiny bit. And that increases the real quantity of money a tiny bit.

Those Darn Microeconomists!

Nick Rowe complains about microeconomists and their apparent inability to grasp macreconomics.

I wrote about the subject some months ago. If wages are stickier than product prices, then it is possible that the unemployment associated with "tight money" will be associated with high real wages. But high real wages aren't really the problem. The problem is that the real quantity of money is less than the real amount demanded at a level of real income equal to the productive capacity of the economy.

On the other hand, recent discussions of the macreconomic impact of the minimum wage has suggested that many macroeconomists can't get beyond thinking of a model where there is "the" wage rate.

I have similarly been troubled by discussion of the liquidity trap and the zero nominal bound. While the interest rates the Fed has traditionally sought to manipulate are near zero, most interest rates aren't anywhere near zero. To what degree is the problem that macroeconomists have models that include "the" interest rate.

Minimum Wage and Employment

Can increased employment follow an increase in the minimum wage?

Sure it can.

All that is necessary is that you start with a shortage of labor.

Of course, if firms respond to shortages of labor by raising wages and hiring more workers, then employment is less than it would have been if the minimum wage hadn't been increased.

And a decrease in the minimum wage could still result in increased employment as well.

Why was the market wage rate at the first minimum wage when there was a shortage of labor? Why hadn't it already risen to the equilibrium? Presumably, it was because the demand for labor had increased, and the slow and clunky market process of firms adjusting wages upward was incomplete.

There is an entire range of increases in the minimum wage that would lead to increased employment compared to where it was before an increase in the demand for labor. There are also any number of even higher minimum wages that would result in less employment.

If there were currently a shortage of labor, then it is highly unlikely that reducing the minimum wage would increase employment. On the other hand, I think it is unlikely that it would decrease employment. Just because firms are slow to raise wages in the face of labor shortages doesn't mean that they will lower wages despite shortages of labor.

And, of course, with the unemployment rate being 10%, and 57% among black men between 16 and 19, I don't think a shortage of labor is relevant to today's situation.

"Tight Money" and Interest on Money

Scott Sumner has again claimed that economists talk about "tight money" without having any idea what it means. I know, I know, he is only counting important economists, and gives me a pass anyway....


"Tight money" is an excess demand for money--the quantity of money is less than the amount of money households and firms want to hold. But because "tight money" can impact the economy, and those changes in the economy impact the amount of money people want to hold, "tight money" must be defined in terms of an imbalance between the quantity of money and what the demand for money should be.

What does that mean? So far, I have argued that tight money is an imbalance between the quantity of money and the amount of money people want to hold when "the" interest rate is equal to the natural interest rate, coordinating saving and investment, and real income is equal to the potential income, the productive capacity of the economy.


What about the interest rate paid on money? While hand-to-hand currency--paper money and coins--generally pays no interest, most money takes the form of deposits. Using the MZM measure of the money supply, zero-maturity deposits make up 90 percent of the quantity of money. While there have sometimes been regulations prohibiting the payment of interest on some types of deposits, most money takes the form of deposits that can pay interest.

Conceptually, the interest rate on money could fall enough to prevent "tight money." Other things being equal, paying less interest on money should reduce the demand to hold money. If the interest rates on deposits used as money are lowered enough, it is difficult to see how "tight money" could continue to be a problem.

From the point of view of the banks issuing the money, paying less interest on deposits reduces their costs and enhances profits (or reduces losses.) There should never be a problem with banks being unable to afford to lower the interest rates paid on money. Further, it is superficially attractive for each individual bank to pay lower interest rates on money, reducing costs, and adding to profits.

There could be problems in the opposite situation of "loose money," an excess supply of money. If the quantity of money were greater than the demand to hold money, banks could pay higher interest rates on money, raising the demand for money to match the existing quantity of money. This would, however, raise bank costs, reduce bank profits, and perhaps result in heavy losses. Perhaps banks could not afford to raise the interest rates paid on money enough to clear up an excess supply of money. Further, banks are less motivated to take an action that at best reduces profits.

Of course, if we assume that the interest rate on money aways adjusts to keep the amount of money people want to hold equal to the quantity of money, and add that competing banks are able to adjust the quantity of money in response to profit and loss signals, then the result is similar to any competitive market. Prices and quantities adjust to maintain a balance between quantity supplied and demanded.

If "tight money" results in lower interest rates on money, lowering bank costs and enhancing bank profits, then the banks will be motivated to expand their balance sheets, funding the purchase of additional earning assets with the issue of more deposits that serve as money. If bank lending plays a large role in credit markets, then the interest rates on earning assets will fall. As the quantity of bank issued money rises, the interest rates that must be paid on those deposits to motivate people to hold them rises. In equilibrium, the difference between the interest rates paid on money and the interest rates on the nonmonetary assets banks hold will shrink to match the cost of providing intermediation services.

These considerations would be more important if there were "loose money." If banks are assumed to raise the interest rates paid on money enough to increase money demand to meet the existing quantity, and they can reduce the quantity of money by shrinking their balance sheets, then there is really no problem. If higher interest rates on money result in losses, then banks can contract their balances sheets. Again, if the banking system is large relative to credit markets, then interest rates on monetary assets should rise as banks shrink their balance sheets. As the quantity of money falls and the interest rate on money needed to motivate people to hold that quantity of money falls, the difference between the interest rates on nonmonetary assets and money grows until it matches the cost of providing intermediation services.

In their "A Laissez-Faire Approach to Monetary Stability," Leland Yeager and Robert Greenfield describe what they call the Black-Fama-Hall Payments System. They briefly describe a supply and demand approach to monetary equilibrium. They even have a graphical and mathematical treatment in an appendix. Black-Fama-Hall refers to papers by Fischer Black, Eugene Fama, and Robert Hall. The Black and Fama citations refer to papers where similar processes are emphasized. The yields on what serves as the medium of exchange are assumed to continually adjust to avoid any imbalance between supply and demand.

Unfortunately, interest rates on monetary liabilities are unlikely to directly adjust to meet the demand to hold them. Why not?

To the degree we are considering the existing monetary regime, convertibility between bank deposits and base money fundamentally changes the process. (Greenfield, Yeager, Black, Fama, and Hall were all writing about alternative monetary regimes which have no base money.) The interest rates paid on deposits are often an avenue by which banks respond to excess supplies or demands for base money--currency and reserves--rather than to excess supplies or demands to hold the money they issue.

For example, suppose there is an excess demand for currency. The likely result is a withdrawal of currency from banks. The banks respond to their reserve deficiencies in the usual way, by selling off assets and contracting loans. An individual bank can obtains more reserves in that fashion, but only by taking reserves from other banks. While the banking system doesn't obtain more reserves, as banks shrink their balance sheets, the monetary liabilities they use to fund earning assets should shrink. If the banking system is large relative to credit markets, then the reduction in bank lending and sales of securities increase the interest rates on earning assets.

Each bank is also motivated to pay higher interest rates on deposits, including deposits that serve as money. By attracting deposits from other banks, an individual bank attracts more reserves. While this is largely at the expense of other banks, they may even dampen or reverse the initial currency drain. Note, however, that the higher interest rates on deposits is both reinforced and reinforces the changes in the interest rates on bank earning assets. With higher interest rates on deposits, banks must earn higher interest rates to avoid losses. And the higher interest rates on loans and securities allow banks to pay higher interest rates on deposits.

However, this process is not correcting the "tight money." The initial excess demand for currency has resulting in a decrease in the quantity of deposits. Rather than the interest rates on those deposits falling to limit the demand to hold those deposits to the now more limited quantity, the reverse has occurred. The banks raised the interest rates on deposits, exacerbating "tight money."

Suppose that the initial problem wasn't an excess demand for currency, but rather an excess demand for checkable deposits. Do the banks immediately respond to this shortage of their product by lowering the interest rates they pay? It is very unlikely because people short on money are unlikely to show up at the bank asking for additional deposits even if they want to hold larger balances.

Those short on deposits will instead obtain more by selling nonmonetary assets and leaving the funds received in payment in their checkable deposits. (They might also reduce their purchases of goods and services or nonmonetary assets out of current income.) While the sellers' banks receive increased deposits and favorable net clearings, those are exactly offset by the adverse clearings faced by the buyers' banks and the decreases in the deposit balances of the buyers. There is no change in the quantity of money, and so the initial excess demand for money remains.

The sale of nonmonetary assets should lower their prices and raise their yields. Given the interest rate on deposits, this increases the opportunity cost of holding money. The amount of money people choose to hold declines to meet the existing quantity of money. This is, of course, the liquidity effect that plays a key role in Keynesian monetary economics.

How do banks respond to the higher interest rates on nonmonetary assets? The most likely scenario is that they raise the interest rates paid on deposits. The individual bank can earn more on its asset portfolio. To expand its balance sheet it needs to obtain more deposits. Those deposits used for monetary purposes serve this purpose as well as any others. So, the interest rate paid on money can easily rise in the face of an excess demand for money.

To the degree that the higher interest rates on deposits attracts increased deposits of currency into the banking system, the quantity of money created by the banks expands, which does help correct the shortage of money. The primary impact, however, is to make the "liquidity effect" disappear. As banks adjust the interest rates they pay to the interest rates they earn, the opportunity cost of holding money adjusts to the cost of providing intermediation services and no longer causes the demand to hold money to adjust to the existing quantity of money.

While the liquidity effect may disappear, the excess demand for money still exists. Something else, presumably lower real income or a lower price level, will be required to reduce the nominal demand for money to again match the existing quantity.

Are there no scenarios where changes in the interest rates on deposits tends to correct "tight money?" On the contrary, there are many scenarios where changes in deposit interest rates prevent or dampen monetary disequilibrium.

Suppose households and firms decide that they are "overleveraged" and have too much debt. As they restrict new borrowing and seek to pay off existing loans, banks and other lenders respond to the lower credit demand by reducing the quantity of funds lent and reducing the interest rates they charge.

The reduction in the quantity of new lending and the repayment of existing loans shrinks the asset side of the banks' balance sheets. The deposits of those repaying the loans will be decreased, reducing the quantity of money, and creating an excess demand for money.

Worse, given the interest rate on money, the decrease in the interest rates on nonmonetary assets reduces the opportunity cost of holding money. The result is an increase in the demand to hold money. Combined with the decrease in the quantity of money, the shortage of money is exacerbated.

If banks respond to the reduction in the interest rates they earn by lowing the interest rates they pay on monetary deposits, then the the reduction in costs makes the expansion of bank balance sheets more profitable. Further, a lower interest rate on money increases the opportunity cost of holding money.

It is possible that the interconvertibility between base money--reserves and currency--and deposits is equilibrating in this scenario. If the demand for currency, reserves, or both are positively related to the supply of bank deposits, and the quantity of base money is fixed, then a decrease in the quantity of deposits results in an excess supply of base money. As each bank attempts to rid itself of excess reserves, it expands loans and increases deposits in the usual way. Lowering deposit interest rates is another way to reduce excess reserves.

However, if the lower interest rates result in an increase in the demand for base money, either an increase in the demand for reserves because their opportunity cost falls as the return on earning assets falls, or else an increased demand for currency because its opportunity cost falls with the lower interest rate on deposits, then adjustments in the yields on bank issued money will fail to prevent monetary disequilibrium.

In the limit, lower interest rates on earning assets will push interest rates on deposits below zero. At some point, storing currency is cheaper than financial intermediation. By far the cheapest way to store currency is for banks to operate as 100 percent reserve institutions--storing currency for depositors. A sufficiently low demand for credit and low interest rates on money could greatly raise the demand for base money.

So, how does the interest rate on money relate to the concept of "tight money?" Ideally, the interest rate on money would adjust to keep the demand for money equal to the existing quantity. If that were to happen, there would be no monetary disequilibrium, even if bank balance sheets are not at the optimal size to maximize profits.

As an analogy, consider the market price of gasoline. Suppose the market price of gasoline is high and gasoline sellers are making high profits, and will expand the production of gasoline. Clearly, the gasoline market isn't in full equilibrium. But as long as the gasoline market clears, and there is no shortage of gasoline, the plans of the buyers and sellers are consistent.

The problem created by "tight money" is just this sort of inconsistency of plans, but with economy wide consequences. Instead of gasoline buyers being frustrated by shortages and lines, people throughout the economy are frustrated by the inability to sell goods and services, resulting in falling output, income, and employment.

However, the interest rates on money are unlikely to adjust to keep the demand for money equal to the quantity of money. Instead, any adjustments are much more likely to be movements relative to the interest rates on nonmonetary assets, particularly the earning assets held by banks. Any movement is likely to be towards the long run equilibrium where the difference between the interest rates on nonmonetary assets and the interest rate on money is equal to the cost of providing intermediation services.

Again, working by analogy to a market for a single good where excess supply or demand depends on the current market price of the good, the definition of tight money should based upon the existing "price" or rather, nominal interest rate, on money.

"Tight money" exists when the quantity of money is less than what the quantity of money demanded would be given the current nominal interest rate on money, the level of real interest rates on nonmonetary assets consistent with the natural interest rate, and a level of real income equal to potential income.

There are two more factors that need to be considered in understanding tight money, perhaps the most important--the price level and its expected rate of change. What should the price level be now? What should it be in the future? Perhaps the answer is whatever is necessary to keep the real quantity of money equal to the demand. But it really depends on the nature of the nominal anchor of the monetary system. More later...

Why Have Prices Increased?

The price level has nearly doubled during the "Great Moderation."

Why? Is it just a law of nature?

No. The price level rose because the Federal Reserve wanted it to rise.

While they prattle on about their dual mandate of high employment and stable prices, their actual policy is to engineer inflation--about two percent each year.

Economists are discussing the "problem" that inflation is "too low." Over the last year, it has been well below the 2% trend that the Fed had engineered. Perhaps it should be hiked to 3%, the level of 2004 and 2005?

But that isn't the real problem. The real problem is that nominal expenditures are too low.

It is possible that a policy of returning nominal expenditures to the previous growth path would result in temporarily higher inflation. But the purpose of the policy isn't to generate higher inflation. It is rather to raise nominal expenditure, increase sales of consumer and capital goods, expand the production of consumer and capital goods, expand employment producing those goods, and reduce unemployment. Any inflation resulting from the policy is an undesirable side effect.

More importantly, a shift to a three percent growth path for nominal expenditure would keep the price level stable over the long run, with temporary inflations and deflations matching changes in productivity. Instead of seeing the price level double over the next 25 years, it would remain roughly constant--price stability.

Bernanke Should Go!.

Brad Delong asked why Bernanke hasn't adopted a 3% inflation target. He responded:

The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy, thereby contributing to stability in both prices and economic activity. Indeed, the longer-run inflation expectations of households and businesses have remained very stable over recent years. The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations. In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored.

I could understand Bernanke arguing that three percent inflation would be a bad thing. I would agree.

I could understand him arguing that higher inflation would not result in higher expenditure. Or that higher expenditure would not result in higher output or employment.

What I cannot accept is the notion that a commitment to price level stability is important because it "enhances the effectiveness of monetary policy," and his worry that targeting a three percent inflation rate would "undermine the effectiveness of monetary policy going forward."

For more than twenty years, making vague statements about high employment and price stability, while making monthly adjustments in short term interest rates with the apparent goal of having the CPI rise at a 2 percent rate from where ever it happens to be, appeared consistent with better macroeconomic performance than in the past. Unfortunately, this approach was not robust in the face of financial problems for a handful of large Wall Street investment banks.

Bernanke is just too focused on putting humpty dumpty back together. All during the crisis last fall, the focus was on jump starting securitization markets. Now, Bernanke appears willing to accept low production and high unemployment for years, because otherwise, they won't be able to return to their traditional approach to monetary policy. And then there is this fantasy that they are going to get the regulations right this time so that there won't be the sorts of financial disruptions that made their traditional approach to policy ineffective!

A new approach is needed. Rather than a vague statement about price stability and an actual policy of two percent CPI inflation from a drifting base, a clear commitment to a slow, steady growth path for nominal expenditure is needed. With a three percent growth path for nominal expenditure, high inflation, much less accelerating inflation, is impossible. Inflation expectations would be anchored without keeping the Fed from reversing catastrophic decreases in nominal expenditure.

Gary Johnson for President

I know who I will be supporting for President in 2012.

Former New Mexico Governor, Gary Johnson.

I certainly hope he will seek the Republican nomination.

• Lower Taxes
• Balanced Budget
• Opposed the War in Iraq
• Opposes Nation Building in Afghanistan
• Opposes the War on Drugs

Can a libertarian Republican win the nomination? Can he beat Obama's reelection effort?

I am skeptical. But Johnson should win.

He has a book.

And a website.

And he is getting started early. Hopefully, he will begin running soon.

P.S. If only he will get on board with nominal expenditure targeting. :)

Unemployment Report (Newspaper Version)

The unemployment rate in November fell .2 percent. Finally, some good news about employment! Still, a 10 percent unemployment rate is too high. There were 15.3 million unemployed last month.

Worse, unemployment isn’t uniform. The unemployment rate for college graduates was 4.9 percent. Those never completing high school had 15 percent unemployment. For white men over 45, it was 7.5 percent. For white women over 45, it was 5.7 percent. For black men between 16 and 19, the unemployment rate was 57 percent!

Duration of unemployment is also important. While approximately 2.8 million have been unemployed for 5 weeks or less, there are 5.8 million who have been looking for more than six months. The median duration of unemployment is now 20 weeks, so about half have been seeking work for less than 5 months and half for more than 5 months.

The unemployment rate is the percent of the labor force that is unemployed--not working, but actively looking for work. The labor force of nearly 153.8 million is made up the unemployed and the nearly 138.5 million employed. When the recession began in December 2007, there were 146.3 million employed, and so, employment has fallen by nearly 8 million workers.

The official unemployment rate may understate the problem. While “actively” looking for work only requires glancing at the want ads during the past month, there are 5.6 million who say they want a job but are not counted as unemployed. Of those, 2.8 million looked sometime in the last year. Why didn’t they look during the last month? There were 863,000 “discouraged workers,” who said they didn’t think they could find a job. But there were others who had family responsibilities or were ill. Finally, there are nearly 2.1 million people working part time because they cannot find full time work. Combining all of those workers with the officially unemployed, the total was 17.2 percent. Beyond the officially unemployed, there are 7.7 million more workers who would be willing to help produce additional goods and services.

When the Great Recession began, the unemployment rate was 4.9 percent. There were 7.5 million unemployed. The more inclusive measure was 8.7 percent, adding another 5.9 million for a total of 16.2 million workers. Why are so many people not working even though the economy is growing ?

In 2007, the last year of expansion, 22.6 million workers were discharged—fired or laid off-- approximately 15 percent of those employed. Total quits in 2007 were 35 million, 24 percent of those employed. With 39 percent of workers leaving their job one way or another, why didn’t the economy suffer mass unemployment? Firms hired 63 million workers during the year. Total employment expanded by about 300,000 workers, from 146 million to 146.3 million. While many of the quits involved leaving one job for another without any period of unemployment, the turnover in the labor force, leaves many workers unemployed and needing time to find a new job. There were 4.5 million unfilled openings in the typical month, equal to 3 percent of those employed and 65 percent of the unemployed.

What happened during the recession? In 2008, 24.4 million workers were discharged and another 23.4 million during the first 10 months of 2009. That was about 17 percent of those employed. During the dark days of the fourth quarter of 2008 and the first quarter of 2009, when production was falling at a 5 percent annual rate, there was a spike in discharges, going from 2 million a month in October 2008 to 2.5 million a month in January 2009, and remaining at that elevated level through March. That adds up to nearly 2 million “excess” discharges last spring.

Surprisingly, the increase in discharges has been more than offset by a reduction in quits. While there have been 49 million quits during the 22 months of recession (through October 2009,) the rate during the recession fell from 3 million a month in 2007 to 2.2 million a month. That people are less likely to quit their jobs during a recession should be no surprise. During 2009, the quit rate has fallen to 1.8 million per month. Remarkably, total separations, including both discharges and quits is down. The 4.7 million per month rate is substantially less than the 5.2 million per month before the recession.

The real problem with employment has not been the separations, but rather the number of hires. There have been many people hired since the beginning of the recession, 97.8 million, but the rate of hires has been 4.4 million per month since the beginning of the recession and 4.1 million per month this year. That is much lower than the 5.3 million hires per month in 2007. Even though separations have fallen, new hires have fallen even more, leading to the decrease in total employment.

It is the gap between separation and hires that creates falling employment. The biggest was the 637,000 gap in November of 2008 and the 613,000 gap in March 2009 was nearly as large. Only in June did the rapid deterioration end, though separations remained 237,000 greater than hires in October of 2009. Openings are lower as well, averaging 3.2 million during the recession and closer to 2.5 million in recent months. This is much lower than the 4.5 million average in 2007.

Reviewing the facts and figures about unemployment is a good start. But what should be done? The Federal Reserve needs to commit to returning total spending to an adjusted growth path—$16.1 trillion for fourth quarter 2010, and then 3 percent growth in the future. A stable macroeconomic environment is important. However, the best role for the government is to stay out of the way, and let the free enterprise system expand the level of openings and the number of new hires. Only a persistent period with new hires greater than separations—a positive gap-- will increase total employment enough to return the unemployment rate to a more reasonable level.

The Ugly Federal Reserve--Criticism from a former Insider

Michael Belongia has a commentary on reforming the Federal Reserve. He is currently a professor at the University of Mississippi. More importantly, from 1983 – 93 he worked in the Research Department at the Federal Reserve Bank of St. Louis and served as Economic Adviser to that Bank’s President for a time.

What I found especially interesting is his claim that the Chairman of the Federal Reserve is more or less a dictator, primarily because of his control of the staff. However, he goes further, writing:

Chairman Greenspan hijacked monetary policy in the late 1980s and early 1990s from the FOMC – allowing the Committee to vote for “no change” in the funds rate on a Tuesday but then used a change in the discount rate on a Friday with a “pass-through” change in the funds rate for “technical reasons”

It isn't only Alan Greenspan that he accuses of being imperious. He is also critical of Paul Volker.

Paul Volcker vetoed nominations by two regional boards of directors (Atlanta and St. Louis) for new bank presidents and, in the latter case, put in place his own candidate as a solution to the problem of having an independent voice on monetary policy from one research department in the System. While some may have argued that Volcker didn’t want monetarists to be presidents of regional banks, another view is that he didn’t want vertebrates to be in those positions.

Belongia advocates closing down most of the 12 Federal Reserve banks and many branches of those he proposes to keep: New York, Chicago, San Francisco, and Atlanta. He favors having the President of the U.S. appoint the Presidents of these five Federal Reserve banks with Senate approval. He proposes that each of the seven members of the Board of Governors have an independent staff.

He insists that the Fed's dual mandate of stable prices and high employment should be replaced with a single goal--price level stability--and that the Fed should be held accountable for achieving that goal. He is very critical of the monetary statistics generated by the Federal Reserve, arguing that Divisia Aggregates, which are weighted averages of various monetary aggregates is the only scientifically valid approach.

I favor a 3 percent growth path for nominal expenditure, which should provide for long run price stability. While I agree with Belongia that shifting targets in the name of high employment is a mistake, keeping the expected future value of nominal expenditure on target should avoid unemployment due to monetary disequilibrium.

I have also been concerned about the Fed's monetary statistics. In particular, sweep account programs allow banks to reduce reported transactions accounts (checking accounts) to avoid reserve requirements. While I oppose reserve requirements and have no interest in tightening their enforcement, it would be good to know how many checking accounts really exist. Looking at advertisements for sweep accounts by banks, it seems to me that some funds in checking accounts is hidden in things that aren't currently measured by the Fed. The Fed no longer keeps track of the quantity of overnight eurodollar accounts or overnight repurchase agreements, much less includes them with the other zero-maturity monetary assets in MZM. And what about overnight commercial paper? Why isn't that included in MZM?

On the other hand, I don't share Belongia's enthusiasm for coming up with weighting schemes for the various assets. I am skeptical of the monetarist quest for the holy grail of a perfect measure of the quantity of money. I reject the theory that there must be some aggregation of monetary assets the total demand for which changes in strict proportion to nominal expenditure.

HT to Scott Sumner.

Unemployment--Layoffs, Hires, and More

Karl Smith posted this very interesting diagram from the Bureau of Labor Statistics. While there was quite a jump in layoffs and discharges as nominal expenditures and output fell during late 2008, the reduction in new hires and vacancies is much more significant and began a year earlier. It is interesting that there are usually more quits than layoffs or discharges, and while that is now reversed, there are still nearly as many quits as discharges.

Total employment dropped by about 7 million since 2007. The green area above the blue line (the sum of total separations less new hires each month) looks very small, but it accumulates fast.

Colbert on The Fed

Steven Colbert defends the Federal Reserve. Not much worse than Bernanke's academic defenders. Check it out!

(Colbert often mentions that he is from South Carolina, and sometimes that he is from Charleston. He spent some of his childhood on James Island, where I live and served as a member of town council. I always think of Colbert as our native son.)

$100 Trillion Bill

David Beckworth has a hundred trillion dollar bill, from Zimbabwe, on his blog, Macro and Other Market Musings. A 3 percent growth path for nominal expenditure would keep the U.S. from having anything similar.

"Tight Money" and Real Income

"Tight money" is an excess demand for money. The quantity of money is less than the amount of money people want to hold. Unfortunately, tight money impacts the economy, which changes the amount of money people want to hold. For example, monetary disequilibrium impacts real output and real income, which in turn, changes money demand.

When people have less money than they want to hold, they reduce their expenditures or sell nonmonetary assets. It is likely that at least some of the effect of an excess demand for money will be reduced expenditure on output--currently produced goods and services. It is likely that firms will partly respond to the reduced sales of output by cutting back production.

Reduced output results in reduced real income. Assuming that the services from money are normal goods, then lower real income reduces the demand to hold money. If output and income are sufficiently low, the demand to hold money will decrease enough to match the existing quantity of money.

Does this solve the problem of monetary disequilibrium? Of course it doesn't. It is the most disruptive and destructive symptom of monetary disequilibrium.

Yeager, following Keynes, describes this process as an application of the "Fundamental Proposition of Monetary Theory." The individual can adjust his or her quantity of money to the amount demanded, but the economy as a whole must adjust the demand to hold money to a given quantity of money.

Because the actions of the individuals in response to an excess demand or supply of money--changing expenditures--plausibly impacts real output and real income, and because the demand to hold money depends on real income, changes in real income is a means by which the demand to hold money adjusts to the existing quantity.

The fundamental proposition of monetary theory is related to the "Paradox of Thrift." The paradox of thrift claims that an individual can increase saving by reducing consumption, adding to net worth, and expanding his or her ability to consume in the future. However, when everyone tries to save by reducing consumption expenditures, firms sell less and produce less. This reduces real output and real income. Since lower real income plausibly reduces saving, the effort to increase saving by reduced consumption expenditures can fail for the economy as a whole.

A variant of the paradox of thrift focuses on credit markets and debt. Saving is the difference between income and consumption. Individual households can save by spending income on assets, like stocks, bonds, or real estate, rather than consumer goods and services. The accumulated assets represent an increase in net worth.

An individual can also save by using income to pay down existing debt rather than purchasing consumer goods and services. By reducing liabilities, this also increases net worth.

Finally, a household can save by reducing expenditures of money on consumer goods and services and not spending it on anything. The accumulated money balances is an increase in assets, and so, in net worth.

It is this last avenue for increasing saving--spending on nothing and accumulating money--that is one aspect of the fundamental proposition of monetary theory. The second avenue--paying down debt--is related to claims that households are currently "overleveraged," with too much existing debt relative to their incomes, and that this results in a decrease in aggregate expenditures and reduced output.

Keynes described the "Paradox of Thrift" and explained how a kind of cumulative rot, which he called "the multiplier," will result in reductions in real output and real income, so that efforts to increase saving are frustrated by growing poverty. The effort to save results in a decrease in expenditure on consumer goods and services. This reduces the income of those selling the consumer goods and services. Because of their reduced incomes, they spend less on consumer goods and services. That reduces the incomes of those who were selling those consumer goods and services. Only when income falls enough so that saving decreases on net, will the cumulative rot end, and the economy stabilize at a lower level of real income.

However, this cumulative rot only applies to an excess demand for money. If individual households choose to save by spending on nothing and accumulating money, then expenditures on consumer goods fall without any offsetting increase in expenditures on anything else. Those selling consumer goods receive less money in payment, and so they now are short on money. In order to rebuild their money holdings, they reduce expenditures, and so on. One way that the demand for money can decrease enough to match the existing quantity of money is for real income to fall.

What about saving by purchasing assets? What about saving by paying down debts? When households use income to purchase stocks, bonds, or real estate, those selling the assets have the money. What do they do with it? If they hold it, then there is an excess demand for money. If not, then they spend it. If they spend it, what do those receiving the money do with the funds?

Similarly, when saving occurs through a repayment of debt, those who had lent the funds receive the money. If they hold it, then there is an excess demand for money. If they spend it, then what do those receiving the money do with the funds? The only peculiarity of the process regarding credit is that if the loans had been funded by monetary liabilities, then the repayment of the loans can result in a decrease in the quantity of money. Other things being equal, that creates an excess demand for money.

Thinking about what happens to the money when it is saved is not supposed to suggest that there cannot be an increase in the demand for money, (or a decrease in the quantity of bank created money.) It is rather to show that saving can only generate the sort of cumulative rot that would create a paradox of thrift if it either directly or indirectly creates an excess demand for money. There is nothing to the paradox of thrift other than a distorted version of the fundamental proposition of monetary theory.

It is hard to imagine that anyone would consider a reduction output, employment, and real income to be an acceptable, much less optimal, response to an excess demand for money. The most important aspect of economic actitivity is the use of scarce resources to produce the consumer goods and services that people want most. The process of production, earning income, and the expenditure of that income on the produced output is essential that activity.

It is possible, of course, that people may prefer additional leisure time to the purposes they can achieve with additional goods and services. If that is true, then reduced production is desirable, but only because of the value of the additional leisure. It is also possible that people may prefer more consumer goods and services in the present. Because of scarcity, the result will be less production of capital goods, and reduced productive capacity and output in the future. But that doesn't make reduced production optimal in the present.

Shifts in the allocation of labor and capital goods between fields of endeavor can reduce the productive capacity of the economy. The relevant productive capacity is the capacity to produce what people want to buy. There are any number of things that can and should temporarily or permanently result in a temporary or permanent reduction in real output and real income. Such temporary or permanent changes in real income are changes in potential income.

But a shortage of money is not one of those things. Disrupting the production of goods and services, reducing real output, employment, and real income, in order to impoverish people enough so that they are satisfied with the existing quantity of money is unacceptable. The level of real income that would exist without such disruption is potential income--the productive capacity of the economy.

So, what is "tight money?"

It is when the quantity of money is less than what the demand for money would be if real income is where it should be.

And where should it be? It should be equal to potential income."Tight money" exists with the quantity of money is less than the demand to hold money when "the" real interest rate is equal to the natural interest rate which coordinates saving and investment and real income is equal to potential income, the productive capacity of the economy.

"Tight money" might cause nominal interest rates on nonmonetary assets to rise, reducing the demand to hold money. "Tight money" might cause real income to fall, reducing the demand for money. But neither of these things count as fixing "tight money," they are rather symptoms of the disruptions created by "tight money."

I have already discussed the interest rate on money, both currency and deposits in other posts, but there is more to be said--especially how changes in those interest rate could, but are unlikely to, correct "tight money."

Of course, there are two other key macroeconomic variables that impact money demand-- the price level and its expected rate of change. How do they relate to "tight money?" In my view, it all depends on the fundamental nominal anchor of the monetary system and the economic order.

Unleasing Capitalism: Free Market for South Carolina

The South Carolina Policy Council has just released a new book, Unleashing Capitalism. The book is available online. I think it is just what South Carolina needs (and not just because they let me be on the Advisory Board.)

Rowe on Banking

Nick Rowe has an excellent post on what he calls the orthodox and the heterodox views of how bad banks cause problems.

What he calls the heterodox view is right out of Yeager. Banks create money and so can lend money into existence. An individual can correct a shortage of money by spending less. The result for the economy as a whole is lower nominal expenditure.

Perhaps banks that have taken losses and so have too little net worth will fail to lend enough money into existence. If banks fail to lend enough money into existence, there can be a shortage of money, and lower nominal expenditures. Rowe does a great job laying out the problem.

Some complications are that banks fund their activities with a variety of liabilities, only some of which plausibly serve as money. Further, banks hold a variety of assets, with different legal requirements for capital. Further, it is plausible that the amount of capital required to reassure depositors is different for different sorts of assets.

A capital constrained bank can fund more of its asset portfolio with monetary liabilities--checkable deposits. It can shift its asset porfolio from commercial loans to short term, low risk securities. Short term government bonds are obvious. In the U.S. there is a zero capital requirement for government bonds, and it would be sensible for banks too keep little capital to the degree Treasury Bills make up a large portion of their asset portfolio. Interest rate risk suggests that some capital is necessary if banks hold long term government bonds, but perhaps less than commercial loans.

My only criticism of Rowe is that he leaves out currency. Bank money is tied to currency by convertibility. The government monopolizes the issue of currency and pays a zero nominal interest rate. As Yeager explained in 1956, if nominal interest rates get very low (and certainly at zero) any excess demand for securities results in a spillover excess demand for money. (It is like the land example. What if people want to save by purchasing land, and there is an excess demand for land. Suppose frustrated land buyers just hold onto money? There is a spill0ver from the excess demand for land to an excess demand for money.)

Since bank money bears interest, and can have negative yields, then as interest rates fall on securities, the interest rates banks are willing to pay on monetary liabilities decreases as well. That reduces the demand for money, and fixes the problem. Tying in the key role of currency, however, shows that if interest rates on deposits get much below zero, the excess demand for securities near zero shifts into an excess demand for currency.

Either the connection between bank money and currency has to be broken, or else the monopoly issuer has to fix the excess demand for currency. If the excess demand for money exists because it is a spillover from an excess demand for securities, then having the central bank create additional currency by purchasing those same securities in excess demand cannot fix the problem. If the central bank wants to provide a perfectly liquid and zero risk asset at a zero nominal interest rate that serves as the medium of redemption for all the rest of the medium of exchange, then it needs to purchase longer term and higher risk securities. The central bank must bear additional risk--interest rate and/or credit risk.

And that is the rest of the story--how Rowe's orthodox and heterodox views can be made consistent.

Does the world need more monetary ease?

My view is that the Fed should explicitly target a return of nominal expenditure to the trend growth path of the Great Moderation, with a slight modification--3% nominal growth starting from third quarter 2008 and forward. The target should be about $16.1 trillion for the fourth quarter of 2010, about 11% higher than the third quarter of 2009.

How to achieve this? First, make the commitment. Second, stop paying interest on reserve balances at the Fed. And finally, make a commitment to significant quantitative easing.

On Free Exchange, a post describes a specific proposal by Joseph Gagnon of the Peterson Institute to implement significant quantitative easing.

Namely: buy an additional $2 trillion in government bonds, with an average maturity of 7 years. That would be in addition to the $1.75 trillion of Treasury and mortgage-related debt it has already almost finished buying.

Gagnon predicts that the effects would be:

the additional $2 trillion would lower Treasury yields about 0.75 percentage points. That, he reckons, would lower private borrowing rates, boost stock prices 13%, and lower the dollar by 5%. The combined stimulative impact would equal a 1.75 percentage point cut in the federal funds rate, and lift GDP by 3% after two years.

Not quite an 11% increase in nominal expenditure over the next year, but this is the sort of quantitative easing that I have been advocating. Gagnon's paper is here.

A Frightening Quote from Too Big To Fail

I have been reading Andrew Ross Sorkin's Too Big To Fail.

The following is a quote from the book regarding Lehman Brothers:

"While the firm did employ a well-regarded chief risk officer, Madelyn Antoncic, who had a PhD in economics and had worked at Goldman Sachs, her input was virtually nil. She was often asked to leave the room when issues concerning risk came up at executive committee meetings."

I added the bold face. Perhaps there is some explanation, but more than a bit odd...no frightening. At least for anyone who had lent money to Lehman brothers.