Tuesday, December 8, 2009

"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.

13 comments:

  1. Great post!

    You're getting so much better at explaining this stuff, or perhaps I am just getting better at understanding it. In any case, there are some great insights here.

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  2. Bingo! Yes!

    (Bill's getting very good at explaining this stuff, Lee).

    You ran out of steam right at the very end, understandably. A follow-up post is coming, I hope?

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  3. Thanks.

    I am thinking of working on the deposit interest rate issue first, because it is easy. (Nick: as I said on your blog, changes in the interest rates on money could correct monetary disequilibrium, but are unlikely to work that way.)

    Then the price level when the regime is a given nominal quantity of money. Which is relatively easy.

    But then the hard part--what if the nominal anchor is something else? Of course, a growth path for nominal expenditure is my particular interest. (P = Y*/yp) But a fixed price level, growth path of prices, or even inflation rate are possible. A fixed price of gold would be another alternative.

    Given expectations, I think it is right to include the nominal anchor into the definition of monetary disqeuilibrium.

    I have said this before, but I think it needs more thought. For example, under my preferend regime, tight money is when the quantity of money is less than the demand to hold money when the interest rate equals the natural interest rate, real income equals potential income, and the price level is consistent with nominal income being on target. And, of course, the expected inflation rate is whay? consistent with the price level remaining on target?

    Base money needs to rise today (I think.) To where? It where the quantity of money equals to the demand to hold base money. But not what the demand to hold base money is with real income way below capacity. It is rather what the demand for base money would be if nominal expenditure is where is should be.

    But the easy, price level adjusts to get the real quantity of money equal to the real demand first, before adding in claims that no, the price level needs to be at the right place.

    So, I am going from teaching the abcs of neoYeagerism, to something a bit more ambiguous and I suspect controversial.

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  4. Well, it seems to me that the paradox of thrift only holds when: 1) people save by increasing their money balances (i.e. bank deposits and/or currency), and 2) financial institutions are unable to offset this decline in spending by issuing currency or creating loans.

    In other words, the paradox of thrift only holds when monetary monopolies "do nothing" in the face of a particular kind of saving. In the absence of a monetary monopoly, with flexible reserve ratios, private currency, etc., the paradox of thrift would not hold, would it?

    In my opinion, a free banking system would have a propensity to reflexively offset fluctuations in money demand, but it seems as though many economists assume that when a central bank (like the Fed) does nothing, we get a glimpse of what a free banking system would be like. Perhaps this assumption (if it is indeed held as suggested) should be vigorously challenged by proponents of monetary freedom.

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  5. I had never before encountered this idea: when newly expected deflation causes a *depression*, people's real wealth will be reduced, which will reduce their demand to hold money (since poorer people demand smaller money-holdings than rich people, *ceteris paribus*). That is, their real demand will be reduced and, if actual deflation (as opposed to merely *reduced inflation*) is occurring, their nominal demand will be reduced even more. This should mitigate the deflation, at least slightly.

    Monetary Freedom correctly points out that increasing demand for money has nothing to do with the Paradox of Thrift unless the people in the Paradox scenario are trying to increase their saving *by hoarding money*. But that is a plausible means of saving only when deflation is expected (a "liquidity trap"), or when there is widespread pessimism about the future of the economy and about the safety of financial institutions such as banks. Thrift in the form of investing rather than hoarding money presents no "paradox." It is not true that "when everyone tries to save by reducing consumption expenditures, firms sell less and produce less." Consumer-goods firms produce and sell less, but, if the savings are invested, *capital-goods firms* take up the slack.

    Even increased hoarding against the background of an inflexible nominal money supply would present no problem if the price system were perfectly flexible. Nominal expenditure would fall, but smooth deflation would keep real expenditure at its accustomed level. The main real effect would be a mere *transfer* of wealth from creditors to debtors.

    Monetary Freedom's proposal is, roughly, for the monetary authority to adjust the nominal money supply to prevent deflation. Another approach would be to make the price system more flexible, so deflation would not cause a depression. Is there any way to accomplish that? Why does the inevitable "stickiness" of prices (wages, etc.) cause devastating real effects?

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  6. James:

    In an earlier post regarding interst rates and "tight money" I went into more detail regarding the natural interest rate, saving and investment. What "should" happen with increased saving is a shift in the allocation of resources away from the production of consumer goods towards the production of capital goods, which in increase future productivity and the ability to produce consumer goods in the future. This is true regardless of whether the saving occurs by purchases of assets, repayments of debts, or the accumulation of money.

    As I mentioned at the end of this post, changes in the price level must be considered. Yes, "tight money" can be solved by a lower price level. This reduces the nominal demand for money to the existing quantity.

    At first pass, I don't think the price level has any other "job" to do but to adjust the nominal demand for money to is supply. (You can also say, adjust the real quantity of money to real demand.)

    But, it really all depends on the best nominal anchor for the monetary order. And given a choice of nominal anchor, that will have implications for the price level. For example, the price level has to clear the gold market for a gold standard.

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  7. Lee:

    I agree.

    But it isn't necessarily about increasing currency. If there is an increase in saving, and people save by holding more money (currency or deposits,) then an increase in the nominal quantity of money matched by increased bank lending will not only avoid the paradox of thrift, but also do an effective job in shifting the allocation of resources away from the production of consumer goods to the producution of capital goods.

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  8. Bill, during modern recessions don't people often "save" by de-leveraging. And doesn't that, in the short term, reduce bank lending?

    Maybe I am misunderstanding what you said.

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  9. Bill,

    I merely mentioned currency because it is one way people can increase their money balances.

    Your point about the shifting of resources "away from the production of consumer goods to the producution of capital goods" is spot on, in my opinion.

    Here is a question: tight money can be corrected by an increasing quantity of money or decreasing price level, but (even assuming that prices are immediately correcting) is one just as good as the other?

    Many Austrians claim that tight money should only be solved by an adjusting price level, and that any monetary expansion will create price distortions. However, it seems to me that by shifting spending away from consumer goods to capital goods, these are just the kind of "distortions" that we want. Will allowing the price level to fall have these same reallocating effects? I am inclined to say not.

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  10. Lee:

    In my view, changing interest rates is a much better signal of the need to make adjustments in the allocation of resources beween the production of consumer and capital goods than changes in the price level. However, a lower interest rate not only signals a need to expand the producction of capital goods, it also signals a need to expand consumption expenditure. (There is a quantity supplied and a quantity demanded respose.)

    When the price level falls, and the real quantity of bank money rises, there is a matching increase in the real quantity of credit supplied by banks. More capital goods can be purchased with a given nominal quantity of loans.

    Now, with the 100% gold standard scheme, nothing that counts as money is matched by any kind of credit. And so that doesn't happen. More wealth is held in the form of gold. I think what is called the "pigou effect" will be very important. The lower price level results in more consumption spneding after all. Still, as real money balances rise, people can expand expenditures on capital goods.

    So, it is complicated. It depends on the exact nature of the monetary istitutions. The current system of mostly bank money in the form of deposits and a significan amount of Fed money usually financing govenrment bonds, it different again. A lower price level makes all government bond holders better off and increases the real burden on taxpayers.

    Complicated, no?

    I plan to write more about the price level and inflation.

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  11. Doc:

    If all loans are bank loans, then deleveraging must decrease outstanding bank loans. But total lending is much larger than bank lending, so people can reduce their borrowing on the whole, and total lending fall, while bank lending expands. A larger proportion of lending can come from banks.

    If all bank credit is funded by monetary liabilities (like checkable deposits) then if banks lend less, checkable deposits will shrink. But not all bank lending is funded by monetary liabilities. A substantial part is funded by CDs and a little by bonds. Savings accounts are intermediate. Checkable deposits are a small source of founds. So, banks can lend less (and hold fewer securities,) while expanding checkable deposits. It just requires that banks fund a larger proportion of their earning assets with monetary liabilities.

    And, of course, banks can match checkable deposits with reserves too. With a monetary authority organized on banking principles, like most of them, including the Fed, then an expansion of reserves means the central bank lends more, perhaps to the government.

    It is important to understand that there is not a one-to-one correspondance between the quantity of money created by banks (or central banks) and the total amount of loans made by the central bank, the banks, and nonbank lenders.

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