Money Disequilibrium and Interest Rates

The monetary disequilibrium approach sees recession as an implication of the fundamental proposition of monetary theory.   If the quantity of money is less than the demand to hold money, households and firms will reduce expenditures out of current income.   As they spend less on current output, firms will reduce production, which reduces real income.   Since lower real income reduces the demand to hold money, the amount of money people choose to hold will fall to meet the existing quantity of money.

Those taking this approach consider this "recession" state of the economy to be a problem.    Real output, real income, and the employment of resources are too low.    There is some fundamental assumption that the employment of labor and other resources to produce consumer goods and services either now or in the future is the point of economic activity.   Disrupting this market process so that the demand to hold money will drop to meet the existing quantity is undesirable.    Nothing in this scenario implies that there was an increase in the desire for leisure relative to present or future consumption.   

If this change impacted every individual in strict proportion, then the problem would be apparent.   Everyone would earn a lower income, and be consuming or saving less.   No one's money balance would be any higher.   Given their reduced incomes, they would presumably think that they need to hold off on their prior plans to increase money balances until after economic conditions improve and their incomes recover.

In the real world, it is quite possible that some individuals will continue to earn unchanged incomes, continue to consume and save as before, and to have increased money holdings.   The reduced income, consumption, and the reduced money holdings are all problems of other people.      As far as they are concerned, there is no disequilibrium.   While I doubt that economists are especially compassionate relative to other people, most are especially sensitive to what is "unseen," including puzzling sacrifices of output and consumption, even if the sacrificed consumption would have benefited other people.

Regardless, there is some sense in which the reduced real income has corrected the monetary disequilibrium.   The demand to hold money matches the existing quantity of money.   Where is the shortage of money?   Those who focus on monetary disequilibrium must reply that the quantity of money is less than what the demand for money would be if real income was at level consistent with full employment of resources.     The quantity of money is less than it would be if real income were at a level consistent with the productive capacity of the economy.

Generally, if real income and output have fallen, so that the demand to hold money has fallen to meet the existing quantity, quasi-monetarists would advocate increasing the quantity of money to match what the demand would be if real income and output matched the productive capacity of the economy.    Most importantly, that is what the quantity of money should have been.   If the quantity of money had been at that level, then there would have been no shortage of money, so real income and output would not have fallen to a level below what is consistent with the productive capacity of the economy.

Of course, the key benefit of having the quantity of money at that level is that output, real income, and employment should promptly rise to a level consistent with the productive capacity of the economy.   Which would, of course, imply that the demand to hold money would promptly rise to match that appropriate quantity of money.

However, assuming output, real income, and employment fail to rise immediately to this level, there is an excess supply of money given the depressed level of real income.    While there is monetary equilibrium in the sense that the quantity of money matches what the demand for money would be if real income matched productive capacity, real income is below that level.

Suppose that the quantity of money increases through the banking system.   The Fed purchases bonds.  Those selling the bonds have additional money balances, and their banks have excess reserves.  The banks also purchase bonds or make loans until some bank or other is willing to hold the added reserves or else currency is withdrawn from the banking system.    Those selling bonds to the banks, or receiving loans, have additional money balances.   While anyone directly borrowing from a bank is likely to spend the money, those that receive the money from selling bonds have additional money balances.    Those with what are now excessive money balances spend them.  Firms sell more, produce more, and hire more resources.   Real income and employment both rise.  The demand to hold money rises to match the increase in the quantity of money.     If the quantity of money was increased the correct amount, the increase in output and income brings it up to the productive capacity of the economy.    The quantity of money matches the demand to hold money at a level of real income equal to the productive capacity of the economy.

Certeris paribus, all of this bond buying (as well as additional bank lending) should lower market interest rates.   And so, it is plausible that if output, income, and employment have already fallen enough to reduce money demand to match a given quantity of money, increasing the quantity of money to the "proper" level will be associated with lower interest rates.   If this should occur, would these interest rates be "too low?"

What is the relationship between these interest rates and the natural interest rate that coordinates saving and investment?

Consider the paradox of thrift.   The thought experiment starts with an increase in the supply of saving.  This is, simultaneously, a decrease in the demand for consumer goods and services.     Ignoring any effect on the interest rate that expands spending by firms on capital goods while dampening the reduction in consumer expenditure, this results in less spending on currently produced output.  As firms sell less, they produce less.  Output, income, and employment fall.    Because of the reduced income, saving falls.    The effort to save more has the unintended consequence of causing real income to fall enough, that saving doesn't increase after all.

The paradox of thrift is very similar to the fundamental proposition of monetary theory.   What is important here, however, is the behavior of saving.    If saving is positively related to income, so that the lower output, income, and employment decrease saving supply as well as the demand for money, then there is an ambiguity in the concept of the natural interest rate.    Is the natural interest rate the level of the interest rate that coordinates saving and investment at the existing level of real income whatever it might be?  Or is it the level of the interest rate that would coordinate saving and investment at the level real income consistent with the productive capacity of the economy?  

If this second approach is taken, and the natural interest rate is that level of interest rates that keep saving and investment equal when real income equals the productive capacity of the economy, then the level of interest rate consistent with saving and investment being equal with the depressed level of output is greater than the natural interest rate.   In that circumstance, increasing the quantity of money to meet what the demand for money would be if real income matches the productive capacity of the economy, should be expected to reduce market interest rates so they will adjust to the level that will cause investment demand to match the supply of saving  if real income matched the productive capacity of the economy.

A scenario where depressed output and income results in low money demand and saving supply is possible.   An increase in the quantity of money could result in lower market interest rates along with higher output, income, and employment, and saving.   The lower market interest rate would be a shift to the natural interest rate.   In this scenario, it would seem that a central bank could lower its target for some interest rate or else raise its target for the quantity of money.

However, there is a second impact of monetary disequilibrium on the natural interest rate that is far more important.    If income, output, and employment are expected to be depressed in the future because of monetary disequilibrium, this will reduce investment demand and raise saving supply.   Both of these factors will reduce the natural interest rate in the present.     And, conversely, expectations that monetary disequilibrium will be alleviated in the future will result in expectations of higher output, income and employment in the future, and that will result in increased investment demand , reduced saving supply, and so a higher natural interest rate in the present.  

Fortunately, it is possible that an increase in the quantity of money will be associated with higher rather than lower market interest rates, even if the increase in the quantity of money is implemented in the usual way--purchases of bonds by the central bank.   All that is necessary is that when the Fed and the banking system purchase bonds (or make commercial loans,) households and firms sell off some of their current bond holdings or borrow by issuing new bonds.  This decrease in the supply and increase in the demand for credit can result in higher market interest rates.   Do these higher interest rates imply that there is no decrease in spending on capital or consumer goods or both?    Not at all.   It simply requires that households selling bonds use the funds raised to purchase consumer goods and firms selling bonds use the funds to purchase capital goods.   Why would they increase spending?   Again, it because output, income, and employment is expected to be higher in the future.   The natural interest rate has increased.

In conclusion, if output, income, and employment are depressed because of an excess demand for money, an increase in the quantity of money can be associated with falling market interest rates that bring saving and investment into coordination at a level or real income consistent with the productive capacity of the economy.    However, the increase in the quantity of money can be associated with rising market interest rates, that also bring saving and investment into coordination at a levels of both current and future real income consistent with the productive capacity of the economy.

P.S.  As Lee Kelly points out in his comment below, this entire analysis assumes perfectly rigid prices.  I don't consider that realistic, but rather as an analytical tool to focus on the effects of monetary disequilibrium on income and output.