Monetary Disequilibrium and Interest Rates

Nick Rowe has argued that Keynesian and New Keynesian models assume that people always borrow money to hold, and that they fail to explain that people borrow money to spend. Since I think that pretty much no one ever borrows money to hold and instead everyone borrows money to spend, this would suggest that Keynesian and New Keynesian models should be rejected.

However, I cannot believe that Keynesians or New Keynesians really believe this. Instead, I think that these models focus on one particular avenue by which monetary disequilibrium can be manifested and emphasize a plausible temporary equilibrium as a way of describing the adjustment process.

It depends on some plausible institutional assumptions. First, at least some people are involved in “cash management,” trading securities on organized exchanges when they have an excess supply or an excess demand for money. Second, the interest rates paid on money balances are “sticky,” and do not immediately adjust with changes in interest rates on other financial assets, particularly the securities that are being traded by those managing their cash positions. Neither of these assumptions is particularly fundamental. Other than that, there is the assumption that the demand to hold money depends on the opportunity cost, the difference between the interest rates that can be earned on other assets, particularly those being managed, and the interest rate on money itself.

If there is an excess supply of money, those who don’t manage their cash positions just spend it on goods, services, or financial assets. Those receiving the money don’t necessarily want to hold the money. They have excess money balances and spend them as well. The hot potato is jumping about. But this hot potato is going to start hitting the money balances of those who manage their money positions, and they will purchase securities on organized exchanges. The prices of these “bonds” rise, their yields fall and the opportunity cost of holding money falls. The interest rate on money remains unchanged, so those that manage their cash choose to hold more money. The demand to hold money rises until there is no more excess supply of money.

There is no borrowing going on at all. What is happening is that there is an increase in lending. Instead of holding money, those who manage their cash positions, lend more by holding more short term bonds. If holding money counts as a type of lending, either to banks or the government, then those managing cash positions are lending less by holding money and more by holding short term securities.

Consider the opposite scenario. If there is an excess demand for money, those short on money may reduce expenditures out of income or perhaps sell assets. Those buying assets don’t necessarily want to hold less money, and it is highly unlikely that those receiving fewer money receipts want to hold less money. They reduce money expenditures as well. However, before too long, those who manage their cash positions end up with less money and sell financial assets to rebuild money holdings. The interest rates on those assets rise. Since the interest rates paid on money are sticky, the opportunity cost of holding money rises, and the demand to hold money falls until there is no longer an excess demand for money.

In this scenario, there is no borrowing. There is a decrease in lending. Instead of lending by holding bonds, they hold more money. If holding money counts as lending to the banks or the government, then they are lending more by holding money and lending less by holding bonds.

But surely this is a peculiar type of credit market where interest rates change without there being any change in the quantity of credit demanded. If credit demand were perfectly interest inelastic, then the story above makes sense. For example, suppose the securities that are used for cash management are Treasury bills, and the amount outstanding doesn’t respond to changes in interest rates. The government doesn’t expand or contract its budget deficit in response to changes in interest rates.

On the other hand, suppose that some of those issuing the securities that some people use for cash management change the quantity issued based upon interest rates. The demand for credit and the supplies of these securities are less than perfectly inelastic. Since those borrowing are unlikely to do so simply to hold money, the changes in the quantity of credit demanded are simultaneously changes in the demand for goods and services or perhaps still other assets.

And this leads us to Nick’s point. If there is an excess supply of money, and lower interest rates clear it up, if there is any increase in the quantity of credit demanded, and those borrowing spend the money, the excess supply of money still exists. Similarly, if there was an excess demand for money, and higher interest rates clear it up, but this results in a decrease in the quantity of credit demanded, and the reduced borrowing involves less spending, then the excess demand for money was not cleared up after all.

Keynesians (new and old,) include this effect as part of the “IS” curve. I suppose it might be rationalized as a rate of adjustment. Short term interest rates adjust very rapidly to absorb any excess supply or demand for money. And then, those new interest rates gradually result in changes in credit markets and spending on output. Assuming money is a normal good, changes in real output and real income cause adjustments in the demand to hold money. If we assume that output adjusts faster than prices (a heroic assumption, though if we “know” that it is prices and wages that need to adjust and that the full price adjustment will fail to occur before there are changes in output, then perhaps looking at what happens to output with given levels of prices and wages is sensible.)

Aside from questions about how interest rates actually change with monetary disequilibrium, which Nick has also emphasized, I would emphasize how this depends on the interest rate paid on money being sticky.

If there is an excess supply of money, and those managing their cash positions buy securities, and this lowers the yields on those securities, and the interest rate paid on money drops in proportion, then the opportunity cost of holding money doesn’t fall, and the excess supply of money and the “hot potato” continues, regardless of the interest elasticity of the demand for credit. Similarly, if there is an excess demand for money, and this raises security yields, but the yield on money rises in proportion, then the opportunity cost of holding money doesn’t rise, and the “musical chairs” problem continues.

So, sticky interest rates on money itself, closely managed cash positions, trading with securities with very low short run elasticity of supply, and we can treat the short term interest rate keeping the quantity of money demanded equal to the quantity of money supplied over some short term time horizon. Of course, if the whole point of the exercise is to help central banks achieve their revealed preference to keep short term interest rates as stable as possible rather than to keep nominal expenditure on output on a slow, stable growth path, the advantages of this approach are clear enough.