Selgin on Keynes and Quantitative Easing

George Selgin favorably quotes Keynes,

"Rising output and rising incomes will suffer a set-back sooner or later if the quantity of money is rigidly fixed. Some people seem to infer from this that output and income can be raised by increasing the quantity of money. But this is like trying to get fat by buying a larger belt. In the United States to-day your belt is plenty big enough for your belly. It is a most misleading thing to stress the quantity of money, which is only a limiting factor, rather than the volume of expenditure, which is the operative factor."

Pushing on a string?

In comments, Selgin expands:

"The problem with the argument that, so long as spending appears deficient, more monetary expansion is called for, is precisely that it overlooks the possibility being emphasized here, namely, that conditions are such that banks simply aren't inclined to lend more, for whatever reason. In that case, some deeper problem must first be addressed before monetary expansion can serve any useful purpose; and then, if it is addressed, the expansion may prove unnecessary because spending revives without it."

While I cannot speak for all market monetarists, my support for quantitative easing was not about encouraging banks to lend.  Rather, it was about increasing the quantity of money enough to return spending on output to a higher growth path despite a large decrease in velocity.

If banks are willing to lend, then any increase in base money will be multiplied, so that the increase in base money necessary for the needed increase in the quantity of money would be smaller.

If banks are not willing to make bank loans but are only willing to hold other sorts of securities, then the impact of any increase in base money on the quantity of money is little effected if at all.

However, if banks are not willing to extend any sort of credit, either through loans or purchases of securities, then increasing base money only increases the total quantity of money dollar-for-dollar.   Worse, to the degree the Fed makes purchases of assets from banks, there might be no increase in the quantity of money at all.

However, whatever the reason for this sort of behavior by banks, this simply means that a larger increase in base money is necessary to generate the appropriate increase in the quantity of money.

What is the target for nominal GDP?   Divide by velocity to get the appropriate target for the quantity of money.  Divide by the money multiplier to get the appropriate target for base money.   And keep in mind that neither the money multiplier nor velocity are constant.

If there is feedback mechanism where open market purchases lower the money multiplier or velocity, or both, then this means that base money needs to be larger than otherwise.

While I can imagine a variety of feedback mechanisms where increases in base money cause decreases in the money multiplier or increases in the quantity of money cause decreases in velocity, the most plausible candidate for that sort of process is the expectation that an increase in base money is temporary.  

In my view, the purpose of quantitative easing is to increase spending on output.   By far the best way to do that is to explicitly target spending on output.  

In my view, the problem was not too little base money or even interest on reserves or tighter regulation of bank capital.   The problem was the Federal Reserve's vague inflation/unemployment rate target.    We are committed to 2% inflation, but we forecast inflation to be lower, but we will let it rise above 2 percent in the medium run and we would like to see unemployment fall, so we will maintain monetary accommodation of near zero short rates and we will purchase longer term assets to lower long term interest rates too.

The slow recovery was primarily due to a growth rate target--inflation is the growth rate of the price level.   A level target would have created a better bounce back.   However, a price level target would have been even more disastrous in 2007.   The supposed benefit of an inflation target is that the increase in the price level due to a supply shock can be ignored.   The Federal Reserve failed to do that for worry that inflation expectations would become unanchored.   A price level target would have required that response and exacerbated it.

Still, if the Fed had a nominal GDP level target, I would favor as much "quantitative easing" as necessary to hit the target.    

Yes, I would certainly propose reducing the interest rate on reserves to zero as well.   And if the Fed approached the statuatory limit on what it can buy, then I would propose negative interest on reserves and even privatizing currency before expanding what the Federal Reserve can buy.