Wednesday, September 23, 2009

Klingonomics 3

Kling is skeptical about the ability of monetary policy to expand nominal expenditures. It is difficult to see how it is much different from the old "pushing on a string" canard.

He argues that if nominal income wants to be 5% lower, then increases in the quantity of money will make no difference. Presumably, Kling means that if the total amount that all the households and firms together want to spend on goods and services is 5% less, then no increase in the quantity of money will cause households and firms to, in effect, change their minds, and not reduce their spending after all. (Of course, some households or firms might reduce spending and others increase spending.) If it is too late to preempt the reduction in spending, so that nominal income has already fallen by 5%, then no increase in the quantity of money can reverse that decrease, and return nominal expenditure to its previous level.

From the equation of exchange, MV = Py, the 5% drop in nominal income is a drop in Py. It must be matched by a drop in MV. And so this desire by nominal income to drop means a drop in either M or V. If M is given, then it is a drop in V, the income velocity of money. But this is just the reciprocal of k, the ratio of real money balances to real income. And so, the desire to reduce nominal expenditure is the same thing as a desire to increase money holdings relative to real income.

Certainly, it is possible that households and firms will prefer to hold more money, which would raise the amount they prefer to hold relative to their real incomes. That raises k and reduces V. The reason an expansion of the quantity of money should solve this problem is that it allows the household's and firms to expand their money holdings as desired without reducing their spending.

Kling's argument that increases in the quantity of money will not prevent or reverse a decrease in spending implies that each increase in the quantity of money generates a further decrease in velocity. In other words, an increase in the quantity of money causes households and firms to being willing to hold larger money balances relative to their incomes. The demand to hold money will passively adjust to meet whatever quantity is created.

This is the liquidity trap. The amount of money people choose to hold passively adjusts to accommodate the amount created. While taking the liquidity trap seriously is a characteristic of Keynesians of one stripe or another, monetarists have a similar concept with their long and variable lags. For the monetarist, the quantity of money is expanded, and only gradually do those holding what are now excess balances begin to spend. How long does it take? Sometimes more quarters, othertimes fewer months. How long will bear speculators keep interest rates high? Few Keynesians claim that it is forever.

Perhaps one might argue that in September of 2008, it was already too late to prevent the rapid drop in nominal expenditure in the fourth quarter of that year. Maybe it was even too late to reverse that drop by the first quarter of 2009. Perhaps it was too late to prevent the equally large drop in nominal expenditure in that same quarter. Now it is September 2009. Nominal expenditure is about 6% below the growth path for the last decade or so. Could prompt action a year ago have impacted nominal income today?

I doubt that nominal expenditure on final goods and services is much impacted by an increase in the quantity of money after a few minutes or even hours. But no effect for a year? I doubt it.

If people were convinced that nominal expenditure would have returned to its previous growth path by now, (a year after the crisis,) how far would the panicky reductions in consumption and investment spending have gone during the fourth quarter 2008 and the first quarter 2009?

1 comment:

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