Saturday, October 17, 2009

Helicopter Drops of Money to Senior Citizens

Tyler Cowen suggested that the Obama administration's proposal to give $250 to each social security recipient is a "helicopter drop" of money a'la Scott Sumner. He argues:

If the helicopter drop substitutes for (part of) a second fiscal stimulus, that's a net gain. The drop of money stimulates aggregate demand, limits deflationary pressures, and, by the way, you're giving it to a lot of people who are not stuck in a liquidity trap. They'd love to buy more stuff in The Dollar Store.
How is this transfer payment money creation? Cowen continues:

How will the expenditure be financed? Obama was vague on that, but as usual the Fed moves both first and last in the monetary policy game
Presumably, then, the relationship to money creation has something to do with the Fed being "last" in the monetary policy game.

Scott Sumner was a bit puzzled by Cowen's argument as well. On Money Illusion, he explains:

This raises two questions; precisely what would the Fed have to do to turn it into a helicopter drop, and how plausible is this assumption? The first question is easy to answer; they’d have to permanently increase the monetary base by $13 billion, relative to the trajectory they had planned before the fiscal authorities came up with this bright idea.
I am not sure what Cowen had in mind either, but I think a good start is to be mindful that the Fed targets the federal funds rate. With interest rate targeting, the quantity of money is endogenous and generally changes with debt-financed government spending.

The government obtains the funds to give to the senior citizens by selling government bonds. The increase in the supply of bonds lowers their prices and increases their yields. Nominal crowding out should occur because those who buy the government bonds have less money to spend.

However, the increase in the interest rate on the government bonds impacts the incentives facing banks in managing their reserves. Banks with excess reserves are more inclined to purchase government bonds than sell federal funds, that is, lend reserves overnight to other banks. Banks with reserve deficiencies are more inclined purchase federal funds, borrow money overnight, than to sell higher-yielding government bonds.

The resulting decrease in supply and increase in demand raise the federal funds rate. The open market trading desk increases open market purchases, buying government bonds with newly created money. This creates excess reserves and reduces reserve deficiencies, reversing the shortage of funds on the federal funds market. And, at the same time, the purchases of government bonds by the Fed creates a demand for government bonds that offsets the added supply of government bonds and the downward pressure on bond prices and upward pressure on bond yields.

In the end, the impact of the government spending financed by bond sales in combination with an interest rate target by the Fed is that the Fed has created new money out of thin air for the Treasury to give to the senior citizens. This is the way "helicopter drops" of money actually occur.

Is it "permanent?" Such a question only makes sense in the context of base money targeting. With interest rate targeting, the quantity of base money adjusts in short run to meet the target. Of course, the target for the fed funds rate changes. If, to pick an example out of the air, the Fed were targeting a growth path of nominal expenditure, changes in base money cannot be "permanent." The quantity of base money must adjust to meet the demand for base money conditional on nominal expenditure remaining on target. Once and for all permanent changes in base money play no role in such a regime.

Sumner doesn't see it this way. He argues:
I think the most likely scenario is that monetary policy would roughly sterilize fiscal stimulus. The Fed has some sort of policy goals, or at least some minimum level of aggregate demand that they find acceptable. If fiscal stimulus doesn’t get us there, the Fed would be more aggressive. If fiscal stimulus does boost AD, then the Fed would be less aggressive.

Trying to figure out what the Fed is trying to do is always a puzzle and it has become much worse in the last year. Sumner's argument suggests that Fed prefers fiscal stimulus to being "more aggressive?" What does more aggression mean? Even lower short term interest rates? Even larger increases in the monetary base? Even larger purchases of longer term government bonds?

I suppose the key question is which current aggressive activity would the Fed reverse due to the Treasury borrowing money to give to Senior Citizens. I am confident that they would not raise the federal funds rate target. Perhaps they would purchase fewer long term bonds or mortgage backed securities.

Regardless, with interest rate targeting, it is almost certainly the case that increased government borrowing to fund additional transfer payments does increase the quantity of money. And these changes should be reversed if and when they cause nominal expenditure to rise above its long term growth path.

P.S. I don't favor helicopter drops of money to the elderly. I favor a commitment to a specific growth path of nominal expenditure, and those more aggressive measures of even lower short term interest rates and even more purchases of longer term government bonds.


  1. I should clarify a few points. I agree that the monetary base isn't the best way of thinking about the stance of monetary policy. I left the wrong impression in my comment on Tyler Cowen. Because he mentioned a change in the money supply, I responded in kind. My point was that it would have had to be permanent to have the anticipated effect. But of course the actual effect would also depend on what happens to the demand for money. So I agree that a more useful way of thinking about monetary stimulus is in terms of expected NGDP growth. In that case the biggest factor explaining large changes in near term NGDP, is expected changes in long term NGDP. So a policy that permanently changes the expected trajectory of NGDP will seem like a highly effective change in the stance of monetary policy.

    When I said the Fed would have been more aggressive w/o fiscal stimulus I was thinking about two possibilities:

    1. Set an explicit nominal target.
    2. Do aggressive QE or lower rates on ERs until inflation expectations in the TIPS markets got up to the desired level.

    I view either of those as permanent changes in policy. On the other hand OMOs that don't change the expected inflation rate are viewed as temporary by the markets, which is why they are ineffective.

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