Wednesday, November 17, 2010

Monetarists: Quasi vs. Old

I suppose I am a quasi-monetarist. My view of QE2 (quantitative easing 2.0) is better late than never.

Quasi-monetarists are very similar to "old" monetarists. The only real difference is that quasi-monetarists have given up on rules for the quantity of money, mostly because they don't believe that M2 velocity (or any other measure of velocity) is more or less unchanging.

Let's review some similarities. Suppose the economy starts in equilibrium and the growth rate of the monetary base is increased. The monetary authority begins "monetizing the debt" at a more rapid rate by increasing its rate of open market purchases--the rate at which it buys government bonds.

Monetarists and quasi-monetarists agree that this may temporarily reduce nominal interest rates on bonds. This would be the liquidity effect. Both also agree that it can cause an expansion in bank lending. However, both consider these effects unimportant. The key result would be a more rapid growth rate of the quantity of money--the amount of currency and various types of deposits available for households and firms (other than banks) to hold.

The more rapid growth rate in the quantity of money generates more rapid growth in expenditures on final goods and services. This more rapid growth in money expenditures may result in more rapid growth in production and employment for a time, but the eventual effect will be a higher rate of inflation. If this change is permanent and the inflation is expected, nominal interest rates will rise to reflect this higher inflation rate. Real interest rates, real output, employment, and the unemployment rate all return to at least approximately their initial levels. For output and employment this would be a return to their prior growth path, since they are generally rising.

I think it is fair to say that all quasi-monetarists would oppose having the Fed initiate this process. If the economy were in equilibrium, more rapid growth in base money would not be a good policy. Both quasi-monetarists and old monetarists agree that shifting to a new growth path of the quantity of money and money expenditure with higher growth rates will not result in permanently higher levels of real output and employment. If velocity is more or less constant, then a higher growth rate of the quantity of money and a higher growth rate of money expenditures are more or less equivalent. And so, quasi-monetarists and monetarists agree.

Quasi-monetarists, however, are puzzled when "old" monetarists criticize quantitative easing using this sort of argument. Quasi-monetarists think it is obvious that the economy is no where near equilibrium, and so arguments that any increase in the growth rate of base money can only have temporary effects on production and employment but result in a permanently higher inflation rate do not directly apply.

A second area of agreement between quasi-monetarists and "old" monetarists involves some relationships between money and banking. Suppose that the demand for bank credit falls. While banks could simply reduce interest rates and keep their lending the same, it is certainly possible that banks would both lower interest rates and lower the quantity of lending, while increasing the amount of reserves they hold. This increase in "excess reserves" would result in a lower money multiplier. Given the growth path of base money, the quantity of money would fall to a lower growth path. The quantity of money would grow more slowly or shrink, and then resume growing, but it would be lower at each future date.

The decrease in the growth path of the quantity of money would result in a lower growth path for money expenditures--spending on final goods and services. In the short run, this will result in reduced output and employment. The unemployment rate will rise. In the long run, however, the result will be that the price level shifts to a lower growth path, the real quantity of money returns to its previous growth path, and real expenditures, real output , and employment will rise back to their previous growth paths. The unemployment rate more or less falls back to its initial level.

In this scenario, there is never a shortage of credit or any particular reason to expect higher nominal interest rates. The decrease in the quantity of money, however, still results in reduced spending, which in the short run results in a recession--reduced output and higher unemployment.

"Old" monetarists favored a rule for the growth rate of the quantity of money. If there is a decrease in the money multiplier, for any reason, such a rule implies that the monetary authority--the Fed--should expand the quantity of base money however much is necessary to offset the decrease in the money multiplier and keep the quantity of money on the target growth path. Generally, this would involve increased "monetization of the debt." Open market operations--purchases of government bonds--would accelerate for a time, sufficient to offset any decrease in the money multiplier.

If the reason for the reduced money multiplier was an increase in the demand for currency by the public, or else banks deciding they need to hold more reserves without there being any decrease in the demand for bank loans, then the decrease in the money multiplier would occur along with shortages of credit and higher interest rates. However, in the special case where the demand for bank credit falls, and the lower interest rates motivate banks to hold more reserves, then the decrease in the money multiplier is associated with surpluses of bank credit and falling interest rates.

For both quasi-monetarists and "old" monetarists, what is happening to bank credit and interest rates is not important. A rule for the quantity of money requires that the monetary authority--the Fed--expand the quantity of base money the amount needed to offset the decrease in the money multiplier and get the quantity of money back up to its target growth path. This will prevent the decrease in the real output and employment. This will prevent the increase in the unemployment rate. It will make unnecessary the decrease in the price level that would otherwise be necessary to allow for the recovery of the real quantity of money and real expenditures.

It is certainly possible, and even likely, that the efforts of the monetary authority to offset the decrease in the money multiplier would result in lower interest rates than would otherwise occur--at least in the short run. It is possible that the expansion in base money would result in higher bank lending than would otherwise occur. However, the purpose of the increase in base money isn't to reduce interest rates or expand bank lending. The purpose to to offset the decrease in the money multiplier, prevent or reverse any decrease in the quantity of money, and prevent or reverse any decrease in money expenditures on final goods and services.

Both quasi-monetarists and "old" monetarists would agree that allowing a decrease in the quantity of money and money expenditures to a lower growth path is disruptive to the economy and should be avoided. If prices, including the prices of resources such as labor, were perfectly flexible, then the decrease in the growth path of the quantity of money and money expenditures on output would simply result in an immediate decrease in prices and wages. The real quantity of money and the real volume of expenditures would be unchanged. Real output and employment would be maintained. The unemployment rate would not rise.

However, prices and wages are not perfectly flexible, and so real output and employment will be depressed, perhaps greatly. That is why preventing a decrease in the quantity of money and money expenditures is important.

Both quasi-monetarists and monetarists share bewilderment when laymen (particularly central bankers) claim that there is no need to expand base money when the quantity of money is falling because interest rates are very low, banks have plenty of reserves, and there is plenty of money available for businesses to borrow.

Both quasi-monetarists and "old" monetarists try to explain that credit is being confused with money. If keeping the quantity of money on target requires unusually low interest rates, then interest rates should fall. If banks are holding large amounts of reserves by historic standards, then their unusually high demand to hold reserves should be accommodated. If the reason banks are choosing to hold more reserves is a low opportunity cost--lending opportunities look bad--that is irrelevant. It doesn't matter why the banks want to hold more reserves. It doesn't matter why the money multiplier has fallen. The quantity of base money needs to be increased to offset the decrease in the money multiplier.

What about foreign exchange rates? Like "old" monetarists, quasi-monetarists favor floating exchange rates. Changes in the relative competitiveness of domestic and foreign industries, changes in desired capital flows, should simply result in a change in the exchange rate. If
velocity is unchanging, then stable growth of the quantity of money implies stable growth of money expenditures. Suppose keeping the quantity of money on target required the monetary authority to make open market purchases to offset a decrease in the money multiplier. If market conditions result in falling interest rates, and this somehow results in a lower exchange rate, then so be it. The purpose of the increase in base money wasn't to lower interest rates or the exchange rate. The purpose was to keep the quantity of money and money expenditures growing on target. The impact on interest rates and exchange rates are consequences of the rule.

What about changes in productivity? Both quasi-monetarists and "old" monetarists recognized that the productive capacity of the economy can sometimes grow more rapidly and other times more slowly. It is even possible that the productive capacity of the economy might fall. The classic examples are a poor harvest or an "oil price" shock.

By simple arithmetic, the immediate effect of such a "supply" shock is a higher price level and lower real output. The price of the good with the adverse supply shock rises, and given all the other prices have yet to change, the price level rises. The shift of the price level from a lower to a higher level is inflation--a rising price level. If the economy already suffers from inflation, the inflation rate picks up for a time as the price level moves to a higher growth path.

At the same time, the decrease in the production of the good with the decrease in supply, given the output of all other goods, is a decrease in real output and real income. If real output is growing normally, the result could be a temporary slowing of production, with real output moving to a lower growth path and then normal growth resuming. However, if the supply shock is large enough, real output might fall absolutely before growth results.

If the growth rate of the quantity of money is maintained and velocity is constant, then money expenditures continue to grow at an unchanged rate. The arithmetic inverse relationship between inflation and output is constrained to be inversely proportional. If prices go up 1 percent, real output falls 1 percent. If prices rise 2 percent faster, output grows 2 percent more slowly.

While some advocates of a money supply rule may consider the inflation resulting from a decrease in productivity as undesirable implication of the rule, others consider it to be a virtue. A contraction of money growth and money expenditures to prevent any increase in the price level would create additional disruption of market coordination, exacerbating the problems created by an adverse change in productivity. Similarly, that unusual growth in productivity would have the opposite effect--that prices move to a lower growth path, implying temporary deflation, is better than some system of engineering an expansion in money growth and money expenditures to keep the price level from falling.

I think that most, if not all, quasi-monetarists take the position that changing money expenditures to prevent changes in productivity from impacting the price level is undesirable.

That the traditional money supply rule, assuming more or less unchanging velocity, would fail to keep the price level stable in the face of shifts in productivity counts as a virtue.

So what is the difference between quasi-monetarists and "old" monetarists? Quasi-monetarists don't believe that velocity is more or less unchanging and so do not favor a money supply rule. Instead, just as "old" monetarists favored having the monetary authority adjust base money enough to keep some measure of the money supply on a stable growth path, quasi-monetarists favor monetary institutions that cause the quantity of money to adjust whatever amount is needed to keep money expenditures on a stable growth path. In other words, the quantity of money should adjust to offset any change in velocity.

Assuming a monetary authority controls the quantity of base money, then that means that base money must change enough to offset both changes in the money multiplier and changes in velocity. An alternative way to describe the view is that the quantity of base money should be determined so that it matches what the demand for base money would be if money expenditures were on target.

Quasi-monetarists understand that adjusting base money to keep money expenditures on target is more difficult than adjusting base money to keep some measure of the quantity of money on target. There is some hope that a strong commitment to a target for money expenditures would help. But more importantly, quasi-monetarists believe that there is no good alternative. The "old" monetarist approach of stabilizing some measure of the quantity of money has become very undesirable in the face of large changes in velocity. The demand to hold money does not grow at a slow steady rate, and so, some scheme of adjusting the quantity of money to accommodate changes in the demand to hold money is necessary.

Still, the views of quasi-monetarists and "old" monetarists on the relationship between monetary institutions and bank lending, interest rates, exchange rates, and productivity shocks are similar. So, for example, the notion that interest rates are currently low and banks have plenty of excess reserves are not an argument against quantitative easing. If the exchange rate falls because of quantitative easing, so what? Did "malinvestment" in single family housing reduce the productivity capacity of the economy? Perhaps, but that is no reason for a decrease in money expenditures.

No, the key difference is that quasi-monetarists believe that if money expenditures remain below the target growth path, then base money was too low, while "old" monetarists would instead say that if their preferred measure of the quantity of money (perhaps M2) is too low, then base money was too low. And they will insist that velocity will bounce back up soon.


  1. Economic planning (by individuals) yields less desirable results when (unexpected) macroeconomic disruptions occur. What monetary regime would minimize the bad effects of such disruptions? One possibility: the authority should target the price level, or the expected price level, keeping it steady or, perhaps, growing at a slow, even rate. In other words, it should target inflation (or inflation-expectations). Another possibility: the authority should target domestic expenditures (measured in monetary terms), or expected domestic expenditures, keeping them growing at a steady rate (the rate having some relation to the long-run average growth in the economy). (I am not interested in the old monetarist rule for targeting the "quantity of [some sort of] money.") As I understand it, you favor the second possibility over the first. Is your argument for this position *a priori* or *empirical*? Superficially, it seems (*a priori*) that unexpected changes in the price level might thwart economic plans just as much as would unexpected changes in total expenditures. You seem to brush the former sort of disruption aside, but why think it has so little importance?

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  3. Anon: take a look at this paper
    This is the argument for why some kind of expenditure targeting is preferable to price level/inflation targeting. There are some counterarguments, but I think on balance expenditure targeting seems preferable.

  4. Anonymous:

    If you assume perfect market clearing (prices are perfectly flexible, then maybe a stable price level would be better.

    The question is always what is the best response to productivity shocks. Do does a monetary institution (or policy rule) generate monetary disequilibrium to reverse them? Or do you let them be?

  5. I don't know whether you will ever read this, but I was reading your comment the other day and I wondered why your list of reasons for why the productive capacity of an economy might fall was so short.

    A poor harvest or an oil price shock, for sure. But the bigger and more common one must be too much statism or atttempts at socialism. At some point the state becomes too big and is always worse at providing goods and services than market solutions. There must be a tipping point, probably different for different countries and times, when productive capacity starts to fall. At some point, hopefully, the population realises the problem and changes the politicians and shrinks back the state.

    I would also argue that productive capacity might fall after a bubble-bursting event occurs. As recently, we had so much energy and leverage going into a few sectors that ends up majorly misallocating resources. The credit growth,both on and off balance sheet, in the US
    and elsewhere was bound to blow up at some point. The shock could easily reduce the productive capacity of the economy while generally excessive prices are corrected and losses taken.

    The US appears in a long-run decline of its productive capacity caused by creeping statism, compounded with banksters increasing leverage happy in the knowledge they will bailed out when things get tough.

    It's a real problem and merely papering over it via QE2 and current political compromises on extending/increasing tax cuts and continuing spending programmes seems particularly unhelpful.


  6. James:

    I agree that counter-productive government policies can reduce the productive capacity of the economy (too much statism or socialism.) Thankfully, I suppose, this usually just result in less growth, but if taken to a an extreme, productive capacity might fall.

    I also agree that misallocation of resources due to a bubble can reduce productive capacity. I have written quite a bit about it. However, I don't believe that too much debt and the need to work out losses have anything to do with it.

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