Perhaps I’ve been overly influenced by the 2008 period, when the advantages of level targeting seem relatively large. I would also point to Michael Woodford’s work on liquidity traps. Woodford argues that level targeting is especially important when a central bank hits the zero bound (as he is even more skeptical about QE than I am.) McCallum may be right that when the central bank is doing its job, growth rate targeting is as good as or even better than level targeting. By “doing its job,” I mean targeting the forecast.
Sunday, October 30, 2011
Targeting the Growth Path vs. the Growth Rate.
The Long Run Equilibrium Price Level
Saturday, October 29, 2011
Christina Romer for Targeting the NGDP Growth Path
The Goldman Sachs and the Reagan Volcker Alternative--About the Same?
Friday, October 28, 2011
The GDP Report--What's New?
Thursday, October 27, 2011
Nominal GDP Grows 5%!
Wednesday, October 26, 2011
Nominal GDP Targeting and Stagflation
In short, its not at all clear that nominal targeting will work as promised—much less generate real economic growth. And it could set off a deflationary spiral that would lead up into low growth and rising prices. In other words, stagflation.
A deflationary spiral that leads to rising prices? What a contradiction!
But stagflation is a possibility. The problem won't be a deflationary spiral. It is rather that if the productive capacity of the economy has been greatly depressed, and the current level of real output is approximately equal to productive capacity, then a shift to a higher growth path for nominal GDP will generate higher inflation. Real GDP will remain at its current low level (relative to the trend of the Great Moderation.) Presumably employment would remain low and unemployment would remain high. Inflation would be high for a time, before settling back to a slower trend rate once nominal GDP reaches the target growth path. High unemployment and temporarily high inflation--stagflation.
However, the problem wouldn't too much debt or odd arguments where people accumulate money that is losing value. The problem won't be that increased demand reduces demand and creates inflation.
The problem would be that firms cannot expand production because they will face bottlenecks. Perhaps there are key employees they cannot find, or special machinery, or some other kind of resource. And so, if the impact of nominal GDP targeting is simply more inflation and little or no real growth or employment, what would be observed is shortages of output as firms struggle unsuccessfully to meet rising sales.
It is important to understand that the problem wouldn't be excessive debt. The problem would be that the productive capacity of the economy fell in about 2007. Nominal GDP targeting keeps the flow of spending on output steady in the face of shifts in the productive capacity of the economy. The result is a higher price level and temporarily higher inflation. Advocates of nominal GDP targeting believe that this is the least bad environment to make the needed adjustments to such a decrease in productive capacity.
Tuesday, October 25, 2011
McCallum and Targeting the Growth Rate of Nominal GDP
Monday, October 24, 2011
WSJ on Nominal GDP Targeting
There are at least three problems with this strategy, however. First, it assumes that the Fed can sensibly determine the "right" trend for nominal GDP. Second, it isn't clear that it can actually achieve any such target. And third, doing so would run a huge risk of conflicting with the Fed's congressional mandate to promote "stable prices"—something that can't unilaterally be rewritten. This is because any boost to nominal GDP may well come more from higher inflation rather than from faster growth in underlying GDP, which Goldman acknowledges. After all, the economy's real potential growth rate has been slowing for decades.
What should we make of these three points?
1. Can the Fed find the "right" trend for nominal GDP?
In my view, the right trend growth rate for nominal GDP is the trend growth rate of the productive capacity of the economy. This generates zero inflation over time. If the trend shifts, then the result will be inflation or deflation, but unless the shift is extreme, it will be modest.
More challenging is determining the correct level at which to start the trend. The obvious choice would be the current value of nominal GDP. However, the U.S. spent 24 years on one growth path, and suddenly shifted to a new one that is 14% lower. If the growth path of prices and wages had also shifted to lower growth paths--14%, or even to something consistent with plausible estimates in changes to potential real GDP, say 7%, then going forward from where we are now would be sensible.
I am still confident that if the U.S. continues on the current low growth path of nominal GDP, eventually real output will recover to potential. It might even help if the Fed came out and explained that they want the growth path of nominal GDP to be permanently lower and that prices and wages need about 7% deflation to adjust to it. In other words, maybe the Fed should stop promising 2 percent inflation if we really need a year of 7% deflation and then 2% inflation going forward.
However, I think that it is much better to shift to a higher growth path. The notion that this is some kind of out of control inflation is absurd as long as the new growth path remains below the growth path of the Great Moderation. As far as I know, no one, and certainly no market monetarist, has advocated that nominal GDP rise above the growth path of the Great Moderation. The limit of these proposals is a return to the 5.3% growth path that existed from 1984 to 2007, and most of us have been advocating something less--at least modestly lower growth rates (say 5%,) and some kind of upward shift to reverse part of the drop.
For example, I recently suggested matching the growth rates in nominal GDP for the Reagan/Volker recovery of 1983 and 1984. After a 19% increase in nominal GDP over two years, then return to a 5 percent or 3 percent growth rate.
An alternative methodology is to return to 2007, and start with a new growth rate from that point. Apparently, the Goldman-Sachs proposal selects 4.5%, which would be the supposed inflation target of 2% plus an estimate of productivity growth of 2.5%. I have used the same approach with a 3% growth rate for nominal GDP starting in 2007. Oddly enough, nominal GDP is currently about 7% below that path, and closing that would be consistent with closing the output gap while leaving the price level stable.
This ambiguity about the proper growth path should not be exaggerated as an weakness. The key idea is that once on a target growth path is selected--stay there. When errors occur, reverse them and return to the path. And let everyone know that is the plan.
Evans doesn't discuss any of these issues. Her arguments are:
First, it is tempting, but probably mistaken, to assume the Great Recession came along and knocked the U.S. off an otherwise sustainable growth track. It wasn't an external shock, but internal weakness, that led to the economy's collapse.
One worrying aspect of GDP growth prior to 2007 was that it came even as real household incomes stagnated. Assuming that boom-era growth rates were sustainable, and not fueled by a surge in house prices and a credit boom that simply pulled forward demand from the future, is a huge leap in logic.
This is a very serious error. The problem, according to Evans, is that households couldn't afford to keep nominal expenditure growing on a 5 percent growth path. Apparently, only the appreciation of the houses and borrowing provided the funds needed to keep nominal GDP growing.
The basic identity of macroeconomics is that income is equal to output. This is true both in real terms and nominal terms. There is always enough nominal income to afford the nominal value of output. There is never any need to borrow in order to afford to buy nominal output. Home or other asset appreciation isn't needed for people to afford a level of nominal expenditure equal to nominal output.
If real household income did stagnate, with a regime of nominal income targeting, nominal household income (when added to business income) would grow exactly the needed amount to provide the means to purchase the growing nominal output. Sadly, unless this is about growing retained earnings, the result would be higher inflation.
There is an issue, but Evans is mistaken about its nature. C-
2. Can the Fed can actually achieve its target.
This is certainly a concern. With the Federal Reserve's target interest rate at .25 percent, skepticism that reducing it to zero--supposedly the lower nominal bound for interest rates--would raise demand, seems plausible. Market monetarists advocate cutting the interest rate the Fed pays on reserve balances to something slightly less than zero and then purchasing as many assets as necessary to reach the target. To the degree it isn't expected to work, then interest rates on these other assets the Fed purchases would fall.
But how does Evan's explain the problem?
Consider how recent gains in the consumer-price index, particularly in food and energy, have outstripped any increase in wages. This has hurt real income growth, undermined consumer confidence, and weakened, not strengthened, the economy.
She is back to this problem about people being too poor to afford the level of expenditures consistent with the target for nominal GDP.
For the Fed to generate inflation, it needs households to believe the central bank is fueling not just higher prices but wage gains, too, so that they start spending more. Otherwise, households will simply tighten the purse strings instead.
Should I play the Zimbabwe card.? The people in Zimbabwe were and are very poor, but their nominal GDP in Zimbabwe dollars far surpassed the growth path of nominal GDP being proposed--probably for the next century or so.
Of course, Zimbabwe is hardly a model economy. But it illustrates the error. A failure to distinguish between real and nominal values.An increase in consumer prices, ceteris paribus, is an increase in nominal GDP. If an expansionary monetary policy raises consumer prices, then nominal GDP increases. This does not create a difficulty for targeting nominal GDP. It would be a way, (not particularly desirable,) by which nominal GDP would increase.
The notion that households expecting higher prices in the future will reduce nominal purchases now, so they can wait and pay the higher prices in the future, is implausible.
Further, while wages form a significant portion of income, there are the other forms of income too--rents, interest, and profit. If prices rise and wages, interest and rents don't rise, then profits rise.
Finally, there is a confusion between real wage rates and total wages. If demand rises, and prices rise and wages don't rise, then it becomes profitable to expand production and hire more workers. While the real wages of those who were already employed may fall, the real wages of those who were unemployed rise.
Unless the increase in nominal GDP is matched by an exactly proportional increase in prices, then there will be at least some increase in real incomes. Regardless, the ability to spend depends on nominal income, not real income.
Moreover, the level of general inflation it would take to transform housing, the thorniest problem facing the economy, would be huge. Boosting home prices by the 15% to 25% that Barclays Capital reckons many households are underwater "would in all likelihood be prohibitively expensive in economic and social terms," says the firm.
The goal of nominal GDP targeting isn't to "transform housing." An increase in nominal GDP to its target growth path would presumably raise housing demand to some degree. This would raise housing prices. Some of those who are "underwater" on their homes would have higher incomes--perhaps some family members would be employed. Perhaps some of them own businesses that would earn more profit. This would make them better able to make their payments. However, there is nothing in nominal GDP targeting that requires that no one be "underwater" on a home mortgage or that total nominal consumption, much less the consumption of each and every person, rise to the growth path of the Great Moderation.
I suppose Evans can be excused for confusing nominal GDP targeting with proposals to raise inflation. Krugman, for example, has said that the "economics" of GDP targeting is increasing expected inflation to reduce the real interest rate and so generate more real expenditure. Rogoff has been calling for inflation to help the housing sector. Krugman treats nominal GDP targeting like a public relations ploy to promote inflation.
No. Nominal GDP targeting is a monetary regime. If nominal GDP falls below target, then it is the responsibility of the monetary authority to get it back to target. If this results in inflation, then the inflation must be suffered. The purpose of the policy is not to generate inflation.
What about Evans' second concern? Again, some justified confusion with proposals to raise inflation. But some very bad economics. D-
And that leads to the third concern.
3. Is nominal GDP targeting consistent with the Fed's mandate for price stability?
The Fed actually has a dual mandate:
The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.
Well, that is more than two things, but maximum employment and stable prices are generally considered the two important bits.
Nominal GDP targeting changes the monetary aggregates in such a way as to accommodate changes in the demand to hold those aggregates, (offsetting shifts in velocity,) so that nominal expenditure on output grows with the long run potential to increase production. That looks good.
When there are short run shifts in that "potential" output, nominal GDP targeting does nothing to reverse the consequent short run changes in prices, allowing the price level and inflation to fluctuate in the short run. Given all of the focus on the "long run" above, that looks consistent.
And what is the alternative? Have the Fed institute a contractionary or expansionary monetary policy to reverse those changes in the price level. Since a contractionary policy aimed at reversing a supply-side shock to the price level is likely to force employment lower, that looks inconsistent with one aspect of the Fed's mandate.
The CBO estimate of the productive capacity of the economy has increased in each and every year. The growth rate has been less than the 3 percent trend of the Great Moderation for the last 5 years, and so, nominal GDP targeting at the 5.4% trend of the Great Moderation would have resulted in slightly higher inflation than the 2.4% trend--close to 3% for many quarters and near 4% for a few quarters.
If the slowdown in productivity is permanent, then perhaps a shifting the growth path to a slower growth rate would be sensible. However, such an adjustment should be deliberate and with plenty of warning. A shift to a 14 % lower growth path, mostly over a period of one year, is not the best way to proceed.
So, what of this final criticism? Complete failure to look at the Federal Reserve's actual mandate. And, more importantly, a focus on the short run consequences of the regime rather than its long run effect--which is the criterion of the Fed's mandate. F.
Saturday, October 22, 2011
Clark Johnson on the Great Recession and the Goldman-Sachs Toy Model
Thursday, October 20, 2011
Williamson on NGDP targeting
Presumably the advocates of NGDP targeting think that standard central banking practice works, i.e. that a sensible approach to policy over the very short term is to specify an intermediate target for the fed funds rate, with the target set according to the current state of the economy relative to the NGDP target.
Thus, we could specify the implementation of the NGDP target as a rule
R(t) = p(t) - p(t-1) + c[y(t) + p(t) - y* - p*] + r*,
where y*p* is the log of the nominal GDP target and c > 0. We can then rewrite this rule as
R(t) = p(t) - p(t-1) + c[y(t) - y*] + c[p(t) - p(t-1) - p* + p(t-1)] + r*
What's the difference between this and the basic Taylor rule? Not much.
(i) The coefficients on the terms governing the response of the fed funds rate to the "output gap" and the deviation of the inflation rate from its target are constrained to be the same.
(ii) The interpretation of y* may be different.
y* may be different. In the NK literature y* is the efficient level of aggregate output ground out in the underlying real business cycle model. The NGDP targeters seem to think of y* as the trend level of output. For practical purposes it does not make much difference, as the people who measure output gaps tend to think of trend GDP as potential GDP.
Could the Fed actually achieve such a target, even if it wanted to? No. Under current circumstances, there are no actions the Fed can take that could necessarily achieve such an outcome. Indeed, it is possible that the Fed could promise to keep the policy rate at 0.25% for five years in the future, and NGDP growth could fall below the target.
There is no magic in a NGDP target. I know people look at the state of the economy, and think that the Fed should keep trying things. Maybe something will work? Well, I'm afraid not. Even the FOMC dissenters, and their supporters are not quite ready to say that there is nothing the Fed can do under the current circumstances that could increase employment. But they should.
DeLong on Nominal GDP targeting
If you are--as we are right now--in a liquidity trap, with extremely interest-elastic money demand, then expansionary monetary policy that involved the Federal Reserve buying financial assets for cash:
- will have next to no effect on the short-term safe nominal interest rate--it's already zero.
- will decrease the long-term safe nominal interest rate to the extent that your open-market operations today change people's expectations of what your target for the short-term safe nominal interest rate in the future.
- will decrease the long-term safe real interest rate to the extent that it decreases the short-term nominal interest rate and changes expectations today of what inflation will be in the future.
- will decrease the long-term risky real interest rate to the extent that it decreases the long-term safe real interest rate and to the extent that the assets purchased for cash by the Federal Reserve free up the risk-bearing capacity of private investors and lead to a reduction in risk spreads.
- will increase spending to the extent that it decreases the long-term risky real interest rate and to the extent that private spending responds positively to decreases in the long-term risky real interest rate.
Lots of steps here, some of which may well be weak.
Other than 5, all of these steps involve a decrease in the real interest rate, and then 5 is the idea that a lower real interest rate would cause firms and households to spend more. At least some of the steps involve creating expectations about future interest rates and inflation.
An alternative process is that expectations of a higher future flow of money expenditures on output will result in an increase in the profit-maximizing level of output and employment. The increase in the future profit-maximizing level of output increases the demand for capital goods now at any given level of real interest rate.
The increase in the future profit maximizing level of employment decreases the risk of future involuntary unemployment. This results in a decrease in saving now at any given level of real interest rate. (Or, we could simply say that an increase in expected future real income lowers current saving.)
In other words, the increase in present investment demand and decrease in saving supply results in an increase in the natural interest rate. Given the level of real interest rate generated by the first 4 steps described by DeLong, the present flow of money expenditures on output rises.
Using IS-LM analysis, the IS curve shifts to the right because of an increase in expectations of future real output and income, so that it crosses the full employment level of real output at a higher real interest rate. (Nick Rowe goes with a positively sloped IS curve to get at this.)
Why is this process ignored? It does, of course, have a "confidence fairy" element. But so does the process based upon higher expected inflation. Expected inflation can only be created if, somehow, nominal expenditure is going to increase in the future.
Suppose that no one believes that nominal expenditure will rise. Sadly, this forecloses both the higher future real output and higher present natural interest rate path, as well as the higher expected inflation and lower real interest rate path.
Does that only leave us with the pathways described above? Expectations about future policy rates and "free up the risk-bearing capacity of private investors and lead to a reduction in risk spreads?"
I believe that DeLong's approach is too deeply tied to the new Keynesian modeling strategy. The market monetarist approach is that the Fed must commit to purchase whatever quantity of assets needed to reach and stay on the target growth path.
That does not involve convincing anyone that policy rates will be lower in the future. They can expect what they want. The Fed will lower long rates by purchasing long term to maturity assets at higher prices. Sure, if the private sector continues to hold some too, and they don't expect nominal GDP to rise, those particular investors holding them must be expecting that future short term rates will be low. But that isn't what the Fed would be trying to do by purchasing the long term to maturity assets.
And, if necessary, the Fed would start purchasing risky assets (and yes, seeking changes in the law if necessary.) Freeing up the risk bearing capacity of private investors is probably not the best way to look at the situation. The Fed would be taking however much risk as is needed to generate sufficient consumption and and investment to get nominal GDP to target.
But just because the Fed would be committed to increase the quantity of base money to an amount equal to the nominal GDP target (or twice that amount,) if necessary, doesn't mean that there is a need to worry about base money being $15 or $30 trillion. It is not realistic to expect nominal GDP won't rise to target, which means that the higher natural interest rate and/or the lower real interest rate through higher expected inflation paths will kick in. And when they do, nominal and real interest rates can rise.
That Woodford and other neo-Wicksellians/new Keynesians developed simple models that show how a central bank can manipulate a short and safe interest rate according to a rule, and thereby manipulate long term risky real interest rates in a way that stabilizes inflation and closes output gaps is very interesting. Those rules very much depend on everyone understanding how the central bank will manipulate future short term interest rates in response to output gaps and inflation.
However, it is a mistake to assume that the only way that central banks can operate is by creating expectations about how short term interest rates will behave in the future in response to future output gaps and inflation. Since telling people that the Fed expects its policy rate to stay low for an extended period of time and even until 2013 hasn't generated a strong recovery, perhaps there is a problem with the model. But more importantly, imagining that heroic quantitative easing works by creating expectations about future short term rates is very implausible.
Why is it that the effect on the "IS" curve is ignored? If the new Keynesian approach works, then we would never get into a situation where saving rises and investment falls because people don't believe that the levels of short and safe interest rates that the central bank will set in the future won't generate a recovery. The only way that an output gap can be generated is if real interest rates are too high. The only way to fix it is to generate expectations of lower real interest rates.
But we know that strong recoveries create strong credit demand which raises equilibrium real interest rates. In my view, the new Keynesian models are just too tied to a regime of a central bank that adjusts a short and safe interest rate according to output gaps and inflation. They are poorly suited to considering an alternative regime where current and future interest rates can be at any level, and what is stabilized is the growth path of nominal GDP.
I don't deny that if no one expects the policy will raise nominal GDP, then lower nominal interest rates are what make massive quantitative easing work despite perverse expectations. But this hybrid approach where real long term interest rates must be lower is wrongheaded. And it matters from a practical perspective, because if and when people expect the policy to work, nominal and real interest rates should rise. And no one must expect that future "policy rates" will be low.
Playing with the Goldman-Sachs Toy
Krugman Advocates Nominal GDP Targeting
My beef with market monetarism early on was that its proponents seemed to be saying that the Fed could always hit whatever nominal GDP level it wanted; this seemed to me to vastly underrate the problems caused by a liquidity trap. My view was always that the only way the Fed could be assured of getting traction was via expectations, especially expectations of higher inflation –a view that went all the way back to my early stuff on Japan. And I didn’t think the climate was ripe for that kind of inflation-creating exercise.
Seemed to be saying? Sumner, especially, has been emphasizing the importance of expectations since the day he started his blog, and long before. Further, he probably writes about how it is important to generate expectations of higher inflation more often than he writes about how it is important to generate expectations of higher level of nominal GDP. I know, because I take him to task every time he makes that mistake.
While it is true that expectations of higher inflation in the future can raise nominal GDP now, and could also create inflation now, expectations of a higher level of real output in the future can also raise nominal GDP now, and create more real output now. Sumner's actual view is that expectations of an increase in the flow of expenditure on output in the future will generate an increase in the flow of expenditure on output now. To what degree firms either now or in the future respond to that by raising either prices or production is not essential to the process.
But, of course, an increase in production would be better than an increase in prices. My own view is that an increase in production would be good and an increase in prices would be bad--a necessary evil to maintain the regime of nominal GDP targeting.
On the other hand, I was much more guilty of ignoring the key role of expectations early on. The relationship between expected future nominal GDP and current nominal GDP played little role in my thinking. I certainly downplayed the problems associated with a liquidity trap.
On the other hand, I have never assumed that modest changes in the quantity of money would generate whatever nominal GDP the Fed wants. I have always thought that quantitative easing in heroic amounts might be needed to keep nominal GDP on target in a situation what would otherwise develop into a Depression. Something causes a large drop in the money multiplier and velocity, so a large, perhaps very large, increase in base money would be necessary.
What is the relationship between expected inflation and nominal GDP targeting? There is no need for the Fed to say that it wants more inflation. However, it does need to be willing to accept higher inflation if that is the consequence of nominal GDP rising to the target growth path. The expectation that the Fed would respond to any increase in inflation that occurs by giving up on the target for nominal GDP would make it difficult and perhaps impossible to reach the target growth path.
The Fed cannot play at nominal GDP targeting. It must adopt the new regime. It should adopt the new regime--it is better.
Tuesday, October 18, 2011
Goldman-Sachs on Nominal GDP Targeting
Tuesday, October 11, 2011
Is DeLong a Market Monetarist?
It is not Republicans in Congress that kept and are keeping the Federal Reserve from charging for reserve balances or engaging in more quantitative easing or targeting the nominal GDP growth path.
He can use IS-LM all he wants.
Yes, the Fed is Breaking the Law!
Balances maintained at a Federal Reserve bank by or on behalf of a depository institution may receive earnings to be paid by the Federal Reserve bank at least once each calendar quarter, at a rate or rates not to exceed the general level of short-term interest rates.
Sunday, October 9, 2011
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.