Wednesday, February 27, 2013

Sumner on Monetary Disequilibrium

Scott Sumner doesn't like the concept of monetary disequilibrium.  

Since Sumner's prefered transmission process for changes in the quantity of base money is "the hot potato effect," I think he cannot help but accept the monetary disequilibrium approach.  

Sumner claims that disequilibrium is a "psychological concept."    Apparently, the "psychology" must be that some individual feels discomfort.   Of course, the entire monetary disequilibrium approach is based upon the distinction between an individual who can easily adjust the actual quantity of money held to the amount desired, and the economy as a whole, which must somehow adjust the desired amount to be held to the existing aggregate quantity of money.    

The second step of the process is that when one individual spends more to be rid of excess money balances, someone else ends up with the excess balances.   This is "the hot potato effect."   If the focus is solely on the one individual who has already adjusted actual balances to desired balances, then that person has no pschological dissastisfaction.    But whoever now has the added, and now excess, balances has the disequilibrium.  (With excess money balances, this is a happy condition, a bit like a seller in a market with a shortage.   Plenty of customers--should I raise prices, produce more, or both?   Is it a problem?  Or an opportunity?)

But when he argues that there is no monetary disequilibrium, "the hot potato effect" is no where to be seen.   He traces though a plausible story by which an economy assumed to be in equilibrium responds through time to a "bolt from the blue," permanent change in the quantity of base money.  

Sumner describes the immediate effect of the permanent increase in the quantity of base money by what appears to be the "liquidity effect."   The traditional Keynesian approach would be that people spend any excess money balances on assets.   This causes asset prices to rise and asset yields to fall.    Base money is assumed to bear no interest.   The lower yields on other assets reduces the opportunity cost of holding base  money.   The amount of base money people want to hold rises.     Once asset prices are high enough, and asset yields are low enough, the quantity of money that people want to hold in aggregate matches the new, increased quantity that exists.

Given that approach, it is common to assert that there is no monetary disequilibrium once "the" interest rate has adjusted.   However, "the" interest rate is now below the natural interest rate, which leads to an amount of investment greater than the amount of saving.  (This could occur through more investment, less saving, or a bit of both.)  An alternative framing is that the sum of consumption and investment spending  is greater than potential output.    Shortages of output lead to higher prices.   This increases the demand for money, which results in higher market interest rates.   Once the market rate rises back to the natural interest rate, saving equals investment and the sum of investment and consumption matches the productive capacity of the economy.   The increase in base money resulted in a proportional increase in both the price level and nominal income.

Sumner usually dissents from this neo-Wicksellian/Keynesian approach.    I think a key problem is that rather than a liquidity effect where people with excess money balances just bid up asset prices and so reduce asset yields until they are willing to hold the existing quantity of money, Sumner is focusing on equities.   The long run effect of the permanent increase in the quantity of base money on the price level is that for any real level of profit, nominal profits will be higher.   This makes the fundamental nominal value of stocks higher.

Stock markets have very flexible prices, and so the market prices of the stocks immediately adjust to their new, higher fundamental values.   Since other goods and services have sticky prices, the real price of stocks  rises, but this is only until other prices catch up.    The nominal stock prices don't fall, but when other prices, such as the prices of consumer goods and services rise, real stock prices fall back to their initial value.

It is true that an exogenous and permanent increase in base money should immediately raise nominal stock prices.   And until other prices catch up, those already holding the stocks are "really" richer.     However, what does this have to do with monetary disequilibrium?   Yes, those who were owning stocks are temporarily richer, but does this cause a temporary increase in the demand to hold money?    

Is the assumption some fixed ratio between desired real money balances and actual real stock holdings?  

Of course, Sumner's usual approach is that "the hot potato effect" results in more expenditures on output directly and on labor indirectly.  This suggests that the temporary increase in real equity prices and the consequent greater real wealth does not increase money demand enough to clear up the excess supply of money.   Suppose nominal stock prices adjust to their new, long run equilibrium values and there remains an excess supply of money.   It would seem like anyone paying more than that price for the stocks would be setting themselves up for a capital loss.    People may have excess money balances, and they could buy stocks and bid their prices up more, but they don't want to buy stocks because their prices would be "too high."   So what do they do with those money balances now?

No, we are simply left with the simplistic focus on the individual that has already gotten rid of the hot potato being in equilibrium, while ignoring that whoever received the excess money now faces the disequilibrium.  (My own view is that the liquidity effect is real when the interest rates paid on money balances are fixed or sticky, but interest rates being different from the natural interest rate is monetary disequilibrium.   Saving greater than investment or total expenditure greater than potential output is monetary disequilibrium.)

Sumner then goes on to argue that the disequilibrium is in labor markets.   There is no imbalance between the quantity of money and demand to hold it, rather there is an imbalance between the quantity of labor supplied and demanded.   With a permanent increase in the quantity of base money, the disequilibrium would be firms feeling discomfort due to their inability to recruit workers.   (Actually, Sumner seems to believe that forced overtime is the problem.)

Is the problem "really" a shortage of labor?   Would an increase in the payroll tax paid by employers solve the problem?   In my view, the "solution" is for prices and wages to rise enough fso the real quantity of money falls enough to match the amount of real balances people want to hold.  To me, given that this is the solution, the problem is an excess supply of money.   Disequilibrium is an imbalance between supply and demand.

Also, this thought experiment of a permanent increase in the quantity of base money as a bolt from the blue is a special case.   Suppose the increase in the quantity of base money is not permanent and there is no permanent increase in future nominal income.  This entire step of stock prices rise immediately because of the long run impact on nominal future profit disappears.    But can't a temporary increase in base money cause a temporary excess supply of money?

Further, Sumner is misled by his emphasis on hand to hand currency.   He writes:

 When the Fed increases or decreases the base I do not walk around weeks later frustrated that my wallet contains $260 in cash, rather than $240 or $280. I’m holding exactly as much cash as I prefer to hold, given current asset prices.

Note the assumption that the Fed increases base money by handing out wads of currency to individuals.   Do they feel frustrated by carrying around excess currency?   Does Sumner personally have the experience of carrying about more currency than he wants?

Well, in reality, there is an easy way to get rid of excess currency.   Deposit it in a checkable deposit account.  So, sure enough, most individuals do not feel that they have too much currency.    Of course, most people would spend currency rather than use a debit or credit card or write a check.   But that shifts the currency into the hands of retailers.  And what do the retailers do?   They deposit it in their banks.   

Now, of course, the excess supply of base money is the hands of banks.   Is the problem that banks feel that their vaults are too full?   Well, banks constantly send worn currency to the Fed and order new currency.   All they have to do is order less new currency.   But then, the excess money balances are in the form of bank reserve balances a the Fed.

In reality, increases in base money directly increase the checkable deposits of people selling bonds to the Fed and the reserve balances of their banks.   And so, thinking about people walking about with wads of currency in their wallets is misleading.

To take Sumner's remark literally, however, he seems to be saying that people with excess currency in their wallet go to their stock broker and use it to purchase stocks or bonds.   And once stock and bond prices have risen, then they are happy to keep more currency in their wallet.  Really?   I am pretty sure that my average wallet holdings are not positively related to the S and P 500.

As for the money balances that actually count (the money in my checkable deposit,) I cannot begin to pretend that I am always holding the optimal amount.   Of course, I never feel "frustrated" as in, "unhappy" when my checking account balance is "too high."   No, I am pleased.   I happily solve this "problem," by spending more.   And, by the way, my money holdings are not strictly proportional to the S and P 500.

I have never had "forced overtime," so I don't really know how that would impact my desired money balances.    What I do believe is  aggregate desired nominal money balances--checkable deposits, currency, and bank reserves, is positively related to aggregate nominal income.

Perhaps it would be better to go back to thinking about a shortage of money, rather than a surplus.   But trying to identify "monetary disequilibrium" with people walking about with overfull wallets and having nothing to buy is wrongheaded.

Sunday, February 24, 2013

Monopsony and the Minimum Wage

A monopsony is a market is characterized by many sellers and a single buyer.    The traditional microeconomic analysis of a monopsony is a bit of a mirror image of a monopoly.  

A monopolist faces the "industry" demand curve.   Marginal revenue is less than price for any quantity the monopolist might produce.   Because of the law of demand, to sell another unit of output requires a lower price.   That price is additional revenue for the firm.   However, lowering the price implies that less is earned on all of the output that could have been sold if the price hadn't been cut.  The decrease in revenue from the other units must be subtracted from the price to get marginal revenue--the additional revenue earned from producing and selling and additional unit of output.

Profit is maximized  at a level of output were marginal revenue is equal to marginal cost.   For this to be a maximum profit, the monopolist must then charge what the market will bear, a price greater than marginal cost.   This is at a level of output less than where price equals marginal cost.   The monopolist's price is "too high" and production is "too low" compared to perfect competition.   

Perfect competition can involve all sorts of assumptions (some wildly implausible,) but the key one in this context is that the typical firm takes the current market price as independent of it particular level of production.   This makes marginal revenue equal to price, and so the profit maximum is where price equals marginal cost.   This exhausts all gains from trade from producing the product.  

A monopsonist faces the "industry" supply curve.   The traditional analysis assumes that the law of supply applies to whatever the monopsonist is buying.   Suppose the monopsonist is purchasing some resource that will be used to produce a product for sale.   The marginal cost of the resource is greater than the price the monoposonist pays.    The law of supply implies that the monopsonist must offer to pay more to purchase another unit of the resource.   The amount paid for that unit is a cost to the monopsonist, but the extra amount paid for all of the other units that could have been bought if the monopsonist hadn't offered to pay more is also a cost.   Together, those represent the marginal cost for the monopsonist, which is greater than price (except for the very first unit.)

The monopsonist maximizes profit by purchasing an amount of the resource where the marginal cost of the resource is equal to marginal revenue product of the resource.   The marginal revenue product of the resource the additional revenue that can be earned by selling the additional product that can be produced with an additional unit of the resource.   For this to be a profit maximum, the monopsonist must pay no more for the resource than he must, which is less than the marginal cost.    The amount paid for the resource is less than the marginal revenue product.   The amount paid for the resource is "too little" and the amount of the resource purchased and utilized in production is "too little" compared to perfect competition.

Perfect competition in this context would require that the typical firm takes the amount that must be paid for a resource as independent of the amount it purchases.   This makes the marginal cost of purchasing the resource equal to the price that must be paid.  The profit maximum would be where that the price of the resource is equal to the marginal revenue product.   This would exhaust all gains from trade.

How does this relate to labor?   Suppose there is a isolated mountain valley.    Some families farm steep and rocky hillsides.   Some have nice bottom land.   The productivity of the each families' land varies.    One lucky hillside farmer discovers a rich vein of coal on his land.   He opens a coal mine and hires his neighbors to work for him mining the coal.   If the coal company offers a low wage, then only the farmers with the worst land will abandon their farms and come to work in the mine.   If it offers a higher wage, more farmers, with slightly more productive land, will give up farming for a life in the mines.    If it pays enough, even those families with the fine bottom land will decide that farming corn isn't worth it, and go into the mines and dig coal too.  

The coal company faces an upwardly sloping supply curve for labor.   If it hires another miner, more coal will be dug and it can be sold generating additional revenue.   The marginal revenue product of labor is the added revenue that can be earned from the extra coal that can be dug by the additional miner.

But to get another farmer to abandon his farm and go into the mine, the coal company must raise the rate of pay.    The wage  the coal company pays that additional miner is a cost, but the extra amount paid to all of the other miners who found the lower wage better than their rocky hillside farms must be included as well.   The wages earned by the added miner, plus the added wages paid to all of those already working in the mine is the marginal cost of labor.

The profit maximum for the coal company is where the marginal cost of labor is equal to the marginal revenue product of labor.     The wage paid to the "marginal" worker plus the added wages paid to all of the other workers already in the mine must equal the extra revenue obtained from selling the extra coal dug by that marginal miner.   The wage paid to that marginal miner is just a bit more than what he could have earned if he stayed on his farm, and it is less than the marginal revenue product of labor, the amount of revenue generated by the coal he can dig.

Consider a farmer who makes just enough money on his farm that going into the mine is not worth it.     He is growing corn and selling it.    If he went into the mine, that corn would not be grown.  That output would be sacrificed.   But he would dig some coal, which the coal company would sell.   Because the marginal revenue product of labor in the coal mine is greater than the wage, it is very possible that the extra coal that could be produced is worth more than the corn that would be sacrificed.     There are gains from trade available.  

The coal company can earn enough more from the coal to more than compensate  the farmer for what he does not earn from the corn he could not grow.   They should be able to make a mutually beneficial exchange.   The "problem," is that if the coal company pays this marginal farmer more, it must pay all of its other miners more as well.   It is the extra amount it must pay them that makes it too costly to hire the additional miner.

Suppose the monopsony breaks down.   All the miners discover than they can easily move to the city and earn a bit more than what that marginal farmer required before he would give up farming.   The coal mine must raise all the miners pay to keep them from moving to the city.   And since it has to pay more than what that marginal farmer required anyway, it hires him.  Now, the "going wage" depends on what they are paying in the city.    There is no longer a monopsony, and the coal company hires the amount of miners such that the marginal revenue product of labor is equal to that given wage.   If that wage is anywhere between what the monopsonist was paying and the marginal revenue product of the amount of labor he was using, then he will pay more and hire more.

Suppose instead that the coal company suddenly has a flood of applications from outsiders seeking employment at the wage that was being paid.   There is no longer a monposony, and the coal company will hire these outsiders until the marginal revenue product of labor equals the current wage. 

This suggests that there is, in a sense, a shortage of labor at the current wage.   If large numbers of workers were too appear willing to work at the current wage offered by the monopsonist, he would hire them.  

A minimum wage mimics the impact of the breakdown of the monopsony.   If a minimum wage is fixed anywhere between the wage the coal company is paying and the marginal revenue product of labor, then the coal company will both pay more and hire more labor.   If the minimum wage were set at the wage where the marginal revenue product of the coal equals what the marginal farmer must be paid to give up farming, which is really the marginal revenue product of the corn they don't grow, then the wage will equal the marginal revenue product of labor and coal employment will be maximized.  Or more exactly, the allocation of labor between corn farming and coal mining will be optimized.  The result would be similar to perfect competition in the labor market.

The fundamental problem with this analysis is that the dilemma faced by the coal company is that to share in the gains from trade from hiring one more worker, it must pay extra to all the other workers too.

But why would the coal company pay the other workers anything more?   The entire "problem" comes from assuming that all workers are paid an identical wage.   That one wage paid to all workers must be increased to attract the marginal worker.

 In a competitive labor market, something like this is true.    If a firm wants to hire more, it may have to pay more.   But that will make other firms pay more too.   And if a firm doesn't pay all of its current workers more, it will lose some of them to other firms.  

But the whole point of the monopsony argument is that the labor market is not competitive.    If the coal mine paid the marginal farmer more than its current workers so that he comes into the mine as well, it is called wage discrimination.     By negotiating separate wage agreements for each miner, the coal mine can obtain an amount of labor so that the marginal revenue product of labor equals the marginal revenue product of the sacrificed corn.   Those farmers that would not have been hired under the uniform wage policy can be paid a differentially higher wage.

Unfortunately for workers, the logic of wage discrimination is that each worker is be paid a different wage, only slightly higher than his opportunity cost.   The wage for each and every miner would be only slightly than what he could have earned by staying on the farm.   This is called perfect wage discrimination.

Just as monopsony is a sort of mirror image of monopoly, wage discrimination is a mirror image of price discimination.    For example, a drug company charges a high price for medication in the U.S., but a low price in Africa.    The difficulty is that there is an incentive for resale.   Purchasing the drugs at a low price in Africa and then reselling in the U.S. results in arbitrage profits.    Perfect price discrimination is the rather impractical policy of charging each and every buyer the most he or she is willing to pay, and somehow preventing resale.  

In the labor markets, resale isn't a problem.   If a monoponist were buying corn for a low price in a region with low costs and paying a higher price in a region with higher costs, then arbitargeurs would by up corn in the region where the monopsonist is paying the low price and sell it to the monopsonist in the high cost region where he pays the high price.    (On the other hand, the coal company in my example would need to worry about some existing miners quitting and instead growing corn on the farm just abandoned by the marginal farmer.   Pretty ugly--I will hire you to mine coal at wage higher than the rest of the workers, but only if you promise to leave your farm idle.)

With perfect wage discrimation, or just sufficient wage discrimation to exhaust all the gains from trade, a minimum wage will not increase employment.   On the other hand, as long as it is no higher than the marginal revenue product of labor, it would raise the wages of all of the workers being paid wages less than the marginal revenue product of labor without there being any decrease in employment.

In reality, there are many firms that expand and hire more workers.  The practice of paying the new workers more than the existing workers probably exists, but doesn't seem common.   Usually, new workers are paid less than existing workers.   On the other hand, firms wanting to expand and facing an upward sloping supply curve for entry level workers might raise starting pay relative to what it was before without also increasing the wages of all current workers.   That is, a firm with a monopsony might cause wage compression.    This doesn't leave much room for higher minimum wages to increase increase employment or raise the wages of substantial numbers of existing workers without reducing employment.   The existing workers already make more than potential entry level workers.

My vision of the real world is that it is rife with monopoly, monopsony, and all sorts of price and wage discrimination.   But,  this is in the context of lots of compeition.   Competition is "imperfect," but  the gains and losses in efficiency are small and fleeting in  world of creative destruction.

Still, I wouldn't be surprised if the monopsony effect resulted in some firms hiring more workers due to a higher minimum wage.   Unfortunately, that same increase in the minimum wage will push the wage above the marginal revenue product of labor for other firms so that they hire fewer workers.   

The notion that government operates like an omniscient benevolent despot and could and would set a wage in each and every market so that competitive equilibrium is approximated is completely unrealistic.     I think a more plausible starting place would be politicians trading off the loss of employment versus the increase in wage income.   That would suggest that minimum wages would be set above the marginal revenue product of the current level of employment.   Of course, reduced profits to firms, very significant politically relevant short run, and higher prices to those purchasing the products might relevant.  

During the Bush administration, the increase in the minimum wage was combined with tax benefits for small business.   I am sure that was all based upon finding a wage rate that would cause employment to expand in monopsonistic markets to approximate the competitive equilibrium.  Right.

Saturday, February 23, 2013

Labor Market Disequilibrium

With President Obama's call for an increase in the minimum wage to $9 per hour, there has been a flurry of discussion about labor market disequilibrium.   Economics 101 suggests that an effective minimum wage creates a surplus in the labor market.   That is what I teach.  That is what I believe.

 Increasing that minimum wage, ceteris paribus, will make the surplus of labor larger.    The result should be both an decrease in quantity demanded and an increase in quantity supplied.   In a disequilibrium market, the short side rules, and so the actual employment of labor should be the quantity of labor demanded.   Basic economics suggests that a higher minimum wage will reduce employment.

Of course, both the supply and demand for labor are shifting over time, likely both increasing.   If demand was rising faster than supply, the quantity of labor demanded and employment would rise faster than quantity supplied and the surplus of labor would shrink.   Unfortunately, if demand was growing more slowly than supply, employment would rise, but so would the surplus of labor.  

Raising the minimum wage, then, could cause employment to rise more slowly or even fall for a time.   The surplus in labor markets would worsen at least temporally, or if demand is growing more slowly than supply anyway, the surplus would just get worse.

Rather than think of the problem in that conventional way, consider a scenario where the wage rate is at equilibrium, but actual employment is below the equilibrium quantity of labor.   The equilibrium quantity of labor is both the quantity of labor demanded and the quantity of labor supplied at the equilibrium wage.  

The quantity of labor demanded is the amount of labor that firms are able and willing to buy--really rent and utilize for production.   It can be divided in to two parts, the amount of labor that firms are actually utilizing and the additional amount of labor that firms would like to utilize.    Measuring this in full-time worker equivalents rather than man-hours of labor, this would be employment and vacancies.    The quantity of labor demanded is the sum of employment and vacancies.

The quantity of labor supplied is the amount of labor households are able and willing to sell.   It can also be divided into two parts--how much the households are working and how much additional labor they would like to provide.   Again, using full-time worker equivalency, that would be employment and unemployment.    The quantity of labor supplied is the sum of employment and unemployment.   Leaving aside measurement issues, that is the labor force.

The equilibrium wage is defined as the wage where quantity of labor demanded equals quantity of labor supplied.   In other words, the sum of the employed and vacancies must match the sum of the employed and the unemployed.    With the number of employed being the same for both quantity supplied and quantity demanded, that means that at the equilibrium wage, the vacancies must match the number of unemployed.   

Again, the equilibrium quantity of labor is both the quantity of labor supplied and the quantity of labor demanded at the equilibrium wage.    Assuming that the wage is at equilibrium, actual employment will equal the equilibrium quantity of labor if both vacancies and unemployment are equal at zero.     However, again, with the wage at equilibrium, if there are positive (though equal) amounts of vacancies and unemployment, then actual employment will be less than the equilibrium quantity of labor.

As firms search for additional workers and households search for new employment opportunities, the matches move actual employment towards the equilibrium quantity of labor.   With the equilibrium wage being below the firms' demand price, the marginal revenue product of labor, and above the households' supply price, the marginal evaluation of leisure, gains from trade occur when actual employment increases towards the equilibrium quantity of labor.

Clearly,  all gains from trade will always be exhausted and actual employment will always equal the equilibrium quantity of labor.


Another portion of Economics 101 explores the concept of frictional unemployment.   At the very least, because man is mortal, workers most separate from their employers at death.   Fortunately, we also reproduce and children grow up to be new workers.   In reality, there is a tremendous amount of movement in and out of the labor force.   Firms come and go.   Vacancies are constantly being created and constantly being filled.   Unemployed workers are constantly finding jobs and new people are becoming unemployed, often by entering or reentering the labor force.

Suppose that actual employment is 95% of the equilibrium quantity of labor.   At the equilibrium wage, the unemployment rate would be 5%.   The vacancy rate would also be 5% of the labor force.  There are enough jobs for everyone who wants to work.   The unemployed find jobs within a reasonable period and firms fill their vacancies.   But there are new people becoming unemployed and new vacancies being created.    That is the Econ 101  version of frictional unemployment.

However, at the current level of employment, the marginal revenue product of labor would be higher than the households' supply price for labor.    This creates a range of possible wage rates where quantity of labor supplied and demanded both remain greater than the current level of employment.  

Considering solely firms, at the equilibrium wage there appears to be a shortage of labor.   The firms want to hire more labor than they currently are employing.   Increasing the wage above equilibrium, up to the point of the marginal revenue product of those currently employed would simply reduce this "shortage."  In other words, vacancies would decrease.

Considering the households, at the equilibrium wage there appears to be a surplus of labor.   There are unemployed workers seeking jobs.   Decreasing the wage below equilibrium, down to the point of the households' marginal evaluation of leisure for the current level of employment, would just reduce this "surplus."  In other words, unemployment decreases.

Of course, considering the entire market, if the wage rises above equilibrium, there is a surplus of labor--the unemployed exceed vacancies.   There are not enough jobs for all the workers.   And if the wage is below equilibrium, there is a shortage of labor.  The vacancies exceed the number of unemployed.   There are not enough workers to fill all of the jobs firms want done.

This suggests that there is a range of minimum wages above the equilibrium wage that will not reduce actual employment.  

Most importantly, no one currently employed would lose their job.    Yes, the quantity of labor demanded would fall, but since actual employment is below that amount anyway, the decrease in quantity of labor demand would solely result in fewer vacancies.   There would also be an increase in the quantity of labor supplied, so there would be a larger number of unemployed workers.

If the firms have constant 5% vacancy rate, then employment must fall with the quantity of labor demanded.   Obviously, 95% of a smaller number is also a smaller number/  An increase in the minimum wage would seem to decrease employment.  

However, as long as the minimum wage is not raised above the marginal revenue product of the initial level of employment, then this would occur solely by attrition.    The firms never would have more workers than they find profitable, it is just that their procedures for replacing those workers that leave from time to time  are such that their actual employment is 5% below what would maximize profit.  

Interestingly, with the wage being pushed above equilibrium, the resulting surplus of labor might make it possible for firms to reduce the vacancy rate.   The typical firm has more applications, it has more applicants that  look like obvious good choices, and it has fewer situations where the preferred potential employee has already taken another job.    There is  a "buyers" market.  

Suppose the minimum wage rose 5% and the quantity of labor demanded fell 2%.    Actual vacancies would fall to 3%.   Further, suppose the quantity of labor supplied rose 4% and that the large surplus of labor makes it so much easier to fill vacancies, so that the firms procedures for hiring results in a 4% vacancy rate relative to the quantity of labor demanded.   Actual employment would only fall 1%, even though the quantity of labor demanded fell 2%.   

For example, suppose the relevant market had quantity demanded and supplied of 10 million.   Actual employment is 9.5 million.   The unemployment rate is 5% and vacancies are equal to 5% of the labor force.   The increase in the minimum wage decreases the quantity of labor demanded to 9.8 million.   The quantity supplied rises to 10.4 million.   However, actual employment falls to approximately 9.4 million, reflecting the 4% vacancy rate (approximately.)   Actual employment fell 100,000, even though the quantity of labor demanded fell 200,000.   There is a surplus of labor of 600,000, much higher than zero.  

Now, it is easy to see that if the surplus of labor improves the ability to fill vacancies enough, then actual employment might not decrease at all.   It is even possible that actual employment would increase!     If the quantity of labor demanded fell 2% and the quantity of labor supplied rose 10%, then firms might find that they can fill vacancies much faster than usual, and actual employment might be only 1% below the quantity of labor demanded. 

For example, suppose quantity of labor demanded (and supplied) was 10 million.   Actual employment was 9.5 million.  Because of the increase in the minimum wage, quantity of labor demanded falls to 9.8 million.   But the number of workers seeking work rises to 11 million.     It is so easy to fill vacancies, that the firms employ 9.7 million, nearly as much as the quantity of labor demanded.    Total employment increases by 200,000!

For free market economics (like me,) there is something right about equilibrium prices, including the equilibrium wage.   Given my framing, having enough jobs for everyone who wants to work seems right.   Having large numbers of workers competing for a few jobs seems wrong, even if the greater ease in recruitment for the firms results in more employment.

Like most free market economists, I would celebrate technological innovations that would improve the matching process so that both vacancies and the number of unemployed shrink, frictional unemployment falls, and employment moves towards the equilibrium quantity of labor. 

I think there is something horrid and offensive about creating an economic order where there just aren't enough jobs for all the workers.  

But then, the politicians who favor a higher minimum have a solution to the problem too few jobs.   They propose government jobs programs.   Having unemployed workers who want to work and are frustrated by the lack of jobs might help their political agenda.   While the frustrated unemployed workers are an obvious potential source of support, perhaps more important would be all of those who feel compassion for those suffering because there just aren't enough jobs.

Of course, the notion that politicians will increase the minimum wage only when it has no negative impact on employment is a pipe dream.    In the real world, there are a variety of labor markets.     Any increase in "the" minimum wage will almost certainly be increasing wages above the marginal revenue product of firms in some markets. 

 Still, it should not be  too surprising that an increases in some minimum wage has been found to have little impact on actual employment in some markets at some times.    It is easy to see.  Just think off the curves.   Think about disequilibrium.

Thursday, February 21, 2013

Dangerous Monetary Policy

Scott Sumner recently was honored by one of the bloggers at the Economist--"Scott Sumner is Wrong!"    M.C.K was pleased by newish Federal Reserve governor Jeremy Stein's interest in having the Federal Reserve use monetary policy to lean against "credit bubbles."  

Sumner, as expected, insisted that monetary policy should be directed solely at keeping nominal GDP on a target growth path.    If the Fed determines that debt is "too high," the last thing it should do is use monetary policy to try force nominal GDP below the target growth path, even if this would motivate reduced lending or borrowing.

Sumner pointed out that this approach was tried by the Fed in the late twenties to control what it considered speculative excesses in the stock market.   Only after forcing the economy into recession, did the stock market fall.   Before long, the recession had become the Great Depression--a decade long disaster. 

M.C.K. then responded with his claim that Sumner is wrong.   He cited "new" research that shows that banks take more risk when they can fund loans at lower interest rates and also that recessions following credit booms are more severe than the typical recession.  

I find these claims reasonable, but I don't conclude that central banks should keep interest rates high to keep banks from making risky loans so that total lending is less and therefore future recessions less severe.  

Instead, the Market Monetarist view is that a monetary regime should keep expected nominal GDP growing on a slow, steady growth path and let market forces determine interest rates.     Having a central bank create an artificial shortage of money so that short and safe interest rates are high enough that banks and other investors are not tempted to take more risk is a mistake--a confused mistake.   Having a central bank create an artificial shortage of money so that interest rates are high so that reduced credit demand will result in less debt and so make future recessions less severe is a mistake--a confused mistake.

However, from a Market Monetarist perspective,  it is desirable for the monetary regime to avoid an excess supply of money.   An excess supply of money will, sooner or later, cause nominal GDP to rise above its target growth  path.    Since the goal of nominal GDP level targeting is to keep nominal GDP on its target growth path, an excess supply of money is inconsistent with the monetary regime.  

That doesn't mean that an excess supply of money could never happen, but rather that it would be a policy mistake.   However day-to-day monetary conditions are determined, a quantity of money greater than the demand to hold it is something to be avoided.  If a central bank or other monetary authority plays a key role in governing current monetary conditions, avoiding an excess supply of money would be a key duty.

What does this have to do with credit?    When there is an excess supply of money, at least some of those with excess money balances will choose to lend them.    This could involve depositing excess currency into banks, which could then choose to lend their excess reserves.   Or, it could be that those with excess balances in their checkable deposits would purchase short term to maturity bonds, which is supplying credit as well.  

However, there is another reason why an excess supply of money might involve credit.    Most money is the liabilities of a banking institution, and the money created by banks is matched by some kind of credit.   This credit could be bank loans, but it could also be some type of bonds purchased by the banks.

Even central banks can be framed (and I think most plausibly are framed) as creating both money and credit at the same time.   An open market operation involves the creation of base money as well as an added demand for some type of bond--typically short and safe government bonds.   (Recently, the Fed has been demanding long term government bonds and government-guaranteed mortgage backed securities.)   This demand for bonds is a supply of credit.

This suggests that any excess supply of money is simultaneously an excess supply of credit.    If interest rates are flexible, (for example, the prices and yields for tradeable securities) then credit markets will clear, though at a lower interest rate, reflecting the excess supply of  credit. In Wickellian terms, the market interest rate is pushed below the natural interest rate.

So, from a Market Monetarist perspective, any excess supply of credit due to an excess supply of money is something to be avoided.    With credit markets assumed to clear, having interest rates below the Wickellian "natural rate," should be avoided.   Sooner or later, nominal GDP will be forced above its target growth  path, which is what Market Monetarists insist must be avoided by a central bank (or whatever other monetary institution or process maintains the regime.)

Suppose that monetary policy works with long and variable lags--the traditional monetarist claim.   In that context, there is no change in "monetary policy" exactly, but rather an excess supply of money is created by mistake, and the market interest rate falls below the natural interest rate.   The "long and variable lags" would be between when the excess supply of money (or unnaturally low interest rates,) commence and the later time when nominal GDP is pushed above its target growth path.

Note that any lag between the time when a exogenous change in the growth rate of the quantity of money commences and the time when its full impact on the equilibrium rate of consumer price inflation would occur is not relevant.     There doesn't have to be any impact on consumer prices or employment or the unemployment rate.   All that is necessary is that there is some impact on either the price or production of any portion of currently-produced output.   

If there were some kind of mechanical feedback rule between the quantity of base money or a target interest rate and the most recent observation of nominal GDP, so that adjustments could only be made to reverse an excess supply of money (or unnaturally low interest rate) after nominal GDP is measured and found to be away from target, then the fact that measurements of nominal GDP are quarterly could be a problem.  

However, Market Monetarists favor targeting the forecast rather than mechanical feedback rules.   Current monetary conditions are to be governed so that the expected future level of nominal GDP remains on target.   Market Monetarists do not favor waiting until an excess supply of money, an excessive supply of credit, or unnaturally low interest rates have already forced nominal GDP to rise above its target level and then take action to correct the problem.   Quite the contrary, Market Monetarists favor correcting an excess supply of money before it has had a chance to impact nominal GDP.   If a central bank or other monetary authority has a key role in managing current monetary conditions, avoiding or promptly reversing an excess supply of money would be entirely consistent with the Market Monetarist approach.

Suppose, on the other hand, an increase in saving supply leads to a decease in the natural interest rate.  The amount saved and amount investment both increase.

Further suppose that those undertaking the additional saving prefer to lend more rather than hold equity claims.     The likely result would be an increase in debt.   The firms financing the additional investment would borrow more and have more outstanding bonds.   The firms would be more leveraged.

While consumption spending would fall due to the increase in saving, investment spending would rise.   This would have no impact on total spending and so, the growth path of nominal GDP.

Suppose further that those saving not only purchase corporate bonds, they also hold additional time deposits in banks.    The banks issue more time deposits and expand their lending.   The firms that borrow from the banks are in debt to the banks.   The banks are also more leveraged, having expanded both their assets and liabilities in proportion.

Suppose still further, that those saving not only hold additional time deposits, they also increase their balances in checkable deposits.   Market Monetarists insist that the banks should expand their issue of checkable deposits in this circumstance.    The demand to hold money has increased and so the quantity of money should rise an equal amount to avoid an excess demand for money.   The banks expand their lending to match the increase in checkable deposits, more or less as they do with the funds raised by issuing additional time deposits.    The banks are more leveraged by issuing more checkable deposits to fund additional loans, and the firms that borrowed from the banks to fund the investment are also more in debt and more leveraged.

In this scenario, nominal GDP remains on target, the quantity of money increases with the demand to hold money, and there is no excess supply of money.   The market interest rate falls, but so did the natural interest rate.   A lower interest rate is needed to coordinate saving and investment.

The increase in leverage by both banks and firms would automatically increase the risk of bank deposits and corporate bonds.    If households didn't want to bear more risk, then banks and other firms would have to increase their net worth, perhaps by issuing more stock or retaining earnings.   This would further depress the return on bank deposits and corporate bonds.   It is certainly possible that households would prefer to accept the added risk rather than accept even lower yields.

 With greater risk, the frequency of bankruptcy and default would be somewhat higher for both firms and banks.   That certainly seems bad, but this is an unfortunate side effect of funding additional, less certain investment projects and adding to  the share of risk borne by creditors.

Suppose sometime after this increase in saving and increase in debt and leverage, a policy mistake results in nominal GDP falling below target.   There is a recession.   Compared to some other economy, where households did not save as much or else they saved by taking equity positions in firms, the disruption caused by the below target nominal GDP would be greater.   The lower than expected nominal GDP makes it difficult for indebted firms (and households) to make their debt payments, bankruptcies are higher, and the disruption to production and employment is worse than in a low debt economy.

However, "fixing" this "problem" by having the central bank prevent the increase in the quantity of money so that it fails to accommodate the added demand for money would be a mistake.   It is true that this would limit the increase in the supply of bank loans as well.   Further, the shortage of checkable deposits could easily result in some firms and households receiving fewer receipts than usual, and so cause them to sell off bonds or cash in existing time deposits.    These secondary effects on credit markets would further restrict the expansion in the supply of credit and prevent and limit any increase in bond prices and decrease in bond yields.

From a Wicksellian perspective, rather than falling with the natural interest rate, the market interest rate would be kept "unnaturally" high.    The interest rate would be too high to coordinate the supply of saving and demand for investment.

It is true that this would avoid the "problem" of households taking greater risks to avoid the decrease in yield.   Firms would not make the marginal investments that would have been encouraged by the lower interest rate.   Some of those investments might have been "marginal" because they involved "excessive" risk.  

With there being less lending, the firms would have smaller debts.   The banks and other firms would both have less leverage.  The central bank would be protecting the economy from the scourge of excessive debt and leverage.

Unfortunately, the excess demand for money would result in reduced expenditure on output.   Production and employment would contract, leaving the economy in recession.   

With the Wicksellian framing, the market rate would be above the natural interest rate.   While consumption would decrease, investment would not increase.   Expenditures on output would fall, resulting in less production and employment, leaving the economy in recession.

Fortunately, inflation would slow as well, perhaps to the point of deflation.   The lower price level would raise real balances, so that the real quantity of money would rise to meet the demand.  With a given quantity of money, an important aspect of the real balance effect is that some of those with increased real money balances purchase bonds, which results in lower interest rates.  

But, of course, the goal of this policy is to keep interest rates up.    Isn't the implication of this policy a downward spiral of ever deeper recession and deflation?   

Now, with outside base money, as with a gold standard, the lower price level increases real wealth.   By increasing wealth, consumption should rise and saving fall.    And so, with a sufficiently low price level, real output and employment could recover despite no decrease in interest rates.

When Market Monetarists dismiss the notion that a central bank should refrain from cutting interest rates in order to avoid excessive debt and leverage, it is this kind of scenario that comes to our minds.   Of course, we favor reversing an excess supply of money and any matching excessive supply credit or unnaturally low interest rates.    But if the economic fundamentals change such that lower interest rates are appropriate, and people choose to lend and borrow more, creating an artificial shortage of money to keep interest rates up and debt levels down is a recipe for disaster.   Last time the Fed tried that, it created a Great Depression.  

And that is why Sumner is right.

Saturday, February 16, 2013

NGDPLT and Central Bank Discretion

Market Monetarists advocate nominal GDP level targeting as a new monetary regime.   The goal is for nominal GDP to remain on a target growth path, but should nominal GDP fall below or rise above that growth path, the monetary authority would be obligated to return nominal GDP to the target path.

Compare this to flexible inflation targeting.   The central bank generally seeks to have the price level rise a targeted amount from its current level, wherever that happens to be.    If past inflation rates are higher or lower than the targeted amount, that is simply forgotten.   The central bank then tries to get the price level to increase next time at the targeted rate.

However, "flexible" inflation targeting allows the central bank extra discretion.   Perhaps it should not aim at the target inflation rate.   Perhaps it should allow inflation to rise above target for a time.  What exactly is causing inflation to rise?   Is it a temporary change in the supply or demand for some particular product?   Or is it a persistent change in potential output--the productive capacity of the economy?   Is this change due to changes in labor supply?   Or is it due to changes in the productivity of labor?    Perhaps it is a good idea to remember past inflation rates from time to time and offset mistakes.   This time, inflation was below target, so it is better to set it above target now.   How will allowing a temporary increase in inflation impact the central bank's credibility?    Will it cause inflation expectations to become unanchored?   

None of these issues are relevant to a monetary authority constrained to target the growth path of nominal GDP.    As Carney has complained:

The main drawback of an NGDP level target in this regard is that it imposes the arbitrary constraint that prices and real activity must move in equal amounts but opposite directions.

A constraint?   A constraint on whom?   The central banker exercising discretion in manipulating inflation and real output.    Is the constraint arbitrary?    Only in the sense that any nominal anchor is arbitrary.

Flexible inflation targeting gives a central banker discretion to tailor monetary policy precisely to current conditions.   

Consider a decrease in the supply of a good with highly inelastic demand and supply.   The price of the good rises more than in proportion to the decrease in the quantity.    Spending on the good rises.    

As a matter of arithmetic, the price level rises. (ceteris paribus.)    In an inflationary environment, this is a shift to a higher growth path for the price level and a transitory increase in inflation.   

Similarly, as a matter of arithmetic,  potential output falls.(ceteris paribus.)   In a growing economy, this is a shift to a lower growth path of potential output, and implies a transitory slowdown in the growth rate of potential output.   In the extreme, this could involve negative growth, a temporary decrease in potential output.

The increase in the price of the good results in an increase in quantity supplied.    This partial offset of the initial supply shock implies a shift of resources away from producing other goods and services.   With supply inelastic, this is a small effect.   

The rest of the story depends entirely on the monetary regime.    With price level targeting, the central bank must force other prices to grow more slowly so that the price level remains on its target growth path.    It does this by slowing spending for  the entire economy.    The demand for the good with the decrease in supply sees slower growth in demand, like every other product, but for the most part, the impact is slower demand growth and smaller price increases in the rest of the economy.   The slower growth in spending will likely result in slower growth in output and employment for the rest of the economy as well.     This has the beneficial effect of freeing up resources to allow for the expansion of the quantity supplied for the good with reduced supply.    Because supply is inelastic, this is a small effect.

Nominal incomes, including wages, will also need to grow more slowly in in aggregate.   Because its demand is inelastic by assumption, nominal incomes increase for those producing the good with reduced supply, so the decrease in nominal incomes must be concentrated in the rest of the economy.  Fortunately, lower nominal wages and other incomes will allow production to recover in the rest of the economy, at least in the long run.

With inflation targeting, if this event has occurred like a bolt from the blue, the central bank ignores the increase in the inflation rate and upward shift in the growth path of prices.    It seeks to have prices rise at the targeted growth rate in the future.   There is no need for a slow down price increases in the rest of the economy.   There is no need to contract nominal GDP growth.   

For example, if a central bank is surprised by a bad corn harvest, the observed increase in inflation is ignored.  The growth path of nominal GDP rises by the increase in spending on corn.  (The increase in spending on corn follows from the assumption of inelastic demand.   If spending in the rest of the economy remains on a constant growth path, nominal GDP must shift up to a higher growth path.)

However, if the decrease in supply is foreseen, then strict inflation targeting requires that the central bank act as it would with a price level target.   It must slow the growth of spending on output so that the expected rapid increase in the price of the good with decreased supply is offset by slower increases in the prices of other goods and services.   Nominal incomes and nominal wages must grow more slowly.  

For example, if rapid economic growth in China is putting persistent upward pressure on the price of crude oil, the Fed would need to restrain nominal GDP growth in the U.S. so that the prices of other goods and services grow more slowly.   Wages and other nominal incomes would need to grow more slowly reflecting the slower growth in real incomes in the U.S. due to increased competition for crude oil by developing countries.

With flexible inflation targeting, the central bank can consider the demand and supply elasticities of the good expected to face the supply shock, and determine what is the optimal increase in the price level.    The arithmetic increase in the price level or growth path of prices, and transitory inflation could be allowed, with real output only falling by the small decrease in potential output.  

With a nominal GDP level target, the response is determined by the rule, and it is clearly less than optimal.  With spending on the good that suffered the decrease in supply rising, spending in the rest of the economy must fall.   With growing nominal GDP, this implies that spending on the good that had the decrease in supply must shift to a higher growth path, while spending in the rest of the economy must shift to a lower growth path.  

This will tend to have an effect similar to a price level target, except that with sticky prices, the slowdown in spending in the rest of the economy is less than what would be necessary to keep inflation on target.    (The slowdown in production also "counts" as reduced nominal GDP. )   Further, nominal income as a whole does not decrease, but the higher nominal incomes earned in the sector with reduced supply must be offset by slower growth of nominal income in the rest of the economy.   Reduced spending, production, and employment in the rest of the economy has the beneficial consequence of freeing up resources to allow an increase in quantity supplied of the good with reduced supply.   Unfortunately, because supply is inelastic by assumption, that is a small benefit.

What would be necessary for a nominal GDP level target to be optimal?    It is instructive to consider one situation where the rule is optimal.   If the demand for the good with the decreased supply was unit elastic, and the supply was perfectly inelastic, then a nominal GDP target would be perfect.   Spending on the good with the decreased supply is constant, or rather, on a stable growth path.   This allows spending in the rest of the economy to remain on a stable growth path as well.   Because supply is perfectly inelastic, there is no increase in quantity supplied, and so no need to shift resources away from the rest of the economy to partly offset the decrease in supply.    There is no need to signal firms producing other products that they should slightly curtail production to free up resources.   

The rest of the economy would be sheltered from the consequences of the supply shock.   Of course, real incomes are lower.   The reduced supply, higher price, and reduced quantity of the one product clearly makes everyone worse off.   What it is avoided is disruption to other parts of the economy.

Keeping the assumption that supply is perfectly inelastic, if demand for the good with reduced supply  was  inelastic, the central bank should allow nominal GDP to shift to a higher growth path.   If, on the other hand, the demand the good is elastic, then the central bank needs a contractionary policy, reducing the growth path of nominal GDP.    At least if the central bank's goal is to avoid disruption to the rest of the economy.

If supply is not perfectly inelastic, then nominal GDP level targeting is only optimal if the demand for a good with reduced supply is at least slightly inelastic.   The less inelastic (more elastic) is supply, the more inelastic would demand need to be.  This provides the proper signals and incentives to shift resources away from other sectors of the economy and expand the quantity supplied of the good with the decrease in supply.  

We can at least imagine a central bank adjusting the growth rate of nominal GDP in a way that manipulates spending in the rest of the economy such that the appropriate amount of resources are freed up to provide the needed adjustment in quantity supplied.   This implies slight changes in inflation in the rest of the economy, which when combined with the inflation generated by the supply shock, suggests a varying target for inflation.   Doesn't it follow that a central bank with an optimal monetary policy must have a flexible inflation target?

Why then, do I still favor nominal GDP level targeting?   Because "flexible" inflation targeting, where central bankers anticipate which goods will face changes in supply, and then carefully consider the supply and demand elasticities, and so allow nominal GDP and inflation to adjust the optimal amount, is entirely unrealistic.   No one has anything like the information needed to accomplish this.   This is the old problem of economists imagining a perfectly omniscient and benevolent despot creating the perfect regulation to correct market failures.   Nothing like that exists.

What is the best, which I consider the same as, least bad, macroeconomic environment for microeconomic coordination?     Maximizing social welfare is not a rule for monetary policy.   What does flexible inflation targeting mean?    Target inflation when that maximizes social welfare, and then allow inflation to deviate from target when that results in more social welfare.   That isn't inflation targeting of any sort, that is giving central bankers discretion to do whatever they think is best.

I am not surprised that central bankers have a natural tendency to favor a policy that simply allows them to do whatever it is that they think is best.   It is natural for them to dislke "arbitrary constraints."   During the Great Moderation, we could pretend that discretion would work just fine.  In my view, the Great Recession proves that we need something new.   Flexible inflation targeting is a proven failure.

HT Scott Sumner

Saturday, February 9, 2013

Helicopter Drops

Carney apparently mentioned "helicopter drops," in his testimony before the British Parliament and Wren-Lewis commented.

Wren-Lewis argued that a "helicopter drop" of money combines fiscal policy--a tax cut funded by government borrowing--along with a conventional open market operation--a central bank purchasing government bonds with newly-created base money.     In this scenario, the net effect is that the given level of government spending is funded by money creation rather than taxes and the private sector pays lower taxes and ends up with more base money in its possession.

I find this a useful framing as well.   For economists like Wren-Lewis, generally focused on interest rate targeting, if the central bank holds its policy interest rate constant, then a debt-financed tax cut will have automatically have this effect.   The government funds its spending by selling additional debt, which puts downward pressure in bond prices and upward pressure on short and safe interest rates.  To prevent those interest rates from rising, the central bank's open market trading desk purchases government bonds, creating new money.    The net effect is that government as a whole, including the central bank, has funded more government spending with money creation and less with taxation.

Of course, with New Keynesian economics, the policy interest rate is adjusted according to deviations of inflation from target (usually two percent) and deviations of real output from capacity.   Starting from equilibrium, the money financed tax cut would require a higher interest rate to prevent output from rising above capacity or else inflation rising above target.   If the central bank increased interest rates by selling off bonds, then the tax cut would have been financed by bonds after all.  

It would be possible for the central bank to instead raise the interest rate paid on reserve balances to increase market interest rates.    Again, looking at the government as a whole, it is funding government spending by borrowing--by enticing someone to hold larger balances of interest bearing money.   It is only through the lens of central bank financial independence that it would be a central bank borrowing by enticing banks to hold larger reserve balances, in turn lending that money to the government, and then collecting interest payments from the Treasury and paying them out to the banks.   Consolidate it all, and the government is borrowing by enticing banks to lend to it.

If, however, the central bank needs to lower interest rates to keep output from falling below capacity or inflation falling below target, or if a shortfall of demand already exists and the central bank needs to reverse it, but for some reason, the central bank considers the current interest rate already too low, then the "helicopter drop" still suggests interest rates would end up higher than otherwise, but under that circumstance, it rather avoids the need for a further reduction.   

Sadly, it appears that central banks just don't like very low interest rates, perhaps because those earning interest income from short and safe assets have substantial political power.   Still, if interest rates were so low, probably slightly below zero, such that a currency drain would develop, the ability to increase demand by money financed tax cuts, and so without further decreases in short and safe interest rates, becomes important.

Wren-Lewis claims that perhaps from a political perspective, handing out free money to people to expand demand is more acceptable than increasing government debt.   I have my doubts about that.    In fact, with a strong commitment to a nominal anchor, it is really no different.

But Wren-Lewis also suggests that a helicopter drop is related to increasing the target for inflation.   He suggests that if the central bank were to take the bonds it purchased and destroy them, then this would be an increase in the inflation target.   The idea is that because the central bank has not government bonds to sell, it would not be able to reverse course and reduce the quantity of base money at some later time.   The increase in the quantity of money would be permanent, which would eventually result in a higher price level.   Getting to that higher price level would involve higher inflation.

The problem with this argument is that simply throwing out the added government bonds would do little good as long as the central bank continues to hold an ample portfolio of government bonds.   For example, a central bank that starts with base money at $1 trillion and an asset portfolio of $1 trillion worth of government bonds would need to increase base money by more than $1 trillion (along with throwing out the government bonds it purchased) to make any increase in base money permanent in the sense that the central bank would not have enough assets to retire the money.

Surely, a central bank that wanted to guarantee that it would never reduce the quantity of money would need to get rid of all of its assets.   (Oddly enough, Ron Paul proposed that the Fed do exactly that, forgiving the Treasury for all the government bonds it holds and so solving the debt limit for a time.)      Of course, there is still the possibility of paying interest on reserve balances.     Again, from the perspective of the government as a whole, including the central bank, the government would be borrowing money by encouraging people to hold more interest bearing money.

Wren-Lewis does say that he would prefer arguing that there is little need to worry about government debts when there is a recession and that the inflation target should be increased.   Hoping that handing out free money without there being any matching government bonds on the central banks balance should would have the same effect with a different political effect is not his first preference.

However, it seems to me that key problem is inflation targeting.    If the goal is to target a growth rate, then a temporary release from that rule, raising the target inflation rate for a time, looks to be irresponsible.   How can a credible central bank credibly promise to be "irresponsible?"    Money financed tax cuts and destroying the central bank's asset portfolio?

Surely the only responsible solution is to change the target.   However, it is not responsible to change the target to achieve today's discretionary goal.   What is needed is a new target that can be adopted permanently.     That is why a nominal GDP level target is so important.     And further, the commitment to the target should be so strong (in my view, constitutional.)   The notion that "money" should be issued in such a way that its quantity cannot be decreased with the demand to hold it falls, given the target level of nominal GDP (the nominal anchor,) is wrongheaded.

In my view, the political problem faced by new Keynesians like Wren-Lewis (or Paul Krugman) is that handing out money to people to cause higher inflation sounds bad.     Keeping spending on output growing with productive capacity sounds more responsible because it is more responsble.   Nominal GDP targeting is the more responsble alternative to inflation targeting.