Friday, January 10, 2014

Market Monetarism and New Keynesian Economics Again

Alex Salter shared a link to an earlier post.  (Thanks.)   Daniel Kuehn commented on facebook.    I had claimed that a backwards looking Taylor rule is the mainstream of New Keynesian economics.  

In other words, I claimed that Svennson's approach of targeting the forecast is not the mainstream.   More importantly, Woodford's recent adoption of nominal GDP level targeting isn't close to being accepted by the mainstream of New Keynesian macroeconomists.   Of course, if both of those positions became dominant among new Keynesian marcoeconomists, then the difference between the new Keynesian and Market Monetarist views would greatly shrink.

What would be the remaining difference?   As I said before, the remaining difference would be the use of interest rates as a policy tool.   New Keynesians emphasize that approach, Market Monetarists oppose it.

As an aside, I am very interested in monetary regimes that have no base money.   Competing private banks issue banknotes and deposits that are convertible to index futures contracts on nominal GDP.   I am not sure that this is workable.    But with such a regime, there is neither a policy interest rate nor a quantity of base money.   All market interest rates and quantities of monetary instruments would be entirely determined by market forces.  

But, leaving aside such alternatives, like other Market Monetarists, I favor having the monetary authority adjust the quantity of base money to meet the demand to hold it while allowing market forces to determine all interest rates.    Daniel Kuehn responded to this as well:

What is the difference between a Taylor rule and "the quantity of money should be adjusted according to the demand to hold money given a level target for nominal GDP"? You back out the Taylor rule's interest rate given a real output gap and an inflation rate, which is precisely the same idea.

I don't think a level target for nominal GDP is the same as an inflation target, even when adjusted for an output gap.     A price level target adjusted for an output gap would be closer.   And one of the benefits of nominal GDP level targeting is that there is no need to estimate an output gap.   Perhaps Kuehn confuses nominal GDP level targeting with nominal GDP growth rate targeting.      Targeting the growth rate for nominal GDP is closer to targeting inflation than is targeting the level of nominal GDP.

However, another point Kuehn appears to be making is that adjusting the quantity of base money to match the demand for base money given the target for nominal GDP is the same thing as adjusting the policy interest rate enough to keep nominal GDP on target.

Or, as Sumner suggests, the new Keynesian approach would be that the policy interest rate should be adjusted so that saving equals investment given the target level for nominal GDP.      And as Sumner points out constantly, the difference is that the lower bound for the policy interest rate is approximately zero, while the upper bound on base money is the total amount of assets the central bank is allowed to purchase.

There are some possible scenarios where adjusting the quantity of base money to the demand to hold it will involve squeezing down the yield curve and risk differentials, and this could require the central bank to purchase long term and risky securities.  The rule--expand the quantity of base money enough to meet the demand to hold it covers that possibility.

The rule, adjust the policy interest rate so that saving equals investment at a level of nominal GDP equal to target, requires substantial modification once that policy rate falls to slightly below zero.   It must become keep the policy rate at zero for an extended period of time so that because long term rates depend on expected short term rates, long term rates will fall.    And with lower safe rates, people will shift to riskier securities, lowering those rates too.     A bit more complicated.  

An alternative to this sort of forward guidance would be a shift in the policy rate.   Rather than using a short and safe rate, as central banks like to do, a longer and riskier rate could be used.   The open market trading desk could be instructed to get that BB corporate rate down to 4 percent.   And then, they would buy up whatever assets they are allowed to buy until that rate falls to the target level.   Of course, they might buy up everything they are permitted and still the rate is too high.  

But this approach doesn't require that there be some commitment to keep the BB Corporate rate low for an extended period of time.

Finally, it is simply not the case that increases in base money must result in lower interest rates.   While that is the ceteris paribus result, if others sell more securities than the central bank buys, and then use the funds to purchase consumer or capital goods, then an expansion in base money can be associated with rising interest rates and increased nominal expenditure on output.   A commitment to keep interest rates low is a commitment to expand purchases of securities to offset these sales and keep interest rates from rising to clear credit markets.

What would be the analogy?   A commitment to keep base money at some level (or growth path) until some particular future date.   Market Monetarists do not favor such a commitment.  


  1. Thanks for elaborating, Prof. Woolsey. I think if the profession treated the Taylor rule as it was originally treated by Taylor--as a description of how central banks actually behaved, rather than a prescription of how they ought to behave--then monetary theory and policy economists would talk about it way less. That would be a good thing. The debate as to whether the policy rate is an instrument or a target seems to be a red herring. Why not just shoot for a stable nominal anchor and eschew the debate entirely?

  2. "As an aside, I am very interested in monetary regimes that have no base money. Competing private banks issue banknotes and deposits that are convertible to index futures contracts on nominal GDP."
    In this case, futures contracts serve as base money. And collateral rules on futures contracts serve as a codification of Taylor Rules.