Wednesday, December 24, 2014

Monetary Policy Effectiveness

Paul Krugman responded to David Beckworth's post regarding monetary policy effectiveness.   Beckworth had pointed out that temporary changes in the quantity of money have approximately no effect on aggregate demand.

Beckworth's point was that the Benanke and Yellen have both emphasized that the huge increases in base money that have occurred since 2008 are temporary.    Beckworth repeated his frequent theme that the Fed should have announced a regime change so that there would have been an expectation that the increase in base money was permanent and aggregate demand would expand.  Beckworth pointed out how Roosevelt's break with the gold standard in 1933 resulted in a large increase in aggregate demand.   This worked because it increased the expected value of base money.

Krugman claimed "dibs" on the argument that temporary changes in the quantity of money have little effect citing his 1998 paper.   He went on to argue that it was not practical for the Fed to engineer a regime change in 2008 or since.   He blames Republican politicians.   That was his defense of emphasizing fiscal policy.   The conservative Republicans wouldn't allow the Fed to change its target. He also argues that leaving the gold standard (or devaluing, really) isn't something that can be done more than once.

Sumner again has pointed out that his version of the argument was published before Krugman wrote his note.   Sumner's argument appeared in the  Journal of Economic Histrory in 1993 in a paper titled, "Colonial Currency and the Quantity Theory of Money:   A Critique of Smith's Interpretation."    I appreciate that he copied a long excerpt.    The price level now can only rise to a point where the expected future deflation rate equals the real interest rate.

Rowe has a post germane to this issue.   He  wrote a very simple model that attempts to translate Sumner and Krugman's argument to nominal GDP.   In my view, that is the right direction for market monetarists.  However, I do not think his argument was entirely successful.  The most interesting implication he drew was that the less interest elastic is the demand for money, the larger the impact of a temporary increase in the quantity of money on nominal GDP.

I am not sure that it is possible to dispense with prices.   It is the real return on money itself that is being impacted rather than solely the nominal interest rate on other assets.  At some fundamental level, the ineffectiveness of a temporary increase in the quantity of money is due to the fact that people don't want to purchase durable goods at temporarily high prices.   That there is some zero-interest outside money to hold as an alternative is implicit in the argument.    When we shift to nominal GDP, the permanent income hypothesis is being thrown in as well--temporary increases in real income are likely to be saved.   But Rowe has at least started on a version of the argument that applies to nominal GDP targeting.

Most interesting is Glasner's post on the debate.   He points to an argument in Hirshleifer's 1970 textbook Investment, Interest and Capital.     Oh yes, I remember that passage.  (Just kidding)

Anyway, Glasner argues that it is better to focus on the current and expected future price level rather than the level of base money consistent with either of those price levels.   Glasner likes this approach because it ties directly to the Fisher effect.    Glasner, of course, has often emphasized the troubling implications of the Fisher effect when the deflation rate is greater than what would otherwise be the equilibrium real interest rate.

But Glasner also emphasizes what I consider the key issue.   What is the monetary regime?    The reason why the changes in base money since 2008 are temporary is because of the monetary regime--inflation targeting.   Further, making the large increases in base money that have occurred permanent would certainly be a regime change--some kind of quantity rule-- and a true hyperinflationary disaster.

Glasner gives his characteristic slam on traditional monetarism, but surely he is correct.  The U.S. does not have a quantity of money rule.   The problem isn't whether a change in base money is permanent or not.   The problem is the nominal anchor--"flexible" (read discretionary) inflation targeting.


  1. A point that I wish everyone in this discussion would address is why the Fed is apparently able to get what it wants without "regime change". Why do markets react to QE?

    My thought is, if regime change is possible (which it always is), then markets will react positively to anything that increases the probability of regime change. QE communicates dissatisfaction with the status quo, which is a prerequisite for regime change. Actual regime change isn't necessarily required.

  2. Bill: good post. I now think I'm beginning to see where you are going with the durable goods angle,

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