Tuesday, February 10, 2015

Richard Wagner's Critique of Market Monetarism

Writing with Vipen Veetil, Richard Wagner of George Mason University has criticized Market Monetarism and particularly nominal GDP level targeting as chasing a mirage.   (Wagner was my public finance professor at Virginia Tech in the late seventies.)

Some of their arguments are mistaken characterizations of market monetarism.   They make an implicit claim of "all" when a more appropriate statement would be "some."   While Scott Sumner's approach to macroeconomic theory is sometimes a bit baffling to me, and I have no problem with them citing the Nunes-Cole monograph, their criticism of Leland Yeager's monetary disequilibrium approach is far off the mark.   Leland Yeager did not use representative agent models, and to transition from claiming that market monetarists are implicitly using a representative agent model to to claiming that they do use such models is an error.

The monetary disequilibrium approach to recession is not based upon the assumption that all increases in the demand for money are proportional for each and every individual demanding more money.   This is no more implicit in the analysis of the supply and demand for money than it is in the analysis of the supply and demand for apples.   An increase in the market demand for apples might well involve some households planning to purchase more apples and others planning to purchase the same amount of apples and even some purchasing  fewer apples.    All the same, there is a shortage of apples at the current market price.   If the market demand were unchanged, despite some households purchasing more and others purchasing less, there would be no market disequilibrium.   And perhaps I am wrong, but I am pretty sure that those who plan to purchase more could complete their plans by purchasing those apples that would have been sold to those households who chose to purchase less.

In the case of money, when those demanding more money restrict expenditures out of current income, this does necessarily impact those who would have otherwise sold them products    And if this is matched by others demanding less money and so spending more on goods and services, then that will also impact those that have increased sales.   In aggregate, total spending, sales, and income are unchanged.   It is conceivable that the person demanding more money would reduce expenditure on the very same product that those demanding less money choose to purchase.   In a one good economy, that is necessarily true.   However, more generally, this shift in the demand for money among different individuals will impact the composition of the demand for output.

There is nothing unique about money.   Suppose rather than accumulating money, an individual saves by purchasing bonds.   At the same time, someone else dissaves by selling bonds.   If we had a single consumer good, then the decrease in demand for the consumer good by the saver would be exactly offset by the increase in the demand for the consumer good by the dissaver.   However, more generally, there will be a change in the composition of demand for consumer goods--less on the particular goods the saver refrains from buying and more demand for the particular goods the dissaver chooses to buy.

Rather than dissaving, a firm might sell bonds that were previously held as retained earnings or perhaps issue new bonds.   In that situation, there is a decrease in spending on some particular consumer goods favored by the households that are saving and an expansion in spending on some particular capital goods that the firms selling the bonds believe can be profitably employed.   This reduced spending would impact those who would have sold the consumer goods and the increased spending would impact those selling additional capital goods.   This would be no different than if the household had saved by accumulating money, while the firm had reduced money holdings and used it to fund the purchase of capital goods. Further, if the firm purchasing capital goods was in a position to fund them by issuing new money, the effects on the sellers of the capital goods and those who in turn sell to them would be the exact same.    

Back to the apples.   If the market demand for apples increased, then at the existing price there is a shortage.   Superficially, the solution is a higher market price for apples.   If the quantity of apples is fixed, then the higher price simply rations the apples to those households that value them most.   There is no assumption that all households end up with the same amount of apples as before.   As the price increases, the quantity of apples demanded would decrease.   The most likely pattern is that those households that did not initially demand more apples would end up purchasing fewer apples and those households that did demand more apples, while purchasing less than they would have liked at the old market price, will end up purchasing and consuming more.   The apples would be redistributed from those with unchanging demand to those demanding more.   And if there had been some households who happened to be demanding less anyway, the higher price would reinforce that reduction further reducing their purchases by more than they had planned.

However, if the supply of apples is not perfectly inelastic, then the sellers of applies will produce more--quantity supplied will increase.  Now, is there an assumption that all apple producers increase quantity supplied in proportion?   Not at all.   Market clearing just requires that the quantity supplied match the quantity demanded by the market.   There could easily be a shift in market shares among apple producers along with the shift in the distribution of apple consumption among households.

If the supply of apples were perfectly elastic, then the shortage of apples would be cleared up by an increase in the quantity of apples at an unchanged price.    Those households demanding less apples would get less, those demanding the same would get the same, and those demanding more would get more.

Now, would it be bad for the supply of apples to be perfectly elastic?   If apples could be produced at constant cost, would it be socially desirable to make sure that the quantity of apples did not increase so that the increase in demand were entirely choked off by a higher price?

I think not, and in fact, there is a sense in which I would think that it would be desirable if the supply of apples were perfectly elastic, so that the quantity could adjust with demand.   Of course, if that isn't the cost structure of the industry, then trying to make the supply of apples perfectly elastic would likely do more harm  than good.

The monetary disequilibrium approach suggests that it is quite possible for the supply of money to be perfectly elastic.   And that there is no problem with the quantity of money adjusting to changes in the demand to hold money.   There is nothing in the approach that suggests  that these shifts in the demand for money accommodated by changes in the quantity of money would have no impact on the the pattern of expenditures in the economy.   In a world with many firms and households and many goods and services, in general, the pattern of expenditures would and should change.

Wagner and Veetil make the same error as Hayek.   They dwell on some bizarre notion of perfectly neutral money, and fail to see that a reallocation of expenditure in the economy is generally appropriate and coordinating when the quantity of money adjusts to meet the demand to hold money.   Imagining that the "proper" way for new money to enter the economy is as a free gift to those demanding more money so that they continue to spend as before, is just groundless.

For example, if households choose to save by spending less on consumer goods and services out of income--refraining from writing checks to purchase consumer goods while continuing to have income payments credited to their checking accounts, then this is going to impact those selling the consumer goods they would have bought.  Those sellers will in turn have to restrain expenditure and so on.    That the banks extend new loans to firms wanting to purchase capital goods will certainly result in those selling capital goods having greater receipts, and they will spend more and so on.   This change in the pattern of expenditure is exactly what would have happened if the households had saved by purchasing bonds newly issued by the firms who wanted to invest.  An increase in saving matched by an increase in investment is exactly the appropriate reallocation of expenditure in the economy.

But what if the banks had to lower interest rates to generate more loan demand?  Is this some kind of distortion of interest rates?   No.   If the households had purchased bonds, the prices of the bonds would have increased and the interest rates would have fallen, which would motivate the firms to issue new bonds and buy capital goods.    This is exactly what should happen.

I am a market monetarist.   I am pretty much a "charter member" of the club.   I hope that this brief analysis shows that at least some market monetarists are well aware of microeconomics (the supply and demand for apples) and do not assume that changes in the demand for money are necessarily proportional and further, do not ignore the impact of shifts in money demand on the composition of spending on output and the allocation of resources.

Personally, I find analogies using the supply and demand for apples much more useful than highly abstract discussions of plan coordination, number matching games, or airplane piloting.

And nothing is a substitute for actually thinking about what happens when households and firms choose to change their money balances along with the money supply process.   And, of course, what happens when there are other changes in the pattern of demands, including changes in saving and investment coordinated by the purchase and sale of nonmonetary financial instruments.

In this post I have focused on Wagner and Veetil's mistaken claims about monetary equilibrium and disequilbrium theory and particular their claim that market monetarists necessarily assume that aggregates directly impact one another or shifts in the demand for money or changes in velocity must be proportional or that there is an implicit or explicit assumption of representative agents.

I will later briefly review why needed reallocations of resources are best coordinated in an environment of stable aggregate expenditure rather than having total expenditure shift.   This includes all sorts of changes, but including especially some need to shift from the production of capital goods to consumer goods (the Mises problem) or with the introduction of new products or more efficient production processes (the Schumpeter problem.)

And finally, I will discuss the theory that an increase in the demand to hold money because plans are not coordinated should not be accommodated by an increase in the quantity of money because it would interfere with the supposedly desirable situation of resources waiting patiently to be utilized in entrepreneurial plans.   In my view, while entrepreneurship and plan coordination are important in economics, it is important not to ignore some fundamental microeconomic concepts such as scarcity.

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