David Andolfatto again brought up the model he had used some time ago to criticize nominal GDP level targeting. The shock in his model is a decrease in the expected productivity of capital. If these expectations are correct, then the output of consumer goods will be lower during the next period.
In his model, the lower expected productivity of capital goods leads young people to accumulate money/government bonds. This decrease in the demand for capital goods and increase in the demand for money "appears" to be a decrease in aggregate demand.
In comments on his blog, I reviewed what I take to be some of the ABC's of saving and investment. He insisted that interest rates and inflation are policy variables, but I presume he was speaking of his model.
My "model" is the supply of saving and demand for investment. Saving is positively related to the interest rate and investment is negatively related. At the natural interest rate, saving and investment are equal. That part of income not spent on consumer goods is saved. Investment is spending on capital goods. With saving equal to investment, that part of income not spent on consumer goods is instead spent on capital goods. Income is here potential output, the productive capacity of the economy.
If the interest rate is below the natural interest rate, saving is less than investment. Spending on consumer goods plus spending on capital goods outstrips the productive capacity of the economy. If the interest rate is above the natural interest rate, investment is less than saving, and spending on consumer goods plus spending on capital goods is less than the productive capacity of the economy.
Andolfatto's shock using my simple model is a shift of the investment demand curve to the left. At the initial natural interest rate, investment is less than saving and the sum of consumption and investment is less than the productive capacity of the economy.
If we consider the market interest rate adjusting from the initial natural interest rate to the new natural interest rate, as it falls, the quantity of investment demanded rises. While the demand for capital goods initially fell, it partly recovers due to the lower interest rate. The quantity of saving supplied decreases. This is the same thing as an increase in spending on consumer goods.
At the new natural interest rate, saving and investment are again equal, and the sum of investment and consumption equal the productive capacity of the economy. However, the amount saved and invested are both lower and spending on consumer goods is higher.
There is no impact on total spending on output now. Nominal GDP would remain on target. There is no impact on the price level. The prices of consumer goods might rise, but the prices of capital goods would fall. (If consumer prices are targeted, which is not unrealistic, then it might be necessary to reduce spending on output and slightly depress the overall price level, further lowering the prices of the capital goods.)
What could go wrong? Suppose there is a central bank targeting the nominal interest rate. Sadly, this is is a very realistic assumption, and one that Aldofatto includes in his model. The decrease in investment demand implies a lower natural interest rate, but should the market interest rate begin to fall, this pushes it below the central bank's target. If necessary, it sells off some of the assets it holds and contracts the quantity of money enough to prevent the interest rate from falling. If the demand to hold money is rising, then failing to expand the quantity of money enough to match the growing demand will also keep the market interest rate from falling.
Because the market interest rate fails to fall with the natural interest rate, investment falls below saving and the sum of consumption and investment is less than the potential output. As their sales fall, firms cut back production, causing output and income to fall below potential.
This decrease in spending on output and income is inconsistent with nominal GDP targeting. Of course, these decreases could be relative to what nominal GDP would have been, and so amount to a smaller than usual increase. A central bank targeting nominal GDP needs to expand the quantity of money and decrease its target for the interest rate.
While firms are likely to respond to the decrease in spending by producing less, they also will likely lower their prices, though this could be solely a matter of lowering them relative to where they would have been. In an inflationary environment, this amounts to raising their prices more slowly. A central bank targeting the price level (perhaps a growth path for the price level) or inflation also needs to expand the quantity of money and lower its target for the interest rate.
Suppose the central bank doesn't target interest rates at all, but rather targets some measure of the quantity of money. In that situation, the central bank takes no action to manipulate the quantity of money as the decrease in investment demand results in a lower market interest rate. If money bears interest, and the interest rate paid on money falls with other market interest rates, then a money supply target would allow all market rates to adjust to the new natural interest rate.
Aldofatto, however, assumes that the both the yield on money and its quantity remains fixed. A central bank following such a policy could keep the market interest rate from falling, and result in reduced investment expenditure, aggregate expenditures, production, and employment. A central bank targeting the price level or nominal GDP would need to lower the interest rate paid on money or else increase the quantity of money or both.
The implications of nominal GDP level targeting, price level targeting, and inflation targeting are all very similar. The market interest rate should be allowed to fall enough to match the new natural interest rate. Nominal GDP, the price level, and inflation should all remain unchanged.
What if the central bank fails to make the proper adjustment in its interest rate target and the quantity of money? In the likely scenario where at least some prices are flexible, then the decrease in spending on output will be matched by a less than proportional decrease in the price level. The central bank must return both spending on output and the price level to target.
With inflation targeting, however, the change in the price level due to the adjustment of the flexible prices is allowed to persist. The flexible prices can only increase again as the other, less flexible prices, especially including nominal wages, also adjust downward.
What about the future?
In the future, the smaller increase in the capital stock, and a perhaps realized reduction in the productivity of capital, will tend to result in a smaller than otherwise increase in real output. The reduced saving and the lower interest rate on accumulated wealth will reduce the claims on that output.
With price level targeting, spending on output must grow more slowly to reflect the smaller expansion in output. Since this effect is predictable, the result would be the same with inflation targeting.
However, with nominal GDP level targeting, spending on output in the future will continue growing as usual. The smaller increase in production will result transitional inflation. The price level will move to a higher growth path.
The smaller capital stock in the future would tend to result in lower real wages. Any decrease in the growth path of nominal wages made necessary by the change in the growth path of the capital stock would be dampened by the increase in the growth path of the price level. If wages are especially sticky, then this is a benefit of nominal GDP level targeting.
Because the inflationary implication of nominal GDP targeting can be expected, the nominal interest rate in the first period will fall by less than the real interest rate. It is possible that the nominal rate would remain unchanged or even rise. This effect of nominal GDP level targeting implies there is less chance of the reduction in the expected productivity of capital causing the nominal interest rate to fall to zero.
Andolfatto's model is different. There are overlapping generations. The young choose to use their endowment of output to produce capital goods or else sell it to old people in exchange for money/government bonds. When they are old, then consume the output of their capital goods or "spend" the money/government bonds on the output that belongs to the next generation of young people. The base line model has the quantity of money/government bonds and the nominal interest rate paid on them fixed. The way the government stabilizes nominal GDP is to vary the nominal interest rate, lowering it when expected capital productivity is low, to maintain the demand for capital goods.
As far as I could tell, a reduction in the expected productivity of capital results in the current old generation receiving a bonanza of cheap consumer goods from the current young people. Those young people try to obtain more money/government bonds but their quantity is fixed. And more importantly, what the young people get from them when they are old is simply the tax payment of the next generation of young people. That doesn't increase when the productivity of capital is low. So, the current young people get less consumption when they are old and the current old people get a bonanza of extra consumption. It seems to me that from the point of view of the current young people, the best strategy is to invest all of current output other than an infinitely small amount to exchange for all of the money/government bonds.
But really, I don't think these specialized, highly unrealistic assumptions really add much to the basic supply of saving and demand for investment approach.
Monday, September 9, 2013
Wednesday, September 4, 2013
Some Thoughts on the Pigou Effect
The Pigou effect is that a lower price level increases real money balances, real wealth, and consumption. It applies to outside money, and not inside money.
In a previous post, I argued that inflation targeting combined with Ricardian Equivalence means that there is no Pigou effect. Inflation targeting makes base money into a type of inside money--fundamentally a type of government debt. Ricardian Equivalence implies that while a lower price level raises the wealth of of those holding base money, it increases real tax liabilities. There is no net effect on real wealth, and so no increase in real consumption.
For many years, the Fed almost entirely held government bonds. But recently, the Fed has shifted to holding a large amount of mortgaged-backed securities. If the price level is lower, then this increases the real wealth of those holding base money, but it reduces the real wealth of the indebted homeowners. To a large degree, there is no longer a Pigou effect for a substantial portion of base money, even without Ricardian Equivalence.
Further, 100% gold reserve banking would substantially increase the proportion of total wealth that is "outside" money. Such a monetary regime would have a much stronger Pigou effect. That is, even if nominal interest rates couldn't fall, say because they were already zero, then a lower price level would have a relatively larger effect on real wealth. The decrease in saving supply, increase in the natural interest rate, and increase in real consumption would be larger. In other words, a smaller decrease in prices and wages would be necessary to bring real expenditure in line with capacity.
In a previous post, I argued that inflation targeting combined with Ricardian Equivalence means that there is no Pigou effect. Inflation targeting makes base money into a type of inside money--fundamentally a type of government debt. Ricardian Equivalence implies that while a lower price level raises the wealth of of those holding base money, it increases real tax liabilities. There is no net effect on real wealth, and so no increase in real consumption.
For many years, the Fed almost entirely held government bonds. But recently, the Fed has shifted to holding a large amount of mortgaged-backed securities. If the price level is lower, then this increases the real wealth of those holding base money, but it reduces the real wealth of the indebted homeowners. To a large degree, there is no longer a Pigou effect for a substantial portion of base money, even without Ricardian Equivalence.
Further, 100% gold reserve banking would substantially increase the proportion of total wealth that is "outside" money. Such a monetary regime would have a much stronger Pigou effect. That is, even if nominal interest rates couldn't fall, say because they were already zero, then a lower price level would have a relatively larger effect on real wealth. The decrease in saving supply, increase in the natural interest rate, and increase in real consumption would be larger. In other words, a smaller decrease in prices and wages would be necessary to bring real expenditure in line with capacity.
Sunday, September 1, 2013
Selgin on Market Monetarism
George Selgin takes Market Monetarists to task for discounting the problem of booms. He recognizes that Scott Sumner and other Market Monetarists advocate a nominal GDP level target that is symmetrical. If nominal GDP should rise above the target growth path, the monetary regime should reverse the upward deviation.
So what is the problem? It is the skepticism among Market Monetarists that such an upward deviation in nominal GDP makes anything worth describing as a recession inevitable. In particular, nominal GDP can be returned to its prior growth path. There is absolutely no need for spending on output to fall below that growth path, much less drop to the level that existed before the upward deviation.
For example, suppose the target growth path for nominal GDP has a 3% growth rate. Unfortunately, there is a 2% upward deviation resulting in a 5% growth rate. Level targeting requires that the growth rate be approximately 1% the next year, so that it is now 6% greater than its level before the excessive spending growth two years before. There was no decrease in nominal GDP at all. Market Monetarists would insist that it is not necessary or desirable for nominal GDP to fall 5%, or even 2%, in the second year.
While Market Monetarists favor a target growth path, few of us would argue that growth rate targeting is unfeasible. In other words, it would be possible for nominal GDP to grow 5% one year, and then return to growing 3% in the future. The extra large upward deviation could be allowed to shift the economy up to a permanently higher growth path for nominal GDP. Not only would there be no decrease in nominal GDP, there would be no future slow down to return to the previous growth path.
What about real output? Recessions are not usually defined in terms of spending on output, but rather in terms of the growth rate of real output. Recessions are usually defined as a negative growth rate. Now, suppose potential output, the productive capacity of the economy is growing 3% and production is at capacity. Nominal GDP is on its target growth path, and the price level is stable. Then, suppose nominal GDP grows 5% and that the more rapid than usual increase in sales motivates firms to expand production more than usual. Rather than expanding their output by the usual 3%, they expand production 4%. The following year, the growth rate of nominal GDP is 1%. Nominal GDP returns to its initial growth path.
Is it necessary that real output fall 4%, reversing the expansion during the boom? Or even that it fall1%, reversing the excess growth? Or is it possible that real output might rise 2%, and return to its previous growth path? That is, like nominal GDP, it would 6% higher than it was two years before, exactly in line with the growth path of potential output.
One possible scenario is that during the year with nominal GDP growing 5%, the price level rises 1%. And then, in the following year, when nominal GDP grew only 1%, the price level falls by 1%, returning to its initial level, as real output rose 2%. At no point would real output fall. It would just grow each and every year, and grow extra fast, 4%, in one year, and a bit slower, 2%, the next year, so that over the entire period, it grows 6%, exactly in line with potential output.
While recessions are usually defined in terms of the growth rate of real output, an alternative approach is to consider the output gap--real output minus potential output. The phenomenon of concern is production below capacity, regardless of whether production is rising or falling. In the scenario above, the more rapid growth of nominal GDP results in real output rising above potential. And then in the next period, it returns to potential. The increase in real output above potential the first year does not require that it fall below potential the following year.
Of course, the notion that real output can rise above potential is a bit of a puzzle. How is it possible to produce more than there is the capacity to produce? Selgin suggests that Market Monetarists follow Milton Friedman in having a "plucking" model. When nominal GDP grows shifts down to a lower growth path, this causes real output to fall below potential. And then, as inflation slows and the price level adjusts to a lower growth path, or nominal GDP recovers, real output returns to potential. While real output falls below potential, on this view, it never rises above potential.
If potential output is assumed to stay on a 3% growth path, this would be a bit implausible. But once it is recognized that potential output almost certainly sometimes grows faster and other times more slowly, then booms can be explained as periods where potential output is above trend. Recessions then can either be potential output growing below trend or else real output falling below potential. It seems reasonable to me that mild "growth recessions" could either be due to a slow down in the growth of spending on output or a slow down in the growth of potential output. Deep recessions, on the other hand, would be due to decreases in spending on output.
Still, I believe that real output can rise above potential, a view,which is shared by at least some other Market Monetarists. With imperfect competition, firms have excess capacity in equilibrium and so can expand output. If their prices are pre-set and there is an unexpected increase in demand, they will find in profitable to expand production. And then, when they reset prices or demand decreases, they will return production to its initial level. If potential output is growing, then it is possible to see real output rise more quickly when spending on output grows more quickly, and then grow more slowly as spending on output grows more slowly.
Sumner emphasizes sticky wages, and it would seem that something similar is likely. When demand grows more rapidly, firms with excess capital capacity use more labor and other variable inputs and produce and sell more output. If the situation persisted, then they will adjust the wages they pay, causing this effect to dissipate. How long does it take firms to recognizes that a higher growth path or rate of spending on output is going to persist and then respond by changing their labor compensation programs? Of course, with nominal GDP level targeting, there is no need to make these adjustments in compensation programs. When spending on output grows more slowly, the production and employment return to the previous growth paths.
The puzzling implication of this reasoning is that booms can be caused by more rapid spending growth, and they are times of enhanced production, employment, and human welfare. It is just that changing the growth rate or path of spending on output to create a perpetual boom is impossible.
Anyway, the puzzle of the boom, with output rising beyond potential has no counterpart in the recession. There is no technical problem with producing far below capacity. It is only that this implies surpluses of products and labor and the result should be lower prices and wages. The lower prices and wages increases real money balances and real expenditures on output. Assuming firms respond to growing sales by producing more, then production will rise back up to capacity. If prices and wages only adjust sluggishly and if the needed adjustment in prices and wages is large, then output can remain below capacity for a substantial period of time.
What happens if prices and wages are also sticky on the upside? In the scenario above, spending grew 5% and production rose 4% and prices 1%. Instead of the usual expansion of production by 3%, it was 1% higher and instead of the usual stable price level, there was 1% inflation. What if prices instead did not increase at all and it was impossible to expand production by more than 4%? Then there are shortages.
Now, shortages are not harmless. The story told in principles classes these days is that markets clear due to queuing costs. Those who have low opportunity costs of standing in line, obtain the goods and others do without. However, with a temporary upward deviation of spending on output, shortages are likely to show up as depletion of inventories and later delivery dates. There may be queuing for services too. Consumer goods and services don't go to those who value them most according to their willingness to pay. Perhaps of more concern, capital goods don't go to firms who can use them most productively.
If spending on output was allowed to shift to a higher growth path, then these inefficiencies of shortages would only dissipate as prices and wages adjusted upwards. If nominal GDP returned to its previous growth path, then any shortages would disappear, largely as growing productive capacity caught up with the level of spending. The increase in spending above was 5%, which is 2% greater than the increase in capacity. But the next year, capacity grows 3% as usual, which catches up with that 2% excess growth in spending, and then some. Spending on output grows 1% more to match.
Anyway, the short answer to Selgin is that scarcity puts a limit on how much extra real output can be produced in a "boom" while putting no constraint on the negative impact of a recession on production and employment. But as Selgin recognizes, Market Monetarists do favor keeping nominal GDP on the target growth path. Just because upward deviations of nominal GDP from target are unlikely to cause significant increases in real output doesn't mean that such deviations are desirable.
So what is the problem? It is the skepticism among Market Monetarists that such an upward deviation in nominal GDP makes anything worth describing as a recession inevitable. In particular, nominal GDP can be returned to its prior growth path. There is absolutely no need for spending on output to fall below that growth path, much less drop to the level that existed before the upward deviation.
For example, suppose the target growth path for nominal GDP has a 3% growth rate. Unfortunately, there is a 2% upward deviation resulting in a 5% growth rate. Level targeting requires that the growth rate be approximately 1% the next year, so that it is now 6% greater than its level before the excessive spending growth two years before. There was no decrease in nominal GDP at all. Market Monetarists would insist that it is not necessary or desirable for nominal GDP to fall 5%, or even 2%, in the second year.
While Market Monetarists favor a target growth path, few of us would argue that growth rate targeting is unfeasible. In other words, it would be possible for nominal GDP to grow 5% one year, and then return to growing 3% in the future. The extra large upward deviation could be allowed to shift the economy up to a permanently higher growth path for nominal GDP. Not only would there be no decrease in nominal GDP, there would be no future slow down to return to the previous growth path.
What about real output? Recessions are not usually defined in terms of spending on output, but rather in terms of the growth rate of real output. Recessions are usually defined as a negative growth rate. Now, suppose potential output, the productive capacity of the economy is growing 3% and production is at capacity. Nominal GDP is on its target growth path, and the price level is stable. Then, suppose nominal GDP grows 5% and that the more rapid than usual increase in sales motivates firms to expand production more than usual. Rather than expanding their output by the usual 3%, they expand production 4%. The following year, the growth rate of nominal GDP is 1%. Nominal GDP returns to its initial growth path.
Is it necessary that real output fall 4%, reversing the expansion during the boom? Or even that it fall1%, reversing the excess growth? Or is it possible that real output might rise 2%, and return to its previous growth path? That is, like nominal GDP, it would 6% higher than it was two years before, exactly in line with the growth path of potential output.
One possible scenario is that during the year with nominal GDP growing 5%, the price level rises 1%. And then, in the following year, when nominal GDP grew only 1%, the price level falls by 1%, returning to its initial level, as real output rose 2%. At no point would real output fall. It would just grow each and every year, and grow extra fast, 4%, in one year, and a bit slower, 2%, the next year, so that over the entire period, it grows 6%, exactly in line with potential output.
While recessions are usually defined in terms of the growth rate of real output, an alternative approach is to consider the output gap--real output minus potential output. The phenomenon of concern is production below capacity, regardless of whether production is rising or falling. In the scenario above, the more rapid growth of nominal GDP results in real output rising above potential. And then in the next period, it returns to potential. The increase in real output above potential the first year does not require that it fall below potential the following year.
Of course, the notion that real output can rise above potential is a bit of a puzzle. How is it possible to produce more than there is the capacity to produce? Selgin suggests that Market Monetarists follow Milton Friedman in having a "plucking" model. When nominal GDP grows shifts down to a lower growth path, this causes real output to fall below potential. And then, as inflation slows and the price level adjusts to a lower growth path, or nominal GDP recovers, real output returns to potential. While real output falls below potential, on this view, it never rises above potential.
If potential output is assumed to stay on a 3% growth path, this would be a bit implausible. But once it is recognized that potential output almost certainly sometimes grows faster and other times more slowly, then booms can be explained as periods where potential output is above trend. Recessions then can either be potential output growing below trend or else real output falling below potential. It seems reasonable to me that mild "growth recessions" could either be due to a slow down in the growth of spending on output or a slow down in the growth of potential output. Deep recessions, on the other hand, would be due to decreases in spending on output.
Still, I believe that real output can rise above potential, a view,which is shared by at least some other Market Monetarists. With imperfect competition, firms have excess capacity in equilibrium and so can expand output. If their prices are pre-set and there is an unexpected increase in demand, they will find in profitable to expand production. And then, when they reset prices or demand decreases, they will return production to its initial level. If potential output is growing, then it is possible to see real output rise more quickly when spending on output grows more quickly, and then grow more slowly as spending on output grows more slowly.
Sumner emphasizes sticky wages, and it would seem that something similar is likely. When demand grows more rapidly, firms with excess capital capacity use more labor and other variable inputs and produce and sell more output. If the situation persisted, then they will adjust the wages they pay, causing this effect to dissipate. How long does it take firms to recognizes that a higher growth path or rate of spending on output is going to persist and then respond by changing their labor compensation programs? Of course, with nominal GDP level targeting, there is no need to make these adjustments in compensation programs. When spending on output grows more slowly, the production and employment return to the previous growth paths.
The puzzling implication of this reasoning is that booms can be caused by more rapid spending growth, and they are times of enhanced production, employment, and human welfare. It is just that changing the growth rate or path of spending on output to create a perpetual boom is impossible.
Anyway, the puzzle of the boom, with output rising beyond potential has no counterpart in the recession. There is no technical problem with producing far below capacity. It is only that this implies surpluses of products and labor and the result should be lower prices and wages. The lower prices and wages increases real money balances and real expenditures on output. Assuming firms respond to growing sales by producing more, then production will rise back up to capacity. If prices and wages only adjust sluggishly and if the needed adjustment in prices and wages is large, then output can remain below capacity for a substantial period of time.
What happens if prices and wages are also sticky on the upside? In the scenario above, spending grew 5% and production rose 4% and prices 1%. Instead of the usual expansion of production by 3%, it was 1% higher and instead of the usual stable price level, there was 1% inflation. What if prices instead did not increase at all and it was impossible to expand production by more than 4%? Then there are shortages.
Now, shortages are not harmless. The story told in principles classes these days is that markets clear due to queuing costs. Those who have low opportunity costs of standing in line, obtain the goods and others do without. However, with a temporary upward deviation of spending on output, shortages are likely to show up as depletion of inventories and later delivery dates. There may be queuing for services too. Consumer goods and services don't go to those who value them most according to their willingness to pay. Perhaps of more concern, capital goods don't go to firms who can use them most productively.
If spending on output was allowed to shift to a higher growth path, then these inefficiencies of shortages would only dissipate as prices and wages adjusted upwards. If nominal GDP returned to its previous growth path, then any shortages would disappear, largely as growing productive capacity caught up with the level of spending. The increase in spending above was 5%, which is 2% greater than the increase in capacity. But the next year, capacity grows 3% as usual, which catches up with that 2% excess growth in spending, and then some. Spending on output grows 1% more to match.
Anyway, the short answer to Selgin is that scarcity puts a limit on how much extra real output can be produced in a "boom" while putting no constraint on the negative impact of a recession on production and employment. But as Selgin recognizes, Market Monetarists do favor keeping nominal GDP on the target growth path. Just because upward deviations of nominal GDP from target are unlikely to cause significant increases in real output doesn't mean that such deviations are desirable.
Saturday, August 24, 2013
The Pigou Effect
The Pigou effect is that a lower price level, including lower prices of resources like nominal wages, will increase the real value of money balances. This will increase real wealth. The greater real wealth will result in greater real consumption expenditures. And so, a lower price level leads to increased real expenditure on currently-produced goods and services.
From a Wicksellian framing, the increase in real wealth reduces saving supply and so raises the natural interest rate. If the market interest rate were above the natural interest rate, this would tend to bring them together. But rather than the market interest rate adjusting downward to an unchanged natural interest rate, it would be the natural interest rate rising up to the market interest rate.
The point of the Pigou effect was to show that there was a long run process that would generate a level of real expenditure on output equal to the productive capacity of the economy. This effect would occur even if the nominal (and real) interest rate could not fall because of a liquidity trap or else consumption and investment were perfectly inelastic with regards to the interest rate. (A vertical savings supply curve could still shift to the left, and match investment.)
Patinkin emphasized that this effect only works with "outside money," and not "inside money." Inside money is the most common type of money. These days it is mostly made up of various sorts of bank deposits. While inside money is an asset to the person holding it, it is a liability to the issuer. That is directly the banks or other financial institution that issued the money.
When the price level goes down, those holding the inside money are wealthier, but those who issued it have larger real liabilities and so are poorer. The banks and other financial institutions have assets, typically loans and bonds. When the price level falls, the real value of those financial assets rise. But those are liabilities to the households and firms that borrowed the money by obtaining the loans or issuing the bonds. And so the lower price level raises their real liabilities, making them poorer.
For the inside money, the lower price level raises the real wealth of those households and firms holding money and lowers the real wealth of those households and firms that borrowed from the banks or other financial institutions that issued the money. There is no impact on net real wealth and so no impact on real consumption. There is no Pigou Effect for inside money.
When Pigou made this argument, it was in the background of a gold standard. With a gold standard, gold coins and gold reserves are outside money. They are an asset to those who own them and they are a liability to no one. A lower price level raises the real value of the monetary gold, this increases real wealth, and it should increase real consumption. Of course, gold as a proportion of total wealth was small, so it would seem that a large decrease in the price level would be necessary to substantially increase total wealth much, and so significantly increase real consumption.
Now that the gold standard is long gone, how does the Pigou effect apply to fiat money? In my view, it depends on the monetary regime. If the fiat money regime is purely irresponsible, so that the government prints money and spends it based upon fiscal needs, then the Pigou effect applies. This framing is realistic sometimes--for example Zimbabwe.
If the fiat regime is based upon a quantity of base money rule, with the level of base money being on some growth path, including remaining fixed, then the Pigou effect applies. However, I don't think this framing is very realistic.
Modern paper money evolved from paper money redeemable in gold. Generally, it was issued by private banks, though one such bank often developed into a central bank. The reason was that the government granted it a monopoly on the issue of hand-to-hand currency in return for a share of the benefits from borrowing at a zero nominal interest rate. As these central banks were gradually nationalized, the hand-to-hand currency and balances private banks held at the central bank became effectively a type of government debt. As long as the gold standard was maintained, it was a liability of the government.
Of course, the gold standard is long gone. But no central bank has adopted any type of base money rule. According to the Fed's dual mandate, it is supposed to be promoting a stable price level. And this, of course, was the goal of many economists who favored leaving the gold standard. Rather than keep paper money fixed to gold, it should be fixed to a composite commodity. This is, in effect, stabilizing some price index.
If there is a real commitment to stabilizing the price level, then paper money is a liability of the issuer just as it is if it is redeemable into gold. What the redemption obligation requires is that the quantity of paper money be adjusted according to the demand to hold it. Those holding the paper money are lending to the central bank. The central bank can only borrow the amount the lenders are willing to lend. With a gold standard, when those holding paper money choose to hold less, they could redeem the paper money for gold, but they can also spend the paper money on whatever it is they want to hold instead. Through a variety of avenues, this tends to raise the demand for gold, which the central bank must supply while reducing the quantity of paper money. A rule requiring a stable price level has the exact same effect, though without the enforcement mechanism allowed by the redemption obligation.
While the dual mandate never changed, during the heyday of Keynesian demand management, there was an effort to reduce unemployment at the cost of higher inflation. And then there was a period when central banks sought to blame rising inflation rates on various supply-side factors while using monetary policy to stabilize interest rates and output. Finally, central banks came to their senses and brought inflation under control, but rather than a stable price level, they ended up with a flexible inflation target.
If the central bank had a real commitment to a growth path for the price level, then base money would be a liability, just as it was under the gold standard. The more flexibility that is added, along with the forgiveness of errors inherent in an inflation target, the more nebulous is the nature of this liability. Still, if the demand for base money should fall substantially, the central bank would need to withdraw it from circulation to keep inflation from rising above target. This means that the money that it borrows by issuing base money is limited by the amount of lending in that form that is desired by those who choose to hold base money.
What does this have to do with the Pigou effect? If central bank paper money is a liability, then it is a type of inside money. There is no Pigou effect. A lower price level would increase the real wealth of those holding paper currency or balances at the central bank, but it would increase the real liabilities of the central bank.
If the central bank is nationalized, then this is an increase in the real liabilities of the government. Given the custom of treating the balance sheets of the central bank separate from the rest of the government, then the central bank has assets to match its liabilities. And so, while the real value of its liabilities rise, so does the real value of its assets. The central bank is no poorer.
To the degree that the central bank makes loans to the private sector, say to banks, or else holds privately-issued bonds, then the lower price level raises the real value of those private liabilities and so reduces the real wealth of those who borrowed from the central bank. There is no Pigou effect.
Of course, many central banks hold government bonds. Until recently, it was approximately true that the Federal Reserve only held government bonds. Back in their formative days, the entire point of providing central banks a monopoly on issuing currency was for the government to share in the benefit of borrowing at a zero nominal interest rate, and that could occur by having the central bank make loans to the government at low interest rates.
To the degree that the central bank holds government bonds, or else the central bank's balance sheet is consolidated with the rest of the government, then the lower price level increases the real wealth of those holding base money while increasing the real national debt. This is where Ricardian Equivalence creates an issue. If the real value of the national debt should rise, then this represents increased future real tax obligations. And so, while the increase in the real value of base money increases the real wealth and consumption of those holding the money, it will reduce the real wealth of taxpayers, and so they will consume less and save more to be able to pay the higher taxes in the future.
While I tend to be skeptical of Ricardian Equivalence, I must admit that the impact of a lower price level on public finance is likely to be immediate and direct. The lower price level decreases the nominal tax revenues of the government and the nominal expenditures it must make to maintain current services. However, the nominal interest and principal payments it makes on the national debt remain the same. This requires an immediate increase in taxes or reduction in real government expenditures on goods and services.
Of course, a price level target implies that any decrease in the price level is temporary. The entire scenario for the Pigou effect just doesn't apply. The lower price level doesn't permanently increase real balances or real wealth. That effect of the lower price level is temporary and will disappear once the price level recovers. Of course, with a price level target, the fact that real balances are temporarily high (and the prices of goods and services temporarily low) provides a very strong incentive to increase current real expenditures. Buy now when prices are temporarily low. With a Wicksellian framing, when the price level recovers, the inflation rate will be higher and so real market interest rates are lower, bringing it into equilibrium to the natural interest rate, even if the nominal market interest rate doesn't fall.
However, with an inflation target, a lower price level (or growth path of the price level,) will be allowed to persist. The change in the price level is permanent. Real base money balances and the real wealth of those holding them are permanently higher, (or on a permanently higher growth path.) But nominal government revenues are on a permanently lower growth path, and the nominal national debt is unchanged, creating an immediately apparent public finance crunch. With perfect Ricardian equivalence, this will exactly offset the Pigou effect.
Unlike with a price level target, there is no effect of prices being temporarily lower, because inflation targeting keeps prices from recovering. But because inflation targeting, like price level targeting, does make central bank/government base money into a liability, this permanent change in real balances and the real wealth of those holding real balances does not create a Pigou effect.
P.S. I favor privatizing hand-to-hand currency, mutual fund type reserve balances, and a very small national debt. Not much room for a Pigou effect in my "ideal" institutional framework.
From a Wicksellian framing, the increase in real wealth reduces saving supply and so raises the natural interest rate. If the market interest rate were above the natural interest rate, this would tend to bring them together. But rather than the market interest rate adjusting downward to an unchanged natural interest rate, it would be the natural interest rate rising up to the market interest rate.
The point of the Pigou effect was to show that there was a long run process that would generate a level of real expenditure on output equal to the productive capacity of the economy. This effect would occur even if the nominal (and real) interest rate could not fall because of a liquidity trap or else consumption and investment were perfectly inelastic with regards to the interest rate. (A vertical savings supply curve could still shift to the left, and match investment.)
Patinkin emphasized that this effect only works with "outside money," and not "inside money." Inside money is the most common type of money. These days it is mostly made up of various sorts of bank deposits. While inside money is an asset to the person holding it, it is a liability to the issuer. That is directly the banks or other financial institution that issued the money.
When the price level goes down, those holding the inside money are wealthier, but those who issued it have larger real liabilities and so are poorer. The banks and other financial institutions have assets, typically loans and bonds. When the price level falls, the real value of those financial assets rise. But those are liabilities to the households and firms that borrowed the money by obtaining the loans or issuing the bonds. And so the lower price level raises their real liabilities, making them poorer.
For the inside money, the lower price level raises the real wealth of those households and firms holding money and lowers the real wealth of those households and firms that borrowed from the banks or other financial institutions that issued the money. There is no impact on net real wealth and so no impact on real consumption. There is no Pigou Effect for inside money.
When Pigou made this argument, it was in the background of a gold standard. With a gold standard, gold coins and gold reserves are outside money. They are an asset to those who own them and they are a liability to no one. A lower price level raises the real value of the monetary gold, this increases real wealth, and it should increase real consumption. Of course, gold as a proportion of total wealth was small, so it would seem that a large decrease in the price level would be necessary to substantially increase total wealth much, and so significantly increase real consumption.
Now that the gold standard is long gone, how does the Pigou effect apply to fiat money? In my view, it depends on the monetary regime. If the fiat money regime is purely irresponsible, so that the government prints money and spends it based upon fiscal needs, then the Pigou effect applies. This framing is realistic sometimes--for example Zimbabwe.
If the fiat regime is based upon a quantity of base money rule, with the level of base money being on some growth path, including remaining fixed, then the Pigou effect applies. However, I don't think this framing is very realistic.
Modern paper money evolved from paper money redeemable in gold. Generally, it was issued by private banks, though one such bank often developed into a central bank. The reason was that the government granted it a monopoly on the issue of hand-to-hand currency in return for a share of the benefits from borrowing at a zero nominal interest rate. As these central banks were gradually nationalized, the hand-to-hand currency and balances private banks held at the central bank became effectively a type of government debt. As long as the gold standard was maintained, it was a liability of the government.
Of course, the gold standard is long gone. But no central bank has adopted any type of base money rule. According to the Fed's dual mandate, it is supposed to be promoting a stable price level. And this, of course, was the goal of many economists who favored leaving the gold standard. Rather than keep paper money fixed to gold, it should be fixed to a composite commodity. This is, in effect, stabilizing some price index.
If there is a real commitment to stabilizing the price level, then paper money is a liability of the issuer just as it is if it is redeemable into gold. What the redemption obligation requires is that the quantity of paper money be adjusted according to the demand to hold it. Those holding the paper money are lending to the central bank. The central bank can only borrow the amount the lenders are willing to lend. With a gold standard, when those holding paper money choose to hold less, they could redeem the paper money for gold, but they can also spend the paper money on whatever it is they want to hold instead. Through a variety of avenues, this tends to raise the demand for gold, which the central bank must supply while reducing the quantity of paper money. A rule requiring a stable price level has the exact same effect, though without the enforcement mechanism allowed by the redemption obligation.
While the dual mandate never changed, during the heyday of Keynesian demand management, there was an effort to reduce unemployment at the cost of higher inflation. And then there was a period when central banks sought to blame rising inflation rates on various supply-side factors while using monetary policy to stabilize interest rates and output. Finally, central banks came to their senses and brought inflation under control, but rather than a stable price level, they ended up with a flexible inflation target.
If the central bank had a real commitment to a growth path for the price level, then base money would be a liability, just as it was under the gold standard. The more flexibility that is added, along with the forgiveness of errors inherent in an inflation target, the more nebulous is the nature of this liability. Still, if the demand for base money should fall substantially, the central bank would need to withdraw it from circulation to keep inflation from rising above target. This means that the money that it borrows by issuing base money is limited by the amount of lending in that form that is desired by those who choose to hold base money.
What does this have to do with the Pigou effect? If central bank paper money is a liability, then it is a type of inside money. There is no Pigou effect. A lower price level would increase the real wealth of those holding paper currency or balances at the central bank, but it would increase the real liabilities of the central bank.
If the central bank is nationalized, then this is an increase in the real liabilities of the government. Given the custom of treating the balance sheets of the central bank separate from the rest of the government, then the central bank has assets to match its liabilities. And so, while the real value of its liabilities rise, so does the real value of its assets. The central bank is no poorer.
To the degree that the central bank makes loans to the private sector, say to banks, or else holds privately-issued bonds, then the lower price level raises the real value of those private liabilities and so reduces the real wealth of those who borrowed from the central bank. There is no Pigou effect.
Of course, many central banks hold government bonds. Until recently, it was approximately true that the Federal Reserve only held government bonds. Back in their formative days, the entire point of providing central banks a monopoly on issuing currency was for the government to share in the benefit of borrowing at a zero nominal interest rate, and that could occur by having the central bank make loans to the government at low interest rates.
To the degree that the central bank holds government bonds, or else the central bank's balance sheet is consolidated with the rest of the government, then the lower price level increases the real wealth of those holding base money while increasing the real national debt. This is where Ricardian Equivalence creates an issue. If the real value of the national debt should rise, then this represents increased future real tax obligations. And so, while the increase in the real value of base money increases the real wealth and consumption of those holding the money, it will reduce the real wealth of taxpayers, and so they will consume less and save more to be able to pay the higher taxes in the future.
While I tend to be skeptical of Ricardian Equivalence, I must admit that the impact of a lower price level on public finance is likely to be immediate and direct. The lower price level decreases the nominal tax revenues of the government and the nominal expenditures it must make to maintain current services. However, the nominal interest and principal payments it makes on the national debt remain the same. This requires an immediate increase in taxes or reduction in real government expenditures on goods and services.
Of course, a price level target implies that any decrease in the price level is temporary. The entire scenario for the Pigou effect just doesn't apply. The lower price level doesn't permanently increase real balances or real wealth. That effect of the lower price level is temporary and will disappear once the price level recovers. Of course, with a price level target, the fact that real balances are temporarily high (and the prices of goods and services temporarily low) provides a very strong incentive to increase current real expenditures. Buy now when prices are temporarily low. With a Wicksellian framing, when the price level recovers, the inflation rate will be higher and so real market interest rates are lower, bringing it into equilibrium to the natural interest rate, even if the nominal market interest rate doesn't fall.
However, with an inflation target, a lower price level (or growth path of the price level,) will be allowed to persist. The change in the price level is permanent. Real base money balances and the real wealth of those holding them are permanently higher, (or on a permanently higher growth path.) But nominal government revenues are on a permanently lower growth path, and the nominal national debt is unchanged, creating an immediately apparent public finance crunch. With perfect Ricardian equivalence, this will exactly offset the Pigou effect.
Unlike with a price level target, there is no effect of prices being temporarily lower, because inflation targeting keeps prices from recovering. But because inflation targeting, like price level targeting, does make central bank/government base money into a liability, this permanent change in real balances and the real wealth of those holding real balances does not create a Pigou effect.
P.S. I favor privatizing hand-to-hand currency, mutual fund type reserve balances, and a very small national debt. Not much room for a Pigou effect in my "ideal" institutional framework.
Thursday, August 8, 2013
Sumner on Summers
Scott Sumner criticized Larry Summers as potential Fed chair in the Financial Times. I agree with Sumner's major point. As the Romer's pointed out, the Fed's three greatest failures (what I call the three strikes against the Fed,) were all caused by the Fed leadership's view that matters were beyond their control. What are the three strikes? The Great Depression, the Great Inflation, and most recently, the Great Recession. It is true, of course, that stabilizing nominal spending on output cannot control employment, production, or real standards of living. The problem is when the leadership of the central bank denies that it can control nominal spending and the price level.
On the other hand, I am not willing to choose between Summers and Yellen. Yellen seems to be more of what we have now. Maybe Miles Kimball? Evan Koenig? Robert Hetzel? Realistically, such people need to be put on the Board of Governors or promoted to Federal Reserve bank President. At least Koenig is a Vice President at the Dallas Fed. If we are really stuck with new Keynesians, then I suppose Woodford is best. Then what about Evans, if the "Evan's Rule," is the best we can get for now? And, of course, why not Christina Romer?
On the other hand, I am not willing to choose between Summers and Yellen. Yellen seems to be more of what we have now. Maybe Miles Kimball? Evan Koenig? Robert Hetzel? Realistically, such people need to be put on the Board of Governors or promoted to Federal Reserve bank President. At least Koenig is a Vice President at the Dallas Fed. If we are really stuck with new Keynesians, then I suppose Woodford is best. Then what about Evans, if the "Evan's Rule," is the best we can get for now? And, of course, why not Christina Romer?
Wednesday, July 3, 2013
CNBC's Kelly Evans shares her thoughts on establishing a futures market on the FOMC.
CNBC's Kelly Evans shares her thoughts on establishing a futures market on the
FOMC.
Transcript:
what are you watching this tuesday morning? well, as much as you are fascinating
with the markets, people want to know what happened. we have been talking about
the weird signals coming out from the ma22nd, whether it is a speed up or
slowing or square from the fed. ing to bring us to a topic here of what is
happening with the prediction market and gdp. can do the gdp bonds, and a lot of
people out there will be familiar in terms of this debate with the nominal gdp.
since may 22nd, again, some confusion to some extent in markets about whether
what we have seen the fed spurring freakout in credit markets or equities or
responding to improvement of conditions on the ground. trying to get the signal
from the noise here would be much eathere were a place the look to saying that
the market participants see the growth and increasing over to the longer term or
decreasing? a couple of ways to do that is that you can, again, set up futures
in the gdp linked bond or do a prediction market. one of the guys calling for
this is noting that if it is done right, the markets, themselves could more
smoothly guide the taper and there wouldn't be any friction back and forth
between what one group is thinking and another at the fmyc, and another fed
notes that without this type of thing in place, we are still flying blind. that
certainly seems to be the case thinking about the market activity over to the
last six weeks. and guys, the jury is whether this is the right thing for the
fed to target gdp instead of inflation, and the tacit market. and there is a
strong case for being set up a market to get this information out there, and
then we would know with clarity, are we taing about the growth or not. well, to
some extent. helping people know what people are thinking. and better than what
finesfelt came out. it is better when he is in the journal, and jim, you didn't
like the piece? well, what you said is more formative and gun to the head -- and
gun to the head may not be the right thing. and his response would be if there
is a supply shock here happening to the economy, it is not something that you
will necessarily as the fed respond to, but it would help to have clarify from
the market itself. i could not agree more.
The Transcript could use a bit of work BW
Tuesday, July 2, 2013
A Post on Private Currency and the Zero Nominal Bound
Miles Kimball reposted a piece from JP Koning that cited a couple of my posts, here and here.
Koning argues that efforts by a central bank to suppress the use of hand-to-hand currency when faced with a zero nominal bound really just proxy what private currency-issuing banks would be compelled to do in a similar circumstance.
Thanks for the citations!
P.S. Getting ready to return home to Charleston from the WEA meetings in Seattle. Seattle was terribly hot at 82 degrees and 40% humidity. (Yes, fellow denizens of the Lowcountry, that is what people around here are saying.) I presented a paper at a session on Nominal GDP targeting. Scott Sumner, David Eagle, and Evan Koenig also presented. Even better than the session was lunch with them after, and then dinner with Scott and David.
Koning argues that efforts by a central bank to suppress the use of hand-to-hand currency when faced with a zero nominal bound really just proxy what private currency-issuing banks would be compelled to do in a similar circumstance.
Thanks for the citations!
P.S. Getting ready to return home to Charleston from the WEA meetings in Seattle. Seattle was terribly hot at 82 degrees and 40% humidity. (Yes, fellow denizens of the Lowcountry, that is what people around here are saying.) I presented a paper at a session on Nominal GDP targeting. Scott Sumner, David Eagle, and Evan Koenig also presented. Even better than the session was lunch with them after, and then dinner with Scott and David.
Subscribe to:
Posts (Atom)