Imagine you are a monetary economist, working in a central bank, and you wake up one morning and find yourself in an alternative universe. You don't realise it's an alternative universe at first, because everything looks the same. But when you get into work and go to the meeting of the monetary policy committee, you realise something is very different.
You are the first to give your views. You discuss all the various indicators, like inflation, unemployment, commodity prices, and give your recommendation for the overnight rate target (Feds fund rate, if you like) for the next 6 weeks, needed to keep future CPI inflation on target. The response is not what you expect. They all look at you like you're crazy. Then someone mentions that it's April 1st, and they all start laughing.
The second person to speak discusses all the same indicators you did, with two exceptions. She leaves the price of gold out of the list of commodity prices. And she adds the overnight rate of interest to the list of indicators. Then the bombshell: she gives a recommendation for the gold price target for the next 6 weeks, needed to keep future CPI inflation on target.
You then realise you are in an alternative universe (plus, she's got orange eyes).
When you regain consciousness, you head for the Bank's library. Eventually you find "The Child's Book of Monetary History" which tells you what you need to know.
The book tells you that monetary history started out the same way, with gold coins, then paper money redeemable for gold at a fixed price. Then sometime in the 1930s, the histories diverged. Faced with a Great Depression, central banks abandoned fixed gold price targets, and moved to flexible gold price targets. They adjusted the time-path of the price at which paper money would be redeemed for gold, at frequent intervals, in response to changing economic conditions. Eventually, after too much emphasis on trying to keep unemployment low during the 1960s, which caused high inflation, and the realisation that monetary policy could only target nominal variables in the long run, they adopted a CPI inflation target.
"All modern central banks target CPI inflation, using the price of gold as the control instrument" the book reads. "We remain good horizontalists (the LM curve is horizontal at a given price of gold) like our forefathers, but recognise that we must shift the LM curve up and down in response to economic conditions to keep future CPI inflation on target. All but a few "verticalists" see the price of gold as the channel through which monetary policy affects the rest of the economy. And the monetarists have never satisfactorily answered the question 'which of the many interest rates is the one that matters?' "
You are stunned. How will you keep your job, and learn to adjust to this totally new way of thinking about monetary policy?
Then you have a stroke of luck. In your pocket you have your brand new macroeconomic model, TOTEM+G.
TOTEM+G is your first revision of a standard New Keynesian macroeconomic model, which includes commodity prices in the terms of trade. You had decided to disaggregate the commodity price sector, and had just finished doing this for the price of gold when you found yourself in the alternative universe.
You plug your model into the computer, and realise it will work fine. All the same equilibrium conditions still hold true. Even the parameter values are the same. You just have to think about it in a different way. You used to solve out for the time-path of the overnight rate that would keep inflation on target, letting all other variables, including the price of gold, adjust endogenously. Now you solve out for the time-path of the price of gold that would keep inflation on target, letting the overnight rate adjust endogenously.
Actually, it is even simpler than that. While checking to see that expectations are model-consistent with your solution for the gold-price instrument rule, you realise you can get rid of all those stupid ad hoc transversality restrictions you previously needed to get a determinate price level under interest rate targeting. As long as the Bank keeps the price of gold finite, and non-negative, those conditions are automatically satisfied.
You check the robustness of your implied instrument rule, and are even more pleasantly surprised. Even if you make a permanent mistake about the natural real price of gold, all that happens is that the price level is permanently off the target by the same percentage amount, while the inflation rate would remain on target. In your original model, if you made a permanent mistake about the natural real rate of interest, the solution would never converge.
Initially you are puzzled by the non-negativity constraint on the nominal overnight rate. It is no longer a constraint on policy, because monetary policy does not operate on the overnight rate. But it is still a constraint on an endogenous variable, and the economy does behave rather differently when it hits that constraint. But then you realise that the central bank could always move away from that constraint, if it wants, by increasing the rate of increase in the price of gold. It's really no different from having a legal minimum rate of inflation on gold.
The implied instrument rule for the price of gold turned out to be very similar to the original instrument rule for the overnight rate. A sort of modified augmented Taylor Rule, with two differences.
First, the price of gold now disappeared as an indicator and was replaced with the overnight rate. Second, the Bank could not allow anticipated discrete jumps in the gold price target, but had to make it a continuous function of time. Rather than adjusting the price of gold every 6 weeks, the Bank would adjust the rate of change in the price of gold.
Of course, your Neo-Wicksellian model does not contain a stock of money, and you wonder briefly how the Bank actually controls the price of gold. You ask your colleague with the orange eyes. "Well" she says, "we just sort of announce what our target is, and it just sort of follows it. Sometimes we do need to buy or sell a little bit of gold, and we do OMOs in the bond market if our gold reserves get too big or small. The stock of money is endogenous, of course, and we never worry about that."
You start to tell her a story, about what it would be like to wake up in an alternative universe, where the Bank uses an interest rate instrument to target inflation. She asks how the Bank could control the rate of interest, and how a change in the rate of interest could affect the price of gold, and the rest of the economy. You try to explain, using her familiar ISLM diagram, which is just like yours, except it has the price of gold on the vertical axis.
"Well" she says "I'm not at all sure it would work, and I really need to think about the transmission mechanism. How does a change in the rate of interest affect the price of gold, again? It's such a strange way of thinking. We have always conducted monetary policy through the gold market, ever since the first paper money. I can't see how you could keep the price level determinate, using such a weird control instrument. But I do like a man with such a great economic imagination."
She leans towards you. Her orange eyes sparkle. Her lips open softly. And then you really wake up, and realise it was all just a dream.
Back to reality.
I am not advocating gold in particular as the good in which monetary policy should operate. In principle it could be the nominal price of any real good (or claims on a real good). I chose gold just because it made the alternative history simpler. Because gold market operations were once the way that monetary policy was implemented, the alternative universe is just one that diverged from our own history.
It is always hard to seem the same world in a different perspective. And it is the same world, because all the equilibrium conditions are the same. But we have swapped exogenous and endogenous variables, so the disequilibrium transmission mechanism becomes very different. And that story of the transmission mechanism is always just that — a story. It is outside the equilibrium conditions of the equations.
It is perhaps easier for economic historians, or historians of thought, to think about the world in different ways. Because that's what they are forced to do as part of their work. And it is perhaps hardest for those who are closest to the current operating procedures, and who know more than anyone else about how things really work.
This is a double experiment. A thought-experiment, which I am trying out as an experiment. I don't know if it will work or fail miserably. But there's little cost in trying.
I came to write it after reading Scott Sumner's post, Jeremy Goodridge's comment on that post, and in response to many critical and useful comments by Adam P and JKH on my previous post.
Worthwhile Canadian Initiative 
Nick,
I admit to being terminally afflicted by cognitive interest rate capture. God help me.
To wit:
“Then the bombshell: she gives a recommendation for the gold price target for the next 6 weeks, needed to keep future CPI inflation on target.”
Did she also give her expectation for the “announcement effect” as it might influence the interest rate on interbank funds?
Presumably she would care about this, because she would use the interbank rate as an indicator in the next iteration of gold price targeting.
How could she not care?
Did she expect that OMO would be required to facilitate the market response to the announcement?
Would OMO be designed to affect the gold price directly, and only the gold price?
Would the central bank no longer directly affect money pricing for the banking system that it was central to?
Or would OMO be designed to affect the interbank interest rate as well?
How did this work when the US was on the gold standard? Did the Fed not affect the interbank interest rate directly at all? Did they not affect it through OMO? Or did they seek to affect it directly when they thought it was consistent with gold targeting?
As in:
“And we do OMOs in the bond market if our gold reserves get too big or small. The stock of money is endogenous, of course, and we never worry about that”.
She may not worry about it, but doesn’t this anchor the gold supply parameter to an expected effect on interest rates? Is she monitoring interest rates as an indicator for some sort of rational relationship with the gold price?
Is she monitoring interest rates for that rational relationship so that one morning, in the meeting, she doesn’t have to say:
“We’ve got a problem. I think we’re going to have to drop gold and go back to interest rates.”
JKH:
Yes, and unfortunately I half share your problem. Half of my brain is also captured by the interest rate approach. It makes it so hard for me to argue with you and Adam P., because I am arguing with myself at the same time! What did Keynes say about the struggle to escape?
Taking your points one-by-one, I think there is an almost perfect symmetry, until the very end. Try that old feminist “gender switch” technique, only augmented. Re-write your comment, substituting “he” for “she”; and swap “gold price” with “overnight rate” at the same time. The “He said – she said” story is then exactly how we might imagine the girl with the orange eyes responding to the protagonist in the Bank cafeteria, when he tells her his story.
But at the very end, she won’t be able to understand his worries about the zero lower bound on nominal interest rates. She will say “But why can’t you just raise the rate of increase in the price of gold, i.e. loosen monetary policy, so that the overnight rate increases (sic) above the lower bound, if it worries you that much?” She won’t be able to imagine any circumstances in which gold-price control wouldn’t work. And if it did, well, game over for monetary policy, and perhaps we should think about fiscal policy instead.
only just reading the post but still…
Nick: “I am not advocating gold in particular as the good in which monetary policy should operate. In principle it could be the nominal price of any real good (or claims on a real good).”
BUT MONETARY POLICY IS ALREADY WORKING ON THE NOMINAL PRICE OF A BASKET OF REAL GOODS. (Hint: the basket of goods in question is completely unrelated to the basket on which CPI is measured.) Incidently, working on a basket of real goods is far better than just one for stability reasons (I believe that was why Milton Friedman advocated that if we insisted on a precious metal banking for the currency we adopt a bi-metal standard).
The issue though is real rate of exchange between claims on the basket of goods backing the currency and all the other stuff on the goods market.
Adam: you lost me. Are you referring to the “backing theory/real bills doctrine/fiscal theory of the price level”?
It’s going to take me some time to re-wrap my head around that theory, but like the Bishop on heresy: “I’m agin it”.
Well, the fiscal theory… money is backed by the basket of goods and services provided by the government.
On the post, still haven’t properly read it but on the first pass I don’t think the story you’re telling works. You still haven’t said how the bank, which is targeting the price of gold is able to control the real exchange rate between gold and everything else without using something like interest rates. Where’s the transmission mechanism?
I have the same sort of question as Adam, in a different way. If you go back to first principles, and assume we’re at the zero bound, what is it about the central bank’s ability to set the price of gold that would cause this to spread to a more general reflation?
The girl with the orange eyes replies:
“If the price of gold starts to slip below the target price, the Bank buys gold, and if it starts to rise above the target price the bank sells gold. More simply, just offer to buy or sell unlimited amounts of gold at the target price. And this is how it used to be done, in the olden days (only there might have been a small spread between buying and selling prices, called the “gold points”.
Remind me again how your Bank sets an interest rate? How does the price of gold affect interest rates?
As for the transmission mechanism: even though gold production and consumption is a very small part of GDP, and the stock of gold is a very small part of total wealth, the price of gold sets the pattern for all prices of goods in the economy. If we increase the price of gold, this creates a ripple effect on the demand, supply, and prices of all goods, first the other precious metals, then base commodities, then all other goods and services. It’s the cross-price elasticities of demand and supply.
(Monetarists say it’s the change in the quantity of money which does the work, not the change in the price of gold. But we know they’re wrong, because the stock of money is endogenous, and adjusts passively to a change in demand. And if the supply of money did ever change exogenously, so there was an excess supply of money, it would immediately return to the bank, in exchange for gold. So I really doubt if ‘quantitative easing’, like adding to banks’ settlement balances, in a futile attempt to change the overnight rate, would make any difference at all.)
Remind me again how the transmission mechanism for the overnight rate works in your world. That is such a small part of the total market for loans, and hardly anyone, except a few specialists, ever trades in that market. If you change the overnight rate, why doesn’t that just change interest rate spreads, and leave all the other interest rates unaffected? And what’s the route from interest rates to the price of goods? A higher price of goods should leave interest rates unchanged, shouldn’t it?”
ooops! Stick brackets around this bit from my above comment:
[And this is how it used to be done, in the olden days (only there might have been a small spread between buying and selling prices, called the “gold points”.]
That was me speaking, not the girl with the orange eyes. She would say:
“We have always done it this way.”
ooops! Stick brackets around this bit from my above comment:
[And this is how it used to be done, in the olden days (only there might have been a small spread between buying and selling prices, called the “gold points”.]
That was me speaking, not the girl with the orange eyes. She would say:
“We have always done it this way.”
“The girl with the orange eyes replies…”
Nick, are you a trekkie?
And remember, the girl with orange eyes really does have much more actual historical support for her transmission mechanism than you do for yours. The price level was determined for centuries by the gold content of coins, and the exchange rate of gold for paper. Interest rate control of the price level is a VERY recent phenomenon.
That’s a statement about our history, not counterfactual history.
“Monetarists say it’s the change in the quantity of money which does the work, not the change in the price of gold. But we know they’re wrong, because the stock of money is endogenous, and adjusts passively to a change in demand”
Can you expand a bit on this, Nick?
Unfortunately, I need my monetary history explained in terms of how central banks actually implemented their policies at an operational level. If I can’t visualize it that way, it becomes counterfactual by ethereal default.
During the era of the gold system from about 1870 to the first world war the Bank of England stood ready to buy any and all gold tendered to it at a price of $21.85.
There were two interrelated reasons this worked. One was that no one expected the $21 price to change and this was because it was massively above any foreseeable market clearing price. Consequently, no private hedgers and/or speculators had any reason to buy gold on the possibility that the price would rise above the Bank of England support price.
But according to Robert Mundell and others, in the 1930s this $21 dollar price was too low and the supply of gold was too small to finance an expanding world economy. This was the fundamental underlying cause of the Great Depression and the depression did not end till countries went off the gold standard and FDR raised the price of gold to $35.
For a gold based monetary system to work the price of gold has to be so high that no private speculator or hedger has any reason to hold gold. Consequently, your story related above is unrealistic or will not work because it only deals with small changes at the margin. But when you get a system wide change in expectations it would be completely unable to deal with the problem.
The results would be something like when the base interest rate approaches zero in the current
system.
I’m not a trekkie! Why? Are there girls with orange eyes on Star Trek?
JKH @4.02 : I think the girl with the orange eyes is wrong when she says the quantity of money is irrelevant, because it’s endoenous. I am just casting her in the standard “horizontalist” Neo-Wicksellian role in her universe, so that she is an exact a mirror as I can make her of our standard views on monetary policy. But she is right that the stock of paper money is endogenous in her world. If the central bank over-issues paper money, there is an excess supply of money, so people return the excess to the central bank in exchange for gold. “The Law of Reflux” it used to be called. And those who say QE is irrelevant in our world rely on that same Law of Reflux, only operating via bank reserves.
I think the way I have described the price of gold being set is about accurate historically. The bank just redeemed paper money for gold on demand, and sold paper money for gold on demand too. Or minted gold coins on demand (taking a seigniorage ‘cut’ as a recompense). But this mechanism pre-dates central banking, and even pre-dates banking. And it even predates much of any sort of financial system. And usury laws that would have made Islamic banking look soft would have prevented interest rates doing much of anything.
I wish a real economic historian would join in. But there are very few monetary historians. I am out of my depth in real history. (And I think I got that bit about “gold points” wrong; if I now remember correctly I think they were the cost of shipping gold across the English Channel, and so created an exchange rate band under the gold standard.)
Nick,
Be careful in casting your primary gold policy operator as a Neo-Wicksellian horizontalist.
Not only will you have Krugman back on your case, but a whole bunch of other more formidable plaintiffs.
🙂
“The price level was determined for centuries by the gold content of coins, and the exchange rate of gold for paper.”
Yes, but there wasn’t so much monetary policy being conducted back then. Your confusing the fact that the price level was determinant with the it being determined by a monetary authority. In both cases we have a price level, the question is whether this helps do good stuff for our economy.
“And remember, the girl with orange eyes really does have much more actual historical support for her transmission mechanism than you do for yours.”
No, not if the issue is monetary policy’s ability to maintain full empoyment or at least avoid deep recessions/depressions.
I’m interested in the role of the central bank as a gold dealer with a natural long position.
I think your link to Sumner’s comments included a comparison with the assets of today’s central banks.
Basically, a central bank must monetize the assets it chooses to hold.
A point most people don’t get is that currency issuance isn’t discretionary monetization. It depends on public demand for currency. You can’t force it except via helicopter drop, which is crazier than the dream you had.
Discretionary monetization requires forced expansion via excess reserves.
So if orange eyes wanted to reflate gold, she’s need to monetize gold via excess reserves.
Then she’d probably have to pay interest on reserves as well, especially if operating above the zero bound – or not. Either way, she’d have a decision to make on interest rates.
Would she understand this?
Very interesting post by Sumner. I like the idea of looking at ‘futures’ but still have to wrap my brain around some of it.
As for Japan? I would take a look at the price of gold in relation to the Yen. If memory serves me correctly, not only were Japanese consumers hoarding Yen they were also exchanging Yen for gold bars. I remember being fascinated by it because one would think they would hold the GBP or U.S. dollar instead of bulk gold.
In the U.S., money supply should have been tightened in the late 90s’ but it wasn’t. The bubble burst. In this latest case? The Fed continued with the Greenspan policy. It was a tornado in the making, just didn’t know when it would hit.
Btw, I hate CPI. I remember while in Uni (seems centuries ago) and grocery shopping every day, cheaper that way. Whenever the CPI was announced the grocery store always raised one or more of the ‘goods in the basket’ by the announced inflation rate. Very irritating. I learnt to buy my items before the announcement. Sorry ’bout the rant but I’ve never seen CPI as an indicator to what was actually happening on the ground, more like permission to increase prices by a set amount while ignoring supply/demand forces.
Wasn’t paper replaced because gold was too heavy to carry? The paper then evolved to legal tender, meaning the bank/government would back the value of that paper? Sellers/buyers could then in turn exchange the paper for the bulk gold and a Fee. If the bank/government wasn’t issuing new paper then those holding the paper would have to pay additional fees for the storage or carry the gold. Would fees be the transmission mechanism or the inflation indicator? But if there was a rush to exchange paper for gold then the bank/government wouldn’t earn any fees but would have the gold they charged and saved to live on but could charge more in fees when someone deposits gold with them.
Elizabeth I tried to rebase the currency with gold. I believe it was called Gresham’s Law. Henry the VIII debased the gold coin to pay for his wars.
Nick,
I think Spencer above has a very important observation on gold standard cycles:
“But according to Robert Mundell and others, in the 1930s this $21 dollar price was too low and the supply of gold was too small to finance an expanding world economy. This was the fundamental underlying cause of the Great Depression and the depression did not end till countries went off the gold standard and FDR raised the price of gold to $35. For a gold based monetary system to work the price of gold has to be so high that no private speculator or hedger has any reason to hold gold. Consequently, your story related above is unrealistic or will not work because it only deals with small changes at the margin. But when you get a system wide change in expectations it would be completely unable to deal with the problem. The results would be something like when the base interest rate approaches zero in the current system.”
Sounds like a sort of “tipping point” or the gold equivalent of a “Minsky moment” when the standard reaches its inflection point of failure.
The girl with orange eyes replies:
“Spencer: I agree that we kept the price of gold too low in the 1930’s. With an expanding world economy, the demand for money was growing. The result was deflation and unemployment. But then our history diverged from yours. We decided that it was a mistake to keep the price of gold fixed. We increased the price of gold, and kept increasing it over time to prevent deflation and unemployment.
Now some gold was held by central banks, but most gold was held by private citizens, as it always had been, for jewelry, other “industrial uses”, and as a store of wealth. I don’t understand what you mean by saying the $21 price was “…massively above any foreseeable market clearing price”. Do you mean “below”? (Because I admit it was too low). But whatever price we set is always a market-clearing price, because we buy and sell gold so the market (including our purchases and sales) always clears. (I admit there were some episodes in which central banks mistakenly tried to use OMO to keep interest rates down, and this misguided intervention in loanable funds market did cause us to run out of gold reserves, but we soon abandoned this barbarous novelty of trying to control interest rates).
Adam P: yes, we didn’t really used to do much in the way of monetary policy. We kept the price of gold fixed. But we eventually switched to adjusting the price of gold on a discretionary basis, to make sure that monetary policy served our needs, rather than fix the price of gold at some arbitrary level, and let the real economy suffer the consequences. So we were able to maintain full employment, though we did have trouble with the Phillips Curve, just as you did, until we switched to targeting inflation.”
JKH: I’m going to think about your comment. Need to cook dinner.
I think Sumner’s idea of intervention in nominal GDP futures is fundamentally flawed.
That’s assuming the idea means that the central bank actually intervenes in the market. I don’t know that. I can’t tell because Sumner doesn’t delineate the central bank’s operational role in the proposed NGDP futures market. I don’t think there is an operational role. That means the operational requirement of some instrument like overnight interest rates remains.
The futures market for any asset, if it is traded, reflects the market’s valuation of that asset.
“Nominal GDP futures” is a bet. That’s the asset. The asset is a bet.
So the market is betting on future nominal GDP.
What does the central bank’s intervention in NGDP futures have to do with the real economy, other than it being a bet on its own policy as it affects that economy?
The central bank’s bet is not the central bank’s policy. It is a bet on its policy.
What is its policy?
It’s not intervention in the futures market.
Sumner’s idea is something the Hunt Brothers tried 3 decades ago in a related market.
JKH, The Hunt Brothers didn’t have a printing press. The Fed would buy and sell unlimited 12 month NGDP futures at a 5% premium. Each sale by the Fed would represent a purchase by the public–a bet that next year’s NGDP would rise more than 5%. This would trigger ofsetting open market sales in securities by the Fed. (ande vice versa) The process would continue until the public expected exactly 5% NGDP growth. This has been run by lots of famous economists in the past 23 years. No flaws found yet.
Nick, Are you familiar with Irving Fisher’s “Compensated Dollar Plan” to adjust the price of gold up 1% each time the WPI fell 1%., and vice versa? Robert Hall likes the proposal, and I did an article about it a long time ago. I think you are right that this would eliminate liquidity traps. I still like my futures targeting idea better, as it deals with policy lags in an optimal way–but your idea will work. And I am in the “anything but interest rates” camp right now. BTW, The plan was first proposed by Rooke around 1820. So its been around for a while.
Scott, Nick,
Thank you for the additional information on the GDP futures idea. I don’t want to derail Nick’s post with distraction, particularly regarding an idea that apparently already has been demonstrated to be indisputably successful, although never implemented, but I’ll just make a few comments on why the idea puzzles me.
If a central bank has enough fire power, I can see how betting on the price of physical or future gold will nearly instantaneously force the price of gold to the price of the bet, although periodic policy breaks can occur. Gold is a commodity where at least some physical movement in the cash market is expected to validate the central bank’s valuation. I assume breaks in policy occur finally when the bank can no longer tolerate such physical movement as it affects its own inventory. But when the policy is in place, and holding, the cash market in the commodity validates it. And because of that, the futures market should converge to the cash market if the policy is working. To the degree that the commodity is being exchanged for actual money, it becomes a monetary policy.
I’m having difficulty intuitively seeing how a bet on future GDP will necessarily converge to actual GDP in the future, simply due to the bet alone.
Suppose the Fed announces today it will start to buy GDP futures as its monetary policy.
Say the economy yesterday was on course for a deflationary depression. The Fed starts to buy GDP futures today. The public sells futures to the Fed in exchange for securities from the Fed. Presumably the reason for such an exchange of securities is to sterilize any potential monetary base effect due to the Fed’s cash outlay, which I suppose must assume that the Fed is subject to “margin requirements” for futures purchases.
The Fed’s futures position, long 5 per cent GDP growth, is a bet.
Surely the Fed must do “something else” other than buy futures in order to win the bet.
When a central bank bets on gold, the bet is the policy. This is because the bank has the capacity to hold a cash inventory of gold of sufficient size, and at its option take futures positions if deemed necessary, to be able to enforce its chosen gold exchange rate. When the bank bets on its own gold policy, and the policy holds, it will be successful in forcing the convergence of futures to cash, because it has the physical commodity in sufficient size to be able to deliver it to or take delivery from any opposing betting counterparty on contract expiry, if necessary, in order to hold the price at its chosen rate.
When the central bank bets on future GDP, it doesn’t have the capacity to hold “actual GDP in inventory”, in order to be able to force the convergence of expiring futures to cash, and therefore enforce the “price” of a 5 per cent growth rate, if necessary. It can’t do this, because there is no such thing as “actual GDP in inventory”.
If the Fed buys futures today, and a deflationary depression occurs one year from now as the natural and predestined outcome of yesterday’s failed policy, how can such a futures market bet make any difference to this outcome, on its own? Those who are convinced that deflationary depression is the inevitable outcome in the absence of any other Fed policy will simply short futures, selling them to the Fed. With an actual deflationary depression outcome, the central bank will lose the bet and be forced to pay out the loss on its bet to the counterparties.
Therefore, I return to my original contention, which is that there must be a separate central bank policy that is used in support of such a bet. This policy hasn’t been specified.
A bet on GDP growth is a bet on an observation, not a bet on participation in that observation, unless some additional participating policy action influences the outcome of the observation. Such a bet requires some “Soros reflexivity” in order to influence the outcome. (And Soros would be just the person to bet against it otherwise.)
Conversely, a bet on cash or futures gold is simultaneously a bet on participation in that market, due to the central bank’s actual and potential participation in the cash gold market, and its ability to force convergence of futures to cash.
Where is the rest of the monetary policy that evidences the central bank’s participation in cash GDP, other than the salaries it pays its employees to design the futures bet?
Nick:
Sounds like your describing the scheme Fisher presented in 1920.
Just so. The classic gold-standard is premised on buying all that is offered and redeeming all notes on demand; however, I think you’d be pained to find a period of time where the CB conducted this policy with a 100% reserve. There has always been a gold cover ratio less than one. CBs conducted policy by manipulating that cover ratio. i.e., by monetizing instruments other than gold.
It cannot be so. The short-rate reflects the position of the economy relative to gold. It is or was, a short-run price-level metric.
I must admit to not having read all the posts, but isn’t there something missing from this story? Gold is internationally traded. Targeting the gold price is essentially targeting the exchange rate. This is essentially a currency board. It will eventually have crises like every managed exchange rate. Ask George Soros.
I see spencer said something similar above. Spencer doesn’t comment very often, but when he does (I know him from other sites) you better listen. Nobody knows the data better than him.
And please – how can Canadians think only domestically. I thought that was an (US) American disease.
“When the central bank bets on future GDP, it doesn’t have the capacity to hold “actual GDP in inventory”, in order to be able to force the convergence of expiring futures to cash, and therefore enforce the “price” of a 5 per cent growth rate, if necessary. It can’t do this, because there is no such thing as “actual GDP in inventory”.
That’s my problem with the NGDP future ideas as well. It seems kind of like setting the path for election results by betting on your candidate at Intrade.
Yes, I also agree with JKH.
Furthermore, their is nothing new in Nick’s story and it doesn’t resolve any of the debates that we’ve been having. Here’s the question, why does adjusting the amount of gold that the note is worth affect the CPI? The reason is that it changes the quantity of money in the economy. Now, the issue is whether changing the quantity of money can stimulate aggregate demand directly (as Nick says) or only by changing real interest rates (as I claim). This is important because if Nick is right then we can stimulate AD today with enough money supply. If I’m right we need to credibly commit to higher future inflation.
Neither story says monetary policy can’t work, but they differ in what will work. The price level determinacy issue is secondary to the question of stimulating aggregate demand. After all, in fully flexible price models monetery policy still determines the price level, we just care less what it is because money is neutral, monetary policy no real effects.
Thinking about Scott Sumner’s GDP futures proposal further, it seems to me that the value of such a GDP futures contract for the purpose of monetary policy lies in its information content only. The central bank, to the degree it pays attention to a GDP futures market, should look to it as an indicator, not an instrument. In Scott’s proposal, GDP futures seem to be the only indicator. Moreover, it seems then that the idea is to “leverage” this exclusiveness by making GDP futures the designated instrument of intervention as well.
It appears the proposed policy includes conventional OMO market intervention, as a knock-on function of “required” intervention in the GDP futures markets. But if the policy includes the “kicker” of conventional OMO, there’s no reason why Fed intervention or involvement in the GDP futures market is required at all. If the market understands and has seen the announcement that the Fed has a particular GDP growth target, the futures market will vote on the expected success of the Fed in meeting this target by setting a futures price that agrees or doesn’t agree with the target. If the market price deviates from target, the Fed will interpret this as a signal that conventional OMO is required. The Fed then will intervene with conventional OMO until the futures price aligns with its target. That’s a potentially workable theory.
But on that basis, there is no need for the Fed to intervene in the GDP futures market. The required monetary policy instrument is conventional OMO, not GDP futures intervention, and not the combination of the two.
And in that case, the Fed must choose a particular OMO instrument, such as the overnight rate. But then we are back to the current system, just with a different indicator variable(s). It’s comparable to Volcker targeting broad money supply. His instrument was still OMO.
When the central bank uses conventional OMO, it is targeting interest rates, either explicitly or implicitly. It’s “target” is to have a demonstrable effect on the level of interest rates, whether a specific level or a non-specific directional change. If it sells, it expects rates to go up. If it buys, it expects rates to go down. It must make the judgement on how much OMO is the appropriate response to its indicator. And the judgement includes either a goal or an expectation as to the elasticity of the interest rate change with respect to OMO. Again, Volcker did not triple interest rates overnight. There’s always a judgement involved as to how much of an interest rate move is appropriate – using either an explicit interest rate target (Greenspan, Bernanke) or a non-specific muddle through process (Volcker).
Finally, it occurs to me that under Scott Sumner’s type of proposal, central bank intervention in the futures market for its indicator is precisely the wrong thing to do. If the central bank wants to formulate monetary policy according to an exclusive indicator, it should make extra sure that the indicator is a reflection of the true market, not one that is manipulated by the bank itself.
Interesting comments for me to digest. Not sure I can do them all justice.
I am going to drop the “Girl with Orange Eyes” persona. (It was probably getting irritating anyway). She is a straw woman, and a flawed monetary economist.
She had one job to do, and I think she’s done it. Her job was to get people thinking about alternative monetary policy control instruments, and alternative channels of the transmission mechanism. And nobody can say monetary policy could never control that instrument, and that transmission mechanism could never work, because for centuries (millenia?) that WAS the control instrument, and that WAS the transmission mechanism (and the effect of gold discoveries, debasement, etc. on inflation proves that transmission mechanism worked).
Did it work well? Was it immune to crises? Is this a good way to conduct monetary policy? No, No, and No. But I don’t need to argue that it was. Because all we need right now is some blunt control instrument, that can be controlled, and that does have some sort of transmission mechanism, to prove that QE CAN work to increase AD.
Yes, I remember reading Irving Fisher’s compensated dollar plan, though my memory is a bit fuzzy. It is certainly relevant to my story, and it was at the back of my mind as I wrote it. But I wanted to keep an exact a parallel as possible between the alternative universe and our own. They have exactly the same inflation target as the Bank of Canada, and use judgment and modeling to find the right setting of the control instrument, so the protagonist’s computer model of the economy will work just as well (or badly) in the alternate universe.
Now, I laid out the girl with orange eyes’ theory of the transmission mechanism above. I have to say that I find her story unconvincing. The link between the price of gold and the prices of other goods in the CPI, via cross-elasticities of demand and supply, sounds like a VERY weak causal chain to me. But then I could say exactly the same thing about the interest rate theory of the transmission mechanism. The cross-elasticities of demand and supply between the overnight rate and all other interest rates also sounds like a VERY weak causal chain to me, and that’s even before we get to the chain from all interest rates to the CPI. The price of gold seems loosely linked to the CPI. But then the overnight rate of interest seems loosely linked to all the other rates of interest. If she got into an argument with one of you guys, and you pointed out that the relative price of gold could fluctuate, she would immediately point to the changing spreads between the overnight rate and all the other interest rates. And empirically, she would win that argument hands down, using recent data. The price of gold relative to the CPI has been much more stable recently than the ratio of the overnight rate to the average rate of interest. Plus, as I said before, she has way more centuries of history on her side.
What’s wrong with her story of the transmission mechanism? It ignores how changes in the price of gold, induced by her central bank’s buying or selling gold for money, would change the stock of money, and create a generalised excess supply (or demand) of money. She is the gold-price counterpart of the Neo-Wicksellian.
But if you have a model in which the CPI, the price of gold, and the overnight rate of interest, are all linked via equilibrium conditions, then if her story of the transmission mechanism is wrong, the Neo-Wicksellian story of the transmission mechanism must also be wrong.
I haven’t replied to anyone directly here, but I hope I have replied to many of you indirectly.
Some direct replies:
JKH @ 5.03. You lost me in this comment, I’m afraid. In particular, I don’t understand what you mean by:
“Basically, a central bank must monetize the assets it chooses to hold.”
spencer: was that a typo in your comment? Did you mean “below” rather than “above” in this: “it was massively above any foreseeable market clearing price”? If so, I basically agree with your general thrust. But I don’t want to get too deeply into an argument over gold standards, and exchange rates, etc., because that’s not the point of the post. It’s really about the existence of ANY alternative control instrument and transmission mechanism, and gold is just a handy example, with much more history than plywood.
“Finally, it occurs to me that under Scott Sumner’s type of proposal, central bank intervention in the futures market for its indicator is precisely the wrong thing to do. If the central bank wants to formulate monetary policy according to an exclusive indicator, it should make extra sure that the indicator is a reflection of the true market, not one that is manipulated by the bank itself.”
This may appear to contradict what I said about gold, but it doesn’t.
Gold as a commodity has the advantage of having an actual cash/futures market relationship. This makes it a conceivable candidate for use as a central bank policy instrument. On that basis, it can potentially serve as both an indicator and an instrument.
The idea of NGDP futures includes no such cash/futures relationship. It is simply a bet. On that basis, it has no useful role as an instrument. Therefore, it can only serve as an indicator. Therefore, the central bank should not intervene in its market.
Scott and JKH:
Assume, just for the sake of argument, that GDP was a costlessly-storeable commodity. Would that change your arguments in any way?
I’m trying to get my head round this myself.
Adam P:
Suppose I were having the same argument with the orange-eyed girl as I am having with you. In other words, suppose I were trying to convince her that changing the interest rate as a control instrument could affect AD. This would be her version of your comment:
“Furthermore, their is nothing new in Nick’s story and it doesn’t resolve any of the debates that we’ve been having. Here’s the question, why does adjusting the amount of [nominal interest-bearing notes] that the note is worth affect the CPI? The reason is that it changes the quantity of money in the economy. Now, the issue is whether changing the quantity of money can stimulate aggregate demand directly (as Nick says) or only by changing [the real price of gold] (as I claim). This is important because if Nick is right then we can stimulate AD today with enough money supply. If I’m right we need to credibly commit to higher future inflation.”
What would make her argument against me invalid, and your argument against me valid? If it’s empirical facts, she’s on stronger ground, since she has more history behind her.
Nick,
“Basically, a central bank must monetize the assets it chooses to hold.”
This is fundamental, in my view. It’s particularly essential in understanding what’s happening to the Fed’s balance sheet right now.
Maybe it’s just my language, but here’s the thinking. I suspect you’re quite aware of it, perhaps using different language, or a different way of thinking about it.
The Fed has embarked on a range of credit programs that have expanded its balance sheet. This expansion starts with the asset side, where its so-called credit or qualitative easing is clearly apparent. The Fed has made the deliberate choice to expand its balance sheet, starting with the asset side.
The effect has been the “monetization” of these assets – the creation of new money that the private sector now holds, instead of the assets or underlying assets that it previously held.
When the Fed disburses this newly created money, the money returns to its balance sheet in the form of increased excess reserves, which are a Fed liability. This is the result of the recipients of the credit program outlays cashing their cheques with the commercial banks. That’s how the Fed’s assets end up being equal to its liabilities when the Fed is in the process of expanding its balance sheet.
“Must monetize its assets” is a description of this causality – a central bank that purchases/lends creates the money to do so, which become a liability and the source of funding to support the asset expansion. The immediate liability and funding source is in the form of new excess reserves.
This is an “other things equal” statement. The Fed has ways of liability sterilization as well, as an alternative response to monetization that is forced by its own asset expansion. E.g. it can request that the Treasury issue bills and leave the money on deposit with the Fed. This effectively converts excess reserves to Treasury deposits. But treasury deposits are still a form of money, so the monetization idea still holds at a more general level.
And I suspect we are going to hear more fairly soon about the idea of the Fed issuing its own interest bearing securities as another liability based sterilization option.
The idea is relevant here I think because a central bank’s purchase of gold must effectively monetize it in the same way, unless the new money is sterilized.
Nick: “Here’s the question, why does adjusting the amount of [nominal interest-bearing notes] that the note is worth affect the CPI? The reason is that it changes the quantity of money in the economy…. ”
NO,NO,NO. I’ll repeat one of my comments from the your last post:
Since price are sticky the central bank can change real interest rates (since changing the nominal rate is a change to the real rate if prices can’t move right away). Changing real rates allows the central bank to affect AD. Buy influencing AD the central bank influences inflation via a Phillips curve.
Nothing to do with the quantity of money per se. The key is being able to change real rates, by whatever means works.
“Assume, just for the sake of argument, that GDP was a costlessly-storeable commodity. Would that change your arguments in any way?”
If all economic units were restricted in their expenditures to the purchase of defined GDP units (equal baskets of GDP-proportionate shares of consumer and investment products), GDP cash and futures markets would seem a bit closer to theoretically conceivable intervention instruments.
But the inclusion of consumer product components would distort the markets in the event of central bank intervention, because the central bank can’t use consumer products.
And the financial system including the central bank might be a little different because the basket includes real investment products.
Another way of looking at it is that gold is fairly simple in the sense that it is an economic stock; GDP is a flow that includes the outright consumption of consumer goods and the partial consumption of investment stock.
So there would seem to be some minor impediments to the premise.
See also my 8:32 a.m. and 8:49 a.m.
JKH: OK. I understand you now. (I’m not sure why I didn’t understand you the first time, since your language was not that unusual, but anyway.)
Sure, if the central bank uses the price of gold as its control instrument, it must stand ready to buy and sell gold for money (monetise gold) at the announced price. That’s how I imagined the gold price control mechanism operating.
“So if orange eyes wanted to reflate gold, she’s need to monetize gold via excess reserves.”
I don’t see where the excess reserves come in. If she wants to increase the price of gold (reflate gold?) she just announces an increase in the price of gold at which her central bank will buy or sell unlimited quantities of gold.
And in her way of viewing the world (through her orange eyes) the increased price of gold would create an increase in real output in the short run, and an increase in the general price level in the long run, and either of these would increase the demand for money, and so her central bank would eventually gain gold reserves and the supply of money would expand in response to the increased demand.
But you and I might say she has the causation backwards. We might see her central bank as needing to increase the supply of money when it buys more gold to raise the price of gold. And it is the increased supply of money that causes an increase in real output in the short run, and an increase in the general price level in the long run, until the demand for money increases to match the increased supply.
We end up in the same equilibrium position as she does, but our story of how we get there differs from hers.
But then our argument with her is exactly parallel to my argument with you and Adam P, I think, when it comes to interest rates as the control instrument.
Adam P.: And here is how Orange Eyes would argue with me:
“Since price[s] are sticky the central bank can change [the] real [gold price] (since changing the nominal [price] is a change to the real [price] if prices can’t move right away). Changing [the] real [gold price] allows the central bank to affect AD. Buy influencing AD the central bank influences inflation via a Phillips curve.
Nothing to do with the quantity of money per se. The key is being able to change [the] real [gold price], by whatever means works.”
“I don’t see where the excess reserves come in. If she wants to increase the price of gold (reflate gold?) she just announces an increase in the price of gold at which her central bank will buy or sell unlimited quantities of gold.”
I would have thought the re-peg of gold up in price would cause inflows of gold to the central bank and therefore monetization? Don’t central banks normally re-peg when the market has been betting against them, i.e. buying their gold and depleting their inventories? Maybe I’ve got that wrong. But you seem to suggest that in your next paragraphs.
Just to be clear about the rhetorical/teaching device I am using here.
I have an argument going with people on one side of me. So I have set up a persona, the Girl with Orange Eyes, on the other side of me. While I am trying to occupy the centre. By showing how their arguments against me have a parallel argument she could make against me, and trying to get them to consider what might be wrong with her arguments, I am trying to get them to consider what might be wrong with their arguments.
I like it. It helps me think more clearly about things that must be wrong with their arguments. But I don’t know if it’s working for anyone else.
“Changing [the] real [gold price] allows the central bank to affect AD”
That’s the part I have a problem with.
“But I don’t know if it’s working for anyone else.”
It’s sort of working, except I don’t see the center as well defined. You’re more a broker and adjudicator of debate, than taking a principal position, aren’t you?
Adam P @ 10.12
So do I, if I am not allowed to talk about the excess supply or demand for money.
We know that in long run equilibrium it MUST be true that an exogenous permanent doubling of the nominal price of gold, with all other nominal variables, including the nominal stock of money, endogenous, will cause the nominal price level to permanently double. So the AD curve (in {P,y} space, must have shifted rightwards/upwards. But what is the causal chain of the transmission mechanism that shifts the AD curve?
I would talk about the excess supply of money created by doubling the price of gold, and how it spills over into an excess demand for all goods in all markets (including, inter alia, the bond market).
But Orange Eyes won’t let me talk about the excess supply of money, because she says it’s endogenous, and says it would immediately return to the gold window of the central bank if there were such an excess supply of money.
So here’s her story: “An increase in the nominal price of gold, holding all other prices temporarily fixed, means the real price of gold is higher. The first-order condition for consumer choice sets the marginal rate of substitution between gold and other goods equal to the relative price of gold. So when that relative price increases, the demand for consumption of all other goods increases.”
Maybe (if I could figure it out) she could also tell a story about how firms’ investment demand increases too.
Do you buy her story? Neither, really, do I. It’s not that it’s logically incorrect. Her MRS=Pg/P story is the logical counterpart of your consumption-Euler equation. But it just seems too unimportant quantitatively. If we pressed her, she might give more details, about how the rise in the price of gold causes a ripple-effect and rise in the demand and price of close substitutes like silver, and other assets like land, physical capital, and stock prices, and thus into investment, and consumption (since real asset prices would rise relative to the price of current consumption). She might even mention bond prices, and hence interest rates, along the way.
But then if she pressed us on our story of the transmission mechanism, she would find it hard to believe that the quantitative effect of the overnight rate on AD could be big enough to matter, since hardly anybody borrows at that rate. And we would resort to talking about ripple-effects from the overnight rate onto other interest rates, share prices, land prices, and hence consumption and investment. And we might even mention the price and demand for gold along the way.
Again, we know that there must be some transmission mechanism from gold prices to shifting the AD curve, both from history, and from the homogeneity thought experiment of long-run equilibrium. But the actual story is less clear. I would tell it through a change in the price of gold initially causing an excess supply of money, and that excess supply of money spilling over into all markets, including the bond market, but also the stock market, land market, housing market, supermarket, and gold market.
JKH: OK, I (think) I understand you now. You mean that increasing the price of gold would cause the central bank’s GOLD reserves to increase? Yes. Agreed.
(I don’t know why I had so much difficulty understanding your comment.)
I will write something a little later on the ON rate transmission mechanism. I think you and/or orange eyes has been looking for something on that.
Target based on the number of newly employed engineering graduates (minus some defense employers). When you need to cool off the economy, imprison them and torture. When you need inflation you release them, but still torture.
Probably better to understand the real causes of economic growth and target that, before changing things now only to have to change them again later. Targetting based on copper or ammonia or novel medical/materials/communications/energy products is superior to gold. Gold would inflate in value as has been stated and has been historically noted (isn’t enough gold). If I understand this correctly, gold is counter-cyclical and you are trying to target based on a cyclical GDP…cycle. If anything target inversely. For instance gold is mined as a by-product of copper so whatever massive affect on mines (5x pointless growth in mining sector my guess) you have by retarding or encouraging gold mining is going to be partially undone by the opposite price movement of copper and nickel. Gold targetting also kills India while helping Canada, South Africa, Aussie! Aussie! Aussie!, Russia, Mexico….
I like the idea of targetting a lagging indicator of GERD (only counts 50% of defence) R+D spending a decade ago.
JKH: That would be worthwhile.
Adam P: Thinking again about Orange Eyes’ story of the transmission mechanism, it would theoretically be derivable as follows:
Solve for the equilibrium nominal price of gold, as a function of the CPI, real income, etc. That’s just standard microeconomics. Now invert that function, to solve for the short run AD function, by solving for real income, taking the CPI as fixed, as a function of the price of gold.
Now strictly, that AD function should have proper disequilibrium foundations, with quantity constraints properly recognised. But since we normally ignore that when we derive our AD function, we can’t hold her to a higher standard.
Nick: “An increase in the nominal price of gold, holding all other prices temporarily fixed, means the real price of gold is higher. The first-order condition for consumer choice sets the marginal rate of substitution between gold and other goods equal to the relative price of gold. So when that relative price increases, the demand for consumption of all other goods increases.”
No, this reasoning doesn’t work. As a passing observation, this story with ‘oil’ in place of ‘gold’ seems at first glance to imply we should have had booming AD around the oil shock in the 1970’s. If so then why all the unemployment back then?
But anyway, what’s the problem with your chain of reasoning? Well, general equilibrium. We’re treating gold as a consumption good here, not as money. So, we start out in equilibrium with marginal rates of substitution equalized and all that. Then we raise the real price of gold, does this raise AD? No. The demand for gold is part of aggregate demand. The rise in demand for non-gold goods is equal exactly to the fall in demand for gold.
Now maybe you might say that’s ok, I’m happy to raise total demand for all non-gold goods. Is that better? No, in fact it’s probably worse. First of all the amount you can increase non-gold AD is bounded by the real value of initial gold consumption. So you have your own version of a zero bound and you can’t get around it with promises for future inflation. Moreover, if gold is a small part of consumption then this bound will bind quickly and limit what you can do to AD. On the other hand, if gold is a large part of the initial consumption basket then raising it’s price has a large income effect that works against the substitution effect and brings AD down, that’s why the effect of the oil shock was to reduce AD. Of course, if gold is an inferior good then the income effect works in your direction, still there’s another problem.
Suppose somehow gold is an inferior good but still a large part of aggregate consumption. Gold is also something that requires resources to produce and arbitrarily raising it’s price will cause resources to be diverted to produce more of this inferior good. That’s not a way to make society wealthier.
Now, why does none of this apply to using interest rates as the intrument. Because government debt (not necessarily money) is not a consumption good, virtually costless to produce and can function as a store of value. It’s also not produced by the private sector. (I’m using as my definition of money anything the government agrees to accept as tax payment.)
Nick,
I don’t have a lot to say on the ON rate transmission effect, because it seems fairly intuitive to me, and I probably have little novel to say about it. First, the ON rate transmits itself through all other rates. I’d go further and say that the Fed funds rate transmits itself to every interest rate in the world, due to the central position of the US dollar.
Yield curve transmission happens in the sense that the risk free yield curve incorporates expectations for the risk free ON rate into the future. The set of risky yield curves is then built on top of the risk free yield curve with market set risk premiums.
Interest rates of all types are then transmitted to the real economy by the demand for credit. E.g. the low rates of a few years ago translated to massive “mortgage equity withdrawals” in the US, which stoked housing and other consumer markets and caused a bit of reflation at the margin. But not enough to prevent the collapse of a credit bubble that seemed foreordained by that point, due to the enormous build in outstanding debt credit over many years.
The Fed doesn’t create the money that leads to inflation. Commercial banks do. The Fed regulates the commercial bank spigot through the fed funds rate and its transmission through the term structure and the prevailing risk premium structure. The money supply that matters to inflation is a function of credit creation, which is a function of interest rates.
In my view, the monetary base is virtually irrelevant. Currency in circulation is determined by public demand, and probably follows a growth path that is reasonably close to nominal GDP. (I don’t know; haven’t checked it; don’t particularly care.) The central bank does not determine the demand for currency; not directly, and certainly not in the short run. The only part of the monetary base that really matters for monetary policy is the level of excess reserves. And that’s only a fine tuning mechanism for the short term interest rate, in that it sets the supply constraint for the competition among banks to avoid penalty borrowing at the central bank. The level of required reserves is irrelevant for this purpose. Only the differential against requirement matters in the competition for funds at a given ON rate level. The requirement can be zero, as in Canada. Countries with positive requirements are only imposing a tax on the banking system.
Economists in general have completely misinterpreted the dynamics of excess reserves at the zero bound. First, they don’t seem to fully understand that the Fed has created the extraordinary excess deliberately as a funding instrument for its unconventional asset expansion. To say that banks are hoarding reserves is absurd, in that they have no control over the creation of the excess. And to suggest that banks should “lend out” this excess is equally absurd. Banks don’t “lend” reserves. Reserves are an accounting mechanism for the balance or imbalance in the flow of funds in the daily clearing of assets and liabilities of banks. Just as the existence of reserves results from Fed creation, the transfer of reserves is almost entirely the result of non-reserve money transactions. The only exception to this is the fed funds market itself, where reserves are transferred directly between banks in order to square their clearing surpluses and deficits at the Fed in a more efficient manner. But like the rest of the market, apart from central bank transactions, fed funds transfers do not create or destroy existing reserves. And to suggest that banks should be attempting to convert the current extraordinary level of excess reserves to required reserves is beyond absurd. This completely ignores the practical reason for the enormous mathematical dimension of the excess proportion that has been created at the zero bound. Required reserves are now about $ 50 billion. The US banking system has about $ 8 trillion in deposits. That’s an average effective reserve ratio of about 63 basis points. Excess reserves now approach $ 800 billion, and will be increasing in coming months. On this basis, in order to convert $ 800 billion from excess to required reserves would itself require sufficient incremental lending to generate a $ 128 trillion expansion in the size of US bank deposits – a 16 fold increase in the size of the US banking system. O…K. Something tells me this is not within the Fed’s expectations. The mathematics of extraordinary excess reserve levels at the zero bound is useful in highlighting the absurdity of the multiplier theory, yet that seems to be how economists in general are analyzing excess reserves.
In summary, the extraordinary excess reserve position exists now, because that is how the Fed has chosen to fund its own credit easing asset expansion at the zero bound. It has nothing to do with attempting to get the banks to lend. The Fed does want the banks to lend, but it knows enough about its own system to know that banks lend on the basis of capital, not on the basis of reserves. The fact that Fed and the Treasury are putting pressure on banks to lend via TARP related moral/economic suasion, and have said nothing themselves about the banks “utilizing” their excess reserve positions, is further evidence of this.
And just as the Fed understands that the excess reserve position it has created for the banks has very little to do with what it should expect from the banks by way of new lending, it also knows that these reserves constitutes a tax on the banks unless compensated at some market rate. Right now, there might be a debate as to whether that market rate should be 25 basis points or zero. The Fed has chosen to play it “safe” (i.e. economically fair) by paying 25 basis points. Because it understands the true reason for and purpose of excess reserves, it does not share the fear of some economists who believe that paying interest on reserves somehow dissuades the banks from “lending out” these reserves. The Fed understands the dynamics of the system it operates.
I understand Scott Sumner will be preparing a response to Greg Mankiw on the subject of reserve interest. Mankiw himself has doubts about charging interest on reserves, but not for all the right reasons. One of the articles that Mankiw references in his post (Edlin and Jaffee) gets the excess reserve story typically wrong in a spectacular way, along the lines of what I’ve described above.
That’s a bit of a digression on excess reserves. But it sort of explains in part why I’m probably one of those “Neo-Wicksellian horizontalists” you speak about. Maybe I can confirm that when I figure out exactly what it means. But I do prioritize interest rates over the quantity of money in attempting to understanding how the financial system works.