Suppose there were an excess demand for antique furniture. Antique furniture is not part of GDP. By Walras Law, if there were an excess demand for antique furniture, there must be an equal and offsetting excess supply of something else, like newly-produced goods for example. Could an excess demand for antique furniture cause a general glut of everything else, a drop in aggregate demand, unemployment, and a recession? Why not?
Why is an excess demand for money (which is also not part of GDP) so different from an excess demand for antique furniture? Most people own a lot more old stuff than they own money, so it can't just be a quantitative difference.
1. Money is the unit of account, and antique furniture isn't. If there is an excess demand for antique furniture, the price of antique furniture must rise to eliminate it. But if there is an excess demand for money, since the price of money is the reciprocal of the price of everything else, the price of everything else must fall to eliminate it. It is a lot easier for the price of antique furniture to rise than the price of everything to fall.
2. That wasn't the most important reason. This is. Money is the medium of exchange, and antique furniture isn't.
Suppose there is an excess demand for antique furniture, and the price of antique furniture cannot rise to eliminate that excess demand. (Just bear with me, and use your imagination to think up stupid legal price controls on antiques). Everybody plans to sell more newly-produced goods than they buy, and use the savings to buy more antique furniture. Walras Law says that the value of the excess demand for antique furniture equals the value of the excess supply of newly-produced goods. So according to Walras Law, price controls on antiques, and an excess demand for antiques, could cause a recession. Why not?
Walras Law is wrong. Or rather, Walras Law is only right for notional excess demands and supplies. Notional demands and supplies are the quantities people plan to buy and sell under the assumption they will be able to go to the market and actually buy and sell those quantities. But if there is an excess demand for antiques, they will go to the antique market and find there is a shortage of antiques, and they can't buy as many as they want. Not enough willing sellers, because by assumption there's an excess demand for antiques. Notional demands and supplies are irrelevant in disequilibrium, because they are plans made under an assumption that people will learn is false.
Frustrated in the antique market, people revise their plans in the market for newly-produced goods, taking that constraint on antique purchases into account. Unable to satisfy their excess demand for antiques, they will revise their plans to buy less newly-produced goods than they sell. Unless they plan to hold those savings in money, creating an excess demand for money, they must now plan to buy exactly the same value of newly-produced goods as they sell. The excess supply of newly-produced goods disappears.
An excess demand for antiques logically cannot create an excess supply of newly-produced goods (unless it creates an excess demand for money as a side-effect). It would violate the budget constraint if it did.
But an excess demand for the medium of exchange is different. Suppose everybody wants to add to his stock of money, rather than add to his stock of antiques. And suppose the price of money (the inverse of the price of everything else) cannot adjust. They plan to go to the market for newly-produced goods (and the market for antiques) and sell more than they buy in all those other markets. Every market is the market for the medium of exchange. They fail, of course, because it is impossible for everybody to do the same thing. They are unable to sell as much as they wanted, and so revise their plans of how much they will buy, taking that constraint into account. They decide to buy even less, which means (since everyone is doing the same), they find they can sell even less….
The Keynesian multiplier process continues until sales, output, and income drop enough that people decide to stop trying to add to their stocks of money. The recession gets worse until the excess demand for money disappears.
Problems in the market for antique furniture cannot cause a general excess supply of goods, unless they cause an excess demand for money as a side-effect.
Similarly, problems in the market for anything else, like mortgages, asset-backed commercial paper, credit default swaps, other fancy derivatives, or pet rocks, cannot cause a general excess supply of goods, unless they cause an excess demand for money as a side-effect.
This recession is a monetary problem. The cure must be to increase the supply or reduce the demand for money.
(Nothing here is really new, of course. Clower for example knew this stuff 40 years ago. But people forget, or are too young to remember, or never learned it in the first place.)
Worthwhile Canadian Initiative 
Nick,
The demand for money is not a demand to hold more green pieces of paper, but a demand to hold more purchasing power. Holding money is always a sacrifice, of both consumption and investment. No one holds money without a compelling reason.
Let’s say that you are paid every Friday. The primary reason to want to increase your holding of money is that you run out of money on Wednesday. To deal with this, you have to cut back your purchases. (and/or investments, but ignore that). But if you cut back your purchases enough to stretch your paycheck until Friday, that will turn out to be an excessive cutback. That is because other people will cut back on their purchases of the goods that you continue to purchase. This will drop their market prices and effectively increase the purchasing power of the money that you spend.
So there are two mechanisms to satisfy the increase in demand for money without inflating the supply of money. First you reduce your consumption to stretch your paycheck to Thursday, and the market prices of the goods you continue to buy fall as other people reduce their demand for those goods, stretching your paycheck to Friday.
Regards, Don
Interesting. Would unsustainable levels of debt cause an increase in the demand for money? If so, seems to me that debt restructuring would be a good way to reduce the demand for money. Bankruptcy as monetary policy?
Kudos on crediting Clower. He is still under-appreciated.
Interesting talk on policy: http://www.csis.org/component/option,com_csis_events/task,view/id,1828/
Nick,
I guess I won’t restart our debates over the past few weeks, (I must say I’ve enjoyed them though), but the timing of this post from you along with this one
http://krugman.blogs.nytimes.com/2009/05/02/liquidity-preference-loanable-funds-and-niall-ferguson-wonkish/#more-2237
from Krugman presents a convenient context for rephrasing in less technical language why I think you’re wrong.
So the question to you Nick is this: Is the problem an excess demand for money OR and excess demand for REAL SAVINGS?
The difference matters, an excess demand for money is solved by supplying more of it but an excess demand for real savings can’t be solved by the money supply alone.
Adam P,
I find that Krugman is just about the only economist I can usually hope to understand on an instructional basis (although Nick can be pretty good). The referenced piece is no doubt subtle, but logically presented, and therefore reasonably understandable with a little work.
I find it amazing that he continues to give these blog mini-lectures to other economists on the rudiments of Keynesian economics. Apparently they don’t understand it.
Both of these facts give me hope.
Don: yes, if the general price level adjusted instantly, so that an excess demand for money were always eliminated instantly (I think of it as a fall in the price level increasing the real supply of money. M/P), we wouldn’t have to worry. But I think it doesn’t. (Plus, we have to worry about how expected inflation might react to a change in the current price level, because that might affect the demand for money in the wrong direction).
Patrick: I think that if people suddenly realised that debt had become unsustainable, so the risk of default had increased, that might well increase the demand for money (because other assets are now both less safe and less liquid than they were). I would say that is one plausible channel for what actually went wrong.
Josh: absolutely. Does anyone still read Robert Clower? Has anybody even heard of him? Those two papers he wrote, re-published in the little Penguin paperback on monetary economics, are I think real gems. I was echoing them in this post.
rp: looks a worthwhile link. Haven’t listened yet.
Adam: It is good to re-open our debate. That was one of the things I was doing in this post: trying to approach it from a new perspective.
According to Paul Krugman’s perspective, the recession is caused by an excess of desired “savings” (or insufficient investment, but let’s ignore that for simplicity).
“Savings” in modern (Keynesian) terminology is a weird beast. It represents ANYTHING you can plan to do with your income from selling newly-produced goods, EXCEPT spend it on newly-produced consumption goods. It is defined negatively, so to speak.
So planning to buy antique furniture with part of your income is “saving”, for example. And what I am arguing is that an excess supply of “saving”, if it took the form of a demand for antique furniture, could never cause a recession (unless it caused an excess demand for money as a side-effect).
The same argument would apply if you planned to save in the form of buying bonds, and this is regardless of whether or not the price of bonds clears to eliminate the excess demand for bonds.
It’s only an excess demand for money that causes problems.
Here’s one thought-experiment, for example: suppose the government passes a law making it illegal to borrow or lend money below 10% interest. And suppose the natural rate is 5%. (Assume zero expected inflation for simplicity). So the market rate of interest cannot fall to the natural rate, just like in Paul Krugman’s diagram, only for a different reason. Does this make a recession inevitable? No.
There will be an excess supply of loans at full employment. Unable to lend as much as they want, what will people do with their income? Ignoring other assets, for simplicity, they can either spend it on consumption, or hold it as money. If they spend it on consumption, we can stay at full employment. But if they decide instead to hold it as money, we get an excess demand for money, and we do have a recession (unless the supply of money increases enough to eliminate the excess demand for money, so they spend on consumption instead).
Here’s a second thought-experiment. The diagram is exactly like Paul Krugman’s, where the natural rate is negative. The zero nominal bound is what prevents interest rates falling to the natural rate. In my way of thinking, the reason this creates a recession is that when interest rates fall to zero, all desired saving will be a desire to save in money. So it’s a problem only because it creates an excess demand for money. Suppose people could use barter, with transactions costs only slightly higher than through monetary exchange. Unemployed workers, who cannot sell their labour, would do barter deals with firms, who cannot sell their output. “Gimme a job, and pay me in cars”. He then goes to craigslist and swaps the cars for stuff from other workers, who also get paid in their firms’ output.
In both thought experiments, people want to buy more claims to future output, and are prevented from doing so (by the legal minimum interest rate in the first case, by the zero bound in the second case). But it doesn’t cause a recession. They end up having to consume current output instead. In the first, we can avoid an excess demand for money; in the second, we avoid the consequences of an excess demand for money, by allowing barter exchange.
JKH: But Paul Krugman in that case was pointing out an error made by a historian. It isn’t obvious that a fall in interest rates would be good if caused by the central bank’s monetary policy, but bad if caused by the government’s fiscal policy. Gotta give those guys a break!
No.
Why not?
Because such formulas don’t apply to cause and effect relationships.
(In response to the query: Could an excess demand for antique furniture cause a general glut of everything else, a drop in aggregate demand, unemployment, and a recession?)
Nick, sorry just took a quick glance (taking a break from cleaning house!) but do take exception to this:
“So planning to buy antique furniture with part of your income is “saving”, for example”
Doesn’t that show up in the GDP numbers? I would think the person who sold it to you provided a service and the income they made for the service is counted in GDP. I don’t know, I’m actually asking (it’s not a retorical question).
asp: I think I get your point. Let me re-phrase my original question:
Start in equilibrium. Then there is a sudden change in preferences, away from newly-produced consumption goods and towards antique furniture. Could that change in preferences cause a drop in aggregate demand, unemployment, and a recession?
Adam: The services of antique dealers, measured (I think) by the spread between their buying and selling prices, is part of GDP. But the sales of antiques themselves aren’t. Assume for simplicity no dealers; all private trade.
Nick,
“Don: yes, if the general price level adjusted instantly, so that an excess demand for money were always eliminated instantly (I think of it as a fall in the price level increasing the real supply of money. M/P), we wouldn’t have to worry. But I think it doesn’t. (Plus, we have to worry about how expected inflation might react to a change in the current price level, because that might affect the demand for money in the wrong direction).”
I don’t think that an instant response is rquired, but it is the dollar prices of goods actually purchased that comes into play within a single pay period that likely attempts to bring dollars held into equilibrium with dollars demanded. While expected inflation will strongly affect investment choices, low/moderate inflation levels are unlikely to much affect pay period money holding since holding is already a sacrifice for positive interest rate opportunity costs even if there is no inflation.
Regards, Don
Nick,
Following along from Krugman’s suite of diagrams, could you please specify how we should think properly about the demand for money as a stock (LM, I guess) versus the demand for saving as a flow (IS, I guess). Then, exactly how do you describe or categorize in a similar and integrated way the demand for money as an outlet for saving?
Nick, from Sumner’s blog: “To illustrate the challenges the nation faced last year, Buffett showed a sales receipt for $5 million in U.S. Treasury bonds that Berkshire sold in December for $90.07 more than face value, ensuring a negative return for the buyer. Buffett said he doesn’t think most investors will see negative returns on U.S. bonds again in their lifetimes.”
that’s quite a demand for bonds, do they count as a medium of exchange?
Adam: Ah! Now I understand your point (I misunderstood you when you made it on Money Illusion). No, bonds are definitely not media of exchange. If I own bonds, and want to own a car instead, I do not take my bonds to the car/bond market and do a trade. There is no car/bond market. Instead, I first take my bonds to the bond/money market, sell them for money, than take my money to the car/money market, and sell it for a car.
Clower’s point is that in a monetary exchange economy, with n different goods, there are n-1 markets. (A non-monetary economy has n(n-1)/2 markets.) And we know which good is money because it is traded in every market, while every other good has only one market in which it is traded.
JKH: Good question. I wish I could give it a good answer. I can’t. Because I’m not clear enough on the answer.
An individual’s stock of money is a buffer stock/inventory, held to cope with lumpy and sometimes unexpected inflows and outflows (receipts and expenditures). If we take a long enough time period, and smooth the jagged ups and downs of that stock over that time period, we can talk about a desired average target stock, that individuals plan to move slowly towards. The LM curve is an attempt to model that desired average target stock, and the conditions under which the desired would equal the actual stock. The problem arises when we try to model the economy as being “on” the LM curve all the time (or getting there very quickly). When we do this we forget: that the desired stock represents a smoothed average over a longer period of time; and that one individual’s attempt to move towards his desired average stock may interfere with other individuals’ attempts to do the same thing.
So Nick, back to my question. Is the problem excess demand for media of exchange (plural intentional) or excess demand for saving?
Surely we can agree that treasury bonds are savings instruments.
Nick,
I have this crazy idea way in the back of my mind that what made Keynes an extraordinary economic thinker was his ability to formulate sentence syntax as a conceptual differential equation. He could do this seamlessly, without numbers, in support of his argument. That’s my impression from reading pieces of The General Theory.
I think Krugman attempts to do that, but he’s not as good at it.
But that’s the kind of thinking I’m looking for in answer to my question. That is, unless I don’t know what my own question means, which is very possible.
Adam: Treasury bonds are certainly “savings” instruments, under the standard definition of “savings”. But so are antiques. Neither are media of exchange.
By the way, to expand on my “Clower, n-1 vs n(n-1)/2 point”:
Suppose there are n different goods. Line them up in alphabetical order (apples, bananas, carrots, dates…etc.) Now make a symmetric nxn matrix, with all the goods lined up both vertically and horizontally. (Wish I knew how to draw diagrams, sorry).
There are n^2 cells. How many of the cells contain an active market?
Eliminate the main diagonal, because nobody wants to trade apples for apples, or bananas for bananas, etc. So we are down to n(n-1) possible markets.
Next, eliminate all the cells on one side of the main diagonal, because if there is a market in which apples can be swapped for bananas, it is also a market in which bananas can be swapped for apples. So we are down to n(n-1)/2 possible markets.
We now have a picture of a direct barter exchange economy, with n(n-1)/2 markets.
But if people can use indirect barter, we can eliminate still more markets. If I want to swap bananas for carrots, I can swap bananas for apples, then apples for carrots. So we can eliminate the banana/carrot market as unnecessary. But people are now doing 2 trades where only 1 trade can do the job. (There must be some underlying story of transactions costs to explain why it’s cheaper to do 2 rather than 1 trade, and since Menger, Alchian, etc., there is such a story).
If only one good is used in indirect barter (the one with the lowest transactions costs), then we can eliminate all but n-1 markets. And that good is the sole medium of exchange. We have now described a monetary exchange economy. If apples are the medium of exchange, there is a market in the row (or column) next to apples, but none elsewhere. Apples are money. None of the other goods is money.
A market (and only a market) can be in excess demand (or supply). If apples are money, there is a unique market for every other good, which can be in excess demand or supply or equilibrium. But there is no unique market for apples. The apple market is every market. So I am both wrong to talk about the “excess demand for money”, because it is not well-defined, as there are n-1 definitions, in principle. But I am right to say that if something is screwed up in “the market” for apples, then the market for every other good must be screwed up as well.
The medium of exchange matters in a way that other goods don’t. Money really is special, and weird, because it’s the medium of exchange.
So Nick, back to my question. Is the problem excess demand for media of exchange (plural intentional) or excess demand for saving?
Or are you trying to say they’re the same?
Nick,
Thinking out loud here, and way over my knowledge level:
It seems like the medium of exchange has value because it is an accounting mechanism for income. Income is ground zero for non-barter, isn’t it? Or maybe this is the medium of account view that Scott Sumner talks about. I’m not sure of the difference or its importance.
Anyway, as an accounting mechanism it then has two different values:
a) Value in “simultaneous” exchange, a limiting case
b) Value in deferred exchange, which leads to interest rates
Then, is there a distinction between a collateralized and non-collateralized medium of exchange – e.g. gold versus paper?
Make any sense?
A few brief comments. I don’t like the Krugman link others talked about, because he assumes that monetary policy cannot shift IS. But it can, as I believe Krugman himself acknowledged in other contexts (when he spoke about creating inflation expectations.) If I’m wrong, show me the effect of the BOJ announcing it will sell unlimited yen at 1000 to the dollar, in terms of the IS diagram shown by Krugman.
JKH raises a good question about media of account. My view is that gold has a value from non-monetary uses, but monetary uses may increase that value. The value of fiat currency comes from monetary uses. For the U.S. dollar the main use of base money is as a tool for hiding income from the IRS. Most base money is hoarded for tax evasion purposes. It is also a convenient tool for small denomination transactions–although I think this use will disappear in a few decades. The U.S. may eventually have to go with interest-bearing electronic cash–in that case we may be back in a Keynesian world where interest rate control is all we need. But I’ll be dead by then so I won’t have to worry about commenters like JKH saying they were right all along. (Just kidding JKH.)
Nick, I agree with your view on the distinction between money and credit. Nice post.
“Most base money is hoarded for tax evasion purposes”
Whoa. That’s quite a claim. Absent supporting data my tin foil hat detector is going to go off.
Scott says: “I don’t like the Krugman link others talked about, because he assumes that monetary policy cannot shift IS. But it can,as I believe Krugman himself acknowledged in other contexts (when he spoke about creating inflation expectations.) ”
Scott, what you said represents a fundamental misunderstanding both of the IS curve and what Krugman said when he spoke of creating inflation expectations.
In the diagram that Krugman drew, the IS curve, had the REAL interest rate on the vertical axis (the IS-LM model holds prices fixed so in the usual, non-liquidity trap case, changing the nominal rate changes the real rate one for one). The central bank creating inflation expectations does not shift the IS curve it just allows the possibility of choosing a point on that curve with negative r.
Adam P: ”
So Nick, back to my question. Is the problem excess demand for media of exchange (plural intentional) or excess demand for saving?
Or are you trying to say they’re the same?”
I’m saying they are different. The problem is an excess demand (or excess demands) for the medium of exchange, not an excess of savings in general. If people wanted to save in the form of bonds, stocks, newly-produced investment goods (of course), antiques, etc., we wouldn’t be having this problem.
JKH @ 8.55: I think I understand what you mean. You would like a clear verbal description of the dynamics at the back of my mind for the monetary transmission mechanism, with both stocks and flows, and individual and market experiments (what each individual is trying to do, and what is happening when all individuals try to do the same thing). Tall order, unfortunately. Some day I may try. (But I first need to get my own head clear!)
JKH @ 9.39 : The “medium of account” is the good in terms of which prices are quoted. We could measure prices in gold, for example, even if we actually bought and sold goods for dollars (so that dollar bills are the medium of exchange). And the unit of account is the quantity of that the medium of account (ounces of gold vs kilograms of gold, for example). In principle, the medium of account could be a good that doesn’t even exist. There is even a small literature on the history of “imaginary” media of account. But I find it hard to figure out how the general price level gets determined with a purely imaginary medium of account. England used to (maybe still does) come close to having an imaginary medium of account, when prices for certain goods were quoted in “Guineas”, which disappeared centuries ago. But the convention that “one Guinea” meant one pound and one shilling kept prices determinate.
Normally, the medium of account is some good that actually exists, which may or may not be the medium of exchange (it usually is the same, because it’s usually easier, except in hyperinflations or border zones, to quote prices in the same good as what you will actually be using to buy the thing). So there has to be a demand and supply for the medium of account. But, as nobody needs to actually hold a medium of account in order to use it as a medium of account, it is not obvious that the demand for the medium of account is affected by it’s being used for that purpose. (Though it is conceivable that price stickiness could make the medium of account a good asset to hold as a store of wealth).
However, the fact that a good is used as a medium of exchange does create an additional demand for it, over and above any non-monetary (“industrial”) uses. Given imperfect synchronisation of inflows and outflows of money, we need to actually hold stocks of money in order to use it as a medium of exchange. Without that demand to hold it as a medium of exchange, irredeeemable paper money, for which there is no “industrial” demand (numismatics and Zimbabwe dollars used as toilet paper aside), paper money would be worthless, even if the supply were limited, and so it could not function as a medium of exchange or medium of account.
Scott and Patrick: Scott’s statement about most paper money being held for tax evasion and other illegal stuff is not an uncommon view (I hold it myself, roughly). There are economists who do empirical studies of the underground economy based on the demand for currency. Though there is probably harder evidence, the sheer quantity of currency per capita, compared with anecdotal evidence of how much most people hold in their pockets, makes this hypothesis plausible.
In the Mankiw, Kneebone, McKenzie and Rowe first year text (I looked the data up myself) it says $1,550 per adult (>14) in 2003 in Canada. And $2,900 in the US (Mankiw’s figure). I hold about $100 on average myself, and I am richer than average.
Scott and Adam: If monetary policy can affect real output (sticky prices), and future real output, and expected future real output, then it can affect current consumption and investment decisions (via the Euler equations), and also shift the IS curve. This is quite apart from any effect it might have on expected inflation and the wedge between real and nominal interest rates. Moreover, the ISLM assumption that an excess supply of money spills over only into the bond market, which clears immediately, and not into any other markets, like the forex market, the stock market, or directly into the market for newly-produced goods, is just that — an assumption. Maybe the relevant portfolio choice is not (or not just) money vs bonds but money vs consumer durables, or producer durables.
Gotta go argue with Scott at his blog on the importance of medium of exchange vs medium of account!
Nick, Scott: If you’re saying that lots of cash is hoarded by a few shady characters (drug dealers with suitcases full of 100’s), as opposed to wide spread use of cash to avoid taxes by otherwise law abiding people, then I withdraw my objection.
Nick,
If oil is priced in dollars and somebody pays for it in Euros, would that qualify as dollar medium of account and Euro medium of exchange?
The medium of account might be considered as the invoicing medium, and the medium of exchange as the payment medium.
Or is FX considered to be an aberration of the basic idea?
I bring up this example because its one way the dollar might gradually lose some of its reserve currency cachet, given your point that there’s more demand for the medium of exchange. (I’m not sure, but I think Iran is paid in Euros for at least some of its oil.)
And the whole account/exchange distinction seems to have an analogue in foreign exchange generally, as in purchasing power parity for example; i.e. an analogue where the medium of account and the medium of exchange are different.
BTW, my comment re Keynes was more an observation than a request. Your previous explanation was good.
Nick: “I’m saying they are different. The problem is an excess demand (or excess demands) for the medium of exchange, not an excess of savings in general. If people wanted to save in the form of bonds, stocks, newly-produced investment goods (of course), antiques, etc., we wouldn’t be having this problem.”
No Nick, you’ve got it backwards. In order to say there is an excess of something you have to specify the excess over what. Investment (real investment that is) demand is basicaly the supply of savings, the problem is that the demand for saving is in excess over the demand for investment. The excess only gets held as money because it has nowhere else to go. But the savers are holding money not as medium of exchange but as store of value, they’re also holding government bonds.
Furthermore, the problem is desired savings exceed demand for real investment. If it all went into antiques (to be held as store of value) we get exactly the same recession problem BECAUSE NOBODY IS EMPLOYED TO BUILD THE ANTIQUES and the antiques don’t add to our aggregate consumption possibilities.
JKH: your oil/dollars/Euros example is exactly the distinction between medium of account and medium of exchange. Forex is probably the best real-world example of the distinction between what prices are quoted in and what people pay with.
Adam: we both agree that if (starting from full equilibrium) there is an increased desire to save in the form of investment in newly-produced goods, that doesn’t cause a problem of deficient aggregate demand. That’s why I wrote “(of course)” in the sentence you quoted, because I knew you would agree in that case.
But we disagree in the case of antiques, and that is important. And I realise that what I am saying is against the grain of what is usually taught and understood.
Start in full-employment equilibrium. Hold investment demand constant. Nobody builds antiques any more. There is a fixed stock in existence. In private hands (forget the services of antique dealers).
Everybody decides to save more (demand less newly-produced consumption goods) and spend their savings all on antiques. The result is an excess (flow) demand for antiques.
Hold all prices fixed, including the price of antiques. The result is that people, in aggregate, cannot implement their plans to buy more antiques. What happens next? Each individual, unable to implement his first-best plan (to spend $100 per year on antiques), is forced to go to his second-best plan instead.
The most plausible second best plan is that he spends that $100 on newly-produced consumption goods instead. If so, we stay at full-employment equilibrium. But the excess demand for antiques remains, because that is still their first-best plan. (They keep looking for antiques for sale).
There are other less plausible, though possible, second-best plans. But all of them will have exactly the same result as trying to buy antiques, EXCEPT if they decide to add $100 per year to their stocks of money (medium of exchange).
Nick,
Unfortunately, I don’t think that many read Clower anymore (although everyone is familiar with the “Clower constraint”). I actually have a copy of his collection of essays, Money and Markets, which should likely be required reading for anyone serious about monetary theory.
If this helps to resolve the paradox:
You could say that we stay at full employment because “second-best” desired savings (at full employment income) still equals desired investment.
But “first best” desired savings (at full employment) nevertheless exceeds desired investment, yet we stay at full employment.
It’s ironic. I have taught the Keynesian Cross Investment-savings model many many times to first year students. And each year, after I have explained how an increased desire to save causes income to drop, one student, trying to understand it better, will ask “savings: is that like putting money under the mattress?”. And I follow the party line and say “No, it could be putting money under the mattress, but it doesn’t have to be. All it means is that you don’t spend part of your income on newly-produced consumption goods”.
And the first year student is basically right, and I and the party line are just wrong. He’s basically right, because if you don’t put the cash under the mattress, it will eventually have to be spent on newly-produced goods.
Josh: would you happen to know the titles of the two Clower essays I’m thinking about?
The first is all about the difference between the number of markets in a barter vs a monetary exchange economy. The second is about the dual decision hypothesis/constrained demands.
My copy is in my office somewhere.
Nick, you say “The most plausible second best plan is that he spends that $100 on newly-produced consumption goods instead”
No, the basic thing he wants is saving. Why doesn’t he then buy a bond or a stock, basically lend/invest the money with someone who will then spend it on a real investment good and pay him back plus returns?
Nick: “There are other less plausible, though possible, second-best plans. But all of them will have exactly the same result as trying to buy antiques, EXCEPT if they decide to add $100 per year to their stocks of money (medium of exchange).”
No, if I don’t have any real investment good to invest my savings in why don’t I lend the money to someone who does?
Adam: I was thinking that spending that $100 on newly-produced consumption goods was the most plausible second best plan because new furniture is perhaps the closest substitute for antique furniture.
But suppose it isn’t. Suppose the second best plan is that he buys a bond or stock, or some such form of loanable funds. Remember that everyone else is trying to do the same thing. I can think of 3 possibilities:
1. If the $100 extra supply of loanable funds finds no willing borrowers, because investment demand stays the same, he is lending constrained, just as he was previously constrained in the market for antiques, and we are right back to where we started, with him spending that $100 on newly-produced consumption goods as a third best plan.
2. If the $100 extra supply of loanable funds does find willing borrowers, who want to invest the whole $100, (they were previously borrowing-constrained), aggregate demand stays the same, because investment expands to offset the decline in consumption.
3. Naturally, if the extra $100 of loanable funds would only find willing borrowers by forcing up the prices of stocks and bonds (forcing down interest rates), and this change in prices leads him to choose to hold some of that $100 as cash, we get a drop in aggregate demand and a recession.
That third scenario is the implicit ISLM story.
Nick : “I was thinking that spending that $100 on newly-produced consumption goods was the most plausible second best plan because new furniture is perhaps the closest substitute for antique furniture.”
But that’s not how you said it. You said, I want savings and my chosen intrument for savings is antique furniture (presumably because I think it offers a high return). If I bought the furniture because it’s pretty then that is consumption, not savings.
Adam: fair point. And it leads in an interesting direction: so much depends on the “framing”, on what words we use to describe a decision.
1.”I decide to spend part of my income on antique furniture”
2.”I decide to save part of my income, in the form of antique furniture”
The first is the more natural way of talking. But the second is correct under the standard economists’ definition of “saving”.
I am mulling over building a very simple model, where “saving” is defined as “adding to your stock of money”. And I’m thinking:
A. Would my new model (at best) just be an easier way to teach students, so they don’t get hung up on special meanings of words, but lead to the exact same conclusions as a standard model with the same structure, once the words have been translated?
B. Or does the language, the framing, really matter, because a model is just a way of framing reality? Just as the way of framing the decision to buy antiques carries with it a host of implicit assumptions about what people would do as a second-best if they found themselves constrained in the antique market?
I came here looking for JKH (to ask him to look at my blog attempt to explain the practicalities of monetary policy implementation) and got absorbed in the content of this post. Greetings!
It seems to me that one does need an idea of the monetary transmission mechanism with both stocks and flows. It is not obvious to me what happens to a flow like output if a stock like antiques is more or less desired. As one who studied science before encountering economics as a trainee central banker, I was never convinced by ISLM, which seems to depend on various dubious assumptions, so I am sceptical when people like Krugman gloss over such basic steps saying “Econ 101” – as he does in his response to Niall Ferguson. Nor do I see why it matters much if people prefer to save in the form of money. Given that the central bank commits to trade money for debt at a fixed price (interest rate), if people want more money and less interest-bearing debt, they do not have to drive the price of debt down much before they can have all the money they want. The supply of loanable funds is simply channelled via the central bank instead.
Nick: “I am mulling over building a very simple model, where “saving” is defined as “adding to your stock of money”.”
If you do that your model is useless before it gets built. Fundamentaly saving is a substitution of less consumption today for more consumption tomorrow. SAVING ONLY ADDS TO YOUR STOCK OF MONEY WHEN THERE IS NO REAL INVESTMENT DEMAND TO ABSORB IT. The fact that right now it seems as though people are saving by hoarding money is a symptom of the excess demand of saving over demand for investment. It is not the cause of anything.
RebelEconomist, Krugman is using ISLM as a simple context for making a point that is valid in proper intertemporal models. I can assure you he knows quite well what he’s saying and he’s quite correct. I should add that the point is actually far SIMPLER than people seem to be making it out to be.
Adam,
Maybe Krugman does know what he is talking about, but for me, he fails to prove it. In this case, the handwavy bit was “some of this increase in income will be saved, pushing the savings schedule to the right. There may also be a rise in investment demand, but ordinarily we’d expect the savings rise to be larger, so that the interest rate falls”. I immediately thought “Why? It’s not obvious”. I had a similar impression of his debate with Fama (and made a comment to that effect on his blog, but Krugman does not respond to comments). Considering that he is advocating massive shifting of resources, Krugman’s arguments lack rigour.
RebelEconomist,
Briefly the idea is something like this:
1) Consumption: Start out in a case where we are in equilibrium so at the current interest rate you are happy with your consumption levels for today and tomorrow (ignore the uncertainty in tomorrow’s consumption). Now I give you more income today but hold tomorrow’s consumption unchanged (and prices/interest rates have not yet changed). Since you where before at a maximum you were indifferent between an extra bit of consumption today or tomorrow. Now you have extra consumption today and so by the usual declining marginal utility idea your marginal utility of today’s consumption has fallen below your marginal utility of tomorrow’s consumption. Thus, to re-establish your first order condition you need to reduce today’s consumption and increase tomorrow’s. Thus, the fact that you want to save some is not an assumption but comes from the fact that you’re maximizing utility.
2) Investment: Still assuming prices/rates have not yet changed. Firms maximization problem says they want to employ capital until the marginal product of capital (MPK) equals the real interest rate. Since rates haven’t yet changed there is no change in investment demand. (Firms also started in an equilibrium where they were happy with current investment plans).
3) We now have a situation where desired savings exceeds desired investment. How are they re-equated? Well, the excess saving starts to drive down the interest rate. This has two effects, it reduces saving demand by making tomorrow’s consumption more expensive (in terms of today’s) and it increases investment because reducing the real rate means firms need to increase the capital stock to re-establish MPK = r (declining MPK). The real rate falls until savings demand and investment demand are equal.
So in the simplest, baseline model you actually expect no extra investment just from the increase in income. The added investment comes from the lower interest rate.
Hi Rebel!:
JKH will probably see it. I may wander over to your blog too, and take a look.
If there’s an excess demand for money, and the central bank can and DOES immediately satisfy it by increasing the supply, that solves the problem. But I am not so sure it can obviously satisfy it, under present circumstances, without using quantitative easing to bypass the banking system. Have a look at my recent post http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/04/bad-banks-and-the-effectiveness-of-fiscal-and-monetary-policies-on-ad.html , especially the comments at the end.
On savings, investment, and income:
Let’s assume the opposite to Paul Krugman, so that an increase in income causes investment to increase more than savings increases. [This means the marginal propensity to consume plus the marginal propensity to invest must be greater than one.] The result is an upward-sloping IS curve, rather than the normal downward-sloping one.
Provided the LM curve is steeper than the IS curve, (and that the rate of interest adjusts to keep us on the LM curve more quickly than output adjusts to keep us on the IS curve, IIRC), the ISLM equilibrium is still stable. An increase in government spending will shift the IS curve vertically upwards (n.b. not rightwards), and cause income and the rate of interest to increase, as in the normal case.
But monetary policy now has weird effects. An increase in the supply of money, moving the LM rightwards, will now cause income to rise, as in the normal case, but the rate of interest to rise too, which is the opposite of the normal case.
But if the central bank uses monetary policy to hold the interest rate fixed, so the LM curve is horizontal, the ISLM equilibrium is unstable (under the assumption I made about the adjustment speeds of interest rates and income).
Here’s the intuition. If the central bank loosens monetary policy and cuts interest rates, consumption and investment will expand, which causes income to expand, which causes an even bigger expansion in income in the second round, etc. So the simple multiplier, holding the rate of interest constant, is infinite. To prevent income rising to infinity (remember this model ignores the aggregate supply constraint), the central bank needs to raise interest rates enough to choke off further increases in demand. So interest rates must rise by more than the initial fall, and eventually end up higher than where they started.
Actually, once we start thinking about investment responding to expected future income, rather than current income, this weird unstable case is not at all weird. If monetary policy could restore confidence in future demand, investment and consumption demand will increase, and interest rates could actually rise. (This is one interpretation of what Scott is saying when he says that monetary policy can shift the IS curve).
Adam: I’m still thinking how best to respond. Not ignoring your comment.
Nick: “Actually, once we start thinking about investment responding to expected future income, rather than current income…”
Krugman pretty much said he had an econ 101 version of the model in mind which is entirely a comparative statics excercise – you start from equilibrium and then you change current income holding all future expectations constant.
Adam @ 12.25: we were posting at the same time.
That’s a clear exposition of the New keynesian approach, but it leaves something out.
Think about the labour market first, before switching to capital.
It’s been known since Patinkin (1955, or 1965?), but forgotten by almost everyone, that the MPL(L)=W/P condition for labour demand is invalid when the firm is constrained in the output market, and cannot sell as much as it wants. In the simplest model, it gets replaced by L=F^-1(y), where y is the constraint on sales, given by the demand side. The firm only hires as much labour as it needs to produce the output it can sell, regardless of real wage, provided MPL>W/P
We could do the same thing for capital services. The firm chooses the mix of capital and labour services to minimise the cost of producing the level of output it is able to sell, y. In this case, y enters as an exogenous variable (along with the real rental rate R/P and W/P) in the capital demand function.
That is an interpretation of what the old Keynesians were talking about with their accelerator model of investment. If firms were able to sell more output, they might increase investment, even if the real interest rate stayed the same. Just as they might demand more labour, even if the real wage stayed the same.
(I’m not sure how this gets handled in sticky-price monopolistic competition NK models.)
The IS-LM model leaves lots out, that’s why it doesn’t appear in graduate school (I had to read myself, after graduation). I was giving the econ101 version, so was Krugman.
We can fight over what complications matter and which don’t forever, Krugman’s point is valid.
Adam, I agree Krugman had a ec101 model in mind, but is that the model he should be using to prove his points? Models where monetary policy doesn’t affect expectations? OK, then we have a long run Phillips curve again, just keep accelerating the rate of inflation. I’ll admit I thought he was using the nominal interest rate (as in EC101) but my point remains. You can’t assume monetary policy doesn’t shift expectations. And by the way, Robert King showed as far back as 1994 that monetary policy shifts the IS curve even using the real rate, again through expectations. After all, in a severely depressed economy if monetary policy creates inflation expectations, it is almost certain to also change the expected real growth trajectory.
Someone asked for evidence of currency hoarding. If anyone is idiotic enough to want to look at my dissertation, it was on that topic. I also published an article in the early 1990s on the subject. I found that hoarded currency in the U.S. was highly correlated with the ratio of marginal tax rates to nominal interest rates. I interpreted that ratio as the number of years you could hoard cash and forgo interest, before you would have been better off reportaing the income and paying taxes in the first place. Nick’s evidence suggests that some U.S. cash is hoarded outside the U.S., although the difference with Canada is a bit smaller than he indicated, I believe. Again, tax evasion may be a motive, otherwise foreigners might (in normal times) prefer interest-bearing dollar (or euro) accounts. Yes, rates are now near zero, but cash demand was almost as high a few years ago (surprisingly.)
RebelEconomist,
I did a quick scan of your post the other day. Rather than rush, I’ll plan to drop off a comment hopefully at some point next week.
As I understood the original debate at the time, Krugman rejected arguments by Cochrane et al on the basis that the CURRENT identity between savings and investment is not a constraint on the magnitudes of each changing over time, due to “other factors”, while preserving the identity at each point in time. I believe the interpretation that the identity is a constraint on movements in the current magnitudes is known as the “Treasury View”. What I find baffling about explanations from there by Krugman and others is that the ISLM dynamics are difficult to follow when they venture into savings and investment not being equal. How are they not equal in an actual situation? I get totally lost between such a situation and the ultimate identity constraint. This is the type of thing where I think Keynes had superior pure descriptive ability, as I noted in an earlier comment. Given that Krugman’s original point was on the correct dynamics of the identity, I can’t figure out why the explanation of the true operation of the identity over time is so difficult to follow.
I am truly confused in a fundamental way on this issue.
Scott, I take your point about whether the model is good enough for policy critiques. I wasn’t arguing it was, that would be another long discussion no doubt :).
The model (econ 101 variety) keeps prices completely fixed so changes to nominal rates are one-for-one changes in real rates, hence the distinction is not always made clear. Even adding in intertemporal utility maximization gives the model more micro foundation then the usual econ101 variety, usually you just give a constant marginal propensity to consume (assumed between zero and one).
But at the end of the day you’re doing comparitive statics, partial equilibrium. If you try to make it dynamic you get silly stuff like a long run phillips curve, that’s why I don’t do that.
And btw Nick, I actually lied before. I did cover Mundell-Fleming in international macro, basically open economy IS-LM.
Nick,
Regarding the dual constraint: “A reconsideration of the microfoundations of monetary theory.”
Also, I might be wrong, but regarding money and barter, I think that you are referring to his introduction to Monetary Theory: Selected Readings.
Thanks Josh! Yes, “A reconsideration of the microfoundations of monetary theory.” was definitely one. I will have to check on the other.
JKH: Let me have a go. It’s not really dynamics vs statics. It’s the distinction between quantity demanded vs quantity bought. Quantity of apples demanded is the quantity that people want to, or desire to, or plan to buy, ex ante, if you like latinisms. Quantity of apples bought is the quantity they actually buy, ex post. Quantity demanded equals quantity bought only in equilibrium. But quantity bought equals quantity sold by definition.
(And forget quantity supplied, because these models don’t have a supply-side, or else we are off the supply curve).
Instead of apples, aggregate over all newly-produced goods and services.
1. Quantity bought = quantity sold, by definition.
2. Quantity demanded = quantity sold, only in equilibrium.
The dynamics work like this: If we start in equilibrium, then suppose quantity demanded increases, we assume that firms will respond to that excess demand by increasing output and quantity sold. So actual quantity bought will adjust to equal quantity demanded. (Remember we are ignoring the supply side, of whether firms would find it profitable to increase output and sales).
Now, you might ask: what’s all this got to do with Savings = Investment?
Answer, it just a way to rearrange the above two equations.
Forget government spending, taxes, exports, imports.
Divide all quantities bought (demanded) into consumption (demanded) and investment (demanded).
Define “income” as quantity sold and divide income into consumption and savings, where ” is just defined as “income minus consumption”, so it’s true by definition.
We can rewrite equations 1 and 2 as:
1′. Consumption bought + investment bought = quantity sold = consumption bought + actual savings
2′. Consumption demanded + investment demanded = quantity sold = consumption demanded + savings demanded (aka desired savings)
Simplify 1′ and 2′ by subtracting consumption from both sides to get:
1″ investment bought = actual savings (true by definition)
2″ investment demanded = savings demanded. (true only in equilibrium)
So really, it’s just a very roundabout way of thinking about whether the quantity of goods that people want to buy will equal the quantity they actually buy, and what happens if they are different.
I have no idea if that helps at all.