Scott Sumner argues that nominal interest rates are near zero because monetary policy (specifically expected future monetary policy) is too tight. He argues that tight (expected future) monetary policy makes expected inflation low, which makes nominal rates low. He also argues that tight (expected future) monetary policy makes real rates low as well. I want to re-state Scott Sumner's argument in terms of a standard ISLM model. I know Scott doesn't like the ISLM model, but I do. And more economists understand the standard ISLM model than perhaps understand Scott's verbal reasoning.
Scott talks about monetary policy affecting nominal GDP. I am going to talk about monetary policy affecting the position of the Aggregate Demand curve. My way of talking is both more conventional and more accurate. (Because the effect of a shift in AD on NGDP depends on the slope of the Aggregate Supply curve, unless the AD curve is unit elastic, which it probably isn't, and because price times quantity is conceptually distinct from price times quantity demanded).
If a loosening of expected future monetary policy caused the expected future Aggregate Demand curve to shift to the right, this would have two effects on the position of the current AD curve.
First, if the expected future AD curve shifted right, this would cause the expected future price level to increase, which would increase the current expected rate of inflation, which would increase the wedge between current nominal and real interest rates, which would increase current AD. There are three ways of showing this in an ISLM diagram, all equivalent. If you put the nominal interest rate on the vertical axis, a 1% (i.e. 1 percentage point) increase in expected inflation shifts the IS curve vertically up by 1%. If you put the real interest rate on the vertical axis, a 1% increase in expected inflation shifts the LM curve vertically down by 1%. If you put both nominal and real interest rates on the vertical axis, then expected inflation creates a vertical wedge between the IS and LM curves, on the right of their intersection, and a 1% increase in expected inflation increases the size of the wedge by 1%. This point is usually well-understood by any student of second-year macro, so I won't dwell on it more.
Second, if the expected future AD curve shifts right, this would cause the expected future level of real output to increase (unless the future AS curve were vertical). There are (at least) two reasons why an increase in expected future real output (real income) would shift the current IS curve right. First, an increase in expected future real output and income would increase current demand for consumption (reduce current saving), which would shift the current IS curve right. Second, an increase in expected future real output (and real output demanded) would increase the expected profitability of current investment, which would shift the current IS curve right. (A third effect would be if an increase in expected future real output and income caused current asset prices to increase, which might increase current investment and consumption.)
One way to define the current "natural rate of interest" in the ISLM model is the real rate of interest at which the IS curve intersects the natural rate of output (or "full employment", if you prefer). An increase in expected inflation reduces the real rate of interest relative to the natural rate of interest, even if the nominal rate of interest is stuck at zero. Nearly everybody understands that first point. But an increase in expected future real output, by shifting the current IS curve right, will raise the current natural rate of interest relative to any given actual real rate of interest. Fewer people understand that second point.
And it's to help people understand that second point that I have written this post.
If expected future monetary policy is too tight, and so expected future AD is too low, that lowers the nominal rate of interest relative to the real rate of interest, but it lowers the natural real rate of interest as well. That is two reasons why an expected future monetary policy that is too tight can force nominal rates down to zero, yet still leave the rate of interest above the natural rate.
The standard ISLM model can be used to exposit the conventional view that monetary policy is powerless to increase AD when nominal interest rates are zero. But the standard ISLM model can also be used to exposit Scott Sumner's "unconventional" view that the power of a misguided (expected future) monetary policy is precisely what makes (current) monetary policy appear to be powerless.
Worthwhile Canadian Initiative 
Winterspeak: If you define the debt to include currency in public hands, then of course a helicopter operation increases the national debt. But if you exclude currency from the national debt, because unlike bonds currency pays no interest, then a helicopter operation does not increase the national debt.
Scott Sumner,
“I think you are right about the distinction, but only once you start paying interest.”
That’s right, and that was the context of my question, although it has to do more directly with the size of excess reserves, which is reflected indirectly in the Fed’s decision to pay interest on them. I think it’s worth pointing out in discussions of massive base growth during the credit crisis that an extremely disproportionate amount is coming from excess reserves. That the reserve growth is a disproportionate contributor (and that currency has been a relative “underperformer” in the sense of growth) should in itself be a warning signal that the interpretation of the excess reserve component may not be “textbook” boiler plate, and that the purpose of such reserves may not be what at first blush seems natural. (There are more fundamental reasons as well, but this circumstantial divergence is a flashing signal, IMO.) If behaviour in the two base components is so wildly divergent, it should call into question just why that is. This is the sense in which I think differentiation is critical. Not to get into it again, but my interpretation of the excess reserve component is described several posts on here; I’ve probably noted it on your blog several times in the past as well.
BTW, with a NORMAL Fed balance sheet, there are two types of targeting. The Fed ACTUALLY targets excess reserves on a daily basis in order to steer the overnight trading rate (effective Fed rate) toward the target policy rate. Conversely, I assume that monetarists, to the extent they believe the base should be targeted longer term (limited as per your M2 comment), would be inclined naturally to use the total without reference to composition, given that the reserve components are usually a relatively minor dollar contributor to base growth. In that sense, I agree that differentiation is a less important or more predictable explanatory factor in normal times.
“I just want the Fed to do enough OMOs to get NGDP expectations on target, and let the market sort out how the base will be allocated”
I understand that, particularly if it refers to your NGDP futures targeting idea. Also, the idea of letting the market sort out how the base will be allocated is consistent with an emphasis on distinction. Excess reserves would be created initially via OMO, and then converted to currency partially, according to market demand at the teller’s wicket or at the ATM.
Sorry, I’d either forgotten or didn’t appreciate you weren’t a monetarist. If I’d been reading your blog more regularly of late, I’m sure I would have been reminded of that. My crude idea of a monetarist is that of an association with the idea of the importance of the stock of money in some sense as opposed to other variables (such as the interest rate). No doubt that’s wrong or oversimplified.
Nick said: “Winterspeak: If you define the debt to include currency in public hands, then of course a helicopter operation increases the national debt. But if you exclude currency from the national debt, because unlike bonds currency pays no interest [MY EDIT: and has no repayment terms END MY EDIT], then a helicopter operation does not increase the national debt.”
If the treasury/gov’t won’t let the fed fail and if excess reserves are actaully debt instruments (even if they did not pay interest until recently), does that mean that helicopter dropping excess reserves is increasing the national debt (excess reserves are gov’t debt in disguise)???
winterspeak said: “You are incorrect, bank lending is not reserve constrained. It is capital constrained. If you want a link explaining how banks handle reserves, I can get you one, although it is well documented elsewhere.”
I’ll take some links, please.
And, “Too Much Fed: Be careful, if you continue down this path, you too may understand how the financial system works!”
That’s why I’m posting, to learn.
I’m still thinking that excess reserves allowed the fed to overpay for “toxic” debt assets. That allowed the banks to “maintain” bank capital. The fed then hoped for their usual solution, create more currency denominated debt to solve a bad currency denominated debt problem.
JKH said: “I think it’s worth pointing out in discussions of massive base growth during the credit crisis that an extremely disproportionate amount is coming from excess reserves. That the reserve growth is a disproportionate contributor (and that currency has been a relative “underperformer” in the sense of growth) should in itself be a warning signal that the interpretation of the excess reserve component may not be “textbook” boiler plate, and that the purpose of such reserves may not be what at first blush seems natural. (There are more fundamental reasons as well, but this circumstantial divergence is a flashing signal, IMO.) If behaviour in the two base components is so wildly divergent, it should call into question just why that is.”
Let’s stay with this topic.
Let’s also add why is the “fungible” money supply (the money supply that can be used to purchase either financial assets or goods/services) skewed towards so much currency denominated debt.
Ok, I had to revisit Adam P’s blog:
http://canucksanonymous.blogspot.com/2009/05/what-do-liquidity-traps-have-to-do-with.html
http://canucksanonymous.blogspot.com/2009/05/consumption-euler-equations-explained.html
to remember why I had a sick feeling about the effects of high and rising unemployment on real expectations:
“A negative real interest rate comes about via the consumption Euler equation from some combination of expected consumption growth being low (possibly negative) and (for risk averse agents) consumption growth being perceived as very uncertain (volatile). In particular, a negative natural real rate of interest can occur even in a world without money.”
So, I think I’m thinking starting at low interest rates, unemployment feeds into creating risk aversion and low (or negative) expected consumption growth, which produces the dreaded negative real rate of interest.
But not having any real econ background, Adam’s (and Nick’s!) posts are admittedly a little over my head at times, so I may not be making any sense.
Patrick: Think about diminishing marginal utility of consumption. People would normally prefer to have the same consumption today and tomorrow. You can only persuade them to have higher consumption tomorrow than today (postpone consumption) with a high real interest rate. Conversely, you can only persuade them to consume more today than tomorrow with a low (or even negative) real interest rate. Therefore, today’s desired consumption depends (positively) on tomorrow’s expected consumption, and (negatively) on the real interest rate.
It’s a bit more complicated, but you get the same thing with investment.
Since C+I=Y (ignore G and NX), today’s desired expenditure (=Y) depends positively on tomorrow’s expected expenditure (=Yt+1) and negatively on the real interest rate. A dynamic IS curve.
Patrick said: “So, I think I’m thinking starting at low interest rates, unemployment feeds into creating risk aversion and low (or negative) expected consumption growth, which produces the dreaded negative real rate of interest.”
Are you sure the fed did not produce it?
For Patrick, Nick, & others:
Nick’s post said: “Patrick: Think about diminishing marginal utility of consumption. People would normally prefer to have the same consumption today and tomorrow. You can only persuade them to have higher consumption tomorrow than today (postpone consumption) with a high real interest rate. Conversely, you can only persuade them to consume more today than tomorrow with a low (or even negative) real interest rate. Therefore, today’s desired consumption depends (positively) on tomorrow’s expected consumption, and (negatively) on the real interest rate.”
I’d rather view the situation like this. There are the few who have extremely postive real earnings (think someone working at goldman sachs making more than $1 million per year who spends say $500,000 per year or less). Then there are many others who have negative real earnings (think someone who makes $20,000 per year and needs to spend $30,000 per year). Lower interest rates don’t get the excess saver to spend while the excess debtor can only go so far into currency denominated debt and be able to make the interest payments. If the lower interest rates don’t get the excess saver to spend and the excess debtor can’t go further into currency denominated debt, what happens?