How will we know that "QE2" is working? Judging from rising stock and bond prices, some will conclude it's working already, even though we haven't seen it yet (which is no surprise, because expected future monetary policy matters as much or more than current monetary policy). But I'm waiting for stock and bond prices to de-couple. When I see stock prices rise, and bond prices fall, then I will know that QE2 is working (or, at least, that something is working).
The simple ISLM model has: a flow of newly-produced goods and service; and a stock of money. That's all there is explicitly. But we know that somewhere in the background there must be another asset, besides money. There's an interest rate in the model, and there must exist some asset that pays that interest rate. And there's investment, which represents the flow of newly-produced capital goods. So there must be a stock of capital goods.
The simple canonical New Keynesian model is just the same, except that money is also pushed into the background. We know it must be there, because firms set sticky money prices. And central banks are able to set "the" interest rate somehow (it's hard to see what gives central banks this peculiar power over other larger commercial banks otherwise). And it must be a monetary exchange economy, because otherwise unemployed workers could simply barter their labour for the goods they could produce at demand-constrained firms, so bad monetary policy could never cause a recession.
The simple models that determine how we see the world are just too impoverished to handle questions like "Is QE2 working?" At a very minimum, we need to distinguish stocks, bonds, real capital, and money.
Just for simplicity (so I don't need to keep talking about present value formulae) assume that all bonds are perpetuities that promise to pay a fixed dollar coupon every year forever. The yield on a bond is then the annual coupon divided by the market price of the bond. Yield and price are two equivalent ways of talking about the bond market.
Again for simplicity, assume all earnings are paid out as dividends. Stocks are a promise to pay a fixed percentage of the firm's earnings. The yield on a stock is the growth rate of earnings plus the ratio of those earnings to the market price of the bond.
Real capital goods can be newly-produced. Ignore depreciation for simplicity. The yield of a capital good is equal to the growth rate of its marginal revenue product plus the ratio of marginal revenue product divided by the market price. (If the capital good can be rented out, the rental should equal the marginal revenue product, but only if that rental market is in equilibrium with no unemployed capital goods).
Money is the medium of exchange and medium of account (sometimes these functions get separated, but let's ignore that here). That measn that all markets are markets for money, and no market exists in which money is not one of the two goods traded. And all prices are quoted in money. Some money (currency) pays no interest. The nominal yield is zero. Other monies are redeemable in currency.
These four classes of assets are not perfect substitutes. They won't all have the same yield in equilibrium.
They differ in liquidity, with money the most liquid, by definition, since it is the medium of exchange for all other goods and assets. Bonds are usually the next most liquid, followed by stocks, followed by real capital. People care about liquidity, so there is no presumption that all four assets will have the same yield. We simply cannot talk about "the" market rate of interest.
They also differ in risk. Money is usually the least risky, simply because it promises no dividends, and because prices are sticky so inflation is usually easy to forecast. Bonds are usually the next safest, followed by stocks and real capital. People care about risk, so there is no presumption that all four assets will have the same yield. Again, we simply cannot talk about "the" market rate of interest.
An increase in the expected rate of inflation will affect the relationship between yield and market price of the four assets differently. The main dividing line is between the nominal assets (money and bonds) and the real assets (stocks and capital). Other things equal, the nominal earnings on real assets should grow with inflation, while the real earnings on nominal assets should fall with inflation.
An increase in the expected rate of real GDP growth should also the relationship between yield and market price of the four assets differently. Earnings on stocks and real capital should grow faster if GDP grows faster.
So, trying to keep all that in mind, what should we expect to see happen if QE2 was working?
Expected inflation will increase, which means that prices of real assets like stocks and capital goods should rise relative to nominal assets like money and bonds.
Expected real growth will increase, which also means that prices of real assets like stocks and capital goods should rise relative to nominal assets like money and bonds.
The riskiness of risky assets, and people's aversion to holding risky assets, should fall too. This means that the prices of riskier assets should rise relative to safer assets.
The illiquidity of illiquid assets, and people's aversion to holding illiquid assets, should fall too. This means that the prices of less liquid assets should rise relative to more liquid assets.
And finally, people's marginal willingness to defer consumption to the future, should fall as their expected future consumption increases. Their marginal rate of time preference should rise, and since time-preference — the fact that people are not indifferent between consuming in the present and the future — underlies the whole pattern of interest rates, all asset prices should fall.
If you are looking for a signal that QE2 (or something) is working, don't look at "the" interest rate, because there isn't one. And don't just look at bond prices, especially since they could go in either direction. Look at all asset prices. And especially look at relative asset prices. Look for stocks and real capital to rise relative to bonds and money.
Worthwhile Canadian Initiative 
http://www.qe2.org.uk/
Sorry … couldn’t resist.
“The simple ISLM model has: a flow of newly-produced goods and service; and a stock of money. ”
Again, demand and supply is defined flows, not stocks.
You need some form of fixed multiplier/velocity assumption in order to pass from the stock of money to a supply curve in LM space.
Here is Hicks:
“Now let us assume the “Cambridge Quantity equation”-that there
is some definite relation between Income and the demand for money.
Then, approximately, and apart from the fact that the demand for money may depend
not only upon total Income, but also upon its dis-tribution between people with relatively
large and relatively small demands for balances, we can write
M = kI.
As soon as k is given, total Income is therefore determined. […]
Taking them as a system, however, we have three fundamental equations, [I = Income, I_x = investment, i = interest rate]
M=kI, I_x=C(i), I_x=S(i,I)
to determine three unknowns, I, I_x, i.
[…] It follows directly from the first equation that as soon as k and M are given, I is completely determined; that is to say, total income depends directly upon the quantity of money. Total employment, however, is not necessarily determined at once from income… ”
This entire approach relies on an assumption of constant velocity that allows you to talk, via abuse of language, about a demand for money, when in reality the demand is for income.
Borrowing, lending, spending and saving are all flows that can be supported with an arbitrarily small stock of circulating money. Only the technical characteristics of the payment system determine the quantity of the medium of exchange necessary to support all the desired flows, and any excess media of exchange provided sit idle as excess reserves.
Now do you believe that quantitative easing — which is a balance sheet operation that swaps government bonds for cash — is going to increase incomes? It is unlikely to do this. Whereas deficit spending by definition increases household incomes.
It’s my contention that you don’t need to add more complexity to this model by introducing heterogenous investment vehicles — not while there is a glaring constant velocity assumption at the heart of the model.
Well, in the past ~year my pool of gold-mining stocks has gone up around 130%.
The bond fund in my IRA is only up $30.
So what does this mean? Nothing I imagine. The yield curve is not decomposable into real-return-to-capital + inflation + return risk + inflation risk.
Its a market clearing price, nothing more. Ergo, so long as the Fed keeps buying to support a certain bond price-level. So prices will remain, and suppliers, in pursuit of excess profits thus created will shift their production of assets into things that the Fed elastically buys–lowering the yield of everything else too.
So the only thing that will rally is stocks, whose supply is fixed not produced. Yield will rise if the Fed keeps its finger off the scale but that will be decoupled and signal not that things are working but that the Fed thinks they are working.
Lee: My God! They named a ship after monetary policy!
RSJ: The ISLM does not assume constant velocity. The whole point of the ISLM model was to show what happens when you drop the assumption of constant velocity, and make the demand for money depend on the interest rate. What John Hicks is doing in those passages you quoted is taking a limiting case of the ISLM model, where the interest elasticity of the demand for money is zero, so you do get constant velocity (at least, if the income elasticity of demand for money is one) and showing how you get “classical” results in that limiting case. That’s where the LM curve is vertical. But in general the LM curve is not vertical.
Jon: QE via buying bonds has a paradoxical result. The Fed tries to push bond prices up. But if the policy works, and people expect recovery, they want to sell bonds and bond prices fall. My guess is that the rest of the market is bigger than the Fed.
RSJ:
Demand for income?
The closest thing to a demand for income in economics is the supply of labor and other resources.
Personally, I think supply and demand determination of asset prices makes lots of sense, so the supply and demand for this stock or bond is what determines its price. To me, thinking about the stock of money and the demand to hold it makes perfect sense. Fitting it all back to the flows of money expenditure, saving, investment, and output, just requires that one consider changes in the demand to hold money and the quantity of money over time.
Of course, you can also look at the yields of those assets, and since they are yields over time, this fits in with flows. And you can look at the flow of new issues. As long as you understand it can be negative as long as their is an outstanding stock, I suppose that works.
If you insist on that approach, then the demand for money can depend on the flow of monetary services (and for most of it, its pecuniary yield.) Hutt used this approach.
Click to access Subjectivist%20Money%20JEEH%201990.pdf
Part of the problem is that money is a buffer stock, rather like an inventory, that lets us have a bumpy (or smooth) pattern of income flows that doesn’t precisely match our bumpy (or smooth) pattern of expenditure flows. So when we speak of the “demand for money” it is easier to think of this as the “desired average stock of money”. And we choose whether to hold (say) one week’s average inventory of money, or two weeks’ or whatever. (A fixed velocity model says we hold x weeks’ inventory of money, where x is exogenous.)
But when we take a very fine-grained approach, most of the things I buy are stocks too. I buy a stock of milk, and eggs, and apples. My inventory of milk, eggs and apples is sitting in the fridge, and gets drawn down by my lump consumption. The only pure flow I can think of right now is my electricity consumption. When we speak of my demand for apples it’s best to think of this as my desired average flow consumption, where we smooth out lumpy expenditures and consumption.
Nick, I think you are bringing up two separate issues here:
1. Do people desire to hold a given buffer stock of cash — of course, but this is negligible, is not correlated with the trade cycle, and need not be included in a model of recessions.
It’s interesting that you brought up deposits, since I did some research on this, and the actual level of checkable deposits held by households, adjusted for the sweeps reporting distortions — has not grown since about 1980, in nominal amounts. Not per capita, but in aggregate. For non-financial businesses, it’s been growing with GDP. And it is tiny — about 2% of household financial assets and a bit more for firms. I think the introduction of credit cards is responsible for the lowered amounts, but in either case, this has nothing to do with recessions and doesn’t need to be in your model.
On a technical level, nothing prevents anyone from keeping X% of their weekly income in checkable deposits, and I would agree that over short periods, the percent can be constant — but note the order of causation: the expected future flows determine the level of present buffer stock demanded, not the other way around.
But monetarism says that if you can force someone to hold a larger buffer stock, then the flows will increase! I.e. if banks are supplied with M more in vault cash and M less in bonds, that they will somehow increase lending so that M becomes the vault cash required.
And the similar logic for households would be that if, households could be induced to hold somewhat higher levels of deposit accounts and somewhat lower levels of longer term assets, that this would cause households to spend more. This is backwards.
The reason why there is a statistical correlation between the monetary base and the price level is because the latter sets the former, precisely because of this buffer stock logic. It is only because historically, we rarely performed QE that gives people the hope that QE can work. But when Japan tried to replace bonds with cash, they found that banks just had more cash than they needed (and fewer bonds). Lending did not expand so that the additional cash became required, anymore than forcing a business to hold larger levels of inventory will force them to sell more each period.
2. Are stocks or flows demanded? I think they are flows, at least in the models. If you are doing an intertemporal model, it is a sequence of flows. I think because we primarily talk about consumption goods, we get sloppy, and instead of speaking of the supply of this year’s corn harvest and this year’s demand to eat corn, we just talk about about the supply and demand for corn. That’s OK because corn is a consumption good, and only consumption goes into the utility function. But as soon as we introduce a long lived asset, then we have to first convert it into a well-defined sequence of consumption flows, together with an intertemporal substitution mechanism before we can determine its utility. The actual utility is always a flow of consumption.
Bill,
Certainly in principle you can talk about demand for stocks of things — e.g. antiques. But you have to be careful when converting from stocks to flows. For cars or houses or anything that generates a predictable flow of consumption that simultaneously depreciates away the original stock, then we can talk about changes to the stock as determining a flow: e.g. dS/dt = F, provided that S is “counted” as the discounted set of consumption flows.
But this is not true for immutable goods such as money. I.e. it is not true that dM/dt = I, where M is the monetary base and I is national income. And with a broader definition of assets — say that M = sum of all financial assets in the economy, then it is still not true that dM/dt = I.
And similar remarks apply to demands:
Suppose I want to increase my deposit account from $50 to $100. This could be because my consumption demand is increasing, or because my consumption demand is decreasing. In one case, I may keep a fixed proportion of planned expenditures in my deposit account and the increased deposit demand comes from an increased consumption demand, and in the other case, I may be changing this proportion because of income uncertainty, so it comes from a decreased consumption demand.
So while there is nothing wrong with arguing that supply and demand can apply to stocks, the problem is in transitioning from the stocks to the flows, and using changes in the monetary base to determine changes in the price level or incomes. And the big whopper is the I = kM assumption behind IS-LM.
Thank you for the reference.
Nick,
I read your paradox of hoarding post late, but I do have an objection: you keep money supply fixed, and seemingly also velocity (?), so in aggreagte there cannot be more hoarding. But then, there is no problem, and no recession. And no paradox!
Only, if individual hoarding leads to a decrease in velocity (given a fixed money supply) do you get a recession. I am not sure what is paradoxical about this because people hoard (that means, hold money longer) and that leads by deflationary pressures to a higher value of this hoarded money, so actually, hoarding in the aggregate does increase in value.
You or the commenters never mentioned any of this. Am I wrong?
mark: I do keep the money supply fixed. An increase in desired hoarding, for given nominal income, means a decrease in desired velocity. With prices fixed (or sticky in the short run) that leads to a recession. With prices flexible, the price level falls with no recession.
You are not wrong, if I understand you correctly.
Thanks for your reply, Nick.
“An increase in desired hoarding, for given nominal income, means a decrease in desired velocity.”
To me, this sentence is THE KEY to all the things you describe. But you did not mention this in your post. Only JKH mentions it in a comment.
But now, where is the PARADOX? Desired hoarding decreases desired velocity. But then in aggregate people cannot hoard. But that is almost trivial. However, given the deflationary pressures, what happens next? The value of the money they hoard (in terms of goods and services) increases. That only leads to more hoarding “demand”, which might reduce velocity even more…?! Sorry, somewhere here I get lost. But you get my point?
mark: yes, the paradox of hoarding is sort of obvious, much less obvious than the paradox of thrift. But the really non-obvious thing, that I was arguing, is that the paradox of thrift is really the paradox of hoarding.
Nick,
I’ve been thinking a bit about your earlier proposal for the Fed to buy equities (or to credibly commit to buying equities) in a quantity sufficient for its forecasts for NGDP/price level to be hit.
Just a question about the practical side of this: when the Fed did ‘QE1’ they quickly found themselves way too deep in the credit allocation process – should they purchase ABS backed by mortgages only; what about credit card loans, and loans for holiday houses etc. The adverse effect on their actual/perceived independence (both within the Fed and outside, notably Congressional ministers) was far greater than what the Fed probably expected. Given the Fed’s demonstrated conservatism, they won’t easily forget this experience.
So, what equities should the Fed buy? If it buys (derivatives linked to) an index, then the critique could be they are favouring large, listed firms at the expense of smaller (listed and unlisted) firms who are typically the “engines” of growth. If they target unlisted equities (as favoured by Adam Posen, for example) then the critique is that Fed is taking on excessive illiquidity risk and effectively inflating a small, relatively undeveloped market.
In contrast, buying Treasuries and MBS could be argued as minimising the adverse impact on their independence (and in the case of MBS, their purchases were targeted at rectifying a clear market failure). Perhaps basing QE2 on the Treasuries-TIPS spread would provide clear signals when the policy was successful, as recently discussed by Cochrane?
”
I’ve been thinking a bit about your earlier proposal for the Fed to buy equities ”
Under the current law, the fed cannot buy private company shares until the congress changes the law (FRA).
vjk be that as it may, Nick’s ideas are still worth thinking about. Also, laws do change, such as the widening in the Fed’s eligible collateral which can be held under repo, or held outright.
TALF asset backed securities (ABS) is the only widening that comes to one’s mind.
MBS has always been used for OMOs.
What do you mean by “held outright” ?
In any case, those are loans, not outright purchases.
Alan:
TALF ABS, as well as lending to AIG, was made possible thanks to a loophole in FRA (“exigent circumstance”, 13(3)) without any law change.
Note, the word “lending” though, not purchase.
vjk:
my definition of “held outright” means direct securities purchases from banks.
sorry I had the BoJ in mind when I responded to your comment, not the Fed (as I mistakenly wrote).
Your point about the Fed — as it currently stands — is well made, but just as the BoJ decided to buy equities outright in 2001 — which was remarkable considering the BoJ’s degree of conservatism (perhaps even greater than the Fed’s) — so it is not outside the realms of possibility that laws may be changed to allow the Fed to embark on such a program (and so Nick’s post is worth considering)
Alan and vjk: Yes, there are practical and possibly legal problems in the Fed’s buying stocks. To my mind, those practical problems are not fatal, if the Fed buys a wide enough index of stocks. Yes, it is a problem that the policy will be biased against stocks outside the index. But, if that’s what it takes to get out of the recession….I think that’s a price worth paying.
I really don’t have anything else useful to add. You guys are making all the good points.