There's something really wrong with the way we do short run macroeconomics. We focus all our attention on the output of newly-produced goods and services. That's what we call "Y". We talk about Aggregate Demand and Aggregate Supply, and what we mean by AD and AS is the demand and supply of those same newly-produced goods and services.
Keynesians then go on to divide Y into C+I+G, and C+S+T. Monetarists talk about MV=PY. Both agree that a recession is a fall in Y, caused by a drop in demand for Y.
But a moment's reflection tells you this is wrong. It's not just new stuff that is harder to sell in a recession; it's old stuff too. New cars and old cars. New houses and old houses. New paintings and old paintings. New furniture and antique furniture. New machine tools and old machine tools. New land and old land.
If you want to sell new stuff in a recession, you have to either drop the price, or not sell it. If you want to sell old stuff in a recession, you have to either drop the price, or not sell it. And some people can't or won't drop their price, and some stuff doesn't get sold. That's true for both new and old. There is absolutely nothing special about new stuff.
Imagine, just imagine, a world in which newly-produced goods and services never ever get bought or sold. There are apple trees, that produce apples, that live for ever, and have existed since the beginning of time, and you can't grow a new tree. But nobody ever buys and sells the apples. It's tabu. They only buy and sell the apple trees. And pear trees, and peach trees, etc. And imagine that people's tastes change, year by year, so one year I want to eat only apples, and the next year I want to eat only pears, and so on. But in order to switch from eating apples to eating pears I have to sell my apple tree and buy a pear tree. And suppose everyone else's tastes are constantly changing too, in random ways. And that it's very unlikely there will be a double coincidence of wants, and that multilateral barter is hard, so we all buy and sell trees for money. We live in a monetary exchange economy.
By assumption, there cannot be a drop in the output of newly-produced goods and services in this economy. The trees keep on producing fruit, regardless. And that fruit will get consumed, regardless. And we can't even talk about an excess supply of fruit, because there is no market in which fruit is bought and sold. Y=C, and both Y and C are fixed.
But there can be a recession, nevertheless.
Suppose the price of trees is sticky, and the stock of money falls. There is now an excess demand for money. People stop buying trees, because each person wants to increase his stock of money. And because people stop buying trees, people find they cannot sell trees. There's an excess supply of trees. The quantity of trees bought and sold falls. And everybody is worse off, because they are stuck eating apples when they want to eat pears, or stuck eating pears when they want to eat peaches, or stuck eating peaches when they want to eat apples.
That's a recession, even though Y hasn't changed. Recessions aren't (just) about Y.
I have no idea how I would modify Keynesian macroeconomics to handle an economy like that. How can you talk about a demand function like C=a+bY, when C and Y are never bought or sold, and Y is fixed anyway?
I know exactly how I would modify monetarist macroeconomics to handle an economy like that. You know that MV=PY equation? OK, scrap it. Replace it with the original MV=PT. Where T is the quantity of transactions in trees. No problem.
Worthwhile Canadian Initiative 
Isn’t Y=E and what’s the big difference between T and E? Don’t Keynesians mean E, when they’re talking about Y anyway? ‘Simply’, rewrite all equations in terms of E instead of Y and you’re done. Y then just serves as a ‘check’ on E.
“But there can be a recession, nevertheless.”
Not in the usual sense of the word. There’s no unemployment, is there? What you’re describing is something akin to a property bust, where every second house has a For Sale sign on it, but nobody is buying.
Martin: “E” is desired expenditure on newly-produced goods and services. “T” is transactions in everything.
Kevin: an apple tree, owned by someone who would rather be eating some other fruit, is as unemployed as a worker digging his own garden, when he would rather be paid for digging somewhere else.
I actually had a comment on The Money Illusion that made a similar point, albeit with no such elegance or confidence: if the ratio of PT to PY is very high, then you can have instability in PT (over prolonged periods) without any such instability showing up in PY. You might even have, say, 15 years of PY growing at a steady 5% or so while PT is exploding; in such a situation, you would expect to see major asset price inflation and financial instability even when the “real” economy was chugging along quite nicely. You’d expect to see periods of wild instability in the income velocity of money, with the money stock following/leading assets well but NGDP poorly. That sounds to me a lot like the world in which we have lived since the beginning of the Great Moderation.
At one point in “Keynes, the Keynesians and Monetarism”, Tim Congdon criticises the textbook income-expenditure model on about three counts: (1) it has no place for private property and therefore no place for running down assets, (2) it has no place for saving in one period and consuming in the next, and (3) it has no place for our portfolio preferences that are central to understanding expenditure decisions.
I think one can extend the point: if we are to understand economies with private property and financial systems, then we have to include wealth and net transactions in our analyses. Your hypothetical brings that out very well. A real world example would be: the West has had an external productivity shock from East Asia. It should be obvious that such a shock should lower inflation ceteris paribus. However, it didn’t even boost NGDP, because people used the skimmed savings from their purchases on importable goods (cars, electronics, clothes, toys etc.) to spend on existing goods that couldn’t be imported and which concomitantly were going up in price i.e. property and stocks. Since asset price inflation doesn’t show up in NGDP, the US had stable NGDP from 1995-2007 even though total inflation (inflation of ALL prices) was running out of control.
PT may be very hard to measure and it may have been legitimate to use PY as a proxy when the financial sector was a smaller proportion of GDP. However, that ship has sailed and one of the challenges for macroeconomics in the 21rst century is to understand the business cycle in economies where financial transactions make up the overwhelming majority of transactions. After all, if Scott Sumner is right and large financial sectors are necessary for proper capital allocation in an advanced economy, then one day the most recent business cycle is going to be the norm for all economies.
Call it “paleo-monetarism”: back to the MV = PT of Hume and Fisher.
An interesting empirical paper on PT and PY-
Click to access Howels.pdf
(I started thinking about this topic when thinking about the endogeneity of broad money. Deposits expand when loans are made and when bonds are bought by banks. Since they pursue expected profits, banks lend on the basis of creditworthiness. What determines creditworthiness? The probability that someone will pay back. What determines the macroeconomic ability to pay back of an entire economy of borrowers? Their net wealth i.e. the price of their total assets, which is the P in PT. So PT determines the expansion or contraction of M.
Imagine a central bank targeting NGDP. Let’s say it engages in some OMOs. These alter the value of P in PT by changing the quantity of appreciating liquid assets, which alters M through the endogenous determination of broad money in the financial sector, which alters PY. It also alters interest rates and V, of course, but I like to think of interest rates as an epiphenomenon of the supply of credit and the demand for credit.)
“There are apple trees, that produce apples, that live for ever, and have existed since the beginning of time, and you can’t grow a new tree. But nobody ever buys and sells the apples. It’s tabu. They only buy and sell the apple trees. And pear trees, and peach trees, etc. And imagine that people’s tastes change, year by year, so one year I want to eat only apples, and the next year I want to eat only pears, and so on. But in order to switch from eating apples to eating pears I have to sell my apple tree and buy a pear tree.”
Too clever. If the reason that I buy a pear tree is to consume the pears, I am really buying the (current and future) pears.
Nick “It’s not just new stuff that is harder to sell in a recession; it’s old stuff too. ”
Nick, do you actually know this for a fact? Sure, old houses might be harder to sell, but what about old clothes? Old cars?
Think back in time – when we as people were far poorer than we are today there used to be thriving markets for things that we just trash today.
E.g. remember (’cause it’s Christmas) that scene in the Christmas Carol where people are selling off Scrooge’s bedclothes, bed curtains, even the shirt that he was to be buried in…
This doesn’t necessarily invalidate your overall point about the need think carefully about what Y means however.
But a moment’s reflection tells you this is wrong. It’s not just new stuff that is harder to sell in a recession; it’s old stuff too.
And not just old stuff–Y is final goods and services, but presumably intermediate goods are also harder to sell in a recession.
“…an apple tree, owned by someone who would rather be eating some other fruit, is as unemployed as a worker digging his own garden, when he would rather be paid for digging somewhere else.”
Nick, that’s why I wrote “Not in the usual sense of the word.” I’m quite well aware that you can think of my apartment as unemployed if you want to define your terms that way. I’m pretty sure you can’t think of my bond-holdings as unemployed however. Humpty-Dumpty could, but not you. And why not? Presumably because that’s what Hicks called a flexprice market. Or do you have some other reason?
So are there any direct or indirect measures of PT?
Nick – another old thing that’s easier to sell during a recession: wine. This is a newspaper report from last summer…
Buy gold—the real thing, or the liquid version, i.e. Château d’Yquem. Both of them are apparently recession-proof: The precious metal topped $1,500 an ounce for the first time this year; 200-year-old Yquem, on the other hand, is trading closer to $4,600 an ounce this week. A bottle of 1811 Château d’Yquem was purchased in London for a Guinness World Record price of $117,000, making it the most expensive bottle of white wine ever sold.
I guess this is similar to W. Peden’s point – if we are to understand economies with private property and financial systems, then we have to include wealth and net transactions in our analyses.
David Beckworth,
Howell and Mariscal get their series from the various facilities used for non-cash transactions in the UK.
It seems like you have multiple goods. In this case it appears that aggregation is extremely important. C and Y will both be low in this model if the misallocation is treated in a serious and logically appropriate manner while doing the aggregation. Every person will have an ‘unintended inventory’ of the wrong kind of trees. People will be ‘underconsuming’ (just like with underemployment) because they will be consuming less (in terms of the quality of consumption) during the recession. An accurate measure of C would capture this drop in C, just as an accurate measure of unemployment would capture the underemployed. Similarly, an accurate measure of Y would capture the misallocation effects there as well (there would be underproduction, i.e. people will throw away fruit they don’t like).
Nick:
Start with MV=PT and replace M with “shares of GM stock”. The equation is just as ‘true’ of GM stock as it is of money, but it tells you nothing about what determines the value of GM shares. Same for money.
W. Peden: “Call it “paleo-monetarism”: back to the MV = PT of Hume and Fisher.”
That was sort of my thinking too. I had thought of MV=PT as just a way-station on the road to MV=PY. But now I think that MV=PT is more like the real deal, and MV=PY is just a subset of what’s happening in a recession. And yes, by adding old goods to new goods I’m still leaving out a lot of stuff, like financial assets, and intermediate goods.
Min: “Too clever. If the reason that I buy a pear tree is to consume the pears, I am really buying the (current and future) pears.”
If all markets work perfectly, then it doesn’t matter if I buy the apple tree or buy the apples. We get exactly the same allocation of resources, whether it’s an Arrow-Debreu economy or a central planner. But if markets don’t work perfectly, and they don’t in a recession (IMHO), then it really does matter what markets exist. For example, it matters whether we have a monetary exchange or a barter economy. It matters whether there’s a market in consumer durables or in the services of consumer durables.
Frances: “Nick, do you actually know this for a fact? Sure, old houses might be harder to sell, but what about old clothes? Old cars?”
Ummm. No. I was bluffing, and hoping nobody would ask me that question!
I think it’s true for old and new houses, and for any other good where old and new are close substitutes, and where the prices of old and new are roughly equally sticky. It might be false if the old good is an inferior good and the new good is normal. But then it would be equally false for any new good that happened to be an inferior good. KD is probably easier to sell in a recession.
Other than houses, I’m not sure if there’s good data on sales of old goods.
vimothy: “And not just old stuff–Y is final goods and services, but presumably intermediate goods are also harder to sell in a recession.”
Yep. But if intermediate goods are sold in a fixed ratio to new goods, existing theory can handle that more easily, I think.
Kevin: “Presumably because that’s what Hicks called a flexprice market. Or do you have some other reason?”
Suppose a monetary disequilibrium causes an excess supply of everything at the initial price. If half the goods have flexible prices, and the other half have sticky, then the flex prices fall, and there’s a micro substitution away from the fix-price towards the flex-price goods. That’s true for new goods, old goods, and financial assets too. Sure, financial assets are more likely to be “commodities”, in the sense that they are all alike (like oil and wheat), and have lower transactions costs, and hence more flexible prices.
David: “So are there any direct or indirect measures of PT?”
I don’t know. Ah! W. Peden has answered you!
Frances: that’s strange. I wouldn’t have thought that expensive wine would be recession proof. Maybe it’s just this recession, with low real interest rates. Farmland prices, and gold prices, are rising too.
primedprimate: I think you are right. I think that GDP, or employment, as conventionally measured, couldn’t really capture more than a small amount of what is happening in a recession (and in my hypothetical economy they capture nothing). The only way we could really capture it would be if we could measure utility??
Mike: GM stock are not used as a medium of exchange. If GM stock disappeared, the rest of the economy could carry on as usual. If money disappeared, the rest of the economy would grind to a halt as we figured out how to do barter, or else gave up on exchange altogether.
Mike Sproul,
Why would the equation of exchange tell you about “what determines the value of money”? It’s primary function is to give us a way of calculating velocity (and thereby the demand to hold money).
Nick Rowe,
It seems that top-end luxuries (like fine wines and fancy chocolates) and low-end luxuries (popcorn, cinema tickets and ice-cream) both do well in recessions. That makes sense though: the former are mostly consumed by people who aren’t income-constrained in their annual consumption, while the latter are ways that people on lower incomes can have a good time without spending too much money.
“And we can’t even talk about an excess supply of fruit, because there is no market in which fruit is bought and sold.”
What about fruit rotting on the ground?
Luxury Giffen goods? Maybe. Certainly most high end consumption does not hold up in a recession. High end tourism Caribbean economies (Barbados, BVI, etc) basically collapsed in winter 08-09. But I can see “Maybe I can’t justify $25K on vacation this year so I’m going to stay home and drown my sorrows in really excellent wine (that I deserve). “
Is the observation about gold and wine a reflection of a two distinct populations?
There have been several indications that some people believe in high inflation and others in low inflation. So there at two disjoint populations each driving the value of its preferred asset class. Shorting markets isnt as easy or as powerful as some people think it is. So it’s quite reasonable for this sort of thing to happen.
Touching on old clothes though; I plead differently. Old clothes are inferior goods. So there is a boom in old clothes during a recession–just as there is a boom in fast food.
Old houses are not inferior goods or at least not as a rule.
If Y = C+I+G and MV=PY then what’s stopping me from saying MV/P=C+I+G and going from there? When I see two equations with a common variable, my first instinct is to equate them and break out the analysis from there.
Nick: Agreed that money shortages cause recessions. What bothers me is that Keynesian types can’t just leave it at that, and instead go on to invent these twisted concepts of aggregate demand and aggregate supply.
Also: Suppose GM shares (and various derivatives of GM) were used as a medium of exchange. The share price wouldn’t have to rise as a result, since GM (and issuers of derivatives) could easily issue new shares whenever the share price exceeded backing value. The equation of exchange would still be just as irrelevant to the share price. The same could easily be true of money.
W. Peden: I’d go further and say that the equation of exchange is also useless for calculating velocity, which is itself an empty concept.
Why? If S and I form a time-shifting pair, then you would expect V = 1/sqrt(SI) which is common to see in second-order differential equation models.
Min: eating apples is better than nothing, even if you would prefer to eat pears. They won’t leave fruit on the ground. In any case, “excess supply” means the quantity they want to sell exceeds the quantity people want to buy. If things are never bought and sold, we can’t really talk about demand and supply.
Determinant: But MV=PY is useless. And MV=PY is only a sub-category of MV=PT anyway. MV=PT works fine. And MV=PT has no variables in common with Y=C+I+G.
Ok, but if V = 1/sqrt(SI) then M/(P*sqrt(SI)) = Y
More to the point, in a second-order differential model S can be expressed as = -j/vS and I as jvI. There is a fundamental velocity determined by S and I where everything is in balance. At low velocities S forms a limiting factor as its resistance increases. At high velocities I forms a limiting factor. Or turning it around, at low economic velocities the economy needs more I to compensate for S or less S, while at high velocities we need more S to compensate for I or less I.
This is all university-level Laplace modelling with differential equations. Your colleagues over in the Engineering Faculty torture students with it every year Nick, it’s what they do.
MV=PT works fine? In what sense? Can we do something with it?
Do something with it? Sure, you can do this: http://www.eurojournals.com/ejsr_40_1_03.pdf
BTW “Aggregation” in this context is simply a justification to have a simple enough model to be solvable by hand.
Nick – “Ummm. No. I was bluffing, and hoping nobody would ask me that question!” yeah, sorry, I know that was kind of a low blow. Couldn’t make any more substantive comments however. On the bright side, 3/8 questions marked.
Mike Sproul,
Then you’d be wrong twice.
Isn’t there a rather foundational difference between transactions and final expenditure–namely, that demand for money is roughly proportional to income? Suppose that Alice is willing to reduce her holdings of money balances and buys a newly produced consumption good from Bob; Bob will want to keep some of the money he got from Alice and save the rest; so he’ll buy something else from Charlie and so on. But there is no “hot potato effect”; the process is dampened as real income rises. With transactions, there is no such dampening factor, because transactions such as selling a tree leave demand for money mostly unchanged. So excess transactions happen which can only stop with a rise in P or Y.
anon: I would say that the demand for money depends both on transactions and on income. We only need to hold money to make transactions, but we want to “spend” part of our income on convenience, and the bigger the bigger the stock of money we hold, as a proportion to the flow of transactions, the greater is our convenience.
Maybe we focus on new stuff, because the supply for old stuff is perfectly inelastic. Only the production of new stuff is dependent on the current/expected state of the economy, so that is the variable we seek to optimise.
Zac: fair point. The total supply of old stuff is (approximately) inelastic, but that leaves open the question of whether the people who own the old stuff are the people who value it most. Old stuff does get traded, for a reason, and if that trade diminishes, the allocation of resources won’t be as good.
So basically what we’re looking at here is “money times the number of circulations” multiplied by “value times the number of transactions.”
That’s worse than a circular argument, as Benjamin Anderson noted, it’s a tautology.
In 1917, he wrote: “The equation asserts merely that what is paid is equal to what is received. This proposition may require algebraic formulation, but to the present writer it does not seem to require any formulation at all. The contrast between the ‘money side’ and the ‘goods side’ of the equation is a false one. There is no goods side. Both sides of the equation are money sides.”
When you “solve” this relationship for M, you have an identity that suggests that the money supply is a function of the price level (but why?) multiplied by T/V. Can anyone give me a good, solid economic description of what the expression “T/V” is supposed to mean?
Old stuff is grouped broadly under ‘capital’. When it is traded, someone purchasing it is grouped under ‘investment’ and the seller dissaves. That works, no?
David: “savings” is word best reserved to mean accumulating cash balances, not increases in your capital stock.
Ryan: MV=PT is a tautology. So is Y=C+I+G. But if you add some sort of behavioural relation, they can be converted into a theory.
david: “Investment” means “newly-produced capital goods”. My trees are old trees. If you buy a tree, it’s more like buying land.
Jon: given the existing meaning of the word “saving” (Y-T-C), my preference is to use the word “hoarding” to refer to accumulating cash balances.
Yes, and “consumption” means “consuming newly-produced goods”. But let’s be fair here, the terminology isn’t accurate and we do a lot of vague handwaving about what “inventories” is defined to mean to cover all the situations where economic activity avoids monetary trade anyway.
The desired point about “I” is that it is sensitive to the interest rate on money, decreases with it, and is durable and that’s pretty much it as far as desirable features go, yes? “I” is stuff humans pay money for in order to postpone consumption. Behaviorally, that’s about it. That “I” also should be new is to render collecting data simpler, because running around collecting all that fine data at garage sales is annoying whilst new stuff is made in businesses that often have accountants to fill out all their statistical forms.
david: even if you consider an individual buying a tree to be “investment”, there is no investment at the aggregate level in my model. The aggregate stock of trees is fixed. A recession is bad because the trees are owned by the wrong people, not because there are too few trees.
If investment-trees are stickily owned by the wrong people, doesn’t their real value change? You get the same physical amount of fruit but not the same value of fruit.
(and by god, if we descend into cambridge capital debates again, I am going to, I don’t know, murder a kitten. And cry of the tendency of macroeconomics to rehash itself.)
Okay, it’s like this. Y=C+I+G. Trees are I. Fruit is never traded and makes no impact on Y, so C=0. No state, G=0. I varies cyclically because the real value of trees drops when the wrong people own them, even though the amount of trees never goes away. The wrong people own them because monetary problems jam up the exchange mechanism. Is that an appropriate description?
Can anyone give me a good, solid economic description of what the expression “T/V” is supposed to mean?
Well, it’s just M/P a.k.a. real balances. As Nick said, to get a theory you need to add a behavioural relation. AFAICT, he hasn’t. I suppose the obvious thing to do is make V=V(x) some sort of money demand function, where x is a vector of exogenous variables. I can’t see that leading anywhere however.
david: nearly. Trees are the stock K, not the flow I. (Strictly, trees are land, not Kapital, because they cannot be reproduced, but never mind that). Y=C is positive and fixed. The value of K varies cyclically, because the wrong people own them, because monetary problems jam up the exchange mechanism.
BTW, I think this is happening in the US, where trees are houses. People are stuck owning and living in the wrong house. Mobility has fallen. (It doesn’t work exactly, because you can rent houses, which is like selling the fruit.
In the olden days, economists talked about the “trade cycle”. The amount of trade varies cyclically. That’s what is happening here. The amount of trade in old goods (trees) varies cyclically.
Kevin: yep. But in my story, I implicitly assumed desired V=Vbar. So a fall in M, with P sticky, causes a fall in T.
Yes, but people buy and sell trees, not fruit. NGDP is made out of transactions of money for trees. So, Y=I, not C, which is zero: economic activity that is not made in money terms doesn’t show up in Y. Although physical trees cannot be reproduced, their real value can appreciate or depreciate (depending on who owns them) so the aggregate capital stock measured in dollars changes. Physically it doesn’t, but that is irrelevant; K is not aggregated in physical terms. It is no different if the each tree remained the same real value and a hurricane removed some instead, shrinking K by the same amount.
If you want to link to the housing stock, one might observe that real household wealth (which often counts a house as much of its store of value) has fallen. That the amount of physical houses remains largely the same is, again, irrelevant. But the analogy seems tenuous; the point of interest is what the future path of housing value should be and the model makes some strong assumptions there, so it is not especially illuminating.
Nick,
disproof of Keynesian economics? A bit strong isn’t it. You are showing that in a very special case, the Keynesian view of the world is not sufficient. I’m sure I can find a special case that disproves monetarism.
But yes, I think this is a useful way to think about things – particularly with the post by W. Peden.
BUT
“PT may be very hard to measure and it may have been legitimate to use PY as a proxy when the financial sector was a smaller proportion of GDP. However, that ship has sailed and one of the challenges for macroeconomics in the 21rst century is to understand the business cycle in economies where financial transactions make up the overwhelming majority of transactions. After all, if Scott Sumner is right and large financial sectors are necessary for proper capital allocation in an advanced economy, then one day the most recent business cycle is going to be the norm for all economies.”
I don’t think any of this speculative stuff is right. I think the 1930s, 1990s Japan and the 2010s rhyme. And I think the size of the financial sector has a lot to do with income/wealth distribution and middle class stagnation not the real need for a massive financial sector. I think a lot of financial transactions are, in a social welfare sense, wasteful.
“I actually had a comment on The Money Illusion that made a similar point, albeit with no such elegance or confidence: if the ratio of PT to PY is very high, then you can have instability in PT (over prolonged periods) without any such instability showing up in PY. You might even have, say, 15 years of PY growing at a steady 5% or so while PT is exploding; in such a situation, you would expect to see major asset price inflation and financial instability even when the “real” economy was chugging along quite nicely. You’d expect to see periods of wild instability in the income velocity of money, with the money stock following/leading assets well but NGDP poorly. That sounds to me a lot like the world in which we have lived since the beginning of the Great Moderation.”
Yes and no. I see no need for a definitive relationship between PT -(by which I think he actually means nominal transactions – I’m not sure what P means in that case) – and asset prices (except that if PT growing is more likely to correspond to asset prices growing than merely a growth in T). Assets could also change hands rapidly when the prices are sinking. It seems to me the key relationship is between asset prices and growth in private debt. And that seems to be missing (except that it is part of M).
Krugman – make banking boring?
http://economistsview.typepad.com/economistsview/2009/04/paul-krugman-making-banking-boring.html