I know what it's like to live in a demand-side world, because I used to live in one. Let me tell you about it. Maybe it's like the world you live in.
I wasn't stupid. I knew that potential output wasn't infinite, so there had to be a supply curve out there somewhere, but we never seemed to be on it. Firms almost always wanted to sell more output, and there were always some unemployed workers who wanted jobs if the firms needed more labour to produce more output. There might be occasional shortages and bottlenecks in particular sectors, but generally speaking output and employment were demand-determined. Supply was almost always bigger than demand.
Sometimes there would be inflation, but inflation could not have been caused by excess demand, because I could see with my own eyes that there was almost always excess supply. Inflation must have been caused by something else. Maybe there would sometimes be inflation in particular sectors due to bottlenecks in that sector, and that inflation might push up costs and prices in other sectors too. Or maybe inflation was due to monopoly power, in labour markets and output markets, that caused wages and prices to rise long before the economy got to full employment potential output and excess demand. Or maybe inflation was caused by conflicting claims over the distribution of income, where the sum of the groups' claims on output added up to 110%, so we got 10% inflation as each group tried to raise its price and nominal income relative to other groups.
Whatever the cause of inflation, it wasn't caused by generalised excess demand, and it didn't seem sensible to reduce aggregate demand to cure it. Even if the cure worked, which wasn't at all obvious since the cure didn't attack the underlying cause, the cure seemed worse than the disease.
So if output and employment were demand-determined, what determined demand? And how could we increase demand? It seemed sensible to divide demand up into demand by households, firms, government, and foreigners. Y=C+I+G+NX. So it was immediately obvious that an increase in G would cause an increase in aggregate demand, output, and employment. Indeed the increase in Y would generally be bigger than the increase in G, because if an increase in G caused an increase in Y, that would cause C to increase too, as households' incomes increased. And probably cause an increase in I too, since firms would invest more if they needed to produce more output to satisfy increased demand.
A cut in taxes was nearly as obvious a way to increase aggregate demand. If you cut taxes households' disposable income would increase, and so would their consumption demand.
Monetary policy was a little less obvious, but we conceded it might work too. If the central bank cut interest rates, that might encourage firms to invest more. But would firms really want to invest more to produce more output, if they couldn't actually sell any more output?
Sometimes we played around with Y=C+I+G+NX, to look at the same thing from a different side. I+G+X=S+T+iM told us that injections had to equal withdrawals, and if we wanted to increase Y we needed to increase injections into the circular flow, or reduce withdrawals.
So, if the cure was so easy, why didn't governments do it?
Well, they did. But sometimes they lost their nerve and chickened out from doing what needed to be done.
Some people would worry about government deficits and debts, even though we knew we owed it to ourselves, except for some of the debt that was held by foreigners.
Some people would worry that increased government deficits might push up interest rates. But they didn't have to, unless the central bank didn't cooperate.
Sometimes there would be a balance of payments crisis. If only we could have persuaded other countries to do the same as us in a coordinated fiscal expansion, or had just let the exchange rate float.
And sometimes governments would fear inflation. But we knew that inflation had to be caused by something else, and that the cure, if it was a cure, was worse than the disease.
I left that world: when I discovered we lived in a monetary exchange economy (like a fish discovering it swims in water); when I saw the Phillips Curve shift in the 1970's; when I discovered Milton Friedman, and learned not only that units didn't matter but that the rate of change of units didn't eventually matter either. But mostly I left that world when I discovered how to do macroeconomics with imperfect competition and learned how to see the world both ways at once. But I think I will leave all that for another post.
Any economist old enough to have learned macroeconomics about 40 years ago, especially in the UK, should recognise my old world.
Worthwhile Canadian Initiative 
@Nick: to be fair, there are people around that still think in Gold Standard terms (although I think a few MMTers use it as a weird hand-waving catch all). This has been my other frustration, they’ve done the hand-waving “inflation is the only constraint on fiscal policy” without actually delving into price theory. There actually have been a lot of developments in heterodox price theory, but “MMT” has made literally no attempt at translating it into their blogging.
Has anybody else had this earworm yet: “We all live in a Demand-side world, and I am a Demand-side Girl!!!!2” 😉
I admit It was a little out of topic here Nick(considering your post). You were talking about MMT few comments earlier so It really gets me how you cannot get the basic ideas of It.
1.Is It possible at all for the quantity of reserves to be endogenous?
2.What would need to be done to make the quantity of reserves endogenous?
3 Let’s say you would become the chairman of the federal reserve and your task would be to make the quantity of reserves endogenous. What would you do?
4.Is It possible that bank lending is not reserve constrained? If yes, then how? What needs to be done for it not to be reserve constrained?
I am just trying to find out how you think about It since you are intelligent IMO.
Imagine how this story would change if Nick had been born in 1910.
Reason:
“How does printing money take money from anybody? ”
The newly-printed money normally would be lent to someone, who might use it to buy a car. If the government instead uses that money to hire the unemployed to dig and fill holes, then the world is poorer by 1 car.
Nathan Tankus, I don’t know if this is of any use:
Full Employment and Price Stability, Prof. Paul Davidson (1997)
Exogenous Pricing: A Basic Case of Monopoly
quote:
How does the monopolist price his product? There are two options:
1.Set price, p, and let quantity, q, float, or
2.Set q and let p float.
The first option is generally preferred, with a gold standard or the proposed ELR program two examples of using the first option.
cont…
http://moslereconomics.com/mandatory-readings/full-employment-and-price-stability/
“The newly-printed money normally would be lent to someone, who might use it to buy a car. If the government instead uses that money to hire the unemployed to dig and fill holes, then the world is poorer by 1 car.”
Not sure why these should be mutually exclusive, could you elaborate?
Also, the money spent employing someone filters through the system, moves from one person to the next. Someone might use it to buy a car. It also has a added benefit of having no private liability or debt attached to it, unlike a loan. Not that it would be worth paying someone to dig and fill in holes. That’s a waste of time and labour.
I am sure that there will be a truly ‘worthwhile’ post someday.
Nathan: “@Nick: to be fair, there are people around that still think in Gold Standard terms….”
Among non-economists, many. But funnily enough, the only name that comes immediately to mind, if we are talking educated economists, is our Mike Sproul who is commenting here. (Is that roughly correct, Mike?) He is a rare bird, and can argue his position cogently. Click on his name to see his writings. But Mike’s position is very far from mainstream. He is definitely not a monetarist or quantity theorist. He and I have argued to a stalemate over the years.
Back later.
ArijitBanik: “I am sure that there will be a truly ‘worthwhile’ post someday.”
And that was a really useless stupid comment, that did absolutely nothing for the conversation here. Did you read any of the above comment thread? I have been very patient and polite. Enough. Get lost. Don’t come back, until you have learned some manners and commonsense. Oik.
philippe: “Also MMTers often say things which are basically true and that others completely ignore. Such as, a state that issues it’s own currency can’t ‘run out of money’, and that the real constraint on budget deficits is inflation.”
Suppose I said to the Bank of Canada: “Print as much money as is needed to keep inflation at the 2% target, and hand the revenue from printing that money (minus your expenses of paying salaries etc.) over to the government!”
Would you associate that directive with the MMT position? Because if I told the Bank of Canada that, they would look at me strangely, and reply: “Nick, you know very well we are already doing that.”
It’s totally mainstream economics. It works out a bit over $2billion a year, on average, last time I looked. A nice little earner, but no real biggie. They could make it a bit bigger if they wanted, by targeting higher inflation, or bringing back reserve requirements and not paying interest on reserves, etc.
Kristjan: It’s been slowly dawning on me this last few days, especially since I read Milton Friedman this morning using the same word on a weird way, that people mean many different things by “endogenous” and “exogenous”.
Tell you what, swap the word “reserves” for “stock of money” in your questions, and I have my (approximate) answer right here, in the post I did a couple of days ago.
Under inflation targeting as currently done by the Bank of Canada, the stock of money (and by extension reserves) is “endogenous” in the normal economics sense of that word (which might not be what you (or Milton Friedman) means by “endogenous”.
Ok, good point.
But then do you mean to say that if the government were to significantly increase deficit spending (and this was to be accomodated by the central bank), this would result in higher inflation? Because of course this is not what the MMTers argue (at least not if the spending is done in the way that they advocate).
What MMTer’s might describe as the ‘imaginary sovereign debt-default risk’, is currently being used by numerous governments to massively cut back public spending. In general the argument goes: “we’ve run out of money, there’s nothing we can do but cut social security and sack teachers. Sorry”.
The argument is often made that if the deficit isn’t reduced then the US could end up like Greece. This completely ignores the basic difference between the two countries, in terms of their abilities to issue their own currencies and repay debts.
From the MMT perspective the current debate on deficit unsustainability is completely wrongheaded. Even if the argument were rephrased in terms of inflationary risk rather than default risk, the argument against deficit spending would still be wrong, as far as they’re concerned. I’m assuming you would disagree with this? Could you explain why, if you do?
Also, assuming the treasury could issue new money directly, do you think that financing government deficits with newly-issued money would necessarily be more inflationary than spending with ‘borrowed money’ (i.e. issuing bonds)?
(Sorry if you’ve been over this already, I only started reading your blog very recently).
*(‘increase the deficit’ includes cutting taxes, of course).
Philippe:
The fed prints $20,000 of new money. If the fed lends it to a guy who uses it to buy a car, then he has a car, the car maker has $20,000 which he uses to buy steel, etc.
If the Fed spent $20,000 digging and filling holes, then the diggers have $20,000, which they spend. The end result is that the world has a filled hole instead of a car. Frederic Bastiat famously explained this as the “Broken Window Fallacy” in “That which is seen and that which is not seen”
Nick:
Correct.
“Rare bird” I like that.
philippe: short answer: the US is very different from Greece, because the US can print money and Greece can’t. The debate between monetarists and keynesians (crudely) is over whether printing money to buy back government bonds is enough. Keynesians say it’s not enough at the moment. This is the worry about deficits: when the US economy recovers, and it must stop printing money to avoid inflation, it may have to increase taxes by more than it otherwise would if the debt is higher.
Thanks Nick. That post of yours is based on loanable funds. I’ve read Friedman a little, wich material you were reading( where he talks “endogenous” “exogeneous”)?
Kristjan: the ISLM is a mixture of loanable funds and liquidity preference. It becomes pure loanable funds only in the long run, where the interest rate is determined where the IS curve crosses the long run phillips curve.
Friedman: Us monetarists were having an internal debate over hot potato money in disequilibrium here.
Nick, this is why post keynesians look at income, private debt, structural and institutional dynamics, and capacity utilization to determine to determine what happens next(in terms of inflation or what not), as opposed to looking at a single number, the national debt, to make that determination. It’s utterly devoid of detail and is sorely lacking as any sort of indicator.
Nick,
The question from the MMT camp would probably be: why should the Fed’s printing of money to buy government bonds in itself lead to inflation (once the economy recovers)?
The Fed’s ‘money printing’ to buy bonds leads to huge excess reserves, but this in itself isn’t necessarily inflationary (from the MMT point of view).
If we ignore the argument that low interest rates aren’t in themselves inherently inflationary (debateable), the Fed can still set the interest rate at a higher level by paying interest on reserves if it wants to. The point being that it is the interest rate, rather than the quantity of reserves per se, which is (potentially) significant.
Alternatively, rather than controlling lending through the overnight rate other mechanisms could also be used. Scott Fullwiler mentioned in another post some possible alternative approaches to monetary policy:
1. Procyclical adjustments to capital requirements, which would raise costs of funding assets and be passed on to borrowers.
2. Procyclical adjustments to default risk ratings.
3. Tom Palley’s asset based reserve requirements, whereby the CB adjusts the reserve requirements of banks (and others that have access to the discount window–which could be expanded for purposes here) based upon the assets they are holding. So, if the CB wants higher mortgage rates, it could institute and then increase a reserve requirement on mortgages. This effectively raises bank costs and this will be passed on to borrowers.
– All of which would ideally be combined with the sort of wholesale regulatory change to the banking system laid out by Warren Mosler http://moslereconomics.com/wp-content/pdfs/Proposals.pdf , for example.
Nick, I invite you to revisit the bottleneck/structuralist theories(primarly latin american) that served as an alternative to Friedman’s wrongheaded account of inflation. Look up Marcelo Diamand’s paper on bottlenecks from 1977, it’s a good read.
Philippe,
You can’t just raise “The Fed’s ‘money printing’ to buy bonds leads to huge excess reserves, but this in itself isn’t necessarily inflationary (from the MMT point of view).” This isn’t necessarily the point. The point is that the government spent money into existence(remember fiscal operations are helicopter money/high powered money) while the resulting bond didn’t soak up any of the resulting idle money. The result is (somehow) that private sector participants get all this high powered money, but they aren’t spending it right now due to some confidence gap. Eventually they start spending when the economy recovers, and inflation results.
I think this accurately describing this mainstream position above, and if that’s true then…yeah, it’s pretty bad.
Mike Sproul,
“The fed prints $20,000 of new money. If the fed lends it to a guy who uses it to buy a car, then he has a car, the car maker has $20,000 which he uses to buy steel, etc.
If the Fed spent $20,000 digging and filling holes, then the diggers have $20,000, which they spend”
What I don’t get here is why the Fed in your example can’t do both – lend and spend?
Assuming the hole digger is part of a (so-called) “employed buffer stock” on a fixed wage, which acts as a flexible ‘automatic stabiliser’, there is no inherent reason why the Fed’s ‘lending’ and ‘spending’ couldn’t go hand in hand.
If the hole digger wasn’t being employed, he’d still be in the public sector, so to speak, only he’d be unemployed and presumably receiving the ‘fixed wage’of unemployment benefits.
Plus, as you say, the hole digger spends his money. The money circulates and those that receive it may well buy a car.
…
An added bonus of public deficit spending is that it introduces money into the economy without a concurrent private liability or debt.
This generates an increase in demand without creating an equivalent increase in financial ‘leverage’ or private indebtedness.
An optimal balance of public and private debts is more sustainable than simply excessive levels of private debt…
Public spending can therefore also potentially lead to a reduction in ‘financial fragility’, or aid in the process of deleveraging.
I’m not sure why you keep using the hole digger as an example though. I don’t know of anyone who’s advocating paying people to do such pointless work. As I said, it would be a waste of time and labour (unless the aim was simply to get people fit and healthy, which could be done more efficiently in other ways anyway). There are plenty of jobs which could be done that don’t involve pointless tasks.
Keynes originally used that example to highlight what he saw as the absurdity of the gold standard. He suggested burying money underground and paying people to dig it up again. He was taking the mickey, whilst making a significant point.
Philippe:
Suppose that in addition to printing and lending $20,000, the fed also prints and spends $20,000 on holes. The fed did both, as you said. What’s the result? We now have a useless hole, produced at great effort. The whole idea is to avoid producing useless holes. If the money is lent, the borrower will naturally spend it on something useful. Spending involves waste of resources while lending does not.
Keynes only advocated digging holes as being “better than nothing”. My point is that digging holes is worse than nothing. The labor used to dig the holes had an alternative use, and whatever that use was is lost.
Mike sproul, are you serious dude? I think you forgot to hide your ideological preferences there when you were giving your economic analysis…
DDJ: here’s a simpler way to look at it: suppose (and that’s the big debate, of course) that either monetary or fiscal policy could get us out of the recession. In a couple of years, the economy will recover, and the Bank of Canada will have inflation back at the 2% target either way. But if we use fiscal, we will have a bigger debt than if we had used monetary.
phillipe: “The question from the MMT camp would probably be: why should the Fed’s printing of money to buy government bonds in itself lead to inflation (once the economy recovers)?”
Let’s put it this way. 20 years ago the Bank of Canada decided to target 2% inflation. Fiscal policy was not used to keep inflation on target. Fiscal policy has changed a lot over the last 20 years. But inflation has averaged almost exactly 2%. If monetary policy alone were unable to control inflation, this would be an amazing fluke.
DarkJaws: thanks. But if I read all the 1001 things I should be reading….just not enough hours in the day.
“The labor used to dig the holes had an alternative use….”
Keynes had a rough way with objections of that sort:
“You must not press on with telephones or electricity, because this will raise the rate of interest.”
“You must not hasten with roads or housing, because this will use up opportunities for employment which we may need in later years.”
“You must not try to employ every one, because this will cause inflation.”
“You must not invest, because how can you know that it will pay?”
“You must not do anything, because this will only mean that you can’t do something else.”
“Safety First! The policy of maintaining a million unemployed has now been pursued for eight years without disaster. Why risk a change?”
“We will not promise more than we can perform. We, therefore, promise nothing.”
This is what we are being fed with.
They are slogans of depression and decay—the timidities and obstructions and stupidities of a sinking administrative vitality.
Negation, Restriction, Inactivity—these are the Government’s watchwords. Under their leadership we have been forced to button up our waistcoats and compress our lungs. Fears and doubts and hypochondriac precautions are keeping us muffled up indoors. But we are not tottering to our graves. We are healthy children. We need the breath of life. There is nothing to be afraid of. On the contrary. The future holds in store for us far more wealth and economic freedom and possibilities of personal life than the past has ever offered.
There is no reason why we should not feel ourselves free to be bold, to be open, to experiment, to take action, to try the possibilities of things. And over against us, standing in the path, there is nothing but a few old gentlemen tightly buttoned-up in their frock coats, who only need to be treated with a little friendly disrespect and bowled over like ninepins.
Quite likely they will enjoy it themselves, when once they have got over the shock.
One of the really great rants.
a damn good one I might add, shit how did I miss that?
Nick, I read the link you provided: “They contrast this “more conventional view” with the “new view” that “open market operations alter the stock of money balances if, and only if, they alter the quantity of money demanded by the public.”
I agree
what follows is not very logical to me. May be I am too stupid but I don’t get the hot potato thing.
“The stock of currency (or the monetary base) can function as the hot potato that determines (in conjunction with all the other variables affecting the demand for currency or the monetary base) the price level.”
If the CB overnight rate is close to zero, so are the treasury rates. CB buys treasuries, banks will have excess reserves and those potatos are somehow hot, the potatos they had before(treasury securities) were cold? They could always borrow against them if they needed reserves. I just don’t see how you argue this Nick. You could say that lowering interest rates created more borrowing but not the quantity of reserves.
Thanks again for your reply and sorry if I didn’t represent your views correctly.
Mike Sproul,
Agreed, if the unemployed person could be employed within the private sector (or within a ‘proper’ public sector job) then that would be better.
But the only reason the person would be employed on a fixed wage by the government in this way is that alternatively he/she would be languishing in unemployment, presumably still getting paid at a fixed rate by the government (unemployment benefit).
At present the standard policy is basically to have a portion of the population in unemployment, as a way of disciplining inflation. Simply flip that on its head and put the same portion of people in employment, at a fixed wage (what becomes the ‘wage floor’), and you kill two birds with one stone.
You still have the inflation-controlling ‘buffer’ – but it is employed rather than not.
The ‘automatic stabiliser’/counter-cyclical function of this ‘buffer’ generates additional demand in a downturn, and then shrinks as the economy recovers and people are hired back into the private sector. At the same time, the additional financial and social costs of unemployment are minimised.
What it requires is a kind of ‘step up’, in which the previously unemployed ‘buffer’ is now paid a higher (but still fixed) wage to do something useful rather than wasting away.
The fixed wage is at or below the private sector minimum.
In theory this entails a general shift upwards towards a living minimum wage over time, rather than the current situation of an ‘unlivable’ minimum wage regime.
There are many possible variations – the work could be full or part time and could be combined with training and all the other stuff that goes along with unemployment today (help with finding jobs etc).
But as I said, there’s no point in paying people to dig holes only to fill them in again. If you are going to employ the unemployed then they should at least do something that is useful (both for them and for everyone else). This doesn’t have to mean direct employment by the government. The government could simply fund the employment by private (probably non-profit) organisations. It could be scaled up over time from small initial experiments.
None of this would mean that ‘the fed’ couldn’t ALSO lend, as it normally might. The ’employed buffer stock’ is simply an ‘automatic stabiliser’ program in essence no different to current unemployment programs, only better and less wasteful.
Its potentially a solution to the problem of systemic unemployment, a way of helping to stimulate demand in bad times, and a less wasteful (less hit-and-miss) alternative to NAIRU-oriented policies.
Nick,
“inflation has averaged almost exactly 2%. If monetary policy alone were unable to control inflation, this would be an amazing fluke.”
Agreed,
but the point I was trying to make is that the central bank can still set the interest rate and try to control inflation in that way even if the quantity of reserves is much larger than it typically has been in the past.
My understanding:
The CB’s inflation control mechanism at present seems to work through the interest rate. The quantity of available reserves isn’t necessarily the important thing – the two are not inherently connected when the interest paid on reserves can simply be set by the central bank at its target rate.
It’s the ‘price’ rather than ‘quantity’ thing.
The reserves themselves don’t leave the reserve system unless they are withdrawn as cash, and in any case the CB makes cash available if it is really needed so excess reserves don’t add anything new there.
As it stands, the CB provides reserves as needed at a given ‘price’. It sets the rate through OMOs, letting quantity of reserves float in response to the demand at that particular interest rate.
The quantity of reserves is not a constraint nor a stimulatory factor in itself, the important thing is the interest rate (within the current regime at least).
(There are also other possible alternative/ additional ways of controlling inflation/ conducting monetary policy, as mentioned (in part) above.)
This is all my personal understanding. Please don’t consider it to be representative of anyone else’s views.
Thanks for the response.
Nick,
Okay points accepted. (As in I am a huge believer in the balance of payments constraint and that its not dead horse but the most active horse and that’s why Geither goes to China regularly – but anyway someday later).
The reason I linked it was that I thought – at least from my perspective – the most useful summary of what was going wrong in the period and as admitted by him, Monetarism came to popularity at the worst possible time and completely changed the policy discussions and focus in the wrong way.
That’s a story I attempt to tell to various people on blogs – including “heteredox” economists.
But thanks you actually read it. I will anyway send you the scans since Google Books doesn’t show up all the pages (for the sake of completeness – not for anything important you may have missed – which you may not have.)
Nick,
I think the argument made by Mosler et al is not that interest rate setting can’t be used to control inflation, but rather that it’s not really the best way to do it – and that it doesn’t always deliver the intended result (or even if it does it only does so in an inefficient way).
So, for example, low interest rates can potentially depress demand because they remove income from the economy, and high interest rates can paradoxically stimulate demand because they increase interest income. Super high rates succeed in crushing inflation but only by simultaneously crushing the economy.
It probably has a lot to do with distribution of income and the current situation regarding private debt at any given point in time. A bit beyond me, really. But the thing I take away from it is that monetary policy in its current form is seen to be a blunt instrument, and other ways of achieving similar outcomes vis a vis inflation would be better and less distortionary or disruptive.
The ‘natural rate of interest is zero’ thing is a bit tongue in cheek, in the sense that they don’t seem to believe in the natural equilibrium rate in the mainstream sense.
Instead, in the absense of additional actions by either the treasury or the CB to support the interest rate through either bond issuance or IOR, the interest rate ‘naturally’ falls to zero when the government deficit spends, which in a fiat money system it has to do to provide currency to the economy with which the taxes imposed can be paid.
The point being that the government necessarily has to spend before it can tax or borrow in the currency which it alone issues (bank credit not being government currency).
Any additional actions (bond issuance to ‘drain reserves’ or IOR are additional interest rate maintenance measures – policy choices and neither inherently necessary or ‘natural’.
Ramanan – you know about these things. Am I giving a fair description here or not?
Darkjaws:
Ideological? You are misinformed. People who disagree with me are ideological; unless they disagree a lot, in which case they are crackpots.
Philippe:
Sorry, but there’s just too much to disagree with in your post, so that I don’t know where to begin. This is why I usually restrict my comments to issues relating to the backing theory of money, where I have a comparative advantage. There are thousands of economists who are well-equipped to address what Frank Knight called the “notorious fallacies” of Keynesianism.
Mike Sproul,
Fair enough, I get that you’re in a totally different mindset/paradigm.
If the basis of your objestions is that Keynesianism is a load of balls then that’s kind of the end of the debate I guess, for now.
I suppose these things ultimately have to work themselves out through the democratic process. Two wolves and and lamb deciding what to have for dinner…
I note the sarcasm but still, making statements like “Spending involves waste of resources while lending does not” is purely political, if you’re going to make such a statement don’t dress it as some economic argument. Now that’s not to say that all economic arguments have a political basis, but we admit it…you on the other hand, i’m not so sure.
Although it would be interesting and useful for me to know more about what your objections are, as a wolf determined to devour the poor little gold standard lamb along with my fellow raving statists (!).
DarkJaws:
“The point is that the government spent money into existence(remember fiscal operations are helicopter money/high powered money) while the resulting bond didn’t soak up any of the resulting idle money.”
That’s not really how it works, as far as I can see.
My understanding (simplified):
When the government deficit spends and issues bonds, the quantity of deposit money in the economy increases, but the quantity of reserves remains the same. If the government deficit spends without issuing bonds, the quantity of deposit money in the economy increases and the quantity of reserves increases. Understanding the difference and relationship between deposits and reserves is crucial.
Increased reserves lead to a lower interest rate unless the Fed sells govt bonds (which it had previously purchased) or pays interest on reserves (with newly created reserves). Lower interest rates may be stimulatory or they may not, there’s some disagreement about this. But increased levels of reserves are not necessarily more inflationary than unchanged levels of reserves if the interest rate remains the same in both cases (which is possible with interest paid on reserves).
Super Simplified example:
Lets say you deposit $100 in a bank.
The bank credits your account with $100.
You now have $100 credit (i.e. $100 deposit money) and the bank has $100 reserves.
The bank keeps $10 reserves and uses $90 reserves to purchase a government bond.
The $90 reserves are taken by the treasury. You still have $100 credit in your account, the bank now has $10 reserves and a $90 bond.
The treasury then spends the $90 reserves it borrowed from the bank to pay Mr B, who has an account at that same bank (for simplicity).
The bank receives the $90 reserves and credits Mr B’s account with $90.
The bank now has $100 reserves as well as the $90 bond. You have $100 credit (deposit money) in your account and Mr B has $90 credit (deposit money) in his account.
Overall, at the end of this process, bank reserves are the same quantity as they were before, but now the bank has a bond worth $90 and $90 of new deposit money has been added to the economy.
The bank can now use the reserves it has in excess of its reserve requirement to ‘invest’ in something else.
Please Correct.
Resp,
“Ramanan – you know about these things. Am I giving a fair description here or not?”
Philippe,
Haven’t followed your discussion but here’s a take on your last comment. I see the MMTers say often certain things about interest rates and I simply do not agree with the way it is presented.
This is assuming business investment has no interest elasticity. Low interest rates can have stimulatory effect on demand – especially residential investments. Since purchases of residential apartments itself adds to demand and even if business investment has low interest elasticity, the demand created by residential investment can stimulate business investment.
Monetary policy does have an effect. I understand fiscal policy is very powerful but that shouldn’t be highlighted by giving zero role to monetary policy.
Ramanan @02.20am = sensible Post Keynesian.
philippe: “So, for example, low interest rates can potentially depress demand because they remove income from the economy, and high interest rates can paradoxically stimulate demand because they increase interest income.”
Price (including interest rate) changes have: income effects; substitution effects. Your analysis looks only at income effects and ignores substitution effects.
philippe: “This is all my personal understanding. Please don’t consider it to be representative of anyone else’s views.”
Your views there are (roughly) representative of the large majority of mainstream macroeconomists. New keynesians would say (roughly) the same thing. But:
1. Some would say that’s not the only way of looking at it, or doing monetary policy.
2. All (most) would say that what you have just described, where you treat the central bank’s interest rate target as the exogenous variable, is correct only for the very short run (about 6 weeks in Canada). In the longer run, the Bank of Canada targets inflation, not interest rates, so the interest rate becomes endogenous. Again, see my recent posts here and here.
I gotta grade exams.
Kristjan: “May be I am too stupid but I don’t get the hot potato thing.”
Most very smart economists, including some of my fellow-monetarists, don’t get the hot potato thing either. They can’t handle disequilibrium analysis 😉 I’m the heterodox one!
Try my old post here.
Ramanan:
“Monetary policy does have an effect. I understand fiscal policy is very powerful but that shouldn’t be highlighted by giving zero role to monetary policy.”
I agree with you actually. There seems to be abit of disagreement among MMT people about this. Bill Mitchell seems to be more of a ‘fiscal policy puritan’. But I asked Scott Fullwiler about this and he said the following:
Some potential alternative approaches to monetary policy:
“1. Procyclical adjustments to capital requirements, which would raise costs of funding assets and be passed on to borrowers.
2. Procyclical adjustments to default risk ratings.
3. Tom Palley’s asset based reserve requirements.
“None of these really matter or would be all that effective without wholesale regulatory change, and that’s why one sees a lot more focus on that from MMT’ers rather than alternative approaches to monetary policy. But that doesn’t mean we are against using monetary policy per se.
“Remember, ZIRP only applies to the overnight, risk-free rate. Other rates are going to be higher. And with no manipulation of short-term nominal rate, longer-term rates would be less inclined to have negative holding period returns. On average, those returns might be about the same but with less risk.”
”’
You also have Rodger Mitchell who advocates a kind of MMT in which monetary policy plays the same role/ is done in more or less the same way as it is at present.
This could either be through the usual system of bond issuance and OMOs, etc, or by taking the approach of paying interest on reserves and setting rates that way.
philippe and Ramanan: BTW, income effects don’t really exist.
Phillipe: I didn’t get a chance to go over your post fully, but thanks for clearing up any confusion I may have.
Nick: Income effects don’t exist? be sure not to say that in a room full of post keynesians. In fact, they argue that substitution effects are so negligible that they don’t exist. There is a paper by Lavoie that goes over this.
Hell, you’re in Ottawa too, why don’t you go across the street and have a friendly discussion about this with Dr. Lavoie?
DarkJaws: Funny you say that. I first said it about 15 years ago while lunching with Marc Lavoie! His eyebrows did shoot up, IIRC! So I explained why I believed it. It follows from getting the accounting right. For every x apples bought there must be x apples sold. For every one dollar borrowed there must be one dollar lent. (There may still be distribution effects, of course.)
I know Marc’s a smart economist, BTW, and I’m pretty sure he understood my argument. Though whether or not I convinced him, I dunno. Maybe not.
Nick: “There may still be distribution effects, of course.”
Yeah, but whatever. IIRC, all agents have about the same amount of money. 🙂