When economists say that something is "linear", rather than "non-linear", they normally mean it is a straight line, rather than curved. Y=a+bX is linear; Y=a+bX2 is non-linear.
That is NOT what I am going to mean by "linear" in this post.
Instead, I am going to use the words "linear" and "non-linear" in the way Artsies use those words. A "linear" plot is one that starts at the beginning, then continues with day causing following day, until it gets to the end. A "non-linear" plot curves back on itself, with simultaneity, flashbacks and flashforwards, and self-referential asides where the characters wonder if they are in a story and how it's going to end.
Economics is now, and has been for hundreds of years, a non-linear discipline, in the Artsie sense of the word.
[Update: anyone who doesn't get my point, or who wants to see the point explained by someone who understands math modelling better than me, or who wants to see it from the perspective of a real scientist (not an economist) who studies predator-prey dynamics, should read Jeremy Fox.]
The very simple story of demand and supply, as we teach it in ECON1000, is a fundamentally non-linear story. If you try to tell the demand and supply story as a linear story, you always get into deep trouble. "Bad weather causes a decrease in supply, which causes an increase in price, which causes a decrease in demand, which causes a decrease in price, which causes a decrease in supply, which causes an increase in price…."
Explaining demand and supply to first year students is difficult, precisely because it is a non-linear story. They want to know whether a change in quantity causes a change in price, or whether a change in price causes a change in quantity? And in which direction will price change if quantity changes, or will quantity change if price changes? And you can't answer that question, because it doesn't make sense. We can only answer "both".
And so we draw a supply and demand curve diagram, point to the intersection of the two curves, and say that price and quantity are co-determined simultaneously in equilibrium by the supply and demand curves. Where the supply curve is the whole relationship between price and quantity supplied; and the demand curve is the whole relationship between price and quantity demanded. And explain that supply, quantity supplied, and quantity sold are three different concepts. And explain how demand, quantity demanded, and quantity bought, are also three different concepts. And tell a story of the disequilibrium sub-plot in which an excess supply causes price to fall to the equilibrium, and excess demand causes price to rise to the equilibrium. And distinguish that disequilibrium sub-plot from the main equilibrium plot in which shifts in supply or demand curves cause the equilibrium price to rise or fall.
"Equilibrium" is economists' code-word for "this is a non-linear story".
The very simple standard story of demand and supply is a non-linear story. That's what makes it so hard to teach properly. Students really really want to hear a linear story. They like linear stories, because linear stories are so much easier to understand, remember, and explain. You can even write linear stories in point-form. "S up arrow P down arrow D up arrow Q up" would say it all, if the plot were linear. The "arrows" indicate "precedence", in both the causal and temporal sense. If the plot were linear, we could easily lay out the concrete steps through which an increase in supply caused a decrease in price and an increase in quantity, taking one causal step at a time. But it's not linear.
My car has a linear transmission. The engine turns the main shaft, which turns a cog, which turns another cog, which turns the auxilliary shaft,..which turns the axles, which turn the wheels, which make the car go forward. The monetary policy transmission mechanism, even in the very simplest and crudest version of that story, is non-linear. Even calling it the "monetary policy transmission mechanism" is a highly misleading metaphor, because it leads people to expect a linear story.
The simple story of monetary policy I teach in ECON1000 is non-linear like the demand and supply story, only more so. That's because there are more goods, more supply and demand curves, more endogenous variables that get determined simultaneously, and almost everything depends on almost everything else.
I have a shameful admission to make. A couple of times, after some students still didn't get it, I broke down. I told them that this wasn't exactly right, and then wrote down: "M up arrow r down arrow I up arrow Y up arrow P up". And the students loved it. Yes! This they could really understand! They all wrote it down in their notes, memorised it, and regurgitated it on the exam.
What I did was wrong. I linearised a non-linear story. But that's not the point of this post.
The point is that the students really really wanted a linear story of the monetary transmission mechanism. And when I gave them a linear story they thought they understood it. They didn't. They misunderstood it. They misunderstood it just as badly as a student who thinks "an increase in supply causes a decrease in price causes an increase in demand causes an increase in quantity" misunderstands demand and supply.
My students were like the people from the concrete steppes. The people from the concrete steppes want a linear story of the monetary policy transmission mechanism. Sorry, but you can't have it. If you think you understand monetary policy through a linear story, you don't understand it. The true story is non-linear. There is simultaneous causation, so endogenous variables are co-determined in equilibrium. Expectations matter, so the story has flashforwards and flashbacks, where the future affects the present. Those expectations are self-referential, because the characters in the story know the author who works at the central bank, and can anticipate the future plot he plans to write, which affects their actions today. That means a loosening of monetary policy could mean that interest rates rise, not fall. You cannot reason from an interest rate change (Scott Sumner), because interest rates are endogenous variables.
The people from the concrete steppes find this all very frustrating. They want a story with a linear plot, because a linear plot is what they understand. And if they think the linear plot cannot work at the Zero Lower Bound on nominal interest rates, they conclude there must be no plot in which monetary policy works. And they think that any non-linear story is just handwaving and mystification.
Here is a very simple non-linear story, which the people from the concrete steppes won't like. We know that for any equilibrium time-path there exists a second equilibrium time-path along which all nominal variables (like NGDP, and the money supply) are higher or lower. This means that a permanent loosening of monetary policy will eventually move the economy towards one of those time-paths along which all nominal variables are higher. This means that the expectation of a permanent loosening of monetary policy will mean the expectation of an eventual permanent increase in all nominal variables like NGDP. (This is how monetary policy always works, regardless of the ZLB, because interest rate changes are an endogenous symptom of monetary policy changes, not an integral step in a linear causal chain.) An increase in expected future NGDP will increase demand today, and increase current NGDP. It would really help people to expect a permanent loosening of monetary policy and a permanent increase in future NGDP if the central bank announced a commitment to a higher future NGDG target, because hitting that target would require the central bank to loosen monetary policy permanently.
Not very linear, is it? But then economics isn't a linear subject, and hasn't been for hundreds of years. So what did you expect?
Worthwhile Canadian Initiative 
This is a very very good post. It is extremely logically coherent, remorselessly so, to invoke Keynes. It would be true, if economics was purely an abstract system of propositions. It is the most Austrian (and best) non-Austrian narrative I have ever read.
But what about the empirics?
Critics (Ashwin, Dan Alpert, FT Alphaville, BIS) are arguing with data. They’re looking at oil/commodity prices. At wage growth trends. At SNB reserves. Where is yours?
Plus, there is a simple enough narrative challenge to your narrative – Sorosian reflexivity. Economies behave as the constituents of the economy behave. If financial market/other influential participants think like your undergraduates (and there’s no reason to suppose why they won’t), monetary policy transmission becomes linear-ish. Since their beliefs are borne out by what they see happening in the markets, they see no reason to change their linear beliefs. And we’r eback to square one and concrete steppes.
Rather than indulging in yet another determined attack on your “concrete steps” straw man, it would have been more to the point for you to have responded to what Brad DeLong says here: http://delong.typepad.com/sdj/2012/06/a-fragment-on-the-interaction-of-expansionary-monetary-and-fiscal-policy-at-the-zero-nominal-lower-bound-to-interest-rates.html.
Because if Brad is right, the implication is that it ain’t the people of the concrete steps who don’t understand non-linear stories and expectations; it’s Nick Rowe, market monetarist.
OK, I don’t disagree with a lot of that, though a lot of it sounds more like “multiple simultaneous equations” rather than “non-linear.” Of course, it’s both.
I don’t even have a problem with the last paragraph. So long as what you are expecting the CB to do is not beyond what’s in principle achievable with its instruments! (yeah, I know, that’s the part where you cringe… keep reading) I.e. assuming they can’t buy anything other than government bonds, then the limit on the quantity of demand they can achieve via expectations is equal to the effect of credibly committing to keeping the short rate at zero forever. If they are allowed to buy real assets, then I think there is very little limit to what can be achieved via expectations (so long as the policy respects time consistency).
Non-linearity is a very good way to explain this. Thanks. For one thing it’s easier to imagine than the idea of multiple simultaneous equations that may or may not correspond with other factors.
K, I think Nick prefers to refer to multiple simultaneous equations as ‘artsie non-linearity’.
“You cannot reason from an interest rate change (Scott Sumner), because interest rates are endogenous variables.”
And isn’t that exactly what invalidates Taylor-rule thinking?
p.s. Artsie? Oh you Canadians…
I can’t comment on this as an understanding of how monetary policy works, but as a post on how difficult it is to teach students to think about equilibria and stability, it’s spot on. And it’s not just economics students who love linear, “A causes B causes C causes D”-type stories. Ecology students are exactly the same. And I too am guilty of giving in sometimes and telling the linear story, and the reaction of my students is exactly the same.
Great post.
Phill: The Brad is right because he did not respond to the Bernanke he quoted. He responded to Quantitative easing conducted exactly in “concrete-steps” fashion, that is that increase in M will cause increase inflation (causality) – only expectations of CB reverting this in future will negate this very mechanical step.
So it is the very opposite to what you claim – DeLong endorses MM way of thinking. Only Brad thinks that the only credible way to convince the markets that the stimus is permanent is to make it physically permanent (like building bridges to nowhere). Market Monetarists disagree – the problem is not with CB (and the monetary policy it conducts) not being credible – it is that it is credible in its goal not to expand demand. It is DeLong who is horribly wrong. He assumes that CB will just watch by as fiscal stimulus “mechanically” does its magic to restore the economy.
PS: Another proof of DeLong and other Keynesians being firmly anchored in concrete steppes is that they do not work with expectations. Not really. Let’s assume that for whatever reason (ZLB) they think that fiscal policy is the only game in town. Why could it not work via expectations? Like Obama saying – “Dear citizens, if the GDP growth does not recover by 2015 we will start to borrow and spend a lot of money so that the economy recovers, did I tell you my boyhood dreams about Mars expedition?”
Ritwik, on empirics, are there any central banks who have failed to hit the nominal variables they target? The SNB are hitting theirs, as are the BoE, ECB, etc; even with half of Europe disintegrating around them.
The SNB would have failed if they hadn’t bought $60B Euros last month. Eventually the balance sheets of arbitrageurs will grow so full of Euro’s that they will stop doing the SNB’s job of satisfying the demand for Francs. Then the SNB will start buying. Then their balance sheet will get terryfyingly full of Euros too. Then they’ll be scared, i.e. vulnerable. Then we attack.
Britmouse
1. SNB’s monetary bazookas are not as costless as first imagined. http://www.macroresilience.com/2012/06/07/monetary-policy-targets-and-the-need-for-market-intervention/
2. BoE has openly admitted that it won’t target a precise rate of inflation because it can’t forecast it in the first place and has warned of higher inflation. http://www.reuters.com/article/2012/05/16/column-boe-inflation-idUSL5E8GGALG20120516
http://www.myfinances.co.uk/savings/2012/05/16/bank-cuts-growth-forecast-and-says-inflation-will-stay-above
3. ECB’s target is to keep inflation below 2%. It’s not really a precisely defined target. But even if we believe that it is, there are good reasons to believe that in high-wage developed economies, monetary easing as currently practised (rate cuts, QE) only leads to asset price and commodity price inflation and will not lead to a sustainable increase in aggregate demand. Thus, the ECB’s asymmetrically conservative bias is not even a good test case for targeting success.
http://www.economonitor.com/danalperts2cents/2011/07/06/commodity-speculation-monetary-policy-and-temporary-inflation/
http://www.economonitor.com/danalperts2cents/2011/09/21/dear-paul-krugman-letter-inflation-would-be-dandy-but-try-to-make-it-happen/
First of all great post. If there’s anything that non-macro macro pundits (i.e. investment managers) screw up most consistently when opining and predicting it is forgetting joint determination, particularly when it comes to supposedly exogenous interest rates. But…
I think you are probably mistaking some people who understand joint determination well for people of the concrete steppes. And the reason for this is that you are not taking the difficulty of the game theory between the Fed and the market seriously enough. I don’t think it’s enough to merely state that Chuck Norris can threaten to buy all the assets in the room. That’s only the beginning of the question. The room is full of smart (though combat inept) people, who as a whole might well determine that Chuck is ultimately bluffing. After all, Chuck has his own incentives and his own weaknesses. Those weaknesses would come on full display long before he owned every asset in the world and started having to decide whether to vote out the HP board and how to rent out all those Vespas it owns. He would surely cave, or perhaps be relieved of his Chuckness by voters, or maybe would find that he was kicking his own butt around the room, at some point long before he could actually clear the room. And the room knows this.
And that’s a wild understatement of Chuck’s flaws and weaknesses. In the US, the Fed has the power to buy some unusual assets like foreign sovereign bonds and muni debt in some circumstances, and can attempt to exercise other powers creatively to buy even more stuff, but is it not at all obvious how far it can go in this pursuit before other government actors or lawyers or popular sentiment make it clear that whatever they are doing is putting their tenure — and thus their power — in jeopardy. I don’t think it’s quite enough to say Scott Sumner’s “every CB that has wanted to inflate has succeeded” or to simply point out that Chuck is technically strong enough to beat everyone up if you ignore his potential weaknesses. This seems like an incomplete answer because “want” is nothing but a part of “can.” Do we describe the BOJ as not “wanting” to inflate — maybe — but “wanting” might be a lot more complex than just changing the minds of a few chosen human beings. It is the interaction between the BOJ incentives and limitations and what the market knows about the BOJ incentives and limitations.
I think many of the Concrete steppes people take this problem seriously (“commitment problem”), and so implicitly assume that the Fed is working within some undefined limited equilibrium. And that is why they focus on the supposed hydraulics and are always so pessimistic about their effectiveness. In fact, it is exactly because they know about joint determination that they so pessimistic about many of the actual concrete steppes. Don’t get me wrong, the concrete steppes are still the wrong conversation. It is distracting. But I don’t know that orchestrating a preferred expectations equilibrium is as simple as just saying “printing press.” The printing press needs power to run, and the market knows that. Saying that Zimbabwe can inflate doesn’t seem like enough. It’s easy to direct the expectations equilibrium if you’re not bluffing about self destruction. If there are even potential, extreme scenarios where the Fed cannot go to the mat for its NGDP target and the market knows this, are those enough to create so called expectations or commitment traps?
Is monetary policy endogenous or exogenous?
A central bank, especially a rule based bank or the like, is responding to the conditions it influences
The stability/fragility tradeoff is an example of a non-linearity that macro does not capture. Credibly promise no small fires and the forest eventually succumbs to a conflagration.
Out in the steppes, actors translate a credible promise of stable NGDP into, “my VAR model says I don’t need to maintain much capital or liquidity as a hedge.” This eventually creates enough dry tinder to spark a conflagration. Like in a forest, a promise of no small fires leads eventually to a catastrophic one. Except its worse than the ecology example, as in the economy, actors rush to hedge once the perceive the promise is broken, creating a non-linear cascade — a run. Thus, the 2007-2008 crisis was arguably caused by the Fed making a promise they could not keep (“no threats to the integrity of collateral”). The promise itself created a condition that made the promise non-credible.
K,
“assuming they can’t buy anything other than government bonds”
There’s no reason to make that assumption for any modern central bank, as far as I know.
“If they are allowed to buy real assets, then I think there is very little limit to what can be achieved via expectations”
Do private sector assets like corporate bonds qualify as “real assets” in this story?
Is this the only kind of liquidity trap you give credence to, K? Is it just a matter of short-term government debt and money supposedly being perfect substitutes when interest rates approach zero? (One of these days, someone is going to have to write a dictionary on liquidity traps. It would just be one entry with about 56 different definitions.)
W. Peden,
“Do private sector assets like corporate bonds qualify as “real assets” in this story?”
Corporate bonds qualify if they are positive beta, in which case buying them would lift the whole market. When and where spreads are very tight, corporate bonds are close substitutes for treasuries, but those times rarely qualify as periods of deficient demand, so when relevant I suspect the broad corporate bond market almost always qualify.
“Is this the only kind of liquidity trap you give credence to, K? Is it just a matter of short-term government debt and money supposedly being perfect substitutes when interest rates approach zero?”
Yes. In practice, I think buying corporate bonds and stocks would result in the required AD way before we have to debate whether the CB can further stimulate the economy by threatening to turn us into a communist state. Nick and Ashwin have both discussed such general traps. Like Ashwin, I can’t dismiss it out of hand, but unlike the liquidity trap you describe, I don’t have good theoretical reasons to believe in it.
K,
So, since in the real world central banks can and do buy private sector debt, the notion of a liquidity trap has no application in our current monetary arrangements. Therefore, we’re in agreement that fiscal stimulus is superfluous*; at this point, I think the boundaries between New Keynesianism and Monetarism become extremely murky. Notice how it makes your qualification to your agreement to Nick’s post irrelevant in all but high theory and to some extent practical policy i.e. it’s a good argument for moving central banks to purchasing assets on the basis of independent and non-oligopolistic ratings agencies’ assesments of quality, rather than assuming that government debt should be specially privileged..
* Although it makes sense to increase government investment during recessions (demand-side or supply-side) on the grounds of good public finance: it’s cheaper to invest in a downturn and the government isn’t constrained in doing so, provided it is prudent when revenues are strong.
Nick,
I really liked your last post with Aswin. You can guess where I came down on that one…
But I cannot agree with this.
“Any sufficiently advanced technology is indistinguishable from magic”
I think this is where we are heading here. Our system has plumbing, it has numbers, it has…more information. Going in this direction dooms the outcome to Tyler Cowen economics “We can’t do anything or ever tell what’s happening, so why bother?”
Economics = Social Sciences = B.A. = Artsie.
Economists are not part of The Club. Sorry Nick.
Says he who has a B.Eng.
Don’t you need a linear story to show convergence? 🙂
W Peden: “in the real world central banks can and do buy private sector debt”
There’s plenty of doubt about the legal and political limits of that, both in the US and the EU. Certainly the Fed is prohibited from buying corporate bonds. Maybe they’ll be able to structure their way around it, maybe they won’t. The odds that they can’t are, in my opinion, high. If the market thinks like I do, then we have significant odds of still ending up in a trap.
Do I think we need fiscal policy then?
First of all, buying real assets is fiscal/industrial policy as targeted risk transfers can be every bit as much a bailout as lump sum transfers. If you are going to pick and choose real assets, I request that you start by buying real estate in my neighbourhood.
Second, no, I don’t think we need it. The 10yr bond can still rally by $16 before rates are at zero. The Fed hasn’t even tried to communicate the conditional path of rates. How about “we’ll keep rates at zero until the NGDP level reaches 5% compounded from Jan 2008. Then we’ll do what it takes to keep it growing at 5%.” Real rates will plummet and all real assets will rally. If that doesn’t work, then we will have to try something else. Meanwhile, lets leave negative beta treasury bonds in the hands of investment portfolios where they can enable the maximum amount of real risk taking. Treasury bond QE is totally bogus.
Equilibrium thinking is not “non-linear”, it is utopian. It’s a slur to the noble field of non-linear dynamics to call the assumption that prices and quantities at the national level can be solved by drawing a few supply and demand curves and assuming that all transactions occur at the intersection of these curves. It is just panglossian bullshit.
In the absence of an auctioneer, you need to look at actual mechanisms that arise from purchases and sales, and see how the economy evolves as a result of millions of these purchase decisions occurring in real time — rather than look at some idealized equilibrium, and assume the economy is following this magical path continuously.
K,
“Certainly the Fed is prohibited from buying corporate bonds.”
?!
Why?
And doesn’t this cast serious doubt on Paul Krugman’s professional qualifications to advise the UK on macroeconomic policy, given that he probably isn’t aware that the Bank of England can (and does) buy private debt like corporate bonds?
“First of all, buying real assets is fiscal/industrial policy”
Then we’re in the interesting position where much of what is known and conducted as “monetary policy” in much of the world isn’t monetary policy in the theoretical definitions here. I suppose that, as usual, reality will be made to accomodate theory rather than vice versa.
(I only pick on Paul Krugman because he’s been over here recently telling us how to run things. Milton Friedman did the same thing in the early 1980s and also showed an embarassing lack of familiarity with UK institutional arrangements.)
?!
Why?
There is this thing called the “Federal Reserve Act” that specifies what the CB is and is not allowed to buy. And to whom it may or may not lend.
Because purchasing risky assets bears a possibility of loss, which corresponds to fiscal policy, and the constitution specifies which branch of government is required to do fiscal policy. Said branch tends to be jealous about delegating its powers to other institutions when it writes laws. That is why the CB can only purchase assets backed by the government. In that case, there is no risk of loss to the government.
You may also be surprised to know that there is this thing called a “Debt Ceiling”, which Treasury is not allowed to exceed. Once again, prior to the creation of the debt ceiling, each bond sale required an act of congress. When this got too burdensome (at the time of the Panama Canal), Treasury was allowed to borrow up to a limit set by congress.
Once again, congress controls fiscal policy, it may allow another institution to tweak it on the edges a bit, but basically it is not going to give real fiscal authority to anyone other institution.
Attempts to do back-handed fiscal policy via the CB run into this problem. In the real world.
cough
Strictly speaking, linearity means f(x+y) = f(x)+f(y) AND f(ax) = af(x) for all a.
f(x) = mx+b fails this second test because the test test implies that f(0) must be 0, though in popular usage (popular in scientific circles even) y=mx+b is considered linear, even though f(0) != 0.
W. Peden,
A suggestion: if the activity does not stem from a unique capability of the central bank, it is not “monetary policy”. It is just the action of a publicly-owned bank with a rather large balance sheet. The Fed has two unique attributes: it issues dollar reserves, and its liabilities are irredeemable. When dollar reserves are not demanded for payments, or when the liquidity premium is normal, the only monetary policy tool is signaling regarding future actions (ok perhaps also a negative IOR, but it is, strictly speaking, a tax on certain bank assets that Congress could also impose, which is why its probably illegal for the Fed to implement).
For instance, the Fed swapping ER’s for risk assets simply results in a transfer of risk from private actors to taxpayers. It can be exactly replicated by Treasury (swapping Tbills for risk assets). Of course there is a signalling component: signaling that the Fed will engage in fiscal policy until its monetary policy goals are achieved.
Determinant: “Strictly speaking, linearity means f(x+y) = f(x)+f(y) AND f(ax) = af(x) for all a.”
I didn’t know that. But, AFAIK, Y=a+bX is what economists call “linear”.
Some economics degrees are BSc’s (but not at Carleton). But yeah, we’re members of the Wannabe tribe, and don’t think of ourselves as artsies!
rsj: Not all equilibria are Walrasian equilibria. E.g. there are search equilibria, where there’s no Walrasian auctioneer. And not all equilibria are good. E.g. there’s the Prisoners’ Dilemma Nash Equilibrium. And see the comment by Jeremy Fox above? Jeremy is a real scientist, and he says he teaches the same concepts in ecology. And I don’t think critters use a Walrasian auctioneer to get to a utopian/Panglossian predator/prey equilibrium.
Min: “Don’t you need a linear story to show convergence? :)”
Funnily, I was just wondering the same thing myself. I don’t think so, is the answer I came up with. More generally, there’s no rule that says economic theories can’t be linear. But I confess the only linear theory I can think of offhand is the old Labour Theory of Value. Socially Necessary Quantity of Labour arrow value. There must be others, that aren’t defunct.
Mike S: “Going in this direction dooms the outcome to Tyler Cowen economics “We can’t do anything or ever tell what’s happening, so why bother?” ”
I don’t think it’s quite that dire. Sure, it’s harder to understand, explain, measure, and test, but it’s not impossible. And we can look for analogies in history around the world. FDR’s announcing a price level target, and raising the price of gold until he hit it, is one that I found reasonably convincing, for example. The gold price probably now lacks the salience to work as an intermediate target and indicator, of course, but there are others.
David Pearson: “The stability/fragility tradeoff is an example of a non-linearity that macro does not capture. Credibly promise no small fires and the forest eventually succumbs to a conflagration.”
(I’m not sure if you are maybe using “non-linearity” in both senses there.)
Ashwin’s blog has some interesting stuff related to that idea, I think. Haven’t fully got my head around it yet, but I reckon he’s onto something.
In Engineering land Y= a + bx^2 is linear (of 2nd order). Y = a + x^b is non-linear. Linearity in the parameters, not the plot on the graph…
There are lots of nice math and proofs for linear systems. Some non-linear ones work as well, but it is much harder to have general results for non-linear systems. Linear systems also generally allow superposition, where a change in two different inputs, or contributors to inputs can be considered separately, and then added together.
But in the sciences, while you are certainly interested in the equilibrium points (and phase diagrams, etc), you do so because your behavioral equations produce the equilibria.
In economics, you write down the equilibria based on preferences (e.g. “demands” or the solution to optimization problems) not behavioral relationships, and then assume that the equilibrium is achieved.
That is why I call it utopian.
If you were to derive ODEs from behavior, and then find an equilibrium, it would be more believable, and it would be comparable to what is done in the physical sciences. I would not call that type of analysis Panglossian.
foosion: “Is monetary policy endogenous or exogenous?
A central bank, especially a rule based bank or the like, is responding to the conditions it influences”
It’s both. Or rather, it depends on what you mean by “monetary policy”, and how you model it. For example, suppose you model monetary policy as a sort of Taylor Rule, where the central bank sets i=a + b.inflation + c.Ygap. Then you are saying that i is endogenous, but the parameters a, b, and c are exogenous. In that context, does “monetary policy” mean i, or the whole Taylor Rule?
If you think something is endogenous, you need to explain it in terms of things you consider exogenous.
dlr: Thanks!
“I think you are probably mistaking some people who understand joint determination well for people of the concrete steppes.”
Yep. We need to keep them distinct. Someone who (for example) argues that future central banks will push future NGDP all the way back down to where it is today, regardless of what the current central bank says and does, and that people will expect this to happen, so that’s why it won’t work, is not someone from the concrete steppes. I just don’t think that’s plausible. FDR’s example suggests it isn’t either. But it does all depend on what people understand by “doing nothing”.
Remember too, it’s not a binary game. Chuck doesn’t need ex ante 100% certainty of 100% success in order to hit his target. 10% probability of 10% success increases E(NGDP) 1% of the way towards the target, which will be enough to show up in asset prices, and raise current NGDP a bit, which creates a positive feedback effect (aka multiplier), and causes people to revise upwards their expectations. And we’ve already seen how the mere announcement of finite QE, even without a target, affects markets.
rsj: Just in case you didn’t know, there are actually models in ecology and evolution, and probably other fields, in which organisms have preferences (e.g., predators choosing among various prey types so as to maximize their rate of energy gain and thus fitness). You can still derive ODEs from assumptions about those preferences, and then find equilibria and other attractors, analyze their stability, etc.
I’m sure Nick will correct me if I’m wrong, but it’s my impression that economists often do the same thing. That they prefer to work with the phase diagrams doesn’t imply that they’ve never derived those diagrams from underlying equations.
Now, if you want to complain that economists generally make very unrealistic assumptions in order to derive their equations, well, there are often good reasons to complain (which doesn’t mean there aren’t also good reasons why economists make those assumptions in the first place; models have many useful purposes besides “duplicate reality”). FWIW, you can make the same complaint about ecology and evolution, and many have.
Jeremy, predators choosing among which prey to pursue is a behavioral assumption. Once you have behavioral assumptions, you can run the system and see what the behavior leads to. The fact that the behavioral assumptions are explained by preferences is beside the point.
You still have:
preferences –> behavior –> differential equations –> find equilibria, dynamics. (non-panglossian)
Rather than
preferences –> differential equations to maximize satisfaction –> find equilibria (Panglossian)
That is very different from optimizing based on preferences, and assuming that the system follows that optimal path.
In the case of predator-prey, a preference-type solution would be for the wolf to look ahead and realizes that excess hunting leads to a poor outcome, and therefore select the appropriate quantity of sheep to eat to maximize their expected lifetime satisfaction.
And then assuming that that is what we would observe in nature. When someone points out — no the wolf will overconsume and then perish, you do not have an army of biologists accusing the modeler of ascribing irrationality to wolves.
Nick,
I’m willing to bet that you too, are “of the concrete steppes.”
Imagine three different central banks:
Bank One is the Fed
Bank Two is like the Fed but has absolutely unequivocal rules sayin that their only powers are to create reserves in exchange for treasury bonds
Bank Three is like Bank Two but can only do overnight repos and buy IBM stock. No treasury bonds.
Bank Four can only do overnight repos against treasury bonds.
Bank Five can’t do anything but talk.
All of these central banks are free to say whatever they want in order to affect expectations in order to achieve their target.
Which of these banks could successfully hit an NGDP level target at all times. I say none of them. I’m willing to bet that you don’t believe in Bank 5 and possibly also Banks Four and Three and even Two? No?
Oops! Five banks!
K: Bank one won’t talk (at least, not about anything worth saying).
You haven’t said Banks two to four can talk.
Maybe Bank three could “talk”, in the same way bridge players “talk”, by bidding for IBM shares? The IBM share price is a much better language than Tbill prices, because the IBM share price will be positively correlated with E(NGDP).
I would pick Bank Three.
Bank Five isn’t a central bank. It can’t print money.
rsj,
“There is this thing called the “Federal Reserve Act” that specifies what the CB is and is not allowed to buy.”
I know that. My question is: why determine purchasable assets on the basis of the type of debt issuer rather than the quality of the asset?
“Because purchasing risky assets bears a possibility of loss, which corresponds to fiscal policy, and the constitution specifies which branch of government is required to do fiscal policy.”
Sure, I understand the issue of purchasing risky assets. However, government debt is not riskless and private debt is not always riskier than government debt.
(I know that the actual REASON for the rule is that it artificially boosts demand for government debt. I’m just interested in whether or not there are any covering arguments.)
“You may also be surprised to know that there is this thing called a “Debt Ceiling”, which Treasury is not allowed to exceed.”
It’s only a slightly less ridiculous one of those quaint antique institutions that characterise the US (as opposed to the hyper-modern United Kingdom! /irony) which puzzles me only slightly less than the rules you put on the Fed. The debt ceiling has never stopped debt growing above the prescribed levels and its key function seems to be to create even more infighting between the legislature and the executive than would already occur in the US system. I’d never thought about how it might hobble effective monetary policy, though.
“Attempts to do back-handed fiscal policy via the CB run into this problem. In the real world.”
You misspelt “America” as “the real world”. 😉
Diego Espinosa,
“A suggestion: if the activity does not stem from a unique capability of the central bank, it is not “monetary policy”. ”
No, I think that definition is deficient for several reasons: (1) in one sense, the central bank has no ‘unique capabilities’, separate from those monopolistic arrangements created and enforced by the state; (2) it differs from established usage, which identifies monetary policy with interest rates/monetary base operations; (3) in most countries today, the important practical distinction which ‘monetary policy’ and ‘fiscal policy’ should capture is between those actions which are carried out by the central bank and those operations which are carried out by the finance ministry.
Notice how this definition leads you, a very clever person, to say something like-
“Of course there is a signalling component: signaling that the Fed will engage in fiscal policy until its monetary policy goals are achieved.”
– perhaps that’s right and perhaps that’s wrong. I have no idea, because I don’t know what “monetary policy goals” means in this sentence.
Still, my point isn’t primarily about definitions, but about macroeconomic policy. I worry that local institutional arrangements in the US can make people think that, for example, the implications of restrictions on the Fed apply to the BoE and the ECB.
It’s somewhat simpler in Canada, where the Bank of Canada Governor and the Finance Minister have offices down the block from one another. The Bank sits on Wellington Street just opposite the West Block of Parliament Hill, Finance is headquartered in L’Esplanade Laurier. If the Governor of the Bank of Canada needs something he can walk down the block, ask the Minister for it and the Minister can then introduce a bill in the House if he needs to.
Extra points if they both walk to one of the bars on Sparks Street afterwards.
W. Peden,
Perhaps its more accurate to say that a profitable risk asset purchase by the central bank is likely to be identified as “monetary policy”; while a loss-making one will ultimately be labeled “fiscal policy”. This is because when a taxpayer is presented with a bill for a central bank recapitalization, it is tough for him to escape the notion that his tax liability can only rise as a consequence of his government spending money. My sense is German taxpayers are about to realize that the ECB is quite capable of non-appropriated fiscal spending.
Of course, the central bank is exposed to losses in its LOLR function. This is a special case: the central bank controls liquidity premia by virtue of its uniquely irredeemable deposit base. Specific legislation imbues the central bank with the power to appropriate (lend) funds in cases where liquidity premia are high. According to the spirit of the legislation, in no other case should a central bank create contingent tax liabilities for taxpayers.
rsj:
You kind of lost me in your reply to my last comment. Afraid I don’t see what you’re getting at. In many evolutionary models in particular, organisms are indeed assumed to maximize, or try to maximize, the evolutionary equivalent of “lifetime utility” or whatever economists call it, namely fitness.
I think you’d be very interested in Alan Grafen’s “formal Darwinism” work linking dynamics (births and deaths) and optimization, and specifying with great precision the conditions under which individual organisms can be regarded as trying to optimize something.
You seem to be questioning whether organisms other than humans have expectations about the future that shape their actions in the present. They sure do! Even plants do. Predictive germination is an example. Plant seeds can actually “learn”, based on cues present in the environment in early spring, whether it’s likely to be a good or a poor growing season for them, and then “decide” accordingly whether to germinate, or remain in the ground until next year (when they’ll make the same decision again).
And yes, there are situations in which predators eat all their prey and then starve. It actually happens in my lab all the time (I work on protozoan predators and prey, but they’re far from the only example). It’s a sort of tragedy of the commons, which optimizing organisms will be selected to avoid only in rather specific circumstances. Natural selection doesn’t routinely favor what are known as “prudent predators” in the evolutionary literature.
Diego Espinosa,
“Of course, the central bank is exposed to losses in its LOLR function. This is a special case: the central bank controls liquidity premia by virtue of its uniquely irredeemable deposit base. Specific legislation imbues the central bank with the power to appropriate (lend) funds in cases where liquidity premia are high. According to the spirit of the legislation, in no other case should a central bank create contingent tax liabilities for taxpayers.”
So the LOLR is indeed fiscal policy, under this definition? I see…
Determinant,
Back when the UK Chancellor took explicit responsibility for monetary policy, he could almost instaneously get what he wanted from the finance minister by asking himself (politely, of course- this were Englishmen).
If he needed the backing of the govermment to pass new legislation, he could theoretically get it via morse code by banging on the walls through to the Prime Minister living next door. Hence the phrase “Westminister village”.
W.P,
You need to read the act. Short summary is that for bills, there is a bit of latitude as to what can be purchased, although notes funding the purchase of equities are expressly forbidden.
For bonds, it needs to be guaranteed by the U.S. There are some exceptions, but these have lots of strings attached.
However, government debt is not riskless and private debt is not always riskier than government debt.
LOL. It’s not risk as modelled by a finance book that we care about. It is risk of loss to the government that we care about.
The Treasury has a claim on all Fed profits, and the Treasury must pay for all Fed losses.
Therefore any debt purchased by the Fed potentially exposes Treasury to a risk of loss, with one exception — the purchase of treasury’s own debt, or debt guaranteed by the government more generally.
The CB was specifically designed to not be a risk bearing agent, and to not lose money, despite all the kooky proposals (such as the CB selling NGDP futures) that assume it is OK for the CB to do exactly that.
Making investments and risking losing money is what the government does when it engages in public works projects and the like. There is enormous opportunity for fraud as well as favoritism, and Congress wants to keep that power to itself.
Whether you personally believe that some private sector debt is less risky than Treasury debt is beside the point.
Nick: “Bank one won’t talk (at least, not about anything worth saying).”
:-)))) LOL!
I did mention that they are all free to say whatever they want. How about bank 4? Can they always hit their target?
Jeremy, I am not saying that plant behavior cannot be predictive and does not reflect preferences in some sense. Nevertheless, it is the behavior that you are modeling. The wolf’s preference is to eat a full meal each day. But the aggregate behavior of all wolves may cause them to starve. Biologists acknowledge this fact because they observe it. They do not rule it out purely on principle.
In the same way, pre-panglossian economists observed that an excess of savings results in a decline in income and did not rule it out on principle. We can observe it even today.
rsj: Um, I’m not aware of economists as a group ruling out things like tragedies of the commons or other market failures “on principle”. I mean, maybe there are bad economists out there who simply assume optimal outcomes at the aggregate level, but my admittedly-limited experience hasn’t brought me in contact with any. Nick for one and Paul Krugman for another have plenty of posts about how aggregate behavior of collections of people can’t be understood by thinking of the aggregate as analogous with a single person (“fallacy of composition” and all that). So I’m afraid my limited reading in economics hasn’t equipped me to follow what you’re talking about.
I’m going to refrain from pursuing this any further, as at this point I think we’re just talking past one another.
Remember too, it’s not a binary game. Chuck doesn’t need ex ante 100% certainty of 100% success in order to hit his target. 10% probability of 10% success increases E(NGDP) 1% of the way towards the target, which will be enough to show up in asset prices, and raise current NGDP a bit, which creates a positive feedback effect (aka multiplier), and causes people to revise upwards their expectations. And we’ve already seen how the mere announcement of finite QE, even without a target, affects markets.
You had to bring Chuck into this, didn’t you Nick? I hate Chuck. Chuck Norris, meet http://en.wikipedia.org/wiki/John_Byng, whose example caused Voltaire to write “Dans ce pays-ci, il est bon de tuer de temps en temps un amiral pour encourager les autres – “In this country, it is wise to kill an admiral from time to time to encourage the others.”
England’s sea dogs were kept bloodthirsty by the fact that they could be charged and shot for “Failure to do their utmost”. From time to time the threat must be carried out in order for it to maintain credibility.
rsj,
I’m actually currently struggling to maintain any interest in the particular arrangements of the US central banking system, except insofar as they distort the language of economics.
If exposing the Fed to risk was the real rationale, then why is it able to conduct other risky activities, including its LOLR function? Arguably, because these activities are necessary to perform its function adequately. So why is effective demand management at the zero level bound less worthwhile than lending to banks who can’t borrow on the market? (If we make the assumption that treasuries and base money are indeed perfect substitutes under current circumstances.)
As I said, the real reason is the one that explains the existence of central banks in the first place and much of the history of reserve requirements: these are means to make it easier for governments to finance expenditure without (overtly) taxing their subjects. It would be interesting, however, if there were arguments other than a bogus risk argument, because then it would suggest than the purchasing of (say) corporate bonds by the BoE, ECB etc. were somewhat importantly flawed.
As for fraud: the eurozone’s problems have largely been the result of government fraud and riskiness. The ECB’s holdings of private debt have not been problematic, as far as I know. However, the ECB is different in many, many respects from the Fed, which is generally my point.
rsj, the Fed is a govt agency and yet is not subject to the govt debt limit. What’s more the Federal Reserve Act isn’t the key statute, the relevant one is the Gold Reserve Act of 1934 as amended.
“Consistent with the obligations of the Government in the International Monetary Fund on orderly exchange arrangements and a stable system of exchange rates, the Secretary or an agency designated by the Secretary, with the approval of the President, may deal in gold, foreign exchange, and other instruments of credit and securities the Secretary considers necessary.”
The question of whether “instruments of credit and securities” includes shares or debt of publicly trade comnpanies has a pretty clear-cut answer earlier in the statute— S.T.F.U. (“Decisions of the Secretary are final and may not be reviewed by another officer or employee of the Government.”). The Secretary’s discretion is so broad as to edge into unlimited– remember he can designate a govt agency to act instead of (or in conjunction with) Tsy itself . Imagine for a minute there were a go agency that, for whatever reason, was NOT subject to the govt debt ceiling. Yeah I can’t think of one either. :o)
“Treasury and Federal Reserve foreign exchange operations are closely coordinated and typically are conducted jointly. Operations on behalf of the Treasury are made under the legal authority of the Secretary of the Treasury and those for the Federal Reserve System under the legal authority of the Federal Open Market Committee, the central bank’s policy-making group. The ESF does not provide financing to the Federal Reserve System for foreign exchange operations. Rather, the Federal Reserve participates with its own funds.”
http://www.newyorkfed.org/aboutthefed/fedpoint/fed14.html
I think that even market monetarists have to admit that there is a range of feasibility of nominal outcomes that can be achieved by monetary policy. The easiest to hit would be money supply targets, followed by currency ceilings where the central bank can buy any foreign currency with its essentially unlimited printing capacity. Targeting indices would be after that.
Aggregate NGDP targets feel more difficult because it is unsure as to how the target will be achieved.
Per-capita NGDP and Wage targeting feel even more difficult. The number of “concrete steps”/decisions to be taken by actors who are out of your control, seem to be more on the way to a wage target .
However, if market monetarists believe in expectations setting overriding eveything, then the central bank should target something that has the distributional aspect also taken care of. Targetting the median wage or even better the 25th percentile wage should be what they aim for. Do you disagree?