Most macroeconomists make a distinction between the short run (sticky prices) and the long run (flexible prices). I want to talk about the very short run. We mostly ignore the very short run, and I don't think we should. Because the very short run probably isn't really that short.
Old Keynesians used to talk about the very short run. So did Old Monetarists. New Keynesians maybe won't even know what I'm talking about.
When Old Keynesians were talking about the successive rounds of the multiplier process, they were talking about the very short run.
When Old Monetarists were talking about how the monetary hot potato gets passed from person to person, they were talking about the very short run.
You can agree or disagree with the Old Keynesian or Old Monetarist analysis of the very short run, but at least they did have an analysis. They talked about the very short run. New Keynesians don't. Something important in the parental DNAs got left behind and forgotten when the Old Keynesians and Old Monetarists made their New Keynesian baby.
I find Hayek's language the best language to use when talking about the very short run. My plans depend on my expectations, and my expectations include what I expect others to do, and what others will do depends on their plans, which in turn depend on their expectations. Each individual's plans and expectations are assumed to be internally consistent, because each individual is rational and can add and subtract, so nobody plans to do something which he expects to be impossible. But that doesn't mean that all individuals' plans and expectations are mutually consistent in aggregate. Two people may both be planning to get up early and grab the prize first, because each expects the other to get up later than him. They can't both be right.
The very short run is about plans and expectations that are mutually inconsistent in aggregate. When Old Keynesians talk about the successive rounds of the multiplier process, they are talking about plans and expectations that are mutually inconsistent in aggregate. When Old Monetarists talk about the monetary hot potato process, they are talking about plans and expectations that are mutually inconsistent in aggregate. And both were talking about the same thing, even though each emphasised one aspect and ignored the aspect the other emphasised.
Old Keynesians talked about planned purchases and expected sales of newly-produced goods, and ignored the distinction between money and other non-newly-produced goods. Old Monetarists talked about planned expenditures and expected receipts of money, and ignored the distinction between newly-produced and other non-money goods.
The very short run is a disequilibrium process. Not merely a non-market clearing disequilibrium, but a disequilibrium between expectations of others' plans and those plans themselves. Others aren't planning to do what we expect them to do, but we don't know this, so we keep on being surprised, and wish we had planned to do something different.
Let's start in short run equilibrium. There's a consistency between plans and expectations in aggregate. But it's a recession, with excess supply. The representative agent would like to sell more than he expects to sell. But the representative agent is also planning to buy the same amount that he expects to sell to others. So he is sad, but not surprised, when he can't sell as much as he would like to sell.
Now let me tell the Old Keynesian story.
For some reason each individual plans to increase his spending on newly-produced goods by $100 per period. But what he doesn't know is that every individual is planning to do the same thing. The representative agent doesn't know that he is a representative agent. Why should he? So he plans to buy more newly-produced goods but doesn't expect to sell more newly-produced goods. Individuals' plans and expectations are now mutually inconsistent in aggregate. We are now in the very short run. The representative agent is surprised to discover that he is selling $100 more newly-produced goods per period than he expected to sell.
What happens next? The Old Keynesian story normally assumes that the representative agent immediately revises his expected sales of newly-produced goods by $100 per period, and then immediately revises his plans to purchase an additional $60 (or whatever) per period. And so on.
Now if he does revise his expectations immediately, and also revises his plans immediately, and implements those revised plans immediately, then the very short run will last only a very short time. We jump immediately to the new short run equilibrium where plans and expectations are once again mutually consistent. But that isn't very likely. It's much more likely he will think that his $100 unexpectedly increased sales was a temporary fluke, at least in part. Because at the individual agent level, there will be slow days and fast days for sales. It's only when he sees that increased $100 sales persist day after day that he will slowly revise upwards his expected sales.
The Old Keynesian multiplier process is indeed a process, that takes time. It would only happen instantly if every individual knew what every other individual was planning to do, and adjusted his own plans and expectations instantly to make them consistent with other individuals' plans and expectations. Hayek would insist, correctly, that that wouldn't be a very plausible assumption.
Now let me tell the Old Monetarist story.
For some reason each individual finds his stock of money is greater than he wishes to hold, and plans to increase his spending on all goods (not just newly-produced goods) by $100 per period in order to get rid of that excess supply of money. But what he doesn't know is that every individual is planning to do the
same thing. The representative agent doesn't know that he is a
representative agent. Why should he? So he plans to buy more goods but doesn't expect to sell more
goods. Individuals' plans and expectations are now mutually inconsistent
in aggregate. We are now in the very short run. The representative
agent is surprised to discover that he is selling $100 more goods per period than he expected to sell.
(The perceptive reader will notice that I just copied and pasted everything past the first sentence in that paragraph from the same paragraph in the Old Keynesian story. I just deleted the words "newly-produced".)
What happens next? The representative agent's stock of money is right back where it started. He bought $100 more goods, but also sold $100 more goods. What happens next depends on whether and how quickly he revises his expectations. If he thinks the extra $100 in unexpected sales was just a temporary fluke, the second period is the same as the first. He failed to get rid of any money, and still wants to get rid of it. But eventually, if the higher flow of sales continues period after period, he will revise upwards his expected flow of sales, and will also revise upwards his desired stock of money and his planned flow of purchases.
The Old Monetarist hot potato process is indeed a process, that
takes time. It would only happen instantly if every individual knew what
every other individual was planning to do, and adjusted his own plans
and expectations instantly to make them consistent with other
individuals' plans and expectations. Hayek would insist, correctly, that
that wouldn't be a very plausible assumption.
(And the perceptive reader will notice that I just copied and pasted that paragraph too, simply changing "Old Keynesian multiplier process" into "Old Monetarist hot potato process".)
The very short run is a process that will be observed in real time. It does not happen in meta-time, coordinated by some non-Walrasian version of the Walrasian auctioneer who ensures individuals' plans and expectations are always mutually consistent in aggregate so that nobody is ever surprised by what other people do and wishes he had done something different.
How long will it take for the very short run process to play out? Dunno. It depends. It depends on whether individuals' sales are smooth from day to day or lumpy and fluctuating. It depends on how well-informed individuals are about what is happening in aggregate. If the initial change in individuals' plans is caused by some policy change, then it matters how the monetary or fiscal authority communicates that policy change. There's a signal-processing problem underlying all this, that Bayesians could probably have fun with. Is it just day-to-day noise, or will my sales stay higher?
Old Keynesians and Old Monetarists had something important to say about the very short run. Their New Keynesian children seem mostly to have forgotten it. They are embarrassed when the old folks mutter about income-expenditure multipliers and monetary hot potatoes. And the two old folks don't seem to realise they are talking about the same thing in different ways. Time to educate the kids, by making them sit down and listen to the old story. But maybe the old story needs updating too.
Worthwhile Canadian Initiative 
Nick: “the wealth effect is almost always (unless we are talking about massive increases in the money growth rate) is too small to matter much. For example, the Bank of Canada normally (before the recession) earned about $2 billion per year.”
I disagree. The rate to discount these profits is very low, both because the cost of capital is very low, and as profit increases during depressions, you have negative risk premium. Your views on the irredeamability of central bank money, and views on the wealth effect contradict each other.
rsj,
What if there are alternatives to bank deposits other than bank bonds, like student loans?
“we are always able to maintain the quantity of deposits that we want”
That’s the heart of the matter, perhaps: as far as I can tell, you and Mike Sproul (and Nicholas Kaldor) are saying that money is always in equilibrium, whereas monetarists and Keynes saw monetary disequilibrium and equilibriating processes as the core topic of macroeconomics.
Ritwik: Suppose there’s an increased demand for bank loans. Or an increased supply of bank loans. I give the bank my IOU, and the bank gives me its IOU. No net wealth is created. But the bank’s IOU is money, so money is created.
K: But I’m confused by your description of your representative agent. Rather than “a” representative agent, why do you not just say that there are multiple agents with different priors, different information, etc? This is not a representative agent economy.”
Even if there are lots of different agents, with different priors, and different information, it may (or may not) be possible to talk about what is happening in aggregate in terms of some fictional representative agent who is like the average, but who doesn’t realise that he is the average. If it is possible to do this, it would only be possible under special assumptions (e.g. everything is linear). If it is possible to do this, it would be nice to do it that way. Easier for our intuition. My guess is that it is possible.
123: I’m not sure. Currency/GDP ratio in Canada is about 5%. Suppose the BoC did a one-shot helicopter doubling of the money supply. At existing prices and incomes, that would be an increase in wealth equal to 5% of one year’s GDP. Total wealth is (say) 20 times annual GDP?? A 100% increase in the money supply, but only a 0.25% increase in wealth?
BTW, if I’m wrong on this, then the old Pigou effect, which everyone says theoretically exists but is too small in practice to bother about, is very important.
W Peden: “as far as I can tell, you and Mike Sproul (and Nicholas Kaldor) are saying that money is always in equilibrium, whereas monetarists and Keynes saw monetary disequilibrium and equilibriating processes as the core topic of macroeconomics.”
My guess is that’s roughly right. Weird bedfellows! I wonder where the Austrians belong? My guess is in with me and monetary disequilibrium theorists across the old monetarist/keynesian spectrum. I don’t think it’s an accident that I had to use Hayek’s language to talk about this properly. I find it impossible not to talk like Hayek when I’m talking about this topic.
Where’s Greg Ransom when you need him, and when I’m saying something very nice about Hayek??
Nick
The bank’s IOU has a smaller haircut than my IOU, which is why it circulates as money. Presumably, there’s some economic reason convenient to do this type of transaction. Net wealth has been created. The bank is just monetizing this wealth.
Nick, I roughly estimate the pre-crisis market value of BoC’s equity at approx. 15% of GDP ( 5% currency that will never be redeemed, 5% option value due to additional balance sheet expansion during depressions, 5% is the NPV of the future seigniorage from base money that will be regularly issued in the future). In December 2008 probability of depression was much higher than in 2007, so the option value could have easilly tripled. This 10% GDP boost of the BoC’s equity value looks quantitatively important in the context of TSX index losses that were roughly 50% of GDP from stockmarket top to bottom. And the process is non-linear – further losses in TSX generate progressively larger increases in BoC’s equity value. So Pigou effect stabilizes the expected AD.
In a pure gold coin standard where coins are widely distributed every person has the opportunity to exploit the Pigou effect. With central banks, it is the responsibility of the central banks to share the gains in central bank’s equity value. Basically bernanke has underestimated the Pigou effect in late 2008, he could have helped much more.
Nick Rowe,
It gets weirder: Keynes’s version of the liquidity trap doesn’t make any sense in contemporary Post-Keynesian theory and I doubt it makes much sense in most New Keynesian models either, because Keynes regards broad money as exogenous and causally significant, while Post-Keynesianism regards broad money as always (?) endogenously determined and a lot of New Keynesian models seem almost designed to neutralise money from having any importance whatsoever. I seem to remember that Kaldor felt the need to correct Keynes on this point in “The Scourge of Monetarism” (a title that Kaldor obviously awarded to himself, not Keynes).
Nick,
Are you familiar with the El Farol Bar Problem? Your post reminded me of it. I suppose it’s a bit of game theory – W. Brian Arthur from the Santa Fe Institute came up with it. From his paper “Complexity and the Economy”:
“The conventional approach asks what forecasting model (or expectations) in a particular problem, if given and shared by all agents, would be consistent with—would be on average validated by—the actual time series this forecasting model would in part generate. This “rational expectations” approach is valid. But it assumes that agents can somehow deduce in advance what model will work, and that everyone “knows” that everyone knows to use this model (the common knowledge assumption.) What happens when forecasting models are not obvious and must be formed individually by agents who are not privy to the expectations of others?
Consider as an example my El Farol Bar Problem [10]. One hundred people must decide independently each week whether to show up at their favorite bar (El Farol in Santa Fe). The rule is that if a person predicts that more that 60 (say) will attend, he will avoid the crowds and stay home; if he predicts fewer than 60 he will go. Of interest are how the bar-goers each week might predict the numbers showing up, and the resulting dynamics of the numbers attending. Notice two features of this problem. Our agents will quickly realize that predictions of how many will attend depend on others’ predictions of how many attend (because that determines their attendance). But others’ predictions in turn depend on their predictions of others’ predictions. Deductively there is an infinite regress. No “correct” expectational model can be assumed to be common knowledge, and from the agents’ viewpoint, the problem is ill-defined. (This is true for most expectational problems, not just for this example.) Second, and diabolically, any commonalty of expectations gets broken up: If all use an expectational model that predicts few will go, all will go, invalidating that model. Similarly, if all believe most will go, nobody will go, invalidating that belief. Expectations will be forced to differ.
In 1993 I modeled this situation by assuming that as the agents visit the bar, they act inductively—they act as statisticians, each starting with a variety of subjectively chosen expectational models or forecasting hypotheses. Each week they act on their currently most accurate model (call this their active predictor). Thus agents’ beliefs or hypotheses compete for use in an ecology these beliefs create. Computer simulation (Fig. 1) showed that the mean attendance quickly converges to 60. In fact, the predictors self-organize into an equilibrium “ecology” in which of the active predictors 40% on average are forecasting above 60, 60% below 60. This emergent ecology is organic in nature. For, while the population of active predictors splits into this 60/40 average ratio, it keeps changing in membership forever.
Why do the predictors self-organize so that 60 emerges as average attendance and forecasts split into a 60/40 ratio? Well, suppose 70% of predictors forecasted above 60 for a longish time, then on average only 30 people would show up. But this would validate predictors that forecasted close to 30, restoring the “ecological” balance among predictions. The 40%–60% “natural” combination becomes an emergent structure. The Bar Problem is a miniature expectational economy, with complex dynamics.”