Scott Sumner and Bill Woolsey have been fighting valiantly against the Austrians. The fight is about "Cantillon effects" — non-neutralities of money that are supposed to arise not from the increase in the money supply itself but from where exactly that new money enters the economy.
Sometimes you get a clearer answer to a question if you change the question. That's what I'm going to do here.
Let's stop asking whether the effect of a change in the level of the money supply depends on where that new stock of money enters the economy. Instead, let's assume the money supply is growing at a constant rate, and ask whether it matters where that constant flow of new money enters the economy. We are simply redirecting that constant flow of new money, not changing the stock and redirecting it at the same time. It's easier to keep our heads straight that way.
Suppose there is zero real growth, base money is 10% of Nominal GDP, and base money is growing at 10% per year. So there's a steady 10% annual inflation, and a steady flow of new money equal to 1% of GDP.
1% of GDP isn't peanuts. But it's not very big either. And I've stacked my assumptions to make it bigger than it would be in most normal economies. If NGDP is growing at 5% per year, and base money is 5% of NGDP, the flow of new money would be 0.25% of NGDP.
I will assume the government owns the central bank. Any profit the central bank gets from printing money is government revenue. We can consolidate the government's and central bank's balance sheets, so any interest the government pays on bonds owned by the central bank is a wash. The government is paying that interest to itself. The central bank earns profits of 1% of GDP, and gives those profits to the government, which decides how to spend them.
Let's compare 5 different ways the same flow of new money could enter the economy.
1. Interest on money. The baseline scenario is that all new money is paid as interest on existing money. So every year people earn 10% interest on their money, which exactly offsets the 10% depreciation through inflation. It's a wash. It's really just like a stock-split.
2. Helicopter money. Scenario 2 is that all new money is paid as transfers to the population. It's no different from scenario 1, except that the opportunity cost of holding base money is higher (because it depreciates through inflation but doesn't pay interest), so the real stock of money would be smaller. (Plus some individuals might get lucky and others unlucky depending on whether the helicopter does or does not fly over them.)
2a. Cut taxes. The government uses the new money to cut taxes. Same as scenario 2. A tax is a negative transfer payment. So a tax cut is a transfer increase.
3. Debt reduction. Scenario 3 is that all new money is handed over to the government, which uses it to retire government bonds. Scenario 3 is the same as an open market purchase of bonds by the central bank. Scenario 3 is identical to scenario 2, plus a tax of 1% of GDP used to pay down the debt. Does it matter if the government increases taxes to pay down debt?
4. Government spending. Scenario 4 is that all new money is handed over to the government, which uses it to buy goods. Scenario 4 is identical to scenario 2, plus a tax of 1% of GDP used to buy goods. Does it matter if the government increases taxes and spending? Obviously it matters whether the government buys bridges or schools or roads or whatever. One gives us more bridges and the other gives us more schools, or roads, or whatever.
5. Other financial assets. Scenario 5 is that all new money is used to buy some other financial asset, like shares in IBM. Since the government owns the central bank, it doesn't matter if it is the government or the central bank that buys the IBM shares. Scenario 5 is identical to scenario 2, plus a tax used to buy IBM shares. Scenario 5 is also identical to scenario 3, plus a bond-financed purchase of IBM shares. Does a bond-financed purchase of IBM shares matter? I expect it depends on how close substitutes the two assets are in people's portfolios.
Sorry. What was the question again? Was it: "Do Cantillon effects matter?" Or was it "Does fiscal policy matter?" I can't tell the difference. There is no difference. "Cantillon effects" are just another name for "the effects of fiscal policy".
OK. I suppose that Austrian economists believe that fiscal policy matters. I suppose it does. And monetary policy has fiscal implications, because a faster growth rate of the money supply will mean bigger seigniorage profits for the government (as long as we stay on the left side of the Laffer Curve).
But the size of those fiscal implications depends on the ratio of the monetary base to nominal GDP.
In Canada, non-interest paying currency is currently around 4% of nominal GDP. An increase in the inflation target from the current 2% to 12% would mean a 10 ppt increase in the growth rate of the money supply. That would be a very big change in monetary policy. Even if the currency/NGDP ratio stayed the same at 4% (it would fall), the fiscal implications of that very big monetary policy change would be 0.4% of GDP.
What do you think would be the bigger deal: increasing the inflation target from 2% to 12%, or changing taxes or government spending by 0.4% of GDP?
[Update: hoisted from comments. J. V. Dubois says:
"You guys really do not get the gist of what Nick is saying?
1. Seigniorage of government controlled money IS TAX on base money
2. "Where" and how much of newly printed money is injected – even if that has any effect on redistribution IS FISCAL POLICY.
If you say that it makes a great deal of difference (deforming long-term
capital structure etc) if money is injected into salaries of government
employees vs purchase of bonds, then you by the same argument think
that it makes a great deal of difference if government decides that from
now on it spends 0.25% of GDP gathered in taxes on one versus another.
If you for instance say that Bond Dealers gather undue profits from
these bond operations of the size of 0.25% GDP – then by the same
account you have to be outraged that those very same bond dealers gather
undue profits from regular yearly government deficits an order of
magnitude higher. It is a problem of interest group capturing government
and preventing competition from access to the bond market, it is not a
problem of money printing."]
Worthwhile Canadian Initiative 
Ritwik,
Really excellent, interesting comment (but perhaps too OT for me to respond to most of it). Your explanation #1 sounds like my perspective: a) Someone has to establish a common numeraire (unit of account), b) controlling that numeraire means controlling the risk-free nominal short rate c) controlling the nominal short rate also means controlling the real short rate because inflation expectations move in the opposite direction of the nominal short rate (this last bit is at the core of what’s so horribly wrong with the entire RBC literature). Since the monetary authority inevitably sets the real rate, they don’t have a choice but to have a monetary policy.
Here’s Sheldon Richman’s original article (it is only now online).
Bob: Long run (flexible prices): if a central bank permanently loosens monetary policy by raising the inflation target (increasing the money growth rate), nominal bond prices will fall.
Short run (sticky prices): if the central bank temporarily loosens monetary policy, but leaves the long run target unchanged, nominal bond prices may rise.
“Man, but you Austrian guys must think the market economy is an awfully fragile flower.”
Tyler Cowen made a similar point here:
http://marginalrevolution.com/marginalrevolution/2008/01/the-return-of-h.html
I’m also reminded of Noah Smith’s point that the “PSST”/”recalculation” view of the economy is one where the “invisible hand” doesn’t seem to do its work:
http://noahpinionblog.blogspot.com/2011/05/note-i-wrote-this-post-quite-while-ago.html
Alex, you said: “Yes, and when the Fed employs specific people, they receive two things: (1) …, and (2) a salary. But I don’t complain bitterly about how Ben Bernanke is getting rich off my tax dollars, and why can’t we ALL get salaries from the Fed, etc.”
But surely you know that there are large numbers of people who do see government salaries as being paid at the expense of hard-working ordinary people? Just because you don’t sympathize with a libertarian argument against coercively confiscating rescurces and funneling them into the hands of others doesn’t mean the entire argument is invalid.
At the minimum, then, we can agree that Fed OMOs are no different than gov’t salaries or gov’t subsidies.
RPLong:
Again, only inasmuch as the FBI is a toilet paper subsidy. The money going to banks is a minor operating cost of the Fed, and minuscule relative to actual things the Fed does. It is macroeconomically irrelevant.
K,
“c) controlling the nominal short rate also means controlling the real short rate because inflation expectations move in the opposite direction of the nominal short rate (this last bit is at the core of what’s so horribly wrong with the entire RBC literature).”
No, controlling the nominal short rate does not mean controlling the real short rate. Inflation expectations are only part of the story (they can affect liquidity preference). You are forgetting about credit (new money) demand and productivity.
This is a chicken and egg problem. The real short term interest rate is determined after the money is borrowed not before. If new borrowing increases the demand for goods more than the supply of goods then prices as measured in that money will rise. If new borrowing increases the supply of goods more than the demand for goods, then prices as measured in that money will fall. The price change happens after the money is borrowed.
If a consumer borrows money on his credit card to buy some good, then the immediate effect on prices is an increase in demand over the current supply – real interest rate falls. Likewise if a producer borrows money to fund the production of some good (pays employees), then the immediate effect on prices is an increase in supply over the current demand – real interest rate rises.
Cantillion effects can be liquidity preference issues that happen after newly borrowed money is spent.
Thanks Nick. One more from me please. (And I’m not asking these to trap you, I’m asking so I fairly recapitulate what your position is.) If the Fed were to suddenly dump its mortgage-backed securities and replace them with gold, would that have any impact on the real estate and mortgage industries, and the world price of gold, relative to the counterfactual? Again, list any caveats you need.
Frank, goods prices (particularly retail) are sticky – fixed, even – over time scales in which asset prices are fully flexible.
Alex, I thought we understood that I was not talking about macroeconomic relevance, but rather microeconomic relevance? So long as we agree that OMOs are conferring on specific individuals profits that they would not otherwise receive in absence of the existence of central banks, then we agree on every claim those crazy Austrians are making.
I agree with you and Sumner that the overall impact of these benefits is negligible with respect to the money supply and NGDP growth. So, too, would it be macroeconomically irrelevant if my personal salary quadrupled tomorrow. But no one would suggest that I am personally no better off in light of that quadrupling’s negligible impact on the macroeconomy.
I think we’ve reached a good meeting of the minds here, though. You now have all the information you need to see that the Austrian claims in this case are microeconomically significant; the Austrians likewise have all the information they need to understand that those same gains are macroeconomically irrelevant.
So we’ve cleared the debate up now, despite its requiring some five major economics blogs to do it. 🙂
Nick,
Is the key dispute here is over market competition?
I think you’re saying that competition squashes the Cantillon effects into a wealth subsidy. Sort of: “I know the Fed is buying stuff, but you guys could all sell that stuff to the Fed. Or buy up that stuff and resell it to the Fed.” If everyone knew that the Fed was going to buy up GM stock or bananas, then the producers and current holders of GM stock and bananas would adjust their prices higher (or the prices would be higher at equilibrium, whatever). The producers and holders get subsidized. Everyone else pays in real terms. But there’s no “price ripple” from the final sellers to the Fed and everyone else.
I think the wealth transfer argument is weaker for markets where producer entry is easy (and capital goods are not very specific?). If you see the Fed making the banana producers wealthier, then I’d like to also be a banana producer.
Also, if the Fed buys up stuff with a monopoly producer (say US government bonds), then only the producer (and those who hold this stuff when the policy is announced?) get subsidized. For government bonds, this “subsidy” is basically seniorage.
RPLong
No, because
1) The Austrian critique is not that the banks earning a few tens of millions in fees or whatever is this horrible distorting thing.
2) I’ll go one further and say it has no “economic” relevance at all. It is an incredible waste of time to even be talking about it. The “economic” distortion is, again, equivalent to the distortion caused by the government buying paper. No one talks about government purchase of office supplies as economic policy, no one cares about it at all.
Yes, your argument on this point has wasted space across many blogs. Are you proud that you’ve proven to everyone that the government – gasp – has to actually spend money on basic administration?
Note that the actual Austrians here (e.g. Bob) never talk about this stuff because they know it’s inane and irrelevant.
Frank,
r = i – pi, plain and simple.
The CB controls i. pi does not go up if the CB surprise-raises i (if anything, it goes down a bit). Therefore r goes up by at least as much as i. Therefore the CB has powerful control over r (ignoring the ZLB).
This is a very nice demonstration, Nick. Here I recommend how you can apply the same technique to another contentious issue. (I am trying a link in here; if it doesn’t work I will paste in the URL.)
Alex, did I miss something? Did I insult you (or anyone!) and not realize it? I posed a question I hoped Nick Rowe would answer – nobody begged you to engage me in any kind of discussion or debate. I am sorry that your need to respond to me resulted in a waste of your time. I am also sorry if I accidentally insulted you.
ssumner:
Nick, I of course agree that fiscal differences matter. I was discussing the Austrian view that if the central bank buys injects money by buying bonds, it depends who they buy them from. But fiscal policy is the same whether the bonds are purchased from person A or person B. I assume you agree with that. Appearently some Austrians don’t.
That wasn’t the initial dispute. You’re changing the subject. Austrians are not arguing that “fiscal policy” per se has to change if bonds are bought from A rather than B. They are saying that the Cantillon Effects take place when the Fed buys bonds, the same way it takes place when the Fed buys cars or gold.
Call it “monetary, not fiscal policy” if you want, but the Fed is doing it in the bond market.
Nick Rowe:
Bob Murphy asked:
In normal times (not when we’re up against ZLB), if the Fed decides to cut short-term interest rates and buys Treasuries, do you agree that this really does push down short-term interest rates (raise price of short-term safe bonds)? You can give whatever caveats you want, but I want to understand what power you think the central bank has over the market price of bonds, if any.
And you responded with:
Bob: Long run (flexible prices): if a central bank permanently loosens monetary policy by raising the inflation target (increasing the money growth rate), nominal bond prices will fall.
Short run (sticky prices): if the central bank temporarily loosens monetary policy, but leaves the long run target unchanged, nominal bond prices may rise.
If the Fed decides to lower interest rates, so that they can do what you call “boosting the economy”, and you believe that permanent inflation will not be able to keep rates low, and will raise rates in the long run, due to price inflation, then does that not mean that if the Fed wants to KEEP interest rates low (say for slightly more than “the long run”, and this can be longer than 1 year or 1.5 years or whatever), that the Fed has to increase the rate of monetary inflation, repeatedly, so that it can always exploit “sticky prices” so as to keep rates low and avoid the price inflation effects pushing interest rates back up?
Nick, I call your attention to Gene Callahan’s post above. You really need to read that please, when you get time. He has Mate in 3 moves.
“We can consolidate the government’s and central bank’s balance sheets”
Yow. Income statements too, by necessity? Going all MMT on us here. And: Where’s JKH when we need him? (http://monetaryrealism.com/treasury-and-the-central-bank-a-contingent-institutional-approach/)
“by the same account you have to be outraged that those very same bond dealers gather undue profits from regular yearly government deficits an order of magnitude higher.”
And I am. Just because people want or “demand” >0% nominal returns on perfectly safe assets doesn’t mean that the government is obligated to provide them. They could just be printing dollar bills instead of T-bills, and using some other vehicle to set the floor on interest rates.
IOR comes to mind, though of course that is also a “gift” to banks… Looking forward to JKH’s upcoming on the old “Chicago Plan” for full reserve banking.
Save your fingers, Nick.
While the controversy about public works was developing, Professor Robbins sent to Vienna for a member of the Austrian school to provide a counter attraction to Keynes. I very well remember Hayek’s visit to Cambridge on his way to the London School. He expounded his theory and covered a black board with his triangles. The whole argument, as we could see later, consisted in confusing the current rate of investment with the total stock of capital goods, but we could not make it out at the time. The general tendency seemed to be to show that the slump was caused by [excessive] consumption. R. F. Kahn, who was at that time involved in explaining that the multiplier guaranteed that saving equals investment, asked in a puzzled tone, “Is it your view that if I went out tomorrow and bought a new overcoat, that would increase unemployment?”‘ “Yes,” said Hayek, “but,” pointing to his triangles on the board, “it would take a very long mathematical argument to explain why.”
This pitiful state of confusion was the first crisis of economic theory that I referred to…
St. Hayek was just plain wrong.
Attributed to the august Joan Robinson.
K,
“r = i – pi, plain and simple. The CB controls i. pi does not go up if the CB surprise-raises i (if anything, it goes down a bit). Therefore r goes up by at least as much as i. Therefore the CB has powerful control over r (ignoring the ZLB). ”
The CB can set the nominal interest rate above or below the rate of inflation, this is true (limited by the ZLB). But that measure of the rate of inflation is based upon previous price changes. If the CB sets the nominal interest rate at some level and no one is willing to borrow at that rate, then has the CB set the “real” interest rate?
Step #1: Central bank sets nominal interest rate at some level
Step #2: Individual / Company / Government borrows money at that rate and spends the money
Step #3: Depending on how that money is spent prices could rise or they could fall
Only a Keynesian could conflate a decrease in government expropriation with a “transfer increase.” That is much like saying if a man is holding another man’s head under water and decides to stop holding him under water, he has increased him.
It’s also like mobsters deciding not to collect protection money one week and treating the money they have not stolen as an “increase” to those who were left in peace.
…very, very odd logic.
(I didn’t finish that thought…which is why it is very odd logic for a non-Keynesian to use)
I start by seeing this:
Scott Sumner and Bill Woolsey have been fighting valiantly against the Austrians. The fight is about “Cantillon effects” — non-neutralities of money that are supposed to arise not from the increase in the money supply itself but from where exactly that new money enters the economy.
I think, oh, you mean like different fiscal multipliers? And then end up reading this:
Sorry. What was the question again? Was it: “Do Cantillon effects matter?” Or was it “Does fiscal policy matter?” I can’t tell the difference. There is no difference. “Cantillon effects” are just another name for “the effects of fiscal policy”.
Pats self on back
Although the name sounds familiar, I can’t recall “Cantillon effects” being discussed in any other context, or in any of my textbooks. Romer’s Macro is right here, and that’s not in it.
Are the Austrians basically like Marxists – with their own vocabulary, frequently just to describe very mundane phenomena?
I can’t recall “Cantillon effects” being discussed in any other context, or in any of my textbooks. Romer’s Macro is right here, and that’s not in it.
Must not be important then.
Frank:
Measured inflation is based upon previous price changes. Current inflation (alternately: expected inflation) is an instantaneous thing that exists and has some value even if we can only measure it ex post.
Must not be important then.
You get ten internet points for snark – but actually, yeah, important macroeconomic concepts usually show up in recent macroeconomic textbooks.
The Austrians love the market. In the market for ideas, Austrian economics hasn’t done well. Should this not give one pause?
There is definitely a stocks vs flows issue here. If you ignore the stocks aspect–all exchanges are of new production, I think you will get a different answer.
The OMO is income to someone. Now suppose P > MC. So the seller is not merely transferring assets at cost. it isn’t an exchange of like for like. So, there is a profit. Now, we have utility from the transaction. This person then exchanges the income for goods and the seller profits, and again there is utility.
When the Fed buys treasuries, these first around effects accrue to the monopolist who manufacturers treasuries: the treasury.
Proper name for them: Falscher Osterreichischer Sturmtruppen.
Alex,
“Current inflation (alternately: expected inflation) is an instantaneous thing that exists and has some value even if we can only measure it ex post.”
For the federal reserve to set or have any control over the real interest rate they must have foresight of what future inflation will be. Sure inflation expectations and their affect on liquidity preference shape future realized inflation but those are not the only factors.
The central bank could expect 5% inflation and only get 1%. If a central bank sets the nominal interest rate to 8%, expects 5% inflation, and gets 1% inflation, what is the real interest rate that was set by the bank – 8% nominal – 5% expected = 3% real or 8% nominal – 1% realized = 7% real?
Credit demand and productivity also shape what future inflation will be.
Yes, if they want to fine-tune the real interest rate they would need that. But since inflation expectations and nominal interest rates tend to move in opposite directions (in the short term), the central bank can be reasonably sure that a cut in nominal interest rates will cause a cut in real interest rates, even if they aren’t sure of the precise magnitude.
(Also, they can get a pretty good measure of inflation expectations right after the cut by looking at TIPS spreads.)
Alex,
“Also, they can get a pretty good measure of inflation expectations right after the cut by looking at TIPS spreads.”
TIPs spreads presume the existence of TIPS. They are a relatively new invention (first introduced in the US by Bob Rubin in 1997). TIPs are a form of debt that pays a fixed interest rate plus a measure of previously incurred inflation. Ultimately the value of TIPs is influenced by previously incurred inflation AND the supply and demand for TIPs.
Suppose the federal government decides to run a budget surplus and reduce the quantity of TIPs in circulation relative to the quantity of nominal bonds in circulation. The spread between TIPs and nominal bonds closes – but not because of a change in inflation expectations.
1. How does the central bank separate supply / demand changes in TIPs & nominal bonds versus changes in inflation expectations?
2. Ultimately inflation expectations are one way to look at changes in liquidity preference, but the two can move in opposite directions. Inflation expectations can rise while liquidity preference also rises. People can expect higher prices (war induced supply shortage) while still having a high liquidity preference (recession induced loss of permanent income).
“The central bank can be reasonably sure that a cut in nominal interest rates will cause a cut in real interest rates, even if they aren’t sure of the precise magnitude.”
If that were the case then the deflation of the Great Depression could never have happened.
Alex,
[ INT * ( 1 – LP ) / LP + f'(t) / LP ] / ( 1 + IR ) = PROD
IR = [ ( INT * ( 1 – LP ) / LP + f'(t) / LP ) / PROD ] – 1
Inflation Rate = [ ( Nominal Interest Rate * ( 1 – Liquidity Preference ) / Liquidity Preference + Change in Credit Demand with Respect to Time ) / Productivity ] – 1
INT – Nominal interest rate is set by Federal Reserve
f(t) – Change in credit demand with respect to time is set by combination of market and government
LP – Liquidity preference is set by combination of market and government (liquidity preference of government is 0)
PROD – Productivity is determined by market
If the change in credit demand with respect to time is sufficiently negative, then the inflation rate will go negative irrespective of the nominal interest rate.
Frank:
Well then it’s a good thing that they really do exist, don’tcha think? 😉
Possibly (probably?) not. It depends on three things:
1) The demand for inflation hedges.
2) The supply of inflation hedges (including but not limited to TIPS).
3) The supply of TIPS (only at the extreme end; if TIPS are sufficiently rare then the market in them will be illiquid).
Basically, so long as the demand for inflation hedges doesn’t so far outstrip the supply as to make them unsubstitutable with other financial assets, the TIPS spread should be a pretty decent measure of inflation expectations.
Regarding all the equations, I don’t see how you are improving on the simple model of:
[Expected] Real Interest Rate = Nominal Interest Rate – [Expected] Inflation
combined with “If I, Ben Bernanke, announce a nominal interest rate cut, ceteris paribus expected inflation will probably go up,”
to get “therefore reducing the nominal interest rate will also reduce real interest rates”.
Alex,
Regarding all the equations, I don’t see how you are improving on the simple model of:
[Expected] Real Interest Rate = Nominal Interest Rate – [Expected] Inflation combined with “If I, Ben Bernanke, announce a nominal interest rate cut, ceteris paribus expected inflation will probably go up,” to get “therefore reducing the nominal interest rate will also reduce real interest rates”.
The simple model of interest rates does not include
1. Someone must borrow at those rates for them to have any economic effect ( credit demand = f(t) )
2. Someone who borrows the money must spend the money for it to have an economic effect ( liquidity preference = LP )
3. How the money is spent will determine in part what the economic effect of the money is ( productivity = PROD )
IR = [ ( INT * ( 1 – LP ) / LP + f'(t) / LP ) / PROD ] – 1
Realized inflation does not depend on inflation expectations but instead on liquidity preference, productivity, nominal interest rate, and credit demand.
Hasn’t economics evolved beyond confidence fairies, inflation expectations, and pink unicorns?
Alex,
Snipe hunt much?
Re: my previous, I see that JW Mason has a new post coming at this the same way, about the IMF’s reincarnation of the Chicago Plan:
“If government liabilities are more liquid than the liabilities of even the biggest banks, as they certainly seem to be, then the banking system plays no function with respect to federal borrowing. The banks that hold federal debt are providing “anti-intermediation” — they are replacing more liquid assets with less liquid ones. In this sense, whatever income banks get from holding federal debt and providing means of payment are pure rents – it would be more efficient for federal liabilities to serve as means of payment directly.”
Or as I said, issue dollat bills instead of t bills.
“The goal of the plan is to, in effect, collapse the categories of inside money, outside money and government debt by eliminating the first and turning the third into the second. Equivalently, it’s an attempt to legislate the economy into functioning the way monetarists (and some MMTers) say it already does”
The way it’s depicted here, no?
Edmund: Austrians are indeed like Marxists. Something about central european water?
Loser in the market for ideas? They should heed Chris Dillow moto “An extremist not a fanatic” but like all true believer the smaller the number of followers, the truer they are to the faith.
BTW, my german being rusty I tried Babelfish
in french: Incorrects Beauceron storm troopers
in english: Incorrect Beauceron storm troopers
in italian :Errata Beauceron storm troopers
Canadian readers ,and Québécois especially, will appreciate. We know Beaucerons have a reputation for hardy entrepreneurship but at that level…?
Googletranslate got it but it isn’t as fun… so I might get into a Google
automatic car but probably not in a Yahoo one…
BAck to grading
Frank:
<
blockquote>Realized inflation does not depend on inflation expectations but instead on liquidity preference, productivity, nominal interest rate, and credit demand.
<
blockquote>
Most of us assume that market forecasts of inflation have at least some predictive value. But fine, let’s throw that one out. Which do you think is more likely:
1) If the Fed cuts nominal interest rates, inflation will probably go up (relative to what it otherwise would have been).
2) If the Fed cuts nominal interest rates, inflation will probably stay the same.
3) If the Fed cuts nominal interest rates, inflation will probably go down.
4) None of the above
If we live in universe 1 or 2 (most people believe we usually live in 1) then reducing nominal interest rates also reduces real interest rates.
Steve Roth:
Bank liabilities (i.e. deposits) are far more liquid than T-Bills, reserves, or even currency. I can use my debit card at the store; I can’t use T-Bills or reserves, and currency is inconvenient to carry around.
Alex,
None of the above. That is why I went through the process in my head and on paper on how realized inflation can be calculated. Obviously this calculation is way oversimplified. It does not include equity financing, it does not include fiscal policy effects (taxes, government spending, etc.), it does not included default premiums in private credit (AAA, BBB, junk debt), it does not include trade balance and currency effects, and it does not include a few other things that I am missing.
What I was trying to do was isolate the independent variables of choice (credit demand, liquidity preference, nominal interest rate, productivity) from a result (inflation or lack of inflation). Inflation / deflation is a result of economic choices, it is not an original input. Of course past changes in inflation can affect future choices (feed back effects), but those need to be modeled as such.
Frank:
OK, so I went back and looked at your equation. Let’s take the partial wrt INT, howabout?
IR = [ ( INT * ( 1 – LP ) / LP + f'(t) / LP ) / PROD ] – 1
dIR = (dINT*(1-LP)/LP)/PROD
LP and PROD are supposed to be positive numbers, right? Thus sign(dIR) = sign(dINT), so you think we live in world 3. This should give you pause, because AFAIK pretty much no one else believes this and it is opposite the usual intuition.
Alex,
IR = [ ( INT * ( 1 – LP ) / LP + f'(t) / LP ) / PROD ] – 1
dIR/dt = dINT/dt * ( 1 – LP) / ( LP * PROD ) + f”(t) / ( LP * PROD )
You forgot that credit demand ( f(t) ) is a function of time as well. And so sign( dIR/dt ) may not equal sign ( dINT/dt ).
I said partial derivative with respect to the nominal interest rate. There’s no dt.
Alex,
Sorry. I misunderstood your terminology.
dIR/dINT = ( 1 – LP ) / ( LP * PROD )
Assuming that credit demand, liquidity preference, and productivity are constants – yes lowering nominal interest rates will lower the inflation rate. That is a lot of assumptions.
Jacques,
I was going for “false Austrian storm troopers” with what little German I know.
Assuming that credit demand, liquidity preference, and productivity are constants – yes lowering nominal interest rates will lower the inflation rate. That is a lot of assumptions.
Understated.
Frank: “Assuming that credit demand, liquidity preference, and productivity are constants – yes lowering nominal interest rates will lower the inflation rate.”
Oh Christ