Imagine you lived in a world where the central bank issued two types of money: paper money; and electronic money. If you want to pay for something with the paper money, you have to physically transfer it. If you want to pay for something with the electronic money, you just need to tell the central bank to transfer it for you, perhaps by setting up an automatic system (just like how I pay for my car insurance now).
The two monies have a pegged exchange rate of one. The central bank swaps paper money for electronic money at par, on demand.
Anyone can use the paper money, but only a very select group of customers are allowed to use the central bank's electronic money.
The paper money always pays 0% interest nominal. The electronic money can pay whatever nominal interest rate the central bank chooses to pay.
The nominal interest rate on paper money is always 0%, but that does not mean the real interest rate on paper money is always 0%.
The strategic objective of the central bank is to try to ensure that the real interest rate on the paper money does not vary over time. It targets a fixed real interest rate on paper money.
The central bank adjusts the nominal interest rate on electronic money to try to hit that target real interest rate on paper money.
The central bank has a theory about the relationship between the nominal interest rate on electronic money and the real interest rate on paper money.
According to that theory: if the central bank wants to lower the real interest rate on paper money (because it thinks there's a danger the real interest rate on paper money will rise above target unless it does something) it needs to lower the nominal interest rate on electronic money. The central bank calls this the "short run" part of its theory.
But, according to that same theory: if the central bank's target for the real interest rate on paper money were lower, the nominal interest rate on electronic money would need to be higher. The central bank calls this the "long run" part of its theory.
Very few people understand the central bank's theory. Even some very good monetary economists don't get the short run part, and think that if the central bank wants to lower the real interest rate on paper money, all it needs to do is raise the nominal interest rate on electronic money.
Just in case you haven't figured it out yet: this is not an imaginary world. It's the real world. But it definitely is weird. Only a finance theorist could have dreamed up a world this weird.
Worthwhile Canadian Initiative 
“Now let the apple producer produce one more apple, and the banana producer produce one more banana, and let them both do a barter swap of one apple for one banana.”
In Gali’s model, there’s nothing to stop them from doing that; as I say, any agent can sell at Pa and buy at Pb, with no net change in money held. (You’re not alone in having made these points before.)
The fact that both Kevin and Jeff are clearly very bright, and have been well-trained (or have trained themselves well) in New Keynesian (Neo-Wicksellian) macroeconomics, is what I find very depressing. Because it is being left to a clapped-out old guy like me to explain this very basic point in monetary economics. For all Woodford’s brilliance (and he is brilliant) he has created another Dark Age in macroeconomics, by focussing our attention on interest rates and away from monetary exchange. People used to understand this point, back in the olden days, of disequilibrium macro.
A comment of mine seems to have gone astray. Such is life.
Nick, I haven’t forgotten the days of disequilibrium macro. But you’re making a claim about the NK model which is not a disequilibrium model. There’s no axiom involved which effectively prohibits barter. If A and B want to swap apples for bananas, where does Gali say they can’t? The problem is, they don’t want to, because the prices they are required to trade at are not optimal prices.
Kevin: I fished your comment out of the spam filter. It seems to be playing up again.
“There’s no axiom involved which effectively prohibits barter. If A and B want to swap apples for bananas, where does Gali say they can’t?”
AFAIK, he doesn’t. It’s an implicit assumption. he probably doesn’t realise he’s making it. Which is the problem. Like Jeff, he is saying “Look at the consumption-Euler equation! See! Consumption and output must fall if the central bank sets r above r*!”!”
“The problem is, they don’t want to, because the prices they are required to trade at are not optimal prices.”
If both apple and banana producer have the same elasticity of demand curve, and if the Calvo fairy has visited neither since the last shock, then the relative price Pa/Pb will be exactly the same as in perfectly competitive frictionless equilibrium.
If you allow free barter at the NK relative prices, then the only difference that Calvo pricing makes is that relative outputs will be distorted.
Yes, relative prices can be exactly what they would be with no output gap. But that’s not enough, because all agents know that the disruption caused by the creaky pricing mechanism will affect their real incomes.
Here’s a version of your argument which does work, I think, though it doesn’t quite give you what you want:
Suppose agents are allowed to make contingent contracts of the following sort: for as many future periods as A and B find themselves constrained to trade at their existing prices, they commit to supply each other with goods of equal value. Once one of them is free to change price, the contract expires. That arrangement increases the lifetime income of both parties and consequently it supports their demand for each others’ products. I think that works. But it’s crucial that it applies (with Prob > 0) to one or more future periods.
BTW, thanks for the kind words but at 62 I’m pretty sure I’m older than you and I’m certainly more clapped-out! Even thinking about this stuff wears me down, never mind blogging about it. Many thanks for the effort you put in.
Now for my nightcap.
Nick, have you ever brought any of these points up to Woodford directly? JP Koning wrote him an email once and he responded. For all I know, you guys converse on a regular basis… but I don’t get that impression.
“clapped-out” eh? Is that a Canadian thing?
Kevin: “Yes, relative prices can be exactly what they would be with no output gap. But that’s not enough, because all agents know that the disruption caused by the creaky pricing mechanism will affect their real incomes.”
Fair point. Calvo pricing will disrupt relative output prices, which will make real income lower than it would be with perfectly flexible prices, even if we allow barter at those relative prices.
But this to me is the important point: the Consumption-Euler equation will not determine consumption, if we allow barter. Agents will be “off” their consumption-Euler equations.
Tom: “clapped out” is Brit (and Aussie and NZ and Irish?) slang. Usually applied to old cars.
Nick, you’re description of the “long run” part of theory is somewhat misleading. The accurate way to state it is, “If the Central Bank successfully achieves it’s target to lower the real interest rate on paper money, then the nominal rate on electronic money will be higher.
Which, BTW is obvious and trivial even when described in an obtuse manner.
D.T.: OK. Your wording of the long run part is better than my original.
Is the Fisher effect that obvious and trivial? Try explaining it to some heterodox economists!
(And remember that money will generally not be precisely super-neutral, if the nominal interest rate on currency is stuck at 0%.)
“Like Jeff, he is saying “Look at the consumption-Euler equation! See! Consumption and output must fall if the central bank sets r above r*!”!””
Seriously?!? That stupid comment is all you heard me say? I must have patiently repeated at least 3 times how disparate agent preferences which result in inter-agent borrowing could aggregate to a representative agent with non-zero EIS. I gave you words about rational choices of indebted economic agents, not equations! You never replied to it, and now I see you simply ignored the explanation, and accuse me of just pointing moronically at an equation, like some kind of autistic savant.
Nick,
Was the Kocherlakota brouhaha about the sort of thing you explain in this post?
………..
Alex: “I don’t like this post. It looks convoluted and non-informative to me. I have a suggestion: try to reformulate it in the terms of supply and demand.”
NR: It is supposed to look convoluted and non-informative. The whole point of the post was to show how weird things look when you only talk about interest rates and don’t talk about supply and demand!
………..
I like this post very much.
It looks like an incisive and very direct explanation of central bank generated interest rate cycles to me.
It’s the opposite of convolution – as far as the explanation of how it works is concerned.
I suppose I should be worried.
Jeff: I am perfectly willing to grant the NK assumption of a representative agent with a non-zero elasticity of intertemporal substitution, (for the purposes of this argument).
In general you can not aggregate heterogenous agents into a representative agent, but all models need to make simplifying assumptions, and that assumption of a representative agent with non-zero elasticity of intertemporal substitution is not what I am arguing against.
The reason I ignored your argument about aggregating heterogenous agents into a representative agent is that you were using an argument I did not agree with to persuade me to accept an assumption I was already perfectly willing to accept without that argument.
The standard NK model assumes agents with identical preferences with non-zero EIS. Let us accept that assumption. The standard NK model says that if the central banks sets r above r*, then C and Y will fall below C* and Y*, according to the consumption Euler equation. Let us see if that conclusion still follows if agents can costlessly barter at the sticky relative prices.
JKH: “Was the Kocherlakota brouhaha about the sort of thing you explain in this post?”
Yes. I think it’s related.
Nick: “Is the Fisher effect that obvious and trivial? Try explaining it to some heterodox economists!”
What is a heterodox economist?
Nick: “(And remember that money will generally not be precisely super-neutral, if the nominal interest rate on currency is stuck at 0%.)”
By this are you referring to changes in V caused by changes in nominal r on non-currency money.
Nick: “The standard NK model assumes agents with identical preferences with non-zero EIS. Let us accept that assumption. The standard NK model says that if the central banks sets r above r*, then C and Y will fall below C* and Y*, according to the consumption Euler equation. Let us see if that conclusion still follows if agents can costlessly barter at the sticky relative prices.”
Don’t want to jump into the middle of an entertaining discussion, but wouldn’t that require perfectly elastic supply and demand curves.
Nick,
Having slept on it I think you have a point, but it’s not the point you think you have. I’m pretty sure this monetary-exchange-versus-barter discussion obscures the issue. In Gali’s model, any barter transaction you might contemplate can be accomplished simply by transforming it into a Goods -> Money -> Goods transaction. So nothing which barter can do is actually ruled out; at least, it’s not explicitly ruled out.
Where I think you have a point is this: the equilibrium concept is a bit dodgy. The firms are monopolistic competitors whenever they get the okay from Calvo. But what are they at other times? They are price-takers of a sort. But of what sort, exactly? After all, Keynes’s firms are price-takers too, but not in the sense that Walras intended.
I might look for Calvo’s original paper which introduced this trick and see just what his ground-rules were.
DT: “What is a heterodox economist?”
Good question! I don’t really like that term myself, because all of us have different beliefs about different things. But, for this purpose, it means “those who self-identify as heterodox economists”.
“By this are you referring to changes in V caused by changes in nominal r on non-currency money.”
That wasn’t what I had in mind. What I had in mind was: if money growth increases, and inflation increases, the real rate of interest on currency falls, so people will hold smaller real currency balances, which is one real effect, and that real effect will sometimes cause other real effects too, depending on the model.
“Don’t want to jump into the middle of an entertaining discussion, but wouldn’t that require perfectly elastic supply and demand curves.”
I don’t think so. As long as they aren’t perfectly inelastic.
Kevin: take a very simple case. Suppose you and I buy from each other. Start in competitive equilibrium, then double both our prices (by law). I want to buy less from you, and you want to buy less from me. You want to sell more to me, and I want to sell more to you. The short side rule says we both actually buy and sell less from each other. (It’s a mini-recession.) But I can offer you a deal, that can get us both out of our mini-recession. “I will buy $100 more bananas from you if and only if you buy $100 more apples from me in return.” You would accept that deal. But that deal, where I give you $100 in exchange for bananas, and you give me that same $100 right back in exchange for apples, is identical to a barter deal, where we forget about the $100.
The equilibrium concept: Suppose we have an economy with n goods, each good produced by one firm. Cournot Nash equilibrium is well-defined. Each firm sets its own Qi taking others’ Qj as given. But Bertrand equilibrium is not well-defined. We cannot have n firms setting n-1 relative prices. We need some n+1st good, so that each of the n firms can set Pi in terms of the n+1st good. We definitely need an extra good to serve as medium of account. My argument is that it matters a lot whether that n=1st good also serves as medium of exchange.
The key assumption in NK models with monopolistic competition is that firms choose Pi (when the Calvo fairy lets them) and customers choose Qi. (I’m OK with that assumption, but if we changed it we would get very different results.)
“But that deal, where I give you $100 in exchange for bananas, and you give me that same $100 right back in exchange for apples, is identical to a barter deal, where we forget about the $100.”
That’s my point exactly! If an ideal barter economy can solve the problem, then a monetary economy can too, since it doesn’t cost anything to book two deals involving money for goods, instead of one deal involving goods for goods. Barter solves nothing unless it permits a deal which would otherwise be impossible.
I had a quick look at Calvo (1983). There seems to be a tacit assumption that all trades take place in a market and the kind of deals you envisage are ruled out. But that’s not stated explicitly.
In other words, I think there’s an unstated assumption in the NK model that I can pocket your $100 and leave you holding both kinds of fruit. So naturally you won’t part with your $100 in the first place. We can’t write a contract which ensures completion of a compound, equivalent-to-barter deal.
Kevin: Great! We are in agreement.
In practice, of course, it would be very unlikely that the purely pairwise trades would get an economy out of recession. If I bought bananas from you, and you bought carrots from Jeff, and Jeff bought apples from me, then all three of us would need to meet together to do a 3-way deal. And that meeting would be hard to arrange. And this is precisely why people use a medium of exchange instead.
“There seems to be a tacit assumption that all trades take place in a market and the kind of deals you envisage are ruled out. But that’s not stated explicitly.”
I would say there seems to be a tacit assumption that all trades are pairwise trades using a medium of exchange and only one other good. But yes, it is not explicit. I think it needs to be made explicit. Otherwise people think that money is not in the model, except as a medium of account.
Nick said: “According to that theory: if the central bank wants to lower the real interest rate on paper money (because it thinks there’s a danger the real interest rate on paper money will rise above target unless it does something) it needs to lower the nominal interest rate on electronic money. The central bank calls this the “short run” part of its theory.”
And, “That wasn’t what I had in mind. What I had in mind was: if money growth increases, and inflation increases, the real rate of interest on currency falls, so people will hold smaller real currency balances, which is one real effect, and that real effect will sometimes cause other real effects too, depending on the model.”
Are you assuming that “money” growth increases means the nominal interest rate falls on electronic “money” of the central bank (EMCB)?
I don’t believe the second part has to be true for firms like Apple. If prices go up and quantities stay the same or go down, Apple is not going to use currency or demand deposits to expand capacity. I think you are assuming an aggregate demand shock. What if it isn’t an aggregate demand shock?
The central bank announces QE at the zero lower bound. They buy a gov’t bond from Apple. Apple holds the demand deposits. Nothing happens. The fed gets an existing bond. Apple gets new demand deposits as an asset and a liability of Apple’s bank. The bank where Apple has its account gets its EMCB account at the fed marked up where EMCB is its asset and the fed’s liability.
“The two monies have a pegged exchange rate of one. The central bank swaps paper money for electronic money at par, on demand.”
Now add demand deposits that are 1 to 1 fixed convertible to currency.
And, “That wasn’t what I had in mind. What I had in mind was: if money growth increases, and inflation increases, the real rate of interest on currency falls, so people will hold smaller real currency balances, which is one real effect, and that real effect will sometimes cause other real effects too, depending on the model.”
Will that part still work if demand deposit growth is substituted for “money” growth?
Nick,
“The reason I ignored your argument about aggregating heterogenous agents…”
If you repeatedly ignore someone’s extensive explanations, and just keep reasserting your premise (agents are all the same), they are going to think you aren’t listening at all. How would I know if you are even reading what I’m writing? This is a lot of work.
“let the apple producer produce one more apple, and the banana producer produce one more banana, and let them both do a barter swap of one apple for one banana. Both agents are better off. The marginal utility of a extra banana (apple) exceeds the marginal disutility of the extra labour need to produce an extra apple (banana).”
I’ll give you a loan (at the policy rate) to buy my apple, but I’m not buying your banana! Instead I’ll cut my consumption, invest my savings above the natural rate, wait one period and then have a fruit salad party when I collect your loan.
Am I being irrational?
Jeff: “Am I being irrational?”
That depends. If someone else wants to buy all the apples you want to sell, and wants to borrow from you to finance those apples, you are not being irrational. But if you find that other people don’t want to do that, so you can’t sell as many apples as you want to sell, and they can’t sell as many bananas as they want to sell, then you (and they) would be irrational to turn down a barter deal.
Nick,
Lets assume your barter solution works. In that case it must work for any pair of goods, including identical goods, so if you can prevent a recession in a two-good world, you can also prevent one in a one-good world, which makes the analysis simpler.
Lets say we have lots (millions) of agents. The CB sets the real rate at 100% and I decide to reduce my consumption by 100% this period (assume linear utility), so I can consume 300% (100% of my output plus I double my savings at the 100% real rate) in the next period. Since there are lots of agents and a large lending market, there is no way the rest of you can coordinate to prevent me from depositing almost all my attempted savings (lets assume that lending is anonymously intermediated). By defecting, I will fail to save my attempted savings only in proportion to my fraction of the whole economy. I.e. I will succeed almost perfectly. So I’m arbitraging the rest of you in a big way, and very quickly everyone is going to join in and help me cause a depression. But if the rest of you all hold out, I’m just going to make big profits. Your equilibrium is not stable. In a world with many players, there is no way to coordinate against a defector.
Jeff: OK. I’m pretty sure I am following you in this example. To keep it simple, assume zero investment, G, and NX. So C=Y.
So you buy zero output from others. Suppose everyone else does exactly the same as you. So nobody buys any output. So your income is zero, and so is everyone else’s. We have a very big recession. 100% unemployment rate. And since your income is zero, you cannot save and lend.
[If it were literally a one-good world, you would now produce output for your own consumption, because it is better than sitting idle. But let’s assume there is a taboo against eating apples you have produced yourself, so you can’t do that.]
So I offer you a deal: I will buy X apples from you, and you in return will buy X apples from me. You will accept this deal (unless X is very large).
You would prefer that I buy apples from you, without you buying apples from me, so you could save and lend your income. But nobody is offering to do that, in a recession, if you are unemployed. So your second-best action is to accept my deal.
In a one-good world, a pairwise trade gets both people back to full-employment.
The tricky case is where we have n goods. A produces apples, and wants bananas; B produces bananas and wants carrots; C produces carrots and wants dates; D produces dates and wants eggs; and so on in a very big circle; until X produces xylophones and wants apples. All 26 people in the Wicksellian circle have to meet together to do a 26-way barter deal. Which is a hard deal to negotiate and a hard deal to enforce (witness the UN.)
But it is precisely because 26-person deals are hard to do that people use a medium of exchange. That’s why people use money. If we assume that people need to use money as a medium of exchange, in the NK model, it all starts to make sense. But you can’t implicitly assume a medium of exchange, and then turn around and say that money is only a medium of account in NK models.
Nick,
I think you meant a 24-good economy!
“But it is precisely because 26-person deals are hard to do that people use a medium of exchange.”
Not hard. Impossible! The problem is apples are produced in the fall and last a few days, while bananas are produced year round; dates are produced in the fall, but last a long time; a xylophone is really a capital good, bought rarely buy consumed frequently. All of which means that trade is intrinsically intertemporal so exchange happens via intermediated credit balances, not simultaneous exchange. So money doesn’t solve anything that credit can’t solve, but credit, also solves the intertemporal exchange problem. Now modern credit uses central bank liabilities as the unit of account, but nowhere have I “assumed” the need for any outstanding quantity of a medium of exchange. Just centrally intermediated credit balances.
Now back to our one-good example:
I see your game now. You are circumventing the banking system by
extracting a self-sufficient coalition, like in the core equivalence theorem (We’re going Galt!). The problem is that in a modern economy such a coalition is going to have to be big enough to sustain its own currency and banking system, and also legally extract itself from the sovereign jurisdiction (governments don’t take kindly to circumvention of their currency). The cost of doing so are probably well described by the optimal currency area literature, but it’s obviously more favoured if the central bank is running a really crappy monetary policy. But given that Greece hasn’t left the Euro, it must take some seriously bad policy for a coalition to break off.
Which is to say, real rates matter and can have huge impacts on economies without the financial system being circumvented by self-sufficient coalitions (or barter, as you say).
Nick: “But you can’t implicitly assume a medium of exchange, and then turn around and say that money is only a medium of account in NK models.”
I think we’re in agreement and then you write something like this. This Medium of Account/Medium of Exchange stuff confuses the issue I think.
In the NK model we have a law which says:
Rule 1.1) You may not exchange apples directly for bananas;
Rule 1.2) If you try to circumvent Rule 1.1 by setting up a compound deal which exchanges apples for money and money for bananas, your counterparty can leave you with twice the amount of fruit you want and no money.
The crux of the matter is that you can’t work around the Calvo pricing system. It’s not about the nature of money. It’s got more to do with how you calculate your lifetime income. That is defined in terms of how much you can sell on the trading-floor, so to speak; the fact that you could increase your purchasing power by doing fancy bespoke deals is irrelevant because such deals aren’t enforceable, whether they employ money or not.
But I very much agree with you on the need for New Keynesians to make this aspect of the model explicit. What you’ve changed my mind about is the relevance of the old “Disequilibrium Macro” literature. That stuff clarified what was going on in Old Keynesian models. NK models need similar clarification.
Nick said: “So you buy zero output from others. Suppose everyone else does exactly the same as you. So nobody buys any output. So your income is zero, and so is everyone else’s. We have a very big recession. 100% unemployment rate. And since your income is zero, you cannot save and lend.”
Jeff, did you mean that you save all your income (say $1,000) and lend all $1,000 to someone else so that other person can keep spending?
Jeff said: “Now modern credit uses central bank liabilities as the unit of account”
What about demand deposits?
Let’s summarize: Kevin changed his mind slightly, but Nick and Jeff haven’t budged a bit. Correct?
Too Much Fed,
“did you mean that you save all your income”
Yes
“What about demand deposits?”
Those are also denominated in units of central bank liabilities. But we don’t need any quantity of central bank liabilities as a medium of exchange (that would be way too much Fed!).
Kevin,
I agree with pretty much everything you are saying. But not this:
“I very much agree with you on the need for New Keynesians to make this aspect of the model explicit.”
There is no shortage of literature complaining about Calvo pricing. It’s a well publicized fact that explicitly time-dependent (rather than state-dependent) price setting is weird, and it would be nice to have better micro foundations. Even the chapter in Woodford’s book is littered with discussion about the meaning and the theoretical limitations and evidence for and against the Calvo model. It’s not like the experts have never thought about this stuff and are obliviously waiting for someone to notice.
Jeff said: “”What about demand deposits?”
“Those are also denominated in units of central bank liabilities.”
I’m not sure about denominated in central bank liabilities. There is 1 to 1 fixed convertibility.
And, “But we don’t need any quantity of central bank liabilities as a medium of exchange (that would be way too much Fed!).”
Can you expand on that one? Are you saying there should be no currency?
What do you think is the MOA in the USA? You can’t just say dollars. Be more specific.
Nick, just curious: have you read Woodford’s book?
Too Much Fed:
“Can you expand on that one? Are you saying there should be no currency? What do you think is the MOA in the USA? You can’t just say dollars. Be more specific.”
It sounds like he’s saying the UOA for bank deposits is dollars. I think he’s implicitly also saying that bank deposits are an MOE, but they are not the MOA: thus bank deposits work fine for an MOE: no need to print up reserve notes to do the job. That would be “too much Fed” (Haha). That’s my read! I’m not sure he’s getting the idea that you are theorizing that bank deposits themselves are MOA. And if he is getting that, then I think he’s implicitly rejecting it. You might still be the only one in the world that thinks that. 😀 … well actually you might be able to convince Cullen Roche … if you could get him to agree that UOA, MOA, and MOE are super important concepts, which I’m not sure he’s inclined to do. I’ve tried to drag him into that kind of discussion and he’s never shown much interest, suggesting that people are overthinking the concept(s). I also tried dragging Mark A. Sadowski into it (I was hoping Sadowski would swoop down with a storm of empirical data to demonstrate that either Nick or Scott were on thin ice regarding their differences on this subject). But he too was reluctant to get dragged in, saying he could find nothing testable to distinguish Nick’s and Scott’s views. So good luck with your quest!
Jeff,
Thanks, I should read Woodford’s book. I’ve been relying on Gali, who does most things well but not quite all. I don’t doubt that these guys think hard about their theory. But from what I’ve seen they have not done a good job of communicating it, to students and indeed to other professors. Something is wrong when John Cochrane can write “the marginal propensity to consume is exactly and precisely zero in the new-Keynesian model”, which is really quite blatantly false, without being subjected to hoots of derision.
Jeff: “So money doesn’t solve anything that credit can’t solve, but credit, also solves the intertemporal exchange problem.”
Since there is always a delay between selling and buying, and we hold money in between, money also solves the intertemporal exchange problem.
But I think money vs credit can be a false dichotomy. Some credit is not used as a medium of exchange (my IOU’s for example). But other credit can be used as a medium of exchange (Bank of Canada IOUs for example).
Imagine that the central bank issues paper currency, which people use as a medium of exchange. Every other good is bought and sold for paper currency. The central bank pays interest on that paper currency (ignore the practical difficulties), and can vary that rate of interest, and chooses to vary that rate of interest to try to keep inflation on target (maybe by following a Taylor Rule). Now suppose, to reduce the risk of muggers, instead of physically transferring the paper currency to the seller of goods, you send an email to the central bank telling it to transfer currency from your “safety deposit box” to the seller’s “safety deposit box”. Now make that paper currency an electronic currency which is transferred between electronic safety deposit boxes (which makes no theoretical difference). Now allow people to have negative balances in their electronic currency accounts.
It’s still money. Do we now have the New Keynesian model?
Kevin,
The only thing that’s more ridiculous than criticizing a book one hasn’t read is blaming the author for one’s not bothering to to read it.
Nick,
“Do we now have the New Keynesian model?”
Yes, I don’t think any of those economies are fundamentally different. Like I said, you get the same equilibrium whether the quantity of outside money is positive, negative, or zero. So long as prices are a bit sticky, and people can lend and borrow, and the central bank exercises its ability to determine the short rate, I think you have everything you need to get an NK economy.
And, BTW, when the central bank raises IOR you get a recession.
Jeff: “Yes, I don’t think any of those economies are fundamentally different.”
Now we are on the same page.
I would say that both the interest rate the central bank pays on that money, and the quantity of that money, will matter. If the central bank raises the interest rate holding quantity constant, or cuts the quantity holding the interest rate constant, you get a recession.
Nick,
“Now we are on the same page.”
It’s an internet first!
“I would say that both the interest rate the central bank pays on that money, and the quantity of that money, will matter.”
I think Eggertsson and Woodford 2003 basically answered that question from a theoretical perspective (contingent on the rate, the quantity doesn’t matter under fairly general assumptions). But also from the perspective of bank capital requirements and every other bank economic decision that I can think of, I find it hard to see how swaps of t-bills for equal yielding reserves can impact decisions of any economic agents in any significant way.
“If the central bank raises the interest rate holding quantity constant, or cuts the quantity holding the interest rate constant, you get a recession.”
Are you saying they can offset each other or do you believe we need to get them both right to avoid a recession?
Kevin,
The tone of that comment was unnecessarily harsh. The harshness wasn’t really intended for you. Sorry.
Jeff,
No problem. People who criticise books they haven’t read surely are ridiculous. I my own case, I’ve made it clear to Nick that when we’re discussing the basic NK model I take that to mean Chapter 3 of Jordi Gali’s book.
Jeff: “Are you saying they can offset each other or do you believe we need to get them both right to avoid a recession?”
Normally, within limits, they can offset each other. If I cut the quantity and cut the rate at the same time by the right amount, we can avoid a recession. Expected future rates and quantities matter too.
Central bank credit, that is used as a medium of exchange, is not generally a perfect substitute for other forms of credit.
Nick,
The quantity offset must be very small. The Fed has done trillions of QE in the past five years. If they could have lowered the real rate by 10% instead, the impact would have been huge. So we have two policy
instruments, one of which has very large and clear effects and one of which appears to depend, at best, on how much economic agents believe in it. Given that I’d say that 1) the focus, during normal times, on rates policy makes a lot of sense and 2) we need to think about implementing ways to eliminate the ZLB (like revoking physical currency).
What is the mechanism whereby you think the quantity acts (contingent on an invariant path of rates), and how do we ballpark the size of the effect? (The exchange equation clearly can’t help us, given that the Fed has changed M by several orders of magnitude in the last few years without any obvious economic effect.)
“Central bank credit, that is used as a medium of exchange, is not generally a perfect substitute for other forms of credit.”
No, but the demand to hold it rather than t-bills can be satiated. The price that demand is the difference between the risk-free interbank rate and IOR. If that price is zero and demand is infinitely elastic, then t-bills and reserves are perfect substitutes and it’s hard to see how OMOs could work. What price in the economy is being affected? What agent’s decisions change?
Jeff: Here’s how I think of it:
To keep it simple, consider only stationary equilibria (and with no recession). Nothing changes over time.
Start out in an equilibrium with a very low (i.e. very negative) real interest rate paid on central bank monetary liabilities. The quantity will be very small. I.e. the size of the central bank’s balance sheet (both assets and liabilities) will be very small as a percentage of annual NGDP.
As we raise the interest rate on the central bank’s monetary liabilities, the equilibrium size of the central bank’s balance sheet (as a percentage of annual NGDP) gets bigger and bigger.
Eventually, as we keep on raising that interest rate, the central bank needs to own all of the short term bonds, then all of the long term bonds, then all of the commercial bonds, then all of the shares, then all of the land and houses, …..and so on.
Finally, if we push Milton Friedman’s Optimum Quantity of Money to its logical conclusion, we end up with communism, where the government-owned central bank owns all the assets in the economy.
And the further we move along that spectrum of equilibria, the bigger the absolute change in the size of the central bank would be, for a given change in the interest rate paid on money (or to compensate for a given sized shock to the economy).
Nick,
OK, but there is no mechanism there. I was really wondering why it would work. I.e. “What price in the economy is being affected? What agent’s decisions change?” Especially given the fact that demand for reserve-tbill swaps is clearly satiated (the price is zero and doesn’t change any more as a function of supply).
Also, I understand that buying stocks might have all kinds of portfolio balance effects (Woodford appears willing to go full Wallace here, but I’m not). But those effects aren’t “monetary,” (they could just as well be done by the treasury), and as you say, they are dangerous.
Jeff: “But those effects aren’t “monetary,” (they could just as well be done by the treasury), and as you say, they are dangerous.”
Yep. As we transition along my spectrum of equilibria, at what point does “monetary” policy become “fiscal” policy? Who knows. One merges into the other. If central banks had always bought and sold and held farmland, rather than Tbills, we might think of “monetary” policy differently. But they are all “monetary” in the sense that the quantity of money changes.
As to the quantity mechanism: let me go old-school.
Start in equilibrium, hold the interest rate paid on money constant, then suppose the quantity of money magically halves. Each individual tries to sell more goods and buy fewer goods to rebuild his money balances. They would each fail to sell more goods (since nobody else wants to buy more from them) but would each succeed in buying fewer goods. In aggregate, of course, they all fail to rebuild their money balances, but their individual attempts to rebuild their money balances by buying fewer goods results in a reduction in the volume of trade (a recession). Until, much later (given sticky prices) the price level eventually halves, and each individual stops trying to increase his money balances.
“But they are all “monetary” in the sense that the quantity of money changes.”
If t-bills and reserves are the same, the treasury could just as easily issue t-bills and buy assets with the same effect, and no change in the quantity of money. So it has nothing to do with money. It’s an asset swap between risky and risk-free assets.
Since we can separate the two kinds of swaps (reserve-tbill and tbill-risky asset), we should for clarity purposes. Woodford calls the first monetary policy and the second “targeted asset purchases.” Keeps the conversation clear.
“suppose the quantity of money magically halves”
There’s no magic allowed! Like I said above (Jan 25, 6:07 am), Hume’s thought experiment is not well defined. To know what’s going to happen we need details about what, exactly, the central bank is doing (buying, heli dopping, whatever…). So let’s assume the Fed halves the quantity in the US by selling $2Tn of t-bills…
“Each individual tries to sell more goods and buy fewer goods to rebuild his money balances.”
Except that the demand for money is satiated at both values of the quantity, before and after your OMO. So the spread between t-bills and IOR is unchanged by the operation.
In my old-school story above, I halved the supply of money. Now suppose instead that I had kept the money supply constant, but had increased the interest rate paid on money, to double the demand for money. The rest of my story would be exactly the same.
Quantity of money or interest rate paid on money; supply of money or demand for money; an excess demand for the medium of exchange causes a recession. One story to rule them all.