Simplify massively. Ignore investment, government spending and taxes, and exports and imports. All output is consumed.
Assume a Keynesian consumption function: Cd = a + bY. Draw Samuelson's "Keynesian Cross" diagram. Real consumption demand Cd on the vertical axis, and real output (real income) Y on the horizontal axis. Demand for consumption this current period depends on realised sales of output this current period. "Equilibrium" is where the consumption function crosses the 45 degree line. Because that tells us the level of output at which demand for output equals that same level of output. But that "equilibrium" is not necessarily a full demand = supply equilibrium. Output may be less than "full employment" equilibrium. Firms and households may want to produce and sell more output and labour than they are able to sell, if demand is too low. The multiplier (the change in "equilibrium" output divided by the upward shift in the consumption function that caused it) is 1/(1-b). There is positive feedback in this model, because demand depends on itself.
What does that Keynesian Cross diagram look like in a New Keynesian model, with infinitely-lived consumption-smoothing agents who never face binding borrowing constraints? That depends on how long the "current period" is, and on whether income in the current period affects expected future income.
Assume that the representative agent is perfectly confident that his income will be equal to "full employment" income in all future periods, regardless of what happens to current income. (Yes, this assumption is very questionable.)
If the current period is very short, the consumption function will be almost horizontal (the marginal propensity to consume "b" will be almost zero). Because changes in current income have a negligible effect on permanent income. And if the central bank reduces the current period real interest rate, the consumption function will shift up, causing an increase in "equilibrium" output. If the central bank sets the right interest rate, so the real interest rate equals the "natural rate", the intercept of the consumption function (autonomous consumption "a") will be almost equal to full employment income.
Now let's make the current period longer and longer. So that current income has a bigger and bigger effect on permanent income. Autonomous consumption (the intercept) gets smaller and smaller, and the marginal propensity to consume (the slope) gets bigger and bigger. Less obviously, a given-sized cut in the real interest rate will cause a smaller and smaller upward shift in the consumption function.
Now let's take this lengthening of the current period to the limit. Suppose the current period lasts forever. So my bolded questionable assumption above becomes redundant, because there is no future period. Let us put permanent income on the horizontal axis, and permanent consumption on the vertical axis. Autonomous consumption drops to zero, the marginal propensity to consume rises to one, and the effect of a cut in the real interest rate drops to zero. The budget constraint (plus non-satiation) ensures that permanent consumption must equal permanent income, for any level of permanent income, and for any real interest rate. This means that the consumption function necessarily coincides with the 45 degree line.
And this means that any level of permanent income, between zero and full employment income, is an "equilibrium". Animal spirits are the only thing that determine which of those equilibria will be chosen. Since b=1, the multiplier would be infinite, if it were possible to shift the consumption function up. But the budget constraint says it is not possible to shift the consumption function up, so that infinite multiplier is purely hypothetical.
Now let us introduce a stock of money into the model. The representative agent holds a stock of money. He has a desired stock of money, and an actual stock of money, and the two stocks may not be the same. Introducing money into the model breaks the identity between permanent consumption and permanent income. If an agent holds more money than he wishes to hold, he will plan to run down his stock of money over time, by spending more than his income, so that his permanent consumption will be greater than his permanent income. And if an agent holds less money than he wishes to hold, he will plan to increase his stock of money over time, by spending less than his income, so that his permanent consumption will be less than his permanent income. But even though each individual agent can add to or subtract from his stock of money, by spending less or more than his income, this is not possible in aggregate.
If the desired stock of money is independent of permanent income, an increase in the actual stock of money, so that it is greater than the desired stock, will cause an upward shift in the consumption function. It does not matter if that upward shift is very small, because b=1 and so the multiplier is infinitely big. An extra $1 hot potato in circulation will be enough to expand the economy from 50% unemployment to hit the full employment constraint. And withdrawing a single $1 from circulation would cause the economy to collapse to 100% unemployment.
But a more plausible assumption would be that the desired stock of money is an increasing function of permanent income. This ensures that the consumption function has a slope of slightly less than one, so we get a determinate "equilibrium" level of permanent income where the desired stock of money equals the actual stock.
The model would be more plausible still if we assumed that the desired stock of money depends on permanent nominal income. There is a real stock of money at which equilibrium permanent income is equal to full employment permanent income. Maybe (or maybe not, if it causes destabilising expectations) a slow adjustment of prices, in response to output being greater or less than full employment, would eventually bring the economy to full employment equilibrium.
Keynes understood that demand depended on itself. General Theory chapter 3. Keynes understood that the only thing that might (or might not) bring the economy to full employment income was some sort of real balance effect on aggregate demand (and that the central bank could do the same thing quicker and better than waiting for prices to adjust to get the right level of real money balances). General Theory chapter 17. New Keynesians have forgotten Keynes' two insights about aggregate demand. They have forgotten that demand depends on itself. They have forgotten that some sort of real balance effect is the only thing that might (or might not) bring the economy to full employment automatically. New Keynesians are guilty of an intertemporal fallacy of composition: even if the right rate of interest will ensure full employment in any single period, it does not follow that the right rate of interest will ensure full employment in all periods. New Keynesians just assume, without any explanation, without anything in their models that would make this the only rational expectation, that agents expect that future income will equal full employment income. New Keynesians are the "classical" economists who just assume (the agents in their models expect) an automatic tendency towards full employment. New Keynesians have models of monetary exchange without money. New Keynesians are not Keynesians.
Just continuing my lovely argument with Roger Farmer about Keynes and modern macro.
Worthwhile Canadian Initiative 
“autonomous consumption (the intercept) gets smaller and smaller”
What’s making that happen?
JKH: Suppose your income was 0 for t years, and 100 per year thereafter forever. “Permanent income” is defined as the annuitised value of your income from today till the end of time. The longer is t, the less is your permanent income, so the less you consume, because consumption depends on permanent income, and on the rate of interest, and your “permanent consumption” (the annuitised value of consumption from today till the end of time) equals your permanent income.
I understand that.
But not in context. Why does increasing current income as you describe mean autonomous consumption goes to zero?
It seems like an important point to be very clear on, given that it’s essential (to the geometry) for the rest of your thesis. Maybe it’s obvious to everybody else, but I’m not seeing it.
JKH: You misread me. Autonomous consumption means “how much the representative agent would want to consume if his current income were zero”. We are not increasing current income. We are increasing the length of the “current period”. If the current period of zero income lasts for 2 years, rather than one year, before we get back to full employment, that will cause current consumption to drop. And increasing the “current period” to 3, 4, 5, etc. years, will cause it to drop more and more. And if the “current period” lasts forever, autonomous consumption would drop to 0.
JKH- Autonomous consumption here simply means the consumption that is based on future periods’ income, as opposed to the current period’s income. So the longer the current period is, the smaller the share of income coming from future periods, and the lower is autonomous spending.
In this model there is no autonomous consumption in the Old Keynesian sense, consumption unrelated to income.
An increase in current income will always increase current consumption, by an amount “b”. If the “current period” is very short, b will be very small, and near zero. If the “current period” is very long, b will be large, and near one.
Agree with all this, except I don’t think it needs specifically to be money. The same applies in relation to any financial asset, provided an increased desire to hold that asset doesn’t imply an increased desire to provide funding to someone who is credit constrained. So you could replace the term “money” with “safe assets” say and your analysis should apply. (And telling the story using “safe assets” rather than “money” is probably closer to the situation of the last few years).
JW: “In this model there is no autonomous consumption in the Old Keynesian sense, consumption unrelated to income.”
I would say that in the NK model (PIH), and with expected future income exogenous, if the current period is very short, (almost) all current consumption will be autonomous in the sense of being (almost) unrelated to current income.
“Autonomous consumption here simply means the consumption that is based on future periods’ income, as opposed to the current period’s income. So the longer the current period is, the smaller the share of income coming from future periods, and the lower is autonomous spending.”
Now that would explain it clearly for me if that is generally understood.
This is the ‘traditional’ KC right, where a = autonomous consumption?
Maybe its basic stuff, but I hadn’t realized that this definition was specified as time period dependent in precisely that way.
Nick-
As usual, I see no problems with the logic of your argument. I agree with it as a critique of New Keynesian models. And I agree, you can find this argument clearly stated in the GT.
But, this is not the only way to resolve the problem, and you can find other resolutions suggested in the GT too.
At the point where you introduce the money stock, there’s a different option. You can consider everything up to that point as a proof by contradiction of the permanent income hypothesis. Rational expectations means, strictly speaking, that a model should assume that agents’ belief about the future values of a variable are the same as the values the model itself predicts. In this case, the model makes no predictions about the future level of income. So we can’t describe people as acting on the basis of its predictions.
At this point, we have to fall back on the kind of behavioral story that Keynes used. It is for whatever reason a “psychological law” that expenditures move with income, but less than one for one. (We could come up with reasons.) It will still always turn out to be the case ex post that that aggregate income equals aggregate expenditure. But it will not be the case for any individual unit. There is no such thing as an intertemporal budget constraint.
In this story, there is no automatic mechanism bringing the economy to full employment. (Altho there is a tendency for the economy to return to whatever level of output is deemed normal, provided the disturbance was not large and/or long enough to change agents’ views of what is normal.) Changes in interest rates or in the money supply are just one instrument among others for changing the flow of current expenditure.
(I think this is basically Roger Farmer’s position. But he feels professionally obligated to describe this kind of indeterminacy as being consistent with rational expectations.)
DISproof by contradiction
Nick Edmonds-
People often say this but I don’t think it’s right. Excess demand or supply for safe assets can be eliminated by a change in their price. There is no reason to think it requires income adjustment. Price adjustment doesn’t work for money because of its special role as the unit of account.
Incidentally, Keynes himself does make a version of the safe asset argument made by Nick Edmonds above, suggesting that historically land — as the safe asset — might have depressed demand for currently produced goods and services in the same way that demand for liquidity in the form of money has in more recent times. But as Samuelson pointed out (in “Land and the Rate of Interest”), this was a mistake on Keynes’ part: “Keynes erred in likening land to money: he can be charged with forgetting that the price of land is a variable that can be bid up to whatever level is needed to bring the interest rate down indefinitely close to zero.” Samuelson goes on to say that Keynes was right to think that a preference for land as a store elf wealth could indeed depress growth, because investment in land competes with investment in fixed capital. But that effect doesn’t show up in the simple model we are discussing here.
JKH-
It isn’t. In the normal presentation, we have expenditure as a function of (a) current income and (b) everything else. Autonomous expenditure is the everything else part. Nick is saying that IF you apply this in a New Keynesian framework where agents are exactly satisfying an intertemporal budget constraint, then “everything else” reduces to future income.
JW
I think that comes down to elasticities. A change in the price (yield) on bonds might have very little impact on the overall demand for safe assets, but may have a big impact on what proportion of those safe assets people want to hold as bonds. In that case a change in the price of bonds may eliminate the excess demand or supply of money.
Keynes was wrong on land. Only money works. Back later.
“An extra $1 hot potato in circulation will be enough to expand the economy……” More or less what MMTers have been saying for some time. To use MMT parlance, a deficit increases “private sector net financial assets”, which tends to increase demand.
Nick-
I don’t think so. If there is excess demand for bonds, the price of bonds will rise. The elasticity of demand for bonds tells you how big the price rise will be, but it doesn’t provide any reason for the rise to stop while there is still excess demand. Since we observe safe assets being held at a positive yield, we can be sure that excess demand for safe assets is not holding back expenditure.
Keynes was wrong on land. Only money works.
Right, in this model. If we introduce investment in fixed capital, then the existence of land can depress output.
More or less what MMTers have been saying for some time.
Yes, MMT (at least the older versions) and monetarism are equivalent. The only difference is whether you call the the money-emitting entity a central bank or a budget authority.
To be clear — I agree with Nick R. and Samuelson that Keynes was wrong on this point. But — as Samuelson also says — there is a related point where he was right.
Look at it another way. Say there are only two safe assets – money and bonds. And we have a household that has $200 of safe assets – $100 in money and $100 in bonds. But they would prefer to have $300 in safe assets, with the extra $100 in bonds, because they don’t need more liquidity.
So we might say there’s an excess demand for bonds, but it’s not going to be one that moves the bond price, because they can’t as yet bid for the extra bonds. We could call it an excess demand for money, but that’s a bit odd because they don’t actually want any more money, except in that they want more money so they can buy bonds. And if we tried to put more money into the system by lowering bond yields, so that they’re happy to switch to $50 in bonds and $150 in money, say, it doesn’t necessarily mean they don’t still want an extra $100 in safe assets.
@Nick Edmonds and @JW: Banging my spoon on the high chair again: I think you’re talking past each other cause you’re doing the old thing of confuting money with currency and close equivalents, conceptually.
If money is, rather, the exchange value embodied in financial assets (including currency and everything else), then Nick Edmond’s statement:
“I don’t think it needs specifically to be money. The same applies in relation to any financial asset.”
Is true, prima facie.
And if we consider deeds to be financial assets (claims on real assets, though without an offsetting balance sheet liability on anothers’ books) — embodiments of money — I think that also defuses the Samuelson objection to the Keynes argument. Or at least partially unties the gordian knot they’re twisted into.
it’s not going to be one that moves the bond price, because they can’t as yet bid for the extra bonds.
I don’t understand this. Why not? Everyone offers unsafe assets for sale in exchange for the safe ones, until relative prices change sufficiently that they are satisfied holding the current stock.
I don’t think New Keynesians “just assume (the agents in their models expect) an automatic tendency towards full employment.” What they assume is that the agents in their models expect reasonable price level behavior in the long run, where “reasonable” means anything except hyperinflation or hyperdeflation. If you drop this assumption, there are an infinity of other equilibria for output but, if I’m not mistaken, only two other equilibria for the long run price level: it either approaches zero or it approaches infinity. Perhaps New Keynesians should regard these equilibria as theoretically possible, but that doesn’t mean they must regard them as interesting. Hyperdeflation is something we have never seen in history, and it just seems insane that people might expect money to become infinitely valuable in the long run. (OK, I’ve snuck money into this argument, and you can say this is “something like a real balance effect,” but it’s surely not very much like a real balance effect. I’d think of it more as a temporary concession to the real world. IRL we know that money exists, and that fact is important for ruling out hyperdeflation, but otherwise, from a NK view, not very important and can be ignored in the model.) As for hyperinflation, I believe it can be ruled out by allowing the central bank to specify a reaction function in which it can, in principle, deviate from the “right” interest rate. Basically, “If y’all start to expect hyperinflation, we’re going to do something crazy to make sure it doesn’t happen.” But Chuck Norris doesn’t actually have to beat anyone up, and the actual path of the interest rate doesn’t have to deviate from the “right” path.
Steve, I don’t think that works. Again, financial assets’ prices can change. And they do change, very easily. I don’t think the idea of excess demand for financial assets in general makes sense.
To make this kind of argument work, you need to consider the liability side of balance sheets as well as the asset side. What units want is not liquid or safe assets, but a safer or more liquid balance sheet position. This includes demand for less debt. But the price of outstanding debt cannot change, it is fixed in nominal terms. And if units devote more of their expenditure to paying down debt and less to currently produced goods and services, the price adjustment runs in the wrong direction. Nor can units with excess liquidity transfer it to the units with excess demand for liquidity, except to the extent that the latter hold salable assets. But by definition, a unit with excess demand for liquidity must hold only relatively illiquid assets, so netting them out against debts will be costly and slow.
This is basically the balance-sheet recession idea (often, but incorrectly, attributed to Richard Koo — it goes back at least 30 years, probably more). It is the logical extension of Keynes’ liquidity preference story of aggregate demand as the inverse of money demand, for a modern financial economy.
This story works logically, unlike the safe asset shortage story. That doesn’t mean it describes what’s going on in the US or elsewhere right now. I don’t think it does. I think what we have now is precisely the situation Nick describes before he brings money in. Spending is low, so incomes are low, so expected incomes are low, so desired spending is low. No excess demand for anything.
Nick: “New Keynesians have models of monetary exchange without money. New Keynesians are not Keynesians.”
You’ll never settle the question, who are the true heirs of Keynes? He left umpteen Last-Will-&-Testaments, so to speak, without saying which one was really his last word. In The Crisis in Keynesian Economics John Hicks describes a model which is every bit as objectionable (from your point of view) as the NK model. Hicks calls it Keynes’s wage-theorem. He writes: “It is because of the theorem that investment, and income, and money supply are measured in wage-units; for it follows from the theorem that when so measured, they are independent of the level of money wages.”
He sums up: “the view which emerges from the General Theory…is nothing less than the view that inflation does not matter.” To me, that looks remarkably like the NK model (or Jordi Gali’s version at least, since that’s the one I happen to have wrestled with). Keynes really wasn’t as bothered by nominal indeterminacy as you are; not always, anyhow.
(I think Hicks was wrong to call this endogenous-money wage-theorem notion the view which emerges from the GT; it’s just one of the many possibilities Keynes envisaged.)
“Demand for consumption this current period depends on realised sales of output this current period.”
Ah! The time travel assumption. Demand for the next time period depends on current sales.
“‘Equilibrium’ is where the consumption function crosses the 45 degree line.”
Equilibrium only makes sense if we are talking about a time lag, so that future demand equals current demand (and future sales equals current sales). Because:
“There is positive feedback in this model,”
Without a time difference there is no feedback.
“because demand depends on itself.”
Because future demand depends on current demand.
JW
“Everyone offers unsafe assets for sale in exchange for the safe ones, until relative prices change sufficiently that they are satisfied holding the current stock.”
That assumes that they want to reduce holdings of unsafe assets / increase holdings of safe assets. What I was meant was when they want to reduce consumption / increase holdings of safe assets, which I think is the parallel to what Nick is saying. Otherwise if people wanted to reduce holdings of unsafe assets / increase holdings of money, presumably what you are saying would also apply, i.e all that would happen would that the price of unsafe assets would change.
That’s probably my fault for talking about safe assets. I only did so, because I wanted to distinguish the case where increased appetite for assets led to some credit constrained person increasing consumption. But I can see it’s confusing, because demand for safe assets is sometimes discussed in the context of a switch out of unsafe assets. I’d tend to agree that that argument is more problematic.
Nick, to say there is excess demand for X means that at current prices, you would like to exchange more not-X for X.
What I was meant was when they want to reduce consumption / increase holdings of safe assets
Right. You still have not explained why this does not silly lead to a rise in the price of safe assets.
That’s probably my fault for talking about safe assets. I only did so, because I wanted to distinguish the case where increased appetite for assets led to some credit constrained person increasing consumption.
If you didn’t mean safe assets, why did you say safe assets? And what did you really mean?
Anyway, we have not even gotten to the argument you make here — that even if asset prices could not adjust, non-monetary assets (and, for that matter, money as well) are produced by the private sector. So why doesn’t an excess demand for assets of whatever kind lead to increased issuance of such assets, i.e. increased borrowing? Your notion here is that there is only increased demand for safe assets, and that issuers of safe assets will not issue more, for some unspecified reason. So in this story, asset prices adjust, there is no excess demand for safe assets from asset owners, and income is not being held down by people’s inability to realize their desired asset position. However, the shift in asset demand changes the interest rates faced by different borrowers. And for some reason, spending by safe borrowers is less responsive to interest costs than is spending by risky borrowers.
This story is logically coherent. But it’s quite different from the model Nick is presenting here. You cannot just do a find-and-replace of “money” with “safe assets”.
It’s also not supported empirically, at least for the US. Risk spreads are have narrowed, not widened, and there is no evidence that credit constraints on consumption or investment are tighter than pre 2008.
(simply, not silly. I should turn off autocorrect.)
I should add: I think the flight from risky assets and resulting credit-rationing is a good story for the crisis period itself. But not for the slow recovery following it.
In general, I think it’s more in the spirit of Keynes to say you need to talk about money/finance to explain transitions between high and low-level equilibria; but not to explain the existence of a low level equilibrium, once you are in one.
Introduce a fixed stock of land into the model. Suppose there is an excess demand for land. Would that cause desired permanent consumption to fall below permanent income?
Either the price of land is perfectly flexible or it is not perfectly flexible.
If the price of land is perfectly flexible, the price of land jumps up instantly, to eliminate the excess demand for land.
If the price of land is not perfectly flexible, there is an excess demand for land, but people will not be able to buy land, because there aren’t enough willing sellers. Unable to buy land, people buy consumption instead.
Either way, an excess demand for land cannot cause desired permanent consumption to drop below permanent income.
For “land” read “bonds”, or “whatever it is that MMT guys are talking about, except money”.
Money is different. It is the medium of account, so its price is sticky. And it is the medium of exchange. There are two ways an individual can satisfy his excess demand for money: sell more goods; buy fewer goods. Nobody can stop him buying fewer goods. There is only one way to get more land: buy more land. If there are no willing sellers of land, you can’t buy more land.
Kevin: “Keynes really wasn’t as bothered by nominal indeterminacy as you are; not always, anyhow.”
But what we have here is real indeterminacy.
Andy: we can’t rule out nominal indeterminacy (hyperinflations or deflations) unless we can rule real indeterminacy. Given a Calvo Phillips Curve.
JW: Interesting what you say about Samuelson and land. Yep, if the price of land is flexible, keynes is wrong. But even if the price of land is stuck, it is still wrong that an excess demand for land can cause a recession. There is an excess demand for unobtainium too, but that doesn’t cause a recession. The bit about land reducing investment and growth is the old “Junker Fallacy”, except it isn’t a fallacy in the OLG model.
Nick to Andy: “we can’t rule out nominal indeterminacy (hyperinflations or deflations) unless we can rule real indeterminacy.”
AFAICT the point Andy is making is that if we rule out hyperinflation & deflation, the real variables become determinate. I’m no expert but I’d guess he’s right. Simon Wren-Lewis says much the same thing.
As for Keynes, he was fussy about some things but I don’t think he’d have been too bothered about the assumption that Classical results emerge in the long run.
BTW, has anyone ever documented an instance of this alleged Junker Fallacy which crops up from time to time? Tyler Cowen gave some vague reference to Fritz Machlup years ago but I’ve never been able to locate the guilty party. Is it one of these “said nobody, ever” things?
Nick R.-
Agree on all counts. The only thing I would add is that there are also two ways to reduce your liabilities: sell more, and buy less. So in this sense borrowing less is just like increasing your money holdings. But with the difference, there is not a fixed stock of not-being-in-debt in the way that there can be a fixed stock of money.
@JW:”I don’t think the idea of excess demand for financial assets in general makes sense.”
I couldn’t agree more. But then I don’t think the idea of excess demand for money in general makes sense. I think you may have asked in the past: if there’s excess demand for money, why aren’t people maxing out their credit cards?
You have the answer:
“What units want is not liquid or safe assets, but a safer or more liquid balance sheet position. This includes demand for less debt. ”
Isn’t that safer balance sheet comprised of both — safer assets and less debt? Both balance sheet moves reduce the stock of exchange value as embodied in financial assets (the stock of “money”). The former through trading of price-volatile equities for less-volatile financial assets that have fixed payouts, the latter through debt payoff. That big balance-sheet shrink is far more rapid and far greater than is readily corrected via monetary or fiscal moves.
Those with limited assets can only shrink their balance sheets by spending less (on real goods). So while V might rise algebraically as M contracts, illiquidity and debt repayment is fighting against that.
It doesn’t seem like demand-for-money or safe assets adds much understanding to all that.
Steve, Cullen Roche has essentially asked this of Nick before:
“I couldn’t agree more. But then I don’t think the idea of excess demand for money in general makes sense. I think you may have asked in the past: if there’s excess demand for money, why aren’t people maxing out their credit cards?”
I think his response was that the credit card companies, because there’s an excess demand for money, don’t want to part with money (i.e. credit in this case) to purchase IOUs from people (i.e. there’s a glut in the IOUs from people market): if you view getting the lending process as exchanging IOUs (with one of the IOUs being “money”). I probably butchered Nick’s explanation, and perhaps it doesn’t address the particulars of credit cards… but I thought I’d throw that out there.
I’m following the above discussion with Nick Rowe, Nick Edmonds, Steve Roth and JW Mason with great interest, because I think it gets close to answering a question I have… but not quite. In a discussion with Nick Rowe elsewhere I’ve identified (I think!) a case where the quantity of MOA (M) can change, but this change has no long term effect on the average price level (P) because demand for MOA also changes. This happens because non-MOA (bank deposits) are exchanged for MOA (CB liabilities). The specific situation is a cashless society where a CB with $R of reserve-liabilities takes over the banking sector with $D deposit-liabilities, thus changing M by 100*(D-R)/R%, but not changing P at all. My question: are bank deposits the only non-MOA good this can happen with? What if the CB were to take over all money market funds and replace them with deposits at the CB? What about short term bond funds? The CB might pay a premium to make up for loss of interest in either case, or it could just pay interest. Can these also be examples of demand transference between non-MOA and MOA which eliminates any change in P?
“even if the right rate of interest will ensure full employment in any single period, it does not follow that the right rate of interest will ensure full employment in all periods”
I’m not sure I get the implications of this. If the single period in question is the current period, and in each period the interest rate is used to ensure full employment what different does it make if this doesn’t ensure full employment in the future (you can set the appropriate rate for that period when you get there.)
Is the implications of this rather that if expectations aren’t for full employment in the future that there may be no interest rate that will achieve full employment in the present either ?
TMF: that’s the fallacy of composition. Each individual can see the stage better if he stands up (holding constant whether other people are sitting or standing), therefore (invalid inference) if every individual stands up they will all see the stage better.
Kevin: “AFAICT the point Andy is making is that if we rule out hyperinflation & deflation, the real variables become determinate. I’m no expert but I’d guess he’s right. Simon Wren-Lewis says much the same thing.”
He’s right (for any reasonable Phillips Curve). But it’s just a way to assume full employment by the back door.
Nick Rowe.
“Now let us introduce a stock of money into the model. ……”
At this point in the post, you introduce a second measure of trade into the Keynesian Cross. Now we have trade plus “stock of money”. The volume of trade has increased because we have begun using “stock of money”. It is easily seen that the exchange volume increase only occurred because not only goods were being exchanged, money was also exchanged.
As macroeconomist, we make a mistake when we only place money on the x and y axis of the Keynesian Cross. We should sum money and debt, clearly identify that we are doing that, and present our Keynesian Cross nomograph as a simple demonstration that income is always the same as expenditure WITH BOTH DEBT AND MONEY TRADED. The parties of the trade accepted both money and debt for labor and materials.
If we take this approach, we can see that the economy produced a result measured with last years data. The employment achieved was accomplished with a measured amount of DEBT AND MONEY. If even more employment is desired, we would need even more debt and money.
Of course we would argue about when debt BECOMES money. At least we would be recognizing that trade is not only for money; it also for debt.
JW and Nick,
I feel that maybe we’re making some different assumptions about what other things change respond when one thing changes.
I’m going to focus on bonds, specifically treasuries, rather than land. Let’s say then that there is a money demand Md = m(Y,R), a demand for treasuries Td = t(Y,R) and a demand for other assets Ad = a(Y,R). R is the vector of yields.
So let’s say that the function Td changes, so that Td increases, but the other functions stay the same. At current yields, people want to hold more treasuries, but no less money or other assets. So they try to do two things: a) they try to buy more bonds and b) they try to spend less on consumption.
I think this is where the difference is coming in. As far as I see it, they can’t only try to do (a) because if they were successful that would result in a fall in their money holdings, and I have assumed that their money demand is unchanged. So they have to try and do (b) as well.
Then, of course, income falls so all the asset demands are potentially affected. What ultimately happens, depends on the elasticities in the functions but, in the extreme, the change in Y could entirely eliminate the excess demand for treasuries with no price changes at all. (It’s worth noting that a fall in income may in practice increase the supply of treasuries as well, due to budget deficits, but that’s not necessary for the argument.)
In your story about the land, Nick, people try to buy more land, whilst keeping consumption unchanged. They’re only doing (a) not (b). This implies to me that they want to reduce their money balances. After all, if they were successful, that is what would happen – their money balances would decrease.
The corresponding position in your main post is where people want to hold more money, but they want to do so by reducing their treasury holdings. In that case, they would not cut their consumption. They would just try to sell treasuries and the yield on treasuries would rise. We might then find we end in a position where they decide that actually they’re better off keeping their savings in treasuries after all, so they’re happy sticking with the money holdings they’ve got.
I assumed when I read you post that this was not what you meant, but instead you meant that people wanted more money, whilst retaining the existing quantity of other assets. My point is that if people want to hold more treasuries, whilst retaining the same quantity of other assets (including money), then you get the same result as for money.
(The difference potentially arises when people wish to hold more of an asset that might fund someone who is credit-constrained, because that then potentially has impact on spending elsewhere. That was the reason for my careless use of the term “safe asset”, but I think that was a bit of a red herring, so I don’t think I should have used it in this context. Anyway, my main point, is that I don’t think the effect is limited to money, but it really depends on what else you assume changes when the asset demand changes. If you assume that an increase in demand for money will be funded by reducing consumption, but that an increase in demand for other assets will be funded by running down money balances, then you will get different results.)
Does that sound right?
Nick E: start in equilibrium. Then all of a sudden each individual wants to consume less and hold more bonds/land/whatever.
This creates an excess demand for bonds/land/whatever. So the price of bonds/land/whatever rises (and the yield R on bonds/land/whatever falls) until people stop wanting to hold more bonds/land/whatever and stop wanting to consume less. We stay in equilibrium.
Unless the fall in yields on bond/land/whatever causes an excess demand for money.
JW: “Agree on all counts. The only thing I would add is that there are also two ways to reduce your liabilities: sell more, and buy less. So in this sense borrowing less is just like increasing your money holdings. But with the difference, there is not a fixed stock of not-being-in-debt in the way that there can be a fixed stock of money.”
I’m still thinking about this. I’m thinking about red money.
BTW, OT: did you see the link I posted in the last comment on the 45 degree post. A real world supply-side multiplier in the Paul Krugman babysitter case. An increase in M causes Y to fall.
Nick,
Any model which tries to combine Keynesian and Classical features will have “a way to assume full employment by the back door”, so I don’t think that’s a telling criticism. It all depends on how soundly the back door is constructed. In the case of the NK model (Gali version) it’s done by assuming that (a) the interest-rate policy followed is sensible (it doesn’t, for example, violate the Taylor Rule); and (b) agents draw comfort from this, in the sense that they don’t foresee catastrophic inflation or deflation simply because these outcomes are mathematically possible.
If I’m right in saying that’s the NK rationale, then I can’t see much reason to object to it. If I’m wrong I’d appreciate you and/or Andy telling me.
“Unless the fall in yields on bond/land/whatever causes an excess demand for money.”
Aha. I think I see the source of disagreement. This statement I totally agree with. The effect on income of an increase demand for bonds depends, amongst other things, on the interest elasticity of demand for money. If demand for money is completely inelastic, then it will have no effect. (That’s in the simply model. In the real world, and if we want to specify money as being the balance of transaction accounts, we also have to consider supply elasticities of money).
So our disagreement is not about whether a change in the demand can impact on consumption at all – it’s a disagreement about likely parameter values.
Kevin: take my “model” above, once I introduce a stock of money, the demand for which depends on nominal permanent income. That model does not assume full employment via the back door. It goes in the front door. (It might miss the front door, if expectations are destabilising, but there is a front door.) Keynes talked about the front door to full employment in chapter 17, but said it would be easier for the economy to get in the front door if the central bank moved the door.
Nick E: I’m not sure we disagree on parameter values. I’m not sure we disagree at all. I want to force us to think in terms of X causing deficient AD only via the effect of X in causing an excess demand for money. And this forces us to think about whether a better monetary system/policy could prevent things like X causing deficient AD.
I insist on my perspective, because I think it is both theoretically correct, and policy-relevant. Monetary policies/systems are not written in stone. Things like X only cause deficient AD because bad monetary policy/systems let them.
Nick E: let me put it this way: when we talk about AD, we are really talking about the excess demand and excess supply of the medium of exchange. There is no such thing as “AD” in a non-monetary economy.
Plus, concentrating on the demand for newly-produced goods only is far too narrow. An excess demand for money causes a disruption in all monetary exchanges, not just exchanges of newly-produced goods. What happens in the markets for old houses, used cars, etc.? They get disrupted too, and they matter too. It’s not just about AD=Cd+Id+Gd+NXd.
One old post.
A second old post.