I am not an orthodox New Keynesian macroeconomist (ONKM), but I can pretend to be one.
Q: What determines the rate of interest?
ONKM: "The central bank sets the rate of interest."
Discussion: the above answer is a pure liquidity preference theory of the rate of interest. By having a perfectly elastic money supply curve, at some rate of interest chosen by the central bank, the stock of money adjusts to equal whatever quantity of money is demanded at that rate of interest. Like in all liquidity preference theories, the rate of interest is determined by the demand for money and the supply of money. The only difference here is that the money supply curve is perfectly interest-elastic.
Q: But what determines where the central bank chooses to set the rate of interest?
ONKM: "Loanable funds."
Discussion: this is the bit that needs some explanation. Because the ONKM won't actually say the words "loanable funds". What the ONKM will actually say is something like:
ONKM: "The central bank chooses to set the rate of interest that it believes is compatible with keeping output at potential and inflation on target."
So we need to translate that answer into loanable funds language:
Let output demanded (call it Yd) be a negative function of the rate of interest r, a positive function of actual income Y, and a function of other stuff X.
Yd = D(r,Y,X)
And the ONKM central bank wants to set r such that output demanded equals potential output Y*, so that:
D(r,Y*,X) = Y*
Assume a closed economy for simplicity, subtract Cd (consumption demand) plus Gd (government demand) from both sides, remember the accounting identities C+I+G=Y and S=Y-C-G, where I is investment and S is national saving, and we get:
Id(r,Y*,X) = Sd(r,Y*,X)
The central bank sets a rate of interest such that desired investment at potential output equals desired national saving at potential output. Which is precisely the loanable funds theory of the rate of interest.
An inflation-targeting central bank will set a rate of interest equal to the rate of interest predicted by the loanable funds theory.
One problem with the above is that the central bank does not observe potential output Y*, nor does it observe all the elements in the set X, and it does not know the function D(.) either. It has to make estimates/guesses of all these things. So it would be more correct to say that the central bank sets the rate of interest where it thinks the loanable funds theory says it will be. So the loanable funds theory will only be true up to a random(?) error caused by the central bank's mistakes in hitting its inflation target.
Any ONKM will immediately acknowledge that problem.
A second problem is that there is not just one rate of interest but a whole slew of interest rates. Differing by indexed or not, by term, by risk, by liquidity, etc.
Any ONKM will immediately acknowledge that problem.
Setting those problems aside, I have my own disagreements with the ONKM perspective on this question. But this post is not about my own views.
This post is about Lars Syll's views. I would like to ask Lars if he agrees or disagrees with the ONKM view, as I have presented it/translated it above. Because a lot of stuff really does get lost in translation sometimes.
[Update: Here is Lars' response, and my comments on his response.]
[My guess is that both Paul Krugman and Greg Mankiw would roughly agree with the above, but I could be wrong.]
P.S. Astute readers may have noticed that I have said nothing about either "the natural rate of interest" or "the money multiplier" in this post. That's because they are irrelevant to this question. Whether or not there exists an inflation-invariant natural real interest rate depends on the functional form of D(r,Y,X). If we interpret r as the nominal rate of interest, then an inflation-invariant natural real rate of interest requires the derivative of D wrt r always equal minus the derivative of D wrt expected inflation. (Expected inflation will be one element in X.) Whether or not there exists a stable "money multiplier" depends on whether or not commercial banks expand and contract their balance sheets in exact proportion to expansions and contractions in the central bank's balance sheet. Neither affects the loanable funds vs liquidity preference question.
Worthwhile Canadian Initiative 
Before I attempt to do so: am I correct in assuming that you were speaking as Nick Rowe the Monetarist, as opposed to Nick Rowe the ONKM, in your second response (to me, above)?
Oliver: Yes. When I start rabbiting on about how money is really different, that’s the real me speaking.
Can there be 5 quantities?
quantity demanded
quantity bought
quantity sold
quantity supplied
quantity potential
TMF: No. That’s only 4. Quantity bought and quantity sold are the same thing.
Nick,
totally OT, but reminded me in a weird way of things you’ve written about the reserve system:
http://monetaryrealism.com/the-full-monty-on-naked-short-selling/
Nick @Sep 19, 04:49PM: Only if 2 occurs does my investment automatically rise with my saving.
This is technically correct since you talk about “my” but I think that it may hide a little bit of truth hre. If saving is income minus consumption AND Saving = Investment (which it does) then investment “automatically” occurs whenever you have income and do not spend money on consumption. Even if you hold that income in your purse. Andy Harless explained very succinctly in his post here: http://blog.andyharless.com/2009/11/investment-makes-saving-possible.html
So what happens when you receive a cash income and you put it into the box? The thing is that you received the income in exchange for something. The person that paid you either bought investment or consumption goods from you. If it is consumption that was bought from you, then the buyer dis-saved money (he spend money he had saved in his purse for consumption goods) but since he gave money to you, and you by definition “saved” that exact amount the second after you recieved the payment – the net saving is unchanged. If buyer bought investment goods from you then he “invested” (as opposed to consumed) and you saved in equal equal amount. So both: saving and investment increased.
I understand that this is nothing new and it tells nothing about overall income over some time periods or anything else except that S=I by definition. But I think it is a useful exercise for everybody who things investment is something else – people who talk about financial capital, wealth and whatnot inevitably confusing discussions. I know that Andy’s article cleared that for me quite well.
There is nothing to prevent an individual manicurist from saving more, in the form of money. He just buys fewer haircuts. So there will inevitably be a recession (unless the central bank supplies more money).
It is saving in the form of money — the medium of exchange — that causes the problem. The medium of exchange is very very different from other assets like land.
What you are describing is the paradox of thrift, which goes back to Keynes (possibly further, I don’t know). But in any case, I doubt any Keynesian, New, Post or otherwise would deny the existence of the phenomenon.
Tying in with my point above, though: there is also nothing, save taxes (which applies to the manicurist, too) or expropriation, to prevent a house owner from continuing to own his house (save). So there must be a similar phenomenon to the paradox of thrift wrt to land or bonds or whatever. An asset market freeze-up? A liquidity trap?
But I agree with you that there must also be a significant difference. Here’s my take on what that is:
The manicurist, through not spending his income, is preventing something new, output (in this case a haircut) from being produced. Income = output. A recession is defined as a drop in output. It is an interruption of the flow of newly produced goods for immediate or gradual consumption (investment).
In an aset price recession, it is only already existing things that are not changing hands. There is no income and no output involved.
That is also why I would say that the term ‘printing money’ is too much of a simplification to properly address this issue. And it has nothing to do with the fact that money comes in bits and bytes nowadays. My beef is that it only captures one half of the transaction. The other half – what is it printed for? – is lost.
Helicopters do not drop money from the sky. New money, and I’m referring to bank money here, not CB money, is ‘printed’ explicitly for a purpose. It can either be directed at providing income by financing output, thus tackling the problem of a recession directly or at proppoing up prices of existing assets, addressing a recession indirectly, at best (via the wealth effect).
That is also why I would say that accounting is a helpful tool, because it reminds us to always think of both sides of a transaction. It is a mental crutch for more consistency in our fariy tales.
And maybe the term medium of exchange is confusing in this context, too. Asset swaps also involve the medium of exchange, but they do not produce recessions.
re: quantity demanded
quantity bought / quantity sold
quantity supplied
quantity potential
Matias Vernengo seems to think it’s all woo-woo (in the comments):
http://nakedkeynesianism.blogspot.ch/2011/11/neo-wicksellian-macroeconomics.html
Actually no. No need for any discussion of desired and actual I and S.
A loving couple have a history of exchanging favours. Husband H likes giving his wife manicures, whereas Wife W likes giving his husband haircuts.
To keep track of each others favours over time, they decide to introduce a simple monetary economy.
They agree initially that 1 haircut = 1 manicure.
In the first preiod, they each perform one haircut / manicure, respectively, issuing an IOU to the other each time.
So, we can say: output = 2; consumption = 2; money extant = 2
Now, in period 2, assuming they always take turns, we have two choices:
economy 1) W & H can redeem their respective IOUs.
economy 2) W & H can do the same as in period 1 and issue new IOUs for their respective services.
So in period 2, we can say: output = 2, consumption = 2, money extant is either 0 or 2.
Which economy is more prone to recessions? Does the amount of money matter? And in what way? Does adding an interest rate change things? Does it matter whether the IOUs are evenly distributed?
We can imagine further that one day W finds out H has been having an affair, so she withholds her haircuts in response to which H withholds his manicures. We have a recession.
Enter marriage counsellor CB. She diagnoses that it is an acute lack of money that is causing the recession. So, while nobody is watching, she flies her toy helicopter into H & W’s house and drops a bunch of IOUs into each of their wallets. Will that cure the recession?
If I were the counsellor, I’d personally convince H (lend him money) to perform a bunch of manicures on W as an apology and hope that that restores confidence. It ain’t the money, it’s the manicures.
JV and Oliver:
If I want to buy a newly produced machine, but can’t find a seller, then my Id > I.
If I want to sell a newly-produced machine, but can’t find a buyer, so have to hold it myself, then my Id < I.
If I want to buy land, but can’t find a seller, then my Sd < S.
If I want to sell land, but can’t find a buyer, then my Sd > S.
But money is different, because it is flowing both into and out of our pockets. I can always reduce my inventory of money, by buying less money or selling more money. Nobody can stop me buying less money. I can always increase my inventory of money, by buying more money or selling less money. Nobody can stop me selling less money. But in aggregate, we can’t all do that.
Andy talks about money a bit. Matias just says “Actually no. No need for any discussion of desired and actual I and S.” without explaining why he thinks that. We do need a discussion, and we need to distinguish money from all other goods.
@Nick: “is it r, M, or NGDP, or what? Then ask your question.”
Been pondering, not sure if you’re still following here…
I get this. It’s taken me years…
But:
I think that thinking only makes sense given the assumption I question in the second part of my comment: that monetary saving by real-sector entities increases the stock of monetary savings. (Back to my — and your — old bugaboo word…) No matter how many times I go around with IS-LM, that assumption seems to be at its core.
And I don’t think that’s true, don’t think it can be true.
I’m talking about “personal saving” here as defined in the NIPAs — disposable income less expenditures. (DI being income +/- taxes/transfers to/from guv sector).
As for “savings,” the only measure I can think of for that is household net worth (with firms’ value imputed to households as shareholders).
Nick: I get what you are saying and I kind of agree. I say “kind of” because technically you are incorrect as it is impossible to increase your money inventory without selling something else for money first. You may stop purchasing anything and live only from home production. But to actually get some money you just have to sell something for it. It will not magically appear in your wallet. And at the moment you do it you have an income that you saved automatically the nanosecond after you earned it.
– If you sold consumption goods for money then net saving (and investment) did not change. Money were dis-saved from wallet of your buyer but they are now in saved in your wallet in
equal amount.
– If you sold investment goods for money then your buyer increased part of his income that was not spent on consumption (increased his saving). He also dis-saved equal ammount of money from his wallet but similar to previous example that money was just transfered and saved by you. This increased aggregate saving is equal to amount of investment goods that were purchased. S=I.
JV: you are right, of course. What I said only works for someone who already has a flow of money coming into his pocket, as well as a flow out. If everyone cuts their flow out in half, it is possible that some people will see their flow in be cut to zero. They are unable to buy money any money at all. I was considering a small change, starting from an initial equilibrium where everyone has a flow in and a flow out.
When the representative agent reduces his flow out, he is surprised to discover that his flow in falls by exactly the same amount, so he has not increased his stock of money at all. I say “surprised”, because the representative agent does not know he is the representative agent. Plus, even if he did know, it’s a Nash equilibrium, where he takes others’ actions as given.
W.Peden
Thanks, not quite sure what all the implications of holding the position I described are – best guess is you end up somewhere between Leijonhufvud amd Mehrling. more Leijonhufvud than Mehrling.
@Rowe: ‘Matias just says “Actually no. No need for any discussion of desired and actual I and S.” without explaining why he thinks that. We do need a discussion, and we need to distinguish money from all other goods.’
Matias followed-up and explained: “–The actual I and S are not equal”. Not sure what he means by ‘actual’ but he might be mistaken here.
Jussi: I just read Matias’ comment. I too think he is mistaken. Read literally, his comment makes no sense. But I think his mistake can be fixed. This is exactly the same as the problem Steve Keen ran into, which can also be fixed.
Matias has responded:
http://nakedkeynesianism.blogspot.ch/2011/11/neo-wicksellian-macroeconomics.html
Not sure whether this reflects Matias’ position, but I think I would agree with this:
Click to access gnos.pdf
Thanks Oliver: I find Matias’ answer unsatisfactory. If each agent’s choice depends on the choices of other agents, and all agents move simultaneously, and makes his choice without knowing what the others are choosing, what ensures we get to the Nash equilibrium? (Unless we have common knowledge and all agents can solve the model.) If something changes, and agents make different choices, they will all be surprised by others’ choices, and will regret their own choices (unless they all have perfect information and can solve the model).
I found the paper by Claude Gnos unhelpful.
I don’t want to beat a dead thread, nor plow your front lawn, but I’m still a bit confused. So if you’ll excuse me, I’ll try and dumb this down to my own level:
At all measurable points in time, I=S.
From one point in time to the next, I=S may change, so I1=S1 =/= I2=S2.
Payments are points in time.
Changes in I=S over time are due, on the one hand, to to the fact that people don’t always do the the same thing did before, both individually and in aggregate. They change their minds for various reasons that are subject to studies by psychologists, historians, economists, theologists, biologists etc… Individuals may see an overall trend and conclude that although their own actions change, overall outcomes won’t. They’re often wrong. Furthermore, the ideas people have now may not turn out to be as good as they want them to in future.
Thus, neither individual nor aggregate expected outomes must equal actual outcomes. Actual outcomes can exceeded or fall behind expected outcomes. Nevertheless, for each actual outcome, S=I. There is never a measurable ex ante point in time where S=/=I.
Payments can be explaind in exact accounting terms, all else can’t. We need a story. Nash equilibrium may be one of those stories of how we get from a to b, although I very much doubt it’s sufficient to account for the complexity of humanity.
I understand Matias as saying that the main determinants of the discrepancy between aggregate expected and aggregate actual outcomes is when saving/investment decisions do not translate 1:1 into the productivity development of capital. This can be plotted as trend curves with an intersection portraying actual outcomes.
Personally, for someone who likes to cry ‘radical uncertainty’, such curves send the wrong message. But anyway…
The balancing item between nominal investment/saving and actual productivity of capital is the market value of assets invested in. So, if I borrow new bank money to invest in a new piece of machinery but nobody buys its produce, the value of overall investment = aggregate saving remains the same, but the value of my asset (the machine) will decline. Ultimately to 0, leaving the economy with a debt that it cannot repay.
This can happen if the products of the machine are effectively bad. But also if, for whatever reason, people decide not to spend out of their income, i.e. they don’t consume. Collectively, such action will render the initial investments unprofitable.
This is the point that Gnos is stressing (I think). He seems to be saying that distribution of income must be such that the spending power of labour keeps up with productivity of capital. Effective demand is a function of the propensity to consume out of income. That propensity insures that investment remains profitable.
Which part(s) do you not agree with?
Oliver: apples bought and apples sold are just two different ways of describing exactly the same number. We cannot say that apples bought determines apples sold, or apples sold determines apples bought, because they are the same thing.
Same with actual saving and actual investment.
You can’t even draw two different curves.
None of this helps us explain what determines apples-bought-and-sold, or saving-and-investment.
“This can be plotted as trend curves with an intersection portraying actual outcomes.”
What are the two curves? What is on the axes?
Hey, that is what I’ve been trying to say :-)! (Matias is the one arguing with curves, not me…).
I thought you were saying that there was a state of the world in which S =/= I.
Can we agree that nobody is saying that but that we’ve falsely been accusing each other of doing so?
Oliver: “Hey, that is what I’ve been trying to say :-)!”
Yep. And I was repeating it, in my own words, to ensure we are on the same page!
There is a state of the world in which desired/planned/expected S =/= desired/planned/expected I.
And what happens when that happens tells us what determines I (or S, same thing).
OK, great! We can team up on Matias :-).
Re your second sentence:
Are you looking for a tool by which to equilibrate expectations about S and I?
If so, I think that’s an oxymoron. We cannot have differing expectations about one and the same thing. Hopes, maybe, but that’s moving into religion…
If the economy plans to invest 1 billion next year, it cannot expect to save more or less (money) than that amount.
That doesn’t change if you break it down.
If investors decide to invest more than consumers want to save, consumers will consume more, leaving investors to either save their own investment or disinvest (pay down debt). In the latter case, there is no saving / investment over the whole period.
And in either case, I don’t think you can say that there is a disequilibrium of aggregate saving and investment desires at any point.
What I think one can say though is, that there are more or less desirable absolute levels of investment & consumption for an economy. But I would say that is important to look at them in terms of flows, not in terms of money stocks accumulated. Flows determine activity levels, which determine employment, whereas the stocks are just residuals of saving desires. Hence my insistence on the importance of income as opposed to the money stock. Of course, a money stock can be considered potential for future activity, but then so can an overdraft facility.