Thursday, November 11, 2010

Reply to Richard Serlin

Richard Serlin, who deserves an award for time spent writing blog comments, asks:
You know, Stephen, you would be doing a great service to economists as well as the general public if you would finally answer the question asked of you many times, in many ways, how can we get inflation -- in the US, right now, in our current situation, with our current employment level, inflation level, etc. -- without also getting an increase in employment and real GDP.
Here's my stab at an answer.

The key question here is: "how can we get inflation ... without also getting an increase in employment and real GDP." The question is a bit odd, as we usually ask it the other way around. Monetary policy seems to be about manipulating nominal quantities, so how on earth can that have anything to do with real quantities like employment and real GDP? As for many economic questions, it is useful to start with the simplest case and then make it more complicated. An uncontroversial notion in macroeconomics is that money is neutral in the long run. If the central bank increases the level of the quantity of outside money - currency and reserves - in a one-time fashion, in the long run all nominal quantities, including prices and wages, will increase in proportion to the money supply increase, and there are no real effects.

Now, think about something more complicated. Imagine that the central bank permanently increases the rate of growth rate in the stock of outside money. Would this be neutral in the long run? Well, clearly not, as otherwise why do we care about inflation? If increasing the level of the money stock increases the price level, then increasing the rate of growth in the money stock increases the inflation rate in the long run. Leave aside the question of what these long-run nonneutralites from changes in money growth are (more on that later when I have time), but suffice to say that a higher money growth rate implies a higher inflation rate in the long run, and this relationship is roughly one-for-one.

Another complication is thinking about what the short-run non-neutralities of money are. This is much more controversial. There are many different ideas about short-run nonneutralities, and the implications for monetary policy. Among these are:

1. Lucas (1972 "Expectations and the Neutrality of Money"): Monetary policy has short run effects because monetary intervention confuses price signals for private sector producers. I am producing a product for which the market price goes up. I produce more thinking that this is because my price went up relative to other market prices, but I was fooled into thinking so. Actually, what happened was that the Fed increased the money supply and all prices went up. All producers are in fact doing the same thing. Policy conclusion: The Fed should behave in a predictable fashion. This monetary intervention may move output around, but those fluctuations are inefficient. Is this theory any good? I don't think many economists pay much attention to it any more, principally because it seems the information friction in this type of model is not plausible.

2. Sticky prices: The New Keynesian story is that only some firms can or wish to change their prices in the short run. If I am a sticky-price firm, I produce more when demand for my product rises. Demand for the products of all firms can rise in the present due to monetary intervention which reduces the nominal interest rate, which also reduces the real interest rate (remember the prices are sticky), and therefore induces intertemporal substitution of goods, increasing the demand for goods in the present. Policy conclusion: It need not be efficient for the central bank to increase output, even though it can. However, there is a role for monetary policy in minimizing the welfare losses from the relative price distortions induced by sticky prices. A key flaw in the theory is the link between monetary policy and output. We have to think that is somehow less costly for the firm to hire more factor inputs and produce more output in the face of higher demand than to increase its price.

3. Sticky wages: In modern macro, this works much like (2), with the same caveats.

4. Market segmentation: Early models of this type were Grossman and Weiss and Rotemberg. Lucas worked on this, as did Fernando Alvarez, Andy Atkeson, Pat Kehoe, and Chris Edmond, among others. The idea here is that different people, firms, and financial institutions have different degrees of participation in financial markets. Some hold stocks, others don't; some trade frequently in sophisticated asset markets, others don't; some have transactions accounts with banks, but others don't. What this leads to is a distributional wealth effect from monetary policy actions. For example, an open market operation will have its first round effects on the economic agents who trade frequently in financial markets, and thus have initially large effects on asset prices, e.g. nominal interest rates. Over time, the effects become more diffuse, affecting everyone in the economy. These models never gained much traction, though Christiano and Eichenbaum did some empirical work in the early to mid-1990s on this stuff. I think they are interesting, but I don't think this mechanism will give you much in terms of effects on aggregate output and employment.

5. New Monetarist Models (shameless advertising): You can read about that stuff here, here, and here. One idea in here is that asset liquidity and liquidity premia are determined by how assets are used in exchange, and monetary policy actions can have subtle effects on asset prices and output that we can understand by being explicit about the exchange process in retail markets and financial markets.

6. Models with Illiquidities: Here, I am thinking of work by Mark Gertler, Nobu Kiyotaki, and John Moore, among others. This is somewhat related to (5), but is less explicit about the financial frictions. Interesting ideas though.

Where does that leave us right now? I more or less dismissed (1) as a useful theory of monetary policy. What does (2) tell us about what the effects of QE2 will be? This theory tells us that, once we are at the zero lower bound on the nominal interest rate, there is nothing the central bank can do. We can lower the interest rate on reserves from 0.25% to zero, but that won't do much, according to the theory. Of course there are some nominal interest rates - the yields on long maturity bonds - that are positive, but New Keynesian models are silent about how the quantities on the central bank's balance sheet can move those long-term interest rates. Ditto for (3).

Now, market segmentation might be able to tell us something here. Indeed, old-fashioned "preferred-habitat" models (though I don't want to call these things models - they are really just stories) are essentially about market segmentation. Given enough market segmentation, the Fed could in principle reduce long bond yields by purchasing long bonds. Also, (5) and (6) may have something to say as well. Exchanges of outside money for long-maturity Treasury bonds by the Fed could indeed increase the average liquidity of the outstanding debt of the Treasury and Fed combined. To the extent that the marginal value of liquidity in financial markets is high, this will matter, and could reduce long bond yields.

Now, how much will any of these things matter for real activity in the short run given the size of the QE2 operation? I think not much. With short-term nominal interest rates close to zero, and the market already flooded with liquidity from the previous large-scale asset purchases conducted by the Fed, I can't see that it will matter much, for real activity. It can certainly matter for inflation though, and this depends on the extent to which the outside money injections are not just held as reserves. One way you can think of the price increases happening without any increase in output is that price increases feed through the chain of supply. The price increases start in the markets for commodities - a storable commodity is just another asset, and we can think of this fitting into the array of available assets. Even if there are few good investment projects to fund, monetary policy actions can have the effect of bidding up the prices of commodities. These commodities are used in production processes, and increases in their prices increase the costs of production, and therefore lead to increases in final goods prices and in wages. All prices and wages go up together with little or no real effects.


  1. "If the central bank increases the level of the quantity of outside money - currency and reserves - in a one-time fashion, in the long run all nominal quantities, including prices and wages, will increase in proportion to the money supply increase, and there are no real effects."

    This doesn't make sense to me. Why will an increase in narrow money cause an equal magnitude increase in the price level?

  2. How about the fact that if the nominal rate is fixed an increase in expected inflation will imply a reduction in the real interest rate, hence increasing aggregate demand. If prices are sticky (and too high, so that output is too low) then output is demand determined, so a fall in the real interest rate will lead to higher output.

  3. What I mean is, if you are correct and increasing the monetary base increases inflation one-for-one, then QE will be a rip-roaring success. Won't it?

  4. vimothy,

    Did you carefully read the statement? Somewhere in it it says 'in the long run'.

    I agree that the 'long run' is a loose concept and whether 1, 10 or 1000 years is a good approximation of it depends on the model and on parameter values.

    I also assume that the statement abstracts from real growth. That may break the one-to-one relationship between money and prices in the long run.

    To the other anonymous:

    Are you saing that, given that we are in this mess because prices are too high (and thus output is too low), the solution is to increase prices even more?

  5. Steve,

    Maybe you were already aware of this paper. It's a formal model of the preferred-habitat hypothesis.

    They make some extreme assumptions but they also make progress, as far as I'm concerned.

  6. Okay, so it will be a rip-roaring success "in the long-run". I'm still confused about how increasing narrow money increases inflation one-for-one. What is the mechanism that produces this effect?

  7. vimothy,

    You can find the long-run neutrality of money discussed in any intermediate-level undergraduate macro text book. It's pretty much as I described in the paragraph beginning "The key question..." The money supply increase that QE2 will accomplish over the next 8 months, if it stays out there forever, will in the long run increase prices and wages in proportion to the money supply increase. That's not a rip roaring success, as in the long run it does not matter. What the Fed is concerned with is the short run, and there we enter to the contentious and the unknown, which is what the rest of the piece is about.

    First Anonymous,

    Yes, I'm afraid that's not how your sticky price model works.

    Last Anonymous,

    Yes, I read the Vayanos paper. I found it disappointing. Preferred habitat there amounts to putting assets in the utility function, which is not a sound basis for a theory of asset pricing.

  8. Abstracting from banks, suppose that for a given price level, agents want to hold a given amount of coins and notes, for whatever reason.

    No consider the case that the Central Bank doubles the amount of coins and notes in the hands of each agent. The Central Bank doesn't buy anything in return, it just gives away those extra notes and coins. The result is that for that initial price level, agents find themselves with more coins and notes than the ones they need and thus want to spend them. This causes an increase in prices until agents are happy with their cash balances.

    I think this is the main mechanism that most people have in mind.

  9. Yes, I already have plenty of them, thanks. And I know that in the long-run there is a strong correlation between narrow money growth and inflation. What I'm asking about is the causality and the mechanism that translates new narrow money into inflation. Que?

  10. Anon at November 12, 2010 6:26 AM:

    I agree with you that that sort of thing is what most people have in mind. We even get that story from some of our macro lecturers.

    It doesn't seem very realistic, though.

  11. I'm afraid that's not how your sticky price model works.

    Well, if you think of a traditional Keynesian model, investment depends negatively on the real interest rate, and the way monetary policy works is by reducing that interest rate, and hence increasing demand and output.

    Now, the standard story is that a one-off increase in the money supply reduces the nominal interest rate via the liquidity effect, and inflation expectations are either given or will increase, so the real rate falls. What I'm suggesting is that in this case, QE is part of the Fed committing to higher inflation, which has the effect of increasing inflation expectations directly, so the net result is the same.

  12. anonymous,

    I see what you are saying. Other people (Kocherlakota for example) have argued that there is a commitment implicit in long-maturity asset purchases that could convince people that the Fed really wants higher inflation. Ultimately, of course, the Fed has to be able to actually produce the inflation.

  13. Stephen,

    Thank you very much for the effort. I am putting together a response, but I may be too busy for the next few days to complete it. Thanks again.

  14. Stephen,

    You seem to be answering too limited a question. I think everything you've said is correct here (not a surprise, you're just reviewing the literature) but why does the causality have to go from real GDP growth to inflation.

    In your supply chain story why doesn't the increase in inflation, and expected inflation, feed back into the Euler equation as a lower real rate and increase demand that way?

    After all, Bernanke has been quite clear that the extra QE is because inflation is lower than he wants it, thus there is room for an increase in inflation that won't prompt an increase it the nominal policy rate. The Fed would only tighten if inflation got higher than they want.

    So, if they want 2% then an increase from the current roughly 1% to their preferred 2% would be a 1% reduction in the real rate. That would then cause an increase in demand.

  15. Stephen,

    "Ultimately, of course, the Fed has to be able to actually produce the inflation."

    Exactly, but you've already said that in the long run, the Fed has produced the inflation, by increasing base money. Sorry, not intending to be argumentative. Genuine question from a student. I don't understand how you square the argument--what about the monetarist counter-factual? Isn't it more likely that the causality goes inflation > base money than vice versa?

    Since I'm here, I'd like to ask a couple of question about Ricardian equivalence as well. This is totally off-topic, but... I hate the ISLM model, which is about half my econ course. It's driving me nuts! You mentioned in your post critiquing ISLM that you want to model forward looking agents and that this implies some form of Ricardian equivalence. Are agents only forward looking with regard to the government sector or is this principle applied consistently to all in your model? E.g., do agents look at a corporate sector deficit, forecast some form of tightening and so cut spending in anticipation? Can agents apply it to themselves?

    It seems to me that the Ricardian proposition implies that no one is ever in deficit, which is empirically false, and so therefore Ricardian equivalence must be false.

    Second question: Is this circular? Does it even make sense to describe behaviour like this?


  16. vimothy,

    In modern macroeconomic models (standard neoclassical growth model, New Keynesian, New Monetarist, whatever) everyone is foreward-looking. The typical statement of Ricardian equivalence is that, if we fix government spending on goods and services, under a certain set of conditions (no frictions in credit markets, no distorting taxes, infinite-lived economic agents) the timing of taxes does not matter. If the government cuts our taxes today, we understand that this means that the government issues more debt, and must tax us more heavily in the future to pay off the debt. Our lifetime wealth is unaffected, our consumption does not change, and we simply save more to pay the higher taxes in the future. You can relax some of the conditions, including adding credit market frictions. Ricardian equivalence is very useful as a starting point. It helps us understand why deficits matter in practice. You can extend the idea to monetary policy too. There are conditions under which monetary policy doesn't matter, and once you understand that, this helps you understand why it can matter. What you said about the Ricardian propostion implying no one is ever in deficit is not correct.

  17. Stephen,

    Thanks. I (think I) understand the principle, but why doesn't it apply to the rest of the economy? That was my question. A forward-looking infinite-lived agent should recognise that any flow of net spending from any sector will have to be reversed in the future, and will therefore increase saving in anticipation.

  18. last anonymous,

    That is certainly an important element of non-neutrality: can the Fed move the real interest rate, and what real interest rate? In this case, they seem to think they can have an effect on the real long-term rate of interest. A problem might be that if, indeed, we start to get more inflation, and a lower real short-term rate, trying to hold the interest rate on reserves at 0.25% will imply increasing inflation, and the Fed will have to increase the short rate to stop that.

  19. "If the central bank increases the level of the quantity of outside money - currency and reserves - in a one-time fashion, in the long run all nominal quantities, including prices and wages, will increase in proportion to the money supply increase, and there are no real effects."

    This makes no sense to me (my fault probably, but bear with my rant).

    If money increases and so wages and prices go up, there are real effects because debts are nominal and remain the same. Debtors therefore benefit. Given that debtors and savers probably have different propensities, some parts of the economy will do better than others. And, in spite of the "one-off" promulgated, in the real world savers will not be easily fooled a second time, and will demand a inflation-risk premium in the future, which will again have real effects.

    OK maybe you are talking about models (of theoretical agents and in the long-run) in which this is true, but that would only seem to show that the models are worthless as models of the real world, since the models are not even close as an approximation.

    Am I missing something? What is it?

  20. "If money increases and so wages and prices go up, there are real effects because debts are nominal and remain the same."

    Sure. That's a short run effect. Debt contracts are written in nominal terms, so unanticipated inflation redistributes wealth from lenders to borrowers. What I was discussing at the outset was long-run monetary neutrality - the effects long after those wealth redistributions have gone away.