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In Which I Protest at a Little Monetarist Revisionism by Scott Sumner...

SS writes:

TheMoneyIllusion » Don’t mind the gap: In philosophy the “god of the gaps” hypothesis suggests that while science can explain most phenomena, certain seemingly inexplicable events (the origin of life, the universe, the laws of nature, Morgan’s comments, etc) must be attributed to a deity.  In this recent post, I argued Keynesians were using a similar argument for fiscal stimulus. By the 1990s, most macroeconomists attributed changes in the expected level of nominal spending to monetary policy, and this made fiscal stabilization policy redundant, a sort of 5th wheel.  During the recent crisis, some Keynesians have attempted to revive the arguments for fiscal stimulus, arguing that monetary policy was ineffective at the zero rate bound.  When a group of quasi-monetarists reminded them that there are all sorts of unconventional monetary policy tools, the Keynesians argued that these tools would only be effective if credible, and it was unlikely that markets would believe central bank promises to inflate.  Then the quasi-monetarists showed that markets did react to rumors of QE2 in a way that implied the policy was credible.  Once again, Keynesian fiscal stimulus would seem to have no role to play...

As I understood (and understand) the argument, it goes like this:

Monetarism gives you a relationship between the nominal stock of money M and the level of nominal spending in the economy P via the quantity theory of money thus:

PY = M • V(i)

where V is the velocity of money, and V(i) indicates that the velocity of money depends on the opportunity cost of holding money i, which is the short-term safe nominal interest rate on Treasury Bills--the higher is i, the higher is the velocity of money.

An open-market operation that expands the monetary base and thus the money supply M is a central bank swap of cash for Treasury Bills, which decreases the economy-wide supply of Treasury Bills. By supply and demand, if you decrease the supply you increase the price of Treasury Bills--which means that the interest rate i on Treasury Bills goes down. This means that the opportunity cost of holding money falls and hence the velocity of money falls.

Does i fall by enough to make monetary expansion completely ineffective? Almost surely not. Does i fall by enough to make monetary expansion relatively ineffective? Perhaps in situations like the one we are in now—certainly the track of the high-powered monetary base in 2008-2009 suggests that that is so.

What then should we do? Analytically, we should follow John Hicks, who pointed out that the quantity theory of money needed to be supplemented by another equilibrium condition in order to pin down both nominal spending PY and the nominal interest rate on Treasury Bills i. He chose bond market equilibrium: supply equal demand in the market for savings vehicles to move purchasing power forward into the future:

I(i-π, other stuff) + (G-T) = S(i-π, Y, other stuff)

This two-equation system tells us that open-market monetary expansions may only be substantially fruitful if they are accompanied by other policy interventions to make monetary expansion effective--to keep the OMO from pushing nominal interest rates down--by shifting the interest rate that equilibrates demand and supply for financial assets.

And even if you don't change the money stock M, interventions in the bond market that raise equilibrium i will raise PY to the extent that V is interest elastic.

What kinds of policies would qualify as interventions in the bond market to raise i, or at least to keep it from falling in response to expansionary open-market operations?

  • Policies that increase inflation expectations and thus boost I and so increase the supply of financial assets.
  • Policies that increase the government deficit and thus boost G-T and so increase the supply of financial assets.
  • Policies that increase business confidence and so boost I and so increase the supply of financial assets.

Note that, at least in this Hicksian framework which Milton Friedman used for his "Monetary Theory of Nominal Income," the channels through which Sumner claims that expansionary monetary policy raises spending in a liquidity trap--the "unconventional monetary policy tools" of which he speaks--work through altering the supply-demand balance in the bond market and thus through the same mechanism that expansionary fiscal policy works.

(And, in addition, expansionary fiscal policy has direct effects on V all by itself--government purchases, after all, do not require as much liquidity backing as your average transaction.)

Think of a model in which the government tunes its fiscal policy to hit a target for the nominal interest rate on Treasury Bills, expanding spending when i is too low and contracting spending when i is too high. In such a model expansionary open market operations are very powerful precisely because fiscal policy is then always tuned to making monetary expansion and contraction effective.