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I thought of that too.

Greg Ransom @11.22 December 5th. I'm sort of on the same page as you there. But I would say that "money" (medium of exchange) is the "trace data" and loose joint. Money matters, and matters a lot. But why does it matter where money is injected?

Nick,

For credit demand, liquidity preference, and productivity to be constant a lot of things have to happen that don't exist in reality.

1. For increases in debt levels to always be matched with increases in real growth (constant productivity) we need either a non-resource bound economy (think Star Trek energy to matter converter) or we need a never ending stream of value added enterprises.
2. For constant liquidity preference we would need some sort of command and control economy (think of coal mines and company stores).
3. For constant credit demand we would need credit rationing - say Friedman's constant money growth recommendation.

Assuming you can get all three then what I said is true.

Frank: think about worm gears. Or think about balancing a pole upright in the palm of your hand. If you want the top of the pole to go North, do you move your hand North?

Nick, let's redirect the flow of government bonds and Fed bond purchases by giving taxpayers the option to buy bond rather than pay their taxes. What if the Federal Reserve begins buying these bonds.

What do we have going on here?

We could add other background premises to the story, but lets start with that.

Monetary policy or fiscal policy .. at what point is which, which.

If we switched from what we have today to this alternative regime, does anything at all happen?

Greg: "Nick, let's redirect the flow of government bonds and Fed bond purchases by giving taxpayers the option to buy bond rather than pay their taxes."

That doesn't work. Nobody would pay taxes if they had the option to buy a bond instead (for the same amount of money).

Idle ruminations: if it doesn't matter how the money goes in, does it matter how the money comes out? Is reversely the process qualitatively different?

Blast - "Is reversing the process"

Nick,

The original question posed by Alex was:

Most of us assume that market forecasts of inflation have at least some predictive value. But fine, let's throw that one out. Which do you think is more likely:

1) If the Fed cuts nominal interest rates, inflation will probably go up (relative to what it otherwise would have been).
2) If the Fed cuts nominal interest rates, inflation will probably stay the same.
3) If the Fed cuts nominal interest rates, inflation will probably go down.
4) None of the above

And my original answer to this question was 4) none of the above. Through some manipulation of the equation I presented (take derivative of both sides with respect to the nominal interest rate) you can show that the nominal interest rate is positively correlated with the inflation rate. However, that assumes that no other variables (liquidity preference, productivity, credit demand) change with respect to the nominal interest rate.

You can make the argument that credit demand and liquidity preference are negatively correlated with the nominal interest rate to which I would agree. But when Alex and I were taking the derivative we did not allow for that (assume all other terms constant).

And so my answer is still 4).

Nick,

"That doesn't work. Nobody would pay taxes if they had the option to buy a bond instead (for the same amount of money)."

Nobody would buy bonds if they realized that there were no taxpayers to make the interest payments on the bonds.

Frank: read my post. That's what happens when you let engineers/mathematicians loose on economics. They mistake correlation for causation. Some causal processes don't run in reverse (worm gears, poles balanced upright).

Edmund: that one should work in reverse too. ;-)

Nick: "Oh Christ"

Yup. That's why I said this is at the core of the thinking you have to adopt if you believe in the RBC model. Since you can't deny that the CB can control the nominal rate then in order for the real rate to be determined by the free market at the equilibrium natural rate, you *have* to believe that every move in the nominal rate is accompanied *one for one* by an equal move in expected inflation. If the CB hikes by 10%, inflation will rise by 10% as required in standard RBC.

BTW, your first example *really* doesn't work :-)

Frank,

If your answer is 4 then you are saying that inflation is on average independent of the nominal rate. In that case the real rate, on average, moves up by 1% when you move the nominal rate up by 1%. To claim that the CB can't control the real rate the burden is on you to prove that expected inflation goes up on average by exactly 1% for every 1% increase in the nominal rate. That's a high hurdle. You're simply deluded if you think a 10% rate hike is going to cause an inflation spike.

Nick,

My original answer was 4) None of the above. I did not say that the positive correlation between nominal interest rates and inflation was an accurate reflection of reality nor did I say it implied direct causality between the two.

I believe you are arguing for sticky prices and / or market failures (hence the reference to worm gears working one way - debt expansion, but failing the other way - repayment of debt). It is a valid point. The model I presented does not allow for credit default - it assumes that all debts are paid in a timely fashion.

Sorry for the confusion.

K: "That's why I said this is at the core of the thinking you have to adopt if you believe in the RBC model. Since you can't deny that the CB can control the nominal rate then in order for the real rate to be determined by the free market at the equilibrium natural rate, you *have* to believe that every move in the nominal rate is accompanied *one for one* by an equal move in expected inflation. If the CB hikes by 10%, inflation will rise by 10% as required in standard RBC."

That is a very good point.

"That's why I said..."

Where did you say it previously? (Sorry, my brain is fried, from too many comments.)

"BTW, your first example *really* doesn't work :-)"

You mean worm gears? Depends on the gearing, and the friction, doesn't it? My toy trains couldn't be pushed to make the motor turn.

K,

"If your answer is 4 then you are saying that inflation is on average independent of the nominal rate. In that case the real rate, on average, moves up by 1% when you move the nominal rate up by 1%. To claim that the CB can't control the real rate the burden is on you to prove that expected inflation goes up on average by exactly 1% for every 1% increase in the nominal rate. That's a high hurdle. You're simply deluded if you think a 10% rate hike is going to cause an inflation spike."

You are reading way too much into what I said. I said my answer is 4 because answers 1,2, and 3 do not accurately reflect what I believe. Inflation is not on average TOTALLY indepedent of the nominal rate. There are other factors at work. If the fed does a 10% nominal rate hike, if productivity does not increase to accomodate that 10% rate hike, if credit demand does not fall to accomodate that 10% rate hike, and if liquidity preference does not fall to accomodate that 10% rate hike then one of two things will happen:

1. A lot of borrowers will default on their loans (something that is missing from my model)
2. You will get higher inflation

Nick,

I said it yesterday at 12:24pm in this comment thread.

As far as your "first example" goes, I was talking about the current post, not the old one. The old one is great. In the current post I was objecting to the idea that paying 10% on money would cause inflation. By arbitrage, nominal interest rates would have to rise to 10% which (as we're discussing now) would definitely result in disinflation, not inflation. That's why it's very different from the helicopter drop in the second example.

Edmund,

"The Austrians love the market. In the market for ideas, Austrian economics hasn't done well. Should this not give one pause?"

Hayek #1 seller in "Theory of Economics" on Amazon:
http://www.amazon.com/gp/bestsellers/books/2602?ref=sr_bs_1

Alexa rankings:
- Zerohedge: 1,963
- Ron Paul: 9,176
- Mises.org: 18,072

Meanwhile, other popular economics sites...
- Marginal Revolution: 43,237
- Freakonomics.com: 43,389
- Scott Sumner: 239,824
- Steve Keen: 260,609
- Greg Mankiw: 313,373

Not too bad. Like it or not (and there are many times that I don't), look forward to seeing a lot more "Internet Austrians" in the future.

"Greg Ransom @11.22 December 5th. I'm sort of on the same page as you there. But I would say that "money" (medium of exchange) is the "trace data" and loose joint. Money matters, and matters a lot. But why does it matter where money is injected?"

The language of "injected" isn't particularly helpful.

Money, credit & highly liquid substitutes for money snowball in the banking and finance sector in ways tied to lengthening of production processes, with pushes from Fed Reserve policy, pushes which lower risk and perceptions of risk on some margins, change relative price relations etc. It might be added that too big to fail is part of monetary policy.

Things would be different if the Fed were targetting pushes toward individuals who prefer expensive back rubs to long production goods and other assets, for example, by distributing free cash that can only be used in its first use for back rubs, validated by licensed back rubbers.

Greg: compare two policies:

A: The Fed gives $1 billion new money to people who are very impatient to consume now.

B=B1+B2, where B1. The Fed buys bonds with $1 billion new money. B2. The government issues $1 billion bonds and gives the proceeds to people who are very impatient to consume now.

A is identical to B. Are the effects of A identical to the effects of B?

In scenario A the government has no bonds, in scenarios B the government has outstanding bonds or issues bonds.

Tomorrow the government defaults on its bonds.

How is A identical to B?

Let me roll with my snowball metaphor.

Snowballs can roll and snowballs can met, snowballs call roll in thick wet snow and snowballs can find themselves hitting bumps or hills in the road and slowing down. Snowballs roll even faster are steeper slopes.

Now, snowballs can roll on their own and they can melt on their own.

Now Fed actions and expectations of Fed actions and implicit too big to fail guarantees from the Fed -- and changes in the realities and expectations of all of these, can give the snowball a push. And the can give the snowball new fresh snow. And they can assure people that is will all be downhill rolling (the Greenspan put, too big to fail, Keynesian 'aggregate demand management' scientific assumptions).

Now, the 800 lb gorilla of the economy is the financial and investment sector. This is the snowball that gets the special care and feeding of the Fed and the government more generally.

I don't think it helps a lot to use the metaphor of saying the Fed or the government "injects" anything into the snowball.

I think its better to say they are rolling a snowball, pretending they can make it roll as fast and as big as they can make it -- and every time its about to hit a cliff sized hill, all they have to do is make it snow and tilt the playing field some more to keep it rolling. Cliffs don't exists if the Fed just keeps that snowball ripping.

Nick,

Presuming a demand for goods that are consumed (purchased) with money
Scenario A: The Fed creates money to meet a demand for money equal to the demand for goods times the price level.
Scenario B: The government borrows money from the Fed equal to the demand for goods times the price level. Government then creates an additional demand for money through taxation to make the payments on the bonds.

Scenario A - Demand for money = Demand for goods x price level
Scenario B - Demand for money = Demand for goods x price level + Taxation

If demand for money and demand for goods is constant in both scenario A and scenario B.

Scenario A - Price Level = Demand for Money / Demand for Goods
Scenario B - Price Level= ( Demand for Money - Taxation ) / Demand for Goods

Greg Ransom,

"Tomorrow the government defaults on its bonds. How is A identical to B?"

The bonds are issued by the government to *itself*. It's pure accounting, and it can me modified at any time with zero impact. In scenario A, for example, the treasury could just issue a $1Bn bond and give it to the Fed (then the accounting is identical to scenario B). No difference, default or not.

"Proceeds" -- I thought there was a sale of the bonds to the public here.

"The government issues $1 billion bonds and gives the proceeds to people who are very impatient to consume now."

The bonds are issued by the government to *itself*.

Nick, if the bonds are at 150% interest, compounding daily and maturing short term, and most taxes are payed by folks who are investors, it looks to me like we have a process which shortens the production process and eventually sterilizes cash.

K -- We are talking about publicly traded bonds, I thought. If the government defaults on its bonds, taxpayers are off the hook, and the Fed and banking system lacks the reserves which give solvency to their balance sheets. There is a time structure component of flows of money and resources implicit in bonds. That's why they are anything at all. If there wasn't a time component to bonds, they'd just be money, right?

Are there special bonds that are exchanged only between the Fed and the US government and are not traded with the public?

What if we eliminated the bonds and just made the US government pay a tax whenever the Fed credits money into the US governments account. What if there was a delayed time element on the tax -- a tax payed over a period of time.

And what if the right to these taxes could be publicly traded. Do we now have a "bond" again?

Isn't the key thing the fact that government bonds compete with investments in time-taking production processes among those who refraining from consumption in the promise of some future return?

If we have government bonds circulating and being traded, we have an alternative to production goods investments trading almost as money, the way stocks can trade almost as money.

But the distributional effects are different.

To be explicit, we have a process that works to shorten the production process at both ends, not just one.

I wrote,

"Nick, if the bonds are at 150% interest, compounding daily and maturing short term, and most taxes are payed by folks who are investors, it looks to me like we have a process which shortens the production process and eventually sterilizes cash."

Finally, I found out what "Cantillon effects" are supposed to mean.

But I don't like your dissection. (Admittedly, I'm not an Austrian and you were arguing with them.)

As far as I'm concerned, the only relevant "Cantillon effect" is the question of whether the money enters the economy in the hands of people with a *high propensity to spend the money* (poor people, mostly), or whether it enters the economy in the hands of people with a *low propensity to spend the money* (rich people, mostly). This determines the velocity of money, the multiplier effect, etc.

It's the only relevant "how the money gets into the economy" question: shovelling the money into zombie banks which dump it in vaults to "repair their balance sheets" doesn't help the economy at all, while shovelling it to poor people who immediately spend it on food (and the supermarkets spend that on labor, and pay truck drivers to move the food, and then the money goes to the farmers, who spend it pretty quickly too) does help the economy.

"What do you think would be the bigger deal: increasing the inflation target from 2% to 12%, or changing taxes or government spending by 0.4% of GDP?"

Well, this depends very much on where the money goes. Money to the poorest has a *massive* multiplier, so 0.4% of GDP directly to homeless people would have a definite effect. Meanwhile, changing the inflation target... depends on the transmission channel through the banks, and if the transmission channel is broken, then you can raise the target to 5000%, and there still won't be any inflation, the money will just sit in the pockets of the bank executives.

Is this really in dispute? I'm using extreme examples deliberately. In the range of "cut taxes on professors" versus "building bridges" versus "cheaper mortgage lending" I'm sure the "Cantillon effects" are not macroeconomically important. But in the range of "money in the bank accounts of billionaires" versus "food stamps", they pretty clearly are macroeconomically important.

I think I agree with you -- "deciding where the money will enter the economy IS fiscal policy" is something I agree with -- but I'm just not clear on what you're saying.

Nick: "deciding where the money will enter the economy IS fiscal policy" reminds me of an earlier comment I made this winter:
"fiscal policy is for those who don't have money to play games with and whose portfolio choice is between milk and bread"...

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