« Loanable Funds and Liquidity Preference; DeLong vs. Fama | Main | One useful insight from Austrian business cycle theory »


Feed You can follow this conversation by subscribing to the comment feed for this post.

Since commitment is possible, why not look at cooperative solutions?

Another point here... there's only one (consolidated) government budget constraint. Seigniorage, taxes, public debt, it's all in the same pot.


Your second point first: all the "profits" go in the same pot, so we can't push the analogy to duopolistic firms too far. But if the central bank and government disagree on the right level of aggregate demand, or disagree on the inflation or output/employment target, or disagree on the numbers in the model of the transmission mechanism, they can still have diffeent objective functions defined over {monetary policy, fiscal policy} space, and that's all we need to get a fun game going.

Your first point: I'm still trying to think up a good answer. For some reason, governments want an independent central bank (they seem to do better). So the government has in effect deliberately ruled out a cooperative solution to the game. Something to do with the government's inability to pre-commit would be the standard answer, I think.

Nick, good stuff. The only part I do succintly agree with is that fact that monetary policy is now, more or less, useless. I sincerrly hope Friedman and his ilk are turning over in thier graves.

" If the Bank of Canada wants (say) slightly lower aggregate demand than the Department of Finance, then if the Bank sets monetary policy to get aggregate demand where the Bank wants it to be, Finance will respond by loosening fiscal policy, to which the Bank responds by tightening monetary policy, to which Finance responds...etc. "

Have you thought this through? Great!

Could you explain how the Fed lowering the Fed funds rate changes aggregate demand? Before you answer, please consider that the lowering of interest rates would lower interest payments to lenders from borrowers which would lower aggregate demand provided by lenders while raising aggregate demand created by borrowers. A wash?

The Fed raising interest rates and inverting the yield curve can force fixed rate loans, made by lenders, upside-down thereby destroying the lender's capital base (as in the present case and previous cases in history). It therefore seems the Fed can destroy aggregate demand quite easily but with a very blunt instrument.

Is there any direct evidence where monetary policy can be isolated as causing an increase in aggregate demand? No new technological boom, no fiscal deficit spending, no relaxation in lending standards, just a simple lowering of the Fed Funds rate causing an increase in GDP.

Logically monetary policy doesn't seem to have any ability to alter demand unless lenders are less likely to spend than borrowers or we want to destroy the financial sector.

Winslow: I am glad you made that comment. A lot of people (including expert economists) totally miss the perfectly valid point you have just made. But then you have missed another valid point that they make. So I'm going to take the opportunity to kill two birds with one stone (not an environmentally correct metaphor).

If the price of apples falls, it creates "income effects" and "substitution effects". (ECON1000, Micro)

Income effects: A fall in the price of apples makes buyers of apples better off (and so increases their demand for stuff), but it also makes sellers of apples worse off (and so decreases their demand for stuff). (Where "stuff" can include apples). But in macroeconomics, at least in a closed economy where we neither export or import apples, the value of apples bought equals the value of apples sold. So the gain in real income to the buyers is equal to the loss in real income to the sellers. So, unless the buyers and sellers of apples have different marginal propensities to consume, it's a wash. Exactly as you say.

This is something few macroeconomists seem to understand, so I will say it explicitly: price changes do NOT have aggregate income effects in macroeconomics; they only have distribution (of income) effects, if any. (This is not true if the country is a net importer or exporter of the good in question).

That was the bit you got right. Here's the bit you forgot:

Substitution effects: A fall in the price of apples will cause buyers of apples to substitute away from consuming pears into consuming more apples, now that apples are relatively cheaper compared to pears. And it will cause sellers of apples to substitute away from producing apples into producing more pears. So it creates an excess demand for apples both from the supply and the demand sides.

In macro, to a first approximation, we should ignore income effects of price changes and look only at substitution effects. Only look at income effects if we either export or import a relatively large amount of the good in question. Only look at distribution effects if you are interested in them in their own right, or have some idea about which direction they go, because otherwise they probably wash out.

For "apples" read "loans".

A fall in the rate of interest causes a substitution effect, towards consuming more goods today, and fewer goods tomorrow. Forget income effects.

For "apples" read "loans".

Substitution effects: A fall in the price of 'loans' will cause buyers of 'loans' to substitute away from consuming pears into consuming more 'loans', now that 'loans' are relatively cheaper compared to pears. And it will cause sellers of 'loans' to substitute away from producing 'loans' into producing more pears. So it creates an excess demand for 'loans' both from the supply and the demand sides.

Huh? :)

Thanks. I am inclined to agree 'at best' aggregate demand may be shifted forward or backwards by raising and lowering interest rates and therefore the current transmission mechanism is a very weak policy tool.

Why not strengthen the monetary policy and actually alter aggregate demand through a channel similar to fiscal policy?

A 'monetary tax' can be implemented by redesigning the broken transmission mechanism where the Fed loans directly to the states on a per capita basis at the current Fed funds rate in large quantities ($6 trillion). This will allow the monetary authority to remove ('tax') funds from circulation in large quantities, subtracting from aggregate demand. In slow times, by lowering the interest rate, the monetary authority could slow or stop the removal ('tax') of funds from circulation. These loans would greatly strengthen the Fed and the effect of its monetary policy tool.

Any ideas why this wouldn't work?

Seems like state governments would be slower to respond to a change in the rate.

"Seems like state governments would be slower to respond to a change in the rate."

Good point, and one of reasons to post such ideas is to improve them.

Perhaps state governments would tie their tax rates to the current fed funds rate allowing for monetary policy to be counter-cyclical and immediate.

To get even closer to the foundation of the economy, perhaps the Fed could make per capita loans direct to those citizens that desired them.


Winslow: Let me re-phrase. The (real) rate of interest is the relative price of present vs future goods. A 10% interest rate (adjusted for inflation) means that if you want to consume 100 more goods today, you must cut consumption by 110 next year (or 121 the year after that, etc.)

So a fall in the real rate of interest reduces the relative price of buying goods today (for consumption or investment) vs. buying goods in the future. That's the substitution effect.

Andrew: "state" as in "provincial"? (US - Canada translation).

I don't know about slower. But it is interesting to add provincial/state governments to the game. Provincial fiscal policy has a smaller multiplier (because of greater marginal propensities to import). (Though maybe the fixed vs flexible exchange rate question would change that, since each province has fixed exchange rates relative to other provinces). Also, provinces are small relative to the Bank of Canada, or the Federal government, so couldn't really play Stackelberg leader. Would be an interesting exercise to throw provinces into the game, as a third set of players.

The comments to this entry are closed.

Search this site

  • Google

Blog powered by Typepad