Deflationary death-spirals and the social construction of monetary policy

I present a simple macro model and use it as a vehicle to explore the idea that it matters how monetary policy is framed. One framing leads to a deflationary spiral, which an alternate framing can avoid or escape. The model is an otherwise bog-standard New Keynesian/Neo-Wicksellian model, but with a minor modification in the financial sector.

Phillips Curve: p = 0.25(y-y*) + 0.5p(t-1) + 0.5E(p)

Lower case p is inflation between this period and the next (sorry, but I can't do Greek), y is real output, y* the natural rate of output, and E(p) expected inflation. There's a 50-50 mix of forward- and backward-looking elements. There's a whole literature on the backward-looking elements, which are needed empirically to give inflation inertia. I need the backward-looking element to slow things down so we can see deflationary spirals evolving slowly when monetary policy makes a mistake under the wrong framing. Otherwise they would happen instantly.

IS curve: y-y* = n-r

Where r is the real rate of interest, and n the (time-varying) natural rate of interest. I am tempted to replace y* with expected future y. This would be better theoretically (the IS curve then has the standard Euler equation interpretation). It would also give more interesting results, because a deflationary spiral would then have an additional channel of positive feedback, since a fall in expected future output would mean the real interest rate would have to fall even further to break the cycle. But it's not needed to illustrate my point, and makes the maths a little harder.

Substituting the IS into the Phillips Curve gives us the IS-PC equation:

p = 0.25(n-r) + 0.5p(t-1) + 0.5E(p)

It is important that the coefficient on the real interest rate be small relative to the coefficient on lagged inflation, if we want to see the deflationary spiral evolve slowly. Otherwise it would happen instantly.

Financial sector. There are two financial assets: nominal bills and "real bills". Firms/households issue both to fund their spending. (As in all Neo-Wicksellian models, there's really a third financial asset, the medium of exchange, that is implicit in the model, because the violation of Say's Law makes no logical sense otherwise.)

A nominal bill is a promise to pay $1 in the next period. If B is the nominal price of a nominal bill, we can define the nominal interest rate i as

B=1/(1+i)

A "real bill" is a promise to pay 1 unit of real output in the next period (or its monetary equivalent). If R is the nominal price of a real bill, and P the current price level, we can define the (ex ante) real interest rate r as

R=P(1+E(p))/(1+r)

(I hate using the term "real bill" in this context, when it already has two different and contradictory meanings in the history of monetary thought. I would rather replace my "real bills" with shares in a stock price index mutual fund, but doing so would complicate the model. I still think of them as representing shares nevertheless.)

People are risk neutral, so in equilibrium the two financial assets give the same inflation-adjusted expected rates of return

(1+i)=(1+r)(1+E(p))

I approximate this as i=r+E(p) when I need to.

Monetary Policy.The central bank wants zero inflation and a constant price level (where P = $1). (I know there's an important distinction between inflation targeting and price level path targeting, but I will largely ignore it, because it doesn't matter for my purposes). The only time-varying parameter in the model is the natural rate of interest, n. Assume the central bank observes n contemporaneously.

If the central bank gets what it wants, we can describe the equilibrium as:

1. P=1 (or p=0 and E(p)=0).

2. B=1/(1+n) (or i=n)

3. R=1/(1+n) (or r=n)

[Update: typos fixed in 2 and 3, thanks to himaginary]

An outside observer, who saw the evolution of data for this economy, would be unable to distinguish between three different ways of "framing", or social constructions of monetary policy: 1. "The central bank is targeting inflation"; 2. "the central bank is targeting the price of nominal bills"; 3. "the central bank is targeting the price of real bills". All three are observationally equivalent, even if the observer knows the structural equations, and observes the natural rate of interest n. And there are many more ways he could describe monetary policy, including complex ways of describing it, like: 4. "targeting the nominal interest rate in order to target inflation".

Suppose the outside observer is a sociologist, who wishes to discover how people in this economy themselves construct reality. He induces a breach in the equilibrium. Suppose there is a temporary drop in the natural rate, n, by one percentage point, but the sociologist hides this fact from the central bank, by falsifying the bank's data. What happens?

What happens next depends on how the population and central bank frame monetary policy. And it is precisely because what happens depends on the framing that the sociologist's experiment succeeds in revealing that framing.

Suppose that people believe the central bank targets inflation, so E(p) stays at zero. And they maintain this belief in inflation targeting, despite temporary evidence that the central bank has failed to hit its target. But the central bank does not target inflation directly, and instead frames monetary policy as targeting the price of nominal bills (equivalent to the nominal interest rate), in order to hit its ultimate target, zero inflation.

In period 1, the natural rate drops, but the bank doesn't see it, so the price of nominal bills stays the same. The real and nominal rates of interest stay the same, and are now above the natural rate. So output drops below the natural rate y*, which means that actual inflation drops below zero.

In period 2, the bank learns that the sociologist has falsified the data, and takes the necessary steps to bring inflation immediately back to target. Because lagged inflation appears in the Phillips Curve, this requires the bank to engineer a boom, with output above y*. This in turn requires setting the nominal interest rate on nominal bills below the natural rate.

In period 3, everything returns to normal, except that the price level is lower than before the sociologist's experiment.

Now suppose people believe the central bank targets the price of nominal bills (the nominal interest rate). (Or they originally believed the bank targets inflation, but lose faith in this framing when they see the bank fail to hit its target.)

In period 1 the results are exactly the same as above, because people don't see what the sociologist is doing, and so continue to expect zero inflation.

In period 2, suppose people expect the bank to set the nominal rate equal to the natural rate. What would they expect to happen? (What would happen if the bank did what people expect it to do?). Substituting the IS into the Phillips Curve, setting i=n, and imposing rational expectations we get

p = 0.25(n-i+E(p)) + 0.5p(t-1) + 0.5E(p) = 0.5p(t-1) + 0.75E(p) = 2p(t-1)

So if the population stops framing monetary policy as targeting inflation, and instead frames it as setting the nominal rate of interest, then they expect a deflationary death-spiral with deflation doubling every period, the real interest rate rising continuously relative to the natural rate, and output falling continuously with the output gap doubling every period.

Central banks are aware of this danger, of course, which is why they don't frame nominal interest rate targeting as setting

i=n+p*, where p* is target inflation.

The above interest rate rule fails to obey the "Taylor Principle". If the population ever loses the frame of monetary policy as targeting inflation, so that expected inflation differs from target, the central bank needs to frame monetary policy as setting:

i = n + E(p) + a(E(p)-p*), where a is some strictly positive number.

But if our central bank (with a target of zero inflation) cannot observe expected inflation, and can only observe lagged actual inflation, it would need to frame monetary policy as:

i = n + (2+2a)p(t-1)

[minor math mistake fixed, thanks to himaginary]

If the inflation target is credible, so that expected inflation never deviates from target, an outside observer would be unaware of the existence of the (2+a)p(t-1) term. It's rather like police reserves. As long as the crowd knows they are there, even if hidden, the crowd obeys the social rules, and we never see the reserves deployed. But if the crowd ever did start to riot, would the reserves be big enough to restore the original social reality -- the mutual expectations of following the rules?

If the central bank ever lost control of expected inflation on the upside, there is no limit on how high it could raise the nominal rate of interest to restore order. But if it ever lost control on the downside, the zero lower bound on nominal interest rates does impose a limit on the bank's ability to restore order. The police have limited reserves, and if too many in the crowd run riot, there won't be enough reserves to restore order; and the crowd knows this. With deflation and expected deflation doubling every period, a central bank that waited too long to call in the reserves would lose control of the inflation target.

Now suppose we change the way monetary policy is framed. Suppose people believe that the central bank targets the price of real bills, rather than nominal bills, in order to maintain its inflation target. Let's re-run the sociologist's experiment.

In period 1 exactly the same thing happens as before. The central bank doesn't learn that the natural rate of interest has decreased, and so sets the price of real bills too low, and the real rate of interest is therefore above the natural rate. Output falls below y*, and inflation is negative.

In period 2 and thereafter the central bank once again learns the correct value of the natural rate of interest, and is expected to set the nominal price of real bills at R=1/(1+n) thereafter. This framing of monetary policy rules out the possibility of a deflationary spiral as a rational expectation. To see why this is so, substitute R=1/(1+n) into the definition of the (ex ante) real rate of interest to get

(1+r) = (1+n)P(1+E(p))

In a deflationary spiral, the price level P would fall without limit, and expected inflation E(p) would fall without limit. If the real interest rate were constant, this would mean the nominal price of real bills would fall without limit too. But if monetary policy were framed as holding the nominal price of real bills constant, a falling price level and falling inflation would mean the real interest rate would fall without limit too, so output would rise without limit, and that rising level of output would put ever-increasing upward pressure on inflation.

My math isn't good enough to solve for the time-path explicitly (though any competent graduate student could probably solve it), but it is easier to show that deflation cannot accelerate into a spiral. Suppose E(p)=p(t-1), and the IS-PC equation yields:

p = 0.25(n-r) + p(t-1)

Since P<1, and E(p)<0, we know that r<n, so there will be less deflation in period 2 than in period 1. With rational expectations, people will know this, which reinforces the brake on deflation. Inflation must eventually turn positive, and the price level must eventually return to its original level. Setting the nominal price of real bills anchors the long run equilibrium price level in a way that setting the nominal price of nominal bills can never do.

[Update: himaginary in comments provides the solution:

"I'm not good either, but here is some try:
p = 0.25(n-r) + 0.5p(t-1) + 0.5E(p)
= 0.25(1+n){1-P(1+E(p))} + 0.5p(t-1) + 0.5E(p)
= 0.25(1+n)(1-P) + {0.5-0.25P(1+n)}E(p) + 0.5p(t-1)
Assuming E(p)=p by rational expectation, it becomes
p={0.25(1+n)(1-P)+0.5p(t-1)} / {0.5+0.25P(1+n)}
The coefficient of p(t-1) is 1/{1+0.5P(1+n)}, which is less than 1. So deflation-spiral surely doesn't happen in this case."]

This result shows that framing monetary policy as targeting the price of real rather than nominal bills can prevent a deflationary spiral from ever getting started. Even if the central bank were permanently ignorant of the natural rate, and set R too low permanently, the cumulative fall in the price level, and rising expected deflation, would eventually mean the real rate would fall below the natural rate, ending the deflationary spiral.

Suppose nevertheless that a deflationary spiral did begin, perhaps because monetary policy had initially been framed in terms of targeting the nominal interest rate. Could a re-framing of monetary policy in terms of targeting the price of real bills break the spiral? Could it do this even if the zero lower bound on nominal interest rates were binding? If the re-framing were successful, and if the central bank can credibly commit to a future price of real bills, the answer is yes.

To see why this is so, remember that the price of real bills anchors the long-run equilibrium price level. By promising a high enough future price of real bills, the central bank can promise a future price level that is high enough to make current expected inflation positive. If monetary policy were framed as targeting the nominal interest rate, there is no way the bank can make this promise. People just wouldn't understand the language in which the promise were made, so it could not be credible.

To repeat what I said in a previous post: it's the framing of what central banks do that caused the mess, not anything central banks are actually doing. (The bank does exactly the same thing in period 1, whether monetary policy is framed as targeting the price of nominal bills or of real bills.) The social construction of reality is what dunnit!

Addendum: if you make two small changes in the model (replace y* with E(y(t+1)) in the IS curve), and change my "real bills" (which I think of as shares) into "nominal GDP futures contracts", my model would come close to what Scott Sumner is talking about. The small change in the IS curve would mean that the level of current output would depend on i-n plus the expected growth rate of nominal GDP (as opposed to the expected rate of inflation). But I can never remember the difference between a forward and a futures contract; the ones I want are where you pay $R this period, in return for a fixed percentage of nominal GDP next period, so a change in R for given expectations affects the real interest rate.

Comments

[noname]

And if output is at the natural rate of output, and not below it as presumed (as the consequence of a credit bubble) -- there is no 'cure'

[Adam P]

Nick, this is getting silly.

In first case (inflation targeting) you and the CB correctly reason that in order to get the price level back to the target they need to engineer a temporary boom and thus they lower the the nominal rate below the natural rate. That is, they obey the Taylor principle.

In the second case (nominal interest rate targeting) they, somewhat mysteriously, don't do this. Instead they set i=n and get the deflationary spiral because they have violated the Taylor principle. But why don't they try to engineer the boom in this case?

Now the third case (real interest rate targeting) where they are back to adhereing to the Taylor principle. The trick is that you said they set R=1/(1+n), THAT IS THEY SET r < n!!!! After all, in period 2 after we've had a fall in prices the current value of R such that r=n is P/(1+n) with P<1!! So they are back to setting r

So what does social framing have to do with anything? You engineered the bank to follow the Taylor principle in all but the second case.

[Adam P]

Correction to the last sentance in fourth paragraph (discussing the third case), should read:

So they are back to setting r

[Adam P]

And of course there's the problem of how exactly the CB controls R, if you have in mind the CB buying and selling stocks then say so and I'll begin explaining why that's a horrible idea that won't work like you hope it will.

We need to keep in mind that the CB has pretty tight control of overnight inter-bank lending rates. It can't control other types of nominal rate that easily nor can it control real rates or inflation.

[Adam P]

r

[Adam P]

I'm trying to say "r less than n", apparently everything after the "less than" symbol is getting lost.

[Adam P]

btw Nick, the Taylor principle is really saying that what CB's need to do is adjust nominal rates (viewed in the NK paradigm as a control variable not a target) to target the real rate. So you could view CB behaviour as already targeting the real rate, the problem of course is that they can't control it that well. You haven't said how they control it here.

After all, UK and Eurozone had explicit inflation targets and that didn't prevent recessions in those places.

[Patrick]

Adam: the less than symbol is interpreted as opening an html tag. Use &lt; (ampersand 'l' 't' semicolon) and it'll display as < . Greater than is &gt;

[Nick Rowe]

Patrick: how do you learn that stuff?

Adam P: If you can credibly communicate monetary policy in terms of an inflation/price level path target, everything is fine. And everything was fine until people doubted banks would be able to hit their targets ("where's the mechanism?").

If you can credibly communicate monetary policy in terms of a nominal interest rate target with Taylor Principle coda i=n+(1+a)E(p) then everything is fine. But if people see there's a contradiction here between that instrument rule and the zero lower bound, it cannot be credible (unless they ignore that contradiction, which they won't). The coda {my shorthand for (1+a)E(p)) loses its force when implementing it would violate the lower bound. It's as if the bank says to the people: "if you continue to expect deflation greater than n, I will set nominal interest rates below zero, which will cause actual inflation to be greater than you expect, so you had better revise upwards your expectation of inflation". It's not a credible threat.

The bank needs some way to communicate an easing future stance of monetary policy that will, if believed, cause the equilibrium nominal interest rate to rise above zero, so there's no contradiction between believing the promise and violating the lower bound. That's where communicating the stance of policy in terms of the price of real bills comes in.

The bank controls r indirectly by controlling the price of real bills. I can't see any difference between the bank's ability to control the price of nominal bills and control the price of real bills.

[Nick Rowe]

Gary: you are way off topic. I've got a serious argument going here with Adam P., who understands what this argument is about. Please stop cluttering up this thread with your own agenda. Copy and paste it as a comment on the "asymmetric redeemability" post if you want. It belongs there.

[anon]

The same fool @ 5:24 has been banned right here:

http://bilbo.economicoutlook.net/blog/?p=5762&cpage=1#comment-2061

Suggest you do your readers a service and do the same now.

[Nick Rowe]

anon: thanks. I notice Gary Marshall has been posting almost identical responses to Billyblog as he has posted here, even though Bill and I have very different views on how monetary policy works. Which shows he totally ignores the content of anyone's response to him. I'm deleting his comment.

Gary: please stay away.

[anon]

On the same topic, you and Stephen may want to look at similar comments here. It's a bit disturbing for the National Post to allow this:

http://network.nationalpost.com/np/blogs/fullcomment/archive/2009/10/21/stephen-gordon-economic-illiteracy-goes-viral.aspx

[winterspeak]

Ah.. credible communication. That magic mechanism that turns nothing into something.

Can anyone please point me to a mechanism by which monetary policy can take effect that has real balance sheet consequences for people today instead of requiring folks to clap and believe in Tinkerbell, that would be awesome.

Fundamentally, for there to be inflation, too many dollars have to be chasing too few goods. So, monetary policy either needs to actively destroy real (not financial) goods OR it needs to somehow convince people who are being crushed by their current debt loans to do some combination of taking on more debt and spending more on things other than debt service.

NICK: I think you and Summers will get more traction if you could point to something that is real enough to appear on a balance sheet instead of increasingly elaborate models that all boil down to people changing their savings preference because of expectations. If that really is all that monetary policy is boiling down now, then would a modern day Nostradamus claiming that the end of the world was nigh (so better start parting!) be conducting monetary policy? If he was convincing enough he might have more luck getting the private sector to start taking on debt again.

[Nick Rowe]

Hi Winterspeak!

By the way, one of your previous comments has been favourably noted here!: http://freethinkecon.wordpress.com/2009/11/15/a-pithy-response-to-the-panglossian-theory-of-monetary-economics/

"Fundamentally, for there to be inflation, too many dollars have to be chasing too few goods."

Not exactly right. The way I would phrase it is this: "For there to be inflation, there would have to be too many dollars chasing too few goods if there weren't inflation." Inflation is what prevents there being too many dollars chasing too few goods (prices rise so the dollars are worth less, and now worth the same in total as the goods they are chasing). The equilibrium response of the endogenous variable (inflation in this case) eliminates the very excess demand for goods that causes it.

Yes, monetary policy works by increasing aggregate demand (shifting the AD curve to the right), so that people want to buy more goods. At the existing level of output and prices, there is an excess demand for goods, and an excess supply of the media of exchange (we live in a monetary exchange economy, where one good, the medium of exchange, appears in all markets). You can think of an increase in expected inflation creating this excess supply of money/excess demand for goods either via its direct effect on the real return on holding money, or via its indirect effect on real interest rates. (In this post, since I'm following a Neo-Wicksellian model, where the medium of exchange is only implicit, only the latter transmission mechanism is apparent.)

On interest rates and debt: I have done a number of posts on this topic in the past, and I'm not sure I want to re-enter this debate again (watch Too much Fed jump in here ;) ), but here is the short version:

For every dollar borrowed there is a dollar lent. An increase in debt requires BOTH borrowers wanting to borrow more AND lenders wanting to lend more. If real interest rates fall, other things equal, borrowers want to lend more, BUT lenders want to lend LESS. It is this excess demand for loanable funds that creates the excess demand for goods, and the rise in AD, output, and prices. In principle, the level of debt could go either way, increase or decrease. And debtors' ability to service debt, if income rises, is something else again.

A balance sheet shows you ACTUAL levels of assets and liabilities. It doesn't show DESIRED levels of assets and liabilities. And it is the difference between actual and desired levels that creates the disequilibrium that changes in real output and prices eliminates. I just don't find it generally helpful to view this sort of process through balance sheets (and I can never remember which side to put the assets and liabilities anyway!).

[scott sumner]

Nick, This model seems correct to me. The problem we face is making the "real bills" target operative. You know where I stand, but there are a variety of other options as well. These include foreign exchange baskets and commodity baskets. Neither is my preference, but both seem superior to equities. I'm not saying equities wouldn't work, but the pricing of equities is very complex, and I think there is the risk of multiple equilibria. High stock prices are consistent with very sound macro policy (a la the 1920s and 1990s), but they are also consistent with high inflation. So, in order of preference:

1. NGDP futures
2. CPI futures
3. Forex (samll countries)
3. Commodity basket (big countries)
4. Equities
5. My house

If Adam is concerned about targeting equities, I share his intuition. But I think the model is correct. I don't do math any more, so I'm not competent to evaluate how it compares to other models out there.

I hope you keep pursuing this issue. What is so fascinating is that the entire world economy may be screwed up because of a subtle intellectual puzzle that we've never quite grasped in the right way. Thought experiments like this get us steadily closer to the right way of addressing the issue. Perhaps someday nominal bills will be viewed as a barbarous relic of 20th century monetary policy. Wouldn't it me ironic if nominal bills targeting was tripped up by the same problem as the gold standard: Deflation.

[Too Much Fed]

Nick said: "For every dollar borrowed there is a dollar lent. An increase in debt requires BOTH borrowers wanting to borrow more AND lenders wanting to lend more. If real interest rates fall, other things equal, borrowers want to lend more, BUT lenders want to lend LESS."

Not exactly right. goldman sachs employees (extremely positive real earners) do not spend more when interest rates fall. They might buy a riskier financial asset (like a newly created piece of currency denominated debt).

In today's wealth/income inequality world, borrowers with negative real earnings growth might want to borrow more. People who used to save but now need to borrow because of negative real earnings growth might want to borrow more (notice the more borrowers). And, the fewer and fewer with extremely positive real earnings want to lend more (especially if they think the fed/the gov't will bail them out).

Notice that credit/debt is becoming more concentrated in fewer and fewer entities.

"BUT lenders want to lend LESS." In today's wealth/income inequality and bailout world, false but could be true in different circumstances.

Another idea I am thinking about is debt deflation (bad to defaulted debt) with the idea being the fed needs to create new debt/asset gains to make up for the losses when there are big blowups (S&L & others). If the excess savers sold debt to spend, wouldn't that make things for some lenders worse?

[Too Much Fed]

scott sumner, where is real earnings growth for the lower and middle class on your list?

That way they could spend and pay down currency denominated debt and eventually save.

[Too Much Fed]

"I just don't find it generally helpful to view this sort of process through balance sheets (and I can never remember which side to put the assets and liabilities anyway!)."

How about a real world example?

Xal-Mart decides to open colleges teaching economics. They want to be the low price leader so they get the gov't to allow visa programs (or other ways to lower wages) and hire people for 50% of what people are being paid now. Eventually, everyone goes there for college. The people who were making more and had mortgages with assumptions of no Xal-Mart lowering their wage income during the 30-year mortgage now have a problem of making the interest payments. Do they borrow more and hope, default, or try something else?

Here is another one. What if the lower and middle class were a stock? What people say they have too much currency denominated debt and not enough (wage) income?

[Too Much Fed]

From:

http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/09/who-is-increasing-their-spending-debtors-or-creditors.html

How about "Who was increasing their spending - debtors or creditors?"

Lessons From The Fall: Household Debt Got Us Into This Mess

http://www.npr.org/blogs/money/2009/09/lessons_from_the_fall_househol.html

"Our research suggests that the historic growth in household debt preceding the financial crisis was the primary driver of the onset and deepening of the current recession.

The central lesson we as economists have learned from the crisis is that an unsustainable increase in household debt is one of the most serious threats to the U.S. economy."

I SERIOUSLY doubt if anyone at the fed has learned anything from this.

Posted by: Too Much Fed | September 11, 2009 at 01:50 AM

Sorry if this is a repeat.

[Patrick]

Nick: professional necessity. I earn my living writing software.

[Too Much Fed]

From:

http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/09/who-is-increasing-their-spending-debtors-or-creditors.html

About debt and inequality:

http://rortybomb.wordpress.com/2009/08/04/debt-and-inequality/

Here is one quote: "Now remember our original assumptions: Income inequality is large. Consumption inequality is smaller. So savings inequality must be huge."

Posted by: Too Much Fed | September 08, 2009 at 01:46 AM

How about "currency denominated debt" inequality (as in many and many borrowers and fewer and fewer lenders)?

[Too Much Fed]

winterspeak said: "Ah.. credible communication. That magic mechanism that turns nothing into something."

What if credible communication / expectations are wrong vs. reality?

[Nick Rowe]

Scott: I'm still not sure the model is doing all I want it to do. Adam P. may have a point (he's a hard critic, but knows some stuff). The key is the relative importance of the forward and backward-looking elements in the IS-PC equation. I wanted to have a strong backward-looking element in order to model the deflationary death-spiral as happening slowly over time, rather than an instantaneous collapse to a zero price level. But a strong forward-looking element is needed to break the spiral by raising expected inflation, so that real interest rates fall while nominal interest rates rise. I'm wondering if I should have replaced y* with E(y(t+1) after all, despite the extra math, because that would certainly strengthen the forward-looking elements without violating the neutrality postulate that forward and backward-looking coefficients must sum to 1.

Partly it's math; partly it's intuition. Wish my brain were younger and keener. But I am going to keep working on it. The key point that a central bank's ability to commit to future monetary policy depends on the "language" or framing in which such commitments can be made is a valid one. You can't promise to lose a card game if the promisee doesn't know whether "losing" means having the highest or lowest card on the table.

The nice thing about real bills, as a modelling device, is the direct parallel between real and nominal bills. Same ability of the central bank to target their price; same transmission mechanism to AD. That's why I chose them. I'm unhappy about any good that cannot be stored in the basement of the Bank of Canada. Though in principle the Bank could buy houses, but going into the landlord business and collecting rents is not part of its comparative advantage. Clipping coupons is easier. Though there's no difference in principle. But I don't see the problem with targeting a share price index, and the Bank owning index mutual funds (except maybe shares traded in Canada aren't really the same as shares of companies doing business in Canada).

I will keep pursuing this issue. Nominal bills will go the same way as the gold standard. "(Nominal) interest rate fetters" have a hold on our thinking in the same way that gold once did.

[warren mosler]

[Edit by NR. This comment by Warren should I think be understood as a (sensible) reply to a (not so sensible) comment by Gary Marshall that I deleted that was posted immediately above this. I just added this because it makes it easier to understand the context.]

the currency is a simple public monopoly

the price level is necessarily a function of prices paid by govt when it spends (and/or collateral demanded when it lends)

see 'mandatory readings' at www.moslereconomics.com

[Adam P]

Nick,

you need to decide whether or not you mean for R to be a traded asset and if you want the CB to actually trade it. If R is a share index and the CB will actually buy and sell shares then that is one discussion. If it is just a price target and the CB adjusts the quantity of money to hit it then you haven't really solved anything, which is my point. That's what I keep trying to get you to see about Sumners futures targeting scheme, it solves none of the problems because it still works through the quantity of money.

Keep in mind that Euler equations don't specify cause and effect, just an equilbrium condition. Thus, even if you think that changes in the money supply can have effects on behaviour through some other channel, changing the path of consumption/investment will cause the real interest rate to change because it changes the other side of the Euler equation.

Regardless what you think is the transmission mechanism, if you manage to change consumption/investment decisions then one or more of the following three things MUST have happened:

1) real interest rates changed
2) expected future output growth and/or risk of that output growth changed
3) people/firms stopped maximizing their objective functions

I assume you don't want to claim that monetary policy can accomplish 3!!

Against the zero bound you can only accomplish 1 with higher inflation expectations and this reqires controlling expected future monetary policy. Changing expected future monetary policy can also change 2 but I repeat that now we are not just talking about the quantity of money today and so all the problems resurface. After all, the BoE had an inflation target and the UK is still in recession.

None of this has anything to do with the framing of monetary policy, Euler equations don't care how you frame things. You are not being helpful here.

[Adam P]

BTW, sorry I went all Gary Marshall on Sumner over the weekend but it's getting annoying how he fails to see why his pet idea doesn't solve anything at all but instead introduce more problems.

That said, what he's been saying recently about the need for a price level/inflation target and need to commit to expansionary policy that actually accomodates some inflation once we start getting some is much better.

[Nick Rowe]

warren: Gary Marshall is a boor who breaks into a conversation, changes the subject, goes on at length with his own topic, then pays no attention to your answer to him. He has ignored requests to stop doing this, so I have deleted now 3 comments of his on this thread. At least one other blogger, BillyBlog, has banned him for doing the same thing.

I know you have made a genuine attempt to respond to him, and it's to your credit, but so have I and others, several times. It just encourages him.

[Nick Rowe]

Adam P.

1. My model doesn't specify whether the central bank trades nominal bills, real bills, and/or output. It has this feature in common with standard Neo-Wicksellian models. They are silent on this question.

The implicit assumption in a Neo-Wicksellian model is that the central bank does not trade output (so cannot target inflation directly) but does trade nominal bills (or trades something else that is a close substitute for nominal bills). Whatever that implicit assumption is about nominal bills in the standard Neo-Wicksellian model, I would like to make the same implicit assumption about real bills. I see them as parallel in this model.

2. From your list of 3, I want to go for 1 (I would like to go for 2 too, but that would mean adding more math to the model).

The Euler equations don't care about framing, but they do care about expectations. And expectations care about framing. Commitments (as in Kydland/Prescott rules vs discretion) are promises. The interpretation of a promise (indeed, whether it can even be understood) depends on the framing.

Let me try another analogy, from micro. It is well known that the Bertrand equilibrium is generally different from the Cournot equilibrium. Yet the only difference is that firms' strategies are framed as setting a price in Bertrand, and setting a quantity in Cournot. The framing affects how each player expects the other to respond to an out-of-equilibrium move. These out of equilibrium moves are never observed in equilibrium. Yet they affect the equilibrium.

I wish I had thought of that analogy before. What I am trying to do is to make that same point in a macro context.

[Nick Rowe]

In my Bertrand/Cournot analogy: assume firms have the same demand and cost functions whether it's Bertrand or Cournot, of course.

[Adam P]

But Nick, if you want to go for 1 then the whole point is that the key is getting people to believe that in the future you'll stick to what your promising now. How you frame the promise is beside the point, any of the framings work if the CB is believed and none work if it's not.

In your example everythign is driven by the CB failing to follow the Taylor Principle in the second case. So what does framing have to do with anything?

[Nick Rowe]

Adam: what do you think of the Cournot/Bertrand analogy? Isn't that an example where framing matters? I think it definitely is, which means framing can matter in principle. I just(!) need to translate it into macro.

I wish my mind were clearer on this, but I think that the Taylor Principle coda is the bank's attempt to play (say) Cournot, but the public doesn't see the coda (because it is never observed in equilibrium), and the public thinks the bank is playing Bertrand. So we get the Bertrand equilibrium.

[Adam P]

still thinking about the Cournot/Bertrand analogy, I don't remember what's the difference. But wouldn't either framing require promises about future behaviour to generate increased expected inflation?

And if so, wouldn't either work if the promis is believed and neither work if it's not?

[winterspeak]

Nick: Thank you for your response (and the pointer). Again -- I'm going to press you for a real mechanism that shows up on a balance sheet.

Your argument is that if interest rates fall, borrowers want to lend more, but lenders want to lend less. Why do lenders want to lend less? Lenders make money by making loans that get paid back. How do low interest rates reduce a profit maximizing lender's desire to continue making as many good loans as they can subject to capital constraints, market demand, etc.?

Finally, spending a little more time on balance sheets would do a world of good. The gap between "actual" and "desired" did not slow you down in your extension of what causes inflation; similarly you can think about actual and desired in the balance sheet world. If the private sector has an desired target for net financial assets, and it is below that desired target in actual terms today, it will attempt to reach that target by increasing saving, which at a sector level reduced AD and makes that target even more impossible to achieve. This is the classic Paradox of Thrift. Monetary policy may or may not shift the private sector's demand to collectively increase or decrease the size of its balance sheet, but it CANNOT impact the NET assets that sector holds. In other words, monetary policy is completely impotent at supplying net financial assets within the private sector. And if that is the disease, then monetary policy cannot be a cure.

Also, think operationally about that "expectations of future inflation" would mean operationally at the household level. It would change savings, or V in the quantity of money model. Now think about the forces driving household savings decisions today. (You can be even more radical and think what impact the massive reduction in interest income has had, but I'm not sure you're ready for that level of Home Economics ; ) )

This savings element (net financial assets) is completely critical because it demolishes and quantity of money theory, and therefore the transmission mechanism in monetarism, and hence monetarism itself. Adam P is completely correct in this. Banks do not lend out savings. Savings just sit there, doing nothing. More savings do not enable more bank lending. And the best analogy I have for savings desire is as an endogenous factor (like WTP in Micro. It is what it is, and it changes as it wants to change). The FFR rate and ramblings by Greenspan, Bernanke, or whomever may impact savings desire, but so may wandering around with a sign saying "the end is nigh", a slick TV commercial campaign, or a bout of extremely good (or bad) weather. Of you could, you know, actually increase savings through fiscal spending, but again, that's too straightforward.

[Nick Rowe]

Adam P.: In the Cournot-Nash equilibrium, each firm (in a symmetric duopoly with imperfect substitutes, say) chooses q to maximise profit given the other firm's q'. In Bertrand-Nash equilibrium, each firm chooses p to maximise profit given the other firm's p'. The Bertrand equilibrium gives a lower price and higher quantity than the Cournot equilibrium, even if everything else is the same.

The intuition is that a firm's demand curve, drawn taking the other firm's p as given, is more elastic than the same demand curve, drawn taking the other firm's q as given.

What matters is not whether a firm chooses p or q (there isn't really any difference, since each firm is picking a point on its demand curve and you can define that point either way), but whether it *expects* the other firm to hold p fixed or q fixed if it were to deviate from the Nash equilibrium. If you assume Nash is the correct equilibrium concept, then it all comes down to how each firm "frames" the other firm's decision, or how it "frames" the strategy space.

What I need to try to do is translate what I am saying about how people frame the central bank's strategy space into the same kind of game-theoretic language. If I can show a parallel between the distinction between one or other target and the distinction between Bertrand and Cournot, I've got all the game theorists on my side.

If the promise to create more inflation were believed, this would mean nominal interest rates increased. So there's a sort of paradox in promising to create more inflation by lowering nominal interest rates.

Winterspeak: Households choose a point where the marginal rate of substitution between present and future consumption equals 1+r. Firms chose a point where the marginal rate of transformation between present and future net output equals 1+r, where r is the real rate of interest. 1+r is like a relative price, and a change in r changes demand between present and future goods in exactly the same way that a change in the relative price of apples changes the demand between apples and bananas. When r goes down, households choose to consume more today, and firms choose to invest more today.

Absolutely orthodox economics. I can show it with indifference curves and budget lines. But I have no idea how to show it with balance sheets. It's a substitution effect, not some sort of income, wealth, or balance sheet effect.

[winterspeak]

Nick:

Thank you for your clarification. In your model, you have households basing consumption/savings decisions based on tradeoffs between current consumption and discounted future consumption, with the discount rate being r (which I assume will be around the FFR, thus creating your mechanism between monetary policy and reality).

I have derived this in the standard ways in the past, so we're on the same page.

The problem is it is a bad model when you include certain balance sheet conditions, conditions which are very apparent now. All balance sheets have assets, liabilities, and equity (or "savings") which is in the liability column but is a good thing, and so does not carry the negative associations with equity. Assets - Liabilities = Equity.

Entities pick a degree of leverage they are comfortable with, or how much liability they balance on top of their equity. This preference can change -- income to service debt starts to look less reliable, asset values no longer going up that much, etc. So, to reduce leverage, either assets and liabilities can start to get paid down/written off (debt deflation) and/or the sector tries to increase equity. But the sector cannot increase equity by itself, it is impossible by Accounting.

Consumption decisions between now and the future may be driven in part by discounting, but they are certainly also driven by preferences regarding equity and leverage. If the sector is working to reset its equity/leverage position (as is now) then low interest rates become impotent at best, and counterproductive at worst. If people just want more money in their bank account, you cannot get there through monetary policy.

(I'm pretty sure that the not sure if the discounting r model has applicability at the macro level either, but I'll need to dredge up the old derivations. I believe that it disconnects price from income, which you cannot do at a sector level of course. Many micro formulations do not scale to the sector level, and I believe this is one of them, but I'll need to double check)

Let's stay focused on balance sheet effects by me asking you a simple question:

*If* the private sector wants more savings, (more net financial assets) would you agree that the only way it can get those is by fiscal policy (Govt deficit spending).

Thanks

[anon]

saving is net financial assets plus gross real investment assets

[Nick Rowe]

Yep. In a closed economy:

S-I = G-T

That's just an accounting identity. It's a way of using words in a consistent way; it doesn't tell us how the world works.

If desired savings increases (i.e. desired consumption falls), then the rate of interest falls until desired savings falls back to where it started (or desired investment increases, or some mixture of the two).

[Scott Sumner]

too much Fed, I favor 5% NGDP growth in normal times--enough for 3% real income growth for the average American. In this recession I favor faster NGDP growth for a catchup period, so I don't see my policy as ignoring the middle and lower classes. Like a Democratic politician, I believe jobs are our number one problem. I oppose bailouts for the rich.

Adam, I've always favored level targeting, indeed I made the argument in a published paper 10 or 15 years ago. I have emphasized it more recently than in the first few months, as we fall further below trend every day. I also think a lot of the Bernanke/Woodford inderterminacy problem relates to proposals for inflation rate targeting, but does not apply to price level targeting.

Nick, On further reflection stocks might work, if you had level targeting. My earlier comment about multiple equilibria reflected the fact that inflation hurts stock prices but higher price levels raise stock prices. In the real world (in real time) it is often not apparent whether a price level increase should be viewed as a rise in the inflation rate, or a one-time rise in the price level. So stocks prices could go either way. If you have level targeting (P or NGDP) it pins down the inflation rate. Then all price level increases would boost the price of real assets. That was roughly true under the gold standard, where expected inflation was roughly zero. That might make the system more stable than I first thought. I'm sorry that I lack both the time and brain cells to help you with the math.

[Nick Rowe]

Scott: if stock prices were the target, you would want to target a price level path, for the total return index (i.e. dividends reinvested) growing at (say) 7% per year. The main transmission mechanism would be via Tobin's Q (if the price of output fell relative to the target price of stocks, Q would rise, so it would be cheaper to finance investment, so AD would rise).

One of the neat features would be that investing in the stock index would give you a risk-free nominal return over all holding periods. Stocks would become the ideal investment for widows and orphans! I bet that would get rid of the equity premium!

But like gold, I don't think the real equilibrium stock price would be stable enough for it to work well in practice.

[winterspeak]

ANON: Yes, I'm focusing on financial assets, not real assets.

NICK: For someone who said they weren't sure which side of the balance sheet assets and liabilities are, you are very quick to dismiss accounting entities. Accounting matters, particularly in finance.

Accounting identities are, in fact, stronger descriptions of the world than economic models like the ones you opened this post with. I've experience on both sides of this, so I'm not one of those guys who dismisses models out of hand. Nevertheless, people lose their homes over accounting, lose their jobs over accounting, make fortunes over accounting, go to jail (or gaol) over accounting and more. If I had to pick between an accounting identity and an economic model, I'd pick the identity. And if I'm talking about finance, accounting IS reality.

Desired savings CANNOT increase in the private sector unless the Government runs higher deficits, ie. fiscal policy. It does not matter what the rate of interest does. The mechanism for this is clear -- either the number in your checking account lets you make your mortgage payment and you keep your house, or it doesn't. Or, if you prefer, the number in your checking account lets you make payroll, or you fire all your workers. This is a real, solid lever that shows "expectations" to be the Nostradamus-on-the-street-corner stretch that it is.

I was not sure if you understood balance sheets or accounting well enough to see that interest rates cannot help a sector increase its net financial savings to a new target. But now it is clear, and it's no wonder to me that you find balance sheet recessions so "mysterious"!

I really enjoy our exchanges on this blog and find them very fruitful. Thank you.

[Nick Rowe]

Winterspeak: "Desired savings CANNOT increase in the private sector unless the Government runs higher deficits,.."

Hold investment constant (or assume that by "savings" you mean "savings minus investment"). Assume closed economy.

Then I would say that DESIRED savings CAN, but ACTUAL savings CANNOT, increase unless the government runs higher deficits.

"I was not sure if you understood balance sheets or accounting well enough to see that interest rates cannot help a sector increase its net financial savings to a new target."

Given the above assumptions. A rise in interest rates indeed cannot help households increase actual savings (holding govt. deficit constant). The purpose of a fall in interest rates is precisely to stop households wanting to save more. (They want to save more, so interest rates fall until they stop wanting to save more.)

[Adam P]

Nick: "If the promise to create more inflation were believed, this would mean nominal interest rates increased. So there's a sort of paradox in promising to create more inflation by lowering nominal interest rates."

No, longer term nominal rates increase, short term INTER-BANK nominal rates don't. There is a term structure to expected inflation, it's future inflation that is being promised here. Current inflation, the rate of inflation that prevails for the life of an overnight loan or 2 week repo is unchanged.

Furthermore, by supplying enough money the CB can always lower real rates (even the longer term ones) because just as inflation lowers the real return on a nominal interst loan (and thus encourages lenders to ask for higher interest rates) there is the offsetting effect that inflation makes it more costly to keep the cash sitting idle earning nothing (velocity increases). Of course, lowering the longer term real rates does require that the extra money growth be expected to continue through the life of the loan.

[Adam P]

Nick, just to finish the last thought. If the Fisher effect held completely and immediately then money would be completely neutral because real rates would never change (as a result of monetary policy that is).

This is true no matter what you think of the transmission mechanism because it would leave only option 3 above (my comment at November 16, 2009 at 06:38 AM) and monetary policy can't make people stop trying to maximize their objective functions.

This is a point that Scott Sumner appears not to understand as he seems to think money can be non-neutral and the Fisher effect hold completely. He got this badly wrong in a small minded and incorrect critique of Keynes a while back.

[anon]

“I'm focusing on financial assets, not real assets”

I’m focusing on your arbitrary exclusion of the rest of savings; i.e. I = S.

Desired savings CANNOT increase in the private sector unless the Government runs higher deficits

Not if more I is produced at the same time. You actually believe that CANNOT happen?

[Adam P]

Nick, I don't think your Bertrand/Cournot analogy helps you here. The differnce is not due to framing, it's due to differences in reaction functions. In your example though the market demand curve for the product is constant (this is what generates the differences in reaction functions). What you would need is an example where the framing actually changes the market demand curve. In neither the Bertand game or the Cournot game can the players induce the market to accept a (p,q) pair that is not on the market demand curve.

In the macro case the market demand curve traces out current demand for goods (AD) against it's relative price where price is relative to future goods. The CB can't get the private sector accept a (quantity, relative price) pair off that demand curve. But relative price means real rate here! Framing has nothing to do with anything.

Your monoplist example was better, one supplier and one market demand curve. But then whether you say that the monopolist chooses price or quantity (how you frame the problem) doesn't change the outcome.

[winterspeak]

Nick:

"Then I would say that DESIRED savings CAN, but ACTUAL savings CANNOT, increase unless the government runs higher deficits."

Yup, you are correct. If actual savings fall below desired savings, AD will continue to fall as the private sector tries (and fails) to reach its desired savings level. If there is nominal debt in the economy, you'll get debt deflation.

If the private sector is overly leveraged, then a fall in interest rates will not reduce their desire to save, as it's driven by balance sheet considerations, and not interest income. That's my point. Moreover, if AD is falling, then the desire to save more becomes HIGHER, swamping out any effect lower interest rates may have. Lower interest rates start working in reverse as they rob the sector of interest income which could be saved, thus undermining AD further. By savings, I mean the financial assets listed in the equity column on the liability side of the balance sheet. This is net investment, as investment is someone else's income and savings is not.

I think you understand the model now, but may not agree that it is applicable to our current situation.

ANON: I did not arbitrarily exclude I. In a closed economy Y = I + C + G. So, G-T = Y - I - C - T. Including an export sector does not change this materially. I, like C, is someone else's income, so is net of savings which is no one else's income. I passed on Nick's characterization because it is not critical to the concept.

I hope this makes it clear why the private sector's net financial assets CANNOT increase unless there is deficit spending. The private sector balance sheet, of course, can expand to any size if it makes more inter-sector loans, or collapse down to just its net financial position, which precisely equals the National Debt.

ADAM P: Thank you for keeping the focus on the core mechanism. If interest rate does not change savings demand, and there are LOTS of factors that impact private sector savings demand, then monetary policy is impotent if (unfunded) savings demand is decreasing aggregate demand.

[anon]

"I did not arbitrarily exclude I"

You did - you say the only way private sector can increase saving is by increasing net financial saving - which is not true.

Net financial saving = government deficit is obvious; but not full story for private sector saving

[anon]

"By savings, I mean the financial assets listed in the equity column on the liability side of the balance sheet. This is net investment, as investment is someone else's income and savings is not."

makes no accounting sense

[Nick Rowe]

Winterspeak: " If actual savings fall below desired savings, AD will continue to fall as the private sector tries (and fails) to reach its desired savings level. If there is nominal debt in the economy, you'll get debt deflation."

Not necessarily. That's the simple Keynesian mechanism by which desired savings adjusts to actual savings (income falls until they are equal). The alternate classical mechanism is that the real interest rate falls until they are equal. Or you can have a mixture, where both y and r fall. Usual assumption is that the classical is true in the long run, when prices are flexible, but a mixture is true in the short run, when prices are fixed, depending on monetary policy.

You are using the words "saving" and "investment" in different ways than economists, but that's OK, as long as we remember which version we're using (or make simplifying assumptions like ignoring investment so they end up the same).

"I think you understand the model now, but may not agree that it is applicable to our current situation." Man, I learned that simple Keynesian model in high school nearly 40 years ago, and have taught it God knows how many times!

"Lower interest rates start working in reverse as they rob the sector of interest income which could be saved, thus undermining AD further."

Two points:
1. The main effect of real interest rates on desired savings (and investment) is a *substitution effect*, not an income effect. And I'm not sure if you understand that that's my reason why r affects S and I.
2. In a closed economy, no government, there is NO income effect from a change in interest rates (though there may be a distribution effect if opposing income effects on different people do not wash out in aggregate, because of different marginal propensities to consume across different people). For every borrower who is better off when interest rates fall, there is a lender who is worse off. It washes out, unless they have different mpc's. Some economists don't understand that. But I do, and have done so for several decades.

[Scott Fullwiler]

Hi Nick

Winterspeak is presuming a situation in which the private sector is desiring to increase its NET saving. The only way it can actually achieve this is for the govt deficit to increase (in the closed model).

You are assuming the fall in the interest rate reduces the desire to net save. This certainly could be true, though I would suggest (and I think Winterspeak agrees) it might not be, and it might actually increase the desire to net save as interest income is reduced. But regardless, you are assuming away the situation Winterspeak was presenting.

Best,
Scott

[JKH]

Scott,

I’m wondering, do you think there is any difference between the following two statements:

a) The non government sector desires to increase its net saving. The only it way can achieve this is through net saving with the government sector.

versus:

b) The non government sector desires to increase its saving. The only way it can achieve this is through net saving with the government sector.

FYI, I think there is a subtle (or maybe not so subtle) difference between the two, and that the second is more accurate. But the first seems to be more common among MMT adherents.

[Scott Fullwiler]

Interesting question, JKH.

Yes, the two are different. Regarding accuracy, how are you defining "saving"?

Best,
Scott

[Nick Rowe]

Hi Scott: By NET saving I presume you (and Winterspeak) mean "Saving minus investment"? That's what I figured he meant, but wasn't sure, so I just assumed investment = 0 always, to remove any ambiguity between saving and net saving.

(In economics, "saving" normally means "income minus taxes minus consumption", and "investment" means production/purchases of newly-produced capital goods (plus increase in inventory). (And "net saving" means saving minus depreciation of capital goods, just to confuse us all further.)

Yes, I am assuming that a fall in real interest rates causes desired savings to fall and desired investment to increase. To an economist, this is like assuming that demand curves slope down. But our reasons for assuming this have nothing whatsoever to do with any purported effect of interest rates on income. It's a substitution effect, not an income effect. To a first-order approximation, there are no income effects from relative price changes in macro.

And if demand curves don't slope down, and supply curves don't slope up (i.e. if "net" demand curves don't slope down), then there's no reason to believe that the market for apples will ever reach equilibrium, where desired net demand for apples = 0. No different for the desired net savings = 0

[JKH]

Scott,

I define saving as income that is not spent on consumption.

And just to add some colour to my question:

The “demand for net saving” version troubles me a bit because it suggests that the non government sector actually targets net saving with the government sector as a form of saving. It’s not clear to me that the non government sector has the capacity itself to differentiate the best channel for the expansion of its own saving in this way. For one thing, it seems to contradict the operative causality in all cases, which is that expenditure of some type is first required in order to generate income and saving from income. With respect to non government saving, that expenditure could either be government expenditure or investment expenditure.

[JKH]

And noticing Nick's comment, saving should also exclude taxes paid, of course.

[Scott Fullwiler]

Hi Nick

There's no problem with a demand for investment sloping down with respect to interest. The point is regarding an aggregate spending curve sloping down with respect to interest . . . assumptions have to be made there. Take Japan, for instance . . . reduce interest rates (real or nominal) and you could very well reduce aggregate spending as savers' incomes fall.

Best,
Scott

[JKH]

Scott,

Yet another follow up thought:

It’s always seemed to me that the most natural explanation is that non government “net saving” with the government sector “falls out” as a consequence of its demand for saving of some type, followed by the fact that the government comes to the rescue in supplying saving to meet that demand in the more specific form of net saving.

Notwithstanding that, it’s also occurred to me that the non government sector does have a very specific demand for saving with the government, but not because it is in the form of net saving. Rather it’s because such saving is in the form of government credit risk, which is a very attractive risk attribute in the kind of environment that leads to the excess demand for saving in the first place.

Supply/demand cross currents.

[Nick Rowe]

Scott: for every $100 lent there's $100 borrowed. For every 1% drop in interest rates, lenders' disposable income falls by $1, but borrowers' disposable income rises by $1. Unless lenders and borrowers have different mpc's, it's a wash.

[Scott Fullwiler]

Nick . . . yes, that's one of the assumptions that is made. Another is that the lender/borrower relation you note doesn't apply to govt debt service. And the cb could take the further step of QE and eliminate still more coupon income to the non-govt sector.

JKH . . .agree with your follow-up thoughts.

[Scott Fullwiler]

Hi JKH

Regarding your comment at 441

I agree with regard to your point about what troubles you about "demand for net saving." I usually consider it a demand by the non-govt sector to save (or leverage) on balance, with the result of net saving (or net dissaving). Much of this is via automatic stabilizers, as you noted in your follow up.

That's probably something that could be clarified/explicated a bit more carefully, say, in the description and labeling of the desired private sector financial balance schedule in my sector financial balances model posted to the KC blog back in late July.

[JKH]

thanks Scott

[Scott Sumner]

Nick, I've never liked the terminology in monetary economics--terms like "target" are too vague. I know that it would make no sense to rigidly target stock prices, the price level would be unstable. I assumed you meant something like an intermediate target, something to help one avoid liquidity traps.

[Nick Rowe]

Scott: yes, using stock prices as an intermediate target would be more sensible, I think. But I still find it interesting to think about what would happen if stock prices were rigidly targeted. Would the equity premium disappear? What would be the consequences for investment, growth, and financial stability, if all the people who now clamour for safe bonds held stocks instead, because their nominal rate of return were fixed?

[winterspeak]

ANON: I'll tell you what. If you can show me a series of t-table transactions that result in a sector increasing its equity (net financial assets) I'll change my mind and say you were right. Conditions: 1) has to be within a single sector, cannot have gold mines or some external sector capitalizing the sector under consideration. 2) has to be financial assets, not real assets. So improved land, piles of apples from an abundant orchard etc. do not count. 3) has to be a sector wide improvement. One actor within a sector increasing its equity as another actor loses it does not count. OK?

NICK: I'm trying to be precise and consistent in my use of the terms "savings", "investment" etc. I am pulling directly from the standard accounting identities, Y = I + C + G (ignoring NX). The entity I am talking about is G-T, which equals the deficit, which equals Y - I - C - T, or income minus investment minus consumption minus taxes. I believe the standard identity term for this is Net Private Savings. The direct translation for this into balance sheet terms (where I am also being absolutely strict and correct and using standard financial definitions) is the financial assets recorded in the equity section on the liability side of the balance sheet. You can also think of it as money in your bank account, which is a very straightforward common sense notion of "savings". I don't count investment as a form of savings for the simple reason that it is not, not in an accounting sense, and I hope not in an economic sense (although I find economists are incredibly sloppy about terminology when talking about finance, usually this is because they don't know any better though). Savings is no one else's income. It is an increase in savings that causes velocity to fall. Every other entity counts as income to one actor or another. This is all very straightforward, and if economics treats the same transaction as income from one side, and savings from the other, well, GIGO I guess.

"Not necessarily. That's the simple Keynesian mechanism by which desired savings adjusts to actual savings (income falls until they are equal)." Not if you nominal debt in the picture, which is when you get Fisher Debt Deflation (I assume you are familiar with that given the title of your post). Ultimately, it leads to all private debt being written off or paid down, leaving the sector with just the financial assets paid-in by Govt (equal to the National Debt). All prices fall to the price willing to be paid by the unlevered buyer. This would be greater than the Great Depression.

"1. The main effect of real interest rates on desired savings (and investment) is a *substitution effect*, not an income effect. And I'm not sure if you understand that that's my reason why r affects S and I."

I understand the model, and I am pointing out that it's a crap model because household savings desires are impacted by balance sheet considerations as well as time preference. My discount rate can stay the same, but other changes can make me want a different balance sheet. Imagine that you lose your job -- does that make you a short term thinker? Might you change your spending decisions?

"2. In a closed economy, no government, there is NO income effect from a change in interest rates (though there may be a distribution effect if opposing income effects on different people do not wash out in aggregate, because of different marginal propensities to consume across different people). For every borrower who is better off when interest rates fall, there is a lender who is worse off. It washes out, unless they have different mpc's. Some economists don't understand that. But I do, and have done so for several decades."

By "closed economy" I thought you meant no imports/exports, not no Govt. Sorry for misunderstanding that. I am looking at our economy, which has a Govt, which once-up-a-time paid interest on bank deposits, interest which used to support aggregate demand via spending and saving, but is no longer around to do so. Govt interest payments are a fiscal measure, and so directly change (increase) the net financial assets held by the private sector.

[anon]

"If you can show me a series of t-table transactions that result in a sector increasing its equity (net financial assets) I'll change..."

That's not the correct definition of equity... equity is investment PLUS net financial assets.

Your "conditions" contradict the definition of equity. That's the whole point. The t-table is trivial ... nfa and investment as assets, equity on the right hand side

... equity defined properly is the same thing as saving. That's where you're making the mistake.

[Ramanan]

Nick,

The interest rate dependence of investment on interest rates is weak in my opinion. Entrepreneurs borrow not because it is cheap but because it will be profitable. We are in a situation where the aggregate demand is low. The US households want to save a lot and this means that the sales of the production sector will also go down. This further reduces the wages paid and/or layoffs and reduces the households savings and consumption in the next period. Its a feedback effect and the GDP will keep reducing unless automatic stabilizers come in. The terminology should actually be changed to "delayed stabilizers" In a downfall scenario, increased government spending and lesser taxes paid because of less activity stabilizes an economy but the new level of GDP will be less than the level it started from unless the size of the fiscal stimulus is reasonably high. For the new level of the GDP to be the same as the present, both the size and the timing of consumption and investments should match a fiscal austerity measure.

Of course the bottom is not really a bottom because increased deficits in the downfall period leads to higher interest payments from the government sector and hence it is a bit cyclical and uncertain. There is however no guarantee that the GDP will come back to its high. There is also an uncertainty about how long it will take.

A bit about investments - if you look at the Flows Of Funds data of the United States, you will see that investments are funded not just by bank loans and issuance of corporate debt but also undistributed profits. Firms typically not only have retained earnings to fund investments, they also use it to buy financial assets. The ratio of internal funds to investments is typically more than 1!! This is at the aggregate level but you can see what I mean.

At a more general level imagine two countries - country A wants to save twice the proportion of income as country B. The citizens of both countries are the same when it comes to ability and hard work opportunities etc. The only way countries A and B can have identical standards of living is by having the government of country A take on higher public debt than B.

[Nick Rowe]

Winterspeak: " I don't count investment as a form of savings for the simple reason that it is not, not in an accounting sense, and I hope not in an economic sense (although I find economists are incredibly sloppy about terminology when talking about finance, usually this is because they don't know any better though)."

Economists do define saving differently. Economists define "private saving" as Y-T-C, not as (Y-T-C-I). Standard economics textbook definition. So investment certainly is one of the things I can do with my saving, in the economic sense. (And NET savings to us usually means Y-T-C, but where Y is Net domestic product, not Gross domestic product. I.e. it's net of depreciation.)

Now, economists certainly do tend to be sloppy, but this is not one of those cases. We have deliberately chosen to define saving this way. If accountants want to define it differently, that's fine, but we are going to stick to our definition. Our definition works better for us, given our behavioural theories.

To show what I mean by this, consider Y=C+I+G+X-M. Why do we divide output up this way? Why don't we divide it up into Y=goods+services? Or Y=organic goods + inorganic goods? Or Y=red stuff+blue stuff+ yellow stuff+ other stuff? Because our behavioural theories (or some behavioural theories) say this is the most useful way, because each element is determined in a different way. The other ways to divide up Y don't divide it up into any useful way (though they might be useful from a very different theoretical perspective).

"By "closed economy" I thought you meant no imports/exports, not no Govt. Sorry for misunderstanding that." No, you understood me right the first time. "Closed economy" means no exports and imports. When I wrote "In a closed economy, no government,..." I meant "In an economy which is closed and also has no government.." My writing wasn't clear.

Now, in a closed economy, but with a government and government debt, does a fall in interest rates have a negative income effect on AD? That depends. The private sector is better off, but the government sector is worse off. If the government has the same marginal propensity to spend as the private sector, it's a wash. Or if the private sector internalises the government budget constraint, because the private sector realises it's ultimately on the hook for all government finances (Ricardian Equivalence), it's a wash.

Ramanan: "The interest rate dependence of investment on interest rates is weak in my opinion. Entrepreneurs borrow not because it is cheap but because it will be profitable."

That's like saying "Costs don't matter for the level of a firm's output. Firms expand output when it's profitable to do so, not because costs are low." Profits are the difference between revenues and costs. An investment that is profitable at a low rate of interest may not be profitable at a higher rate of interest.

Sure, expected AD matters too, as well as the rate of interest. If firms can't sell the extra output, other things equal, they are less likely to invest. But if a fall in the rate of interest causes some increased investment directly, that will induce an increase in AD and expected AD and have additional multiplier/accelerator effects.

"At a more general level imagine two countries - country A wants to save twice the proportion of income as country B. The citizens of both countries are the same when it comes to ability and hard work opportunities etc. The only way countries A and B can have identical standards of living is by having the government of country A take on higher public debt than B."

Assume both A and B are closed. If the people in A want to save twice as much as people in B, then interest rates need to be lower in A than B, so that A will want to invest more and want to save less, and B will want to save more and invest less, until desired S=desired I in both countries at "full employment".

[anon]

"So investment certainly is one of the things I can do with my saving, in the economic sense."

this is precisely correct, of course ... consistent with the correct definition of both saving and equity... I wonder who's being sloppy here?

[anon]

re: flow of funds info: it uses correct definitions ... investments are real, as per normal economics ... financial assets are not "investments"...

[Ramanan]

Anon: re:flows of funds .. I know! Please check table F.102 of FoF! Plus good to be non-anon even if you have a nickname

[Scott Fullwiler]

The point about being "sloppy" is with respect to accounting. Economists can define things however they want, but they are always talking about transactions that affect financial statements, so the accounting is important and defining things differently from the accounting is being sloppy. Winterspeak's defintion of equity is the CORRECT one for financial accounting.

If the term "net saving" is confusing here given different definitions in use, then let's use the term "net acquisition of financial assets" or "NAFA," to describe Y-C-T-I, as in this paper . . . http://www.levy.org/pubs/wp_569.pdf (discussion of these terms begins on page 10)

The point of NAFA is not to describe how much investment spending can occur (as that operationally never depends on the ex ante flow of saving), but rather to understand the changes in the financial status of different sectors of the economy.

[anon]

"Winterspeak's defintion of equity is the CORRECT one for financial accounting."

a firm that spends retained earnings on real investment hasn't saved and hasn't increased it's equity?

- that's not correct financial accounting

[anon]

"re:flows of funds .. I know!"

sorry, you're right ... although there are sub-category distinctions

[Scott Fullwiler]

Retained earnings from profits are an increase in equity and they are an increase in NAFA if they are held as financial assets. I didn't see where Winterspeak suggested differently, but perhaps I missed something.

[anon]

he suggested and stated the only way to increase equity is by increasing NAFA ... which is incorrect

[Scott Fullwiler]

Winterspeak's talking about the aggregate for the private sector. An individual firm can increase it's NAFA, but the private sector as a whole cannot unless there is (in our closed model) an increase in G-T.

[anon]

right ... but any unit or any aggregate can increase equity with saving and real investment ... point being that increasing NAFA, either unit or aggregate, is not the only way to increase equity

[Scott Fullwiler]

It's the only way to increase aggregate net financial assets for the sector. Net financial assets is a measure of net financial wealth, which is a measure of "net" equity.

[winterspeak]

ANON: There is one subtle and one not-so-subtle point about equity. Not sure which one you are making. The subtle point is that a stock claim is accounted for as an asset, but it is still held by one entity and issued by another, so still follows the asset/liability rule that, within the sector, nets out to zero. JKH pointed this out originally.

The not-so-subtle point refers to "paid-in capital and retained earnings" in the equity form. "Paid-in capital" is capital that come from another source, and so is a redistribution of financial assets within the sector, but not a net increase or decrease. "Retained earnings" had to originally come from payments from some other source, so it decreased their financial assets, and those payments were not all paid out, so some were retained within the corporation. Again, this is a redistribution of financial assets and not a net increase or decrease.

I specified I was talking about sector level increases in financial assets in a single sector model. Your opportunity to change my mind still stands.

(Another way for you to think about this is: whenever you create a financial asset you must also create a liability. Therefore, within a sector, all assets and liabilities must sum to zero. For there to be a net positive amount, there must be some other sector creating financial assets and liabilities and then giving those assets to the original sector. There is simply no way for a sector, within itself, to increase its net financial assets).

SCOTT: You are correct, "An individual firm can increase it's NAFA, but the private sector as a whole cannot unless there is (in our closed model) an increase in G-T." I am happy to call NPS NAFA, but it's harder to get someone to go through a t-table exercise with NAFA.

NICK: "Now, in a closed economy, but with a government and government debt, does a fall in interest rates have a negative income effect on AD? That depends. The private sector is better off, but the government sector is worse off."

The Government is no longer on a gold standard and is unconstrained in its spending. It has no need for income.

Also, I final note on whether "investment" is savings or not. I'm on the same page as JKH here, I save whatever I do not spend. I can spend on consumption, or I can spend on investment, but either way, my spending decision is creating income for someone else. Maybe I expect to be paid back in the future, or maybe I don't. And even if I expect to get paid back, maybe I won't.

When I buy a stock, if I count that as "savings" for me, it triggers "income" for the seller of that stock. Isn't that weird to you? When I want my money back from my stock, I need to find a buyer, in order for me to get my "savings" back as "income". And yet, if I buy an antique, is that really "saving"?

When I put my money in a bank however, or under a mattress, no one else gets income from my action. That money is effectively taken out of circulation. These two things are profoundly different, and are fundamental to understanding NAFA, savings, V etc. Understanding what actions take money in and out of circulation is critical to understanding how the financial system works, and if economics is muddying this by classifying the same transaction as both 1) being savings and 2) producing income it isn't going to get stuff right.

[Adam P]

Winterspeak you said: "When I put my money in a bank however, ..., no one else gets income from my action. That money is effectively taken out of circulation. "

No, is is a pretty bad misunderstanding about the economy works. Putting it under a mattress would be as you say, putting in a bank is not.

[Scott Fullwiler]

Putting it in a bank doesn't help the bank's operational ability to make a loan. It might improve the profitability of the loan (which could then help capital) compared to holding other, interest bearing liabilities, but the loan can be made, regardless.

However, if in the aggregate households are making the decision to put $$ in the bank instead of spending, then this reduced spending could actually reduce the likelihood of loans being made as it could reduce firm's expectations of profits and potentially the banks' perceptions of the credit risk of the borrower.

[anon]

"Net financial assets is a measure of net financial wealth, which is a measure of "net" equity." OK ... but a bit of a dance in the invention of new terms ... "net equity"... although with that the original error of using “equity” is crystallized

[anon]

“The subtle point is that a stock claim is accounted for as an asset” ... equity = saving ... e.g. retained earnings ... NOT = common or preferred stock ..."Retained earnings" had to originally come from payments from some other source, so it decreased their financial assets” ... retained earnings = equity = saving ... NOT a financial asset ... accounting 101 ... “Your opportunity to change my mind still stands.” accuracy here is independent of that. “Another way for you to think about this is” good, but trivial ... you’ve missed the point about the potential sources and uses of equity.

[dlr.myopenid.com]

Winterspeak,

However you want to define the letters s-a-v-i-n-g, I wonder if you still agree that the behavior you exclude from conventional savings in your definition (i.e. investment) can still be economically interesting. So, if I decide to forgo my annual $200K birthday party and instead hire some people to build a house (maybe to rent out, maybe to live in sometime in the future), I have not engaged in your "savings" but I have nonetheless furthered my preference for future consumption over current consumption. And even though my behavior results in income to someone else (workers and supppliers), it also still has interesting sector-wide effects. In world A, I throw my party and provide income to others, with the resources disappearing into entropy. In world B, I build my house with the same income to others, but almost certainly end up with more resources for myself and the private sector as a whole. You focus on the fact that the private sector's additional resources don't reflect additional net financial assets. They also don't represent more money. Nor do they represent more government debt. But they do represent something, and that something is related to the time preference expressed by people choosing to consume or not-consume. You apparently find that distinction between consuming and not-consuming uninteresting (since you leave it out of your dictionary), whereas other people find it much more interesting. Or, if you do find it interesting, do you have a name for "not-consuming," i.e. in your language, investment plus savings?

Instead of caring about consuming versus not-consuming, you focus on either consuming or investing versus not consuming or investing. Other people care about this, too. Instead of calling it "savings" they call it "demand for money" and they talk about it a lot (though they still have a use for conventional definitions of savings). But I can guess that this doesn't work for you, because you believe it is more useful to group money together with government debt when the government issues a fiat currency. So when you talk about savings, you aren't primarily talking about time preferences, nor are you even talking about the acquisition of financial assets (because the "net" and the sectors are so important to your perspective). You are really just talking about an expanded version of the demand for money: Demand for money or government debt. My guess is that this issue -- whether we should talk about demand and supply of money or money plus government debt when we talk about shocks like the one we've just had - is where you'd be having your most interesting discussions with traditional monetary disequilibrium people if the conversation didn't get bogged down in savings semantics. If I have this right, I can't help but think you've chosen a clunky way to express your perspective. It almost seems like you had a big revelation based on changing your terminology, and assume that this is the only way that other people will be able to see your point. In my experience, when one person has some kind of epiphany based on changing their vocabulary, one of the hardest ways explain that epiphany to most people is to start by redefining terms.

[anon]

accounting 101 – corporate retained earnings is not a financial asset...it is a financial accounting entry ... it is one of two basic financial accounting equity entries...the other equity entry is capital paid in when equity is issued...both are equity accounting entries ... neither are financial assets...the financial asset is the stock that’s issued, which takes on a life and value of its own... financial accounting entries are not financial assets...when a corporation has stock outstanding, the financial asset is the stock and its market value, not the retained earnings accounting entry... corporate retained earnings is no more a financial asset than household net worth ... both are accounting entries...you’re very confused on financial accounting versus financial claims ... which is why you’re missing the basic point on the nature of equity

[winterspeak]

ADAM P: There were two things I learned that totally changed my understanding of the financial system and converted me away from monetarism. These were:

1. The private sector can only increase its holdings of net financial assets (NAFA, or NPS, or whatever) if the Govt funds it. Public deficits fund private savings.
2. Bank lending is not reserve constrained. My deposits in the bank do NOT fund that bank's ability to make new loans. In fact, bank loans create the deposits.

It was very hard to understand these two points, and it is very hard to get others to understand them as well. I've found that if you can get people to see 1), it is easier to get them to see 2), but 1) and 2) together is too much and causes overload. But my success at communicating any of this has been terrible, so who knows.

ANON: If you believe that the private sector's incapacity to increase its net financial assets is trivial, that's fine. That is the number that private leverage is built up on, though, and I think it's pretty obvious that it's having profound consequences today. I have still to see t-tables, but you aren't the first person who has gone from "impossible!" to "obvious and trivial". I guess you can return to arguing about interest rates, but my offer stands.

dlr.myopenid.com: Thinking correctly about savings is extremely interesting. Nevertheless, to understand money you have to be consistent with how you count it, and conflating activities that do not count as income with those that do is, frankly, garbage. It is obvious why this is the case.

I find the distinction between consumption and non-consumption to be something you only know in hindsight. Your $200K house -- was it consumption, or investment? Suppose there is a housing collapse (I know, impossible to imagine) and the house is now worth just $100K. How do you classify the $100K you've lost? Or suppose you bought a lottery ticket and got lucky -- did that act of consumption suddenly become a shrewd investment?

Either way, in your example, your $200K is someone's income, either a catering company, or a home builder. In the former case, it's pure consumption. In the latter case, you get a real asset out of it, which you can live in, which may or may not go up or down in value. It's a mix of consumption and investment, even in the good case where the value goes up, because by living in its you are foregoing rent. I don't like housing as an investment example because it's a mixed-use good, and thus often causes confusion. Also, you have to keep real assets separate from financial assets. I've repeated this, but it's easy for it to get lost.

You are correct in that govt debt and money are close substitutes. When the Govt issues debt, the reserves to buy that debt must already exist, so you're just moving the money from one container ("reserves") to another ("treasury bills"). The Govt isn't really borrowing money, it does not need to, it's just changing the term structure of the money out there because that's the mechanism it's chosen to set interest rates.

I don't know enough about the "demand for money" literature to say whether it's what I'm talking about or not. I instinctively don't like it because it does not seem to distinguish between privately issued debt, and Govt deficit spending. The private sector is free to create, or uncreate, as much internal debt as it chooses. But it cannot change the amount of NAFA, or NPS, or NFA, or net financial equity, or whatever it has, that can only come from some external sector.

Time preference is one element in savings, but not the only one. Balance sheet considerations matter too. They may even matter more. At a sector level that is almost certainly true.

I have yet to find a good term for the money the Govt injects into the non-Govt sector when it deficit spends, that people can then take a model out in t-tables. My batting average in this is zero, so I know I need help and am open to suggestions.

[Scott Fullwiler]

Let's try a different route rather than regurgitating lectures for classes I already teach . . . back to Winterspeak's original question:

How does a sector, within itself (no transactions with outside sectors), increase its net financial assets?

[anon]

"How does a sector, within itself (no transactions with outside sectors), increase its net financial assets?"

That's trivial. It can't. Never said it could. That's never been in question, and hasn't been the point of my objection. Where have I said it could?

[anon]

"you aren't the first person who has gone from "impossible!" to "obvious and trivial"

that's it; change the subject and distort the record when you can't understand or answer the question

[Adam P]

Winterspeak, when GE issues a bond that doesn't create a net financial asset? I suppose that you'll respond that since it's paid in money on the net they haven't created a new financial asset, they've just repackaged government debt.

Fine, what about a bond that is paid in goods? There is in fact a precedent for this. During the civil war the South issued bonds that actually paid sugar cane. Russia has suggested issuing debt redeeemable for oil.

But anyway the question is a hypothetical. Suppose GE issued a bond that pays in some basket of GE produced goods. Would that increase total net financial assets?

[anon]

"when GE issues a bond that doesn't create a net financial asset?"

every financial asset is also a financial liability; net zero; that's why that part of the subject is trivial

[anon]

"what about a bond that is paid in goods"

that's not a financial asset

[Scott Fullwiler]

"Never said it could." OK!

[anon]

"that's why that part of the subject is trivial"

meaning from an accounting perspective ... the economics are profound ... never said otherwise

[winterspeak]

ADAM P: Anon is correct in his description of what happens when GE issues a bond, and in what happens when the bond is payable in real goods.

ANON: Help me out here. It seems like you understand that the private sector cannot increase its "increase its net financial assets" by itself. Great. So, suppose all all private sector credit was paid down or written down, all loans were paid down or written down, all stocks issued were bought back, every receivable was received, or written off, etc. etc. All the financial assets created in the private sector were uncreated

The balance sheets would not be zero. You would have something like "cash" on the asset side, and an equity entry on the liability side, that would be called something like "paid-in equity" or "retained earnings". That is the entry that I'm trying to name.

What would you have left, and how would that be represented on a balance sheet? (Again, I'm focused on financial assets, no real assets).

[anon]

...unusual question ... only makes sense on consolidation because you’re eliminating almost all inter-unit claims ... I’ll answer it in the context of net financial assets but you can’t ignore real assets in the real world so... you would be left with real investment (corporate and household) as assets, with a combination of corporate retained earnings and household net worth (i.e. household equity) as offsetting equity ... no private debt in the economy at all.... no common stock in the economy at all ... consolidated result: real investment offset by equity ... good illustration of my first point ... PLUS net financial assets with the government sector offset by the same amount of additional equity ... all equity represents cumulative saving ... to my point total equity or saving splits between real investment, and net financial assets with the government ... if you want to ignore real assets, your "net equity" entry would still be a combination of corporate retained earnings and household net worth, depending on who owns the government debt ... small detail in the banking system - allow for reserves and equal offsetting deposits for that part of net financial assets plus currency – everything else eliminated by supposition ... also, have excluded external sector here to keep it simple ... my first take on a wild question

[anon]

P.S.
external sector adjustment – a foreign current account surplus is net foreign saving which is a piece of net foreign equity – chase down the micro accounting entries at origin in the foreign country – note that the foreign surplus is a surplus with the combination of all domestic sectors, not with the government sector directly or only... then bundle in foreign sector with domestic non government sectors and proceed to net financial assets with government, etc. ... a little complicated in untangling it all ...

[anon]

P.P.S.

Mr. Fullwiler coined the term “net equity”... suggest a high level balance sheet terminology consisting of net financial assets offset by “net financial equity” (as opposed to “real equity”.) Net financial equity then breaks down to some combination of retained earnings and household net worth...depending on who owns the government debt and currency and reserves.

[Scott Fullwiler]

My use of "net equity" (and I used quotation marks because I knew it was not the standard use of the term) was only an attempt to explain the same thing Winterspeak is asking about, not an attempt at redefining.

Also, we are quite aware that you can't abstract from real assets. We don't want to do that at all. The point, though, is that we are in this case describing the changes to financial statements due (at least mostly) to financial transactions.