Money, interest, employment, and luck

Monetary disequilibrium theorists must face this question: "If this recession was caused by an excess demand for money, how come interest rates are so low? Doesn't an excess demand for money mean an excess supply of bonds and rise in interest rates?"

[Warning: this post is long, rambling, and unclear. I ought to tear it up and write a couple of shorter and clearer ones. I may do that later, when (if) I get my head clearer. Read at your own risk. Maybe skim it first.]

Despite all my brilliant theoretical proofs of the metaphysical necessity of monetarism -- how a general glut can only be caused by an excess demand for the medium of exchange -- Brad DeLong has got the perfect comeback: "OK, the 1982 recession was caused by an excess demand for money, as shown by the very high interest rates. But the recent recession must have been caused by an excess demand for safe assets in general, otherwise we wouldn't be seeing interest rates on safe assets near zero." (He didn't actually say those words, but he might have done.)

So I'm going to sketch a simple model where an excess demand for money causes a recession but no rise in (real or nominal) interest rates.

The basic idea is simple. An excess demand for money causes unemployment for the "unlucky". The unemployed can't borrow (nobody will lend to the unemployed), and can only spend down their money balances by buying from those who are "lucky" and remain fully employed. The lucky employed get the money that used to be held by the unlucky unemployed. So nothing changes for the employed. And the unemployed are shut out of all markets, so can't affect the equilibrium. And if unemployment causes expected deflation, nominal interest rates will fall via the Fisher effect.

[Warning to lefties: before you get too excited by this model, remember that the distribution of money is not the same as the distribution of wealth. This model is much closer to Milton Friedman than to Karl Marx.]

Before getting started on building the model, I need to talk about loanable funds vs liquidity preference, the ISLM model, and take a sort of cheap shot at Paul Krugman to illustrate my point. (It would be a cheap shot if I didn't admit it were a cheap shot, if you can handle the Liar Paradox.)

Digression on loanable funds vs liquidity preference and ISLM and Paul Krugman and stuff.

The price of apples (if it is flexible) is set in the apple market to equilibrate the demand and supply of apples. If there's an excess demand for apples it rises; if there's an excess supply of apples it falls.

OK. So where is the rate of interest set? What market? What are the demands and supplies it is supposed to equilibrate?

Liquidity Preference says it is set in the money market, to equilibrate the demand and supply of money. Which is totally stupid, because there is no money market. Or rather, in a monetary exchange economy every market is a market for money plus one other good. When finance guys talk about the "money market" they are really talking about the market for short-term loans. When you lend someone money, you get an IOU in return. That IOU is a bond. So when we talk about "the money market" we are really talking about the bond market. So let's call the thing by its proper name. The "apple market" is the market where money is exchanged for apples; the "bond market" is the market where money is exchanged for bonds.

But isn't the "bond market" just another name for the market in "loanable funds"? If so, what the hell is the difference between the liquidity preference and loanable funds theories of the rate of interest?

Another way of describing the loanable funds theory is to say that the rate of interest adjusts to equilibrate desired savings and desired investment. OK. But since (closed economy) national savings is defined as Y-C-G, we can do some trivial math and re-write S=I as C+I+G=Y. So loanable funds says that the rate of interest adjusts to equilibrate desired consumption plus desired investment plus desired government spending to desired sales of newly-produced goods? In other words, loanable funds says that the rate of interest adjusts to equilibrate the output market?

Which is weird. Sure, the demand for output may depend on the rate of interest. But can we jump from that to saying that the rate of interest is set in the output market? Can we say that an excess demand for output will put upward pressure on the rate of interest? The rate of interest is the (reciprocal of) the price of bonds, not the price of output. The demand for apples may depend on the price of pears. But we don't say that the price of pears is determined in the apple market.

The ISLM model was supposed to reconcile the liquidity preference and loanable funds theories of the rate of interest. IS shows the loanable funds answer, as a function of Y; LM shows the liquidity preference answer, as a function of Y. In the short run, with M/P fixed, Y adjusts until both curves give you the same answer. In the long run with P and hence M/P flexible, and Y fixed by the LRAS curve, M/P adjusts until the two curves give the same answer.

But the ISLM is trying to reconcile two opposing theories of the rate of interest, neither of which make any sense.

Here's my cheap shot at Paul Krugman:

Paul says (H/T Brad De Long): "Now equilibrium in a three-good model can be represented by drawing curves that indicate combinations of prices for which each of the three markets is in equilibrium."

No it can't. At least, not if one of the three goods is called "money". In a barter economy, with n goods, there are n(n-1)/2 markets. So if n=3 that means three markets. But in a monetary exchange economy with n goods (including money) there are (n-1) markets. So if n=3 that means two markets.

Paul also says: "Although there are three curves, Walras' Law (if all markets but one are in equilibrium, that market is in equilibrium too) tells us that they have a common intersection, which defines equilibrium prices for the economy as a whole."

But Walras' Law is wrong in a monetary exchange economy. It only works in a Walrasian General Equilibrium model with a single market in which all n goods can be traded for each other and no agent is ever unable to buy or sell as much as he wishes. That's very different from a model of a monetary exchange economy used to explain excess supply recessions where people can't sell as much labour as they want.

This is a cheap shot because lower down Paul says: "Sixty years on, the intellectual problems with doing macro this way are well known. First of all, the idea of treating money as an ordinary good begs many questions: surely money plays a special sort of role in the economy."

Yes. Money does play a special role. For one thing, money does not have a market of its own. It is traded in every market against every other good; and all the other goods are traded only against money. For a second thing, if we lump all output into one good, we have to recognise that every agent is both a buyer and a seller of that good. We sell our own output for money; and use money to buy others' output. We don't barter our own output for others' output.

So let's start from scratch.

A sketch of my model.

There are three goods: backscratches; bonds; and money. There are two markets: the output market, where backscratches are traded for money; and the bond market, where bonds are traded for money. The rate of interest (aka the price of bonds) is perfectly flexible. It adjusts instantly to excess demand or supply for bonds, so the bond market always clears. The price of backscratches is sticky, or fixed if you like, in terms of money. So the market for backscratches may not clear.

People must trade, because you can't scratch your own back. And you can't barter backscratches, or trade them for bonds (promise to pay later) because you can't see a person's face when you are scratching his back. (OK, so cook up your own silly story for the microfoundations of monetary exchange).

That makes the output market very different from the bond market. Each agent is either a buyer of bonds or a seller of bonds. But each agent is both a buyer and seller of output.

All agents are identical, except: agents differ by "luck". Luck is distributed along a continuum. In the event of an excess supply of backscratches, where demand is only 60% of supply, the luckiest 60% of agents will be able to sell as many backscratches as they want, and the unluckiest 40% will be able to sell none.

Unlucky agents, who are unemployed, are unable to access the bond market. Everyone knows they are unemployed, and therefore unlucky, so they cannot borrow money from lucky agents because they might stay unemployed and not be able to repay the loan. (OK, this assumption could be relaxed a bit, but shouldn't affect the results too much).

In advance of a recession, agents don't observe their own luck, so all agents are identical ex ante, and the unlucky won't save more than the lucky.

Start in full-employment equilibrium. All agents are buying and selling backscratches for money. But no bonds are traded, because all agents are ex ante identical. In full-employment equilibrium, it's a representative agent model.

Now let's shock the model.

Shock 1. This example is very contrived, but is also the simplest. Assume that a fire destroys all the stock of money held by the unluckiest half of the population. In this example, the unlucky are doubly unlucky. They are unlucky in the market for backscratches, and they are unlucky in the fire too. What happens?

In the new equilibrium the economy carries on exactly the same as before for the lucky half of the population, while the unlucky half of the population is shut out of all markets, and so has no effect on the equilibrium. The rate of interest initially stays the same.

The unlucky unemployed have no money, so can't buy backscratches. They will want to borrow money, but nobody will lend to them, because they are unemployed. They want to sell backscratches, but the lucky employed are already buying as many backscratches as they want from each other, and the unlucky are at the end of the queue supplying backscratches, so the demand runs out at the halfway point. The fire that destroyed their money might as well have destroyed them too, in terms of how it affects the equilibrium in the luckier half of the economy. Except:

Of course, the excess supply of backscratches will slowly cause the price of backscratches to fall (assuming it's sticky but not stuck). Given long enough, this fall in the price level will increase the real money supply by enough to restore full employment. But in the meantime the expected deflation will lower the equilibrium nominal rate of interest.

Shock 2. Now assume half of each agent's stock of money gets destroyed by fire. (So, unlike Shock 1, the unlucky agents are only unlucky in the market for backscratches, not in the fire.) What happens?

Initially, each agent will respond in three ways. He will supply more bonds. He will supply more backscratches. He will demand fewer backscratches. All to try to rebuild his stock of money. But since the stock of money is fixed, they must collectively fail.

Since there is an excess supply of backscratches, some agents near the unluckiest end of the spectrum will be unemployed. They cannot sell backscratches to earn income. They cannot sell bonds to tide them over till the recession ends. They can slowly run down their stocks of money, which is earning 0% interest. Or they can sell some of that money to buy bonds, to earn positive interest, then slowly run down that stock of bonds. Either way, the money once held by the unemployed will, immediately or over time, end up in the pockets of the employed.

What does the new equilibrium look like?

To a first approximation, the equilibrium in Shock 2 will look exactly the same as the equilibrium in Shock 1. The only difference between the two shocks is a small change in the distribution of wealth. The unlucky half of the population is slightly better off, and the lucky half of the population slightly worse off, in Shock 2 than in Shock 1. At the previous equilibrium rate of interest, the unlucky unemployed will want to buy bonds with money, and the lucky employed will want to sell bonds for money. So both the demand and the supply of bonds will increase relative to Shock 1. This small change in the distribution of wealth will have an ambiguous effect on the rate of interest, compared to the equilibrium in Shock 1. And that effect will be small anyway, since stocks of money are such a small part of total wealth.

So, in Shock 2 as in Shock 1, the initial impact of the excess demand for money will be to leave the rate of interest (approximately) unchanged. And since the excess supply of backscratches will eventually cause expected deflation, the nominal rate of interest will fall.

Relaxing the key assumption.

What happens when we relax the assumption that the unemployed cannot borrow by issuing and selling bonds? The unemployed would want to borrow to smooth their consumption stream over time, and will be able to pay back the loan if the recession is short-lived. But the IOUs (bonds) they issue will be riskier, and will have to pay a higher rate of interest, than the safe bonds issued by employed agents. That might be a way to reconcile my model with Brad DeLong's theory that the recession was caused by an excess demand for safe assets. But, I would want to insist that it was the recession that caused previously safe bonds to become unsafe, and the recession was caused by an excess demand for money.

Comments

[jesse]

Pardon me for being ignorant: isn't money these days akin to a zero coupon bond?

[edeast]

Why can't we just say the excess supply model of recessions is wrong? Instead of limiting our focus to a theoretical exclusive monetary economy, barter does exist, my brother just traded motorbikes with a stranger. And just like there is no money market, no other good has a market of it's own until you add a time dimension, then you have self good markets, and a way of adding interest rates. Indifference curve between goods today vs same goods future.

[edeast]

sorry for being a pain, I'll be off the internet for the next couple of months, hopefully you will all have it sorted out.

[Scott Sumner]

The premise of DeLong's argument is wrong. Real interest rates soared in America between July and November 2008 (on 5-year TIPS, from 0.57% to 4.2%), which is when very tight money drove NGDP much lower. Later on real rates fell, as you'd expect when the economy is very weak.

His second mistake it to assume interest rates are the price of money; they are actually the price of credit. There are new Keynesian models that predict tight money will raise real interest rates, but there are also new Keynesian models that suggest tight money could reduce real interest rates (by lowering expected real GDP growth.)

Mishkin's textbook (which I assume is conventional macro) says tight money will show up in all sorts of asset markets. In late 2008 the dollar soared in the forex markets, commodity prices plunged, stock price plunged, TIPS spreads plunged, real rates soared, real estate prices plunged, commercial real estate prices plunged. Is there any asset market that wasn't signalling tight money in late 2008? Maybe gold.

BTW, I gave DeLong the benefit of the doubt by assuming he meant real interest rates, not nominal rates. If he meant nominal rates . . . well I'd rather not consider that possibility.

[anon]

The liquidity preference theory is not expressly about the market for short-term bonds: it is about demand for money, which (in principle) affects every market in a monetary economy.

Essentially, cash ordinarily has a convenience yield over other safe assets, and this convenience yield shows up as an interest rate premium in the market for short-term assets. But this needs not always be so; occasionally, the demand for safe assets is high enough that cash is the best "bond" available, given its direct return and its option/liquidity/convenience value: other assets must then pay at least as much as cash does. Nevertheless, it remains the case that a recession is caused by excess demand for money, not merely by demand for safe bonds.

[Nick Rowe]

Jesse: can you buy all other things directly with a zero coupon bond, or do you first have to sell it for money, then use the money to buy all other things with?

edeast: barter does exist, but it's very costly, and so rare. People will resort to barter if there's an excess demand for money, but it's a very imperfect substitute. You lost me on the other stuff.

Scott: In 1982, both real and nominal interest rates on safe assets increased. That is different to 2008/9.

NK theory says that the *expectation* of future tight money, and the consequent expectation of a future recession and lower future real income, could reduce short term real interest rates. But when you are in a recession now, and expect to come out of it, you expect an abnormally high growth rate of real income. So the recession could only be an equilibrium today if the real interest rate were abnormally high.

[anon]

edeast, yes, assuming complete markets you can exchange apples today with apples tomorrow, which is a "self-good" market. But given a monetary economy, all you need is spot markets for apples (today and tomorrow) and a market for trading money-today for money-tomorrow, i.e. a bond market. (You also need cash-settled apple futures, but only if there's uncertainty about the future price of apples.)

[Nick Rowe]

anon: "The liquidity preference theory is not expressly about the market for short-term bonds: it is about demand for money, which (in principle) affects every market in a monetary economy."

Agreed that the demand for money will affect every market in a monetary exchange economy. But why should the rate of interest on bonds be expected to adjust to eliminate the excess demand for money, rather than the excess demand for bonds (when one is not merely the converse of the other, and this is not just a stock/flow distinction because we can re-write the problem to make everything flows)?

[jsalvatier]

Fabulous.

[jsalvatier]

I am curious whether you have given more thought to the question of whether optimal currency areas make any sense in monetary disequilibrium theory. See (http://goodmorningeconomics.wordpress.com/2011/02/02/optimal-currency-areas-are-nonsense/) for my argument (which I have described here before).

[Phil Koop]

"Real interest rates soared in America between July and November 2008 (on 5-year TIPS, from 0.57% to 4.2%)"

No, they didn't. Yes, the Treasury labels TIPS yields as "real yields" but you can't calculate real rates directly from TIPS at any time, and to do so during a panic is completely meaningless. During the same period, nominal 5Y treasury yields fell from 3.3% to 2%; does that mean the market was "predicting" 2.2% deflation? No, no more than the fact that the basis between on-the-run and off-the-run issues exploded implied that the US government was more likely to default on the latter. It just means there weren't any buyers for TIPS.

If you want the market to tell you what the "real rate" is, the place to look is the zero-coupon inflation swap rate.

[Phil Koop]

[sorry, hit post too soon.]

Having said that, 5Y inflation swaps did go negative in your period. I would be cautious about reading too much into that, however, without volume data. It isn't a "real rate" unless you can actually put on the trade.

[Phil Koop]

The lowest inflation print looks to be about -0.64%; a long way from the TIPS number, and the negative inflation quote period for 5Y didn't last long: http://www.bloomberg.com/apps/quote?ticker=USSWIT5:IND&n=y#chart.

[Phil Koop]

One more thing: the difference between TIPS breakeven and market quoted inflation is even bigger than it looks above because in a low-inflation environment, the inflation floor on TIPS principal has appreciable value.

[jesse]

Nick: "can you buy all other things directly with a zero coupon bond, or do you first have to sell it for money"

This is probably pretty banal but important to many (like me) understanding what you're talking about: The $20 bill in my pocket can be thought of as a zero coupon bond. I can use it to buy goods/services (and the seller of the goods/services need not accept it!). So there are really three players: the buyer, the seller, and the issuer of the zero coupon bond, namely the central bank.

Money is a representation of real wealth and debt markets are designed to reflect this. Me burning my money changes the money supply and re-distributes, but does not alter, aggregate real wealth. But I don't think money was "burned" during the GFC, however real wealth did change. Maybe thinking about it in terms of the actors' balance sheets might be another way of looking at this.

[Nick Rowe]

jsalvatier: Thanks! I am still trying to get my head around monetary disequilibrium with just one money!

Phil: I can't help but notice the parallel: markets in TIPS and off-the-run bonds drying up -- markets in backscratches drying up. When there's an excess demand for money, people stop buying and selling things. You get big gaps between demand prices and supply prices, aka bid-ask spreads, on backscratches and some financial assets.

jesse: a $20 bill is like a zero coupon bond, except they recognise it at the supermarket. So it can do stuff a zero coupon bond can't do.

The financial crisis caused an increased demand for money. I have modelled it as a fire that causes a decreased supply of money, just because it's simpler. Both cause an excess of demand over supply for money.

[David Beckworth]

Phil Koop:

The Cleveland Fed has a model that corrects for the problems you raise with TIPs and finds that the real rate did significantly increase in late 2008, early 2009. See the second figure on the link below:
http://www.clevelandfed.org/research/data/inflation_expectations/index.cfm

[anon]

"Agreed that the demand for money will affect every market in a monetary exchange economy. But why should the rate of interest on bonds be expected to adjust to eliminate the excess demand for money, rather than the excess demand for bonds?"

AIUI, excess demand for money today would tend to lower all prices, including the price of future money. The general price level tends to fall, but some prices are stuck at high levels. Demand and supply for bonds are in equilibrium: the interest rate only rises because folks want to hold fewer bonds and hold money instead.

[anon]

"Phil: I can't help but notice the parallel: ... When there's an excess demand for money, [y]ou get big gaps between demand prices and supply prices, aka bid-ask spreads, on backscratches and some financial assets."

Is this really the case, though? Markets in financial assets should have very flexible prices; large bid-ask spreads are better explained by trading costs, or else by concerns about asymmetric info and perhaps counterparty risk.

Yes, if such concerns suddenly became widespread they would cause some sort of economic contraction. But this would not be the same as a recession caused by excess demand for money, e.g. the policy response would be very different.

[jesse]

Nick: "So it can do stuff a zero coupon bond can't do."
It does this because it is possible to divide it up but I could pay for a car with Canada Savings Bonds, cutting a cheque, trading in my old beater, or anything else for that matter. Money is simply convenient but it is still in its essence a bond issued by a supporting actor.

When looking specifically at events in late-2008, yes there was definitely a lack of money in the system: interbank overnight rates started increasing way above the central bank rate -- cash was King. The events then were based on an inherent mis-pricing of assets: a debt bubble; and yes that was very different to the situation in the early 1980s.

[Phil Koop]

David Beckworth:

I know about the Cleveland Fed model. It is nice because it tries to account for the market price of risk, and to that extent gives real-world rather than risk-neutral expectations of inflation. But it is only a model; real-world expectations are not observable. I would not trust any model during a panic, when none of the inputs are valid (people are still suing each other over what LIBOR "really" was.)

[Phil Koop]

Nick, I think to get the real effect of a panic in the back-scratch market, there would need to be bonds trading in the model ex-ante. So if I had discounted a bill against future back-scratches, my banker would be in trouble when the back-scratch market froze. And if I needed financing to supply future back-scratches, then I would be in trouble.

[edeast]

yep anon, I was trying to describe the general case.
n-1 good is special, so is an n-2 good but less so, n-3 lesser still, for their effects on the aggregate. I was pointing out that every good has the same theoretical properties, can have markets with themselves through time.

I understand about the barter Nick, I've been around here long enough. I'll stop bringing it up. n-1 subset of n choose 2. no walras, proves your point.

everyone is saying monetary economy, and I'm thinking the monetary part of the economy. I'll do some more work, before I spout off again. I was reading Fisher, and he seemed helpful to how I'm thinking.

[RSJ]

OK, this is a pet peeve of mine:

"The "apple market" is the market where money is exchanged for apples; the "bond market" is the market where money is exchanged for bonds.

But isn't the "bond market" just another name for the market in "loanable funds"? If so, what the hell is the difference between the liquidity preference and loanable funds theories of the rate of interest?

Another way of describing the loanable funds theory is to say that the rate of interest adjusts to equilibrate desired savings and desired investment. "

When you are talking about persistent goods that can be resold -- e.g. capital, then anyone who currently owns the good is a (potential) supplier, and anyone is a (potential) demander.

As the price increases, some of the demanders become suppliers. With a price of zero, everyone is a demander, and with a price of infinity, everyone is a supplier.

The equilibrium price is going to be such that the ratio of demanders to suppliers = 1.

This has *nothing* to do with clearing demands for flows, for savings or investment.

An increase or decrease in the flow is going to leave the current period quantity unchanged. It will only affect future period quantities. This holds for any persistent good that can (or is) re-sold.

The marginal increment in quantity of the stock of capital as a result of investment goes to zero as the time period in which prices are set goes to zero.

With continuous real-time prices as you see in the capital markets, interest rates will be set completely by the re-sale market and reflect the level of indifference in which ratio = 1.

That will set the price of capital goods, and then investment will be whatever flow of capital goods can be profitable supplied at that price. But that flow may not correspond to the flow of savings that is being demanded. Math here.

In particular, if households prefer to hold deposits rather than capital goods, they will sell capital goods up until at the higher yield (or lower price), households again are indifferent between holding the capital goods and holding deposits.

However at that lower price, the suppliers of capital goods are only willing to supply fewer of these goods (assuming a non-vertical short run aggregate supply curve for capital goods). But the (aggregate) flow of savings is going to be exactly the quantity supplied at that price, which is set at the indifference level for stocks, not for flows. Households may well demand more savings (as a flow), but if they prefer to allocate their savings as deposits rather than capital goods, then they will end up with fewer savings.

To get back to Brad DeLong's argument, one reason why households would change the relative price of capital goods to deposits is because they are risk averse and want safer savings vehicles or demand a higher premium for holding capital. But there are other reasons. For example, they may have bid up the price of capital goods in expectation of price appreciation (e.g. ponzi investment) and are now bidding down the price of capital goods when the price appreciation is not realized. They could be facing a loss of income, or expect to face a loss of income, and so they need to sell some of their capital goods, etc.

There could be many reasons why households would adjust downward the indifference price in which the ratio of secondary buyers to sellers of the capital stock is 1 -- none of which have anything to do with a decline in the demand for savings -- but this re-pricing inevitably results in a decline in savings, assuming the non-vertical SRAS curve for capital goods.

[K]

Certainly in this recession, the financial markets provided a lot of evidence for what you are saying. In particular, there is one pretty good piece of evidence against the "excess demand for bonds" theory: the corporate bond basis. Basically, you can synthesize (not exactly but almost) a risk free bond by buying a corporate bond and buying default insurance on that bond via a credit default swap (CDS) of the same maturity. Historically (until early '08) the yield you would earn on such a "bond basis" trade was roughly equal, within 10-20 basis points, to the yield of a government bond of the same maturity. The yield on bond basis positions gradually widened through '08 and then, with the Lehman default, suddenly exploded, at which point the basis on some bonds was as high as 600-800 basis points. You can quibble about counterparty credit risk on the CDS - and I'm happy to - but if you do the math there is no conceivable justification for such a large excess yield over treasury bonds. If there had been an excess demand for bonds, people would have been just as happy to own bond basis trades as treasuries. But because corporate bonds are *not money* and treasuries are (you can just repo them for cash ), nobody wanted the corporate bonds. Same goes for the TIPS. And Phil is right - you can't use TIPS in that period to make direct inferences about implied inflation. TIPS had a large liquidity premium just like anything else that wasn't the on-the-run 2 year T-note.

In general though, I think this is quite particular to financial crises, and not general evidence for your theory of recession.

[Joe]

Nick,

This is a fascinating post. As a student, to this day I never have understood the parallel "loanable funds vs liquidity preference" explanations in textbooks.

My question is this: Why have for 100 years economists decided that the money market only includes bonds? Why? Who decided this? Why can't we just say that the "money market" includes everything? The majority may be bonds, but why can't it be filled also with equities, and insurance, and derivatives, and commodities, and consumer and capital goods, and services, etc. etc. etc.

In other words, if Mankiw's textbook hadn't told me that the money market is made up exclusively of buying and selling bonds, I would have automatically assumed that it included everything that can be purchased with money. This is why, as a student, "Monetarism" always appealed to me more. It always felt more "complete." I recall Brunner and Meltzer offering a monetarist alternative to IS/LM, one that includes both prices and interest rates.

Thanks,

Joe

[edeast]

the general case of Rowe's law would be excess demand for widely traded good causes excess supply of multiple goods. the moe being the most extreme case resulting in general glut. or something like that.

[vimothy]

Surely the recession caused the excess demand for money, not the other way around. There was then the possibility of a "secondary recession" (as the Austrians say).

[Lee Kelly]

vimothy,

The collapse of the housing market seems to have instigated the rise in money demand. Whether that would have caused a recession if the rise in money demand had been met is unclear. Perhaps a short recession, but we'll never know. What pushed this recession over the edge, so that people now call it the Great Recession, was the excess demand for money that followed. Moreover, the excess demand for money was not an inevitable consequence of the collapsing housing market -- the Fed should and could have done more to prevent the sharp decline in NGDP.

I think it is quite reasonable to say the recession was caused by tight monetary policy, though we should not forget that the sudden rise in money demand was not a inexplicable occurrence. There are lessons to be learned for monetary policy both before and after the bust, in my opinion.

[Nick Rowe]

RSJ: I actually followed that. IIRC, it's Frank Fetter's theory of Capital you have just described. According to Fetter, capital is just like land, except there's an upward-sloping non-vertical supply curve of newly-produced capital goods. (It's actually how I think about capital and investment). Just a couple of semantic quibbles: it's better not to call that an SRAS curve, because it's the short run supply of capital goods, not *all* goods; and it's best to call the point on that curve "investment" rather than "savings".)

[pcle]

joe 1:23.
I think Tobin extended the model to n assets in a paper he wrote in 1969, called something like "General Equilibrium Approach to Monetary Theory"
There's a good undergraduate treatment in the textbook by Stevenson, Muscatelli and Gregory.

[Nick Rowe]

vimothy: my view is similar to Lee Kelly's. The financial crisis caused an increased demand for money, which caused the recession. (Maybe, just maybe, the financial crisis also caused a decreased *supply* of money, when all the finance guys could no longer do weird things that meant that meant bonds could be used to create media of exchange in shadow banking etc. But despite my efforts, I can't really get my head around that stuff.)

Joe: that's a good question. I don't know the answer.

Part of the answer is that, in the long run, when P adjusts so that Y is determined by the vertical LRAS, the liquidity preference theory fails. Because a change in Ms or Md simply causes an equiproprtionate change in P. Loanable funds (S and I) determines r, and r and Y determine M/P, not the other way around. That's not controversial. So Mankiw lays out loanable funds for the long run, then switches to liquidity preference for the short run (with feedback effects from r to I to Y to Md handled with arrows on Chapter 15 diagrams, as a crude way of doing ISLM in first year). It's the short run that's controversial.

[vimothy]

Lee,

I don’t find the argument that the recession was caused by tight monetary policy very convincing. How do you reconcile it with the fact that the recession was global? Even if you are right, OMO don’t do anything directly to the broad money supply, so what could (or should) the Fed have done?

[vimothy]

Also, circularity: surely you could point to any recession and say, see, the recession was caused by policy makers not preventing the recession...?

[Lee Kelly]

vimothy,

The recession was global because there is only one economy: the global economy. The housing market did not collapse in just one country, and among the countries with the worst trouble was the most important country of all: the United States of America. With the U.S. dollar being the global economy's reserve currency, major problems in the United States were bound to have far reaching consequences. The uncertainty and panic that instigated the rise in money demand was not limited to a particular country or group. The global nature of the recent recession is not a surprise to me: it is difficult to imagine a severe recession that would not turn global given the interconnectedness of trade.

In any case, the Fed has more tools at its disposal than open market operations (which I don't think should be underestimated), and it should also be remembered that the Fed is still paying interest on excess reserves, which can only increase the demand for base money. Most importantly, the Fed has significant control over money demand by signaling its intent for the future path of monetary policy (e.g. inflation or nominal spending targets). It should also be remembered that had the Fed responded quickly to the rise in money demand, then only a modest increase in the monetary base would probably have been necessary. It was their failure to react that let the problem snowball until nothing short of a doubling of the monetary base would come near satisfying demand.

[RSJ]

Nick,

I will look at Fetter. Yes, I should have said short run supply curve of capital, not the aggregate supply curve.

It is a long hike towards clarity!

But if you really believe this view, or at least lend it credence, then that's all you need for Keynesian type effects. You just need to define the portfolio allocation demands as "liquidity preference". If asset prices (whether land or capital) clear portfolio allocation preferences of existing wealth, and the flows of investment and savings are whatever rate of production is profitable to supply at those prices, then you cannot argue that there is a loanable funds market that ensures no excess demand for savings and investment.

If, for some reason, households decide to sell capital goods and buy bonds, then the price of capital goods declines, the rate of production of capital goods declines, (new) investment declines, and therefore aggregate savings decline. But households did not want their per-period savings, or the growth rate of their wealth, to decline. They only wanted to allocate their existing stock of wealth differently, but as a side effect, the growth rate of their wealth also changed.

Perhaps one way to think about this is that the problem with Walras' law is a missing market. There is a market for capital goods and bonds (e.g. stocks), but there is no market for the rate of change of these stocks. There is no "investment market" for flows. The excess demands for flows arising from supply of labor and consumption cannot spill over into an investment and savings market because it doesn't exist. Excess demands for flows don't result in excess demands for stocks -- you cannot sum the demand functions for stocks with the demand functions for flows and get zero. Even in a discreet model, unless your time period is very large, changes to velocity, or the rate of production of capital goods, cause insignificant changes to position, or the quantity of capital goods. Leftward or rightward shifts in the supply of investment goods are not going to cause the quantity of capital goods to increase so much that households will value the goods differently in their portfolio allocation indifference curves.

It appears as though interest rates are completely unresponsive to changes in savings demands and investment demands.

Once the time period is so large that capital goods depreciate away to zero in each period, then you can argue that the flow equals the stock, so that the capital market becomes an investment market. You get the missing market back and can now argue that excess demands sum to zero in the long run.

[RSJ]

"Most importantly, the Fed has significant control over money demand by signaling its intent for the future path of monetary policy (e.g. inflation or nominal spending targets)."

Hmm, that depends on what you mean by "money demand" :)

Within the financial sector, the Fed has enormous control over the demand for reserves, by directly controlling the price of reserves.

But we don't care about the demand for reserves in the financial sector, we care about the demand for deposits in the non-financial sector.

Deposits pay zero, regardless of what interest rates the central bank sets on reserves.

As a result, the demand for deposits is whatever expected expenditures happen to be. Deposits are a cost to households in the same way that reserves are a cost to banks. But when the central bank hikes interest rates, households do not get (materially) higher deposit rates, rather the opportunity cost of holding the deposits increases as households are giving up the opportunity of purchasing higher interest bonds. But households are already minimizing their deposit holdings, so the interest-elasticity of deposits is small. I think you would need really large changes in interest rates to affect household demand for deposits.

If the central bank lowers the interest rate so much that bonds pay basically nothing, then households might not bother with bonds and will just hold deposits. So demand for deposits is a decreasing function of the interest rate, as the opportunity cost of holding the (non-interest bearing) deposit declines. But it is a relatively inelastic function of the rate.

I *think* the main effects are via changes to borrowing and lending, not non-financial sector money demand. As rates go up, investment declines, etc. That's the big tool in the toolbox. The power of the CB lies in its ability to encourage an increase in the quantity of investment, not in its ability to affect either money demand or money supply outside of the financial sector. I don't believe it has much power to do that, given our current institutional arrangements.

[Roland]

Umm... the whole insight of Keynes (okay, maybe not the whole insight, but a very big one) is that S does not equal I after financial crises. So your proof assuming S=I therefore makes a pretty huge assumption, and one that is pretty much demonstrably false (especially in times of turmoil, people and corporations sit on money instead of investing it).

People go into bonds and treasuries, etc. because they are safe- they certainly weren't buying bonds during the height of the financial crisis (when they actually had a negative rate of return!) for the great yield they provided. It was because, relatively, they were safe.

The thing I find disturbing about this post is that it throws all of the insights of Econ 101 and the rest of the field's major body of work from the past 80 years overboard for an ad hoc analysis that seems to be made to cling to a belief/point of view. You are really going to dismiss IS/LM?

[Scott Sumner]

Nick, My criticism of DeLong referred to his comments about the current recession, not 1982. But since you made this assertion:

"Scott: In 1982, both real and nominal interest rates on safe assets increased. That is different to 2008/9."

I must take strong exception. Yes, real rates may have risen a bit (we lacked TIPS markets then, and don't know) but nominal rates on one year T-bills fell from 12.77% to 8.01%--that's almost 500 bps! If new Keynesian economics relies on the stylized fact that interest rates rise during recessions, it's even worse than I thought. Investment is highly cyclical, and Robert King showed that in a new Keynesian model with rational expectations tight money can so depress expected investment demand that real rates of interest fall, rather than rise. Real rates were extremely low during most of 1933-41 (and probably 1932, ex ante), and they've been really low during recent years. I hope the new Keynesian model doesn't say what you seemed to indicate:

"But when you are in a recession now, and expect to come out of it, you expect an abnormally high growth rate of real income. So the recession could only be an equilibrium today if the real interest rate were abnormally high."

That's a stylized fact that's just not true. Here's my data source for the US rates in 1982:

http://research.stlouisfed.org/fred2/data/TB1YR.txt

Final question: In 1929 you look into a crystal ball and find the Fed will soon tighten monetary policy so much that NGDP falls in half. Do you buy or sell T-bonds? All you know is the future path of NGDP. I sure hope the new Keynesian model doesn't say sell T-bonds because rates will rise.

Phil Koop, I don't understand your argument. TIPS were default risk-free. They are probably as liquid as most corporate bonds. Your argument seems to be not that TIPS yields were distorted by a liquidity panic, but that nominal Treasury bond yields were distorted. The real rate on risk free TIPS rose sharply. It may have been partly caused by liquidity problems, but that doesn't change the fact that a bank thinking about lending money out at a real rate of 4% to a risky borrower, had to think about the fact that they could lend money to the Treasury at a real rate of 4.2%. I say it was the nominal yields that were distorted, not the TIPS. In any case, if there's not enough liquidity and TIPS rates are that distorted, that's virtually a definition of tight money.

Finally, TIPS yields aren't just labeled real yields, they are real yields. They are not estimated, like the real yield on Treasuries. The real yield on TIPS is the same ex ante and ex post. So your claim that my assertion was false is itself false. You may not like TIPS. But you can't say the real yield on TIPS didn't soar. It most certainly did. A better argument on your part is that the CPI isn't perfect, and that TIPS are adjusted to the CPI with a slight lag.

[david]

@Rowe:

When Walrasians talk about money, in the sense of denoting price vectors in terms of monetary units, surely they don't mean "money" in the sense that Keynesians do? If you imagined a Walrasian auctioneer letting people trade in a monetary economy (in your sense), at the end of the period, nobody actually wants to hold money. They all want to hold the things that money buys. So treating money like a good is tricky. Walrasian money is something like a loanshark line of credit - make sure you end the period with zero balance (i.e., meet your budget constraint).

In fact, at the end of a period - after all trade is done - no agent has any money, despite having apparently traded extensively with it. Mysterious!

But when Keynesians talk about liquidity preference, don't they really mean preference for liquid assets like, well, money, not short-term bonds? It's a desire to hold money, independent of its ability to claim goods at prevailing prices. So they can treat money like a good, but then it's not the same as the monetary units in those price vectors. You keep saying that there's no third market, but there is - I can see it every time I go to supermarket armed with a Visa card: I can buy an apple, and I can buy a cash advance from the cashpoint. There's a market for apples for money, and another market for Keynesian liquidity-preference money for money.

If money is to be treated as a good, then it should have a (possibly fixed) price, and at least one agent should end the period holding some of it.

[david]

But besides harping on that argument: suppose that the problem is, as you say, excess demand for the medium of exchange. Okay, we can fix that, by issuing more medium of exchange through the banking system.

... but doing so only fixes Shock 2, but not Shock 1. So meeting the excess demand isn't a solution, so why is it the problem?

Also: empirically speaking, how might one identify groups of people who are thought to be isolated from bidding interest rates upward? The model does imply that one has to issue these groups more medium-of-exchange instead of tossing it at random passers-by.

[Max]

Scott, the TIPS yield spike was a market dislocation. Leveraged investors have finite capital and at times become forced sellers. Eventually they either replenish their capital or new investors step in, but this doesn't happen instantly.

See http://pages.stern.nyu.edu/~lpederse/

for some good papers on the subject.

[Scott Sumner]

Max, Call it what you want, but it happened. I don't object people saying it was a "market dislocation", but it was a market dislocation that raised real rates on TIPS and was caused by excessively tight money. I'm not claiming that real rates were equally high on nominal Treasuries.

Suppose someone said the 1987 stock market crash never happened, because it was caused by "panic?" That doesn't mean an investor couldn't buy stocks much more cheaply the day after the crash than the day before.

It's important to distinguish between the question of what happened, and why that event happened. What happened is that in late November 2008 investors could earn a 4.2% real return, risk-free on TIPS. That became the opportunity cost of the banks lending money out to the private sector. The banks could buy TIPS, so had little reason to make loans.

I happen to think that neither Treasury yields nor TIPS yields are a particular important causal factor in monetary policy. Other asset prices are much more important, and just about all of the other asset prices were signalling extremely tight money--the same as TIPS. TIPS weren't the outlier in late 2008--nominal Treasury yields were the number that everyone misread, as is now obvious from the fact that virtually anyone who is not a nutty inflationista realizes the Fed should have been much more expansionary in late 2008.

[Nick Rowe]

Scott (or anyone): Do you have a link to that Robert King paper. Or a title?

"Investment is highly cyclical, and Robert King showed that in a new Keynesian model with rational expectations tight money can so depress expected investment demand that real rates of interest fall, rather than rise."

I had a look at Canadian data. Nominal interest rates spiked in late 1981, remained high but falling during 1982. Unemployment followed with a lag. You are right that the lag does create a problem for the simplest NK model. IIRC, that's why they need to build in assumptions like sticky consumption (habit persistence), and time-to-build in investment, etc., to explain why there's a lag between their conception of tight money (the bank sets the interest rate above the natural rate) and a recession. The simple model I was thinking of has no lags.

[Nick Rowe]

david: "@Rowe: When Walrasians talk about money, in the sense of denoting price vectors in terms of monetary units, surely they don't mean "money" in the sense that Keynesians do?"

In a Walrasian auction, there is no medium of exchange, only a numeraire. But any good can be numeraire, and it makes no difference which good is chosen as numeraire.

Keynesians certainly *shouldn't* think about money in the same way that Walrasians do. But I have just been arguing with one very well-educated New Keynesian who says that in New Keynesian models the only role of money is to be medium of account. (The medium of account is not exactly the same as a numeraire, because if prices are sticky, as they are in NK models, it matters which good they are sticky in terms of, but it's close.)

I keep arguing that Keynesian macro makes no sense whatsoever without a medium of exchange that is essential for trade. But not all Keynesians agree.

A cash advance on your Visa is a bond market. You get cash, and you give an (electronic) IOU (bond) in exchange. You just sold a bond.

[Nick Rowe]

If you get change for a $20 bill, or cash a cheque, or withdraw cash from an ATM using your debit card, I expect you could call that a "money market".

[Andy Harless]

"A cash advance on your Visa is a bond market. You get cash, and you give an (electronic) IOU (bond) in exchange. You just sold a bond."

But then isn't a merchandise advance also a bond market? And if that's the case, doesn't it rather invalidate the distinction between money as MOE and bonds as non-MOE? I can go to the store and issue a bond in exchange for groceries.

I don't know if it is still the case, but in my experience in other recent recessions, it seems that unemployed people could make a lot of purchases by issuing such bonds. The problem was that that interest rate on such bonds (after the first month) was very high, so one would, to some extent, choose to curtail consumption instead. This seems to argue for a neo-Wicksellian view, except that most of the action is in the risk premium rather than some abstract interest rate.

[Nick Rowe]

Andy: If the storekeeper used my IOU to buy supplies (as opposed to using it as collateral for supplies), and the supplier used it to pay his workers, (et., etc., )who in turn came to me for payment at the end of the month, then yes, my IOU is circulating as a medium of exchange. Otherwise, it's just a way for me to postpone payment.

If you pushed it though, I would admit that the precise dividing line between what is and is not money isn't always precise. But that doesn't mean there's no difference between a monetary and a barter economy.

"This seems to argue for a neo-Wicksellian view, except that most of the action is in the risk premium rather than some abstract interest rate."

Imagine a world with apples, bananas, and money. If the prices of apples and bananas were both fixed, we would be forced to see recessions as being due to an excess demand for money. But if the price of bananas were flexible, recessions would look like being caused by the wrong relative price of apples and bananas. For "bananas" read "bonds". We mistake the symptom for the cause.

But your story about the unemployed makes sense to me. They use credit cards perhaps. It was that sort of idea I was trying to get at in this model. In some way, my model here is an analogue of the Krugman/Eggertson model. In both models the interest rate is determined by the behaviour of agents who are not shut out of the bond market. Except there it was the improvident borrowers, rather than the unlucky unemployed, who are borrowing constrained.

[Max]

"I don't object people saying it was a "market dislocation", but it was a market dislocation that raised real rates on TIPS and was caused by excessively tight money."

If entities that are suddenly undercapitalized due to mark to market losses are unable or unwilling to borrow at any interest rate, is that tight money? Or would it be more descriptive to call it tight capital?

[Max]

I should add, not only undercapitalized due to losses, but also due to greatly increased volatility.

[dlr]

I've read this more than once but I keep ending up thinking you're almost losing an argument with your own straw man, so I know must be missing something. I don't understand why the awkward permanent-luck and borrowing constraint features are necessary. Why can't you just have uncertainty or pessimism about future recovery? Maybe because people aren't sure if the problem is nominal or structural or because they are worried that future, unaccommodated surprise fires might render the recession a recurring nominal problem. Then with some kind of stochastic unemployment churn you have the unemployed's demand for bonds offset by the employed's supply of bonds given their greater risk of future unemployment. Then low interest rates reflect the possibility that things might get even worse or the fear of more future deflationary fires.

Moreover, I don't see why this sheds any light on whether it was the chicken (flight to safe future consumption) or the egg (demand for the money as a MOE). The low rate question might be quandary in either case. Say there is a flight to safety because someone makes a scary movie called Future Backscratch Volatility. The supply of bonds increases as future consumption becomes more uncertain, which spills into an excess demand for money. Disequilibrium ensues, production declines and unemployment emerges. If recovery is expected, you still might wonder why bond prices don't decline. Sure, there might be an offset to some extent relative to moment zero if the movie-volatility fear was still around, but not necessarily such that it would actually mean high bond prices net of the expected future recovery. In fact, the economic shock might be seen as a realization of the volatility everyone was fearing (now they are in volatility and expecting recover), so and might go away entirely from expectations. You'd still wonder why rates were low. In other words, the flight to quality leading to an excess demand for money might not be expected to remain a flight to quality once you hit quasi-equilibrium, just as an excess demand for money leading to a flight to quality during disequilibrium might not expected to remain a flight to quality if a recovery is expected. I don't see how you can tease out the prime mover by going around counting the chickens and eggs after-the-fact. Both explanations have some explaining to do if there are too many eggs and not enough chickens.

[david]

"A cash advance on your Visa is a bond market. You get cash, and you give an (electronic) IOU (bond) in exchange. You just sold a bond."

As Andy Harless says - but I can buy apples with said (electronic) IOU (bonds), so this bond functions as a medium of exchange, in the same way actual cash money does. The set of goods which are "medium of exchange" includes both these particular bonds, and cash.

The point here is that there is a money market, i.e. a market in which the unit of account is traded with the medium of exchange, at a price which may be flexible or fixed.

"Imagine a world with apples, bananas, and money. If the prices of apples and bananas were both fixed, we would be forced to see recessions as being due to an excess demand for money. But if the price of bananas were flexible, recessions would look like being caused by the wrong relative price of apples and bananas. For "bananas" read "bonds". We mistake the symptom for the cause."

Well, validating that wrong price by creating more bananas solves the issue...

Besides which, the price of bonds should be lower before the shock and higher after the shock, right? Even if the unlucky are shut out of the market, thus preventing the price of bonds from skyrocketing immediately, at least the price of bonds should not fall, right? How does this square with interest rates actively decreasing during a recession?

[William Peterson]

I think the original post makes too much of the loanable funds - liquidity preference issue (even if this section is only a digression).

In a Walrasian framework it is the *vector* of prices announced by the auctioneer which causes the *vector* of market excess demands to reach zero (ie clear all markets). It is not the case that the apple price clears the apple market, the pear price clears the pear market, and so on.

The reason why it is easy to slip into the argument that the interest rate is set in the loanable funds market, and that the money market doesn't matter, is that money enters excess demand functions in an atypical way. Excess demands for goods are homogenous of degree zero in nominal money and absolute prices, and the demand for money is homogenous of degree 1 in prices. As a result, if the quanity of money doubles, and we focus exclusively on comparison of the final equilibrium states, we find that real variables (including the interest rate) are unchanged, and all that has changed is the absolute level of prices. In contrast a doubling of apple supply would in general affect the relative price of pears and oranges. This special property of money makes it easy to argue that liquidity preference cannot affect the interest rate, which is determined solely in the market for loanable funds. Nevertheless the increased supply of money has affected excess demands for other commodities: it's just that the auctioneer ensures that trade does not take place until these effects have worked themselves out, so they are effectively invisible.

Keynes abolished the auctioneer, and this changes the model fundamentally. If prices are sticky (and it is sensible to assume that goods prices and the wage are stickier than bond prices) the initial impact of a monetary expansion will be on interest rates and possibly (if we believe in direct real balance effects) on the demand for goods. In the short-run this means that investment and output will change. In the long-run (particularly if we start from full-employment) we may get back to the original real equilibrium, but with a higher price level. But the liquidity preference schedule is crucial in explaining the size of the inital effect on interest rates, and the circumstances (the liquidity trap) in which a simple-minded quantity theory breaks down.

On a different issue in the post, surely we should effect the relationship between interest rates and recession to depend on the interest rate policy rule (or alternatively the money supply rule) in effect. many postwar recessions in both the US and UK were set off by official action to tighten monetary policy, either because (in the US) the Fed was 'taking the punchbowl away from the party' or (in the UK) because there was a perceived need to protect the currency from depreciation. This is not the same type of initial shock as 1931, or 2008. In addition, it's important to distinguish beteween the crisis and the subsequent recession. In 19th century Britiah banking crises standard policy was for the central bank to supply liquidity at a high ('penal') interest rate, both because high rates were necessary at such times in a gold-based system (and the high rate could attract additional gold from abroad, and thus help to maintain convertibility) and because the knowledge that a penal rate would be charged reduced moral hazard and punished improvident bank executives. In 2008 (the first major and prolonged banking crisis since 1931) policy-makers opted instead to provide unlimited liquidity at very low interest rates, in the hope that this would be less disruptive to economic activity than the traditional policy. It's not clear we have done much better as a result.

[Edited very slightly to fix formatting. NR]

[Nick Rowe]

dlr, david, William: those are 3 good comments. I'm not ignoring them. I'm thinking about them. Will respond if and when I think of a good response. My mind is currently wandering off onto upward-sloping IS curves.

[Nick Rowe]

dlr: "I don't understand why the awkward permanent-luck and borrowing constraint features are necessary. Why can't you just have uncertainty or pessimism about future recovery?"

You might be uncertain about recovery, but the standard idea of a recession is that output is below trend, so in that sense you must be optimistic in a recession. (Which, I admit, is strange). People (unless they don't realise they are in a recession) believe that things will get better, even if they don't know how soon or how much things will get better.

Still thinking about your chickens and eggs.

david: I might pay for something by Visa, but what really happens is that the credit card company pays for it on my behalf, and I then owe the credit card company. It is as if I sold a bond to the credit card company, and the credit card company pays the merchant in money. My bond does not circulate, so isn't a medium of exchange.

"Even if the unlucky are shut out of the market, thus preventing the price of bonds from skyrocketing immediately, at least the price of bonds should not fall, right? How does this square with interest rates actively decreasing during a recession?"

In my simple model, real interest rates will not rise. But yes, they won't fall either. I reckon I'm halfway there ;-)

William: "In a Walrasian framework it is the *vector* of prices announced by the auctioneer which causes the *vector* of market excess demands to reach zero (ie clear all markets). It is not the case that the apple price clears the apple market, the pear price clears the pear market, and so on."

Understood. I wasn't meaning to contradict that. In my example, I said that the demand for apples may depend on the price of pears, but that doesn't mean the price of pears is set in the apple market. What I am talking about is disequilibrium price adjustment. An excess demand for apples means the price of apples will rise. It does not (necessarily) mean the price of pears will fall.

Fully agree with your next paragraph, down to:

"Keynes abolished the auctioneer, and this changes the model fundamentally. If prices are sticky (and it is sensible to assume that goods prices and the wage are stickier than bond prices) the initial impact of a monetary expansion will be on interest rates and possibly (if we believe in direct real balance effects) on the demand for goods.....But the liquidity preference schedule is crucial in explaining the size of the inital effect on interest rates,..."

But is an excess demand for money really the same thing as an excess supply of bonds? In equilibrium we may say something like the demand for money is Md/P=L(Y,i). But once we are out of equilibrium, there are potentially n-1 different excess demands for money, and the price of bonds will be responding to only one of those n-1 excess demands for money.

[RSJ]

"Even if the unlucky are shut out of the market, thus preventing the price of bonds from skyrocketing immediately, at least the price of bonds should not fall, right? How does this square with interest rates actively decreasing during a recession?"

What is important is the rental rate of capital, not the bond yield per se. If capital values are expected to decline, households will demand a capital rental rate that compensates them for this decline.

The arbitrage free condition would be that buying capital, renting out for one year, and then selling it should give the same return as buying a 1 year bond, plus a risk term.

Even ignoring possible increases in this risk term during a downturn, if capital goods prices are expected to decline faster than bond yields, then the capital rental rate will increase even if bond yields are falling.

[Jacques René Giguère]

Nick
"You might be uncertain about recovery, but the standard idea of a recession is that output is below trend, so in that sense you must be optimistic in a recession. (Which, I admit, is strange)."

You may not be optimistic but you behave opimistically at the very through when for some reason ,maybe merely stochastic, you do something stimulative. Recovery, like depression, might have a Minsky moment.

[Nick Rowe]

RSJ: "If capital values are expected to decline, households will demand a capital rental rate that compensates them for this decline."

What you are talking about there is akin to the distinction between real and nominal interest rates.

Jacques Rene: what you say sounds plausible, but can it be squared with expectations that would be even vaguely rational, i.e. model consistent? If the model says that output is temporarily below trend in a recession, people should expect higher than normal growth.

[RSJ]

Nick,

In the spread

(nominal) bond yield - % change in (nominal) capital goods prices

.. the inflation term cancels out, so the spread is a real quantity. It measures the return from supplying a capital good in terms of consumer goods.

[William Peterson]

I wasn't arguing that the excess supply of money was equal (one-for-one) to the excess demand for bonds. My argument was that in a Keynesian framework (no auctioneer, so sticky prices) an excess supply of money would have more effect on bond prices (which adjust quickly) than goods prices (which are sticky). Any impact on goods markets would be more likely to affect quantities, and this does not send any signal to agents other than the firms for which demand has risen. I'm not sure what is meant by 'potentially n-1 different excess demands for money' - since money is (in my view) the one commodity where rationing cannot occur, the excess demand for money can always be aggregated across markets.

[RSJ]

Here is a quick and dirty regression that takes capital values as well as bond yields into account (assuming risk-premia are fixed). The implied capital rental rate increased during the recession even though the CB was cutting yields. Increases to the implied rental rate correspond to negative shocks to real GDP growth.

[Determinant]

By way of reporting on Academe, what William Peterson said about planned vs. unplanned recessions was also said to me by Torben Drewes of Trent University in a lecture on the financial crisis (it wasn't a recession yet) in 2008.

Part of the problem with the debate over this recession is that many economists can't get their mind around the fact that there is more than one type of recession. 1982 is less relevant to today than 1931 which has more commonalities with what actually transpired.