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Public service announcement: Krugman's retelling of the capitol hill baby sitting co-op parable is concisely recounted in this 1998 Slate piece: http://www.slate.com/id/1937. So no need to use up any precious NYT clicks.

Thanks Phil! Added.

For #1, I think you could go with, "There is no interest rate in Krugman's babysitting story, and yet there is a recession. QED." The counterargument, though, is that there actually is an interest rate; it's just not observable. Babysitting vouchers pay a convenience yield. The yield was higher than the natural interest rate, so there was a recession.

On #2, we can't scratch each other's backs at the same time. If I scratch your back, how do I know you'll scratch mine? Maybe you'll issue a promissory note for a backscratch? That note is a financial asset. What interest rate does it pay? A low enough interest rate to prevent a recession. Even if I just trust you to return the backscratch, your credit is a financial asset, and it pays a low enough interest rate to prevent a recession.

If you want to dispense with interest rates the World’s Smallest Macromodel (not an NYT link) has the advantage that the model is clearly specified, whereas the babysitting co-op is more of a story than a model.

That model tells me that this isn’t quite right: “We can explain the recession in terms of money and/or velocity. Money/velocity is sufficient to explain the recession, while interest rates are not necessary.” Velocity is constant, given the log-linear utility function. It’s the rigid price level that does the trick, in conjunction with the impossibility of barter, not money as such. After all, you could think of M as being moonstones, desired for their appearance alone. Of course, if you want to say that “monetary economy” is a synonym for “economy in which barter is impossible” then this is a monetary economy by definition, even if the representative agent never actually parts with a single moonstone.

I've also done some posts that consider monetary transmission in a world without interest rates. Or a world where prices are completely flexible, and hence money supply changes don't affect interest rates. In either case, there must be SOME mechanism that explains why increasing the money supply 10% causes prices to rise by 10%. What is that mechanism? (I think it's the hot potato mechanism). My problem with Keynesian economics is that they don't seem to recognize that the transmission mechanism in a interest-free economy, or in a flexible price economy, is still there when you add interest rates, or add price stickiness. And since prices are flexible in the long run, that mechanism explains why a 10% increase in M that is perceived to be permanent will cause expected future NGDP to rise by 10%. And if future expected NGDP rises, that's all the transmission mechanism you need to affect current NGDP. It's not necessary that interest rates change at all.

One small quibble. You CAN have a velocity of bling, it's simply NGDP/bling. Some people erroneously believe that V measures the speed that money circulates, but that's only the non-tautological definition of V. The more commonly used tautological definition of V has nothing to do with the speed at which money circulates, as 99% of monetary transactions are for assets unrelated to NGDP.

Andy: "On #2, we can't scratch each other's backs at the same time. If I scratch your back, how do I know you'll scratch mine?"

OK, but 3 of us could scratch each others' backs at the same time ;-).

Kevin: "It’s the rigid price level that does the trick, in conjunction with the impossibility of barter, not money as such."

Well, I would say that "the impossibility of barter" is the same thing as "money" (medium of exchange). But yes, if prices were perfectly flexible, the real supply of money would adjust instantly to equal demand.

Scott: yes, you have been one of the strongest advocates of the view that interest rates are a possible complicating factor of the transmission mechanism, rather than an essential ingredient. But there is maybe a difference in our views on this, nevertheless. I still can't get it exactly right. Your comment is talking about the transmission mechanism from M to P, where the fact that money is the medium of account matters, and the fact that it is a medium of exchange does not matter. I'm talking about the transmission mechanism from M to Y, given sticky P. There the fact that money is the medium of exchange does matter.

(I don't feel I've fully come to grips with your comment.)

On your quibble: Yes, there's a "velocity" of houses too (3 or 4 years income is supposed to be normal), but that doesn't mean that people switch houses every 3 or 4 years. My instinct is to resort to the transactions velocity. MV=PT. Y is a subset of T. When MV falls, we see all transactions falling, including sales of newly-produced goods and services.

Scott: My problem with Keynesian economics is that they don't seem to recognize that the transmission mechanism in a interest-free economy, or in a flexible price economy, is still there when you add interest rates, or add price stickiness.

I’m not sure whose brand of Keynesian economics you are knocking here. It’s a broad church and I only know a few members of the congregation. I think you have a fair point with respect to some Keynesians, Old and New, but not all. Doesn’t your problem turn on whether the model is capable of generating a Pigou effect?

Generalising wildly: every Keynesian model worthy of the name includes, as a special case, a full-employment equilibrium. Call that special case the ‘Classical’ model. We chuck in some imperfection, almost always some kind of price stickiness and, hey presto, we have a ‘Keynesian’ model. The upshot is that pretty well every ‘Classical’ model can generate at least one kind of ‘Keynesian’ model. It might not look anything like the one Keynes sketched in the GT, but it will sort-of rhyme with it.

As an example of the sort of thing I mean, take a look at J.P. Bénassy (2007), "IS-LM and the multiplier: A dynamic general equilibrium model" (available here). It’s quite a short paper. He takes a simple monetary overlapping generations model, introduces sticky prices and ends up with something surprisingly like an old-fashioned IS-LM model. Your objection (as I understand it) doesn’t apply because an increase in M shifts the LM curve, as you’d expect, but it also shifts the IS curve via the interest rate. It’s a ‘Keynesian’ model of a sort Keynes could hardly have imagined, because it starts from a ‘Classical” model that didn’t exist in his lifetime.

Since people frequently refuse to click on links, I'd better add that Bénassy's IS and LM curves are not derived in the same way as in your granny's IS-LM model.

A note about the Time's paywall. It's incredibly porous. Just type the article title into google and you can read the article from the google link. No need for link hoarding at all :)

The most frustrating thing about the monetary transmission process I've ever had is combining them into one grand structural and self-consistent theory of 1) portfolio rebalancing and 2) hot potato process. Here is a list of the most commonly listed transmission mechanisms by group....

1. Traditional Keynesian interest rate channel (bonds)
2. Tobin's q (equities)

3. Direct purchase of consumer goods and services
4. Direct purchase of capital goods

5. Commodities markets
6. Real estate markets
7. Exchange rate markets

8. Wealth effect for consumers
9. Wealth effect for firms

10. Anything Scott Sumner talks about, which I am unable to pigeon whole into any of these categories except for #3 and #4.

Has anyone ever written a clear and concise picture of each individual having a portfolio of such assets and how each transmission story, whether Keynesian or Monetarist, is really just looking at the same story from a different angle?

Joe

Jim: Aha! And I just heard from Niklas Blanchard that if you clear cache and cookies it resets to zero!

Joe: good comment. "Not to my knowledge" is the answer to your question. But I like the idea that, at least in many cases, it's just looking at the same story from a different angle. Take ISLM, for example. Here's the keynesian version. "M increases, r falls, Y increases...and, oh yes, there's a feedback from increased Y to increased Md". And here's the monetarist: M increases, Y increases, ... and, oh yes, there's a feedback from increased Y to increased S and decreased r to increased Md".

David Laidler did a good essay on the transmission mechanism, decades ago.

One thing that often gets left out is the effect on expectations. And how that depends on how people interpret the increase in M. "Why did the Bank increase M? What does it signal about the Bank's future policy?" We really can't answer the question of the transmission mechanism without looking at those questions. Take, for example, Scott Sumner's favourite example, about FDR raising the price of gold. That *meant* something very different in those days than it would today.

The monetary transmission mechanism is a function of the institutional set-up of your model. The reason why so many have abandoned the old-school approach of counting money to predict inflation is not just the empirical problems, but the logical problems of that belief. It just doesn't match how the institutions work. Outside money dominates inside money, and the non-financial sector can obtain more money from the financial sector whenever it wants. The financial sector is more than happy to purchase a bond and create a deposit -- they will earn income from the spread. In the process, the non-financial sector always holds the deposits it wants regardless of what the central bank does. Or rather, it always holds the deposits it wants at a given rate of interest, which is set by the central bank.

So the reason why the interest rate management is the only transmission mechanism is because that is how our institutions are set up. If you change the institutions -- and there is no outside money or banks in your model -- then the transmission mechanism will be different.

What you are doing in your model is throwing away all the institutions that made the old-view irrelevant, in order to restore relevance to that view.

I don't think anyone would disagree, in principle, that if the world operated differently, then there might be a monetary transmission mechanism. And you can look at less developed nations -- say in which there is no banking sector due to a crisis, or the banking sector is so small that outside money is not important -- and then your transmission mechanism might apply to those undeveloped or crisis economies.

But that isn't true of modern credit-based economies and so your transmission mechanism isn't a real transmission mechanism.

Some arguments against using interest rates to adjust AD:

1. There is no relationship between central bank rates and the rate charged by credit card operators. See: http://uk.creditcards.com/credit-card-news/credit-card-interest-rates-bank-rates-1360.php

2. The Radcliffe Report on monetary policy in the U.K. published in 1960 concluded that ‘there can be no reliance on interest rate policy as a major short-term stabiliser of demand’.

3. Interest rate adjustments will not influence house purchases by much because short term interest rates have little influence on long term rates. The longest so called “fixed rate” mortgage available in the UK is around five years. As I understand it, the period is longer in the US, but this is only possibly because of taxpayer funded distortions via the Fanny and Freddie.

4. The idea that there is a close relationship between interest rates and the ACTUAL AVAILABILITY of credit has been shown to be a myth over the last two years or so: we’ve had ultra low rates with banks far more reluctant to lend than prior to the recession, when rates were higher.

5. Interest rate adjustments work primarily via entities that are significantly reliant on borrowing rather than equity finance. This makes as much sense as boosting an economy via entities whose names begin with the letters A-L and ignoring the one’s whose names begin with M-Z.

Ralph,

What you are pointing out is the fundamental asymmetry of the interest rate channel. It affects business investment, consumer borrowing, and mortgage borrowing very differently and at different time scales, with the bulk of the immediate effects concentrated on the housing market. As a result, by raising or lowering interest rates, you are also affecting the relative profitability of different industries.

I don't *think* anyone would disagree with this -- it goes back at least to Bernanke and Gertler.

I view the modern era of CB taylor rule policies as being a de-facto era of asset price management, specifically house price management. But I don't know of models that are able to distinguish between these effects.

It would be interesting to come up with some mitigation policy -- for example, raising downpayment requirements simultaneously to cutting interest rates, or using tax policy to give tax breaks to business investment together with interest rate management, to get a richer policy rule than the one dimensional taylor rule.

My problem with monetarist economics is that they don't seem to recognize that the transmission mechanism in a cash-free economy, or in a flexible price economy, is still there when you add cash, or add price stickiness.

you know it has to be asked since it was brought up above. Does anyone really think that barter was impossible or very expensive in the babysitting economy? Really?

Costless barter doesn't prevent recessions.

Adam P: I'm not sure how you envisage barter in babysitting. The couple going out for the night can give an IOU to the babysitter, avoiding the use of precious scrip. If IOUs are transferable and all issuers are creditworthy then the shortage of scrip won't matter anymore. But I wouldn't call that costless barter, I'd call it a perfect bond market.

Well, first of all the IOU's may not be transferrable, it would be bilateral. But really we're talking about the difference between inside and outside money.

The M in the quantity theory is supposed to be base money, outside money. The cashless models don't eliminate credit, they eliminate outside money.

In general though the point I'm trying to make is that, as a theoretical point, costless barter doesn't mean there can't be a recession. Anyone who's ever seen an RBC model knows this.

The fact the models don't *seem* realistic is irrelevant, they can give insights that apply to the real world.

Nick, It's not entirely about medium of account vs medium of exchange. And my mechanism doesn't require flexible prices. You could have wages be stickier than prices, and tight money still causes unemployment. You just have to stop thinking in Keynesian terms.

Yes, you can use transaction velocity, but I have never once seen it done. Forex transactions alone are probably 100 times NGDP. So the numbers would look nothing like the published velocity numbers that we actually see. When people are talking about empirical estimates of velocity, they are NEVER referring to transactions velocity. Also note that under the tautological definition of velocity, one can have M1 velocity, M2 velocity, etc. With the transactions definition there is only one velocity.

Kevin, I don't doubt there are some Keynesian models that go beyond interest rates, but that seems to be the transmission mechanism generally assumed in both old and NK models. At the zero bound the old Keynesians say the Fed can do no more, and the NKs say that we can still lower long rates, or create inflation to lower real rates. But it's still all about interest rates. That's what I was reacting to. If you define Keynesianism so broadly as to include the 9 transmission mechanisms in Mishkin's textbook, then I suppose I am a Keynesian.

When there is a big apple harvest and the dollar price of apples falls in half, then NGDP in apple terms roughly doubles. How does that occur? I've never heard anyone use the interest rate transmission mechanism to explain why NGDP in apple terms doubles, they always use the excess apple balance mechanism. Now of course dollar NGDP is very different from apple NGDP, because prices are sticky in dollar terms but not in apple terms. So that makes an interest rate transmission mechanism plausible, but it doesn't magically take away the mechanism that caused NGDP in apple terms to double.

BTW, I am pretty sure my model doesn't require a Pigou effect. As I recall that effect tries to explain why consumption might rise via higher real cash balances. But I am assuming that only nominal cash balances change. Or have I misrepresented the Pigou effect?

Scott: But I am assuming that only nominal cash balances change.

But aren’t you also assuming sticky prices, so M/P has to change? There’s a Pigou effect, as I use the term (which is also how Bénassy uses it), if financial assets, or at least a subset of them, are regarded as wealth by households. So that’s number 8 on Joe’s list of transmission mechanisms. I think you’re right in saying that most Keynesians regard that as an unimportant transmission mechanism for practical purposes. Let’s face it, not many of us respond to news of a monetary easing by saying that household wealth is about to increase. But that’s what we see in the interest-free economy of the World’s Smallest Macromodel. It’s still there in some old-fashioned IS-LM models, with a consumption function of the form C = C(Y, M/P) where Y is real income. (But C = C(Y) was certainly more common in old textbooks.)

I think you don’t see a Pigou effect in most NK models and that is because they have immortal agents. Or maybe not. I defer to Nick and Adam where NK models are concerned.

Nick,

I will attempt to give my attempt combining your keynesian and monetarist story. Scott Sumner begins his argument saying that Keynesians are forgetting that on a poor African country with no bond markets, M increases still have real effects. This is because people just directly spend money on consumer and capital goods. Strangely, Mankiw's textbook does not mention that, not even Mishkin's! This is hot potato effect (HPE). But there was an inconsistency, flaw in his idea. After all, even if paradox of thrift is technically wrong, in addition to hoarding or consuming stuff, people can just save of course. So, how in the act of saving are we 1) combining keyensian and monetarist ideas of textbooks (Tobin v Friedman), 2) show portfolio rebalancing story, 3) show HPE story of quasi-monetarists.

Metaphysically, saving is just handing your cash to another person in return for an IOU, who then HIMSELF, consumes it. This is what paradox of thrift proponents forget. An individual saves by going into fancy smancy (American phrase) super duper complex Wall Street financial markets. They wish to purchase bonds or equities. They shout "I have more money balances than my money demand, who wants to borrow my money, at these bond and equity prices?" If no takers then the individual bids up bond prices (lowers interest rate) and equity prices to "seduce" others into taking their cash. Either the market clears with the trade of IO/equity for cash, or potential saver is unsatisfied with too high of the price and leaves the financial markets in order to continue hoarding or just consumer something. I think I have successfully included 1) combining Keynesian and monetarist ideas of textbooks (Tobin v Friedman), 2) show portfolio rebalancing story, 3) show HPE story of quasi-monetarists.

There is a flaw though. I do not know how to combine it with Scott's idea of expectations, of which there are two main ideas (if I correctly understand).

First, monetary policy can work in three ways, 1) Increase M, 2) Increase V (lower Md) through fiscal policy (gov. spending), 3) Increase V through changing expectations by making announcements concerning current and future situation.

Second, you can know whether these are successful by the direction asset prices go in the next coming months. If they go up, then it succeded, if down, then it failed.

I do not know how to shove together 1) my story of the monetary transmission process, 2) Scott's ideas of expectations.

Bill Woolsey described it best over on Matt Rognlie's blog.

Suppose that money earns interest. When interest rates on bonds rise, so do interest rates on money. Changing interest rates have little influence on the demand for money. The "interest rate transmission mechanism" breaks down. However, we can still get monetary disequilibrium, an excess demand for money, and a recession.

At least, that's what I think Bill was saying.

Kevin, No I am not assuming sticky prices. In my first example I asked what would happen if prices are not sticky. Clearly a permanent 10% increase in M causes all nominal aggregates to immediately rise by 10%. Then I asked what was the transmission mechanism if interest rates don't changes (and of course they don't change if money is neutral.) I speculated that the hot potato effect causes the nominal adjustment. Then I asked whether this transmission mechanism might also work in a world where prices are sticky. And it seems to me the answer is yes. Now it is also true that once you introduce price stickiness, then real money balances adjust and you get the Pigou effect, just as you indicated. And I agree with Keynesians that the Pigou effect is probably weak. But the mechanism I was thinking about was a flexible price mechanism, and hence not the Pigou effect.

The flexible price model is not merely academic, as prices are flexible in the long run. I believe the transmission mechanism for long run changes in P and NGDP is exactly the mechanism that you observe in the flex price model (the hot potato effect.) And expectations of higher long run NGDP tends to raise AD right now. Then if prices are sticky in the short run, the higher current AD leads to more RGDP, until prices and wages fully adjust.

Most people get short run effects as follows: Assume sticky prices, that makes interest rates change, and assume interest rates drive RGDP. I assume prices are flexible in the long run, M-policy drives future expected NGDP. Futures expected NGDP drives current asset prices and thus current NGDP, and sticky prices causes some of the current change in NGDP to spill over into RGDP.

Scott,

When you say, "Futures expected NGDP drives current asset prices and thus current NGDP" you refer to all asset prices - bond, equity, real estate, commodities, foreign currency, etc. You are really talking about savings, not direct consumption. But how are such changes in prices representative of the hot potato process? This has never been made precisely and metaphysically clear. You never use the word "savings" to express why these changes in prices happen.

Are you really saying the following... NGDP expectations go up -> money demand falls -> money holders decide to save -> they go into the financial markets -> they bid up prices of assets (bond, equity, real estate, commodities, foreign currency, etc) in order to get borrowers to take their cash -> the markets clear -> borrowers take the saver's cash in exchange for given assets.

Therefore, if the Fed attempts to move MV through changing expectations, you will know that they were successful because prices of all sorts of assets will go up across the financial markets. The increase in asset prices tells you that the hot potato process was channeled through the financial markets. Is that correct?

Here's Scott: "I am not assuming sticky prices. In my first example I asked what would happen if prices are not sticky. Clearly a permanent 10% increase in M causes all nominal aggregates to immediately rise by 10%. Then I asked what was the transmission mechanism if interest rates don't changes (and of course they don't change if money is neutral.) I speculated that the hot potato effect causes the nominal adjustment."

Seriously, does nobody else notice that he's getting his own argument wrong? (or am I the only one who bother pointing it out?)

The thing about the "hot potato" effect is that it only operates *before* the price rise has happened. Once prices have risen 10% then the real value of the money stock has fallen to equal the demand for real balances and money is not a hot potato.

If the price rise is truly immediate, so that interest rates never change, then money is never a hot potato.

If there is a, perhaps brief, transition period in which the money stock has risen but prices haven't fully adjusted then yes, money is a hot potato for this time but then, for this time, interest rates will have changed.

Apparently Scott has in mind the transition period, but then the statement that interest rates never change is inconsistent with the story he's telling.

On the other hand, Scott usually professes to believe in rational expectations (though I know he hasn't done so here). However, the "hot potato" transimission mechanism is *not* consistent with ratex. Under ratex the price rise truly is immediate, basically everyone understands that the money supply increase implies a 10% rise in prices and so prices adjust immediately before any hot potatos have changed hands.

Scott can't have it both ways, if interest rates never change then money is never a hot potato. If the hot potato transmission mechansim is at work then interest rates will change.

"Given sticky prices, an exogenous decrease in the supply of money causes interest rates to rise which causes aggregate demand to fall . . . ." This is too compressed to enable me (a non-economist) to understand the New Keynesian view. I think "aggregate demand" is just spending (or is it spending on consumer goods?), in which case a fall in the quantity of money would itself reduce AD (assuming no corresponding increase in velocity). So money supply looks intrinsically relevant to AD. But how are *interest rates* supposed to be relevant? If I am a debtor, continually rolling over short-term debt, a rise in interest rates will (very likely) reduce my contribution to AD; but if I am a creditor, continually receiving interest payments, won't a rise in interest rates increase my contribution to AD, perhaps by an offsetting amount?

So I understand (or, at least, think I understand) the monetarist picture, but the New Keynesian model remains completely unintuitive. Though this may run against the grain, could you please do a bit more to make the NK picture plausible?

Joe, The HPE explains the long run change in prices, and the expectation of that change causes asset prices to rise in the short run. I don't follow your comment about saving. Saving is a flow, asset prices are stocks. There is no need for more saving to make asset prices rise. Every asset transaction is both a purchase and a sale.

You said;

"The increase in asset prices tells you that the hot potato process was channeled through the financial markets. Is that correct?"

I'd prefer to say the HPE was anticipated by the markets. And I'd prefer to call them asset markets, as my mechanism works even in economies that have no financial markets. On the other hand economies that have no financial markets don't have much of an interest rate transmission mechanism.

Adam P, OK the effect is not immediate. It takes one second for prices to adjust upward. Are you happy now? Don't forget that in a ratex world the anticipation of the HPE makes prices rise even before people spend the money. As the cash falls out of the airplane onto Bora Bora, the natives tell the person about to buy a mango that they changed their mind, the price will now be x% higher, where x% is the expected increase in the money supply from the airplane drop. There are countries where retailers put signs in windows that everything is x% above the sticker price, after a sudden currency depreciation.

Can someone please explain to me why the fed buys bonds, usually t-bills, when it wants to ease?

Why not open a savings account at all the biggest banks, when you want to expand the money supply make a deposit, when you want to contract the money supply make a withdrawal.

The fed deposits could be lent out on fed funds market or to fund, say, mortgages. No need to hold assets in order to sell them when you want to drain reserves back out.

Why isn't it done this way?

Scott,

My use of the word "savings" was incorrect. I apologize. I was defining "the act of savings" as "the act of purchasing assets in the financial markets." That's a bad use of the term. You're simply saying that when people have excess cash balances they might spend it on anything. It can be consumption goods at BestBuy/WalMart/the mall. It could be capital goods like factories/machines/computers. Or, they call up wall street and buy bonds/equities/real-estate/commodities/currencies/derivatives/insurance/etc. You are right, better to simply get rid of confusion and simply say "asset markets" instead of "financial markets."

When you say, "I'd prefer to say the HPE was anticipated by the markets." Wouldn't it be more accurate to say "Future HPE was anticipated by the markets.... and created a current HPE all on its own.... which went through all the asset markets." Expectations go up, money demand falls, HPE happens through the asset markets, price in asset markets go up. Right?

After all, an increase in AD is just the HPE. So when you say, "expected future increase in AD increased current AD," you're just saying "expected future increase in HPE created current HPE." And we can know that the current HPE is happening because we see the prices of all sorts assets, whatever they may be, going up. When we see price going up around us in the asset markets, then we know that the HPE is going through all of these asset markets.

What I just described is precisely what you explained in a brief email with me a few weeks ago (for which I am very grateful). You said "I claim that a policy that doesn't affect the current money supply, but raises the future expected money supply, will tend to boost current velocity." You specifically approved when I described you're idea as "If NGDP expectations go up, then this causes the demand for money to fall, and thus the velocity of money increases, and thus nominal spending/income go up." These two quotes are exactly what I have just described in the first three paragraphs of this post.

In the textbooks, we are told that sellers do not increase prices for any reason. They will increase it only if they get more demand (or less supply). Now, the story I presented in this comment and from our email is precisely this: Asset prices go up because those markets experience more demand from cash holders trying to get rid of their cash because their expectations just went up.

However, in response to Adam P, you seem to be saying something a little bit different. You are saying to him the following: A seller of assets says to himself "My NGDP expectations have gone up. I must immediately increase my prices, even though I have experienced no change in demand or supply.... an increase in AD will follow" But, that's totally different. They are not increasing their prices because they experienced a change in demand or supply. They are increasing prices all on their own, without external pressure, due to a change in expectations. And somehow, that increased AD. This is strange. Page 19 of the Cowen/Tabarrok Micro textbook lists "expectations of future" as one of the things that powerfully affects the market. But that is because it causes demand to increase, not because sellers increase price all on their own before demand has changed. You seem to be presenting two different constructs/stories.

I apologize if at anytime I am rude or disrespectful. I am simply very confused, fascinated, and really really want to understand.

Adam: Deposits are unsecured. Extending credit is pretty different from repo, no?

K, I'm pretty sure that depositors are fairly senior in the capital structure so it would effectively be secured by whatever tier 1 assets the bank had, essentially those same assets that would be repo'd.

However, the point here is that the reason the Fed holds assets or lends on repo is to get reserves back out if it wants. In this case that's not a problem, if a particular bank took the deposit and lent it out randomly to people who couldn't pay it back the reserves would still be in the banking system somewhere (in those peoples deposit accounts) and so could still be retrieved.

In effect the Fed would put newly created reserves on deposit with a bank, the bank would keep some of them in its account with the fed anyway. Unless they somehow exit the banking system wherever they go they end up back in someones account with the fed. But ultimately, at the start of the line they belong to the fed since it has a claim on them through its deposit account. Effectively they are the asset that backs them. (And the problem of reserves leaving the system as physical cash applies equally to the case of the fed buying a bond. If the value of the bond falls due to, say, a surge in inflation then those reserves become irretrievable.)

According to Nick and Scott this would be a simpler and more effective way to conduct monetary policy, so why doesn't any central bank do this?

Joe, Scott is being entirely inconsistent.

To be clear, what he's saying to me is that there never is any increase in AD. The expectation of the eventual price rise (no price stickiness here remember) causes prices to immediately rise and so equilibrium is restored. When the new money shows up it is held since the real value of the newly increased money stock has already fallen to the level that agents want to hold.

Now, this is a perfectly valid story but in this story there is no HPE and no increase in AD (to get more AD you need price stickiness, the response of P is sluggish and so in the meantime people try to rid themselves of soon to be devalued money. Velocity increases.) In this story you can say nothing about what enforces the price rise if one day the ratex mechansim fails, it could equally well be the interest rate channel or the HPE.

But actually a small amount of economic reasoning applied to the way monetary policy is actually conducted tells us that interest rates are the transmission mechansim.

In normal, non-crisis, non-liquidity trap times, the fed conducts monetary policy by buying a t-bill with newly created reserves. Consider the options available to the holder of the t-bill, say the bill's initial price is 98. This agent has the portfolio choice of the bill or 98 in cash, he chose to hold the bill.

Now the fed buys the bill for 98 in cash, if the bill's price hasn't changed then this agent has exactly the same choice. Why doesn't he just buy another bill? The answer is that he does, now if the bills price hasn't changed apply the same reaoning to the agent that sold the first one the bill...

Equilibrium *can't* be restored until the price of bills goes up enough that someone is willing to do something else with the cash. *Only then* can the cash leak out and become a hot potato. Interest rates must change.

Scott wants to say that people are rational yet completely fail to be consistent in the their portfolio choices, that's utter nonesense.

Purchasing "savings" accounts would be neither cheaper nor more cost effective.

First, savings accounts are not demand accounts. In the U.S. you can only make 3 withdrawals per quarter from a savings account, and the bank can impose waiting fees. The CB cannot conduct real time monetary policy with savings accounts.

Second, savings accounts yields are far below FedFunds. That is seignorage to the banking sector that would otherwise be transferred to Treasury. Why should the CB spend more, and how do you select the lucky banks getting the savings accounts?

Third, banks don't lend reserves. Banks extend loans if their cost of funds is less than the risk-adjusted lending rate. The CB manages banks cost of funds. Unless the cost of funds changes, stuffing banks with reserves isn't going to cause a single additional dollar to be lent out, and it isn't going to create a single additional dollar in deposits held by the non-financial sector. The cost of funds is set by interest rates, not the quantity of reserves in the system.

Fourth, why is holding deposit claims on banks easier for the CB than holding bonds? They are both financial claims. Unrolling one is not easier or harder than unrolling the other, except that withdrawing money from a savings account is more burdensome than selling a bond, due to the limit on the number of withdrawals per quarter and the waiting times imposed.

Fifth, the CB is not authorized to do this. The Treasury Act specifies what types of assets central banks are allowed to buy, and they are generally only allowed to purchase outright assets that are risk-free. A savings account is not risk free, which is why it is not an appropriate instrument with which to conduct monetary policy.

RSJ, you've completely missed the point.

first off you can substitute demand deposit account for savings account. It should have been obvious that's what I meant if you actually cared to notice.

Second, it should have been equally obvious that I'm not advocating this as possible or desirable.

The point, should you care to comment intelligently, is that as far as I see Nick's transmission mechanism implies that this would in fact be desirable. But that is a critique of Nick's view, not an argument in favour of changing how the Fed actually operates.

LOL,

Adam, I didn't realize your (idiotic) comments @5:05 and subsequently were ironic, and therefore "intelligent", whereas my pointing out the flaws of said comments were not intelligent.

It is all too meta for me.

RSJ, I think the question of whether or not my comments actually were idiotic is still open. It may well be the case but you haven't made any progress showing it.

So again, if Nick's transmission mechansim is correct then why isn't monetary policy done this way?

The fact that the Fed is not authorized to do it is not relevant, they could be if congress wanted them to be. The fees/waiting times garbage was just silly. I've had many demand deposit accounts in the US that had neither fees nor waiting times for withdrawal.

Care to say something relevant?

And of course your point 2, about deposit accounts yielding less than fed funds is also irrelevant in Nick's paradigm. It's supposed to be all about the money supply.

Adam,

You said

"Why not open a savings account at all the biggest banks, when you want to expand the money supply make a deposit, when you want to contract the money supply make a withdrawal.

The fed deposits could be lent out on fed funds market or to fund, say, mortgages. No need to hold assets in order to sell them when you want to drain reserves back out."

Which suggested that savings accounts, and not demand accounts, was your chosen instrument, and that banks lent reserves. Later on, you suggested that this approach would be cheaper for the CB.

I pointed out that all three claims were wrong.

But of course, the CB *could* do this to manage the marginal price of reserves instead of open market operations. When banks, as a whole, are short of reserves so that they bid up the OIR, the CB can make a large deposit, more reserves are supplied, and the OIR will fall.

Except for the seignorage/risk issues, your approach would be *equivalent* to OMO. Central banks can manage OIR without doing any OMO per se. Apart from the practical unworkability and expense of your plan, it is perfectly equivalent to what Central Banks do today.

The only differences between the different approaches -- A corridor system a la RBC, old-school OMO a la Fed, and the Adam P approach are cost/flexibility/risk.

Hence when you asked *why* don't central banks switch to the Adam P approach, the response is cost/flexibility/risk.

If you want to change the approach to using demand accounts, you get the flexibility back, but at a massive increase in cost (loss of seignorage income) and you still have the risk (deposits are not guaranteed for all amounts).

With savings accounts, there is a smaller cost, but still a greater cost than using bills (as savings accounts pay less than the portfolio of bills/bonds that central banks hold) but with more inflexibility, and still the excess risk.

So that is the answer to why central banks don't do this. When they want to avoid purchasing bills, they use a corridor system instead of your system.

But I didn't realize that you weren't really asking the question, you were making fun of Nick. Specifically, you were making fun of the belief that the mere existence of more deposits must somehow drive up prices. I certainly don't agree with Nick's transmission mechanism, for the reasons I stated previously. I agree that in a modern economy with outside money, there is not going to be a hot potato effect that is somehow distinct from an interest rate effect. The fundamental effect is an interest rate effect, but interest rates are managed by managing the marginal cost of reserves -- by supplying or withdrawing reserves, and this can be done by having the CB make deposits with banks, directly increasing the quantity of reserves, or by having the CB pay interest on reserves, directly controlling the marginal value of reserves, or by having the CB buy bills or bonds or anything else. All these approaches are equivalent for purposes of managing reserves, and differ only in cost/risk/flexibility.

The last sentence in the above should read "All these approaches are equivalent for purposes of managing the marginal price of reserves ..."

This is getting silly but I guess I was unclear if you take the comment out of the context of the post.

The point was not to make fun of Nick, or to advocate that this would be a good idea. The point was whether it would really work, to say it's equivalent to what they already do is a reasonable answer but not an obviously correct one.

The real issue is when you say that policy can be conducted "by supplying or withdrawing reserves, and this can be done by having the CB make deposits with banks, directly increasing the quantity of reserves, or by having the CB pay interest on reserves, directly controlling the marginal value of reserves, or by having the CB buy bills or bonds or anything else".

I'm suggesting that perhaps it matters what the central bank buys and that it buys something at all, that things would be different if it just put money into the system by putting it on deposit. Now, Nick's post clearly implies that it doesn't matter and you've agreed with that. I'm questioning whether that's true or not.

I tend to think the portfolio effects of actually buying the bill, as I described above in the context of disputing what Scott Sumner said, matter at least a bit.

Anyway, since it's really a theoretical point I was getting at whether or not it's more expensive to do things this way is also not really the point.

Imagine it was exactly the same cost, which would be better policy?

Finally though, I don't think it's as obvious as you think that trading in the bond market is cheaper. The NY fed has a team of traders that are decently paid and would not be needed if policy was implemented by simply making deposits and withdrawals.

Adam,

I don't see anything special with having the government directly buy bills, or having the government ensure that the financial sector has a marginal cost of reserves. In the case of the latter, they will buy the bills up until no arbitrage is possible.

Remember that the "interest rate" that central banks set is the overnight interest rate charged by one bank to another. E.g. for Canada, "The Bank of Canada’s target for the overnight rate is the rate on collateralized, market-based overnight transactions". Central Banks can control this rate by agreeing to lend an unlimited amount at the policy rate to other banks, and by paying interest on reserves at the policy rate. That creates a type of corridor, in Canada, a 50bp corridor, and the actual overnight interest rate is typically in the mid-point of this corridor.

None of this requires bond purchases or sales. The OIR can be managed quite effectively without it. I think the Bank of Canada keeps OMO as a backup option, but it certainly does not control interest rates via OMO -- it controls them by implementing the corridor.

The important point is that what matter is the marginal cost of reserves, not the quantity of reserves. This is basically the dispute here. Nick focuses on quantity, and needs some God-given assumption about the relationship between quantity and marginal cost. He should be focusing on the marginal cost of money rather than the quantity of money.

In Canada, the quantity of reserves are targeted at near zero -- I think they want a system wide reserve position of 25 million -- which is near zero as a fraction of deposits. Nevertheless they control the marginal cost of reserves very well, and that propagates to other rates.

Now real-time adjustments of quantity will succeed in adjusting the marginal cost of reserves, obviously, but it is less accurate because you are always driving the system to be in a deficit or surplus reserve position. Banks as whole either have "too much" or "too little" reserves, in which case the reserve rates are going down or going up. Adjusting quantity is akin to controlling the sign of the time derivate of the OIR, in order to keep the actual OIR bouncing around the target. It is better to directly control OIR by adjusting the marginal cost of reserves directly.

In all of these cases, you are controlling lending rates in the interbank market, which propagate out to rates on bills and such. In a modern economy, a currency issuer does not need to intervene in the bond markets in order to control lending rates for its currency.

And IIRC, the ECB also does not perform a lot of OMO, but primarily manages rates by lending to banks at the policy rates -- but that system is a bit hard for me to decipher, so others can clarify that.
--

The expense that I was referring to was not transactional costs, but the lost interest income, which in normal times is turned over to the treasury as seignorage income. There is a huge spread between what depositors get and what banks pay, and we want the CB to be on the right side of that spread.

And the main point of all the above -- getting to criticizing Nick's transmission mechanism (which I am sorry you were not mocking) -- is that there is no a priori relationship between quantity of reserves and their marginal cost that is independent of the institutional framework.

Therefore you cannot talk about a transmission mechanism from the quantity of reserves to prices that is independent of the regulatory framework.

Canada decided to have $25 million in reserves, and it can have any marginal cost that the BoC wants. If it quadrupled the system level of reserves to $100 million, then Scott S. would probably argue that the price level would also quadruple.

But it wouldn't, as long as the marginal cost of reserves remained the same.

The non-financial sector, which sets prices, doesn't know or care about how many reserves are in the banking system. All it cares about are the lending/borrowing rates offered to the non-financial sector. The financial sector only cares about its marginal cost of funds when making a loan or buying up bills.

Similarly, if the marginal cost of reserves is the same (e.g in a zero bound), but the CB floods the system with reserves, then still there isn't going to be an effect on prices.

In any case, only the effect of interest rates on prices can be said to be independent of the institutional framework governing the financial sector, because this is what the non-financial sector sees. The quantity of reserves is an input into the blackbox, and the box spits out a borrowing rate for the non-financial sector. The relationship between quantity of reserves and the output rate is implementation dependent.

Therefore if you are going to be an old school quantity person, then you had better become an expert on the institutional framework, and you need to recognize that your conclusions will change as soon as the regulations change.

You can't use quantity of high powered money arguments in a backscratch economy and then assume you are saying something relevant about our economy. But you can use interest rate arguments in a backscratch economy and say something relevant about our economy.

Adam: "And of course your point 2, about deposit accounts yielding less than fed funds is also irrelevant in Nick's paradigm. It's supposed to be all about the money supply."

Right.  In Canada (and elsewhere too) overnight deposit rates have been stuck at token amounts (25 bps or so) since the early nineties.  Even non-guaranteed deposits (over $100K) have earned basically nothing (40 bps?) for about 10 years.  There's a total market failure in deposit rates - they don't respond to policy rate changes at all. So, what if the BOC tried to stimulate the economy via direct deposit?  Worst case, the banks would just take the free money and buy T-bills, resulting in the same drop in rates as if the BOC had spent the same amount of money on T-bills.  So same thing, except the banks earn the seignorage instead of the BOC. But the banks *could*, if they really wanted, just leave the deposits on balance sheet and do nothing with them.  It doesn't cost them anything. So the money supply *only* affects the economy through the rates channel.

Adam: "if a particular bank took the deposit and lent it out randomly to people who couldn't pay it back the reserves would still be in the banking system somewhere (in those peoples deposit accounts) and so could still be retrieved."

But that money would belong to *other* people now (not the deadbeats who borrowed and spent it).  The CB loses an asset if a bank at which it has made a deposit goes broke.  And the associated liability can't be made to go away.  End of story.  (Unless... you are saying that the Fed doesn't need assets and that M0, since it doesn't mature, should be thought of as Fed equity rather than debt.  But then, if the wants to tighten, the government will have to tax it back. This would be pure helicopter money that totally discards any vestiges of the real-bills doctrine. Maybe not a bad idea.)

There's a big difference between secured and unsecured lending.  If a bank goes bust, the CB gets to keep the security and then claims any loss (hopefully small) on that security as a bankruptcy claim pari passu with other senior unsecured creditors.  Unless the collateral is worthless, recovery will be higher.

Historically, at the discount window, the Fed only took extremely high quality, liquid collateral (typically highly rated sovereigns or government guaranteed).  Post crisis, almost anything investment grade apparently became acceptable and the discount window spread declined to 25 bps.  So Bagehot's principle of lending against good collateral at penalty rates has gone out the window lately. But the principle, at least, is not to take bank credit risk.  Imagine if a bank at which the Fed has made significant deposits, suddenly has problems.  Is the Fed supposed to withdraw its deposits in response (and kill the bank) or ECB/Greece style double up because Trichet would rather take horrific losses later (on somebody else's watch) rather than lesser losses now (on his watch)?  Lending based on collateral quality is fair to all participating institutions and far less fraught with moral hazard.

If the CB lends money that is not repaid, the loss is fiscal policy -- it is paid for by Treasury, not the CB.

Treasury supplies capital to the CB and receives the seignorage income from the CB's operations. So depending on how the CB decides to recognize the loss, that will correspond to either less seignorage income for Treasury as the CB rebuilds its capital or for a one-time replenishment of capital supplied by Treasury.

A good example is the Maiden Lane assets, in which case Treasury has already agreed to absorb the losses. Of course those losses are small in comparison to the seignorage income that the Fed is now providing.

Adam P, Your argument that you need sticky prices to in order for money to affect AD makes no sense. Imagine prices rise immediately in proportion to M. In that case nominal expenditure also rises in proportion to M. That means the AD curve must shift to the right in the AS/AD diagram. That's the only way you can get a higher NGDP. But that means AD has risen. So the entire premise of your argument is flat out wrong.

You discussion of interest rates and monetary policy combines two unrelated issues. One is the fact that when prices are sticky, even a helicopter drop of cash will affect interest rates. Because prices are slow to adjust, interest rates become the shock absorber in the short run. But if prices are flexible, a helicopter drop doesn't produce any "liquidity effect." There is no change in interest rates, all nominal prices immediately rise upward in proportion to M.

Now assume we don't have a helicopter drop, but instead do an OMO. In that case monetary policy reduces the interest-bearing part of the debt, which has a (very tiny) affect in interest rates. But this isn't the effect most people associated with monetary policy, which reflects price stickiness. After all, most OMOs are tiny. Instead it reflects the fact that debt held by the public falls. It's fiscal policy--an inflation tax. And that's true whether the new base money is used to buy fighter jets, or T-bills. If they buy fighter jets, then the government doesn't have to borrow as much, and there are fewer T-bills held by the public. I generally ignore this effect because it is so small.

It can't be true that interest rates cause the long run adjustment in the price level, because interest rates don't change in the long run. Only prices change. So why do prices reach a new equilibrium rising in proportion to M in the long run? Do you seriously believe that low interest rates caused the German hyperinflation? It boggles the mind. Even the 100% inflation rates observed in Latin America a few decades back can only be explained with money growth, not interest rates.

Sorry to intrude from the peanut gallery, but I'm confused by the first paragraph in Scott's last post: Isn't AD a function of M/P?

Patrick, there's a host of confusions here. Scott and Adam seem to be talking past each other. My impression is that Scott thinks of AD in purely nominal terms. So of course money matters even in a flexible-price, Panglossian setup. A k% increase in M means an instantaneous k% increase in NGDP. But there is no impact at all on RGDP in such a model; and Adam is thinking in terms of RGDP. To me it makes no sense to speak of a transmission mechanism in such a model. Everything happens instantaneously.

Kevin, I think you're exactly right. I'd also submit that Scott is the only economist in history who really believes that AD measured in cents is actually higher than AD measured in dollars.

As for the thing about monetary policy by deposit, I think what I'm really wondering is why Nick hasn't written any posts criticizing the Fed for buying long-term bonds in QE. In Nick's view even with T-bill yields less than the IOR rate, increasing the money supply by buying bills should work just as well as increasing the money supply by buying long-term bonds. And with long-term bonds the fed takes more risk.

Patrick. M/P fell by 99% during the German hyperinflation. Would you and Adam argue that monetary policy was depressing AD during the German hyperinflation? M/P is a useless indicator of AD, right up there with nominal interest rates.

Kevin, Whether you want to call it a transmission mechanism is irrelevant, but there must be a REASON why a monetary increase causes prices to rise in a flexible price model. Surely it doesn't happen by magic. I claim that the HPE is the most plausible REASON. Call it a transmission mechanism, or something else, I don't care. It happens quickly, because when rational people see the HPE is going to work, prices rise in anticipation (in a flexible price model.)

Adam, I'm assuming the standard AS/AD model used in every macro textbook. You are the one confusing AD with quantity demanded. In a flexible price model the AS curve is vertical, and when AD increases only prices rise. That's what we teach all our undergrads. I'm talking about the mainstream view of AD, you have in mind some alternative definition, which seems to me to be quantity demanded, not AD.

I think your mistake is in assuming that because output generally rises in response to more AD, that the extra purchases ARE the increase in AD. But that's crazy. It's be like saying that the fall in computer prices has caused more demand for computers. No, the extra supply of computers causes more quantity demanded. And again, flexible prices are not an uninteresting assumption, as prices are flexible in the long run.

BTW, I thought the Fed should have just bought more T-bills.

Joe, You said;

"When you say, "I'd prefer to say the HPE was anticipated by the markets." Wouldn't it be more accurate to say "Future HPE was anticipated by the markets.... and created a current HPE all on its own.... which went through all the asset markets." Expectations go up, money demand falls, HPE happens through the asset markets, price in asset markets go up. Right?"

If I understand you correctly, that is right. I was thinking of the HPE from the future increased money supply, but you're right that it also occurs from the current lower money demand.

I don't follow your other point about supply and demand not changing. Expectations of the future are one of the most powerful determinants of current supply and demand, especially in asset markets. So if the expected future price rises, the current demand rises and the current supply falls, leaving prices higher and quantities unchanged in the very short run.

Scott: “...there must be a REASON why a monetary increase causes prices to rise in a flexible price model.”

The reason is simply that there is a new equilibrium price level. That’s all there is to it. At the old price level, there would be an excess supply of money and an excess demand for goods. That’s disequilibrium and we can’t have that. So the auctioneer stops the clock, like a referee waiting for an injured player to be taken off the football pitch. Time is suspended while the new price is determined. No trading whatever takes place at any price between the old equilibrium and the new.

Is your HPE just a folksy term for disequilibrium? If so you are just wrong to say that Keynesians (Old or New) ignore it. Recall Friedman’s remark that Keynes reversed the classical assumption: “Changes in output (aggregate supply), not in prices, play the major role in producing equilibrium.” So your hot potato is there all right, it’s just not so unbearably hot that we are desperate to get it off our hands. As Friedman clearly implies, prices play a minor role in the adjustment process, but they do play a role. We wait patiently until our firm’s number comes up on Calvo’s fruit-machine and then we change our price.

You know all this obviously, so it’s really quite hard to see what you’re getting at. In some peculiar way you seem to have convinced yourself that Keynesians have a model in their minds which is not the model they have actually written down. Not so. WYSIWYG.

I'm not sure I can really add anything to what Kevin just said but I'll go ahead and put it in my own words anyway...

The point is that in the fully flexible price model there *never* is a hot potato effect. To see why let's see where the hot potato effect was supposed to come from, let's normalize the demand for real balances to equal 1. Suppose that the money supply M = 100, then in equilibrium it must be the case that the price level P = 100. Thus M/P = 1 and we are in equilibrium.

Now, suppose M changes to 200. The hot potato effect is supposed to result from the fact that now aggregate real balances M/P = 2 which is more than demanded and so the desire to get rid of the excess causes the hot potato.

BUT...

with flexible prices P immediately jumps to 200, as Scott has insisted, so there is never any time for which M/P fails to equal 1, hence no hot potato effect.

Now, as Kevin points out, apparently Scott has in mind that the expectation that an HPE would happen out of equilibrium is what enforces the equilibrium. However, in the off equilibrium situation where people have excess real balances the interest rate would also change, unless Scott has some reason why the HPE effect happens in all markets except the bond market. Neither effect has greater claim to be the transmission mechanism.

Now, in the real world how do we know that it's *not* an excess demand for cash balances that caused the recession?

WE KNOW FROM DIRECT OBSERVATION THAT THE DEMAND FOR MONEY DID NOT INCREASE!

We know this because the price of treasury bonds went up, if agents in aggregate wanted more money they absolutely could have had it by selling their bonds for cash.

But, isn't it the case that we can't ALL sell our other assets for cash at the same time because the money supply is fixed? NO. The federal reserve maintains an interest rate target as it's policy instrument, if there was ever a shortage of cash then this would have put upward pressure on the fed funds rate as banks tried to borrow cash to settle their client trades. The fed would have had to respond by increasing the money supply to keep the rate from rising.

If excess demand for the medium of exchange is the problem then why aren't bond prices higher?

Adam, I was with you until your last sentence. I guess you mean why aren't bond prices lower, and bond yields higher. What we actually observe is what Brad DeLong keeps banging on about: excess demand for safe assets.

When Scott Sumner says that "99% of monetary transactions are for assets unrelated to NGDP," is he referring to trading in financial assets? There are also black-market/criminal transactions, and gifts; perhaps I'm missing some other categories. Still, 99% seems kind of high.

kevin, yes I meant why aren't bond prices lower?

and I was agreeing with DeLong.

Scott: I'm not an economist, and I stay away from these theoretical arguments because I have nothing to add. So I'm not arguing anything or taking any position at all - just trying to follow the argument.

Everything I've read about AD/AS is always in real terms and Y = f(M/P, ...). Based on text book AD/AS as read by a rank amateur, I'm confused by your assertion that simultaneous and proportional increases in M and P would affect Y. I'm not saying you're wrong, I'm just saying I'm not following. If you can explain, fine. If you're not inclined to or think I'm too dumb to get it, fine. But I'm not arguing.

On German hyperinflation: Again, I'm not following you. How is that relevant? By definition, wouldn't one expect real balances to crash in a hyperinflation? AFAIK, M/P doesn't say anything about the dynamics and expectations that create the hyper-inflationary conditions in the first place.

Anyway, I'm probably just too out of my element here so I'll leave it at that.

On second thought, I suppose a lot of monetary transactions are sales of second-hand items. Sales of labor, services, and newly produced goods contribute to NGDP, sales of second-hand (not "newly produced") goods are non-NGDP transactions. 99% is beginning to sound less unreasonable, though still dubious.

Further to RSJ's post on how the Bank of Canada implements its interest rate policy, the market used is the Large Value Transfer System, the wire-based collateralized clearing system in Canada. Cheques and other personal items are cleared through the ACSS, where the interest rates are 1.5% above LVTS rates by BoC policy.

LVTS is a deferred net settlement system, it is balanced once per day and transactions are covered by pledged securities in a common pool (Tranche 2) or Bank of Canada deposits (Tranche 1).

LVTS and the corridor are designed so that banks settle their balances among themselves before turning to the Bank of Canada. The corridor is designed so that when the overnight rate gets outside it there is an instant arbitrage opportunity to force it back inside the bank.

Wow. Comments have been flowing well here. I'm just back from a few days holiday, giving the MX6 some exercise -- driving to London via Orillia. My head's still not up to speed yet.

Adam: "Can someone please explain to me why the fed buys bonds, usually t-bills, when it wants to ease?
Why not open a savings account at all the biggest banks, when you want to expand the money supply make a deposit, when you want to contract the money supply make a withdrawal.
The fed deposits could be lent out on fed funds market or to fund, say, mortgages. No need to hold assets in order to sell them when you want to drain reserves back out.
Why isn't it done this way?"

Up until a couple of decades ago, that is very much like how the Bank of Canada *did* control the money supply. They called it "drawdowns and redeposits". It was always a PITA to teach, because I always got it muddled which was which. But it went like this:

The Government of Canada had a chequing account at the Bank of Canada and also at the commercial banks (BMO, TD, etc.). The BoC managed the government's chequing accounts. It it wanted to ease, the BoC would transfer the government's funds out of its BoC account into its accounts at the commercial banks. If it wanted to tighten, it would transfer the government's funds the other way.

It used these "drawdowns and redeposits" for fine-tuning monetary policy, and open market operations for gross tuning.

I *think* (if my brain is working) that is effectively the same as what Adam is talking about. (It was a demand deposit, rather than a savings account, but as Adam says later, that is an inessential detail of his question).

Why did the BoC stop doing it this way?

Good question. I don't know. But I don't think there was any fundamental reason why it was unworkable. Just unnecessarily complex?

Moreover, today the BoC sets a target for the overnight rate, but to actually keep the actual overnight rate as close as possible to that target, the BoC adds or withdraws settlement balances on an hourly/daily basis for "fine tuning". How is that fundamentally different from the old "drawdowns and redeposits" mechanism, or what Adam is talking about?

I should have a sleep, then return to this thread.

Probably when LVTS was introduced. There is a book in pdf form on the Bank of Canada's website which details the evolution of the payments and clearing system in Canada by Canadian Payments Association. The Bank of Canada re-evaluated and changed its Overnight policy implementation mechanism when LVTS went online. LVTS handles something like 80% of the value of the money transfers daily in this country including several large transfers from the federal government to the provinces, according to that book.

"The Government of Canada had a chequing account at the Bank of Canada and also at the commercial banks (BMO, TD, etc.). The BoC managed the government's chequing accounts. It it wanted to ease, the BoC would transfer the government's funds out of its BoC account into its accounts at the commercial banks. If it wanted to tighten, it would transfer the government's funds the other way."

That is *exactly* what I was talking about. So they used to do this and apparently stopped, RSJ thought this was an idiotic thing to do so perhaps that explains why they stopped.

Nick,

I think what you are talking about is something different -- it sounds like the TT&L accounts in the U.S., which is a way for the (Federal) government to coordinate with the CB to prevent excess OMOs from being required when taxes are paid. You can think of the government as having an account with the CB, and when it collects taxes, that is a reserve drain, as funds are transferred from banks to the CB. This would force the CB to do a reserve add in order to prevent an overall system reserve deficiency. One way around this would be for the government (not the CB) to move some funds out of its account with the CB and into a commercial banking account, keeping the reserves available to the banks.

And the reason why this would be stopped would be that the government (not the CB) can get more for its money via a competitive auction, rather than just depositing it. Nevertheless, you still see a version of this today, although I would not call it monetary policy. It is done by the government, not the CB.

RSJ: "I think what you are talking about is something different -- it sounds like the TT&L accounts in the U.S., which is a way for the (Federal) government to coordinate with the CB to prevent excess OMOs from being required when taxes are paid."

No. IIRC, that is what the BoC does *now*. Nowadays, it uses the same drawdowns and redeposits mechanism, but in a purely *passive* way, to offset day-to-day (month-to-month?) fluctuations in government spending and receipts, and prevent these causing fluctuations in the money supply/overnight rate.

But, in the olden days (20 years ago?) it also did this *actively*, to deliberately cause a change in the money supply, and not just to offset those fluctuations in government spending and receipts.

IIRC, Determinant is right about the active use of drawdowns and redeposit mechanism ending when the LVTS came in. And we Canadian teachers of ECON1000 all breathed a sigh of relief and deleted a couple of paragraphs from the textbooks, our lecture notes, and our brains.

Here is the way my very abstract over-simplifying brain thinks about the whole thing:

If the BoC wants to increase the money supply, it buys something. It doesn't really matter (much) what it buys. It could be a bicycle, a computer, forex, or an IOU -- the effect on the money supply is the same. The BoC gets a bicycle to add to its assets, and the seller of the bicycle gets the BoC liability ("cash"). But the BoC buys no bicycles, few computers, rarely (nowadays) forex, and mostly buys IOUs. But what sort of IOUs (whose signature is on the IOU?)? And does it buy those IOUs directly from the entitity that signed those IOUs, or indirectly on the market? For gross-tuning, the BoC buys IOUs signed by the government of Canada, but not directly from the Government. We call this "open market operations." For fine tuning, the BoC buys IOUs signed by the commercial banks. What Adam is talking about is buying a commercial bank IOU directly from the Bank. And that IOU is redeemable on demand. It's essentially a chequing account.

There's some technical reason why the BoC no longer does what Adam is talking about. Maybe because it made JKH's old job (at the commercial banks) a hassle.

RSJ: "So the reason why the interest rate management is the only transmission mechanism is because that is how our institutions are set up. If you change the institutions -- and there is no outside money or banks in your model -- then the transmission mechanism will be different."

[You are using "inside" and "outside" money in the exact opposite ways those words have traditionally been used in economics.]

An institution is a set of beliefs about other players' reactions to your actions. It has no concrete reality aside from those beliefs. The "gold standard" was one such set of beliefs. The current "target 2% inflation by an adjustable overnight rate target" is another set of beliefs. What you call "how our institutions are set up" is not something separate from our beliefs about the transmission mechanism. The Bank of Canada's current operating "mechanism" is a reification of the Bank of Canada's theory of the monetary transmission mechanism. Anybody who says "the BoC sets an interest rate" has simply swallowed the BoC's theory of the transmission mechanism whole, in the same way that someone who describes missionaries as "spreading the word of God".

James Hudson's comment, reproduced in full:

""Given sticky prices, an exogenous decrease in the supply of money causes interest rates to rise which causes aggregate demand to fall . . . ." This is too compressed to enable me (a non-economist) to understand the New Keynesian view. I think "aggregate demand" is just spending (or is it spending on consumer goods?), in which case a fall in the quantity of money would itself reduce AD (assuming no corresponding increase in velocity). So money supply looks intrinsically relevant to AD. But how are *interest rates* supposed to be relevant? If I am a debtor, continually rolling over short-term debt, a rise in interest rates will (very likely) reduce my contribution to AD; but if I am a creditor, continually receiving interest payments, won't a rise in interest rates increase my contribution to AD, perhaps by an offsetting amount?

So I understand (or, at least, think I understand) the monetarist picture, but the New Keynesian model remains completely unintuitive. Though this may run against the grain, could you please do a bit more to make the NK picture plausible?"

NR here:

[AD is just demand for spending on newly-produced goods and services - consumption plus investment goods. And in a world where sellers nearly always sell you what you demand to buy (they don't tell you to wait or join the queue), demand for spending nearly always equals actual spending.]

Now Jame's comment is interesting because, as a non-economist, he has not been "indoctrinated" into the 'official' view of the monetary transmission mechanism. So he can't 'see' how a cut in interest rates is supposed to increases AD.

A cut in r makes debtors better off and creditors worse off. But yes James, those offsetting effects on AD (the "income effects") should roughly cancel (and are usually assumed to cancel in NK models).

Here's how a monetarist would answer James' question: "The fall in r is not what causes AD to increase. The fall in r is simply a possible side-effect of the increased supply of money, because people may try to lend out some of the excess money, rather than spend it themselves. Moreover, that fall in r, because it reduces the opportunity cost of holding money (if the rate of interest on holding money stays the same) simply reduces velocity and actually means that the increase in Ms causes a smaller increase in AD than it otherwise would."

Here's the 'official' answer: "Forget money. People have a choice between holding bonds and buying goods. A fall in r makes holding bonds less attractive, so people buy more goods instead".

But can we forget money? We use money, not bonds, to buy goods.

RSJ: "The important point is that what matter is the marginal cost of reserves, not the quantity of reserves. This is basically the dispute here. Nick focuses on quantity, and needs some God-given assumption about the relationship between quantity and marginal cost. He should be focusing on the marginal cost of money rather than the quantity of money."

How exactly does the BoC keep the actual overnight rate more or less exactly at the mid-point of the 50bp operating band between the interest rate on reserves and the deposit rate? Why doesn't the actual overnight rate fluctuate over that 50bp range all the time?

If you ask people at the BoC this question, they will talk about *quantity*. If the actual overnight rate is above the target midpoint, the BoC increases the quantity of settlement balances in LVTS, so the excess hot potato causes the overnight rate to fall, and when it has fallen to the midpoint the BoC removes the hot potato. If it's below the mid-point, the BoC removes settlement balances (maybe even making them negative?), and the shortage of musical chairs causes the overnight rate to rise, and when it has risen to the midpoint the BoC replaces the chair.

The above is almost exactly how I have heard BoC people describe it.

Patrick (on Scott): "Everything I've read about AD/AS is always in real terms and Y = f(M/P, ...)."

*Most* economists talk about AD in real terms -- Yd. I prefer to talk about AD this way.

But *some* economists (including Scott) prefer to talk about AD in nominal terms -- PYd.

Neither is right or wrong. I will skip a long argument on the relative advantages and disadvantages of each. (Or whether AD should mean the whole AD *curve* instead.). But yes, it can be confusing.

Kevin and Adam: Here's Adam "The point is that in the fully flexible price model there *never* is a hot potato effect."

We would never *observe* a hot potato effect in *real time*. But that doesn't mean it doesn't exist.

Let me give an analogy (stolen from Michael Parkin).

Q. Why is Lake Erie exactly the same height on the Canadian and US sides of the border? Why don't (say) boats have to climb a 1 metre high wall of water when they cross the border to the US?

A. Suppose there were a 1 metre high wall. Then the pressure on the US side would be higher from the extra height and weight of water. Then water would flow from the US side to the Canadian side of Lake Erie, which would equalise the heights of water.

Scott is saying that if P did not instantly double, then there *would* be a hot potato effect, and this explains why P does instantly double.

This all harks back to Patinkin's distinction between the equilibrium experiment and the stability experiment.

We still need to invoke the stability experiment in order to explain why the current state of affairs is an equilibrium, and what maintains it in being.

Nick, I've no idea how you find the time for all these responses. I couldn't and I don't even have a job. Your comments on the hot potato effect tend to confirm that I'm reading Scott correctly. His hot potato is just disequilibrium. Which is fine, but that means that practically every model I've ever seen incorporates the hot potato effect. You could say it's missing from the original fixprice IS/LM model, but that's strictly a short-run model. I've never met anyone who was misled by it into thinking that the price level will stay fixed when demand gets a significant boost.

"But can we forget money? We use money, not bonds, to buy goods."

Speak for yourself mate, I almost always use a bond.

Kevin, I'm confused by your response. Are you saying the interest rate mechanism drives prices higher, but the money supply/demand equilibrium explains the new long run (higher) price level? That makes no sense to me.

Adam and Kevin, Regarding the HPE, see Nick's example with Lake Erie, it's an excellent analogy.

Adam, The demand for money certainly did increase sharply in 2008-09, and it's not even a matter of dispute. We have very precise data on the supply and demand for base money, and the demand soared in late 2008, indeed it more than doubled. So I have no idea why you can claim that it didn't. Perhaps your interest rate theory suggests it didn't but then your interest rate theory must be wrong, and demand for base money more than doubled, even in real terms. The public's demand for of real cash balances is more the double the level of 2007, if you define cash as the base. But other aggregates also increased substantially.

Friedman pointed out that ultra-low interest rates are a sign money has been tight. In a forward-looking model it is very possible that tight money reduces yields on Treasury securities. In December 2007 a contractionary Fed policy surprise reduced bond yields from 3 months to 30 years. Keynesians can't explain that, because they have the wrong model. They focus on interest rates, which is the price of credit, not the price of money.

Philo, I was not intentionally exaggerating. I believe the forex market alone is more than 100 times GDP.

Nick, Those comments were very helpful, but I'm still confused. Let's say AD is not the curve, but rather the real quantity demanded. Then:

1. I've been teaching it wrong all along. I tell my students that in the classical model the AS curve is vertical, and thus an increase in AD will lead to nothing more than higher prices. But I should be saying the classical economists didn't believe AD could be increased.

2. Or perhaps that's wrong also. What if there is a huge population inflow, lots more consumers. I taught my students that this would not directly increase AD, rather it would directly increase AS. But if we care about the real quantity of purchases, then more immigration would reduce prices and increase real AD. Ditto for a productivity spurt. So now I'm hopelessly confused. If AD isn't nominal spending, how do we teach the AS/AD diagram? How do we explain that the slope of the SRAS curve determines how much of the extra AD leads to higher prices, and how much leads to higher output?

3. Until his most recent edition, Mishkin said one interpretation of AD is a rectangular hyperbola, i.e. a given NGDP. Then he dropped it from the new edition. Did someone tell him it was wrong?

4. I'm pretty sure I'm not the only economist teaching students that a rightward shift in the AD curve is an increase in AD. I'd be curious how many teach it that way.

Scott: “Are you saying the interest rate mechanism drives prices higher, but the money supply/demand equilibrium explains the new long run (higher) price level? That makes no sense to me.”

No, I’m not saying that. To avoid misunderstanding, let’s stick to ‘the’ New Keynesian model. (I’m more comfortable with Old Keynesian models but it’s high time I caght up.) I’m assuming that the simple version I know, from Gali’s textbook, is typical. If it’s not then hopefully Adam or Nick will set the record straight.

In each period some firms, selected at random, are permitted to reset their prices. The proportion of firms who get permission can be 100%, so there you have a flexible-price version of the model. If there is an unexpected easing of monetary policy all firms raise their prices. Output is always at the optimal, ‘natural’ level. Money is neutral. The only mechanism at work here is good old-fashioned profit maximization.

If only 30% of firms get permission to change prices in each period then the easing of policy will generate a positive output gap (actual output > ‘natural’ output). That 30% of firms will increase their prices. It’s exactly the same mechanism; it just isn’t allowed to work as freely as in the flexible-price case.

Scott, usually the term "increase in demand" implies an upward shift in the demand curve. That is, after all, how you used the term with respect to AD above.

In the case of money during the crises, while the quantity of money held increased, its price plummeted (the price of holding money is the opportunity cost, the nominal rate).

When quantity increases but price falls it is the supply that has increased, not the demad. The supply curve has shifted and the price fell as we moved along the demand curve. The price fall was what made agents willing to hold the extra supply.

It would be highly unusual for anyone to call this an increase in demand for money.

How exactly does the BoC keep the actual overnight rate more or less exactly at the mid-point of the 50bp operating band between the interest rate on reserves and the deposit rate? Why doesn't the actual overnight rate fluctuate over that 50bp range all the time?

I thought that was a result of the normal function of traders and fund managers in the overnight market doing their thing in a classic micro way. The payments book certainly leans that way. From what I understand the Canadian overnight market operates in a Lombard fashion, where overnight balances are settled among the clearing banks themselves before turning to the Bank of Canada.

With regards to the Bank of Canada's management of government deposits. Even though the old drawdowns and redeposits mechanism is no longer, the BoC still manages government deposits through twice daily competitive auctions. Banks bid for these funds. These are called "Receiver General Cash Balance Auctions", or something along those lines.

The government usually keeps very small balances ($1 billion?) at the BoC. ie most of its balances are auctioned by the receiver general. That changed during the credit crisis - the government held at its peak around $25 billion at the BoC. So if the credit crisis is any indication, cash management is not an entirely passive instrument. For some reason the BoC chose not to auction of those funds.

This is all pretty similar to TTL accounts down south.

Before LTVS, these deposits were allocated. They are now auctioned.

"1. I've been teaching it wrong all along. I tell my students that in the classical model the AS curve is vertical, and thus an increase in AD will lead to nothing more than higher prices. But I should be saying the classical economists didn't believe AD could be increased."

That effectively is what classical econmists, meaning RBC types, think. They don't even think AD is a well defined concept.

As I understand it, in large part the original point behind monopolostic competition and sticky prices was to write down a properly specified model in which AD makes sense as a concept.

"How exactly does the BoC keep the actual overnight rate more or less exactly at the mid-point of the 50bp operating band between the interest rate on reserves and the deposit rate? Why doesn't the actual overnight rate fluctuate over that 50bp range all the time?

If you ask people at the BoC this question, they will talk about *quantity*. If the actual overnight rate is above the target midpoint, the BoC increases the quantity of settlement balances in LVTS, "

No. By being ready to lend in unlimited amounts at rate x+ .5%, and by paying interest on reserves equal to x%, the bank keeps the marginal cost of reserves at x + .25%.

The Central Bank controls price, not quantity.

Moreover, the central bank, in our institutional setup, has no quantity control over currency + deposits.The non-financial sector is easily able to obtain more money, in aggregate, simply by selling some of their bonds to the financial sector. The non-financial sector is easily able to get rid of their deposits by buying bonds from the financial sector.

The money supply, for the non-financial sector, is 100% endogenous. All the central bank can do is alter the short rate, and hope that this causes the non-financial sector to want to hold more or less money, in which case more or less money will be automatically supplied by the financial sector.

This is what I mean about needing to get the institutions right.

Moreover, it makes a very big difference what the central bank buys. If the CB buys consumption goods, it is generating income for someone in the economy -- that is fiscal policy, and central banks cannot do this.

If they could -- if they could hire unemployed labor or buy up excess inventory, for example, then they really would be able to get us out of a liquidity trap with fiscal policy.

But they can only purchase assets, which does not increase anyone's savings. Fiscal policy is an income operation, whereas monetary policy is a balance sheet operation that leaves savings unchanged. Again, the only (indirect) mechanism of the central bank to increase savings is to try to adjust the short rate and hope for capital gains.

RSJ: "No. By being ready to lend in unlimited amounts at rate x+ .5%, and by paying interest on reserves equal to x%, the bank keeps the marginal cost of reserves at x + .25%.

The Central Bank controls price, not quantity."

Stop and think.

If I am willing to sell an unlimited quantity of apples at $125; and am willing to buy an unlimited quantity of apples at $75, this will not ensure that the price of apples will be exactly $100 at all times. All it ensures is that the the price will not be less than $75 or more than $125.

And if you look at the data, you will see that the actual overnight rate is almost never exactly in the middle of the band. But it is far closer to the middle than we would expect if all the BoC did was set those upper and lower bounds. It doesn't wander around all over the place within those bounds, and rarely hits those bounds (last couple of years at the ZLB aside, when the BoC wanted it to).

For example: http://www.bankofcanada.ca/rates/interest-rates/canadian-interest-rates/

At 11.45 am each day, the BoC does repos, or reverse repos, if the actual rate is above or below the target. That's how it gets the overnight rate almost exactly to the middle of the band.

More here on how it all works: http://www.bankofcanada.ca/wp-content/uploads/2010/07/lvtsmp3.pdf

Scott: "1,2,3,4"

With one small exception, you are not doing it wrong, in my opinion.

Leave that small exception aside, for a minute.

In micro, if we are being careful, we make a distinction between "demand" (the demand curve relating P and Qd) and quantity demanded (real Qd). We ought to do the same in macro. But we are sloppy, and most of us use the same words "AD" for both.

Why are we sloppy?
1. Because "Aggregate quantity demanded" sounds a bit of a mouthful, so we use "AD" instead.
2. Because, if aggregate quantity demanded is on the horizontal axis, we often argue among ourselves about what should be on the vertical axis (P or r?) of the AD curve, and often want to slide over potential disagreements by fudging this issue.
3. Because, the AD curve (whether P or r is on the vertical axis) isn't strictly a demand curve, in the pure micro sense. It's strictly a semi-equilibrium condition. That's because Yd is itself (usually) a function of Y. So what we call an AD curve is a locus of points in {Y,P} space such that Y=Yd(P,Y).
4. Because we are innately sloppy.

Everything makes sense if we just adopt the Principle of Charity and interpret "AD" to mean either "Yd" or "the AD curve" according to whichever interpretation means the speaker is talking most sense.

The small exception:

In general, depending on the model, the exact parameter values, and what you are assuming constant when you draw the AD curve, it will not be an exact rectangular hyperbola. An exogenous change in AS will only leave P.Yd constant in a very special case.

The AD curve will have one shape under the gold standard, another if M is fixed, another if the nominal exchange rate is fixed, etc.

If you assume "monetary policy" is fixed when you draw the AD curve, and by "monetary policy" you mean "PYd", then you get a rectangular hyperbola AD curve by assumption. But if you held the price of gold fixed instead, you would almost certainly get a different-shaped AD curve.

This, Scott, is where your normative preference for monetary policy to level-target NGDP has over-ridden your positive theory of the shape of the AD curve. It's hard for you to see an AD curve that has a different shape from the one you think it "ought" to have. As an antidote, ask yourself what the shape of the AD curve would be if the Fed targeted the price level. It would be horizontal.

Adam: "As I understand it, in large part the original point behind monopolostic competition and sticky prices was to write down a properly specified model in which AD makes sense as a concept."

I think I have heard others express the same view. It's an interesting viewpoint, but I think I disagree with it.

(And, as the person who first introduced monopolistic comp into macro, I have some authority on this subject ;-).)

What the monopolistic revolution *did* do is find a way to relate AD to the demand curve facing an individual firm. Under perfect competition, you could say that aggregate Yd was 100 apples, but if 10 firms wanted to sell 12 apples each, you had no coherent way of describing the demand curve facing an individual firm. Strictly, the Qd for an individual firm was 100 apples if the firm priced a fraction under every other firm, 0 apples if it charged a fraction more, and an indeterminate quantity between 0 and 100 if it charged exactly the same price as the other firms. That ugly "non-function" got replaced by a nice smooth demand function when we switched to monopolistic competition. So now you could talk sensibly about the costs and benefits to the individual firm of changing its price.

That was important. And a really good thing. And I expect you could say that it helped us understand AD better, because we could now relate it to the firm's micro demand curve.

But it's not the same as making sense of AD as a concept. I actually think the NK revolution has caused us to go backwards there. Mostly because we have ignored other stuff that got crowded out by the insights of monopolistic comp.

Scott: "We have very precise data on the supply and demand for base money, and the demand soared in late 2008, indeed it more than doubled."

I'm going to side with Adam here. We don't have data on Md or Ms. We only have data on M. ?

Nick,

It would be in the middle because money is not an apple -- e.g. it is not a consumption good.

If one bank is in a surplus position, another bank is in a deficit by the same amount.

The surplus bank can lend to the deficit bank at a rate Y, or it can leave its funds overnight with BoC, getting target - 25 bp. The bank in deficit can borrow from the BoC, paying target + 25, or it can borrow from the surplus bank at the rate Y.

The Nash Equilibrium rate will be Y = target -- which is why the rate is usually in the middle.

So while it's true that at 11:45, the BoC has the contingency option of using SRA or SPRAs, since the first four years since LVTS system was formally implemented, SPRAs were used only 3.4% of the time, and SRAs were used only 0.21% of the time. As each SPRA is unrolled the next business day, that means that at least 96% days, nothing happened at 11:45, as the Nash equilibrium was the actual equilibrium, up to an acceptable margin.

Of course the theoretical equilibrium does not have to be the actual equilibrium price, so it's good to have a fallback with OMO, but that is all they are -- rarely used fallbacks when the ideal results don't hold.

//www.bankofcanada.ca/wp-content/uploads/2010/02/wp06-15.pdf


RSJ: Interesting find. Sounds as though in 2001 the BoC switched from using 11.45am repos to maintaining a positive (but adjustable) early morning Cash Setting Target?

Kevin, I'm fine with that explanation, but still don't see where you need interest rates to play a role in the transmission mechanism. You could imagine an economy with just cash and goods, no interest rates. Goods prices are sticky, 30% adjust each period. OMOs are done with some good, like gold. I'm arguing that the monetarist HPE does the job in that economy, and that expectations of it occurring also do part of the (short run) job in an economy that does have interest rates, and all of the long run job.

Adam, We must be defining money demand differently. To me the price of money is 1/P. That's exactly the same definition we use in microeconomics for the price of any other good or service. And the price of money went up in 2009 (deflation) and has been pretty stable over the entire 2008-11 period. Yet the nominal quantity has doubled. So the real quantity has roughly doubled. people are demanding bigger real cash balances. Again, interest rates are the price of credit, not money.

Suppose we were on a simple gold standard, where gold coins were money. They you'd use simple micro price theory to model the relative price of gold, as any other commodity, and you'd assume gold demand had gone up if you had both more gold and a lower price level (like the 1930s). Regardless of what happened to interest rates.

Nick, I actually do not base my views of AD on my preference for NGDP targeting. Indeed I used the same approach years ago when I still favored price level targeting. Even now, when I teach price level targeting I don't draw the AD curve horizontally, rather I use the same hyperbola, and illustrate it by showing that when there is a supply shock, the Fed must move the AD curve in tandem to keep the price level constant (perhaps worsening the recession.)

I'm astounded by what I am reading from Kevin, Adam and yourself, but I have to assume you guys are right, as you're probably more in tune with conventional Keynesian theory. So I've misunderstood how others interpret the model. But here's what really astounds me. Me and almost every other economist stands in front of the class, showing what happens when AD shifts right and you have a vertical (classical) AS curve. And I'm now being told that when economists draw that rightward shift in the AD curve, they don't actually mean to suggest that there has been an increase in AD. That's quite amazing to me. But I guess it's true.

I also teach my students that the terms "AS" and "AD" are quite misleading, as they aren't really supply and demand curves. That part I got all along. What I never envisioned is that a rightward shift in the AD curve is not an increase in AD.

I've always thought AD should be called "nominal expenditure" and the model would essentially divide up macro into nominal shocks and real shocks, with no assumptions made about what causes nominal shocks (velocity is free to fluctuate.) That seems much more logical to me. Instead we've ended up with Krugman's upward sloping AD curves. In my model (which seems much more straightforward), Krugman's scenario would have the positive supply shock (say lower wages) causing the AD curve to shift left by more than AS shifted right.

I wonder if students understand any of this.

You said;

"I'm going to side with Adam here. We don't have data on Md or Ms. We only have data on M. ?"

Suppose both the price and quantity of oil increased at the same time. Don't we know oil demand has risen? Suppose the price (i.e. value) and quantity of money has increased at the same time?

I was taught that M/P is real money demand. Doesn't Laidler have a book modeling it? How can we not know what M/P is?

I'm beginning to think I should never come back to blogging--maybe I have everything wrong. Remember when Friedman sarcastically criticized Temin's argument that maybe the quantity of money fell in 1929-33 because the demand for money fell? Friedman pointed out that a fall in the demand for money is inflationary. Was Friedman also wrong? I guess if I'm wrong I'm in good company. :)

Scott: "I'm beginning to think I should never come back to blogging--maybe I have everything wrong."

OF COURSE YOU SHOULD GO BACK TO BLOGGING! YOU ARE ONE OF THE VERY BEST OUT THERE!

Even if you might be wrong on a few things. Imaginative original thinkers are often wrong on (at least) a few things. That's a price well worth paying. And blogging is an arena where mistakes are less costly than normal, because nobody takes anything on a blog as gospel, and because feedback comes much quicker.

OK, I was wrong in thinking your rectangular hyperbola AD curve came from your policy proposal of NGDP targeting. So let me try again. What are you holding constant when you draw your AD curve? M? MB? Suppose Y is the only thing that affects the demand for money. Even then, if the income elasticity of the demand for money isn't unit-elastic everywhere, you won't get a rectangular hyperbola AD curve.

AD is not, by the way, conceptually the same as (nominal) expenditure. For example, the Cuban economy almost always has AD greater than expenditure. There is excess demand for goods (and excess supply of money). Qd is the quantity we want to buy, which may be greater than what we actually succeed in buying (when there's rationing or line-ups).

"But here's what really astounds me. Me and almost every other economist stands in front of the class, showing what happens when AD shifts right and you have a vertical (classical) AS curve. And I'm now being told that when economists draw that rightward shift in the AD curve, they don't actually mean to suggest that there has been an increase in AD. That's quite amazing to me. But I guess it's true."

I draw it exactly the same way as you. But I would say "In this case, an increase in AD (shift in the curve) didn't cause an increase in AD (aggregate quantity of real output demanded)." Just to clarify my verbal sloppiness.

"Suppose both the price and quantity of oil increased at the same time. Don't we know oil demand has risen? Suppose the price (i.e. value) and quantity of money has increased at the same time?"

OK. We don't have data on Md or Ms, but we do have data on M and P. By looking at P, we can *infer* whether it was Md or Ms that increased (or which one increased more). OK.

"I was taught that M/P is real money demand. Doesn't Laidler have a book modeling it? How can we not know what M/P is?"

If we are always in equilibrium, then Md=M=Ms. Similarly, Md/P=M/P=Ms/P.
What we observe is the (real or nominal) money stock, not money demand or money supply. But are we always in equilibrium?

Laidler wrote a lot of papers in the 1980s arguing for a buffer-stock conception of money in which, with sticky prices, people could be off their money demand curves. We observe the hot potato process (and the musical chairs game) working itself out in real time. The stock of money people actually hold is not always equal to their desired stock.

You write that "in a world where sellers nearly always sell you what you demand to buy (they don't tell you to wait or join the queue), demand for spending nearly always equals actual spending." This remark has shaken my confidence in my grasp of basic economic concepts. For you make it sound as though *demand for spending* is just *willingness to spend*, which one might express by an *offer to spend*. If I offer you $10 for an hour of your labor, that is $10 of demand for spending, so I am contributing (at least) $10 to AD. If you accept, and give me the hour in exchange for the $10, that is actual spending (by me). If you tell me you're too busy today, but you'll do it next week, I am contributing $10 to AD today, but not $10 of spending--that happens only next week (if at all; I may reject your offer). If you hold out for $15 and I accept that (so that it turns out that in spite of my lowball offer I was all along *willing* to spend $15), my contribution to AD is and always was $15 (and my contribution to actual spending is $15). If you simply refuse my offer, so that no spending takes place, my contribution *to AD* is still $10 (or whatever higher figure I would have been willing to spend); *to spending*, nil.

But is this really how economists use the term 'demand'--for the mere willingness to buy something (at a certain price), even if there is no seller (at that price)? If so, there's an awful lot of what we might call "shadow demand," based on idle, unrealistic wishes.

Continuing with the rest of your answer (for which, by the way, I thank you): you have the monetarist saying that when there is an "increased supply of money, . . . people may try to lend out some of the excess money, rather than spend it themselves." (Therefore interest rates fall.) I think this will be true only if prices are sticky; otherwise the *increased* money supply wouldn't be *excess*. Now, it would be strange to assume that people in general do not realize that the money supply has (more or less permanently, we are assuming) increased; why would they not be aware of this, especially in the modern age of financial news media? And it is hard to see why, if they did realize this, prices would be sticky. But perhaps price-stickiness is, after all, (barely) compatible with a widespread understanding that prices will soon be going up; so let's suppose everyone understands this. But we seem to be assuming that *interest rates* are *not* sticky: they adjust readily to the increased desire of money-holders to lend. So would not interest rates tend to *rise*, due to anticipated inflation--the "Fisher effect," counteracting the contrary effect mentioned by the imaginary monetarist?

Finally, we come to your direct answer to my question. You have the (New) Keynesian say: "A fall in r makes holding bonds less attractive, so people buy more goods instead." This doesn't look plausible. People become reluctant to buy bonds, and try to sell some of those they already own; so the price of bonds falls; so interest rates rise; so the fall in interest rates didn't last long, after all!

But perhaps I have asked too much: perhaps the (New) Keynesian view just isn't plausible.

"Sounds as though in 2001 the BoC switched from using 11.45am repos to maintaining a positive (but adjustable) early morning Cash Setting Target?"

There is still the option to do repos, but according to the author, in that 2 year transition period, reserves were literally zero But when it was officially adopted, the system reserve position was set at +50 million. The author contends that there are frictions, search costs, some banks may have limits to how much they will lend to other banks, etc -- so having a small (e.g. 50 million) net positive reserve position makes it much more likely that LTVS will take care of all the settlement needs without resorting to SPRAs or SRAs.


But the main point is that the non-financial sector sees deposits + currency, whereas the CB is managing reserves. In order to get from a change in reserves to a change in deposits + currency, you need some assumptions about how the system works. That assumption could be a reserve multiplier, for example. Getting the assumptions right is important in determining whether there is a hot potato effect or just an interest rate effect.

In a commodity money model without banks, there is clearly a hot potato effect. Households, in aggregate, literally cannot cause the quantity of money to change.

In a fiat model with banks, and with a central bank, if households have too much money, they buy a bond from the banks and the problem is solved. This comes at the price of a decline in rates -- they have to offer an attractive bid to get the bank to buy the bond (to get rid of the excess deposit), just as the CB needs to offer an attractive bid to get the household to sell their bond to the CB (to create an excess deposit). But for some reason you are assuming that households can only buy goods, and not bonds, and this is because you have no banks in your model.

In equilibrium, the two bids will be the same, therefore you cannot talk about households voluntarily selling bonds to the CB in order to get more deposits, and then madly hot potato-ing goods to get rid of the exact same deposits they just (voluntarily) bought.

It makes no sense to talk about HPE in a modern economy because the money held by the non-financial sector is unchanged as a result of OMOs.

And we have data on this -- during the Fed's first QE (buying mortgages), households sold mortgage bonds to the CB, and bought treasuries (from the Federal Government), leaving their currency + deposit holdings slightly lower than before the operation began.

In other words, even though the Fed bought large quantities of bonds, it failed to increase the money holdings of the non-financial sector.

In the second round of QE, as the Fed was buying bonds from households, households were buying bonds from Treasury, so the consolidated government was still a net bond supplier to households. Again household deposit + currency holdings were unchanged. All that happened was that banks had excess reserves.

Alternately, when China was buying up large amounts of treasuries, households sold them the treasuries and turned around and bought an equivalent amount of (newly created) MBS from the financial sector.

In all of these cases, households were in full control over the quantity of bonds + deposits that they held. They held the quantities that they demanded to hold at the given rate -- the CBs influence over the non-financial sector's money and bond holdings begins and ends with the interest rate.

Scott: “I'm fine with that explanation, but still don't see where you need interest rates to play a role in the transmission mechanism. You could imagine an economy with just cash and goods, no interest rates. Goods prices are sticky, 30% adjust each period. OMOs are done with some good, like gold. I'm arguing that the monetarist HPE does the job in that economy, and that expectations of it occurring also do part of the (short run) job in an economy that does have interest rates, and all of the long run job.”

My contention is that your monetarist HPE effect is part and parcel of the NK model. Either that or I’m just wrong as to what you mean by the HPE. By all means let’s think of an economy where gold coins are the only money. We can prevent nominal interest rates from playing any role whatever in the transmission mechanism by having the interest rate pegged by law. The central bank has a huge stock of gold and it will lend all you can carry at that fixed rate. (I assume the rate is pegged at a high enough rate to ensure that the vaults will never be entirely cleaned out and also that Ponzi schemes are such a grave sin that nobody will contemplate them.)

Now suppose some passing helicopter dumps crate-loads of gold in the main square and the citizens stuff their pockets with coins. Obviously we expect inflation to result. So where does it show up in the NK model? We certainly see it in the price-setting equation, derived from the firm’s profit maximization. 30% of firms will reset their prices right after the coins have been gathered up. They know that: (1) when a new steady-state is established, their marginal costs will be higher; (2) both prices and costs will rise in each period between now and then; and (3) they have only a 30% chance of being able to revise their prices next period and in each period thereafter. So of course they will raise their prices. The HPE effect also shows up in the household’s consumption decision, since the higher anticipated inflation reduces the real interest rate.

Now if the potato is not hot enough for you, just increase the proportion of firms re-setting their prices each period to 60% or whatever looks right. What more do you want?

As to whether you should resume blogging, I think you should be guided by Keynes’s precept: there’s no harm in being wrong if one is found out quickly. I think you can trust the blogosphere for that.

RSJ: "In a fiat model with banks, and with a central bank, if households have too much money, they buy a bond from the banks and the problem is solved."

I frequently read Adam P and Matt Rognlie (and many others) saying something very similar. This, in fact, is at the root of the monetary orthodoxy I wish to challenge.

Compare the following two sentences:

1. If there is a bling bank that is willing to buy or sell unlimited amounts of bling at a fixed price of bling, then there cannot be an excess demand or supply of bling. If households hold too much/little bling, they simply go to the bling market and sell/buy that excess supply/demand to/from the bank.

2. If there is a central bank that is willing to buy or sell unlimited amounts of money at a fixed price of money, then there cannot be an excess demand or supply of money. If households hold too much/little money, they simply go to the money market and sell/buy that excess supply/demand to/from the bank.

The first is very plausible. And if you think in Walrasian terms, where money is just one of the n goods, the second will sound equally plausible.

But is money just like any of the other goods? Is it right to think about money in Walrasian terms? First, there isn't *a* money market. Second, the rate of interest is not the price of money. Third, we all hold money as a buffer stock, precisely because we cannot access all markets instantly and perfectly synchronise our payments and receipts. Fourth, each of us is willing to accept more money than we wish to hold precisely because it is money, and because we know that we, as individuals, can always get rid of it. A willingness to accept money in exchange for other goods is not the same as a willingness to hold money.

"I frequently read Adam P and Matt Rognlie (and many others) saying something very similar. This, in fact, is at the root of the monetary orthodoxy I wish to challenge."

Part of the problem is that currency itself _is_ an asset just like bonds are, in addition to it being a medium of exchange and a unit of account. Hence, it seems natural to analyze its convenience yield as the spread between the return on a short-term bond and the return on money (zero in nominal terms). Which is the nominal interest rate.

Nick and Scott: "Second, the rate of interest is not the price of money"

The problem here is that if that's true then neither is 1/P the price of money. Or, we could equally say both are the price of money.

After all, if apples cost $1 each, bananas $2 each and oranges $3 each then the price of of an apple in oranges is 1/3, in banans it's 1/2 and in dollars it's 1.

As Scott says, the supply of money has increased and its price *in terms of goods* has stayed the same. Thus, the relative demand for money vs the demand for goods has increased.

HOWEVER....

The supply of money has increased but it's price in terms of bonds has *fallen*, so demand for money relative to bonds has fallen.

So has the demand for money risen or fallen? One answer is "neither, it depends". Another answer is that it has fallen but the demand for goods has fallen more. But it is nonesense to claim that it has unambigously risen.

Where talking general equilibrium here, you need all three markets ala http://web.mit.edu/krugman/www/islm.html

Adam: fair point. It would be even better if the bonds were some sort of real bonds, so the price of those real bonds would permanently rise in the long run (when P is flexible) if the supply of money increased.

"Where talking general equilibrium here, you need all three markets ala http://web.mit.edu/krugman/www/islm.html"

No! That should be TWO markets! Three goods (money, bonds, output) - two markets (bonds, output) in a monetary exchange economy ;-)

anon: yes. If all we have is a Walrasian hammer, it's awfully tempting to treat money as just one more asset nail.

Put it another way. In the sort of world where people could instantly resolve an excess demand or supply of money by swapping money and bonds, we wouldn't hold or use money.

Ok, two markets, 3 goods.

So, if it's a fair point then do you agree that the problem was not/is not an excess demand for money?

Adam: nope. Because, "In the sort of world where people could instantly resolve an excess demand or supply of money by swapping money and bonds, we wouldn't hold or use money.". I expect I ought to do another post on this. Oh God. I *can't* do yet another weirdo monetary theory post!

I knew you'd say that:)

But again, since the evidence points to the supply of money increasing but not the demand where's your evidence.

I don't understand what relevance your quote has to this discussion. There was never any excess demand for money to resolve!

Nick,

You lost me @9:18. But then what is *your* explanation of why, after the CB bought a trillion dollars of bonds, household currency + deposit holdings were unchanged? Try to noodle out how something like that can happen, and see how it fits into your "bling" framework. I honestly don't understand your bling framework, or what relevance it has to household deposit holdings.

Professor Sumner,

You said.... "I don't follow your other point about supply and demand not changing. Expectations of the future are one of the most powerful determinants of current supply and demand, especially in asset markets. So if the expected future price rises, the current demand rises and the current supply falls, leaving prices higher and quantities unchanged in the very short run."

My confusion is because this response is a direct contradiction from the following quotes....

Don't forget that in a ratex world the anticipation of the HPE makes prices rise even before people spend the money.

But you said just a second ago in your response that the change in expectations created the current HPE/AD that causes the increase in asset prices. Here you say the exact opposite.

As the cash falls out of the airplane onto Bora Bora, the natives tell the person about to buy a mango that they changed their mind, the price will now be x% higher, where x% is the expected increase in the money supply from the airplane drop.

Once again, the contradiction to the response. The natives are increasing the price of mangos without first experiencing an increase in demand. How can that be? You have created two separate stories of how changes in expectations affect prices.

There are countries where retailers put signs in windows that everything is x% above the sticker price, after a sudden currency depreciation.

Once again, this is a contradiction from your response. In the first, changes in expectations cause changes in supply and demand and THEN asset prices change. Here, you are saying that asset prices changes before those markets experience a changes in supply and demand.

Do you not notice the particular funny little difference in the stories. Your first story is: Change in expectations -> change in supply/demand in asset market-> change in asset prices. The second story is: Change in expectations -> change in asset prices.

No?

Nick, Don't laugh, I hold nominal expenditure (MV) constant when I draw the hyperbolic AD curve. That's a tautology. But I don't assume NGDP targeting, rather I treat any shift in NGDP as a change in monetary policy, even if it's a failure to offset a move in V. Here's how I approach the model. You have nominal expenditure determined by the interaction of M-policy and velocity shifts (fiscal policy, etc). That moves NGDP around. Then sticky wages give you an upward sloping SRAS. As NGDP rises, firms are willing to supply more real output, due to sticky wages. Where you tend to see sticky prices leading to more aggregate(quantity) demanded (AD), I see sticky wages leading to more real (quantity) supplied. AD shifts, quantity supplied responds. You call it an increase in AD, meaning real quantity demanded, for obvious reasons I don't call it an increase in AS, that would confuse the AD curve and resulting quantity supplied.

Yes, short run monetary disequilibrium is possible, but I would still give the same answer to Adam. For me, money is the base. My cash holdings are rarely in disequilibrium for more than the time it takes to get to a ATM. So if the base doubles in real terms for three years (2008-11), I'm comfortable calling that the new equilibrium. People and banks want to hold much larger real cash balances. I do think it is standard practice to assume the central bank determines M, and the public determines M/P (i.e. real money demand). And then try to model why M/P changes in response to interest rates, income and other factors. That's what Laidler did. So I think my definitions are pretty standard in that area, (but not in AD I guess.)

Kevin, You might be right about the NK model, I was relying on an answer Nick gave me earlier--he said they usually just model inflation, not the price level. The HPE allows you to model the price level, at least in a very rough way. Take New Zealand, where NGDP is about 50 times currency holdings. Suppose New Zealanders like to hold enough cash on average to buy a week's worth of NGDP. That gives you the velocity of 52. Now triple the money supply. The HPE says they'd still want to hold about enough cash to buy a week's worth of NGDP. At least in the long run. So the long run price level and NGDP triples. The NK model also predicts inflation will occur. The extra cash will lower interest rates, drive up AD, and eventually drive up prices. What I'm trying to understand is whether the NK model explains how high prices rise in the long run. Does it just predict much higher prices, or does it use the HPE to generate a prediction that the new equilibrium price level will be three times higher? The Post Keynesian model doesn't tell you that. It doesn't pin down the price level. I thought the NK did (via the HPE), until Nick contradicted me. Or else maybe I misunderstood him or he was just referring to a simplified NK model, not the fully fleshed-out model. So I am willing to be corrected. Krugman does sometimes use a QTM approach, so I assumed it was in the NK model.

I wrote the preceding before reading your helicopter example, but my question remain. That example predicts higher prices, but I say the HPE gives you a specific (QT of M) prediction for how much higher. The fact that people and businesses will spend more, doesn't tell us anything about how much higher prices will end up.

I'm not impressed by models that explain the rate of inflation, I want to know why the current price level is not 100 times higher, or 100 times lower than right now. I believe only QT models can do that. Certainly the General Theory cannot. I also believe that if one can't explain the level of prices, any model of inflation will be highly flawed. It will seem to work at low rates, but spin out of control in 1970s-style inflation.

I plan to start blogging after the 4th of July, and I'm counting on you to come over and tell me when I'm wrong--you were one of my best critics.

Adam P. In microeconomics the only price of apples that matters is the real price, the price relative to all other goods. That's the price on the vertical axis on a S&D diagram. Because the nominal price of a dollar bill is always 1, the real or relative price of a dollar is 1/P. So I am being completely consistent. I also had a few comments on money demand in my reply to Nick.

Everyone, Thinking about this discussion, and reading Krugman's new Keynes essay, makes me wonder whether there is any other field where even well-informed people think about basic concepts in such different ways.

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