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Nick, this is getting too easy. The reason that we abandoned Monetarism for New Keynesianism is because the latter works all the time and former doesn't.

"Monetarists say that aggregate demand depends on the money supply." This is sometimes true and sometimes false.

"New Keynesians say that aggregate demand depends on the rate of interest." This is always true, these models give us insights that you just can't get from monetary models (like what to do when the market clearing interest rate is negative).

http://canucksanonymous.blogspot.com/2010/08/can-printing-money-really-make-people.html


and of course, both approaches have the same problem of translating the simple " the money supply" or "the interest rate" into the real world where neither is so cleanly defined.

So that point favours neither approach.

"Which is more stable: the relationship between aggregate demand and the monetary base; or the relationship between aggregate demand and the overnight rate of interest?"

In normal, not liquidty trap, times I'm gonna say neither is more stable because both are exactly the same thing.

In general, including liquidity trap times, I'm gonna say the relationship between the short term real interest rate and demand is the more stable because it continues to exist whereas the other relationship literally disappears.

Correction:

In general, including liquidity trap times, I'm gonna say the relationship between the short term real interest rate and demand is the more stable because it continues to exist in a liquidity trap whereas in a liquidity trap the other relationship literally disappears.

Adam P. "In general, including liquidity trap times, I'm gonna say the relationship between the short term real interest rate and demand is the more stable because it continues to exist in a liquidity trap whereas in a liquidity trap the other relationship literally disappears."

Let's assume, for the sake of argument, that would you said there is 100% true, and that you are talking about the ZLB liquidity trap, for simplicity. It makes no difference in practice, since the central bank cannot push the overnight rate below 0%. So we would be comparing an unstable relationship the Bank can exploit with a stable relationship the Bank cannot exploit.

OK, I expect your response would be: "Yes, but we can only tell where the relationship breaks down by looking at r, not M"?

Yes, that's one response, a correct one I think.

However the more important one is that viewing things through the real rate suggests a solution that looking at M doesn't: the promise of higher prices in the future.

Scott Sumner often points out that increases in M need to be permanent to have an effect, he never explains why. If it's just real balances people want why aren't temporary increases in M enough?

You might say that expectations of future money supplies change current money demand, but to understand why this is you need to look at the interest rate channel. When setting price level targets you need to look at the effect on real rates to decide what target to set... etc, etc, etc.

and looking at real rates of return generalizes more directly to the messy world with many, many "interest rates".

It tells you that QE can work by increasing risky asset prices even if longer-term nominal rates don't fall. It tells you that QE doesn't work by expanding the money supply but that a larger money supply won't be inflationary either. It seems to me that most people who are going out of their minds worrying about inflation are looking at the world through MV=PY and thinking V can increase at any moment. Looking at the world via real interest rates tells us this isn't so.

Great post Nick. Your conversation with Adam P. reminds of a paper by Michael Bordo and Andrew Filardo titled "Money Still Makes the World Go Around: A Zonal Approach." An ungated version can be found here: http://www.aeaweb.org/annual_mtg_papers/2007/0105_0800_0504.pdf
The authors argue the usefulness of money versus interest rate as indicator of the stance of monetary policy depends on inflation zone the central bank find themselves in.

Oh come on, this is irrelevant. The central bank runs the economy like a driver drives a car at high speed, dynamically, but aware that reaction time means that it has to anticipate. It doesn't assume that there are any fixed relationships - only that relationships usually don't change dramatically overnight. I don't care what your models say, this is what happens pragmatically.

There are two issues here - whether aggregate demand can be controlled by manipulating money supply and interest rates, and whether the CB can actually control either money supply or interest rates. On the second point, I think you're mistaken. Central banks can and do influence interest rates across the government bond yield curve and frequently that of private assets as well. QE1 was about increasing prices/reducing interest rates on a variety of private assets and QE2 focused on the govie-bond yield curve. In the post WW2 period till the early 50s, the Fed actually set interest rates on the entire govt bond yield curve.

In the current zero-rate environment, the real question is whether manipulating rates across the curve (private or govt) can increase investment sufficient to reach full employment. I tend to agree with the Post-Keynesians (Shackle, Minsky) who claim that simply reducing rates will not do the trick. Business investment is not going to explode simply because funding costs drop another 0.50% from current levels.

So I see your posts as a criticism of both the monetarist and the New Keynesian approaches. I find the interest rate approach much more explanatory of market action and in my opinion, many central bankers understand their actions in these terms as well. I wrote a post a while ago on viewing monetary policy actions as attempts to manipulate real interest rates here http://www.macroresilience.com/2011/05/10/monetary-policy-and-financial-markets-a-real-rates-lens/

Wow, the old currency vs banking school debate from the 1800s rages on. Round 304!

reason: "Oh come on, this is irrelevant. The central bank runs the economy like a driver drives a car at high speed, dynamically, but aware that reaction time means that it has to anticipate. It doesn't assume that there are any fixed relationships - only that relationships usually don't change dramatically overnight. I don't care what your models say, this is what happens pragmatically."

Well put. I agree.

though I agree with reason's description of what a central bank does I don't think that makes the underlying debate here irrelevant.

Understanding how our models work and how they relate to the real world has deep policy implications. That's important.

"I don't care what your models say..."

And really, that sounds a lot like the typical blog comment: "I don't need to know what your model says to know it's wrong".... I'm always impressed by that, I wish I could judge whether reason is wrong or right without even knowing what he's saying.

Now I can't decide whether to agree with Adam or reason. In defence of reason, and against my own instincts as a theorist, some good drivers don't have a clue what is happening under the hood.

But the issue here is not at all about understanding how the engine works. A much better analogy is from flying a plane.

A good pilot need not understand how the engines work but he needs to understand how the wings generate lift. Most of the time, in normal flight pulling back on the stick increases the lift generated by the wings. However, in a stall the complete opposite is true, pulling back on the stick *reduces* the lift that is generated thus making the stall worse. A simple rule of "pull back on stick to go up" doesn't always work and can kill you (apparently the Air France pilots that crashed in the Atlantic a few months back did exactly this, even after the stall warner went off).

Similar comments apply to various other things, spin recovery for example. Some things you need to understand and some things you don't. Actually, you also need to understand certain things about how the engine works to react correctly to certain engine problems but let's ignore that here.

I suspect that many things reason is completely certain are essential for monetary policy are akin to understanding how the engines work (I'm basing this on his comments here and on other blogs like EV). They're important for engineers to understand so they can make more fuel effecient engines in the future but they wouldn't help the pilot one bit.

On the other hand, what we're discussing here is what to do in a stall. The particularly interesting thing is that stall recovery is the same whether the engine is working fine or already fell out of the plane. And dealing with the engine problem would *always* have to wait until after you've recovered from the stall, getting out of the stall is the immediate concern here.

Ashwin: "I find the interest rate approach much more explanatory of market action and in my opinion, many central bankers understand their actions in these terms as well."

Yes, the central bankers (at the Bank of Canada anyway) do seem to understand their actions in terms of interest rates. But should we, as visiting anthropologists, always explain what the natives are doing using the exact same explanation that the natives themselves would give for their own actions? That's not obvious. Sometimes I think that it was central bankers themselves who created the switch from Monetarism to New Keynesianism. If we wanted to talk with central bankers about what they are doing, they would insist that we use their language ("R-speak"), rather than our own language ("M-speak"). And journalists, who didn't have a language of their own to discuss these things, would naturally gravitate to R-speak too.

Maybe instead (and this is probably where Adam is coming from) if you think of the monetary policy as operating via interest rates, and this is the dominant theory of the transmission mechanism, then talking about money is inevitably seen as just an unnecessary detour. Why talk about M causing r causing PY, when we can simply talk about r causing PY instead? Money is just an irrelevant intermediate target.

But we don't *have* to think of the transmission mechanism that way. I've been mulling over doing a post on that subject. But it will be a hard post to write, because it goes so much against the grain of what we've been taught. Plus, when you get right down to it, there isn't *a* (fixed) transmission mechanism. It all depends on how expectations of monetary policy are framed.

But I'm jumping ahead of myself. Maybe next week.

David: Thanks! From a very quick skim of the Bordo Filardo paper, I think it is related to the thermostat metaphor. The quality of the thermostat tells you which zone you will be in, and also what sort of empirical relationship you would expect to see between variables like money, interest rates, and inflation.

I guess the simplest way to say it is that reason is talking about how to build a better, more stable airplane.

What Nick and I are debating is how best to fly the airplane we got.

Adam P, It's interesting that you connect my name with the view that temporary monetary injections don't matter (very much) only permanent injections matter. I thought everyone believed that. Krugman claims he invented the idea. And Woodford showed it's equally true for interest rates.

I'm interested in explaining aggregate demand (NGDP), not changes in AD. You can't explain AD with interest rates, you can only explain changes in AD. Expected changes in M over time explain expected changes in NGDP. Expected changes in NGDP explain current changes in NGDP.

In Brazil and Argentina inflation averaged about 75% p.a. between 1960 and 1990. I think one can explain that with changes in the base, but not via changes in real interest rates. If I'm wrong, I'll change my views of Keynesianism. The model that one would use to explain why Argentina and Brazil had 75% annual inflation, and not 50% or 100%, is also the model I want to use to explain why the US currently has 4% NGDP growth.

In the previous post you said I was wrong about NK. If the NKs can explain the level of P using interest rates, I'll gladly change my views of NK. I hope I'm wrong.

Adam P; I gather you trained as a pilot. In flight or in a cardiac ICU (Nick, Kesey is old enough to have done everything), long run survival depends on science but the next minute is about technics. So is economics. Even if we are not sure about the precise mechanism, whatever works works. And fiddling around with r still always gives us a somewhat better result than M. Heaven can wait

Going back to Nick's question: "Which is more stable: the relationship between aggregate demand and the monetary base; or the relationship between aggregate demand and the overnight rate of interest?"

Is it fair to say that the short-term correlation between (changes in) AD and interest is much stronger than the short-term correlation between AD and M? If AD responds more directly and quickly to interest rate changes, then interest rates will be a more appealing tool for policy.

Longer-term, the reverse may well be true.

Leigh, I'm not even sure the direction of correlation between AD and interest rates. Is the correlation positive or negative? (BTW, the correlation between current changes in the base and AD is also very weak.)

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