"Monetary policy is just one damn interest rate after another"

No it isn't.

History might appear to be just one damn fact after another, but it's the job of social scientists to make sense of those facts, and try to explain the endogenous facts in terms of (relatively speaking) exogenous facts.

Americans might be forgiven for thinking that monetary policy is just one damn interest rate after another, because nobody understands what the Fed is trying to do at any longer horizon. Canadians have less of an excuse. We know what the Bank of Canada is trying to do, because it tells us. Like many other modern central banks, the Bank of Canada targets inflation. The Bank of Canada does not have an interest rate target, except for temporary 6 week periods between Fixed Announcement Dates (and even then, it will change the interest rate target between FADs if it really needs to). It targets 2% CPI inflation. The Bank of Canada's interest rate "target" is an endogenous variable, that can only be understood as determined by the 2% inflation target plus what is happening in the rest of the economy. The Canadian money supply can also only be understood as determined by the 2% inflation target plus what is happening in the rest of the economy.

"The stock of money is demand-determined at the interest rate targeted by the central bank."

No it isn't. But I can understand someone saying that if they also thought that monetary policy is just one damn interest rate after another. It doesn't make sense to say that if you think of the interest rate as an endogenous variable that follows from an exogenous inflation target. (Actually, I think it wouldn't make sense to say that even if the interest rate were exogenous, but then I'm a very heterodox disequilibrium monetarist who has weird beliefs about hot potato money and the law of reflux being wrong, and I'm just going to pretend I'm an orthodox New Keynesian for this post).

Whether a model is useful or not depends on what question you are asking. It depends on your perspective.

Zoom in for a close-up. Suppose you aren't interested in anything that lasts more than 6 weeks. Assuming the central bank has an exogenous interest rate target is then a good approximation to reality. The Bank of Canada really doesn't like to change the overnight rate target unless something big happens, and the actual overnight rate stays fairly close to target, so the approximation isn't bad, as long as we are talking about small changes.

Suppose the demand for bank loans increases. It doesn't matter why. And commercial banks satisfy that demand. The stock of money in circulation increases as a result. It doesn't matter if the quantity of reserves and currency demanded increases too, because the central bank will allow those stocks to increase by an amount equal to the quantity demanded. Does this mean the stock of money is demand-determined? Absolutely not, because the demand for bank loans is a flow demand for loans, and the demand for money is a stock demand for the medium of exchange, and those ain't the same thing, and just because someone wants to accept money in exchange for an IOU doesn't mean he wants to hold a bigger stock of money, it means he probably wants to spend it instead, so there's a disequilibrium hot potato process in which desired expenditure of money exceeds expected receipts of money and.....Ooops! Sorry! I said I was going to pretend I'm an orthodox economist, so yes, the stock of money is, ahem, demand-determined.)

Now zoom out. Let's take a longer, wider perspective.

Suppose the demand for bank loans increases. It does now matter why. Suppose it's due to increased demand for investment. With a fixed inflation target the rate of interest will have to increase, because if inflation was on target before it won't stay on target if desired investment increases and increases aggregate demand too. What happens to the stock of money? It will probably decrease. Take the standard assumption that the demand for money depends positively on the price level and real income, and negatively on interest rates. Then the rise in interest rates means a lower stock of money demanded, and hence a lower stock of money.

Now let's zoom right in very very close. Lets get right down to machine language, and ignore the higher-level programming languages. What do central banks really really control? They control their own balance sheets. And they can communicate promises about how they will change their balance sheets in future conditional on what happens. (OK, some central banks can control required reserve ratios, but I'm going to ignore them here.) If you really want to get down to the nitty gritty, that's it. Central banks control their own current and promised future balance sheets. Any influence they have on interest rates, and inflation, and anything else, all ultimately derives from changing the size and composition of their own balance sheets. Targeting interest rates is not what central banks really really do, for you people of the concrete steppes. Interest rate targets are merely a communications device (and a bad one at that), that some central banks sometimes use (see Paul Krugman) as an intermediate step between the machine language of balance sheet quantities and the ultimate target of inflation (or whatever). Nobody should confuse a communications device for ultimate reality.

Comments

[wh10]

Nick, from my perspective, you are not taking the argument through to the logical conclusion while also changing the goal posts of the debate, in order to defend your viewpoint.

wh10 | April 2, 2012 at 8:02 am | Reply
To preempt, because I believe I have been down a similar road with Nick Rowe before, my sense is that he is saying the interest rate becomes endogenous because the CB will need to react to endogenous market forces in a very specific way to maintain price stability / full employment / or whatever the CB’s goal are etc. In other words, it will be ‘forced’ to alter the interest rate to specific levels to achieve those goals. In my mind, though, even if we assume Nick is right about the influence and necessary path of the CB’s policy, the interest rate is still exogenous because the CB can still adjust it to wherever it likes, regardless of the impact on the economy. But now we’ve entered into a debate about the influence of CB policy and what constitutes good CB policy and have exited a discussion about the ‘exogeneity’ of the interest rate on reserves.

Would you agree?

Scott Fullwiler | April 2, 2012 at 10:26 am | Reply
Yes. There’s nothing that I’ve said anywhere that precludes the CB from running a Taylor’s Rule-type strategy. This is about tactics, not strategy. Tactically, the interest rate is the control variable, not reserve balances, etc. Strategically, the CB sets the target where it wants, responding to events as in a Taylor’s Rule if it chooses. Nick would say it has no choice but to do that–I would just say nothing I’ve said says it can’t do that.

And Fullwiler's update:
"Update: Paul Krugman has posted a reply to this post that is a straw man. He and Nick Rowe are viewing this all through the lens of the old Monetarist/Keynesian debates in which there was a choice b/n interest rate targets and monetary aggregate targets; the Monetarist critique assumed the Keynesians were going to keep interest rates at the same level forever and not change them. Once John Taylor came up with his “rule,” everyone agreed an interest rate target could work.

What we are talking about here is operational tactics–the CB can only target an interest rate. It cannot target a reserve balances or the monetary base directly. But that is different from strategy–that is, WHERE the CB puts its target and WHEN it chooses to change the target. There is NOTHING in anything I’ve ever said or anything any PK’er, MMT’er, etc., has ever said that suggests the CB can’t set the target wherever it wants whenever it wants. The point is that whatever the target is, THAT is what its daily operations defend directly, not a monetary aggregate, not the monetary base, not reserve balances. There is nothing in anything I’ve said that would preclude the CB from running a Taylor’s Rule type strategy, for instance, that responds at any point in time endogenously to the state of the economy. That is, the target rate is an exogenous control variable (i.e., it is necessarily set by the CB) that it sets endogenously in response to economic events."

[wh10]

"Targeting interest rates is not what central banks really really do, for you people of the concrete steppes. Interest rate targets are merely a communications device (and a bad one at that), that some central banks sometimes use (see Paul Krugman) as an intermediate step between the machine language of balance sheet quantities and the ultimate target of inflation (or whatever). Nobody should confuse a communications device for ultimate reality."

Also this high falutin language you are using to continue avoiding thinking about what CB *tactics* REALLY REALLY ARE in 6 weeks or over the long term. You are simply asserting the qty size of the balance sheet as being the fundamental causal mechanism. Fullwiler has given extensive explanations why its about price, always, regardless of the term considered. I have posted numerous references to this point in the other thread, with regards to how banks change price of reserves - addressing why the intuition from your Chuck Norris analogy is wrong. All I see you offering are assertions and thought experiments that miss the point, supplemented with a "really really."

Sorry- thanks for the debate. It was stimulating. But I think both parties have hit a brick wall, and I wanted to express my final thoughts.

[K]

Nick: Lets say the natural rate rises, but the policy rate is unchanged. So demand for loans increases. And maybe the quantity of money rises, but *maybe it doesn't!* Banks might fund the extra loans entirely in the capital markets. The bank of Canada has already eliminated reserves; they can eliminate paper money too if parliament agrees. *Nothing* whatsoever will change on the day that happens. We don't need a quantity of the medium of exchange for there to be a price level. We just need a unit of account and any quantity of price stickiness *no matter how small*. We should just get on with eliminating currency so we can get this argument over with.

[Nick Rowe]

K: what would the Bank of Canada's balance sheet look like in your scenario? Would it be all zeros?

[Andy Harless]

I don't know about the BoC, but the Fed pays interest on reserves, and my understanding is that it intends to keep the IOR rate close to the federal funds rate target. So if you zoom in very close, the interest rate is more than a communication device. The Fed does have potential control over its own balance sheet, but it chooses not to exercise that control: it chooses to be passive and let private banks expand and contract its balance sheet according to their preferences. Is it true that "...any influence they have on interest rates, and inflation, and anything else, all ultimately derives from changing the size and composition of their own balance sheets"? Not if "changing" means actively changing.

For the zoom out view, I think I agree with Nick, though, but I'm not sure how much I agree with the real Nick vs. the for-the-sake-of-argument New Keynesian Nick.

[Sergei]

Nick, central bank controls short-term (O/N) rate. Interest rates on loans, esp investment loans, are long-term rates. If central bank fights inflation today by raising interest rates, long-end of the curve may go down on such expectations causing a further increase of demand for loans.

[Nick Rowe]

Andy: Interest on reserves is a promise to adjust the size of a commercial bank's credits on the central bank's balance sheet by r% per year until the next FAD (or until further notice). It's a promise about the relation between current and future balance sheet entry sizes.

[Michael Carroll]

"There is NOTHING in anything I’ve ever said or anything any PK’er, MMT’er, etc., has ever said that suggests the CB can’t set the target wherever it wants whenever it wants."

Well, when a PKer says there is a liquidity trap, does that not suggest the CB can't lower its target?

[Ritwik]

Nick

For the purpose of what follows, I will speak in absolutes but the nuanced version should be probabilistic and an answer to 'what is the size of this effect'.

A central bank has control over its balance sheet given an 'exogenous' response function if and only if it has control over the economy/ credit creation. I always understood the PK/MMT position as saying that the central bank does not have much control over credit creation. This was illustrated by assuming an exogenous response function grounded in institutional reality (fed funds rate/ inflation rate) and then showing the indeterminate nature of the central bank's balance sheet if it tries to stick to its response function, or by showing how the response function was violated when it tried to control its balance sheet.

In Scott Fulwiller's latest update to his argument, the claim has been reduced to what a central bank's OMO desk does. With a Taylor rule targeting Fed whose ability to use the Taylor rule to control credit/the economy is not called into question, we're back in the New Keynesian Nick's world.

[K]

Nick,

It depends on the severity of the "punishment" for deviating from target in the interbank market. But assuming that reserves earn the same as right now (i.e. a bit less that the policy rate) then about the same as the currently outstanding quantity of reserves (i.e. less than $25M or so) *plus* the amount of deposits held by the treasury ($2 billionish if I remember correctly). So to first order, zero. So zero economically relevant function of the *nominal* rate. Only the real rate matters.

"Interest on reserves is a promise to adjust the size of a commercial bank's credits on the central bank's balance sheet by r% per year until the next FAD"

Not really. If the rate is less than the policy rate, it's just a way of not punishing a bank too severely for failing to lend reserves (and, in the case of Canada, for not making the net reserve balance zero). If the reserve rate is *equal* to the policy rate then I'd agree with Andy that that is a way of saying they don't care about the size of their balance sheet. Also, banks wont then care if they lend to the CB or another bank (so long as collateral is good). It's the only way you can do QE, but it's really bad policy as it causes breakdown of the collateral/repo markets if you can just lend to the CB. Anyways, those markets broke 4 years ago.

[nemi]

Off course you would not want the interest rate to be exogeneous in some GE model of the economy. With respect to reality, what could possibly be exogenous (or is exogenous/endogenous even meaningful concepts with respect to debates about free will, determinism etc).

However, if you want to do a thought experiment about the CB doing something different than in the GE model (i.e. making something exogenous by assumption), and also want your analysis to be somewhat relevant for the real world, you probably should let the CB set another interest rate (rule/path) while leaving the money stock endogenous. One obvious advantage of doing it this way is that you will do the same type of analysis that every CB is doing (or, well, they probably do not even include the money stock in the model – but your analysis would at least be more similar), and you have some empirics concerning what effect these kind of actions can have.

If you instead put the money supply as exogenous, you probably have to assume a completely different institutional framework for it to even make sense.

[Max]

The power of central banks ultimately derives from the ability to create base money. But it doesn't automatically follow that creating base money must be how central banks "really" steer the economy. What gives CBs their power and how they operate are separate issues.

[Mark A. Sadowski]

I've been reading all this back and forth between Keen and Krugman, as well as Nick's related commentary, as well as the related posts by Frederik, Fullwiler, Mason, Ramanan etc. and all of the many fine comments. And to certain degree my head is spinning but I don't think anyone has succeeded in changing my convictions. However I do think I learned a little something about Post-Keynesianism.

My general sense of things however is that the Post-Keynesians are acting as though they just discovered the Sun is revolving around the Earth (yes I know Keen has also referred to Ptolomy) and celebrating with a bunch of gotchyas. That's not to say Krugman hasn't been a little rude himself but he's never claimed to be particularily polite.

I managed to read Keen's paper and have a few observations, and I find myself in partial agreement with some previous observations.

1) Keen's argument that money is endogenously created by the banking system is based purely on Schumpeter and Minsky. He quotes the scripture like the faithful (which is subject to interpretation) and then moves on. To me this is just pure monetary mysticism.

2) His description of "NeoClassical" (who's he calling NeoClassical?) interpretations of Minsky is a little thin. It seems to me like he is setting up a strawman argument.

3) His statement that "Aggregate Demand equals income plus debt creation" is jaw-droppingly idiosyncratic. This statement, and others like it, render much of what he writes virtually incomprehensible to all the other major schools of economics (be they Neoclassical, NeoKeynesian, Monetarist etc.) He seems intent on inventing his own school (Keensian Economics?), but my advice is that if he's going to invent new concepts he shouldn't borrow old terms that are already well defined.

4) I find his Walras-Schumpeter-Minsky's Law intuitively interesting but poorly expressed and insufficiently justified. To repeat my previous concern, he needs to define new variables, not implicitly redefine old ones.

5) His blog post entitled "Ptolemy and Walras—Brothers in Arcs" reveals he's seemingly unfamiliar with Neo-Keynesian Economics. That's somewhat ironic since I sense that a lot of the Post-Keynesians seem to be offended that "NeoClassicists" are unfamiliar with their literature.

In short if Steve Keen wants be taken seriously by the more orthodox economic community he needs to start using their language instead of missappropriating it. Moreover it would be nice if he displayed a better understanding of the ideas held by the people he's arguing against.

And a final note. The endogenous money people seem oblivious to the fact that central banks don't always target interest rates. They can target any damned thing they want to (reserves, MB, MS, exchange rates, inflation, unemployment, price level, NGDP, the price of tea in China, etc. etc.). They're the CB.

[Ramanan]

Mark A S,

I don't think "Post-Keynesians are acting as though they just discovered the Sun is revolving around the Earth". Post Keynesians have been saying the same thing from the days of Nicholas Kaldor and Joan Robinson. But they have been sidelined. I think Kaldor had a lot of weight in the UK and even advised the government regularly and may have had a lot of weight on the budget.

I think you may be probably somewhat correct here. Post Keynesians have found a lot of fans, given the crisis and the role of the internet, blogosphere etc. So you may see a lot of people realizing - at least behaving as if - they have found something new. From their perspective, they are right because without the crisis and the blogosphere it would have been difficult to come across a school of thought (or schools of thought similar to each other) which appeals to many people.

Also, more communication tools may also have brought heteredox schools and scholars get closer.

There are a few things which may not have gone the Post Keynesians' way. I think within themselves there are differences in approach, style and varied views on how it all fits together. I think a lot of Post Keynesians wouldn't agree with Steve Keen for example but are united with him at least for a cause. So you are right - nobody in the PKE will agree with Keen on his definition of aggregate demand :-) Nontheless they may agree with a lot of what Keen says.

[nemi]

I really do not feel like I have any skin in this game – which makes it very frustrating to not understand what e.g. Krugman and Nick is objecting to. If I hold any kind of bias, it should be towards believing in/rationalizing anything Krugman says.

Are these three statements true?
1: If we fix the interest rate to some path (and keep the current institutional setting), there is no way of knowing how big the money stock will be in five years.
2: If we fix the supply of money to some path (and let interest rates be determined according to some loanable funds framework), there is no way of knowing what the interest rate will be in five years.
3: We cannot have a fixed interest rate and a fixed money supply at the same time (i.e. in any point in time).

If true, does this not imply that if you set the interest rate, the money supply have to be allowed to vary freely (i.e. be determined endogeneously)?

Or is the point that a certain money supply will cause certain inflation, and whether you choose to control money supply or interest rates in the short term, that will have essentially no effect on transaction technology or velocity of money, so the long term money supply is implicitly controlled through the short term interest rates?

I think I have asked before but if the last thing is the case, what is your definition of “money”.

PS:semantics: CB´s do not “target” the interest rate. If the difference between your aim and outcome is that small, and we are in the realm of social/economic policy, you “control” it.

[Philip Pilkington]

"Suppose the demand for bank loans increases. It does now matter why. Say it's due to increased demand for investment. With a fixed inflation target the rate of interest will have to increase, because if inflation was on target before it won't stay on target if desired investment increases and increases aggregate demand too. What happens to the stock of money? It will probably decrease."

Dun dun dun! Nick Rowe is making an awful lot of assumptions here. He's assuming, as far as I can see, an economy operating at full employment (NAIRU?). So, in Rowe's view any increase across the IS curve will lead the central bank to intervene and shift interest rates. Rowe is just shifting the goalposts here big time.

Dean Baker and I had a fairly sophisticated discussion of this based on the long-term (10 year) interest rate and CBs hiking rates due to inflation expectations. After Greenspan we know that this isn't very straightforward and there is a LOT of central bank leeway here. They may try their hand at redefining NAIRU or whatever. But even so, Rowe probably shouldn't take a full employment economy as his case study.

This is all peripheral to the main discussion of course. But my feeling is that this discussion will never stay focused.

[K]

Mark A. Sadowski: "Keen's argument that money is endogenously created by the banking system is based purely on Schumpeter and Minsky."

Maybe. Didn't read it. But it's also standard Woodford. You calling him a mystic? The PostKs and the NKs have essentially no differences as far as the current debate is concerned. It is the MMs and the rest of the monetarists who are "mystics" with their belief in the "money supply." We can't define it, we can't measure it, but gosh darn it, we know it's there. *Beware the velocity*!

"The endogenous money people seem oblivious to the fact that central banks don't always target interest rates."

Rates (repos) are an instrument, not a target.

The monetarists seem oblivious to the fact that central banks don't give two hoots about the money supply, never mind target it. They tried once, a long, long time ago, but it didn't work. They haven't looked back.

[wh10]

I'd just like to point out from Krugman's blog:

Nick RoweChelsea, Canada
FLAG
Yep.

Just working on a new post. What the critics are saying is:
"Monetary policy is just one d**** exogenous interest rate after another".
They need to zoom out a bit.
April 2, 2012 at 12:36 p.m.REPLYRECOMMEND1
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Scott FullwilerIowa
Wrong, Nick. That's not what we're arguing at all. Sorry.

Why put words in the opposition's mouth, like this?

[Philip Pilkington]

Also, I think that it should be pointed out that in high inflation scenarios if the central bank raises rates the money supply -- or, at least, what certain economists call the 'money supply' -- continues to rise. If we take this inconvenient fact into account Nick Rowe's above argument (which is HIGHLY theoretical) falls apart.

It's quite obvious why this might happen, even if we accept Rowe's presupposition. If we have an inflation rate of 50% per annum and the central bank fixes interest rates up from 10% to 25%, it is still probably a good idea to take out a loan and spend/invest because you can be sure the loan is going to be eroded by the inflation.

The empirical evidence supports this. Of course, what I just said is a huge oversimplification, but it puts a rather large dent in Rowe's Canada-centric argument as outlined above.

The great thing about the endogenous theory is that it strips away all the presuppositions and complexities and adds them in later. Rowe and the ISLMic Keynesians start with a model that has lots of presuppositions (NAIRU employment, CB acting in a VERY specific and predictable way etc.) and then tries to pare it down to fit the particular circumstances.

I ask you: which approach looks more like science and which looks more like metaphysics? I don't think I need to answer that question to anyone who is open to posing it to themselves reasonably...

[Mark A. Sadowski]

Ramanan,
Yes, I appreciate the fact that Post-Keynesianism has a long history and several strands. I also appreciate that those who believe that money is endogenously created by commercial banks include not only Post Keynesians but Modern Monetary Theorists and people who are more difficult to classify like Keen.

K,
1) It is most certainly not standard Woodford. Woodford is a Neo-Keynesian and I know no Neo-Keynesian who believes that money is endogenously created by commercial banks. That would imply monetary policy is always ineffective. Some Neo-Keynesians do believe that monetary policy is ineffective in a liquidity trap. Woodford, however, is not even one of those. He has stated unequivocally that it is still possible in principle to achieve substantial stimulus to aggregate demand by changing expectations regarding future monetary policy. In fact he's written more than one paper on optimal monetary policy in a liquidity trap. Saying Woodford believes that money is endogenous is like saying the Pope is an athiest.

2) I see very little similarity between Neo-Keynesians and Post-Keynesians otherwise there would not be this constant back and forth. Moreover Neo-Keynesians have much more in common with Market Monetarists (or whatever they are called these days) as both do not believe in the endogeneity of money and many Neo-Keynesians, like Woodford, believe that monetary policy is still effective in a liquidity trap.

3) During the period when the FOMC was setting a FFR target that was the target. The target may have been set according to a Taylor Rule but nobody really knows for sure (except for the flies on the wall). And it is precisely because the target was an interest rate that open market operations had to be so active during that period. (IMO that period ended in late 2008). Moreover the FOMC did briefly target money supply but gave it up precisely because velocity is so variable. And there are other central banks besides the Fed. There are a variety of possible targets, not just interest rates.

[Ramanan]

Attention. Attention.

http://www.nytimes.com/roomfordebate/2012/04/01/how-to-teach-economics-after-the-financial-crisis/economics-101-not-your-fathers-monetary-policy

Alan Blinder on monetary policy (h/t wh10)

[wh10]

Couldn't be better timed, eh?

[Philip Pilkington]

@ Sadowski

"It is most certainly not standard Woodford. Woodford is a Neo-Keynesian and I know no Neo-Keynesian who believes that money is endogenously created by commercial banks. That would imply monetary policy is always ineffective."

I don't think Post-Keynesians think that monetary policy is always ineffective. The Vaolcker shock was definitely effective enough to cause a recession -- and probably for quite real reasons. Most of the time monetary policy seems to work -- to the extent that it does work, which may be limited -- through expectations. That's why I think we see a lot of mysticism around central bankers who, frankly, come across as modern day shamen (remember what they used to say about Greenspan?.. Ugh... it was f-ing primitive!).

PKers do think that monetary policy has an effectiveness, but they (we?) don't think its very effective at all. And certainly to the extent that it is effective it generally works on the 'animal spirits' rather than on rational decisions undertaken by investors and businessfolk.

Your point (2) is spot on, I think. I see almost no difference between neo-Keynesians (I call them ISLMists... hehehe) and Market Monetarists.

"Moreover the FOMC did briefly target money supply but gave it up precisely because velocity is so variable."

I think that this might only be partially true in the case of the US. While in the UK a few monetarists really got the reigns of power, I don't think it happened in the US. There's a great interview going around where Volcker says that he always thought money supply targets were voodoo but that he cleverly used the political momentum to push for otherwise unpopular interest rates.

In the UK there was a big experiment and many that partook and were not 'true believers' came away bruised. There's a great interview from the 90s with a central banker who says -- figuratively, of course -- that he has nightmares to this day that what was really was going on was a conscious effort to expand the 'reserve army of the unemployed' to break unions. I remember the first time I saw that my mouth fell open... it was coming out of the mouth of a central banker, but it sounds like something Arthur bloody Scargill might have said.

[Lord]

The investment banks created money (debt) by lowering lending standards resulting in inflating housing prices, but while this added to otherwise deficient demand, it did not create (consumer) inflation for the Fed to fight. When the folly was seen and lending standards were raised it destroyed money (debt) and demand leaving us in a hole and the Fed to struggle against. So I would say money (debt) is endogenous, but not wholly out of control of the Fed who can exert force on both lending standards and money (debt) through rates (debt service) but only if collateralizable (not underwater). Am I even close to what is being discussed?

[UnlearningEcon]

Mark A S,

Keen's advocacy of endogenous money is not based merely on the fact that Schumpeter, Minsky, Keynes and whoever else advocated it, but on extensive empirical literature. Read his post here:

http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/

[Declan]

"With a fixed inflation target the rate of interest will have to increase, because if inflation was on target before it won't stay on target if desired investment increases and increases aggregate demand too."

Sure, or people will use the extra money to create a massive housing bubble which is not inflation just a big increase in prices (from BoC perspective).

[Nick Rowe]

Ritwick: you lost me a bit there. But I agree that if we take the central bank's reaction function as exogenous, (for almost any reaction function) then the time-path of the central bank's balance sheet becomes endogenous.

nemi: "Off course you would not want the interest rate to be exogeneous in some GE model of the economy. With respect to reality, what could possibly be exogenous (or is exogenous/endogenous even meaningful concepts with respect to debates about free will, determinism etc)."

I think that the exogenous/endogenous distinction is as much a statement about models, rather than the variables themselves. For example, (nearly) all economic models treat the weather as exogenous, but all meteorological models treat the weather as endogenous. They can both be right. I think we always have to specify: endogenous/exogenous with respect to what?

Max: "The power of central banks ultimately derives from the ability to create base money. But it doesn't automatically follow that creating base money must be how central banks "really" steer the economy. What gives CBs their power and how they operate are separate issues."

I think that's a good point. But I would emphasis their communication channel, which, at root, is the set of conditional promises/expectations they make about their future balance sheets.

Mark: "I've been reading all this back and forth between Keen and Krugman, as well as Nick's related commentary, as well as the related posts by Frederik, Fullwiler, Mason, Ramanan etc. and all of the many fine comments."

Who is Frederik? I missed that one. Anyone got a link?

"3) His [Steve Keen's] statement that "Aggregate Demand equals income plus debt creation" is jaw-droppingly idiosyncratic."

Yep. But deep down I think he's maybe trying to get at the same thing I've been trying to get at like here. Or I could be wrong.

"And a final note. The endogenous money people seem oblivious to the fact that central banks don't always target interest rates. They can target any damned thing they want to (reserves, MB, MS, exchange rates, inflation, unemployment, price level, NGDP, the price of tea in China, etc. etc.). They're the CB."

Yep. And the one thing we know they can't ultimately target, ever since Wicksell, is the rate of interest. Which is ironic. (Actually, we also know, ever since Friedman, they can't ultimately target unemployment either.)

Philip Pilkington: "It's quite obvious why this might happen, even if we accept Rowe's presupposition. If we have an inflation rate of 50% per annum and the central bank fixes interest rates up from 10% to 25%, it is still probably a good idea to take out a loan and spend/invest because you can be sure the loan is going to be eroded by the inflation.

The empirical evidence supports this. Of course, what I just said is a huge oversimplification, but it puts a rather large dent in Rowe's Canada-centric argument as outlined above."

Yep. I'm well aware of that. It's called the Howitt/Taylor Principle. (Most people call it the Taylor principle, but Peter Howitt stated it first.) A central bank following an interest rate reaction function needs to raise the nominal interest rate more than one-for-one with (expected) inflation to increase real interest rates and keep inflation from exploding. See my old blog post, and the first comment by David Andolfatto.

Mark Sadowski: "Woodford is a Neo-Keynesian and I know no Neo-Keynesian who believes that money is endogenously created by commercial banks. That would imply monetary policy is always ineffective."

I really don't get why you say that. Couldn't someone believe all these 3 things: commercial banks create money; the amount they create (generally) depends both on what the central bank does and on other things too (so it's endogenous in that sense); monetary policy is effective? I believe all those 3 things!

[mdm]

Have the fundamental points been resolved yet? Are banks constrained in their lending by the their reserve position? Is it required to include the banking sector in a story about debt and leveraging?

Moving on, Rowe, you've made the point repeatedly that the target interest rate that is set by central banks is an endogenous variable. In the post today you argue that it is targeting inflation, so central banks follow some sort of Taylor's rule, plus another other economic variable (e.g. unemployment) that current theory suggests that monetary policy can influence. My question is, why is this relationship assumed to be a structural one, and not a behavioural react function that is conditional on current theory?

My point of disagreement is that, if you pull the camera back then every action by any agent is ultimately an endogenous variable, everything is connected to everything and determining everything, and any economic agent action by any economic agent that is observing a set of economic variables is also endogenous. The point of arguing that the interest rate is exogenous is because ultimately it is up to the discretion of the central banks what their target will be, their expectations that a change in the target will have or no change in the target will have, upon a set of variables which theory suggests they target. However, even if central banks are placing a heavy weight on inflation, it doesn't necessarily mean that they will then change the target rate when the rate of inflation moves outside their target band, other factors could be more heavily weighing upon their decision, for instance, a small open economy could be experiencing inflation above their current inflation comfort zone (e.g. 2 -3%) however, factors which are currently occurring overseas (a global recession) could make weigh more heavily on their decision, causing them to not raise rates.

Assuming that interest rates are an endogenous variable, how does this change the Post Keynesian story? In their model banks are still not constrained by the quantity of reserves, but by capital, credit worthy borrowers and profitability of potential borrowers. The central bank continues to accommodate the demand for reserves at its target interest rate, and it is still using a short-term nominal rate as its primary tool conditional on the expected impact that this tool has a set of economic variables?

[Ramanan]

mdm,

Good points.

Btw ...

"The only truly exogenous factor is whatever exists at a moment of time, as a heritage of the past."

- Nicholas Kaldor, Economics Without Equilibrium, 1985.

[Mark A. Sadowski]

UnlearningEcon,
The post you linked to helps explain a lot. I'm still digesting it but let me summarize what I think I've learned so far.

First of all read Keen's Berlin paper. Few of the people defending it seemed to have taken the time. In his explanation of the endogeneity of money relies primarily on theoretical explanations by Schumpeter and Minsky. (Keynes is not referred to at all.) Thanks to your link I noticed he does also refer to a paper by Kydland and Prescott and by extension Basil Moore. Basil Moore is a Post Keynesian who I'm not familiar with. Kydland and Prescott I'm quite familiar with, and to be frank, the fact that his empirical justification for the endogeneity of money depends on that dynamic duo raises the hairs on my neck.

The reason is that they are both Real Business Cycle Economists. Without getting too dismissive, RBCers don't really believe in the effectiveness of AD management. What's interesting is this remined me of a paper by Brad DeLong called "The Triumph of Monetarism?" in which he says:

"Twentieth century macroeconomics ends with the community of macroeconomists split across two groups, pursuing two research programs. The New Classical research program walks in the footprints of Joseph Schumpeter’s Business Cycles (1939), holding that the key to the business cycle is the stochastic character of economic growth. It argues that the “cycle” should be analyzed with the same models used to understand the “trend” (Kydland and Prescott, 1982; McCallum, 1989; Campbell, 1994). The competing New Keynesian research program is harder to summarize quickly."

In short Keens apparently traces his support for the endogeneity of money to the same root from which RBC sprung. And if I had quoted further you would see how much Neo-Keynesianism has with Monetarism. No wonder I disagree with Post-Keynesianism. In some ways it is the opposite of what Keynes believed.

None of this of course addressing the Kydland-Prescott observation that monetary lags do not behave according to what the standard money multiplier model suggests. Without getting into much detail I would argue that monetary policy does not function like some hydraulic mechanism where you press down on a bicycle pump inflating an inner tube. It is much more expectations based and I do not, nor have I ever subscribed to the notion of "long and variable lags".

Nick Rowe,
1) The Frederik post is here:
http://rwer.wordpress.com/2012/01/26/central-bankers-were-all-post-keynesians-now/

The highlighted quotes are supposed to be Post Keynesian gotchyas but if take them in context they aren't gotchyas at all.

2) With respect to targeting interest I agree, in the long run. All I ever needed to know about pegging interest rates over the long term I learned from this paper:

http://www.aeaweb.org/aer/top20/58.1.1-17.pdf

3) Given the other two assumptions, monetary policy is only effective if #2 ("the amount they create (generally) depends both on what the central bank does and on other things too (so it's endogenous in that sense") is accepted. But it's not clear to me that engonenous money crowd believe that assumption.

[Ritwik]

The Goodhart paper in the Frederik post is a speech called 'Whatever happened to monetary aggregates' in which he actually extols the need to look at monetary aggregates.

[Philip Pilkington]

"Yep. I'm well aware of that. It's called the Howitt/Taylor Principle. (Most people call it the Taylor principle, but Peter Howitt stated it first.) A central bank following an interest rate reaction function needs to raise the nominal interest rate more than one-for-one with (expected) inflation to increase real interest rates and keep inflation from exploding. See my old blog post, and the first comment by David Andolfatto."

Here's my fundamental problem, Nick. And I think its a rather obvious one. Your arguments -- how shall I put it -- proceed in a scholastic manner. You take a model -- a perfect or almost perfect model -- and then start adding qualifications that subtract from its perfection. These qualifications have fancy names and win people Nobel Prizes; but 99.99% of the time they are common sense propositions -- I pulled my inflation argument out of the air driving home today and checked some simple data to confirm it. (No Nobel for me though... I'll live!).

The Post-Keynesians are far more modest. They strip away all qualifications and posit a 'base model' which to work off. People can then add qualifications as needs be and see how they might impact the 'base model'. They don't even need a Road to Damascus moment like I had regarding high inflation (kidding, its not that clever at all... its quite simple really). All they have to do is look at the world around them.

Now, I ask you: which approach looks more like science and which looks like scholasticism or metaphysics? I think the answer to that is obvious. An ideal model with qualifications added gradually to restrict its perfection is metaphysics of the highest order and leads to mass confusion. A stripped down model with qualifications added as they appear in reality is a scientific model.

Make no mistake everyone, that is what is at issue here. Scientists will see the sophistry from the truth. As will methodologists and philosophers. Those already trained will see only the models. Frankly, the difference is between academic elitism and the pursuit of truth. We've seen this conflict many times before in history. Enlightenment did away with much of the Doctrines. We'll see what happens in the coming years. My feeling is that mainstream economics is rotting badly at the moment. But we'll see. Neither you nor I can steer history.

[Nathan Tankus]

@Mark A. Sadowski: "In some ways it [post-keynesianism] is the opposite of what Keynes believed. "

What Keynes have you read and what post-keynesianism have you read?

You're argument is quite frustrating. Keen uses mainstream empirical literature because he thinks that people will find that easier to digest then heterodox empirical literature. are you actually trying to slam him as an RBC thinker for that? I find it difficult to believe that you see that as arguing in good faith.

[Mark A. Sadowski]

Nathan Tankus,
I hold Keynes in high regard. I keep my well worn copy of the General Theory at hand to combat misquoting anti-Keynesians at all times.

Granted, my familiarity with Post-Keynesians is limited. That's why I'm enjoying this cycle of exchanges. I'm learning (I think).

And I'm sorry if Keens thought quoting Kydland-Prescott would earn him some friends in the more orthodox portion of the economic community. Apparently he isn't aware their is a very deep schism, and the very mention of RBC makes many of us draw our research papers from our holsters.

[Philip Pilkington]

P.S. On a less grandiose note, we have now established that Nick's above statements depend strictly on: (a) an inflation rate lower than nominal interest rate and (b) an economy operating at full output/NAIRU.

What does the endogenous theory presuppose in terms of macrodynamics? Nothing. Zero. Zilch. All it asks is that you can apply it to the very real world around you and understand what effects monetary policy may or may not have etc.

Now, I wonder... which argument would old William of Ockham take his razor to? Hmmm...

And which is closer to science? Again, I will let the reader decide.

[Declan]

On a more serious note, Nick, where is my attribution? :)

Back to the topic at hand, we reached the same impasse we're at now back in this previous post.

I agree with you that the extra money created by bank lending has to go somewhere (reduced velocity or higher prices) and that it could lead to higher prices which would cause the central bank to raise interest rates which cause defaults and a greater flow of interest back to banks and a lower desire to borrow all of which would counteract the initial expansion, but still disagree with your view (implied) that this means we don't need to be concerned about debt levels, the role played by banks in expanding debt levels, potential instability caused by aggregate debt levels, impacts on asset prices and economic growth and so on. The use of the extra funds created by bank lending to create asset bubbles is just one way bank lending can lead to trouble without an inflation targeting central bank having any impact on the process.

[Nick Rowe]

mdm: "Have the fundamental points been resolved yet?"

That had me laughing!

Sorry guys, but I'm feeling a bit burned out, and need to calm down a little and have a quiet night. I'm reading all the comments, but not up to responding to all of them.

[Edwardnh]

Edward Harrison here. I run the blog Credit Writedowns where a number of the Keen and Fulwiller posts ran. I just wanted to commend Nick for maintaining a tone of civility which is exemplary given the snarkiness which pervades many of these monetary policy threads. The Krugman monetary policy threads seem to have been shut down by holding comments in a moderation queue. I hope that isn't the case because it would be disappointing. Ultimately, laypeople are going to learn a lot more from comment threads like yours, Nick. Kudos.

[Mark A. Sadowski]

Edwardnh,
I agree. I had a decision to make today. Where should I post my comments? I found all of the arguments on this topic compelling. I didn't want to get into a tit for tat. Of all the choices Nick's blog seemed the best place. The responses to my comments here have been highly informative and very thought provoking.

[wh10]

Still agree with Edward about Nick, as I had noted in the other comment thread.

[Nathan Tankus]

@Mark A. Sadowski he is aware. does that make their empirical work invalid? I don't think Keen thinks or thought he would ever win any orthodox friends.

I'm happy to hear that. So do I. Remember though, Keynes wrote books before the general theory and wrote many clarifying articles after. many Post-Keynesians draw on that work also. Endogenous money for example, is generally seen to be not in the general theory (Keynes doesn't focus on banking there)but more in the treatise on money and (especially) in his post general theory articles and in his correspondence.

[Nathan Tankus]

I also would like to join the group of people commending Nick for being a facilitator in this argument and being very respectful given the circumstances. i said it in another thread but i thought i would repeat it.

[Nick Rowe]

Edwardnh: Thanks. I'm not sure i always deserve your praise though. Sometimes i lose it a little. I feel a *bit* bad about losing it with steve keen's post. As someone pointed out, he did sort of qualify what he said a bit further down, though it's a bit like saying someone's an axe-murderer, then saying a little later that technically he doesn't have an axe!

It gets a little frazzling when there are hundreds of comments and most people commenting are saying I'm wrong! And I'm not!!

[Nathan Tankus]

@Nick Imagine how we feel when we open a textbook :)

but seriously, you do deserve it. losing it a little bit a couple times doesn't count against you in my book.

[Nick Rowe]

Philip: "These qualifications have fancy names and win people Nobel Prizes; but 99.99% of the time they are common sense propositions -- I pulled my inflation argument out of the air driving home today and checked some simple data to confirm it."

OK, maybe you're smart (not meant as snark). A lot of people don't get that. Joan Robinson was a very smart economist, but she didn't get that point. She thought that the German hyperinflation could not have been caused by loose monetary policy, because the Reichsbank set interest rates at a "very high" level, like 20% (a couple of million % below the inflation rate)!

You want a simple model, that you can add stuff to later? OK. MV=PY?

[Declan]

Nick, as someone who's blogged and commented off and on for many years and knows how it can almost inexplicably drive even the politest people to insults and sarcasm and anger, I don't know how you manage to remain so civil despite being involved in so many contentious blog debates (and people only bother to comment if they think you're wrong, if you're right, why bother).

But looking back through your many posts on this topic over the last few years made me appreciate how much your posts and responses to my comments have improved my own clarity of thought on this issue which has always been a source of great puzzlement to me, so thanks.

[Nathan Tankus]

Nick:"OK, maybe you're smart (not meant as snark). A lot of people don't get that. Joan Robinson was a very smart economist, but she didn't get that point. She thought that the German hyperinflation could not have been caused by loose monetary policy, because the Reichsbank set interest rates at a "very high" level, like 20% (a couple of million % below the inflation rate)!"

I will not argue Joan's position because i have not read her position. I will however, argue John Maynard Keynes's position that he made in real time. He (and others) argued that German hyperinflation was a balance of payments crisis. they had an enormous (foreign denominated) debt burden thanks to losing the war (and the u.s squeezing it's allies for lent money). The debt burden was simply too large to deal with by selling asset. If it tried to export much more, it's revenue would actually fall(and the allies tended to put up higher tariff barriers in response). If they tried to cut imports too much, exports would fall off more because much of it (including food) was a basic input to production. the money printing was the effect, not the consequence of the hyperinflation.

http://www.jstor.org/stable/2224211

[mdm]

Nick, I'm in agreement with the comments above, thanks for providing a civil place to discuss what is a very heated issue.

Wray has the following blogpost for those interested: http://www.multiplier-effect.org/?p=4218

[mdm]

p.s. hopefully all the warmth and fuzziness of the last few comments will make you feel a little better, Nick! I'm really looking forward to your thoughts on my comment :-)

[Lee Kelly]

It's alright Nick, I think you're right ... but maybe that's the problem!

Money is special. If you don't understand that, then you don't understand anything. Pretty much all recessions are reducible to a monetary disequilibrium. I even agree that it's mostly a medium of exchange rather than unit of account issue.

People get confused about money. They know central banks can make inflation, and their models capture that relation, but they can't explain how it happens. It depends on central banks creating a greater quantity of money than people desire to hold, but that is impossible if money is assumed to be little but a safe, zero-interest bond. For example, a government cannot issue a bond (at a given rate of interest and maturity) unless it can find someone who wants to hold it. If people, retrospectively, find themselves holding more government bonds of some kind than they desire, then the price on those bonds fall or they mature and cease to exist. This is not true for money, because money is the medium of exchange. People will accept money even though they don't want larger average money balances, and they can only get rid of money by passing it onto someone else. The end result is inflation--nothing else but money has this effect.

If money is conceptualised as just another asset, then it's impossible for central banks to create a greater quantity of money than people desire to hold. It is assumed that, like a government and its bonds, central banks can only create money if they can find someone willing to hold it, and by that assumption the possibility of monetary disequilibrium disappears. One can assume inflation occurs and even model it, but one cannot explain what is going on.

I'm actually trying to write a guest post for Beckworth about all this stuff.

[Steve Roth]

"the demand for bank loans is a flow demand for loans, and the demand for money is a stock demand for the medium of exchange, and those ain't the same thing,"

Nick, just wondering if you're sourcing Clower here, who Keen cites as one of his key inspirations. ??

[Nick Rowe]

mdm: Oh, you smooth talker you! ;-)

"My question is, why is this relationship assumed to be a structural one, and not a behavioural react function that is conditional on current theory?"

OK, I expect it is conditional on current theory, plus what the CB has learned from recent experience. Especially if the CB is inflation forecast targeting (which is what the BoC does) rather than mechanically following some Taylor Rule (which I don't think any CB does). Let me tell you about my old research where I explored this idea....Off topic Nick!

"My point of disagreement is that, if you pull the camera back then every action by any agent is ultimately an endogenous variable, everything is connected to everything and determining everything,...."

You nihilist you! We have to make some assumptions about something being exogenous!

"Assuming that interest rates are an endogenous variable, how does this change the Post Keynesian story?"

First and foremost, it shows that the PK story is a partial truth, and not the only way of understanding how central bank "behaviour" (choosing a neutral term) affects the supply of money. There is more than one way to think of central bank "behaviour". And if we ask how a change in (say) the demand for loans affects the stock of money, we don't have to assume the central bank will hold the rate of interest constant when the demand for loans changes, and indeed this is a rather bad assumption to make for an inflation-targeting central bank, because it will almost certainly change the interest rate when the demand for loans increases.

"In their model banks are still not constrained by the quantity of reserves, but by capital, credit worthy borrowers and profitability of potential borrowers."

Let me modify your quote slightly, to read:

"In their model banks are still not [influenced] by the [supply function] of reserves, but by capital, credit worthy borrowers and profitability of potential borrowers."

I think it now sounds false, doesn't it. Because if we read "supply function" as an *inverse* supply function (price as a function of quantity, rather than quantity as a function of price), so it means the interest rate charged on reserves as a function of the quantity of reserves, I think most PK's would say the interest rate on reserves matters. Let me modify it again:

"In their model banks are influenced by the supply of reserves, as well as by capital, credit worthy borrowers and profitability of potential borrowers."

Now it's sounding awfully close to a slightly watered down version of the textbook money multiplier story.

[Mark A. Sadowski]

Nathan Tankus,
I'd like to think I am familiar with all of Keynes work. But I draw on the General Theory specifically since that seems to draw the most criticism.

Kydland and Prescott's work is a tough sell to me. You don't seem to get it. As far as I'm concerned they are the dark side. I'll combat with every ounce of energy I have into the darkest corners of hell.

[Nathan Tankus]

I understand your aversion. however, there's plenty of other evidence. we've been citing central bank practitioner literature from the beginning. I have a nice collection of papers and quotes I can send to you if you desire.

[Nick Rowe]

Thanks Lee! I look forward to your next post.

Steve Roth: Clower is definitely one of my inspirations, but not directly on that point. I don't *remember* Clower saying anything like that, but it wouldn't be surprising if he had said something like that. My main inspiration is David Laidler (U Western Ontario oral tradition). Also Leland Yeager.

[Peter N]

I believe you might want to reconsider this:

"What Steve Keen is saying is unadulterated BS. Sorry, but it has to be said. I do *try* to be nice, but Jeeeeez!"

You're letting your prejudices do your reading

Keen says

"Firstly, there are similar underlying principles to the DSGE models that now dominate Neoclassical macroeconomics, and as with Ptolemaic Astronomy, these underlying principles clearly fail to describe the real world."

and you say

*Everybody* knows that New Keynesian DSGE models assume imperfect competition. Imperfect/monopolistic competition is *absolutely central* to NK DSGE models"

You're not talking about what he is. He isn't talking about NK models.

As for the term barter, I think he regards any models without explicit financial intermediation as barter. You can have sticky prices in a barter system. He's being a bit terminologically loose, but no more than you've been and been recently.

Now I'll grant you he doesn't believe in DSGE models, because he doesn't believe in equilibrium in general. In this, however, he is in quite good company, equilibrium models without ridiculous restrictions on agents are probably impossible. Certainly, nobody has ever come up with one. I'll again quote Franklin Fisher:

"The search for stability at great levels of generality is probably a hopeless one. That does not justify economists dealing only with equilibrium models and assuming the problem away. It is central to the theory of value."

His first paper in this area was in 1972, so he's had a bit of time to work on the problem.

Now Y(t) +dD/dt = gdp(t) + NAT(t)

The net asset transfer is certainly reasonable. GDP is production, but realized capital gains aren't. Whether this is double counting is debatable. What's the difference between selling an ounce of gold I found, and ounce of gold I inherited, and an ounce of gold I bought 20 years ago? Since a great deal of borrowed money goes into inflating financial asset prices, the NAT goes with the dD/dt. This probably helps when you want to look at debt and net worth.

On the other side is the controversial change in debt, but note that this is a differential equation. If it were the usual time step model I think it would go something like:

Y(t) D(t-1) - D(t-2) - gdp(t)+ NAT(t)

Keen draws on Sraffa, so there's a bit of Marx here. So output of time t can be input of time t + 1. This is a more realistic view of how capital goods are produced. If you want to make cars, you specialized equipment like dies. This equipment is in turn made by other equipment.

If I borrow money to buy goods, those goods will fall under either GDP or NAT, but the money I borrow isn't income. And net borrowing probably equals newly created credit or it's an asset transfer.

I'm saying probably everywhere because I'm trying to be cautious and not put too many words in Keen's mouth.

Keen has modeled this stuff mathematically, and he even has a tool kit you can use to build your own models.

Now as for evidence, I find this little graph I made on FRED moderately persuasive.

http://research.stlouisfed.org/fredgraph.png?g=67L

I'm not sure I agree with Keen 100%, but he has a decent case. Stable equilibrium, aggregate supply, aggregate demand, decreasing returns to scale, rational expectations - both the math and the evidence are against them, which has been known for years and ignored. The argument is that economics is about tractable mathematical models, and these concepts are necessary for tractability.

And yes, aggregate demand is a useful shorthand term, but you can't actually go and aggregate non-homothetic demand in a model.

[Deus-DJ]

Mark Sadowski...I just wanted to make one comment, actually two. First of all, RBC'ers argued endogenous money because they wanted to make money as super-duper neutral as they possibly could. The ideology of Mark I/II monetarism and RBC was a hatred of government and policy.

Whereas, with PK economics as in heterodox economics overall, we understand that we live in a monetary production economy. Money is not neutral, at all times. To make the insinuation that PK economics gets its notion of endogenous money from RBC just shows you haven't read any PK literature. Then again, we noticed that when you said you've never heard of Basil Moore. Moore is the explicit founder of endogenous money theory (Moore made it explicit...Kaldor was working that way through 70s/80s). Moore is founder of what is called horizontalism, or horizontal approach to endogenous money. There is a small, structuralist approach(has only a few followers) and then there is another approach that wants to maintain Keynes' liquidity preference in the determination of interest rates, so in addition to Moore's exogenous interest rate the interest rate can also be determined by liquidity preference.

one final comment...there is a distinct difference, NICK, between real heterodox economists and neoclassical economists who use the same models that every other economist does(not to mention same deductive reasoning that uses no qualitative evidence whatsoever) yet comes to some different conclusion. You are not heterodox. Drop the silly models, come learn what heterodox economics is all about, and then we can talk.

[Mark A. Sadowski]

Nathan Tankus,
"I understand your aversion. however, there's plenty of other evidence. we've been citing central bank practitioner literature from the beginning. I have a nice collection of papers and quotes I can send to you if you desire."

You have got to be kidding. There's no way anyone can justify RBC especially in the wake of 2008. You have to be delusional. Feel free but get ready for a whole lot of trouble. I've wagered my whole economic life on the defeat of RBC.

[Nick Rowe]

Mark and Nathan, on K&P: Suppose I did a VAR test (using Canadian data for the last 20 years of inflation targeting), identified money supply shocks coming directly from the central bank, and found that those central bank shocks Granger-caused fluctuations in real output and/or inflation, and that I was absolutely certain my results were valid. I would then say the Governor of the BoC at that time should have been fired. Because it's econometrically equivalent to saying the BoC played dice with monetary policy! It ought never happen.

*Please* read my old post on this, because I thought i was saying something both right and important, but I'm not good at econometrics, and nobody really picked up on it.

[Nathan Tankus]

Mark A. Sadowski :"You have got to be kidding. There's no way anyone can justify RBC especially in the wake of 2008. You have to be delusional. Feel free but get ready for a whole lot of trouble. I've wagered my whole economic life on the defeat of RBC."

what are you talking about? I think RBC is seriously flawed. when did i ever, mount any sort of defense of it? I was talking about endogenous money, not RBC. Seriously I have no idea where you got the idea that i defend RBC.

[Nick Rowe]

Mark: You misunderstood Nathan. Nathan's using the K&P econometrics but draws a different conclusion. K&P's econometrics purports to show that monetary policy doesn't affect Y. Nathan thinks that AD matters a lot for Y, but monetary policy doesn't affect AD. K&P think that money affects AD, but AD doesn't matter for Y. Right Nathan? (Oversimplified).

[Mark A. Sadowski]

Nick,
All I know is I run regressions. I look for correlations try to identify statistical errors and hope for the best. If I knew what I was doing I would tell you. I'd like to think I'm an expert in Econometrics but the truth is my Professors constantly have me questioning my wits.

Nathan,
I'm glad you don't defent RCB. I'm still lokking for someone other than Kydland, Prescott, Lucas or Plosser who has the balls to do so.

[Nathan Tankus]

Yup that's the basic idea Nick. although I wouldn't say monetary policy doesn't influence aggregate demand. What i would say is the relationship is much more provisional and contradictory then is commonly supposed. Wynne Godley works through this formally in his modelling book "monetary economics". In new keynesian literature, there is things like the "price puzzle" that also shows the supply side effect of interest rate changes is more significant then is commonly supposed. generally it's thought that one of the biggest boosts interest rate falls have is on the wealth effect. but in a longer term lower interest rates have the opposite effect takes away interest income, which can have a slightly deflationary effect even as it reduces servicing costs for borrowers. This is all very simplified but i just wanted to get across the idea that Post-keynesians think the relationship is very, very complicated and nothing like what is generally posited in (the more popular) new keynesian models.

[Mark A. Sadowski]

My research is primarily in growth theory. Ironically I'm more interested in monetary theory recently. But I don't think the econometric tools should be that different.

[Ralph Musgrave]

Nick said in his post, “Suppose the demand for bank loans increases… Suppose it's due to increased demand for investment. With a fixed inflation target the rate of interest will have to increase…”

Also, under full reserve banking, an increased “demand for bank loans” AUTOMATICALLY increases interest rates, and at least to some extent chokes off the inflationary effect of increased investment or house price euphoria.

Arguably that is a better system than the farce we had prior to 2007 where there was a serious propoperty bubble staring everyone in the face, with virtually no one (central bankers included) seeing it.

[K]

Mark A Sadowski,

"Woodford is a Neo-Keynesian"

No he isn't. His analysis is entirely post-Lucasian: ratex, inter-temporal optimization. Does that sound Neo-Keynesian (i.e. Hicks, Samuelson, etc) to you? Me neither.

"I know no Neo-Keynesian who believes that money is endogenously created by commercial banks."

I'll let the Neo-Keynesians speak to that. *New-Keynesian* money is just interest earning bank debt. It's entirely endogenous, but the quantity is not generally modeled, except in extensions with capital markets (i.e. very fancy/recent models).

"That would imply monetary policy is always ineffective."

No. Absolutely not. The paradox of thrift (Fisherian debt-deflation) is fully operative without money. It is a competitive disequilibrium produced by risk free debt with a too high interest rate, plus rational agents attempting to optimize their own inter-temporal consumption and thereby collectively failing to sufficiently invest in risky projects. No interest-free money, of the inside or outside kind, required.

"Some Neo-Keynesians do believe that monetary policy is ineffective in a liquidity trap. "

The liquidity trap is just a special case of the paradox of thrift where the risk-free rate that happens to be too high is zero.

"He has stated unequivocally that it is still possible in principle to achieve substantial stimulus to aggregate demand by changing expectations regarding future monetary policy. In fact he's written more than one paper on optimal monetary policy in a liquidity trap."

Absolutely. The future short rate matters. So what?

"Saying Woodford believes that money is endogenous is like saying the Pope is an athiest."

I actually don't know what you are talking about.

"I see very little similarity between Neo-Keynesians and Post-Keynesians"

I think the Neo-Keynesian analysis has run its course. Without micro-foundations, you are just going to be talking circles. The Post-Keynesians, on the other hand, I have some hope for. While I don't think any of them have a good grip on the economic foundations of their vision, I think their intuition is possibly consistent with a New-Keynesian goods/labour economy + growth model + fat tailed subjective risk (like this producing a risk-free rate on average below the rate of nominal growth. In particular, I think the main difference between Woodford's interpretation of the NK model and the Post-Keynesian "model" is that when he discusses public debt Woodford always assumes that it needs to be paid off in a finite amount of time. The post-Keynesians don't. The difference comes down to your assumptions about the sign of the asymptotic difference between nominal growth and the risk-free rate. I generally side with Woodford (and Nick) on this point, and I tend to think that a low risk free rate is a temporary disequilibrium, but I'm not totally, 100% sure.

"many Neo-Keynesians, like Woodford, believe that monetary policy is still effective in a liquidity trap"

You really have to qualify that. Monetary policy is *not* omnipotent at the ZLB in the NK economy, *even* under full commitment. Optimal stabilization may require significant fiscal policy. This is very different from the MMs, and I think a gross misrepresentation of the NK literature.

"There are a variety of possible targets, not just interest rates."

Like I said, the rate is not usually the target. It's possible (and not totally crazy) to target long term rates and that is in fact the Fed's *third* mandate. But to the extent that they care about this, they are certainly doing a terrible job. I assume they have been targeting inflation.

[Mark A. Sadowski]

Your're just quibbling me on "new": versus "neo". You know you're wrong. I know you're wrong. I suggest you call it a day.

[K]

Mark: You're mistaken, and you're being quite rude. In fact, I wasn't sure whether you knew what "neo" meant but I was quite sure you weren't familiar with Woodford's model. From the seventh line on, my comment is almost entirely about the NK model (the model used by Woodford), the role of money in that model, and the ways in which I disagree with your interpretation of it. Which part of my discussion exactly do you disagree with?

[Philip Pilkington]

"OK, maybe you're smart (not meant as snark). A lot of people don't get that. Joan Robinson was a very smart economist, but she didn't get that point. She thought that the German hyperinflation could not have been caused by loose monetary policy, because the Reichsbank set interest rates at a "very high" level, like 20% (a couple of million % below the inflation rate)!"

I've never seen what Robinson said, but I think the Reichsbank was... wait for it... an endogenous variable in the German hyperinflation. It REacted, it didn't act. It began, as Keynes said, as a balance of payments crisis. The Germans printed IN RESPONSE TO foreign loan repayments. The situation began to deteriorate. Finally, the hyperinflation kicked in when the French occupied the Ruhr Valley in response to held up payments. This wiped-out productive capacity which was exacerbated by the German workers going on patriotic strike.

I'll bet what Robinson was trying to argue was that this was not some case of government profligacy gone wrong. I seriously doubt that Robinson, with her skepticism of monetary policy, was saying that by running a 20% interest rate the Reichsbank would counteract the inflation. I'll bet you misread her. She was probably saying that you cannot BLAME the Reichsbank in isolation, there was a bigger picture to be taken into account. "And besides," I'll bet she said, "the Reichsbank tried its best with interest rates given the circumstances."

This kind of argument is VERY important because the Wiemar inflation has a mythic aspect that freezes policymakers dead in their chairs. Just look what's going on around the Bundesbank right now. The reality with the German hyperinflation is that it had little to do with domestic government policy or loose monetary policies. It had to do with geopolitics and a forced squeezing of Germany by those who defeated her in the Great War, especially France.

[Christiaan]

The problem of equilibrium arguments is that in the real economy stuff happens long before any equilibrium is reached. Perhaps if you believe that the time needed to reach the equilibrium is less than 6 weeks some of these things may make some sense. But people who believe this live in a cave and I've no interest in listening to them.

[Philip Pilkington]

@Christiaan

In my opinion equilibrium assumptions are rhetorical devices used to keep a metaphysical worldview intact. You can especially see this when you ask equilibrium theorists when equilibrium will be reached. The more thoughtful among them -- starting with old Marshall -- will tell you that they never think that equilibrium will be reached.

So, why do they keep the assumption? Same reason Plato held fast to his Ideal Forms or Hegel insisted that Reason in the abstract is driving History. It's a metaphysical system. Outdated by nearly 200 years in both the hard and the soft sciences. But morally and emotionally appealing on a certain level -- because it gives the thinker a view based on a Kingdom Come that will one day be reached.

[Nick Rowe]

Philip: by the way, I just Googled "The supply of money is demand determined", and got 1520 hits, only 218 of which were from the last week.

I also got 721 hits for "the money supply is demand determined", only 4 of which are from the past week.

I didn't need to make up that quote! An awful lot of economists have said it. I could have picked any one of them, but why pick on one?

[Nick Rowe]

Christiaan: Exactly! I think it depends on the context. When the central bank changes the interest rate target, stock and bond prices may change very quickly (if it was unexpected). But yes, the sort of reactions we would expect to see in stocks of money, bank loans, investment, output, employment, and inflation, are mostly going to take a lot longer than 6 weeks. And that's what matters in this context, so I agree with you.

Thinking in ISLM terms, for example, it's going to take a lot longer than 6 weeks to get to the new point on the IS curve. (I would also say it takes a lot longer than 6 weeks to get onto the new LM curve, but that's just my heterodox hot potato perspective.)

[Nathan Tankus]

@Nick true. I have seen the phrase before and didn't think you were wrong in bringing it up. It should be noted though, you're analyzing the statement using Orthodox conceptions of both supply and demand. This doesn't mean that you are necessarily wrong, it just means more digging needs to be done to see what respective authors mean. Neoclassical arguments could easily be dismissed as non-sense by a Classical Political economist working under different definitions and conceptions of supply and demand.

[Philip Pilkington]

@ Nick Rowe

Neither Keen nor Fulwiller said it. Many of the people quoting seem to be critics. One or two aren't -- I see Rochon in there. However, neither of the two involved in the debate said it. It wasn't a direct quote.

And besides, what I said about semantic argument being a practice of intellectual 'bad faith' (in the legal sense of the term) still holds. It's just too easy to pick away at someone's language. Lawyers are good at it. So are their predecessors: the Greek sophists.

Scholars should aim at the substance of the argument, not a linguistic expression of it given at a certain moment in historical time. Again, the Greeks knew this -- which is why they distanced themselves from the sophists.

[Kevin Donoghue]

The 20% interest rate mentioned by Joan Robinson was a per diem rate, i.e. not so low at all.

[Kevin Donoghue]

From Joan Robinson’s review of The Economics of Inflation by Bresciani-Turroni:

“In his Conclusion the author claims no more than that an
increase in the quantity of money is a necessary condition for
inflation. A clear grasp of the distinction between a necessary and
a sufficient condition seems to be all that is required to settle the
controversy. It is true that a train cannot move when the brake
is on, but it would be foolish to say that the cause of motion in
a train is that the brake is removed. It is no less, but no more,
sensible to say that an increase in the quantity of money is the
cause of inflation. The analogy can be pressed further. If the
engine is powerful and is working at full steam, application of
the brake may fail to bring the train to rest. Similarly, once an
expectation of rising prices has been set up, a mere refusal to
increase the quantity of money may be insufficient to curb
activity.”

Now and then Joan Robinson wrote some wild things, but this has always seemed rather sensible to me.

[Nick Rowe]

Nathan: thanks. Yep. But part of what I have been trying to do in these posts is to convey what both sides might mean, and look at the conditions under which each would make sense. Of course, I'm coming at it from my own angle, and others might disagree with my interpretation.

Philip:

1. I don't think I mentioned Steve Keen or Scott Fulwiller in any of these 3 posts. The view I am criticising is *much* more widely held than any pair of "heterodox" economists. Actually, I would say that "the stock of money is demand-determined at the CBs' interest rate" is the orthodox position, that most New Keynesian macroeconomists (they are the new orthodoxy) hold some version of. I have heard something very similar from Bank of Canada people. In this context, it's *me* who is the heterodox economist!

2. If I had stopped at a merely semantic argument, you *might* have a point. But you know very well I didn't stop there. I re-phrased the view I was attacking so that it was semantically correct. Then I said why I thought it was substantively wrong.

[Philip Pilkington]

@ Kevin Donoghue

Score! I think I just succeeded in reading Robinson's mind -- from beyond the crypt no less...

Why is it that every time orthodox economists quote the "crazy ramblings" of some Post-Keynesian they turn out to apt criticisms? Personally, as alluded to above, I think that orthodox economists operate under a sort of theological or metaphysical system -- one that insulates them from falsifiability, as UnlearningEcon said over at a recent post -- and because the Post-Keynesians point this out they annoy the orthodox at a primitive level. The end result is that the orthodox are led to pretty much constantly stitch up the Post-Keynesians.

Historians of thought will look back on this, folks. There are eyes not yet born looking on from the future. Watch your step... for posterity's sake.

[Philip Pilkington]

@ Nick Rowe

Semantics could have easily been left out. Come on... It's rhetorical. Pick a badly worded quote and pull it apart. You ever seen that done in a courtroom? Is it done to clarify the issue at hand or to undermine the credibility of the witness?

[Luis Enrique]

the way I read it, Nick's post about demand-determined quantities was about substance, it was about a mistaken way of thinking about monetary economics, omitting the "wants" of the supplier from the story. Plus a rant about a way of phrasing things that gets up his nose. Aren't we all allowed a good rant from time to time?

Philip, if your ineffectual complaints in that thread about phrases not intended as definitions not being good definitions are an example of sophistry, maybe it's not as easy as you think it is.

Also, do any economists that use equilibrium models think equilibrium is ever reached?

I remember more or less my first micro lecture having it explained that in reality supply and demand curves are always shifting around, so to speak, the process by which equilibrium is attained after shifts is not modelled and could be erratic, and all sorts of stuff goes on in the real world that isn't included in the model etc. etc. so we should think of equilibrium models has very highly stylzed attempts to capture the tendencies in the system. In reality we may expect prices to be somewhere in the vicinity of what the model says, so to speak, if the model hasn't excluded anything creating systematic errors, but no more than that.

Or something like that.

Meanwhile I look at computable agent based models, in which the price that would be suggested by a simple equilibrium model forms a "strange attractor" (is that the right term?) which the price in simulation spends its time meandering around. (At least that's what I recall from the Kendrick et al Computable Econ book). That looks to me not so different from using an equilibria model in the knowledge that it's providing a simple point estimate of a less stable variable.

I'm all for the idea that it would be fruitful to pay more attention to out-of-equilibria action and models that don't even have equilbria, but that's a different thing from saying equilbrium models are useless.

oh, and in order to characterise mainstream economists as deluded cultists etc., you are first helping yourself to the conclusion that you are right and they are wrong, second you are being very disparaging towards a heterogeneous bunch of people who (mostly) spend their time trying to understand the economy in good faith as best they can, third you are being very self-aggrandizing. So yeah that might be annoying.

[Nick Rowe]

Philip: have a look at figure one in this (ppt) link, which shows the price level and money supply in German hyperinflation.

[Philip Pilkington]

"Also, do any economists that use equilibrium models think equilibrium is ever reached?"

Alfred Marshall, who pioneered them, never thought equilibrium would be reached. The cleverer equilibrium theorists I speak with agree.

"I'm all for the idea that it would be fruitful to pay more attention to out-of-equilibria action and models that don't even have equilbria, but that's a different thing from saying equilbrium models are useless."

Great. Jump on board. Economists have been doing it for years. All they get is a nod when criticism is voiced openly and a frown when real criticisms are raised based on nonequilibrium about their equilibrium models. It's a vicious cycle.

The fact is that nonequilibrium analysis does render the equilibrium models largely useless. But since mainstream theorists have a lot of intellectual capital tied up they never make the leap. One funeral at a time, as Planck says...

"oh, and in order to characterise mainstream economists as deluded cultists etc., you are first helping yourself to the conclusion that you are right and they are wrong..."

Oh, I'm absolutely right that pretty much ALL other sciences -- hard and soft -- have moved on from that paradigm. I have no doubt in my correctness about that. Personally, that suggests to me that the mainstream economics profession is stuck in an historical paradigm that has long been out of date. Why? I cannot answer that for sure. But, as I said, I think that equilibrium analysis has an emotional appeal. It is ordered and consistent. It gives us tidy narratives about a chaotic world.

But we pay dearly for these narratives. Like the tidy narratives of Genesis or Revelations, they blind us from the truth and lead us to act incorrectly.

"...second you are being very disparaging towards a heterogeneous bunch of people who (mostly) spend their time trying to understand the economy in good faith as best they can, third you are being very self-aggrandizing. So yeah that might be annoying."

I'm sorry. I cannot see any other reason other than an emotional one to cling to a paradigm that is so far out of date. Some say that it has to do with ideology and equilibrium analysis seeks to iron out inconsistencies in capitalism to justify the system. I don't think that's true. Maybe for the Austrians, but not for the mainstream. I think the mainstream just like their tidy narratives.

I will say though, outside the profession people tend to see ECONOMISTS as arrogant and self-aggrandizing. Many I speak to see them as priest-like characters who make proclamations that are usually wrong and yet they continue to hold their social positions. I think the reason this is is because professors hand bad economists equilibrium models. These students then go on to work for governments and newspapers. Lacking the flexibility of mind that their professor might have, they then use their models rigidly and use it to justify a crude picture of the world that would, indeed, put your average parish priest to shame.

So, as for arrogance. It's all in the eyes of the beholder as far as I can see. I tend to think the non-economists I speak to are correct. Which is why I don't get on with economists so well, I guess.

[Luis Enrique]

that's a tidy narrative about mainstream economics you have there

[Luis Enrique]

I'd be interested to know who these less clever equilibrium theorists are who think equilibrium is ever reached.

[Philip Pilkington]

@ Nick Rowe

Effect. Not cause. Just like Robinson's 'train brake' analogy says. I lay out the causes of the Wiemar hyperinflation -- which were well-known at the time -- in my above comment.

The situation was similar in Zimbabwe. The hyperinflation can be seen in the expanded money supply. BUT the underlying CAUSE was that the Mugabe government redistributed land to peasants who were so badly educated that they couldn't work it. This led to a wiping-out or productive capacity.

There's a good argument to be made that if the central bank hadn't responded with money printing far more people would have starved. Instead, what the CB did was print. This wiped out wealth and pretty much flattened income distribution. Less people starved as a result.

You see? It ain't all economics. And it certainly ain't all in your models. "There is more on heaven and earth than is dreamt of in your philosophy, Horatio!"

[Philip Pilkington]

"I'd be interested to know who these less clever equilibrium theorists are who think equilibrium is ever reached."

Go read the WSJ or the Washington Post. You'll find them there. They're the people who form public opinion. I guess coming from a journalistic background I'm more sensitive to this.

That sort of stodgy reasoning is also at top policymaking levels. Do you know how many people I have to put up with in Ireland telling me that we can become 'competitive' through 'internal devaluations'? Academics have no idea of the plague they have unleashed on society. No idea.

[Luis Enrique]

"The hyperinflation can be seen in the expanded money supply. BUT the underlying CAUSE was ... "

er, yes, there's normally an underlying cause for money printing. Standard accounts of inflation don't exclude that (i.e. financing a fiscal deficit)

"There's a good argument to be made that if the central bank hadn't responded ..."

fine. that doesn't confute the idea that the central bank's response also caused inflation.

[W. Peden]

Philip Pilkington,

"Which is why I don't get on with economists so well, I guess."

There's no reason to assume that that is the reason. I know lots of people who are very critical of economists and find it quite easy to get on with them.

[Philip Pilkington]

@ W. Peden

I jest. I get on with economists just fine. But many paint me as a loon, intellectually speaking. Just like Krugman did with Keen. Usually through misrepresentation -- which is the fate of all Post-Keynesians.

"Did you know that he thinks the Zimbabwean central bank was RIGHT to print all that money..."

"No, but what I meant was..."

"A Chartalist too, no less. Hey Phil, why didn't they just raise taxes in Zimbabwe to create demand for the currency? Ha!"

"Yeah, screw this. Let's just talk about something else..."

[Luis Enrique]

"Go read the WSJ or the Washington Post. You'll find them there."

can this be the same Philip Pilkington who objected to Nick attributing a line about demand-determined money supply to an unspecified collection of people?

[Philip Pilkington]

@ Luis Enrique

I'd say that's pretty specific. Dean Baker calls them out for their nonsense on his blog day-in day-out. The commentariat generally. I rarely see anyone in the MSM make any economic sense. And all their crap is evidently based on some fantasy of equilibrium that they half-digested in university.

[mdm]

Nick,

Thanks for the reply. I'm liking this smooth talking business, I'll have to try it out for often!

Let me tell you about my old research where I explored this idea....Off topic Nick!

If you have the time, then do share! I may not be able to provide an substantial comments, but I'd be interested nonetheless!

You nihilist you! We have to make some assumptions about something being exogenous!
Well, I don't think it's nihilist, I just think that the way Post Keynesians use the word 'exogenous' is in the sense that the target interest rate is at the discretion of the central bank. If you want to assume that there's some natural rate of interest, then I can certainly see how the target rate is exogenous (in the model sense), but if you don't make the assumption about some natural rate, then I just don't see how we can talk about the target rate being endogenous. Nonetheless, I really don't have any strong opinions on this either way. If the target rate is endogenous because it is ultimately targeting some economic variables, then fine. If it's because of the existence of some natural rate, then I am skeptical.

What if the target rate was held constant at a set rate say 4%? What would the economic effect be? What about in a world where the natural rate isn't assume to exist?

First and foremost, it shows that the PK story is a partial truth, and not the only way of understanding how central bank "behaviour" (choosing a neutral term) affects the supply of money. There is more than one way to think of central bank "behaviour". And if we ask how a change in (say) the demand for loans affects the stock of money, we don't have to assume the central bank will hold the rate of interest constant when the demand for loans changes, and indeed this is a rather bad assumption to make for an inflation-targeting central bank, because it will almost certainly change the interest rate when the demand for loans increases.

Firstly, I don't know where it was stated that Post Keynesians argue that the target rate will remain fixed. Secondly, if a change in the demand for loans causes an increase in inflation which pushes the inflation outside the central bank's target zone, and if the central bank is concerned about inflation, and if it believes that a change in its target rate will alleviate the pressure, then yes the central bank will change its target rate. I'm failing to see how this is anyway inconsistent with Post Keynesian theory?

I think it now sounds false, doesn't it. Because if we read "supply function" as an *inverse* supply function (price as a function of quantity, rather than quantity as a function of price), so it means the interest rate charged on reserves as a function of the quantity of reserves, I think most PK's would say the interest rate on reserves matters.

I should have been clearer in my post. The price at which the banks can obtain reserves matters, but not the current quantity on their balances sheets or in the banking system. It will just affect the profitability of the loan, and the net spread between costs of obtaining funds and the return on the asset.

Let me modify it again:

"In their model banks are influenced by the supply of reserves, as well as by capital, credit worthy borrowers and profitability of potential borrowers."

Now it's sounding awfully close to a slightly watered down version of the textbook money multiplier story.

The textbook model argues that a change in the monetary base leads to a change in the potential amount of bank credit that can be created. It assumes that 1. banks are required to have reserves before they can lend, 2. assuming (1) it argues that reserve requirements instantaneously apply to all specific liabilities, as opposed to the lagged reserve requirement account practiced in the real world. 3. assuming (1) that the central bank can set the quantity of reserves in the system.

Assuming a non-corridor system, if the central bank one day decided to increase the monetary base, and if this monetary base exceeded the amount of reserves that the banking system was willing to hold, then it would cause the overnight rate to drop to near zero. So the textbook story is a non-starter.

Now perhaps the money multiplier story can be interpreted with the opposite causal process. The story would be that, an increase in reserves above the excess rate causes the overnight rate to drop to zero, this causes an increase in demand for bank credit by credit worthy customers, the banking system accommodates the demand from credit worthy customers, and the quantity of bank credit expands. But where exactly does it specify that it works via changes in price?

In other blog you said:
We would say that natural rate of interest is a market rate, and that the central bank cannot set the interest rate where it likes, without reference to the natural rate, without destroying the monetary system through hyperinflation or deflation.

Apart from the obvious empirical difficulties with identifying what the natural rate is and identifying if it actually exists, I have another question: Does the natural rate of interest exist in all economic systems across time and space?

BTW, I'm tired. So hope what I wrote makes sense! Thanks for your time.

[Nick Rowe]

My totally off the top of my head "theory" of the Zimbabwe inflation:

1. Mugabe did things that reduced real output (say by half).

2. The fall in real output reduced the demand for money (say by half).

3. That fall in the demand for money caused the price level to increase (say by doubling). No big deal, given what comes next.

4. Much more importantly, the fall in real output caused (real) tax revenues to fall (say by half).

5. Mugabe didn't have enough tax revenue to pay his supporters, and nobody would lend him money, so he had to print it. Assuming (say) a 10% currency/GDP ratio, and a deficit of (say) 10% of GDP, the stock of currency would have to double every year. By itself, that causes 100% inflation per year, permanently.

6. 100% inflation starts to reduce the demand for money, so inflation accelerates, and the currency/GDP ratio falls, so money growth has to increase still more to pay the soldiers.

7. Mugabe is now on the wrong side of the inflation tax Laffer curve, so it spirals out of control.

8. Hyperinflation.

[Philip Pilkington]

@ Nick Rowe

I think there's a tendency to attribute to much nefariousness to Mugabe on this one -- and I think you fall for it there. It all stems from the idea -- almost Freudian in origin -- that people have in their heads about irresponsible kings debasing currency for their own dodgy ends. It's nice to think that some greedy, power-hungry aristocrat is at the heart of all debasements of the currency. But its usually not true. (Although sometimes it is -- my reading of the Argentinean hyperinflation is that it was largely due to military spending by the junta).

Bill Mitchell researched the Zimbabwe case and it appears to have been a case of rabid anti-colonialism gone terribly wrong:

http://bilbo.economicoutlook.net/blog/?p=3773

After the land grab Mugabe destroyed far more than 50% of productive capacity. Mitchell says:

"From an economic perspective though the farm take over and collapse of food production was catastrophic. Unemployment rose to 80 per cent or more and many of those employed scratch around for a part-time living."

45% of the food supply dried up basically overnight. Remember, this is ALL food. We cannot even imagine that in a Western society. People need food to live -- literally. So, you can imagine what happened when the money in supply started chasing that food. You can imagine that speculators started hoarding food. Etc etc.

Then the Reserve Bank of Zimbabwe started using foreign reserves to buy food and stave off a famine. You can guess where that went. Devaluation-pressures go off the charts.

A tragedy. Just a post-colonial tragedy, like so many others in Africa. Frankly, I think that the projections economists in the West make on Zimbabwe are disgusting (using it to show what happens when we live beyond our means etc.) and some are even bordering on racist. But anyway...

[Nick Rowe]

mdm: what you wrote made a lot of sense. But I may come back to it later.

Just a couple of responses:

"Does the natural rate of interest exist in all economic systems across time and space?"

If I worked at it, and tortured the assumptions enough, I could build a model with no natural rate in which the central bank could set any nominal interest rate it liked, permanently. I wouldn't believe that model. It doesn't seem to be true for Canada. If it were true, I could only explain the fact that inflation has almost exactly averaged the Bank of Canada's 2% target as being the result of sheer fluke.

"Assuming a non-corridor system, if the central bank one day decided to increase the monetary base, and if this monetary base exceeded the amount of reserves that the banking system was willing to hold, then it would cause the overnight rate to drop to near zero. So the textbook story is a non-starter."

Not really. That's where the textbook story would get started. With the overnight rate suddenly dropping to near 0%, commercial banks would want to expand loans and deposits, etc. and the process would continue until the increased demand for the monetary base pushed the overnight rate back up to where they don't want to expand loans and deposits any more.

You don't need required reserve ratios in the textbook story. Actually, they don't really belong in that equation at all. They ought to be replaced with the *desired* reserve ratio (plus the public's desired currency ratio, if it's done properly).

[Philip Pilkington]

"I could only explain the fact that inflation has almost exactly averaged the Bank of Canada's 2% target as being the result of sheer fluke."

Nick, I said this to you before. I suspect that Canada has been able to stick to such a stringent inflation target only due to its high rates of unemployment even in boom times. From both an ethical and a growth perspective I don't think using monetary policy to target a 2% rate is very good policy at all.

You guys would probably be better off letting a little slack. Or, if you're really averse to anything over 2% institute a NAIBER to replace your current (far too high) NAIRU.

And that leads to the theoretical critique: there's no such thing as a 'natural' rate of anything in economics. It's all just constructions based on given policy assumptions.

[K]

Philip Pilkington: "Oh, I'm absolutely right that pretty much ALL other sciences -- hard and soft -- have moved on from that paradigm."

You mean from equilibrium analysis? Condensed matter physics has most definitely not "moved on." Lots of work being done on equilibrium systems, and where that fails "quasi-static equilibrium" analysis is the next best thing before resorting to a full dynamic analysis. The quasi-static approach is very fruitful in cases where some exogenous variables change slower than endogenous ones. In other cases where some variables equilibrate much faster than others the dynamic analysis is restricted to the slow moving variables. But in all cases utmost effort is made to understand the equilibrium state first and to reduce the dynamics to as few variables as possible. Why? Because dynamics is *hard*, sometimes almost impossible.

Similarly in economics, lots is not understood even about equilibrium systems. Yes, it would be desirable to jump directly to the right full dynamic, but to actually make progress in the discipline, there is enormous benefit for developing our understanding of simple, often equilibrium, models, one additional variable at a time.

If you think you know how to go straight to the full dynamic model of everything, good for you. Personally, all I hear from the post-Keynesian crowd is a whole lot of words and very little model (other tribes are guilty of this too). Any self-respecting physicists would accuse you of meaningless post-modern babble. So as far as your plea that we adopt the methods of the other sciences, I wholeheartedly agree. But I think it would find the outcome unpalatable.

[Nick Rowe]

Philip: my *hunch* about Mugabe (based on very little evidence) is that he was riding a tiger. He needed to bribe his supporters to stay in power, which meant he had to do things which harmed the economy and made him unpopular, which meant he needed his supporters even more, just to stay alive, etc. Same story for many dictators.

[Nick Rowe]

Philip: if we look at empirical scattergrams of inflation and unemployment in different countries, it usually looks just like a nasty mess. If anything, I *think* I see a long run Phillips Curve that slopes the wrong way, at least at higher levels of inflation, so that higher inflation is associated with higher unemployment. (But that might not mean causation, of course).

Based on theory and indirect empirical evidence (like cross-section distributions of wage changes etc., plus the recent lower bound on nominal rates) my hunch is that cutting the target below 2% would be unwise. Maybe 3% would be better, or maybe not. I haven't seen a convincing argument, and the Bank of Canada research argues against it. I would prefer an NGDP level path target, but that's a different story.