« Principal-agent problems and level-path targeting | Main | Currency is alpha; bonds are beta »


Feed You can follow this conversation by subscribing to the comment feed for this post.

If I understand it correctly then the FTPL suggests that the current price level will be affected by people's expectations about the ability of the govt to finance its deficit in the future. If there is also a CB that credibly commits to the future price level no matter how big future deficits are then this looks like it would seriously undermine the theory as now people' expectations are being set by monetary policy independent of the deficit. If the government and the CB have different ideas about the future price level then you get a mess. But I think its a mess more consistent with the QT than FTPL.

MF: That sounds like the game of Chicken. Will the central bank stick to its monetary policy target, and let the government default on its bonds? Or will the central bank swerve, and bail out the government? What do people expect? If people expect the central bank to bail out the government, but the central bank refuses to swerve, we would see M fall, and the interest rate on nominal bonds rise, because people would expect a sudden burst of inflation coming any time soon when the central bank swerves.

(Sure, the Bank of Canada only "lends" the shares to its favourite charity, but when its favourite charity pays interest on those loans, the Bank of Canada simply hands back that interest, minus its operating costs.)

Except the Bank of Canada sometimes sells those loans to private owners, who don't hand back the interest. Only a permanent monetary injection is analogous to giving away shares.

Alex: but if the Bank of Canada lends to other firms (like banks) and those firms pay interest to the Bank of Canada, the Bank of Canada gives that interest to its favourite charity. So it doesn't matter whether the Bank of Canada lends to the government or to some other firm. The favourite charity gets the seigniorage profits either way.

"Will the central bank stick to its monetary policy target, and let the government default on its bonds?"

If the government has no control over the CB (and can't just run unfunded deficits like in some MMT-type models) then it can only sell bonds but cannot print money so it will have little direct control over the price level. If the CB refuses to inflate away the debt then either higher (ultimately 100% ?) taxes or default will be the only choices for the govt if it wishes to run a big deficit.

In the real world it seems likely that the govt WILL have control over the CB and can fire the current policy makers and replace them with ones who will accommodate the need for a higher price level. I suppose this fact (that its the govt rather than the CB that has real control) does add a bit more credibility to the FTPL (though its still a special form of QT).

Hmm. It is evident from market behaviour in recent years that markets, at any rate, expect that the central bank would act to prevent default. When there is no central bank willing and able to act as buyer-of-last-resort for government debt, markets panic at signs of economic distress - Spain, Italy etc. As we saw in the Eurozone, markets are calmed by restoration (creation?) of the central bank's implied backstop. Therefore the price of government debt ultimately depends on the credibility of the central bank, and FTPL is a monetary phenomenon.

However, the credibility of the central bank is different in deflationary versus inflationary scenarios. The Eurozone is deflationary: the 2012 market panic was due to the prospect of sovereign default due to severe recession and capital flight. A central bank can 100% offset this without losing credibility (if only the powers that be in the Eurozone understood this!). But the credibility of the central bank is at risk in an inflationary scenario. A basket case government is inevitably attended by a basket case central bank (central bankers with sense are likely to be sacked by basket case fiscals), so fiscal profligacy is bound to be monetarily financed. That's what went wrong in Weimar - indeed it is what goes wrong in just about all hyperinflations. And it is what is currently going wrong in Venezuela. The debate about whether or not a central bank can prevent inflation caused by fiscal profligacy is therefore largely academic. In practice it wouldn't get the chance.

So in summary: FTPL and QTM are the same thing applied to different scenarios. In deflationary scenarios, QTM applies (though we might argue about the definition of M, I guess, Nick!): in inflationary scenarios, FTPL does.

MF: Governments can use the "nuclear option" in the last resort. But if that's the only weapon they've got, and they don't want to use it, it may not be a credible threat. That seems to be the outcome of the "Coyne Affair".

The Canadian government signed off on the Bank of Canada's 2% inflation target. And when in 1995 the debt/GDP ratio was large and rising, and seemed to eventually put that 2% inflation target at risk, they backed off and changed the deficit to a surplus.

Frances: I agree with your distinction:

If the risk is deflation (or inflation coming in below the central bank's target) then it would be quite right for the central bank to act as lender of last resort to the government. If the Greece Problem happened in Canada, the BoC would instantly start buying government bonds, and since everyone knows it would do this, the Greece problem wouldn't happen. (Though provincial bonds are more problematic, so we can't rule out a province having a Greece Problem, though history suggests the federal government would step in.)

But if the risk is inflation (or above target inflation), then there is an open question of who would win the game of Chicken.

But even in Zimbabwe FTPL does not really work. The real rate of interest on Zim dollars was very very negative, and was certainly not exogenous with respect to monetary and fiscal policy.

In this context, "M" means "base money", because that's where the government gets its seigniorage profits.

You seem to be getting by OK with regular text, but why not make the investment to do LaTex on typepad? I'm finally going to have to with a (hopefully) big life's achievement (for me) post on understanding Wallace neutrality coming in the not too far future. From what I've seen, it's not that hard to get LaTex into the major blogging platforms.

With my five minutes of free time per week, I'm first looking into whether I should do the initial LaTex document on Scientific WorkPlace, like in the past, or one of the new ones, like LyX -- maybe better WYSIWYG.

But really, if you could do these kinds of posts in LaTex, it might make them a lot easier to read and understand. They'd certainly look a lot nicer. See the posts of Dieter Vollrath at the Growth Economics Blog, for example:


It is very clear that when a corporation issues stock, it is dividing up the property owned by the company into more parts.

When the company issues more stock and gives the new stock to new owners, the property of the company is now spread over more shares AND more owners. The company has given away a portion of the property owned by pre-gift owners.

When the central bank increases the nation's supply of money and government bonds, it seems to me that the identical dilution effect occurs.


I’m guessing that the section in Cochrane’s paper entitled “cash” did not exactly warm the cockles of your heart. The “degenerate” aspect then is effectively the deliberate decision to set aside cash (i.e. currency) in the model?

“But if it isn't, we can't. And it isn't.”

Although he does allow for some flexibility for what determines what in the short run doesn’t he – i.e. monetary policy under sticky rates?

I used the “find” function to see where the word “growth” appeared in his paper. Every time it’s only in connection with the consumption function. I guess that’s also an important point of contrast between the two methods.

Also, could you get around this just by declaring that money is not debt?

And that surpluses aren’t required to repay money?

And since the CB’s balance sheet position in B is used to adjust the quantity of M (currency is supplied through OMO, in final effect), the amount of debt held by the market always comes out in the wash and always reflects the demand for money, and that’s what fits into the FTPL valuation.

Yes, the FTPL needs a money demand function, but the versions of it that don't assume liquidity satiation have one, no? Don't they just assume that whatever the elasticities in the demand for money, the CB acts in such as way that the fiscal authority's price level target (or the target embedded in its perceived reaction function) is effectuated? That is, they passively supply the money needed such that the present value of future convenience yields does not change. So the money demand function then determines the mix between money and bonds but the price level is still a function of current and expect fiscal policy?

Richard: you are right, of course. But decades ago I sort of learned Latex (or something), and found it very hard and stressful, and forgot it again soon after. I don't think I can do it. But I wish you the best with it.

Roger: I think that's right. But, as I show in the post, it would also be right even if there were no assets that the holders of money could lay claim to.

JKH: your comment is to blame for my delay in responding to these comments! I started thinking about currency. After all, the stock of currency is so much smaller than the stock of bonds, most of the time. So is it so bad to ignore currency altogether, and think about just bonds? And then I remembered that BoC currency is the alpha money. And then I realised that bonds are beta. So I wrote a whole post, just for you!

dlr: I haven't seen a version of FTPL that has a money demand function. But possibly I just haven't read enough. And if they do have a money demand function, what distinguishes FTPL from modern quantity theory, which says that expected future money supplies matter too? The way I see it, the Bank of Canada targets 2% inflation, that plus the currency demand function determines the stream of seigniorage revenues (which is around 0.25% of GDP), and the fiscal authority sets taxes and expenditures in line with that seigniorage stream.


Alex: but if the Bank of Canada lends to other firms (like banks) and those firms pay interest to the Bank of Canada, the Bank of Canada gives that interest to its favourite charity. So it doesn't matter whether the Bank of Canada lends to the government or to some other firm. The favourite charity gets the seigniorage profits either way.

The final destination of seignorage profits isn't the part I was objecting to. It's the equivocation between "giving away" shares and "lending" them. There is a key difference, viz. that merely lending the shares is reversible (because the BoC can always sell the loan to buy the shares back) but giving the shares away is irreversible.

In the case of ordinary shares these would absolutely have different influences on the share price - if MSFT issued a bunch of shares to the government in return for bonds, to a first approximation share price would be unchanged. If MSFT issues the same number of shares to the government in return for nothing at all, share price would fall.

I thought a conventional money demand function was actually standard in the FTPL lit except that it falls out of the cashless models, so maybe I am misunderstanding what you're saying. It is just irrelevant to price level selection because the Fiscal Authority is the equilibrium selector, i.e. acts last. So the quantity of money is endogenous (determined by the money demand function and the exogenous Fiscal Reaction Function) and looks like a necessary part of any price level equation, yet it is not causal because the Fiscal Authority will adjust the PV of future surpluses or B to offset however the money demand elasticities would have affected the price level in the counterfactual. The result is a formula where the money demand function and quantity of money seem to matter but don't.

Revert to money-as-stock, think of Amazon.com, and imagine that thanks to Bezos Amazon's profits are voluntarily below their Laffer curve and so Amazon is choosing its own asset value according to what Bezos thinks is a fair distribution between shareholders and martians. Now let's also say that Amazon has special Bling characteristics where people like to say they own Amazon, so will accept lower returns from it. We don't necessarily need to know the Bling demand function if we accept that Bezos acts last and will adjust Amazon's profits downwards (upwards) for every unit of increased (decreased) Bling value. The end result is an iteration where Bling value seems important but isn't.

Sims: What was really new about the FTPL compared to standard theory is that it insists that the government budget constraint, in economies where large amounts of nominal interest-bearing debt are issued, has to be treated as one of the central equations determining equilibrium and determining the price level. Once you realize that, you realize that there is a kind of a simple connection between outstanding nominal interest-bearing liabilities, taxes and the price level that's comparable to the simple connection between outstanding money balances, demand for money and the price level.
These relationships are both true. That is, it is true that in equilibrium, the total nominal value of the debt, the total real value of interest-bearing debt, has to match expectations of future tax backing for that debt. And that's true in any model.
And then at the same time, it's true, of course, that in equilibrium the real balances held by the public have to match the demand for those real balances. It can be helpful, depending on the circumstances and as a crude first approximation, to think of the price level as being determined by the ratio of the nominal quantity of money to the real demand for money. Or it can be useful to think of the price level as being the ratio of the nominal value of interest-bearing debt outstanding to the tax backing for that debt. It's hard for people who get used to thinking about it in one simple way or another to realize that in equilibrium both these ways of thinking about it are correct.

Rolnick: Do they lead you to different policy prescriptions?

Sims: They can, because, for one thing, once you recognize that the fiscal balance has to be treated symmetrically and is equally as important as the money supply demand relationship, there are several examples of ways this can be important. For one thing, there's a class of equilibria for the economy that are invisible—that you don't realize exist—if you focus entirely on money demand. These are equilibria in which the monetary authority is completely passive, simply picks a nominal interest rate or in some other way agrees to accommodate any amount of debt issue by monetizing it.
In conventional models that kind of monetary policy leads to an indeterminate price level. But in a model in which the fiscal authority is committed to a fixed level of primary surpluses, there is a unique price level. That kind of situation, where the fiscal authority's primary surpluses can be treated as a given, is actually quite realistic in many economies, particularly some of the intermediate-income economies like Latin American economies. When an economy's fiscal effort level is at a politically feasible maximum, so you really cannot increase taxes, treating the primary surplus as a given makes sense. And when that's true, policy prescriptions that act as if by controlling the money stock you can end inflationary pressures are just mistaken.
In Brazil, for example, monetary authorities are very aware of the fact that interest rate changes have large direct impacts on the fiscal balance because so much of their fiscal expenditures are interest expenditures. Once that happens, the monetary authority is thinking about fiscal issues in setting monetary policy all the time. And it's easy to have a conceptual understanding of why that's important and where it comes from if you've thought about a model in which the fiscal balance is given as much importance as the money balance.

Rolnick: Did the Tom Sargent and Neil Wallace 1981 article "Some Unpleasant Monetarist Arithmetic" precede much of this?

Sims: That paper got one side of the fiscal theory of the price level. It recognized that—and this has been a theme of much of Sargent's work—if you have a fiscal imbalance that the monetary authority can't do anything about, then that can completely disrupt the ability of the monetary authority to control the price level.
What that paper didn't get was the other side, which is that a commitment to a positive fiscal primary surplus can produce a unique equilibrium price level even in the face of a passive monetary policy. That side of the fiscal theory wasn't in "Unpleasant Monetarist Arithmetic."
That's important for a different kind of policy issue. As means of payment get diversified with technological advancement, electronic payments and so on, paper money becomes less important, and if you're thinking entirely in terms of monetary quantities as the way the price level gets stabilized, it may seem that this will create unstable money demand, and it might get very hard to set the price level. But if you're thinking of it in a fiscal theory framework, in an economy with lots of outstanding nominal debt, there's no great problem in keeping price levels stable, even if paper money (noninterest-bearing liabilities) becomes an unimportant part of government debt—which of course hasn't really happened yet.

Chris Sims interview.


Fiscal Aspects of Central Bank Independence


"But sensible countries don't do that; the central bank is reasonably independent and will never need to swerve."

Because inflation is on target... everywhere?

"so FTPL still doesn't work even in silly countries."

What does that mean? It doesn't work? What work does the QTM do?

"We call these results the "Quantity Theory of Money Shares","

If 5% more shares are issued without getting any new assets in return, then both the quantity theory and the backing theory say that shares will lose 5% of their value.

The interesting case is where the 5% new shares are issued in exchange for 5% new assets. In that case the backing theory says the shares will hold their value, and the quantity theory says the shares will lose 5% of their value

The interesting case is where the 5% new shares are issued in exchange for 5% new assets. In that case the backing theory says the shares will hold their value, and the quantity theory says the shares will lose 5% of their value

Claim: depending on the asset, a more sophisticated (and correct) quantity theory should predict those shares will lose less than 5% of their value. This is because some assets are so liquid and stable that they are used in a money-like fashion by the financial system, and removing them from the system partially offsets the effect of increasing the regular monetary base.


Wouldn't that effect be the same whether the new money was helicopter dropped or issued for equal valued assets?

Mike: no?

Case A: we helicopter drop 5% more money. Price level goes up 5%.

Case B: we print 5% more money and buy MSFT. Price level goes up ~5% [assuming purchase is seen as permanent].

Case C: we print 5% more money and buy Treasurys. Price level goes up less than 5% [even if purchase is seen as permanent] because those Treasurys were providing liquidity to the financial system as collateral, etc. and so them disappearing increases demand for other monies.


> Case B: we print 5% more money and buy MSFT. Price level goes up ~5% [assuming purchase is seen as permanent].

What are we conjecturing happens to the dividend revenue, and eventual proceeds from MSFT liquidation or buyout?


Case A: Yes, since there are now 5% more dollars backed by the same assets as before.
Case B: No. P doesn't move at all. If the central bank used to have assets worth 100 oz of silver backing $100 in federal reserve notes, then $1=1 oz. After the 5% operation, the central bank will have assets worth 105 oz backing $105, so $1 still equals 1 oz.
Case C: Same as B, but note that the supply of dollars is perfectly elastic at 1 oz/$. If those bond liquidity effects you mentioned drove the dollar up to 1.01 oz, then people would eagerly issue $1 in exchange for 1.01 oz, of silver. Conversely, if the liquidity effects drove the dollar down to .99 oz, then nobody would issue dollars, and people would eagerly buy existing dollars for .99 oz.

Majromax: Excellent question!

A question (on thinking about dlr and Miami's comments): suppose FTPL were *always* true for some government. Who would make the first loan? How did B(t)/P(t) ever get to be positive in the first place?

We start with 0 = EPV[St)], assume that EPV[S(t)] is exogenous with respect to B(t)/P. What idiot would make the first loan to such a government, to make B(t+1)/P(t+1) > 0 ???

The whole point of making a loan is that you expect to get paid back.


Maybe the first loan is made to a government that will use it to build a toll road.


Perhaps what Richard means is you should get MathTex support. If you cannot handle MathTex... It would help, and is completely different then writing a document in latex.

I still find it amazing that latex has thoroughly penetrated certain disciplines--electrical engineering, physics, mathematics, astronomy, computer science, statiticians... then you get odd ones like linguistics. If you cannot write a paper using latex, good luck publishing in those fields. Then you have biology... chemistry... social sciences where the norm seems is to submit papers in word. An amazing example of tribalism at work.

Nick, I'm not sure I understand what you're asking with that question, so this answer might be orthogonal. Why can't initial bondholders have implicit ratex of a Samuelson 1958 Ponzi? The Government doesn't even have to lend the initial bonds; they can be helicoptered out and subsequently valued. Solvency and the fiscal reaction function are still central -- it's not all a Ponzi -- but there is simply an added assumption that B =/ 0 is infinitely sustainable. Alternatively, there could be a ratex equilibrium that says that if the Ponzi breaks down and B = 0, the fiscal reaction function would repay B and undertake a massive "monetary" regime change (switch to a gold standard with no B, perhaps).

dlr: I'm not sure I'm answering your question either! But my reading of Samuelson 1958 is that S(t)=0 for all t, and that the demand function for B slopes down and has (B/P) > 0 where r=g.

"But if every year it increases the stock of shares by 5%, and gives those shares to its favourite charity, and is expected to do this forever, the results will be different from the 5% annual stock dividend. The corporation is giving away 5% of its net worth to charity, so EPV[S(t)] falls by 5%, and so M(t)/P(t) falls by 5%. So P(t) jumps up by 10% for the first charitable donation, and then rises by 5% per year thereafter, relative to what it would otherwise have done."

It's funny. I used a very similar example with people in 09/10 as for why holding assets will be much safer than holding money. In my mind, ethically, owners of an asset class should be the recipient of its dilution.
What I really am missing here is why you think under a charitable distribution EPV[S(t)] 'earnings' should fall? The producing assets inside of the company are not what is being given away, just the ownership, therefore EPV[S(t)] should be unnafected. Once again you would have +M(t) and +P(t) offsetting one another. The loser is the original owner who now winds up with the same amount of shares at a lower share price because he did not receive the dilution that would have kept him whole.

In your analogy, it seems that what the charity does with the money it is given (in the form of shares) might effect P(t).

The charity might bury the money in a big hole, which is what your analogy seems to be assuming. The money is taken out of the closed system and disappears.

Or, the charity might spend the money, perhaps by buying goods from the company. This might increase the company's profits, and thus P(t).

Or maybe the charity spends the money at other companies. This might increase the profits of other company's and thereby change investors demand for return rates and decrease P(t) as investors change their investment mix.

A helicopter drop has different effects on the economy depending on the state of the economy. You will not get the same effects for a slack economy (unemployment is high, there is excess capacity for all industries, and there are plenty of available resources) as you will in a tight economy (unemployment is low, industries are running at full capacity, there are few unused resources).

The comments to this entry are closed.

Search this site

  • Google

Blog powered by Typepad