Why the Fed Should Do More - A Look at Monetary Offset

I have a new article published on Quartz titled on how recent fiscal events have shown the Fed plays still a powerful role in maintaining growth. Thus the interesting question isn't whether the Fed should do more, but rather to ask why the Fed hasn't.

An excerpt:

In its recent minutes, it appears that the US Federal Reserve has been preparing to taper. Yet given the outsize role the Fed has played in supporting the recovery, that would almost certainly be a mistake. Unemployment has been ticking down, yet long-term unemployment is still very high and labor force participation is still low. While the recovery has made progress, it is still not guaranteed, and the Fed’s accommodation will be critical if the economy is to secure the gains it has made. 

The key to understanding the argument is to understand a concept central to economic analysis: the counterfactual. Counterfactuals are alternative histories of what could have been. In military history they are the answers to questions like “What would have happened if Napoleon had won the battle of Waterloo?” In this case, the key counterfactual is “What would have happened to the economy if the Fed hadn’t done quantitative easing?” Throughout this recovery, the federal government has been tightening its belt. Indeed, as MKM Partners chief economist Michael Darda has repeatedly noted, net government outlays have fallen for two consecutive quarters during this recovery, making the recent bout of austerity the biggest since the Korean War demobilization. Had the Fed not offset such a large contraction in spending, the US almost certainly would have been sent into another recession.

This will be my last post here, and I will be continuing to blog back at my home blog, Synthenomics, once the semester is over and things become more settled.

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A History Lesson for Scotland

In Guan's recent post on this blog, "Scotland, sterling and the debt," he notes that Scotland will hold a referendum on independence from the United Kingdom in September 2014. The Scottish Government suggests that an independent Scotland should be in a currency union with the UK. Guan writes:

"There are probably some sound arguments for that: it could take years to join the euro, and much of Scotland’s trade is with rest-of-UK, and vice versa.  

On the other hand, events of recent years have kind of cooled the enthusiasm for currency unions in Europe. It’s not at all clear that it would be a good idea for Scotland to adopt sterling. The UK Government’s position is, sensibly enough, that a currency union would be unworkable without a fiscal and political union, which is kind of absurd when the goal is Scottish independence."

For historical perspective on a potential Sterling Area, we should look back to the Austria-Hungary monetary union of 1867-1918. The monetary union began following the Habsburgs' defeat by Prussia. In "The Logic of Compromise," Marc Flandreau explains that:

"The Austro-Hungarian monetary union was not the result of a monetary marriage but the by-product of a fiscal divorce. Austria and Hungary became in 1867 two sovereign budgetary entities. In the process, they retained a common bank of issue and thus formed a defacto monetary union that would operate until its post-World War I collapse."

A Sterling Area currency union with an independent Scotland would likewise be a product of divorce, not of marriage. An annex to the Scottish Fiscal Commission Working Group's First Report assessing possible currency options for an independent Scotland notes that there are two ways to retain Sterling: through a formal monetary union or through an informal arrangement ("Sterlingisation.") The Scottish Parliament is in favor of the formal monetary union, in which the Bank of England would make monetary policy decisions in consideration of conditions in both Scotland and the rest of the UK.

Scotland's proposed formal monetary union would resemble the set-up in the Austria-Hungary monetary union. At the start of the Compromise, the Austrian National Bank was the sole bank of issue for Austria and Hungary. As Flandreau details, Hungary gained increasing control over the central bank over the years. In 1878 the Bank became the Austro-Hungarian Bank. The Austro-Hungarian Bank inherited its predecessor's balance sheet and became a federal institution, with Managements in both Vienna and Budapest. At least two of the twelve Councillors had to be Hungarian. Over the pre-WWI years, there was "a definite trend in Hungary's formal influence within the common Bank. This trend was also reflected in substantive policies of the Bank...The Austro-Hungarian National Bank transformed itself from being a predominantly Austrian institution in 1867 into being a truly binational institution."

Flandreau explains the political economy behind the transformation at the Austro-Hungarian National Bank:

"Consider a monetary union comprising two parts, a 'large' (Austria) and a 'small' (Hungary) country. The common central bank delivers a range of services that are valuable to both parts, but not equally... If power is proportional to size, the small country has very little control over common decisions. It is bound by the discipline of the union without being able to influence decision-making in a way that would address its own specific interests. Co-operation (that is, participation in the union) is sub-optimal and the small country prefers to quit. Sustained co-operation requires that the large country accepts a decision-making process in which the small country receives a greater voting share than size alone would predict... 

However, it is not clear why the large country should accept this dilution of power. The normal outcome should therefore be secession...[Casella (1992)] shows that if co-operation delivers a number of public goods that are useful to all parts, then the large country may nonetheless accept a reduction of its relative ability to set decisions, since the additional output may compensate for the initial loss."

Flandreau's logic is relevant for a possible Sterling Area. The Fiscal Commission notes that "Over the medium term it may well be in Scotland’s interests to move to an alternative arrangement, should either the performance of the Scottish economy change or the preferences of the people of Scotland change." A "Sterling Area Bank" would have to be acceptable enough to both parts of the Sterling Area to be maintained. In the Austria-Hungary arrangement, Austria had to provide Hungary with considerable incentives to stay on board. Austria was willing to make the necessary concessions because the benefits to Austria of keeping Hungary in the union were sufficiently great. These benefits may have included dynastic and imperial considerations, maintenance of the crown as an international currency, and maintenance of bilateral trade.

According to Flandreau, then, monetary compromises are determined by bargaining power.  It is not clear to me whether the bargaining power dynamics between Scotland and the rest of the UK would be suitable for sustained cooperation. As commenter Absalon says in response to Guan's post, "Scotland would not need the permission of England to continue to use sterling any more than Panama and Ecuador need American permission to use the dollar. Of course, Panama and Ecuador have no say in setting the policies of the Fed." If an independent Scotland wanted some amount of power in a supranational or joint shareholder central bank, it would need enough bargaining power. Bilateral trade is one consideration. Guan describes another attempt to assert bargaining power:

"The argument of the Scottish National Party-led government is that the British pound and the Bank of England (name notwithstanding) are “assets” of the United Kingdom. Assets and liabilities of the United Kingdom should be split up among the constituent countries, and if rest-of-UK refuses to divide the sterling 'asset', then Scotland would refuse to assume its share of the liabilities—the UK national debt."

In Austria-Hungary, Austria was directly responsible for the pre-1867 common debt. Hungary paid an annuity corresponding to a one-third share. (Unlike in the Eurozone, no "stability pact" was signed.) But it took more than just the desire for Hungary to pay its share of the common debt to hold the currency union together. Times were very different during the Austria-Hungary currency union, so there are limits to the lessons that can be drawn. But the union did manage to exist without a formal fiscal union. In many ways, it was beneficial for Hungary. Scotland would like to enjoy similar benefits, but it may not have the necessary bargaining power that Hungary had.

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This is my last post on Not Quite Noahpinion before it reverts to Noahpinion. I really appreciate the opportunity to post here for the past few months and thank you all for reading and commenting. I'll be working on my dissertation and (at least occasionally) posting on my own blog. Keep in touch. 

Happy Thanksgiving!

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Of Course Monetary Policy is an Asset Swap -- But that Doesn't Make it Any Less Useful

Nobel Laureate Eugene Fama made waves in the past few days when he called QE a "neutral event". Fama argued that because QE was just the exchange of one kind of interest bearing asset (money that collects IOER) for another (long term treasuries and agency MBS), the policy could have no effect. In my view, his comments were mistaken because they focused on microeconomic intuition and thus ignored the macroeconomic effects of monetary policy.

Fama's main argument was that monetary policy changed character at the zero lower bound. Starting in 2008, the Federal Reserve started paying interest on excess reserves. Once the Fed started to pay IOER, excess reserves held by banks became interest bearing assets. As a result, now when the Fed conducts QE, all it is really doing is taking the private sector's long term bonds and assets and exchanging them for short term (interest bearing) cash. So no new currency makes it into the economy, and as such QE can have no effect.

The set up is correct, but not the conclusion. By ignoring the role of expectations at the zero lower bound, Fama glosses over the real reason why QE matters. Scott Sumner explained this a few weeks ago:

So QE works for very simple reasons. Permanent monetary injections are effective even at the zero bound. QE programs are a signal that central banks would prefer at least slightly faster nominal GDP growth. Slightly faster nominal GDP growth requires that at least a small portion of the currency injection be permanent. So by signaling a preference for slightly faster nominal GDP growth, central banks are implicitly signaling a preference to have at least a small portion of the QE program be permanent (for any given IOR rate). Markets believe the central banks (and why shouldn’t they?) And hence asset prices react to the QE program.

In short, QE is effective because it changes expectations about the future monetary base. Since QE signals an increase in the monetary base in this period and all future periods, it raises expectations about future nominal income and therefore boosts the economy now. Since the short term rate will not be below the interest paid on reserves forever, then the injection of currency has a positive effect on the future price level. This is not a story of wealth effects from appreciating financial assets or a reach for yield due to lower average bond duration. It's not a story of people borrowing as the result of lower interest rates. It's just a simple tale of price expectations and forward looking monetary policy.

Another peculiar argument Fama made was that the Fed's current policy should actually be raising short term interest rates. Because the Fed is introducing more short term debt (in the form of cash) on the market, then short term rates should rise. Analogously, because the Fed is buying up so much long term debt, then the long term rates should fall.

But this misses the underlying macro context. Because the purchase of assets represents a signal about a desired monetary outcome, the result of this "asset swap" is not as neutral as Fama would believe. Moreover, because the Fed has made a commitment to keeping the Fed Funds rate low for an extended period of time, the short rate will not rise. Instead, by expanding the money supply, the Fed keeps short rate low.

Now, if I were a single market participant, the situation would be different. If I individually decided to sell short term debt to buy long term debt, then with sufficiently large quantities I could raise the short term rate and lower the long term rate. But since the Fed controls the printing presses and has the power to pin down the short term rate, this logic does not apply. Instead, if rates did rise, the Fed could just purchase more T-Bills. Even though QE introduces more short term assets into the system, it does not raise the short end of the yield curve.

Furthermore, Fed's purchases of long term treasuries are supposed to raise long rates, not lower them. Since the the long term rate goes up with higher NGDP expectations, then Fed purchases of long term bonds should raise long term rates. And as Michael Darda has repeatedly shown, rates rose during every period of QE. This is just another example of how microeconomic intuition can fail catastrophically in the world of macro. Because Fed purchases have macro level effects on inflation and economic growth, the Fed can actually buy more of an asset and have the price of it go down.

Source: FRED, MKM Partners

If all this seems counter-intuitive, do not blame yourself. Instead, the blame should go to our obsession with interest rates in models of monetary policy. Because monetary policy has historically been implemented through changes in the Fed Funds rate, people have equated monetary policy with interest rate policy. But in truth, interest rates should be seen as reflections of the money supply. So when we say that the Fed is cutting short term rates, what we really mean is that the Fed is expanding the money supply, and as a result, short term rates are falling.

Thinking in these terms will make sure you don't forget about the macroeconomic side of monetary policy. If Fama had said, "IOER means the Fed's printing of money to buy long term bonds has no effect on long term rates and actually raises short term rates", it would have been immediately clear something was off. Why would printing money have an effect on short term rates given that new mass of money can be used to buy T-Bills? Money immediately evokes macro intuition, whereas interest rates focus on micro intuition. As such, focusing on money allows you to guard against simple mistakes.

Thinking in terms of money also makes sure you don't mix causality. Ronald McKinnon argued in a recent WSJ opinion piece that the Fed should raise interest rates will stimulate banks to start lending. If you translate his statement about interest rates into money, it would read "contract the money supply so banks start lending". The first statement appeals to microeconomics, and seems sensible. But even a little thought about the second statement in terms of money immediately reveals the mistake. To stimulate lending, rates will need to fall as the money supply expands. But over time, when interest rates rise, it will be because of the monetary expansion boosting inflation.

Monetary theory is peculiar because it contradicts a lot of basic microeconomic and intuitions. As such, you often see very smart people (Nobel prize winners included) make smart-sounding arguments that are ultimately false. So for as much as I respect the work Professor Fama has done in the field of empirical finance, I disagree with his description of QE. It's not some neutral event, and to think so distracts from the urgent task of monetary reform.
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DeLong offers his comments here.

Edit: 10/31 -- Added QE and long term rates graph from Michael Darda

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Low Interest Rates, Savers, and the Recovery

This is a brief addendum to my recent post, "Do Savers Need to be Saved?"

Back in March, I wrote about Paul Krugman and Charles Plosser's takes on near-zero nominal interest rates and household saving. Both noted that households were deleveraging and the zero lower bound was binding. Both agreed about Krugman's diagnosis of a "persistent shortfall in aggregate demand that can’t be cured using ordinary monetary policy." But their suggested cures were quite different.

I just came across a piece written in May by Raghuram Rajan, new Governor of the Reserve Bank of India, called "Central Bankers under Siege," that takes on the same issue. He, too, makes a similar diagnosis but suggests different cures. In my post on savers and low interest rates, I discussed the income and substitution effects of low interest rates, and mentioned that near-retirees are commonly cited as examples of people for whom the income effect dominates. Rajan actually uses this exact example:

"First, while low rates might encourage spending if credit were easy, it is not at all clear that traditional savers today would go out and spend. Think of the soon-to-retire office worker. She saved because she wanted enough money to retire. Given the terrible returns on savings since 2007, the prospect of continuing low interest rates might make her put even more money aside. 

Alternatively, low interest rates could push her (or her pension fund) to buy risky long-maturity bonds. Given that these bonds are already aggressively priced, such a move might thus set her up for a fall when interest rates eventually rise. Indeed, America may well be in the process of adding a pension crisis to the unemployment problem."

Rajan and Plosser match up point for point. Here's Plosser:

"In fact, low interest rates and fiscal stimulus spending that leads to larger government budget deficits may be designed to stimulate aggregate demand or consumption, but they could actually do the opposite. For example, low interest rates encourage households to save even more because the return on their savings is very small...

I have heard from various business contacts that the low interest rate environment is spurring institutional and individual investors to “search for yield.” This may entail taking on more credit risk than these investors are typically comfortable with in a reach for yields that may ultimately be illusive and result in losses they are ill-equipped to handle. Very low yields may also be distorting other investment decisions, inducing firms to undertake long-run investment projects that may prove to be unprofitable in a rising interest rate environment."

Both Rajan and Plosser fear that lower interest rates won't help the economy because either the income effect dominates the substitution effect or because low interest rates will cause "reaching for yield." My fellow Not Quite Noahpinion author John Aziz suggests:

"Savers looking for a larger rate of return should... take their money out of low interest savings accounts and out of the failed financial intermediation industry and invest it into quality economic projects that create jobs and growth. This could involve buying the stock or debt of large companies that wish to expand, or it could involve starting your own business, or investing in a startup or a mixture of these things. The easiest way to return to growth — and thus higher interest rates, and higher returns for things like pension funds — is for today’s savers complaining about low interest rates to turn into tomorrow’s investors seeking out and pouring money into quality projects that increase incomes, create jobs and create products that people desire and want to use."

The question is whether low interest rates have the beneficial effect on investment that Aziz describes, or the harmful reach-for-yield effect. Returning to Plosser, Krugman, and Rajan, it is interesting that the three economists seem to diagnose what is ailing the economy quite similarly (a "persistent shortfall in aggregate demand that can’t be cured using ordinary monetary policy"), but make different prescriptions. First, they differ in their opinions of unconventional monetary policy:

• Plosser: "The first step is to wind down our asset purchases by the end of the year in a gradual and predictable manner. As I said, I see little if any benefit from these purchases, and growing costs. The second step is for the FOMC to commit to its forward guidance on the fed funds rate path, that is, to begin treating the 6.5 percent unemployment rate and the 2.5 percent inflation rate in the guidance as triggers rather than thresholds."
• Krugman: "Unconventional monetary policy is both controversial and an iffy proposition (which doesn’t mean that it shouldn’t be tried)."
• Rajan: "We really don’t know. Given the dubious benefits of still lower real interest rates, placing central-bank credibility at risk would be irresponsible."

They also differ in their general policy prescriptions:

• Plosser wants removal of fiscal-policy-induced uncertainty: "There remains significant uncertainty about the choices that will be made. How much will tax rates rise? How much will government spending be cut? U.S. fiscal policy is clearly on an unsustainable path that must be corrected. Efforts by Congress and the administration at the end of last year reduced some of the near-term uncertainty over personal tax rates. But the impact of the sequester, the debate over the continuing resolution to fund the federal government beyond this month, and the debt ceiling, which will once again become binding in the spring, all have clouded the fiscal policy situation. So, the resultant uncertainty will likely be a drag on near-term growth. In my view, until uncertainty has been resolved, monetary policy accommodation that lowers interest rates is unlikely to stimulate firms to hire and invest."
• Krugman thinks the fiscal multiplier is large, and fiscal retrenchment would be destructive: "the logic for a biggish multiplier and the logic of the crisis itself are very closely linked: times like these, the aftermath of a credit bubble, are precisely when you expect fiscal multipliers to be large. And that in turn says, once again, that fatalism — or worse yet, demands for fiscal retrenchment — in the aftermath of such a bubble are deeply destructive."
• Rajan looks to helping households refinance, and (somehow) improving workforce capabilities: "We cannot ignore high unemployment. Clearly, improving indebted households’ ability to refinance at low current interest rates could help to reduce their debt burden, as would writing off some mortgage debt in cases where falling house prices have left borrowers deep underwater (that is, the outstanding mortgage exceeds the house’s value)... But it is also important to recognize that the path to a sustainable recovery does not lie in restoring irresponsible and unaffordable pre-crisis spending, which had the collateral effect of creating unsustainable jobs in construction and finance... Sensible policy lies in improving the capabilities of the workforce across the country, so that they can get sustainable jobs with steady incomes."

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Four Ways to Answer Economics Questions

I recently came across a saying about the four ways of answering questions according to the Pañha Sutta.

1. There are questions that should be answered categorically [straightforwardly yes, no, this, that].
2. There are questions that should be answered with an analytical answer, defining or redefining the terms. 
3. There are questions that should be answered with a counter-question. 
4. There are questions that should be put aside.

A lot of the questions that economists get asked a lot can be answered in all four ways. I thought it would be fun to play a little "Economics Q&4A." I'll provide a few examples. If you wish, chime in with your own Q&4As in the comments.

Q: Is economics a science?

1. Yes.
2. This depends on exactly how you define science and what you consider to be the bounds and scope of economics. For the most part, economists cannot do controlled laboratory experiments. You can see lots of people's opinions on this question here, and you can read Mark Thoma and Paul Krugman here.
3. Does this really matter? If it were not a science, should we stop trying to do it?
4. **goes back to work**

Q: Is all this quantitative easing going to cause an inflation problem?

1. No.
2. You are probably asking about the Federal Reserve's unconventional monetary policies. For an explanation of why they haven't (and probably won't) cause problematically high inflation, see these posts.
3. What do you mean by inflation problem? Isn't it possible that a bit more inflation would be a good thing? Do you see any signs of an inflation problem? Don't we have bigger problems than inflation?
4. **sighs**

Q: If households have to tighten their belts, shouldn't the government?

1. No.
2. By belt-tightening, I presume you mean reducing the deficit of the federal government. You might have heard President Obama say, in 2010, "Small businesses and families are tightening their belts. Their government should too." But households are different than the government. You can read some bloggers' reactions here and here.
3. Is the government a household?
4. **slumps**

Q: How should I invest my money?

1. Wisely.
2. This depends on your situation and your financial goals. I don't know of any guaranteed get-rich-quick investment schemes. You should probably try to diversify, and not keep all your money under your mattress or in gold. I'm also not an investment adviser, just a young academic economist with no experience, so I'm horribly underqualified to help you with this.
3. How much money do you have? And what are your investment goals? And why are you asking an economics grad student?
4. **shrugs wildly**

Q: Should we go back on the gold standard?

1. No.
2. Here is an excerpt from Barry Eichengreen's answer: 

"Envisioning a statute requiring the Federal Reserve to redeem its notes for fixed amounts of specie is easy, but deciding what that fixed amount should be is hard. Set the price too high and there will be large amounts of gold-backed currency chasing limited supplies of goods and services. The new gold standard will then become an engine of precisely the inflation that its proponents abhor. But set the price too low, and the result will be deflation, which is not exactly a healthy state for an economy...The distributional effects of deflation are no happier than those of inflation.... The populist revolt of the 1880s was stoked by farmers with fixed mortgages who labored under growing debt burdens and financial distress as a result of falling crop prices. Nor is deflation likely to support robust economic growth, as any close observer of the Japanese economy will tell you.... 

And even if we are lucky enough to get it right at the outset, consider what happens subsequently. As the economy grows, the price level will have to fall. The same amount of gold-backed currency has to support a growing volume of transactions, something it can do only if the prices are lower, unless the supply of new gold by the mining industry magically rises at the same rate as the output of other goods and services. If not, prices go down, and real interest rates become higher. Investment becomes more expensive, rendering job creation more difficult all over again. Under a true gold standard, moreover, the Fed would have little ability to act as a lender of last resort to the banking and financial system...Its proponents paint the gold standard as a guarantee of financial stability; in practice, it would be precisely the opposite." 

3. What have you learned from history?

4. **cowers**

Q: When is Noah coming back?

1. In about 3 months.
2. If you mean coming back to the blog, that will be in about 3 months. However, he has never left Twitter. If you mean coming back to the United States, I think that already happened. 
3. What, don't you like us?
4. **checks watch**

Your turn!

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Macroeconomics: The Illustrated Edition

This post is meant to be a short summary of how to think about macroeconomics in terms of general equilibrium. During my conversations with Michael Darda this past summer, it became painfully apparent that clients tend to struggle with how to put money and goods markets together. As a result, I thought I should put together a little piece on my basic approach to thinking through these kinds of "across market" effects, and why it matters for some of the policy debates of our day.

Any macroeconomy can be broken down into two main markets: a real market for current goods and services, and a financial market for claims on future goods and services. For brevity, I will reduce the model for financial assets to the market for money, which, because of money's role as a store of value and medium of exchange, captures the notion of "claims on goods". To simplify further, I take all the markets for goods and reduce them down to one composite market, say, for apples. From this caricature, we can start thinking about how markets fit together.

In normal times, people receive apples and money from the sky in the form of endowments (i.e. their wealth), and they make decisions about how to spend their cash and apple balances. Apples are transacted, bellies are filled, and life is good.

But suddenly, a recession hits. What does this look like? By definition, a recession is when there is a general glut of goods that aren't consumed. In this toy economy, this corresponds to a situation in which some people have apples but choose not to eat them! This may seem peculiar, but remember that the market for apples in this model represents a composite of all goods markets. So it could be the case that while everybody has apples, some want Red Delicious while others are looking for the tartness of Granny Smith. In more formal economic models, this is glibly incorporated by requiring that people do not consume their own endowment and instead trade for consumption. In any case, apples aren't eaten and we have a rotten general glut.

But this seems peculiar -- aren't markets supposed to clear? Not necessarily. Prices don't always adjust instantly, so we can have excess supplies and excess demands. However, economists do have a way to constrain what this non-clearing state looks like. In particular, according to Walras' law, assuming everybody spends all of their wealth, if there are excess supplies (i.e. too much produced) in some markets, then they must add up to excess demands (i.e. too little produced) in other markets. In other words, even if supply does not equal demand in each market, supplies must add up to demands across markets.

The requirement that everybody spends their endowment is crucial. It means that Walras' law doesn't apply just to the market for apples. Not everybody spends all their wealth on apples. Instead, some people may put their wealth into money. But once we include the money market, we do have the condition that everybody spends their endowment, and therefore Walras' law does apply to the entire macroeconomy of apples and money.

This leads to the most important conclusion from general equilibrium theory as related to macroeconomics.

If there is an excess supply of goods, it must be the result of excess demand for money.

The goods market by itself is not enough to generate a recession with a general glut of goods. Only when there is the possibility of excess demand in money markets can recessions actually occur. Therefore the market for money is what gives a macroeconomy its business cycle feel. This is why money is so important for macro -- fluctuations in the money market are the proximate cause for any general fluctuation in the goods market. This is why, as Miles Kimball says, money is the "deep magic" of macro.

While this "apples and money" approach is the canonical presentation of general equilibrium, it is not the only representation. For another interpretation, think about what the financial market really is. Since it represents the entire universe of claims on future goods, finance can be understood as a veil between the present and the future. So instead of focusing on the relationship between goods and financial markets at one point in time, we can cut out the middle man and instead think of general equilibrium as a sequence of goods markets that occur across multiple points in time. In this version, there is no financial market per se, but buying an apple in "tomorrow's goods market" represents buying a financial contract in the canonical model. Therefore, instead of thinking about the markets for goods and money, we can instead think about the markets for goods today and tomorrow.

The same excess supply and demand relationship works in this model. If there is an excess supply of goods today, then it must mean that there's an excess demand for goods tomorrow. So we get a corollary to the first diagnosis of recessions:

If there is an excess supply of goods today, it must be the result of an excess demand for goods tomorrow.

Each of these stories has its own strength. Since the first goods-money model includes actual money, it can help us understand how the price level is determined through monetary neutrality. On the other hand, since general equilibrium is only concerned about relative prices, and since individual dollars are not transacted in the second story, the second story has no "goods/money" relative price -- i.e. the second story cannot pin down an aggregate price level. However, the second story does a better job of being explicit about intertemporal choice. And for now, this intuition about relative prices between the past and the future will be powerful enough that I will focus on this second approach.

In particular, the second approach gives a clear reason why monetary policy solves recessions. Microeconomic intuition will suffice. If we want to reduce excess demand for a good tomorrow, all we need to do is raise its price relative to today. And since the price of an apple tomorrow is just the amount of money I need to save to afford it tomorrow, lowering the rate of interest between today and tomorrow is sufficient to raise the relative price of tomorrow's apple and get me to consume today. Note that this has an analogue in the first "goods/money" story. By lowering the interest rate on financial assets (and expanding the supply of money), this makes financial assets less worthwhile to hold. People then pivot away towards the goods market, and the general glut is consumed.

If recessions are generated by this process, the interest rate story shows why monetary policy can be politically difficult. Monetary policy, in this model, tries to change the relative price of consumption today and tomorrow to resolve the general glut. But this means that just when people most want to save, the interest rate falls and it becomes more expensive to do so! This is part of a more general political problem. Under a price system, the most desired objects are the most expensive. While this may be unpleasant, it's certainly efficient and necessary for avoiding recessions.

Now, one question that arises is why the real rate of interest doesn't automatically equilibrate to solve these excess demand problems. This is actually a very good question, and is the reason why monetary economics is so important. The primary explanation is that the Federal Reserve may not move fast enough to provide enough money to serve as claims on tomorrow's goods, and therefor the real rate spikes when a crisis hits. This is why we invest so many resources into studying monetary economics, because it is the proximate cause of most recessions.

So here we close the loop. From a relatively simple model, we now have a theory of employment (apple recession), interest (relative prices), and money (in the canonical representation).

Now we get to the fun part -- applying this framework to some of the policy debates of the day.

Let's start with monetary policy. By visualizing a macroeconomy through a sequence of markets, it becomes apparent why forward guidance matters. Even if the interest rate for today is zero, future interest rates may not be. Therefore, by promising to hold rates low for an extended period of time, that makes future apples more expensive relative to current apples. Now, the exact adjustment path may not be ideal, but so as long as we lower the interest rate enough to create enough excess supply in the future, we will be able to restore demand today.

Interestingly enough, quantitative easing is not in this picture. The only way to integrate quantitative easing is to think of it as a signal for the future path of rates. This has indeed been found to be a powerful channel through which QE has an effect.

We can also think about fiscal policy in this framework. If a recession is just a sign that there's excess demand for goods tomorrow, then for fiscal policy to work, it must convince people to bring some of their future consumption into the present. The conventional old-Keynesian approach to this (i.e. the Intro macro approach), is to argue that by giving people more transfers today, that makes them want to consume more today, which then directly solves the recession. But the actual mechanism is more subtle, and the efficacy of fiscal policy is entirely determined by its effect on intertemporal choice.

The Ricardian critique of fiscal policy also pops out. Ricardian equivalence, roughly speaking, argues that since consumers will take the future costs of taxation into account, therefore fiscal policy will have little effect. In this model, this future cost of taxation means people don't reduce their excess demand for goods tomorrow. Because they know the government will take away those apples, the agents are trying to save up so as to have enough to eat when tomorrow comes. Therefore the whole Ricardian effects/positive multiplier debate again just comes down to whether fiscal policy is actually effective at changing the patterns of consuming today and tomorrow.

In this context, the Federal Lines of Credit proposal from Miles Kimball makes a lot of sense. By extending lines of credit to those people who need it most, Federal Lines of Credit can persuade people to reduce their demand for goods tomorrow in favor of goods today.

I'm not entirely satisfied with this model. In particular there are the glaring omissions of rigorous foundations for inflation or intertemporal production. However, I do think it does serve as a baseline for understanding why intertemporal choice is so important for understanding macro, and I hope to expand on it in future posts.

Pictures were drawn in Paper 53.


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The above post was cross-posted (with edits) from my personal blog, Synthenomics. I wanted to post it here so that all of our readers could get an idea of how I think about General Equilibrium, as I plan on using it to discuss several other issues in monetary policy. But as it is a cross-post, I have the opportunity to address an interesting issue that Basil brought up in the comments:

It looks to me that if the two models are equivalent, then a rise in demand for money is the same thing as a rise in the demand for future goods/services. 

But that's not (necessarily) the case. Sure, as you note, money is a store of value, but lots of things are stores of value. What makes money unique is its role as medium of exchange/unit of account. Seems like most increases in the demand for money are increases in the demand for the *liquidity* that money provides, not for the store of value service that it provides. 

I think the fact that you can't fit quantitative easing into the second model is telling. It can be explained very simply in the first model: QE is an increase in the supply of money to match the increase in demand, in an attempt to restore equilibrium. 

Recessions (defined as output below potential, not as negative GDP growth) cannot occur in pure barter economies. You need money to disrupt things. A recession can occur in your second interpretation, and there's no money.

In sum, Basil argues that thinking about current and future markets cannot replicate all of the features of money. In particular, the notion of claims on future goods leaves no role for a special "unit of account". While I am sympathetic to this view, I wonder if we can't come incredibly close to a money economy through an interest rate construction.

As Basil points out, the real question is whether the interest rate story matches up with the role of money as a unit of account. Well, the reason money's status as a unit of account matters is because of some kind of nominal stickiness - whether through wages or prices. Therefore money's role as a unit of account means that when you print more of it, you can actually get more real expenditures.

But I would argue that a nominal interest rate captures the same dynamic. In the derivation of the New Keynesian Philips Curve (which you can follow along at home with my notes here), a critical step is that firms set price in order to maximize their profits across expected future price levels. In effect, firms set their price on the basis of how much more expensive the future will be relative to the present.

This maps directly into the interest rate framework. By lowering the interest rate between today and tomorrow, this means the relative price of today should be much higher. But since firms are anchored by the Calvo fairy, this means that firms are stuck at a price lower than what the interest rate would suggest. Since consumption in the present is now too cheap, this increases current aggregate demand and the recession is solved. So even though the interest rate is not a unit of account, it does capture the key reason why being a unit of account matters: nominal stickiness.

Liquidity is also a red herring. Assets become illiquid because they aren't being transacted. But if monetary policy can get current demand for goods and services higher, then these assets will become liquid and there's no more demand for money.

As I mentioned above, I will expand on this framework in later posts. Let me know if you have any suggestions on what I should try to draw next!

Update: As a commentator noted, this model is really just a model of demand side recessions. I do apologize for not making that more clear, as I was not really thinking about the supply side when writing this post. For a more interesting take on the supply side, take a look at Frances Coppola's post.

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