Rules v. Discretion

I gave a talk this afternoon at a panel on the Heritage of Monetary Economics and Macroeconomics at the meetings of the Southern Economic Association in Washington. The panel was brought together to commemorate a confluence of significant anniversaries this year: the 300th anniversary of David Hume’s birth, the 200th anniversary of the publication of the Bullion Report to the British Parliament, the 100th anniversary of the publication of Irving Fisher’s Purchasing Power of Money, the 75th anniversary of the publication of Keynes’s General Theory, and the 50th anniversary of the publication of John Muth’s paper on rational expectations. I spoke about the Bullion Report and the contributions of classical monetary theory. At some point, I may post the entire paper on SSRN, but I thought that the section of my paper on rules versus discretion in monetary policy might be of interest to readers of the blog, so here is an abridged version of that section of my paper.

The Bullion Report, whose 200th anniversary we are observing, is an appropriate point from which to start a discussion of the classical contribution to the perpetual debate over rules versus discretion in the conduct of monetary policy. The Bullion Report contained an extended discussion of several important theoretical issues, but its official purpose was to recommend an early resumption of convertibility (suspended since 1797) of Bank of England banknotes, to make them redeemable again at a fixed parity in terms of gold. In other words, the Bullion Report called for a rapid return to the gold standard, then regarded as a safe and workable rule for the conduct of monetary policy.

Despite the rejection by Parliament of the Report’s recommendation to quickly restore the gold standard, the general argument of the Bullion Report for the gold standard undoubtedly influenced the ultimate decision to restore the gold standard after the Napoleonic Wars. But full restoration of gold standard in 1821 did not produce the promised monetary stability, with ongoing disturbances punctuated by financial crises every 10 years or so, in 1825, 1836, 1847, 1857 and 1866. The result of the early disturbances was the adoption of new rules motivated by the idea that monetary disturbances were symptomatic of the failure of a mixed (gold and paper) currency to fluctuate exactly as a purely metallic currency would have.

These new rules seem to me to have been altogether misguided and pernicious, but their adoption reflected a fear that the simple rule embodying the gold standard, the requirement that banknotes be convertible into gold, would not ensure monetary stability unless supplemented by further rules limiting the creation of banknotes by the banks. The rules had to be tightened and spelled out in increasing detail to effectively limit the discretion of the bankers and prevent them from engaging in the destabilizing behavior that they would otherwise engage in.

Thus, over the course of the nineteenth century, there evolved a conception of the rules of the game governing the behavior of the monetary authorities under gold standard. However, the historical record is far from clear on the extent to which the rules of the game were actually observed. The record of equivocal adherence by the monetary authorities under the gold standard to the rules of the game can be interpreted to mean either that the rules of the game were unworkable or irrelevant — in which case following the rules would have been destabilizing — or that it was the failure to follow the rules of the game that caused the instabilities observed even in the heyday of the international gold standard (1880-1914).

The outbreak of World War I led quickly to the effective suspension of the international gold. The prestige of the gold standard was such that hardly anyone questioned the objective of restoring it after the war.  However, there was an increasing understanding that the assumption that the gold standard was the simplest and most effective arrangement by which to achieve price-level stability was unlikely to be valid in the post-war environment. Ralph Hawtrey and Gustav Cassel were especially emphatic after the war about the deflationary dangers associated with restoring the international gold standard unless measures were taken to reduce the monetary demand for gold as countries went back on the gold standard. As a result, the 1920s literature on monetary policy contain frequent derogatory references by supporters of the orthodox gold standard to supporters of managed money, i.e., to advocates of using monetary policy to stabilize prices rather than accept whatever price level was generated by allowing the gold standard to operate according to the rules of the game.

Advocates of price-level stabilization, especially Hawtrey and Cassel, attributed the Great Depression to a failure to manage the gold standard in a way that prevented a sharp increase in the worldwide monetary demand for gold after France, followed by a number of other countries, rejoined the gold standard in 1928 and began redeeming foreign exchange holdings for gold. It was at just this point that the Federal Reserve, having followed a somewhat accommodative policy since 1925, shifted to a tighter policy in late 1928 out of concern with stock-market speculation supposedly fueling a bubble in stock prices. Supporters of the traditional gold standard blamed the crisis on the “inflationary” policies of the Federal Reserve which prevented the “natural” deflation that would otherwise have started in 1927.

Supporters of the traditional gold standard thought that they were upholding the classical tradition of a monetary policy governed by rules not discretion. But Hawtrey and Cassel were not advocates of unlimited policy discretion; they believed that the gold standard ought to be managed by the leading central banks with an understanding of how their policies jointly would determine the international price level and that they should therefore do what was necessary to avoid the deflation to which the world economy was dangerously susceptible because of the rapidly increasing monetary demand for gold.

The Keynesian Revolution after the Great Depression provided a rationale for not allowing policy rules (e.g., keeping the government’s budget balanced, or keeping an exchange rate or an internal price level constant) to preclude taking fiscal or monetary actions designed to increase employment. Achieving full employment by controlling aggregate spending by manipulating fiscal and monetary instruments became the explicit goal of economic policy for the first time. The gold standard having been effectively discredited, opponents of discretionary policies had to search for an alternative rule in terms of which they could take a principled stand against discretionary Keynesian policies. A natural rule to specify would have been to stabilize a price index, as Irving Fisher had proposed after World War I, with his plan for a compensated dollar based on adjusting the price of gold at which the dollar would be made convertible as necessary to keep the price level constant. But Fisher’s plan was too complicated for laymen to understand, and Milton Friedman, the dominant anti-Keynesian of the 1950s and 1960s, preferred to formulate a monetary rule in terms of the quantity of money, perhaps reflecting the Currency School bias for quantitative rules he inherited from his teacher at Chicago Lloyd Mints. A quantitative rule, Friedman argued, imposes a tighter, more direct, constraint on the actions of the central bank than a price-level rule.

The attempt by the Federal Reserve under Paul Volcker to implement a strict Monetarist control over the growth of the money aggregates proved unsuccessful even though the Fed succeeded in its ultimate goal of reducing inflation. Friedman himself, observing the rapid growth of the monetary aggregates, after inflation had been brought down, predicted that inflation would soon rise again to near double-digit rates. That error marked the end of Monetarism as a serious guide to conducting monetary policy.

However, traditional Keynesian prescriptions were, by then, no longer fashionable either, and we entered a two-decade period in which monetary policy aimed at a gradually declining inflation target, falling from 3.5% in the late 1980s to about 2% at present. The instrument used to achieve the inflation target was the traditional pre-Keynesian instrument of the bank rate. John Taylor suggested a rule for setting the bank rate based on the target inflation rate and the gap between actual and potential output that seemed consistent with the recent behavior of the Fed and other central banks. Everything seemed to be going well, and central banks basked in a glow of general approval and gratitude for achieving what was called the Great Moderation. But, perhaps because the Fed didn’t follow the Taylor rule for a few years after the dot-com bubble and the 9/11 attack, there was a housing bubble and then a recession and then a financial crisis, and we now find ourselves mired in the worst recession – actually a Little Depression — since the Great Depression.

The classical monetary theorists, with very few exceptions, believed in some sort of monetary rule, for the most part, either a simple gold standard governed only by the obligation to maintain convertibility or a gold standard hedged in by a variety of rules specifying the appropriate adjustments. Only a few classical economists had other ideas about a monetary regime, and of these they were also rule-based systems such as bimetallism or some form of a tabular standard. The idea of a purely discretionary regime unconstrained by any rule was generally beyond their comprehension.

The problem, for which we as yet have no solution, is that it is dangerous to formulate a rule governing monetary policy if one doesn’t have a fully adequate model of the economy and of the monetary system for which the rule is supposed to determine policy. Ever since the nineteenth century, monetary reformers have been proposing rules to govern policy whose effects they have grossly misunderstood. The Currency School erroneously believed that monetary and financial crises were caused by the failure of a mixed currency to fluctuate in exactly the same way as a purely metallic currency would have. The attempt to impose such a rule simply aggravated the crises to which any gold standard was naturally subject as a result of more or less random fluctuations in the value of gold. The Great Depression was caused by a misguided attempt to recreate the prewar gold standard without taking into account the effect that restoring the gold standard would have on the value of gold. A Monetarist rule to control the rate of growth of the money supply was nearly impossible to implement, because Monetarists stubbornly believed that the demand for money was extremely stable and almost unaffected by the rate of interest so that a steady rate of growth in the money supply was a necessary and sufficient condition for achieving the maximum degree of macroeconomic stability monetary policy was capable of.

After those failures, it was thought that a policy of inflation targeting would achieve macroeconomic stability. But there are two problems with inflation targeting. First, it calls for a perverse response to supply shocks, adding stimulus when a positive productivity shock speeds economic growth and reduces inflation, and reducing aggregate demand when a negative supply shock reduces economic growth and increases inflation. Thus, in one of the greatest monetary policy mistakes since the Great Depression, the FOMC stubbornly tightened policy for most of 2008, because negative supply shocks were driving up commodities prices, causing fears that inflation expectations would become unanchored. The result was an accelerating downturn in the summer of 2008, producing deflationary expectations that precipitated a financial panic and a crash in asset prices.

Second, even without a specific supply shock, if profit expectations worsen sufficiently, causing equilibrium real short-term interest rates to go negative, the only way to avoid a financial crisis is for the rate of inflation to increase sufficiently to allow the real short term interest rate to drop to the equilibrium level. If inflation doesn’t increase sufficiently to allow the real interest rate to drop to its equilibrium level, the expected rate of return on holding cash will exceed the expected return from holding capital causing a crash in asset prices, just what happened in October 2008.

Some of us are hoping that targeting nominal GDP may be an improvement over the rules that have been followed to date.  But the historical record, at any rate, does not offer much comfort to anyone who believes that adopting a following a simple rule is the answer to our monetary ills.

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22 Responses to “Rules v. Discretion”


  1. 1 Luis H Arroyo November 22, 2011 at 2:42 am

    Explendid, David, and I agree totally with
    “But the historical record, at any rate, does not offer much comfort to anyone who believes that adopting a following a simple rule is the answer to our monetary ills.”
    More, If you read the last Minutes of Riksbank of Sweden, teh discussion between Sevensson & the rest is a test of the non sense of one precise objective.

  2. 2 Luis H Arroyo November 22, 2011 at 2:46 am

    Sorry, Splendid, I meant

  3. 3 Mike Sproul November 22, 2011 at 9:51 am

    “the requirement that banknotes be convertible into gold, would not ensure monetary stability unless supplemented by further rules limiting the creation of banknotes by the banks. ”

    A bank with adequate assets can easily buy the necessary gold to maintain convertibility. A bank with inadequate assets can never buy enough gold to maintain convertibility. Ricardo, Thornton, et. al. did not understand that it’s not a question of limiting creation of bank notes. It’s a question of the issuing bank keeping enough assets to always be able to buy back whatever quantity of notes it has issued. Economists’ misunderstanding of this point has only grown worse since 1811.

  4. 4 W. Peden November 22, 2011 at 10:38 am

    A fantastic blog. I think that the disjunction between rules and discretion, however, is a false one and neither will be optimal. What is most desirable is a rule-governed market-driven monetary system based on free-market banking.

    Re: Friedman and the 1980s, I did some reading up about this period in his career recently, especially the 1983-1985 period when he made a lot of embarassing forecasting mistakes. The key factor seems to have been that he regarded the new M1 (after the revision in the late 1970s) as closer to the old M2 that he had been studying. M1 saw then-record growth during that period. However, the new M2 was closer to the old M2 than the new M1, and as a general point of monetary theory an increase in a narrow money aggregate can be simply due to movements into that aggregate from a broader aggregate like M2.

    Had Friedman stuck to M2, he would have predicted a fall in inflation in the early 1980s, followed by a return to potential output in 1984 and a steady moderation of inflation in the late 1980s, i.e. his forecasting would have been very accurate. It’s fortunate that monetarism WAS discredited in the US in that period, however, since otherwise policy in the early 1990s would have been too stimulative.

    Also of possible interest was that Friedman attributed the increase in money demand in the 1980s to the rise in real interest rates.

    While I think that old monetarism has an unfairly bad reputation today, one problem that people in the US rarely bring up (and this is a problem for any monetary policy that involves looking at all at monetary aggregates) is that the US doesn’t have a really good broad aggregate that (a) excludes non-bank financial corporations that have banks as customers and (b) includes large time deposits. M3 has the benefit of including the entire time deposit market, but includes a lot of weird stuff (like repurchase agreements and banks’ deposits). M2 excludes large time deposits and includes financial sector money market accounts.

    Something like the UK’s adjusted M4 would be really useful for understanding what is going on in the US. As it is, beyond the TIPS spread, every indicator seems to be very flawed.

  5. 5 Steve November 22, 2011 at 1:51 pm

    David,

    This is a great post. I’m printing it out and saving it.

    I think the rules vs. discretion debate is very interesting. Certain folks like John Taylor and the Bundesbank are on the side of absolute inviolable rules, despite the extreme dangers posed in unexpected situations.

    However, I think this is an area when monetary policy makers need to expand their minds beyond empiricist ideology. Monetary authorities are ultimately social institutions, not scientific ones. The legal system allows wide discretion to judges. The Bill of Rights was written vaguely ON PURPOSE, so that it could be subject to interpretation in the future. These systems endure BECAUSE they allow discretion, not despite it. My opinion is that monetary authorities will also endure only if they allow reasonable discretion around shocks. Otherwise they and their rigid rules will perish as relics of narrow periods of history.

  6. 6 Peter K. November 22, 2011 at 2:54 pm

    “the FOMC stubbornly tightened policy for most of 2008, ”

    I’m confused, didn’t the Fed cut rates during 2008? March was when Bear Stearns imploded.

    http://en.wikipedia.org/wiki/History_of_Federal_Open_Market_Committee_actions

    “But, perhaps because the Fed didn’t follow the Taylor rule for a few years after the dot-com bubble and the 9/11 attack,”

    Wasn’t Greenspan fighting off recession in 2001-2004?

  7. 7 David Glasner November 22, 2011 at 6:41 pm

    Luis, Thanks. And thanks, too, for the reference to Svensson.

    Mike, It wasn’t Ricardo and Thornton who advocated limiting the quantity of banknotes. That came a generation later in the 1830s and 1840s when the Currency School decided that the appropriate benchmark for a convertible currency was the behavior of a purely metallic currency.

    W. Peden, Free banking is not enough. If we had free banking under a gold standard, we could still have crises and depressions. About M2, the annual growth rate of M2 was over 10 percent through 1984. From 1985 to 1988, M2 was generally between 8 to 10 percent, through dropping below 8% occasionally, so I don’t think that Friedman would have been happy with M2 either.

    Steve, I agree with much of what you say. The way I would put it is that central bankers should be clear about what they are trying to do and explain why they are doing what they are doing. If they have to explain their actions, they will have to do so in terms of some clear principles that people can accept, like price stability and keeping the economy operating close to its potential output. But it makes no sense to impose a numerical or mechanical rule that the central bank is obligated to follow unless you can demonstrate that the rule will never lead to a really bad outcome. I am not sure that I completely accept your analogy to the legal system, because the legal system involves the use of force and coercion, whereas a central bank has no real coercive power over individuals.

    Peter, I admit that the tightening was ambiguous. The Fed cut rates to 2% in March 2008 and left them there till October 7 (I may be a day or two off) when they cut rates to 1.5%. I claim that leaving rates unchanged from March to October (7 months more than half a year) was effectively a tightening of policy given that the economy was sliding deeper into a recession, especially in the 3rd quarter (before the crash) when the contraction was already one of the steepest since World War II. Greenspan was certainly fighting a recession in 2001-02 and the recovery (probably because of uncertainty about whether we would invade Iraq) was very weak until 2003. But I think it is agreed that following the Taylor rule would kep interest rates from going down to 1% and would have raised rates faster than Greenspan did once the recovery started.

  8. 8 David Pearson November 22, 2011 at 11:55 pm

    David,
    If I’m not mistaken, TIPS spreads peaked in July of 2008. There is a case to be made for 3q08 passive tightening, but I would argue the opposite for 1H08.

    Its likely that the policy actions that mattered in 2008 had to do with the Fed’s willingness to bail out shadow bank creditors. Inflation expectations rose steeply after the Bear Stearns bail out; they turned back down with the August GSE preferred shareholder losses; they crashed after the Lehman bondholder wipe-out. The lesson, IMO, is that if the GSE’s and Lehman had been bailed out, inflation expectations could have spiked. Managing monetary policy in a financial crisis is like running in low gravity: small changes in direction can lead to very large deviations from trend.

  9. 9 Mike Sproul November 23, 2011 at 7:31 am

    David:

    Here are some quotes from Ricardo, just from his first letter to the London Morning Chronicle in 1809 (There are many more like them)

    “Whilst the Bank is willing to lend, borrowers will always exist, so that there can be no limit to their over-issues, but that which I have just mentioned, and gold might rise to 8l. or 10l. or any other sum per ounce.—The same effect would be produced in the price of provisions and on all other commodities, and there would be no other remedy for the depreciation of paper, than the Bank withdrawing the superabundant quantity from circulation

    If further proofs of the depreciation of Bank notes were wanting, and that it was caused by an over-issue, it would be found in the present rate of exchange with foreign countries.

    Let the Bank be enjoined by Parliament gradually to withdraw to the amount of two or three millions of their notes from circulation, without obliging them, in the first instance, to pay in specie, and we should very soon find that the market price of gold would fall to its mint price of 3l. 17s. 10½d.

    It would then be evident that all the evils in our currency were owing to the over-issues of the Bank,”

    Clearly, Ricardo DID advocate limiting the issuance of bank notes. So did Thornton, but I’ll spare you those quotes. They were both bullionists, after all, and the fundamental belief of bullionism was that the quantity of bank notes should be made to mimic the fluctuations of a bullion currency. The currency school only repeated this belief.

    In fairness to your assertion, it is also true that they advocated a return to convertibility as the best means of limiting note issuance and thus maintaining stable prices. But in a world of inconvertible currency, both Ricardo and Thornton believed that the quantity of notes had to be forcibly limited, since they thought that natural checks to over-issue were either weak or non-existent.

  10. 10 David Pearson November 23, 2011 at 10:19 am

    David,
    OT, but I thought this chart comparing NIPA profits to NGDP might interest you:

    http://scottgrannis.blogspot.com/2011/11/corporate-profits-are-still-very-strong.html

  11. 11 W. Peden November 23, 2011 at 4:59 pm

    David Glasner,

    “If we had free banking under a gold standard, we could still have crises and depressions.”

    In the simple sense of banks freely issuing their own promissory notes, I agree. By “a rule-governed market-driven monetary system based on free-market banking”, I was thinking of something like Selgin’s proposal in Less Than Zero.

    It is worth noting, however, that the pre-central bank gold standard system in the US was significantly more stable than the post-1914 US experience. 1870-1913 was a period of relative stability, once one uses a modern-like price index to measure the business cycle.

    M2 was high in 1984, but so was the growth of nominal GDP (11.21%). If not for the 7.2% real GDP growth in that year (mostly catch-up from the early 1980s disinflation) the US would have been in a period of inflation. More importantly, if M2 growth had not been checked, the US would have experienced accelerating inflation once again, since the above-trend growth was not going to last.

    Nominal GDP growth was also at 6.73% in 1985-1988 i.e. what Friedman would expect in a period of falling inflation and high interest rates. In fact, that’s how he explained it in the period: the cost of holding M2 had fallen. Symmetrically, that was how monetarists explained the rising velocity of the late 1970s. He wanted a k-percent rule + a computerised Fed in the late 1980s.

    It was the 1990s that saw M2 velocity really go nuts and made any sane person recognise that this was no longer a usuable forecasting aggregate-

    http://research.stlouisfed.org/fred2/series/M2V

    By the late 1990s, even Friedman had totally given up the k-percent rule. But notice that it was RISING velocity, not falling velocity, that changed his mind, whereas most people’s minds were changed by the FALL in >M1< velocity in the early 1980s. The key factor was the relative emphasis on money in transactions (M1) and money as a special topic in the theory of portfolios (M2).

  12. 12 W. Peden November 23, 2011 at 5:02 pm

    “But it makes no sense to impose a numerical or mechanical rule that the central bank is obligated to follow unless you can demonstrate that the rule will never lead to a really bad outcome.”

    Surely the test is “unless you can demonstrate that the rule will lead to really bad outcomes less often than any other alternative”? I doubt that there is any way of having a central bank and avoiding inflationary/deflationary crises.

  13. 13 David Glasner November 26, 2011 at 8:39 pm

    Mike, According to Ricardo and Thornton, the obligation to convert was the only quantitative limit necessary to prevent overissue. Ricardo was arguing for a resumption of convertibility not a quantitative limit on the note issues of the Bank of England. You seem to acknowledge this in the last paragraph of your comment, so I think that the difference between us on this point (as I think is often the case) is semantic rather than substantive. But I am sure you will correct me if I am wrong.

    David, Yes very interesting. Thanks for sharing.

    W. Peden, I am not sure I understand Selgin’s mechanism for achieving steady deflation. I think freezing the monetary base, which Selgin has advocated in the past, is a really lousy idea.

    I don’t know about the pre-Fed, post-Fed comparison. Surely, the instability post Fed has a lot to do with World War I, World War II and the Great Depression (caused by a misguided attempt to reinstate the gold standard). I am not sure that the Fed deserves all the blame for any of those catastrophes.

    You interpret M2 as the cause, I interpret it as the effect.

    You are right that I may have formulated too stringent a test for a rule to satisfy. However, it is often suggested that all we need to do is pick a rule and stick by it. That approach is likely to lead to some really bad outcomes.

  14. 14 W. Peden November 27, 2011 at 12:21 am

    David,

    Even if you eliminate the 1914-1945 period from the comparison, the 1870-1913 period was more or less as stable as the 1945 to present period (excluding the most recent crisis).

    I don’t just see M2 as a cause; in the context of the 1980s and 1990s, M2 was both a cause and an effect of NGDP growth, since changing either variable, ceteris paribus, effects the other.

    I agree that there are costs in adhering to a rule, but I wouldn’t underestimate the dangers of discretion either. Even if you attribute the Great Depression to rule-following, the Great Inflation was a clear case of discretionary policy gone wrong.

    I think that the most important thing is that, whatever way in which the primary variable is targeted (i.e. rules vs. discretion) the primary variable had better be (a) controllable in the long-run, (b) measurable, (c) forecastable to some extent, and (d) should have a minimum of exogenous instability. Targeting the price of gold conflicts with (d); an employment target conflcits with (a); asset price targeting with probably fall down at (b); output-gap targeting has proven to fall down at (c)* in the UK at least, since the output-gap has apparentely been misforecast for three years running.

    So I don’t think discretion is going to help out with targeting the wrong variables and I don’t think that rules are a bad thing if one is targeting the right variable(s).

    * In the most charitable interpretation of BoE actions for output-gap targeting; a less charitable interpretation would be that the gap has been deliberately misforecast to avoid destabilising NGDP again.

  15. 15 W. Peden November 27, 2011 at 12:29 am

    (Now that I think about it, NGDP never causes M2. The demand and supply for M2 is determined by PQ, not NGDP; a rise in asset prices boosts the capacity of banks to lend to creditworthy debtors as surely as an increase in those debtors’ final sales.)

  16. 16 W. Peden November 27, 2011 at 12:34 am

    (So any correlation between NGDP and M2 is a reflection of the correlation of NGDP with PQ. An exogenous change in either PQ or M2 causes a change in the other variable, in the context of the 1980s and 1990s.

    There is perhaps one sense in which NGDP could cause M2: in an NGDP level targeting regime, the central bank would be varying the money supply in line with its expected demand. Then M2 would be partly determined by the previous growth of NGDP. So it wasn’t right of me to say that NGDP never causes M2; it just doesn’t cause M2 in the context of the system of the 1980s or 1990s, when M2 and PQ stood in a mutual causal relation.)

  17. 17 David Glasner November 30, 2011 at 8:52 am

    W., I am not arguing for unlimited discretion; I am voicing concerns about a rule that is so rigid that you are stuck with it because if you don’t follow the rule, you will be considered to have lost all credibility. If that is what following a rule entails, I think it is a disaster unless the rule is infallible or pretty darn close.

    You said:

    “Now that I think about it, NGDP never causes M2. The demand and supply for M2 is determined by PQ, not NGDP; a rise in asset prices boosts the capacity of banks to lend to creditworthy debtors as surely as an increase in those debtors’ final sales.”

    Sorry, I thought NGDP is the same as PQ.

    NGDP causes M2 in the following sense. An change in NGDP causes the demand for M2 to change (other things also affect the demand for M2 but NGDP is certainly one of the causes). A competitive banking system responds to a change in the demand for M2 with a corresponding change in the quantity of M2. Since the change in M2 is endogenous and equilibrating it has no effect on NGDP. What affects NGDP is currency or the monetary base, not M2.

  18. 18 W. Peden December 4, 2011 at 5:33 pm

    David,

    (Apologies in advance for the long post that largely covers issues from before I was born!)

    “W., I am not arguing for unlimited discretion; I am voicing concerns about a rule that is so rigid that you are stuck with it because if you don’t follow the rule, you will be considered to have lost all credibility. If that is what following a rule entails, I think it is a disaster unless the rule is infallible or pretty darn close.”

    I quite agree. It’s a shame that there isn’t a widely used term in economics that means something like “precise orders” to distinguish from our usual use of “rule”, which means something like a restriction on possible action. A rule does not give exact and invariable instructions.

    So, for example, the Taylor rule is really a kind of varying imperative, since it gives precise instructions on the short-term interest rate. In contrast, targeting NGDP along a trend is a rule because it allows for a huge variety of actions within that period; in a once-in-a-lifetime financial crisis like the early 1930s or 2008-2009, it would require quite radical discretionary actions so that the trend could be maintained.

    (The Gold Standard is harder to place, not least because it covers a wide range of possible monetary systems, so I won’t try.)

    “Sorry, I thought NGDP is the same as PQ.”

    NGDP is usable as a proxy, but NGDP is strictly speaking identical with PY, not PQ. The “Q” in PQ refers to ALL transactions (including transactions in intermediate goods, financial assets, and non-financial assets) and therefore of course the “P” must refer to ALL prices. In MV = PQ, therefore, “PQ” is no more measurable in practice than V.

    I do think that the distinction between PY and PQ can be useful, however. Consider the following situation: there is fairly strong money growth (even taking changes in the demand to hold money into account) but the supply of goods viz. assets increases strongly, say due to a massive increase in world trade. Under such a situation, in which people are still disinclined to simply put their millions under the bed pillows, so the price of assets increases at a faster rate than the price of final goods. That is precisely what we saw in the UK from about 2003 to 2007 and it shows up in the relative inflation of house prices-

    The money was also spent on financial assets, fuelling the UK stock market after the weakness at the beginning of the decade. Needless to say, this created a “dance of the pound” effect, since higher financial asset prices make increases in the money supply easier for private businesses and wealth holders.

    (The 1980s is another example. While the income velocity of money fell in the UK during that decade and this combined with an increase in productivity to reduce inflation below 3%, there was a huge asset bubble and this also had an interactive relationship with broad money.)

    “NGDP causes M2 in the following sense. An change in NGDP causes the demand for M2 to change (other things also affect the demand for M2 but NGDP is certainly one of the causes). A competitive banking system responds to a change in the demand for M2 with a corresponding change in the quantity of M2. Since the change in M2 is endogenous and equilibrating it has no effect on NGDP. What affects NGDP is currency or the monetary base, not M2.”

    I agree with the first part here. However, I disagree with the second part. Firstly, we can imagine an intervention that increases M2 exogenously and we know that this will, ceteris paribus, result in an increase in M2. Secondly, desired demand for M2 only becomes effective demand if those demanding new M2* are able to persuade the banks to either lend to them or to buy equity; in other words, only creditworthy borrowers can borrow in a competitive banking system. Since creditworthiness is not causally exausted by NGDP, there are causes of changes in M2 that are not changes in NGDP and these changes increase M2 beyond the demand to hold M2.

    Of course, changes in M2 are equilbriating, but only through a Fisherian dance of the dollar. Since I propose exogenous control of neither M2 or another other aggregate, however, this is an extremely scholastic discussion; all I shall say is that there is a very genuine sense in which changes in the money supply can cause changes in NGDP.

    (I am assuming that it is not controversial that the effective demand for credit is not the same as the demand to hold M2, so there is absolutely no reason to think that M2 is in equilbrium at any moment in time.)

    * As opposed to moving money in from other deposits e.g. large time deposits.

  19. 19 David Glasner December 5, 2011 at 7:44 pm

    W. Peden,

    You said:

    “It’s a shame that there isn’t a widely used term in economics that means something like “precise orders” to distinguish from our usual use of “rule”, which means something like a restriction on possible action. A rule does not give exact and invariable instructions.”

    That is such an astute and insightful point. I am going to try to write a post elaborating on that. What Taylor and Friedman call rules are not anything like what we think of as rules constraining our actions, by limiting the means that we can employ in the pursuit of our ends, but they almost never prescribe specific actions. So Taylor misunderstands what rules, in the ordinary sense of the term, are all about. Thanks for reminding me of that point, which readers of Hayek or Oakeshott will immediately recognize.

    “NGDP is usable as a proxy, but NGDP is strictly speaking identical with PY, not PQ. The “Q” in PQ refers to ALL transactions (including transactions in intermediate goods, financial assets, and non-financial assets) and therefore of course the “P” must refer to ALL prices. In MV = PQ, therefore, “PQ” is no more measurable in practice than V.”

    When I was a student Q stood for output, Y for income, and T for transactions. Have the conventions changed? Or is it another British American difference?

    “we can imagine an intervention that increases M2 exogenously and we know that this will, ceteris paribus, result in an increase in M2.”

    Now it gets complicated. If M2 rises strictly because of an increase in the monetary base, with no increase in deposits, then the resulting increase in NGDP will cause M2 to rise correspondingly. If, however, the increase in M2 reflects only an increase in deposits not matched by an increase in the demand to hold deposits, than the adjustment is in deposits, which fall until the excess supply is extinguished, owing to the operation of the law of reflux.

  20. 20 W. Peden December 5, 2011 at 8:37 pm

    David Glasner,

    On rules versus orders: now that I think about it, you’re right that the K-percent rule is like the Taylor rule in this respect. Our ordinary use of ‘rule’ is something like this- a boundary set on human action. But a boundary doesn’t tell us precisely what to do! There are rules governing castling in chess, but most chess games go by without any castling.

    “When I was a student Q stood for output, Y for income, and T for transactions. Have the conventions changed? Or is it another British American difference?”

    It’s a “student versus non-student” difference. I have never been an economics student, so I’m inclined to forget variable-letter conventions. I should have said that M2 is determined by PT.

    “Now it gets complicated. If M2 rises strictly because of an increase in the monetary base, with no increase in deposits, then the resulting increase in NGDP will cause M2 to rise correspondingly. If, however, the increase in M2 reflects only an increase in deposits not matched by an increase in the demand to hold deposits, than the adjustment is in deposits, which fall until the excess supply is extinguished, owing to the operation of the law of reflux.”

    What if the increase in M2 reflects only an increase in deposits not matched by an increase in the demand to hold deposits, but then the increased demand for transaction money is accomodated for by the central bank? In other words, the increase in the monetary base is caused by the nature of the increase in M2?

    Also, what if the increase in M2 acts as a kind of “buffer stock” of money redeemable at par, such that people as a whole spend their M1 stock at a faster rate because they know that they can fall back on their M2 deposits if they have to? (Yes, I realise that M2 doesn’t cover all the money that acts as a buffer stock, and, from the individual perspective, assets with stable values will work just as well.)

  21. 21 David Glasner December 7, 2011 at 8:09 pm

    W, Quite so, in writing my latest post on Taylor, I have concluded that the Taylor Rule is a recipe which the central bank is required to use in setting the short-term interest rate. So his rule combines a command to use a particular recipe for setting an instrument. In that sense, it is more coherent than Friedman’s rule, which, despite Friedman’s claim to the contrary, targeted a variable that was neither an instrument nor a policy objective with any inherent significance.

    You are right, if I understand you correctly, that an increase in deposits may cause an increase in the demand by the banking system to hold reserves, so that an increase in M2 may itself cause an increase the monetary base if the central bank is willing to accommodate the increase in demand, the alternative being to allow the price level to drop (at least relative to where it would have been).

    Your question about buffer stocks and M1 vs. M2 is getting too complicated for me to follow. The general answer is that banks are, in principle, capable of adjusting the composition of their liabilities in response to shifts the relative preferences of the public to various types of deposits. Such shifts imply corresponding shifts in the banks demand to hold reserves and the extent to which the central bank accommodates those demands will ultimately determine how much prices have to change to restore an equilibrium price level.


  1. 1 Policy Rules Are Not Rules, They Are Policies « Uneasy Money Trackback on December 6, 2011 at 2:55 pm

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About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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