Archive for December, 2013

Never Mistake a Change in Quantity Demanded for a Change in Demand

We are all in Scott Sumner’s debt for teaching (or reminding) us never, ever to reason from a price change. The reason is simple. You can’t just posit a price change and then start making inferences from the price change, because price changes don’t just happen spontaneously. If there’s a price change, it’s because something else has caused price to change. Maybe demand has increased; maybe supply has decreased; maybe neither supply nor demand has changed, but the market was in disequilibrium before and is in equilibrium now at the new price; maybe neither supply nor demand has changed, but the market was in equilibrium before and is in disequilibrium now. There could be other scenarios as well, but unless you specify at least one of them, you can’t reason sensibly about the implications of the price change.

There’s another important piece of advice for anyone trying to do economics: never mistake a change in quantity demanded for a change in demand. A change in demand means that the willingness of people to pay for something has changed, so that, everything else held constant, the price has to change. If for some reason, the price of something goes up, the willingness of people to pay for not having changed, then the quantity of the thing that they demand will go down. But here’s the important point: their demand for that something – their willingness to pay for it – has not gone down; the change in the amount demanded is simply a response to the increased price of that something. In other words, a change in the price of something cannot be the cause of a change in the demand for that something; it can only cause a change in the quantity demanded. A change in demand can be caused only by change in something other than price – maybe a change in wealth, or in fashion, or in taste, or in the season, or in the weather.

Why am I engaging in this bit of pedantry? Well, in a recent post, Scott responded to the following question from Dustin in the comment section to one of his posts.

An elementary question on the topic of interest rates that I’ve been unable to resolve via google:

Regarding Fed actions, I understand that reduced interest rates are thought to be expansionary because the resulting decrease in cost of capital induces greater investment. But I also understand that reduced interest rates are thought to be contractionary because the resulting decrease in opportunity cost of holding money increases demand for money.

To which Scott responded as follows:

It’s not at all clear that lower interest rates boost investment (never reason from a price change.)  And even if they did boost investment it is not at all clear that they would boost GDP.

Scott is correct to question the relationship between interest rates and investment. The relationship in the Keynesian model is based on the idea that a reduced interest rate, by reducing the rate at which expected future cash flows are discounted, increases the value of durable assets, so that the optimal size of the capital stock increases, implying a speed up in the rate of capital accumulation (investment). There are a couple of steps missing in the chain of reasoning that goes from a reduced rate of discount to a speed up in the rate of accumulation, but, in the olden days at any rate, economists have usually been willing to rely on their intuition that an increase in the size of the optimal capital stock would translate into an increased rate of capital accumulation.

Alternatively, in the Hawtreyan scheme of things, a reduced rate of interest would increase the optimal size of inventories held by traders and middlemen, causing an increase in orders to manufacturers, and a cycle of rising output and income generated by the attempt to increase inventories. Notice that in the Hawtreyan view, the reduced short-term interest is, in part, a positive supply shock (reducing the costs borne by middlemen and traders of holding inventories financed by short-term borrowing) as long as there are unused resources that can be employed if desired inventories increase in size.

That said, I’m not sure what Scott, in questioning whether a reduction in interesting rates raises investment, meant by his parenthetical remark about reasoning from a price change. Scott was asked about the effect of a Fed policy to reduce interest rates. Why is that reasoning from a price change? And furthermore, if we do posit that investment rises, why is it unclear whether GDP would rise?

Scott continues:

However it’s surprisingly hard to explain why OMPs boost NGDP using the mechanism of interest rates. Dustin is right that lower interest rates increase the demand for money.  They also reduce velocity. Higher money demand and lower velocity will, ceteris paribus, reduce NGDP.  So why does everyone think that a cut in interest rates increases NGDP?  Is it possible that Steve Williamson is right after all?

Sorry, Scott. Lower interest rates don’t increase the demand for money; lower interest rates increase the amount of money demanded. What’s the difference? If an interest-rate reduction increased the demand for money, it would mean that the demand curve had shifted, and the size of that shift would be theoretically unspecified. If that were the case, we would be comparing an unknown increase in investment on the one hand to an unknown increase in money demand on the other hand, the net effect being indeterminate. That’s the argument that Scott seems to be making.

But that’s not, repeat not, what’s going on here. What we have is an interest-rate reduction that triggers an increase investment and also in the amount of money demanded. But there is no shift in the demand curve for money, just a movement along an unchanging demand curve. That imposes a limit on the range of possibilities. What is the limit? It’s the extreme case of a demand curve for money that is perfectly elastic at the current rate of interest — in other words a liquidity trap — so that the slightest reduction in interest rates causes an unlimited increase in the amount of money demanded. But that means that the rate of interest can’t fall, so that investment can’t rise. If the demand for money is less than perfectly elastic, then the rate of interest can in fact be reduced, implying that investment, and therefore NGDP, will increase. The quantity of money demanded increases as well — velocity goes down — but not enough to prevent investment and NGDP from increasing.

So, there’s no ambiguity about the correct answer to Dustin’s question. If Steve Williamson is right, it’s because he has introduced some new analytical element not contained in the old-fashioned macroeconomic analysis. (Note that I use the term “old-fashioned” only as an identifier, not as an expression of preference in either direction.) A policy-induced reduction in the rate of interest must, under standard assumption in the old-fashioned macroeconomics, increase nominal GDP, though the size of the increase depends on specific assumptions about empirical magnitudes. I don’t disagree with Scott’s analysis in terms of the monetary base, I just don’t see a substantive difference between that analysis and the one that I just went through in terms of the interest-rate policy instrument.

Just to offer a non-controversial example, it is possible to reason through the effect of a restriction on imports in terms of a per unit tariff on imports or in terms of a numerical quota on imports. For any per unit tariff, there is a corresponding quota on imports that gives you the same solution. MMT guys often fail to see the symmetry between setting the quantity and the price of bank reserves; in this instance Scott seems to have overlooked the symmetry between the quantity and price of base money.

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Milton Friedman’s Dumb Rule

Josh Hendrickson discusses Milton Friedman’s famous k-percent rule on his blog, using Friedman’s rule as a vehicle for an enlightening discussion of the time-inconsistency problem so brilliantly described by Fynn Kydland and Edward Prescott in a classic paper published 36 years ago. Josh recognizes that Friedman’s rule is imperfect. At any given time, the k-percent rule is likely to involve either an excess demand for cash or an excess supply of cash, so that the economy would constantly be adjusting to a policy induced macroeconomic disturbance. Obviously a less restrictive rule would allow the monetary authorities to achieve a better outcome. But Josh has an answer to that objection.

The k-percent rule has often been derided as a sub-optimal policy. Suppose, for example, that there was an increase in money demand. Without a corresponding increase in the money supply, there would be excess money demand that even Friedman believed would cause a reduction in both nominal income and real economic activity. So why would Friedman advocate such a policy?

The reason Friedman advocated the k-percent rule was not because he believed that it was the optimal policy in the modern sense of phrase, but rather that it limited the damage done by activist monetary policy. In Friedman’s view, shaped by his empirical work on monetary history, central banks tended to be a greater source of business cycle fluctuations than they were a source of stability. Thus, the k-percent rule would eliminate recessions caused by bad monetary policy.

That’s a fair statement of why Friedman advocated the k-percent rule. One of Friedman’s favorite epigrams was that one shouldn’t allow the best to be the enemy of the good, meaning that the pursuit of perfection is usually not worth it. Perfection is costly, and usually merely good is good enough. That’s generally good advice. Friedman thought that allowing the money supply to expand at a moderate rate (say 3%) would avoid severe deflationary pressure and avoid significant inflation, allowing the economy to muddle through without serious problems.

But behind that common-sense argument, there were deeper, more ideological, reasons for the k-percent rule. The k-percent rule was also part of Friedman’s attempt to provide a libertarian/conservative alternative to the gold standard, which Friedman believed was both politically impractical and economically undesirable. However, the gold standard for over a century had been viewed by supporters of free-market liberalism as a necessary check on government power and as a bulwark of liberty. Friedman, desiring to offer a modern version of the case for classical liberalism (which has somehow been renamed neo-liberalism), felt that the k-percent rule, importantly combined with a regime of flexible exchange rates, could serve as an ideological substitute for the gold standard.

To provide a rationale for why the k-percent rule was preferable to simply trying to stabilize the price level, Friedman had to draw on a distinction between the aims of monetary policy and the instruments of monetary policy. Friedman argued that a rule specifying that the monetary authority should stabilize the price level was too flexible, granting the monetary authority too much discretion in its decision making.

The price level is not a variable over which the monetary authority has any direct control. It is a target not an instrument. Specifying a price-level target allows the monetary authority discretion in its choice of instruments to achieve the target. Friedman actually made a similar argument about the gold standard in a paper called “Real and Pseudo Gold Standards.” The price of gold is a target, not an instrument. The monetary authority can achieve its target price of gold with more than one policy. Unless you define the rule in terms of the instruments of the central bank, you have not taken away the discretionary power of the monetary authority. In his anti-discretionary zeal, Friedman believed that he had discovered an argument that trumped advocates of the gold standard .

Of course there was a huge problem with this argument, though Friedman was rarely called on it. The money supply, under any definition that Friedman ever entertained, is no more an instrument of the monetary authority than the price level. Most of the money instruments included in any of the various definitions of money Friedman entertained for purposes of his k-percent rule are privately issued. So Friedman’s claim that his rule would eliminate the discretion of the monetary authority in its use of instrument was clearly false. Now, one might claim that when Friedman originally advanced the rule in his Program for Monetary Stability, the rule was formulated the context of a proposal for 100-percent reserves. However, the proposal for 100-percent reserves would inevitably have to identify those deposits subject to the 100-percent requirement and those exempt from the requirement. Once it is possible to convert the covered deposits into higher yielding uncovered deposits, monetary policy would not be effective if it controlled only the growth of deposits subject to a 100-percent reserve requirement.

In his chapter on monetary policy in The Constitution of Liberty, F. A. Hayek effectively punctured Friedman’s argument that a monetary authority could operate effectively without some discretion in its use of instruments to execute a policy aimed at some agreed upon policy goal. It is a category error to equate the discretion of the monetary authority in the choice of its policy instruments with the discretion of the government in applying coercive sanctions against the persons and property of private individuals. It is true that Hayek later modified his views about central banks, but that change in his views was at least in part attributable to a misunderstanding. Hayek erroneoulsy believed that his discovery that competition in the supply of money is possible without driving the value of money down to zero meant that competitive banks would compete to create an alternative monetary standard that would be superior to the existing standard legally established by the monetary authority. His conclusion did not follow from his premise.

In a previous post, I discussed how Hayek also memorably demolished Friedman’s argument that, although the k-percent rule might not be the theoretically best rule, it would at least be a good rule that would avoid the worst consequences of misguided monetary policies producing either deflation or inflation. John Taylor, accepting the Hayek Prize from the Manhattan Institute, totally embarrassed himself by flagarantly misunderstanding what Hayek was talking about. Here are the two relevant passages from Hayek. The first from his pamphlet, Full Employment at any Price?

I wish I could share the confidence of my friend Milton Friedman who thinks that one could deprive the monetary authorities, in order to prevent the abuse of their powers for political purposes, of all discretionary powers by prescribing the amount of money they may and should add to circulation in any one year. It seems to me that he regards this as practicable because he has become used for statistical purposes to draw a sharp distinction between what is to be regarded as money and what is not. This distinction does not exist in the real world. I believe that, to ensure the convertibility of all kinds of near-money into real money, which is necessary if we are to avoid severe liquidity crises or panics, the monetary authorities must be given some discretion. But I agree with Friedman that we will have to try and get back to a more or less automatic system for regulating the quantity of money in ordinary times. The necessity of “suspending” Sir Robert Peel’s Bank Act of 1844 three times within 25 years after it was passed ought to have taught us this once and for all.

Hayek in the Denationalization of Money, Hayek was more direct:

As regards Professor Friedman’s proposal of a legal limit on the rate at which a monopolistic issuer of money was to be allowed to increase the quantity in circulation, I can only say that I would not like to see what would happen if it ever became known that the amount of cash in circulation was approaching the upper limit and that therefore a need for increased liquidity could not be met.

And in a footnote, Hayek added.

To such a situation the classic account of Walter Bagehot . . . would apply: “In a sensitive state of the English money market the near approach to the legal limit of reserve would be a sure incentive to panic; if one-third were fixed by law, the moment the banks were close to one-third, alarm would begin and would run like magic.

So Friedman’s k-percent rule was dumb, really dumb. It was dumb, because it induced expectations that made it unsustainable. As Hayek observed, not only was the theory clear, but it was confirmed by the historical evidence from the nineteenth century. Unfortunately, it had to be reconfirmed one more time in 1982 before the Fed abandoned its own misguided attempt to implement a modified version of the Friedman rule.

My Paper on Hawtrey’s Good and Bad Trade

I have just posted my paper “Hawtrey’s Good and Bad Trade: A Centenary Retrospective” based on a series of blog posts this fall on SSRN. Here is a link to download the paper.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2369028

Comments on the paper will be gratefully accepted either as comments to this post or via email at uneasymoney@hotmail.com

Does Macroeconomics Need Financial Foundations?

One of the little instances of collateral damage occasioned by the hue and cry following upon Stephen Williamson’s post arguing that quantitative easing has been deflationary was the dustup between Scott Sumner and financial journalist and blogger Izabella Kaminska. I am not going to comment on the specifics of their exchange except to say that the misunderstanding and hard feelings between them seem to have been resolved more or less amicably. However, in quickly skimming the exchange between them, I was rather struck by the condescending tone of Kaminska’s (perhaps understandable coming from the aggrieved party) comment about the lack of comprehension by Scott and Market Monetarists more generally of the basics of finance.

First I’d just like to say I feel much of the misunderstanding comes from the fact that market monetarists tend to ignore the influence of shadow banking and market plumbing in the monetary world. I also think (especially from my conversation with Lars Christensen) that they ignore technological disruption, and the influence this has on wealth distribution and purchasing decisions amongst the wealthy, banks and corporates. Also, as I outlined in the post, my view is slightly different to Williamson’s, it’s based mostly on the scarcity of safe assets and how this can magnify hoarding instincts and fragment store-of-value markets, in a Gresham’s law kind of way. Expectations obviously factor into it, and I think Williamson is absolutely right on that front. But personally I don’t think it’s anything to do with temporary or permanent money expansion expectations. IMO It’s much more about risk expectations, which can — if momentum builds — shift very very quickly, making something deflationary, inflationary very quickly. Though, that doesn’t mean I am worried about inflation (largely because I suspect we may have reached an important productivity inflection point).

This remark was followed up with several comments blasting Market Monetarists for their ignorance of the basics of finance and commending Kaminska for the depth of her understanding to which Kaminska warmly responded adding a few additional jibes at Sumner and Market Monetarists. Here is one.

Market monetarists are getting testy because now that everybody started scrutinizing QE they will be exposed as ignorant. The mechanisms they originally advocated QE would work through will be seen as hopelessly naive. For them the money is like glass beads squirting out of the Federal Reserve, you start talking about stuff like collateral, liquid assets, balance sheets and shadow banking and they are out of their depth.

For laughs: Sumner once tried to defend the childish textbook model of banks lending out reserves and it ended in a colossal embarrassment in the comments section http://www.themoneyillusion.com/?p=5893

For you to defend your credentials in front of such “experts” is absurd. There is a lot more depth to your understanding than to their sandbox vision of the monetary system. And yes, it *is* crazy that journalists and bloggers can talk about these things with more sense than academics. But this [is] the world we live in.

To which Kaminska graciously replied:

Thanks as well! And I tend to agree with your assessment of the market monetarist view of the world.

So what is the Market Monetarist view of the world of which Kaminska tends to have such a low opinion? Well, from reading Kaminska’s comments and those of her commenters, it seems to be that Market Monetarists have an insufficiently detailed and inaccurate view of financial intermediaries, especially of banks and shadow banks, and that Market Monetarists don’t properly understand the role of safe assets and collateral in the economy. But the question is why, and how, does any of this matter to a useful description of how the economy works?

Well, this whole episode started when Stephen Williamson had a blog post arguing that QE was deflationary, and the reason it’s deflationary is that creating more high powered money provides the economy with more safe assets and thereby reduces the liquidity premium associated with safe assets like short-term Treasuries and cash. By reducing the liquidity premium, QE causes the real interest rate to fall, which implies a lower rate of inflation.

Kaminska thinks that this argument, which Market Monetarists find hard to digest, makes sense, though she can’t quite bring herself to endorse it either. But she finds the emphasis on collateral and safety and market plumbing very much to her taste. In my previous post, I raised what I thought were some problems with Williamson’s argument.

First, what is the actual evidence that there is a substantial liquidity premium on short-term Treasuries? If I compare the rates on short-term Treasuries with the rates on commercial paper issued by non-Financial institutions, I don’t find much difference. If there is a substantial unmet demand for good collateral, and there is only a small difference in yield between commercial paper and short-term Treasuries, one would think that non-financial firms could make a killing by issuing a lot more commercial paper. When I wrote the post, I was wondering whether I, a financial novice, might be misreading the data or mismeasuring the liquidity premium on short-term Treasuries. So far, no one has said anything about that, but If I am wrong, I am happy to be enlightened.

Here’s something else I don’t get. What’s so special about so-called safe assets? Suppose, as Williamson claims, that there’s a shortage of safe assets. Why does that imply a liquidity premium? One could still compensate for the lack of safety by over-collateralizing the loan using an inferior asset. If that is a possibility, why is the size of the liquidity premium not constrained?

I also pointed out in my previous post that a declining liquidity premium would be associated with a shift out of money and into real assets, which would cause an increase in asset prices. An increase in asset prices would tend to be associated with an increase in the value of the underlying service flows embodied in the assets, in other words in an increase in current prices, so that, if Williamson is right, QE should have caused measured inflation to rise even as it caused inflation expectations to fall. Of course Williamson believes that the decrease in liquidity premium is associated with a decline in real interest rates, but it is not clear that a decline in real interest rates has any implications for the current price level. So Williamson’s claim that his model explains the decline in observed inflation since QE was instituted does not seem all that compelling.

Now, as one who has written a bit about banking and shadow banking, and as one who shares the low opinion of the above-mentioned commenter on Kaminska’s blog about the textbook model (which Sumner does not defend, by the way) of the money supply via a “money multiplier,” I am in favor of changing how the money supply is incorporated into macromodels. Nevertheless, it is far from clear that changing the way that the money supply is modeled would significantly change any important policy implications of Market Monetarism. Perhaps it would, but if so, that is a proposition to be proved (or at least argued), not a self-evident truth to be asserted.

I don’t say that finance and banking are not important. Current spreads between borrowing and lending rates, may not provide a sufficient margin for banks to provide the intermediation services that they once provided to a wide range of customers. Businesses have a wider range of options in obtaining financing than they used to, so instead of holding bank accounts with banks and foregoing interest on deposits to be able to have a credit line with their banker, they park their money with a money market fund and obtain financing by issuing commercial paper. This works well for firms large enough to have direct access to lenders, but smaller businesses can’t borrow directly from the market and can only borrow from banks at much higher rates or by absorbing higher costs on their bank accounts than they would bear on a money market fund.

At any rate, when market interest rates are low, and when perceived credit risks are high, there is very little margin for banks to earn a profit from intermediation. If so, the money multiplier — a crude measure of how much intermediation banks are engaging in goes down — it is up to the monetary authority to provide the public with the liquidity they demand by increasing the amount of bank reserves available to the banking system. Otherwise, total spending would contract sharply as the public tried to build up their cash balances by reducing their own spending – not a pretty picture.

So finance is certainly important, and I really ought to know more about market plumbing and counterparty risk  and all that than I do, but the most important thing to know about finance is that the financial system tends to break down when the jointly held expectations of borrowers and lenders that the loans that they agreed to would be repaid on schedule by the borrowers are disappointed. There are all kinds of reasons why, in a given case, those jointly held expectations might be disappointed. But financial crises are associated with a very large cluster of disappointed expectations, and try as they might, the finance guys have not provided a better explanation for that clustering of disappointed expectations than a sharp decline in aggregate demand. That’s what happened in the Great Depression, as Ralph Hawtrey and Gustav Cassel and Irving Fisher and Maynard Keynes understood, and that’s what happened in the Little Depression, as Market Monetarists, especially Scott Sumner, understand. Everything else is just commentary.

Stephen Williamson Gets Stuck at the Zero Lower Bound

Stephen Williamson started quite a ruckus on the econblogosphere with his recent posts arguing that, contrary to the express intentions of the FOMC, Quantitative Easing has actually caused inflation to go down. Whether Williamson’s discovery will have any practical effect remains to be seen, but in the meantime, there has been a lot head-scratching by Williamson’s readers trying to figure out how he reached such a counterintuitive conclusion. I apologize for getting to this discussion so late, but I have been trying off and on, amid a number of distractions, including travel to Switzerland where I am now visiting, to think my way through this discussion for the past several days. Let’s see if I have come up with anything enlightening to contribute.

The key ideas that Williamson relies on to derive his result are the standard ones of a real and a nominal interest rate that are related to each other by way of the expected rate of inflation (though Williamson does not distinguish between expected and annual inflation, that distinction perhaps not existing in his rational-expectations universe). The nominal rate must equal the real rate plus the expected rate of inflation. One way to think of the real rate is as the expected net pecuniary return (adjusted for inflation) from holding a real asset expressed as a percentage of the asset’s value, exclusive of any non-pecuniary benefits that it might provide (e.g., the aesthetic services provided by an art object to its owner). Insofar as an asset provides such services, the anticipated real return of the asset would be correspondingly reduced, and its current value enhanced compared to assets providing no non-pecuniary services. The value of assets providing additional non-pecuniary services includes a premium reflecting those services. The non-pecuniary benefit on which Williamson is focused is liquidity — the ease of buying or selling the asset at a price near its actual value — and the value enhancement accruing to assets providing such liquidity services is the liquidity premium.

Suppose that there are just two kinds of assets: real assets that generate (or are expected to do so) real pecuniary returns and money. Money provides liquidity services more effectively than any other asset. Now in any equilibrium in which both money and non-money assets are held, the expected net return from holding each asset must equal the expected net return from holding the other. If money, at the margin, is providing net liquidity services provided by no other asset, the expected pecuniary yield from holding money must be correspondingly less than the expected yield on the alternative real asset. Otherwise people would just hold money rather than the real asset (equivalently, the value of real assets would have to fall before people would be willing to hold those assets).

Here’s how I understand what Williamson is trying to do. I am not confident in my understanding, because Williamson’s first post was very difficult to follow. He started off with a series of propositions derived from Milton Friedman’s argument about the optimality of deflation at the real rate of interest, which implies a zero nominal interest rate, making it costless to hold money. Liquidity would be free, and the liquidity premium would be zero.

From this Friedmanian analysis of the optimality of expected deflation at a rate equal to the real rate of interest, Williamson transitions to a very different argument in which the zero lower bound does not eliminate the liquidity premium. Williamson posits a liquidity premium on bonds, the motivation for which being that bonds are useful by being readily acceptable as collateral. Williamson posits this liquidity premium as a fact, but without providing evidence, just an argument that the financial crisis destroyed or rendered unusable lots of assets that previously were, or could have been, used as collateral, thereby making Treasury bonds of short duration highly liquid and imparting to them a liquidity premium. If both bonds and money are held, and both offer the same zero nominal pecuniary return, then an equal liquidity premium must accrue to both bonds and money.

But something weird seems to have happened. We are supposed to be at the zero lower bound, and bonds and money are earning a liquidity premium, which means that the real pecuniary yield on bonds and money is negative, which contradicts Friedman’s proposition that a zero nominal interest rate implies that holding money is costless and that there is no liquidity premium. As best as I can figure this out, Williamson seems to be assuming that the real yield on real (illiquid) capital is positive, so that the zero lower bound is really an illusion, a mirage created by the atypical demand for government bonds for use as collateral.

As I suggested before, this is an empirical claim, and it should be possible to provide empirical support for the proposition that there is an unusual liquidity premium attaching to government debt of short duration in virtue of its superior acceptability as collateral. One test of the proposition would be to compare the yields on government debt of short duration versus non-government debt of short duration. A quick check here indicates that the yields on 90-day commercial paper issued by non-financial firms are very close to zero, suggesting to me that government debt of short duration is not providing any liquidity premium. If so, then the expected short-term yield on real capital may not be significantly greater than the yield on government debt, so that we really are at the zero lower bound rather than at a pseudo-zero lower bound as Williamson seems to be suggesting.

Given his assumption that there is a significant liquidity premium attaching to money and short-term government debt, I understand Williamson to be making the following argument about Quantitative Easing. There is a shortage of government debt in the sense that the public would like to hold more government debt than is being supplied. Since the federal budget deficit is rapidly shrinking, leaving the demand for short-term government debt unsatisfied, quantitative easing at least provides the public with the opportunity to exchange their relatively illiquid long-term government debt for highly liquid bank reserves created by the Fed. By so doing, the Fed is reducing the liquidity premium. But at the pseudo-zero-lower bound, a reduction in the liquidity premium implies a reduced rate of inflation, because it is the expected rate of inflation that reduces the expected return on holding money to offset the liquidity yield provided by money.

Williamson argues that by reducing the liquidity premium on holding money, QE has been the cause of the steadily declining rate of inflation over the past three years. This is a very tricky claim, because, even if we accept Williamson’s premises, he is leaving something important out of the analysis. Williamson’s argument is really about the effect of QE on expected inflation in equilibrium. But he pays no attention to the immediate effect of a change in the liquidity premium. If people reduce their valuation of money, because it is providing a reduced level of liquidity services, that change must be reflected in an immediate reduction in the demand to hold money, which would imply an immediate shift out of money into other assets. In other words, the value of money must fall. Conceptually, this would be an instantaneous, once and for all change, but if Williamson’s analysis is correct, the immediate once and for all changes should have been reflected in increased measured rates of inflation even though inflation expectations were falling. So it seems to me that the empirical fact of observed declines in the rate of inflation that motivates Williamson’s analysis turns out to be inconsistent with the implications of his analysis.


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. 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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