Forget the Monetary Base and Just Pay Attention to the Price Level

Kudos to David Beckworth for eliciting a welcome concession or clarification from Paul Krugman that monetary policy is not necessarily ineffectual at the zero lower bound. The clarification is welcome because Krugman and Simon Wren Lewis seemed to be making a big deal about insisting that monetary policy at the zero lower bound is useless if it affects only the current, but not the future, money supply, and touting the discovery as if it were a point that was not already well understood.

Now it’s true that Krugman is entitled to take credit for having come up with an elegant way of showing the difference between a permanent and a temporary increase in the monetary base, but it’s a point that, WADR, was understood even before Krugman. See, for example, the discussion in chapter 5 of Jack Hirshleifer’s textbook on capital theory (published in 1970), Investment, Interest and Capital, showing that the Fisher equation follows straightforwardly in an intertemporal equilibrium model, so that the nominal interest rate can be decomposed into a real component and an expected-inflation component. If holding money is costless, then the nominal rate of interest cannot be negative, and expected deflation cannot exceed the equilibrium real rate of interest. This implies that, at the zero lower bound, the current price level cannot be raised without raising the future price level proportionately. That is all Krugman was saying in asserting that monetary policy is ineffective at the zero lower bound, even though he couched the analysis in terms of the current and future money supplies rather than in terms of the current and future price levels. But the entire argument is implicit in the Fisher equation. And contrary to Krugman, the IS-LM model (with which I am certainly willing to coexist) offers no unique insight into this proposition; it would be remarkable if it did, because the IS-LM model in essence is a static model that has to be re-engineered to be used in an intertemporal setting.

Here is how Hirshleifer concludes his discussion:

The simple two-period model of choice between dated consumptive goods and dated real liquidities has been shown to be sufficiently comprehensive as to display both the quantity theorists’ and the Keynesian theorists’ predicted results consequent upon “changes in the money supply.” The seeming contradiction is resolved by noting that one result or the other follows, or possibly some mixture of the two, depending upon the precise meaning of the phrase “changes in the quantity of money.” More exactly, the result follows from the assumption made about changes in the time-distributed endowments of money and consumption goods.  pp. 150-51

Another passage from Hirshleifer is also worth quoting:

Imagine a financial “panic.” Current money is very scarce relative to future money – and so monetary interest rates are very high. The monetary authorities might then provide an increment [to the money stock] while announcing that an equal aggregate amount of money would be retired at some date thereafter. Such a change making current money relatively more plentiful (or less scarce) than before in comparison with future money, would clearly tend to reduce the monetary rate of interest. (p. 149)

In this passage Hirshleifer accurately describes the objective of Fed policy since the crisis: provide as much liquidity as needed to prevent a panic, but without even trying to generate a substantial increase in aggregate demand by increasing inflation or expected inflation. The refusal to increase aggregate demand was implicit in the Fed’s refusal to increase its inflation target.

However, I do want to make explicit a point of disagreement between me and Hirshleifer, Krugman and Beckworth. The point is more conceptual than analytical, by which I mean that although the analysis of monetary policy can formally be carried out either in terms of current and future money supplies, as Hirshleifer, Krugman and Beckworth do, or in terms of price levels, as I prefer to do so in terms of price levels. For one thing, reasoning in terms of price levels immediately puts you in the framework of the Fisher equation, while thinking in terms of current and future money supplies puts you in the framework of the quantity theory, which I always prefer to avoid.

The problem with the quantity theory framework is that it assumes that quantity of money is a policy variable over which a monetary authority can exercise effective control, a mistake — imprinted in our economic intuition by two or three centuries of quantity-theorizing, regrettably reinforced in the second-half of the twentieth century by the preposterous theoretical detour of monomaniacal Friedmanian Monetarism, as if there were no such thing as an identification problem. Thus, to analyze monetary policy by doing thought experiments that change the quantity of money is likely to mislead or confuse.

I can’t think of an effective monetary policy that was ever implemented by targeting a monetary aggregate. The optimal time path of a monetary aggregate can never be specified in advance, so that trying to target any monetary aggregate will inevitably fail, thereby undermining the credibility of the monetary authority. Effective monetary policies have instead tried to target some nominal price while allowing monetary aggregates to adjust automatically given that price. Sometimes the price being targeted has been the conversion price of money into a real asset, as was the case under the gold standard, or an exchange rate between one currency and another, as the Swiss National Bank is now doing with the franc/euro exchange rate. Monetary policies aimed at stabilizing a single price are easy to implement and can therefore be highly credible, but they are vulnerable to sudden changes with highly deflationary or inflationary implications. Nineteenth century bimetallism was an attempt to avoid or at least mitigate such risks. We now prefer inflation targeting, but we have learned (or at least we should have) from the Fed’s focus on inflation in 2008 that inflation targeting can also lead to disastrous consequences.

I emphasize the distinction between targeting monetary aggregates and targeting the price level, because David Beckworth in his post is so focused on showing 1) that the expansion of the Fed’s balance sheet under QE has been temoprary and 2) that to have been effective in raising aggregate demand at the zero lower bound, the increase in the monetary base needed to be permanent. And I say: both of the facts cited by David are implied by the fact that the Fed did not raise its inflation target or, preferably, replace its inflation target with a sufficiently high price-level target. With a higher inflation target or a suitable price-level target, the monetary base would have taken care of itself.

PS If your name is Scott Sumner, you have my permission to insert “NGDP” wherever “price level” appears in this post.


19 Responses to “Forget the Monetary Base and Just Pay Attention to the Price Level”

  1. 1 Kevin H December 23, 2014 at 9:38 pm

    Targeting M2, M3 and so forth is a bad idea because the Fed doesn’t control these aggregates, endogenous money and all of that. But, the Fed indisputably does control the amount of base money. Is there anything particularly crazy about viewing a k% base growth rate as optimum for a fiat-based free-banking system?

    If banks provide hand-to-hand currency and Federal Reserve notes function mostly as bank reserves, wouldn’t this annual increase of reserves mimic the yearly increase of gold under the gold standard, just without having to actually devote resources to inventing new ways of mining gold and so forth? You’ve complained about Selgin’s proposal for free-banking with a frozen monetary base, so a constant increase in the base should allow for increased demand for bank reserves based on population and wealth growth while maintaining a stable level of nominal spending.

    That isn’t to say that a k% rule and free banking would be better than a nominal income rule and free banking, just that it doesn’t seem self-evidently crazy. Of course, has very little to do with policy issues of what the Fed should in fact be doing today.


  2. 2 dannyb2b December 23, 2014 at 10:36 pm

    “And I say: both of the facts cited by David are implied by the fact that the Fed did not raise its inflation target or, preferably, replace its inflation target with a sufficiently high price-level target. With a higher inflation target or a suitable price-level target, the monetary base would have taken care of itself.”

    The fed didn’t need to raise its stated inflation target, it didnt actually reach it. What about the ZLB?


  3. 3 BH December 24, 2014 at 5:47 am

    Thank you for this post. It has been driving me up the walls the past few days watching Krugman claim that “this is all ISLM!”, whereas *the very model that he developed* demonstrates that it is a problem of temporary vs. permanent money injections, which is not something that can be derived from the non-intertemporal ISLM. Gah.


  4. 4 David Beckworth December 24, 2014 at 6:35 am

    David, thanks for the mention. Just to be clear, I am not advocating the Fed target a monetary aggregate or even the monetary base. Like Scott, I want to see a NGDP level target which would imply a commitment by the Fed to permanently increase the monetary base if necessary to hit the target. That commitment is what matters, not whether it actually has to do so since a credible belief in it may cause the the public to do the heavy lifting via changes in velocity.


  5. 5 Benjamin Cole December 24, 2014 at 7:00 am

    Print more money.


  6. 6 David Glasner December 24, 2014 at 7:40 am

    Kevin, My problem with a fixed rate of growth for the monetary base is that there may be shocks to the demand of banks to hold reserves. The gold standard was actually better able to handle such shocks than a fixed growth rate of the monetary base, because gold could be imported from other countries or transferred from non-monetary to monetary uses.

    dannyb2b, The Fed needed to meet its inflation target but it also needed a higher target.

    BH, Glad you found it worthwhile.

    David, You’re welcome, and sorry for not being more clear that I wasn’t criticizing your policy recommendation, just voicing my discomfort with a certain conventional way of monetary theorizing. But you’re in good company, so don’t feel bad.

    Benjamin, Why am I not surprised to get that message from you?


  7. 7 Rob Rawlings December 24, 2014 at 7:56 am

    There is something about this discussion that is slightly eluding me.

    Start with a fixed money supply and a “normal” level of velocity of money that determines the price level.

    Some sort of shock causes velocity to fall below normal and if prices are not flexible this leads to a recession.

    Lets assume that even without a CB changing the money supply the recession will eventually be over. Even with a fixed money supply, velocity (and real output) will eventually return to .normal.

    Take an alternative case where there is an activist CB targeting NGDP by varying the money supply . When velocity (and NGDP) drop the CB responds with an increase in the money supply and this speeds up the recovery compared to the case with no CB. Now, if the CB just leaves the money supply at the higher level , then when velocity returns to normal NGDP will be above target. The only way that the NGDP target can be hit is if the increase in the money supply is reversed out. The increase that drove the faster recovery was indeed temporary.

    In Krugman’s model it seems that you need an expectation of higher future price level to allow real interest rates to go negative at the ZLB and drive higher consumption now. For this we need a permanent increase in the money supply. Within Krugman’s framework this makes sense.

    But if the CB is targeting NGDP it is very hard to see how this expectation can be rational if velocity is expected to eventually return to normal. So It is eluding me why Market Monetarists also feel the need to say “we need a permanent increase in the money supply/price level” rather than “we need a monetary policy that will stabilize AD both in the present and in the future, and at all points in time we will optimize the money supply to achieve that end”. Setting the expectation that the increase in the money supply will be permanent is likely to be misleading.

    I do not think Market Monetarists need the negative real interest rates story for their framework to work, and therefore don’t need the “increase in the money supply will be permanent” bit either.


  8. 8 JW Mason December 24, 2014 at 9:27 am

    I agree with this post entirely as far as modern economies are concerned. What I’m not sure about is whether there was a point historically when the idea of a fixed quantity of money did make sense, or whether the credit system has always been too elastic for that and the idea was a wrong turn from the beginning.


  9. 9 W. Peden December 24, 2014 at 10:03 am


    I agree with David Glasner’s answer, and I’ll add that NGDP targeting gets what k% rule supporters WANT to be the outcome of their policy, i.e. if V is perfectly stable then perfectly stable M growth produces perfectly stable PQ growth.


    I agree with your conclusion in the post (well, given that your conclusion doesn’t bar the rest of us from replacing the mythical and intellectually confused “THE level” with “NGDP”!) but I think that your argument suffers from trying to do too much. Let’s separate out a number of points-

    (1) A monetary aggregate target is a bad idea.

    (2) A k% rule is a bad idea.

    (3) The quantity theory of money is a bad theory of the price level as defined by the GDP deflator. (Which is the relevant price series for the Friedmanite quantity theory.)

    (4) The quantity theory of money is a bad framework to think about monetary policy.

    (5) The monetary base is endogenous in an inflation-targeting regime.

    (6) It is expectations of future conditions that are ultimately responsible (alongside preferences) for economic behaviour.

    I think that you might want to argue for all of the above, but I don’t think that you ever get around to arguing for (3) and (4), but these are the only points with which I would disagree!

    (My issue with price level targeting is that “the price level” is a vague term used for a variety of significantly distinct concepts, and there is a tremendous amount of discussion of the price level that doesn’t involve its definition. There isn’t even a short list of functional definitions like “the unit of account”, “the medium of exchange” and “liquid assets redeemable at par”, as there is for the money stock. Targeting prices through a level target or an inflation target has all the problems, in principle, of money supply targeting, and I find it somewhat frustrating that your rhetorical wrath always focuses on the one that is almost universally rejected rather than the other that is still well-regarded.)


  10. 10 David Glasner December 25, 2014 at 7:55 am

    Rob, I am saying target the price level (or NGDP) not the monetary base. Given the shock that you assume, the price level would have to fall to restore equilibrium, we want to avoid that messy adjustment. You are saying that the whole problem is a temporary increase in the demand for money, so that a permanent increase in the monetary base is inconsistent with the price level target. I agree with you. That’s why I say don’t adopt a rule expressed in terms of the monetary base, adopt a rule expressed in terms of the price level (or NGDP). If the price level is targeted, the monetary base will increase or decrease as needed to support the price level target. Or in terms of NGDP, the monetary base will increase or decrease as needed to support the NGDP target.

    JW, Interesting point. However, I think that we would have to go back pretty far in history to find a situation in which all transactions were mediated by a tangible medium of exchange and no credit was used. Indeed, it was Hawtrey’s belief (which I don’t necessarily subscribe to) that historically credit preceded money rather than vice versa.

    W, Thanks for your insightful comment. This was a difficult post for me to write, because there were too many strands in the argument that I wanted to make and I couldn’t work through them within my time and space constraints. The title of the post actually changed at least three times in the course of writing it down.

    I think that the quantity theory is a bad theory of the price level and of monetary policy precisely because it is, contrary to Friedman’s infamous characterization of it as a theory of the demand for money, a theory in which the demand for money plays no role, which is precisely how Friedman “solved” the identification problem: by ignoring it!

    I agree that the price level is a fraught concept in practice, but conceptually it can be given a precise meaning if we abstract from relative price changes.
    For certain limited purposes, I think it is ok to think about the price level and inflation in those terms even though the concept is not operational in practice. I also agree that NGDP targeting is better than price level targeting as a policy, but from an analytical perspective, I think something is lost by not distinguishing between price effects and output effects, which is why I continue to speak about inflation even though the term has been banned by Scott Sumner.


  11. 11 W. Peden December 25, 2014 at 9:05 am

    David Glasner,

    Thanks for the reply. I’m torn two ways on the price level, for the reasons you mention. To some extent, I would rather we stopped talking about “the price level”, but rather adopt silence, use “the GDP deflator” and “Cost of Living Index XYZ” instead. The GDP deflator in particular seems to be very useful.

    I see the ambiguity with the quantity theory. I think that some of Friedman’s stuff on the demand for money is worthwhile (extending liquidity preference theory to economies with assets other than money and bonds) but I agree that this shouldn’t be confused with the demand for money.

    I think of the quantity theory in a way inspired by Patinkin and Fisher, plus more recently Claude Hillinger’s empirical studies of the M and PQ relationship. In four broad propositions, I see the quantity theory as-

    (1) A one-time shift in the quantity of money is neutral in the long-run, but not necessarily the short-run.

    (2) An increase in the quantity of money does not permanently lower the interest rate, and in the long-run raises it.

    (3) M and PQ are correlated in the long-run.

    (4) The major inflations of history (including our present one) have been due moreso to the effects of a rise in M than V.

    – and while I think that these are true for all three of the definitions of money I mentioned, I think that the unit of account is the most important definition of money from a policy perspective. Under this interpretation, the quantity theory is entirely independent of a k% rule being a good idea.

    Anyway, my main advice on the issue of crammed posts would be for you to blog more, but that’s easy for ME to say! I particularly liked this one, because as my (2) above suggests, I think that the Fisher Equation is a crucial (maybe the single most important!) part of macroeconomics.


  12. 12 Rob Rawlings December 25, 2014 at 2:32 pm

    “If the price level is targeted, the monetary base will increase or decrease as needed to support the price level target.”

    Thanks David, now I see your point and agree with you.

    BTW: As we approach the end of the year – just want to say what an excellent blog this is. I have learned so much about both economics and the history of economics from reading it over the last few years.


  13. 13 David Glasner December 29, 2014 at 9:03 am

    W, I think that there are major issues and qualifications with each of your four propositions, both theoretically and empirically. (Also see my comment below.) I do agree that believing in the quantity theory does not obligate one to subscribe to the k% rule; that was a uniquely Friedmanian bit of nonsense.

    I appreciate your comment about my not posting often enough, so don’t feel bad. I certainly prefer hearing that to hearing that I post too frequently. And I agree that the Fisher equation is of supreme importance. I would just note that your proposition 2) is misleading because it doesn’t distinguish between a one-time increase in M (which should not increase the nominal rate of interest) from an increase in the growth rate of M (which should increase the nominal rate of interest).

    Rob, Thanks for sharing that thought, very much appreciated.


  14. 14 W. Peden December 29, 2014 at 4:11 pm

    David Glasner,

    I agree that there are qualifications, and I do think that even the most general empirical propositions in economics are statistical generalizations rather than exceptionless laws. And that’s not a big problem for economics as a science.

    Thanks for the point on not confusing one-time vs. growth rate shifts in expressing the Fisher equation.


  15. 15 David Glasner December 30, 2014 at 9:29 am

    W, OK, but we may still disagree about how useful those quantity theoretic generalizations are.


  16. 16 Kurt Schuler January 2, 2015 at 8:19 pm

    “I can’t think of an effective monetary policy that was ever implemented by targeting a monetary aggregate.” How about the freezing of the supply of greenbacks. which was effective in achieving the deflation necessary to return to the pre-Civil War gold parity. The U.S. economy grew during that period, though likely not as much as it would have had the dollar been repegged in 1865 at the market rate with gold.


  17. 17 David Glasner January 4, 2015 at 7:59 am

    Kurt, Good point. But I think that the greenbacks were a special case, because it was more of strategy to lend credibility to the goal of joining the gold standard after convertibility was suspended in the Civil War. I was thinking more in terms of controlling monetary aggregates in place of any other nominal target.


  18. 18 Jason Smith January 16, 2015 at 12:36 pm

    Hi David,

    I wrote a bit about the identification problem; if supply and demand curves come from a more general principle (information equilibrium) then it’s not as much of a problem. And if you use the same general principle for money, you can get the quantity theory and something like the IS-LM model as different limits (a high inflation limit and a low inflation limit, respectively). I’d agree that a monomaniacal focus on the quantity theory is bad (and in fact incorrect for the current situations in the US, Japan, EU, etc), but it does appear empirically to be valid sometimes — so we shouldn’t throw the baby out with the bathwater.


  1. 1 TheMoneyIllusion » Nobody is going to out-”crotchety old man” me! Trackback on December 23, 2014 at 8:38 pm

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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.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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