Repeat after Me: Inflation’s the Cure not the Disease

Last week Martin Feldstein triggered a fascinating four-way exchange with a post explaining yet again why we still need to be worried about inflation. Tony Yates responded first with an explanation of why money printing doesn’t work at the zero lower bound (aka liquidity trap), leading Paul Krugman to comment wearily about the obtuseness of all those right-wingers who just can’t stop obsessing about the non-existent inflation threat when, all along, it was crystal clear that in a liquidity trap, printing money is useless.

I’m still not sure why relatively moderate conservatives like Feldstein didn’t find all this convincing back in 2009. I get, I think, why politics might predispose them to see inflation risks everywhere, but this was as crystal-clear a proposition as I’ve ever seen. Still, even if you managed to convince yourself that the liquidity-trap analysis was wrong six years ago, by now you should surely have realized that Bernanke, Woodford, Eggertsson, and, yes, me got it right.

But no — it’s a complete puzzle. Maybe it’s because those tricksy Fed officials started paying all of 25 basis points on reserves (Japan never paid such interest). Anyway, inflation is just around the corner, the same way it has been all these years.

Which surprisingly (not least to Krugman) led Brad DeLong to rise to Feldstein’s defense (well, sort of), pointing out that there is a respectable argument to be made for why even if money printing is not immediately effective at the zero lower bound, it could still be effective down the road, so that the mere fact that inflation has been consistently below 2% since the crash (except for a short blip when oil prices spiked in 2011-12) doesn’t mean that inflation might not pick up quickly once inflation expectations pick up a bit, triggering an accelerating and self-sustaining inflation as all those hitherto idle balances start gushing into circulation.

That argument drew a slightly dyspeptic response from Krugman who again pointed out, as had Tony Yates, that at the zero lower bound, the demand for cash is virtually unlimited so that there is no tendency for monetary expansion to raise prices, as if DeLong did not already know that. For some reason, Krugman seems unwilling to accept the implication of the argument in his own 1998 paper that he cites frequently: that for an increase in the money stock to raise the price level – note that there is an implicit assumption that the real demand for money does not change – the increase must be expected to be permanent. (I also note that the argument had been made almost 20 years earlier by Jack Hirshleifer, in his Fisherian text on capital theory, Capital Interest and Investment.) Thus, on Krugman’s own analysis, the effect of an increase in the money stock is expectations-dependent. A change in monetary policy will be inflationary if it is expected to be inflationary, and it will not be inflationary if it is not expected to be inflationary. And Krugman even quotes himself on the point, referring to

my call for the Bank of Japan to “credibly promise to be irresponsible” — to make the expansion of the base permanent, by committing to a relatively high inflation target. That was the main point of my 1998 paper!

So the question whether the monetary expansion since 2008 will ever turn out to be inflationary depends not on an abstract argument about the shape of the LM curve, but about the evolution of inflation expectations over time. I’m not sure that I’m persuaded by DeLong’s backward induction argument – an argument that I like enough to have used myself on occasion while conceding that the logic may not hold in the real word – but there is no logical inconsistency between the backward-induction argument and Krugman’s credibility argument; they simply reflect different conjectures about the evolution of inflation expectations in a world in which there is uncertainty about what the future monetary policy of the central bank is going to be (in other words, a world like the one we inhabit).

Which brings me to the real point of this post: the problem with monetary policy since 2008 has been that the Fed has credibly adopted a 2% inflation target, a target that, it is generally understood, the Fed prefers to undershoot rather than overshoot. Thus, in operational terms, the actual goal is really less than 2%. As long as the inflation target credibly remains less than 2%, the argument about inflation risk is about the risk that the Fed will credibly revise its target upwards.

With the both Wickselian natural real and natural nominal short-term rates of interest probably below zero, it would have made sense to raise the inflation target to get the natural nominal short-term rate above zero. There were other reasons to raise the inflation target as well, e.g., providing debt relief to debtors, thereby benefitting not only debtors but also those creditors whose debtors simply defaulted.

Krugman takes it for granted that monetary policy is impotent at the zero lower bound, but that impotence is not inherent; it is self-imposed by the credibility of the Fed’s own inflation target. To be sure, changing the inflation target is not a decision that we would want the Fed to take lightly, because it opens up some very tricky time-inconsistency problems. However, in a crisis, you may have to take a chance and hope that credibility can be restored by future responsible behavior once things get back to normal.

In this vein, I am reminded of the 1930 exchange between Hawtrey and Hugh Pattison Macmillan, chairman of the Committee on Finance and Industry, when Hawtrey, testifying before the Committee, suggested that the Bank of England reduce Bank Rate even at the risk of endangering the convertibility of sterling into gold (England eventually left the gold standard a little over a year later)

MACMILLAN. . . . the course you suggest would not have been consistent with what one may call orthodox Central Banking, would it?

HAWTREY. I do not know what orthodox Central Banking is.

MACMILLAN. . . . when gold ebbs away you must restrict credit as a general principle?

HAWTREY. . . . that kind of orthodoxy is like conventions at bridge; you have to break them when the circumstances call for it. I think that a gold reserve exists to be used. . . . Perhaps once in a century the time comes when you can use your gold reserve for the governing purpose, provided you have the courage to use practically all of it.

Of course the best evidence for the effectiveness of monetary policy at the zero lower bound was provided three years later, in April 1933, when FDR suspended the gold standard in the US, causing the dollar to depreciate against gold, triggering an immediate rise in US prices (wholesale prices rising 14% from April through July) and the fastest real recovery in US history (industrial output rising by over 50% over the same period). A recent paper by Andrew Jalil and Gisela Rua documents this amazing recovery from the depths of the Great Depression and the crucial role that changing inflation expectations played in stimulating the recovery. They also make a further important point: that by announcing a price level target, FDR both accelerated the recovery and prevented expectations of inflation from increasing without limit. The 1933 episode suggests that a sharp, but limited, increase in the price-level target would generate a faster and more powerful output response than an incremental increase in the inflation target. Unfortunately, after the 2008 downturn we got neither.

Maybe it’s too much to expect that an unelected central bank would take upon itself to adopt as a policy goal a substantial increase in the price level. Had the Fed announced such a goal after the 2008 crisis, it would have invited a potentially fatal attack, and not just from the usual right-wing suspects, on its institutional independence. Price stability, is after all, part of dual mandate that Fed is legally bound to pursue. And it was FDR, not the Fed, that took the US off the gold standard.

But even so, we at least ought to be clear that if monetary policy is impotent at the zero lower bound, the impotence is not caused by any inherent weakness, but by the institutional and political constraints under which it operates in a constitutional system. And maybe there is no better argument for nominal GDP level targeting than that it offers a practical and civilly reverent way of allowing monetary policy to be effective at the zero lower bound.

29 Responses to “Repeat after Me: Inflation’s the Cure not the Disease”


  1. 1 Thomas Aubrey June 4, 2015 at 9:50 pm

    David,

    I’m not sure the argument that rising consumer inflation expectations in the 1930s is as relevant to today’s economy as you imply. Firstly there was no specific inflation target during the 30s, so the concept of a permanent rise in the monetary base would have had a much greater chance of increasing consumption. If the Fed decided to target a level of 4% today, many consumers might be persuaded by the argument that once the level hits 4%, the Fed might want to reduce that to 2%, implying that the rise would unlikely be permanent.

    High levels of consumer debt have also played a role in the recent challenge of “re-inflating” the economy which didn’t exist in the 30s. As such even if we had hit higher levels of inflation, the medium term effects may have been minimal as consumers paid down debt instead of spending. Take the recent oil windfall. Consumers have not spent much of that. However I do accept the argument that once sustainable levels of debt have been reached then you would get the desired effect, but who knows how long that might take.

    Also I would have thought that the cause of rising inflation expectations is rather important here as well. Ie there is a significant difference between an attempt to raise the monetary base vs rising expectations driven by a long term commodities boom feeding through into core inflation. I find it difficult to agree that if we had inflation of 4% YOY driven by rising commodity prices this would have been beneficial. (Never reason from a price change?)

    Finally, your claim that the Wicksellian natural rate remains below zero is based on the assumption that the marginal rates of return on capital will naturally tend towards the money rate due to perfect competition. The challenge here is that perfect competition is not prevalent in most markets. The marginal return on capital (Wicksellian natural rate) is still in high single digits in the US, but firms are happy to limit the number of projects to ensure that returns to shareholders are not diluted with high barriers to entry preventing new entrants as mentioned here. http://www.creditcapitaladvisory.com/2014/09/04/swedish-perspective-equilibrium-level-interest/

  2. 2 Ari Andricopoulos June 5, 2015 at 1:00 am

    As a non-economist, I do find the whole idea that inflation expectations drive inflation to be slightly ridiculous. For empirical evidence of this, see what happened after QE when people were talking about hyper-inflation.

    Inflation is driven by an excess of demand over supply. To the extent that high inflation expectations increase demand then they can increase inflation. But this could only be a good thing at the moment when we clearly have deficient demand.

    Even if everyone expected very high inflation, if there was not enough money spent then it would not come. Businesses may raise prices in anticipation but people would simply not be able to afford them.

    I have a feeling that a misunderstanding grew in the 1970s, when I believe that inflation expectations led to higher wages demanded by government employees, which led to more money being printed to pay for it. Since this is not the way central banks work these days, it is irrelevant.

    Excellent article by the way.

  3. 3 Ari Andricopoulos June 5, 2015 at 1:10 am

    Also, I agree with your point. I am a strong believer that we need moderate inflation to have any way of getting out of the secular stagnation. And also to reduce the inequality between savers and workers.

    http://www.notesonthenextbust.com/2015/04/rising-inequality-explained-not-using-r.html

  4. 4 Nick Rowe June 5, 2015 at 3:48 am

    Good post. I think my own take on the backward induction argument is consistent with what you are saying here. It depends on whether we have some sort of level path target, or an inflation target.
    http://worthwhile.typepad.com/worthwhile_canadian_initi/2015/06/back-propagation-induction-does-not-work-under-inflation-targeting.html

    The 1933 example deserves a lot more attention than it gets. I see you and Scott talking about it, but few others. Did any other countries do anything similar around the same time?

  5. 5 JP Koning June 5, 2015 at 7:22 am

    David, I think I disagree with you. You say that monetary policy is impotent because of an inability to raise the inflation target. It seems to me that its impotence can be traced back to flaws in the tools at hand. At positive nominal interest rates, permanent ‘money printing’ has no significant effect once a central bank decides to institute a deposit facility, i.e. pays interest on reserves. See my post on the RBNZ’s cashing up of the system, for instance. The problem is that the interest rate tool overwhelms the quantity of money tool. So even if the RBNZ had announced a higher inflation target and permanently flooded the system with reserves, it would have failed to hit that target unless it had also lowered its deposit rate. At positive nominal rates, this poses no problems since there’s plenty of room for the deposit rate to fall.

    The same principles apply when nominal rates are at 0%, except there’s less room to play around with the deposit rate. This means that a central bank can’t just announce a higher inflation target and expect to print its way towards that goal. It needs to do something to its deposit rate, either by finding a way to get it significantly below 0% or promising to keep it irresponsibly low in the future. The latter, forward guidance, is difficult for markets to grok, which leaves the former as the best option. Unfortunately, to do this we need to modify the institution of cash in several ways. If we can make these changes, then central banks would have a means to hit a higher inflation target at the zero lower bound. So it’s the tools that are to blame, and only after that can we blame political constraints for the lack of a higher inflation target.

  6. 6 sanjait June 5, 2015 at 9:13 am

    Well said. The difference between DeLong’s backward induction world and the real world is expectations.

    The Fed has been vocal about its concerns for too high inflation while inflation has been too low (what BDL calls “crying ‘fire!’ during Noah’s flood.”). It’s clear they don’t intend to promote above target inflation on any time scale, and definitely not permanently. They are even explicit about the fact they intend to undershoot the target in the short run.

    Seems clear to me that the Fed could do more to promote inflation and that it should. It’s failure to do so is a tragically missed opportunity to help the economy and unemployed.

  7. 7 Vivek June 5, 2015 at 3:51 pm

    hmm…surprised that you pay so much heed to the “expectations channel”. i mean inflation expectations will increase when realized inflation increases. not due to some tomfoolery by the central bank.

    that is what happened 1933. promising credibly not to be credible is fine as far as an academic paper goes.

    but what evidence do we have to believe that such declarations by the central bank will move inflation expectations (say wage negotiations) in practice? is there even once instance where this has worked?

  8. 8 Max June 5, 2015 at 4:08 pm

    JP, the assumption is that a higher inflation target raises the equilibrium interest rate. So no need to lower rates. To avoid missing the new target high, the central bank would probably have to raise rates.

  9. 9 Fed Up June 5, 2015 at 4:45 pm

    How about a definition of monetary policy?

  10. 10 Robert Crosby (@Otey71) June 5, 2015 at 4:49 pm

    Good post. A fun read. To a non-economist, it was refreshingly devoid of much of the profession’s jargon. Please do more like it.

    I too would like to know more about 1933. Could you link to some sources? The period strikes me as quite relevant to our current one. An object lesson we have forgotten?

  11. 11 Fed Up June 5, 2015 at 4:50 pm

    “There were other reasons to raise the inflation target as well, e.g., providing debt relief to debtors, thereby benefitting not only debtors but also those creditors whose debtors simply defaulted.”

    I do not agree with that although I have seen it at many places online. What happens if prices go up and wages do not?

  12. 12 cmamonetary.org June 5, 2015 at 6:22 pm

    “in a liquidity trap, printing money is useless.” Print money and give it to people. You will get a different result. The unemployed, people on low incomes etc… all spend.

  13. 13 Ludwig Von Mofo June 6, 2015 at 3:43 am

    The intellectual deficit here is shocking. One can not push on a string. Money will not flow where one wants it to flow. Sure, you can stimulate in an “effort” to create inflation – but the nanosecond capital flows to non productive assets like housing, or is misallocated in terms of return (like our current Internet bubble) then the game of liquidity creation has by definition failed.

    If liquidity creation does not create productivity, and instead flows towards asset price inflation — then the monetary authorities have succeeded in nothing but creating drag.

    This is exactly where we are now. And yet you call for more “drag creation” under the pretense that additional funds will magically flow where you want them to flow.

    This doesn’t work. It provably doesn’t work.

    Your religion has failed you.

  14. 14 Miguel Navascués June 6, 2015 at 9:40 am

    David, great post, but I don’t see the connexion BT higher expected inflation and the NGDP objective. I don’t see that NGDP imply more confidence in central bank objective. What would have happen if the FED had announced a 5% NGDP objective? would it have been more effective? the problem is what you say: FED was not able to announce a higher inflation (or a higher % NGDP). Probably it would have been too much in the political and social context. It was obliged to announce a higher inflation but not much higher than usual.
    Something that we must surely put in charge of the “Great Moderation”.
    FDR had to break very much conventional ideas; probably some radical actions, as the exit of gold, were very more compelling to rise the expected inflation. It is this view that I understand the fiscal policy proposals as a complement for the MP: a more rapid way to rise expected inflation.

  15. 15 ezra abrams June 6, 2015 at 11:36 am

    not an economist, may have missed it, but in all the posts by all the people involved,
    the only empirical thing I’ve seen is the jalil rua paper you cite
    reading the intro, does’nt seem like empirical data all that good

    recently, thoma asked why people don’t trust economists
    couldn’t one of you guys managed to cite an ungated paper that summarizes the empirical data on expectations, that they are a real thing and not just theory ?

  16. 16 JKH June 6, 2015 at 11:47 pm

    ” They also make a further important point: that by announcing a price level target, FDR both accelerated the recovery and prevented expectations of inflation from increasing without limit. ”

    ” preventing … without limit ” is an important risk management idea. Ensuring this may require putting on the brakes and even some degree of reversing at some future point.

    I have trouble accepting or understanding Krugman’s ” permanent ” strategy in this context.

  17. 17 Benjamin Cole June 8, 2015 at 7:12 am

    Excellent blogging. Perhaps the Fed could adopt a 1.5% to 2.5% IT band without political backlash…
    Also the right-wing may go mute on Fed stimulus as soon as there is a GOP president…this fetish on inflation and gold seemed to reach a zenith with Obama…
    Side note: QE working in Japan? Q1 GDP up 3.9%…

  18. 18 David Glasner June 8, 2015 at 10:20 am

    Thomas, FDR on a number of occasions, most notably his message to the International Monetary Conference in June 1933 stated that his goal was to restore the pre-downturn price level. In the message to the International Monetary Conference he specified the 1926 price level. Of course he left the price level undefined, but the general goal was fairly clearly specified. I agree that the Fed could announce that it was only raising its inflation goal temporarily, but the point of the 1933 episode is that a short burst of rapid inflation might generate the biggest output response. That kind of an inflationary burst would be easier to manage with a price level target than an inflation target. For repairing balance sheets, a quick 10% increase in prices would also be more effective than stretching it out over several years. Also you may be misunderstanding my point insofar as you are suggesting that I am not calling for an increase in the monetary base. The question is whether an increase in the monetary base can be effective when the inflation (or price level) target is not changed. I am saying that if the inflation target is held constant, increasing the monetary base creates the very problem that, according to Krugman, renders monetary policy impotent.

    Ari, Thanks. I agree that there is something disturbing about the notion that the primary cause of inflation is expected inflation. But remember that there is no reason, other than acceptability as payment of tax obligations, for fiat money to have value other than the expectation that it will have value in the future. So the value of money is entirely (or mostly) contingent on the expectation of its future value.

    Nick, Have a look at the Jalil and Rua paper, they compare the experience of the US and other countries that went off the gold standard. None had anywhere near the output response that the US had. Their explanation is that only in the US was a clear inflationary (or reflationary) policy articulated when the gold standard was suspended.

    JP, And I thought that I could always count on you. I think that this is a case of overdetermination. I agree that paying interest on reserves is a big problem. I am only saying that expecting monetary policy to be stimulative without raising a relevant nominal target can also be a cause of impotence.

    sanjait, It was actually Hawtrey who compared people warning of inflation in the Great Depression to people crying fire fire in Noah’s flood. BDL was just quoting Hawtrey. Otherwise, we are on the same page.

    Vivek, I am not sure what you think happened in 1933. The gold standard was suspended, the dollar depreciated relative to gold and FDR announced that he wanted to restore the 1926 price level. Is your story any different?

    Fed Up, What ambiguity do you think requires clarification by way of definition. There is nothing intrinsically important about a definition.

    Robert, I did link to the Jalil Rua paper. Also see my 2012 post about Hawtrey and the Short but Sweet 1933 Recovery and my recent post A New Paper about the Short but Sweet 1933 Recovery Shows that Hawtrey and Cassel Got it Right.

    Fed Up, If prices rise and wages do not, employment will probably expand because the profitability of additional workers will be increased. As employment expands, real wages will tend to rise.

    cmamonetary.org, That’s certainly a possible strategy, but the Fed can’t just give money to people. Only Congress and the President can do that.

    Ludwig, Increasing inflation expectations means that you are not pushing on a string. If something fails by definition, it is not clear to me whether the problem is the thing or the definition. It is possible that my religion may have failed me; it is also possible that your definitions may have failed you.

    Miguel, Thanks. I think that announcing an increased target level of NGDP would operate similarly to an increase in a price level target, so it would produce a similar type of effect to what FDR achieved in 1933. But you may be right that it would not. If so, something more explicit would be necessary.

    Ezra, Until the advent of TIPS, there was so market in which one could see any market price corresponding to expected inflation. So inflation expectations were a purely hypothetical and unobservable concept. So I am sorry, it is what it is.

    JKH, Good point.

    Benjamin, Thanks. I agree with you that right-wing critics of the Fed are being very hypocritical. However, they are digging themselves very deeply into a hole, that will not be easy for them to get out of if they take control of the Fed.

  19. 19 jonny bakho June 8, 2015 at 10:53 am

    I agree inflation, specifically WAGE INFLATION is the cure. Commodity inflation does not help if wages are stagnant. Wage Inflation would speed deleveraging & balance sheet repair, stimulate new demand, make borrowing more affordable and increase demand. We get wage inflation by changes in fiscal (stimulus) and regulatory (Higher MinWage) policies and encouragement from monetary policy.

    Monetary policy is like a brake on the economic engine. Apply the brake (restrict the money supply) and the economy will slow, demand will decline, inflation will decline and unemployment will rise. Fully release the brake and the economic engine will run at its full potential. Friedman’s monetary policy works, but only if the economic engine can operate fast enough.

    If the economic engine generates enough demand, demand outpaces production and results in inflation. Inflation dampens demand or leads to application of the monetary brake. We have been through a long period where these conditions held and the monetary brakes were useful.

    In the wake of our financial crisis, the maximum demand that the economic engine generates is not enough to increase inflation or decrease unemployment. The debt overhang continues to suck the fuel out of the economy as money goes to deleveraging (savings) rather than demand, the collapse of collateral has forced deleveraging and impeded new borrowing, the high unemployment, stagnant wages and reduction in hours worked has increased the time to complete the necessary deleveraging and starved the economy of demand. Changes in policy such as moving education costs from government purchase to individual borrowing decrease the money available for demand. Stagnant wages and achieving a 2% inflation target have made borrowing less affordable and more unpalatable. All these policies have slowed the economic engine to where it no longer can meet the desired inflation target with the monetary brakes fully released!!

    Monetary policy is NOT the problem. The problems are a host of fiscal and regulatory policies that restrict economic output and growth, sometimes through unintended consequences, but mostly due to a lack of BigG investment in the domestic economy. The solution is to apply appropriate fiscal and regulatory policy to speed up the economic engine to conditions where monetary policy once again becomes effective. Attention should be directed at fixing the fiscal and regulatory problems, not the monetary non-problem.

  20. 20 Fed Up June 8, 2015 at 2:02 pm

    Let’s assume pre-2008 conditions.

    I have been told the definition of monetary policy is the fed buying assets.

    I believe it is mostly about setting the fed funds rate along with some other things.

    Which is it (buying assets or setting the fed funds rate)?

    Also, I have been told open market operations (including prior to 2008) and QE of buying U.S. treasuries are the same thing. Agree or disagree?

    “Fed Up, If prices rise and wages do not, employment will probably expand because the profitability of additional workers will be increased. As employment expands, real wages will tend to rise.”

    That is possible, but I do not believe that is the most likely outcome. Let’s say prices rise, but quantities do not (or even go down) because supply = demand. The electricity market would be a fairly good example. With productivity = 0, employment will stay the same. The firm will save the increase in revenue from the price rise. Firms respond to quantities, not prices. The people buying the electricity bear the cost by having less to spend on other things.

  21. 21 David Glasner June 8, 2015 at 7:18 pm

    Jonny, Well the 1933 episode suggests that it is price inflation resulting from devaluation of the dollar, rather than wage inflation, that triggered the recovery, and very possibly that the wage increases imposed by FDR’s ill-conceived NIRA that aborted, or at least held back, the recovery.

    Fed Up, Do you think that it is possible for there to be only one method of conducting monetary policy? As I see it, setting an interest rate target is one way of conducting monetary policy, and conducting open market operations is another. I don’t see why that should be problematic? The only difference between open-market operations and QE is that open-market operations are usually restricted to shorter-term Treasury instruments and QE includes longer term instruments, perhaps including non-Treasury instruments.

    Amount supplied equals amount demanded at a market-clearing price, and the price adjusts to clear the market. Supply does not equal demand by definition or under all conditions, so you are reasoning from an incorrect premise.

  22. 22 nottrampis June 8, 2015 at 7:57 pm

    David, yet another wonderful article with great follow up from people and further comment from you. Highly illuminating

    thanks a lot.

  23. 23 Fed Up June 8, 2015 at 8:46 pm

    “Fed Up, Do you think that it is possible for there to be only one method of conducting monetary policy?” No.

    “As I see it, setting an interest rate target is one way of conducting monetary policy” OK

    “conducting open market operations is another.” OK

    “I don’t see why that should be problematic?” There are plenty of people who say monetary policy is not about interest rates, just buying assets/open market operations.

    Also, is there a definition of monetary policy?

    “Amount supplied equals amount demanded at a market-clearing price, and the price adjusts to clear the market. Supply does not equal demand by definition or under all conditions, so you are reasoning from an incorrect premise.”

    I hope we do not get into a long discussion about quantity actually bought and sold is whichever is less: quantity demanded or quantity supplied.

    Let’s say quantity demanded for electricity is 1,000 and quantity supplied is 1,000 at $100. The electricity supplier raises the price to $102 to meet a 2% price inflation target. The quantities stay the same. That rise in price did not reflect an actual shortage. In a market economy, aren’t rising prices supposed to reflect an actual shortage?

    “The only difference between open-market operations and QE is that open-market operations are usually restricted to shorter-term Treasury instruments and QE includes longer term instruments, perhaps including non-Treasury instruments.”

    I think there is a difference. Pre-2008 open market operations allowed both currency and central bank reserves to be reversed at any time. With QE, currency can be reversed at any time, but the central bank reserves can not be reversed at any time. I would also call the conditions of reversal conducting monetary policy.

  24. 24 David Glasner June 9, 2015 at 9:10 am

    Nottrampis, Many thanks.

    Fed Up, I think perhaps what people mean when they say that monetary policy is about buying assets and open market operations is that an interest rate policy will have implications for the central bank’s balance sheet. Two sides of the same coin. I’m sorry but I’m too lazy or too uninterested to come up with a definition of monetary policy for you.

    You said:

    “Let’s say quantity demanded for electricity is 1,000 and quantity supplied is 1,000 at $100. The electricity supplier raises the price to $102 to meet a 2% price inflation target. The quantities stay the same. That rise in price did not reflect an actual shortage. In a market economy, aren’t rising prices supposed to reflect an actual shortage?”

    If the electricity supplier is able to sell electricity for 2% more than previously and his costs (by assumption) have not risen, the supplier will have an incentive to produce a bit more which will mean that the supplier’s demand for inputs will rise, thereby raising the incomes of whatever input suppliers he is buying from. They, in turn, will have more income to spend and will increase their demands for other stuff.

    You said:

    “Pre-2008 open market operations allowed both currency and central bank reserves to be reversed at any time. With QE, currency can be reversed at any time, but the central bank reserves can not be reversed at any time. I would also call the conditions of reversal conducting monetary policy.”

    Sorry, I have no idea what it means for central bank reserves to be “reversed” and why there was any difference in “reversibility” pre- and post- 2008.

  25. 25 Fed Up June 9, 2015 at 3:01 pm

    “Fed Up, I think perhaps what people mean when they say that monetary policy is about buying assets and open market operations is that an interest rate policy will have implications for the central bank’s balance sheet. Two sides of the same coin.”

    Let’s assume a 0% reserve requirement, desired demand for currency is 0, and desired demand for central bank reserves is 0. Ignoring the costs of running the fed, can the fed set the fed funds rate with a zero balance sheet? Is there an announcement effect for the fed funds rate? The point is that if currency is 0 along with yielding 0% and central bank reserves are 0 along with yielding 0%, there are plenty of people who would say monetary policy has to be unchanged even if the fed funds rate is changed because the stance of monetary policy should not be measured by interest rates, excluding what is paid on the monetary base.

    Also, I am not sure that is what they mean. I was led to believe it is buy bonds/sell central bank reserves to lower the fed funds rate, and the opposite to raise it.

    “If the electricity supplier is able to sell electricity for 2% more than previously and his costs (by assumption) have not risen, the supplier will have an incentive to produce a bit more”

    The supplier/seller wants to sell more than 1,000 at $102. However, the buyers still only demand 1,000 at $102. 1,000 will still equal actual quantity bought and sold. No change for inputs.

    “Sorry, I have no idea what it means for central bank reserves to be “reversed” and why there was any difference in “reversibility” pre- and post- 2008.”

    If the fed bought $100 billion in bonds from the commercial banks before 2008 and that created excess central bank reserves in the banking system, the banks could immediately go back to the fed and buy the bonds back. If there is QE (post 2008) and the banks try to buy the bonds back from the fed for the excess central bank reserves, the fed says no. Pre-2008, central bank reserves were demand determined. With QE/post-2008, central bank reserves are supply determined.

  26. 26 David Glasner June 10, 2015 at 8:59 pm

    Fed Up, If there is zero demand for reserves and for currency, there is no monetary policy because the Fed has become irrelevant. It is only relevant because there is a demand to hold its liabilities.

    If it is profitable for the electricity supplier to supply more electricity after the price of electricity rises by 2%, but it is not selling any more electricity than before with a price 2% higher, it will be profitable for the supplier to reduce its price somewhat so that it can sell more. Please don’t respond by saying that consumers won’t increase their purchases if the electricity supplier reduces its price somewhat.

    The Fed is not selling off the bonds that it has acquired because of a policy choice it has made, not because there is anything intrinsic about those bonds that makes it impossible for the Fed to sell them should it decide to do so.

  27. 27 Fed Up June 14, 2015 at 8:59 pm

    “Fed Up, If there is zero demand for reserves and for currency, there is no monetary policy because the Fed has become irrelevant. It is only relevant because there is a demand to hold its liabilities.”

    I do not think the fed/monetary policy would be irrelevant. They could still set the fed funds rate and still set currency and demand deposits at a fixed exchange rate of 1 to 1 thru the commercial banks waiting just in case the demand should change. Demand deposits would be both medium of account and medium of exchange.

    “The Fed is not selling off the bonds that it has acquired because of a policy choice it has made”

    Pre-2008, did it have a policy choice for the amount of bonds? I turn in currency for demand deposits. The commercial bank turns the currency in for central bank reserves. With an IOR at 0%, the bond is probably going to be sold to keep the fed funds rate on target.

    “Please don’t respond by saying that consumers won’t increase their purchases if the electricity supplier reduces its price somewhat.”

    Is there any way to respond?


  1. 1 Links and Tweets Trackback on June 6, 2015 at 5:02 am
  2. 2 Even a Great Stagnation requires planning! | Historinhas Trackback on June 6, 2015 at 2:36 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.

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