Saturday, June 10, 2017

Monetarism and the Neo-Wicksellian Framework

I know I'm about a year late to the party, but recently I have been listening to David Beckworth's Macro Musings podcast. Two interviews that particularly caught my attention were the one with Nick Rowe and the one with Brad Delong. In the ten months since Brad and Nick were on the podcast the world has been too preoccupied with Donald Trump's antics and, more recently, the snap general election in the UK to do much discussion of economics, but now I want to talk a little bit about the relationship between monetarism and new Keynesianism.

Both Brad and Nick argue when talking to David that new Keynesians are really all monetarists, or, more specifically, that in the 1990's everyone agreed that economic fluctuations were caused by disruptions in the demand and supply for money and that the big question was what rule should replace Milton Friedman's k% rule for monetary policy. According to Nick, the absence of money in new Keynesian models is really just implicit because if the model had no money (i.e. if it were a barter economy) agents would just "barter their way back to full employment."

I think the idea that recessions are just excess demand for money is interesting, especially since it applies even in the very Keynesian context of IS-LM. With the LM curve relating real money demand to output and the interest rate, it is clear that shifts in the IS curve are the same thing as higher demand for money at a given interest rate. If we write the LM curve as M/P = L(Y,r) = aY - br and the IS curve as Y = c - dr, then we can figure out what happens if a recession hits -- in this case that means c falls. In a normal IS-LM diagram, the IS curve would shift left, and both r and Y would fall, but if you look at it slightly differently by holding Y constant given the fall in c, you can see that a shift in the IS curve just changes the level of r for a given Y. Substituting this back into the LM curve shows that money demand for a given level of Y has increased: M/P = aY - br = aY - b/d(c+Y) = (a - b/d)Y -b/dc.

That might be really confusing, and I apologize for not being able to explain things as succinctly as Nick can, but basically I'm saying that recessions (drops in aggregate demand) are just increases in the demand for money (given the level of real GDP) that are not met with increases in the supply of money. Since the quantity of money demanded must equal the quantity supplied, output falls to reduce money demand to the appropriate level. That's why if c falls by, for example, 10 in the model above, then the real money supply must increase by b/d*10 for output to remain constant.

Bringing expectations into the money demand function makes things a little more interesting. Let's say money demand increases when inflation expectations are low because, per the fisher equation, low inflation expectations mean low nominal interest rates and low interest rates cause less incentive for people to hold interest bearing assets in place of money. In this case, if something causes inflation expectations to fall precipitously, money demand will increase and, absent central bank action to increase the money supply, a recession will occur. If, as is true in most cases, central banks have control over inflation expectations in the medium to long term, they effectively have the power to shift around the demand for money. Thus, monetary policy can take two forms: open market operations and expectations management.

This is where Neo-Wicksellian comes in. I've written a little bit about this before, but monetarists usually prefer the money demand/supply description of monetary policy because they see interest rates as a bad indicator of economic conditions (never mind that wild swings in money demand also make most measures of the money supply bad indicators of economic conditions). I, however, think that the monetary explanation of business cycles and the Neo-Wicksellian description are very similar, but that using interest rates has a couple of distinct advantages.

In its simplest form, the Neo-Wicksellian framework just says that if the central bank sets a nominal interest rate above the natural interest rate, there will be a recession and vice versa. Thus, with a relatively constant natural interest rate, high interest rates lower aggregate demand while low interest rates raise aggregate demand. The problem is that the natural rate of interest -- which you could consider as the level of r that keeps Y constant in the IS curve above -- fluctuates around a lot, which makes interest rates look procyclical.

Another important thing to notice is that central banks can influence the natural rate by changing inflation expectations, which is basically the same as how they change money demand. In way, the Neo-Wicksellian framework in which recessions are equivalent to interest rates above the natural rate of interest and the "monetarist" view in which recessions are excess demand for money are basically the same thing, just with the focus on different variables.

The Neo-Wicksellian view does have one advantage in my opinion though: it more accurately shows constraints on monetary policy. In the monetarist view, the solution to a shortfall in aggregate demand is always more money, but the Neo-Wicksellian view shows that there are constraints to monetary policy, at least in the present. If the natural interest rate falls below zero, the central bank no longer has the ability to just cut interest rates/just increase the money supply to ward of a recession. At this point, the only way a central bank can end the shortfall in aggregate demand is to increase expected inflation so that the natural interest rate is no longer negative. This is why increasing the monetary base from about $800 billion to about $1.7 trillion didn't stop GDP from collapsing in 2008.

Given that Neo-Wicksellian and monetarist frameworks both work as ways of looking at the same IS-LM model, I don't know how valid it is to say that everyone became a monetarist or that everyone became a "new Keynesian" in the 1980's and 1990's. It seems like there really isn't that much difference between either group in the first place. At least over the last few years, the real split in economics seems to be between people like John Cochrane who are skeptical of sticky prices and that fiscal policy can raise aggregate demand at all and everyone else.


  1. Is there a typo here: "With the LM curve relating real money demand to output and the interest rate, it is clear that shifts in the IS curve are the same thing as higher demand for money at a given interest rate."? Should "shifts in the IS curve" be "shifts in the LM curve"?

    "If we write the LM curve as M/P = L(Y,r) = aY - br and the IS curve as Y = c - dr, then we can figure out what happens if a recession hits -- in this case that means c falls." Well, a fall in c would be *one* possible cause of a recession, in this model, but changes in a, b, or d could also cause a recession. (Perhaps that's what you meant.)

    "That might be really confusing,..." Nope. Quite clear.

    One way (my preferred way) to introduce changes in expected inflation into ISLM is to stick a vertical wedge between the IS and LM curves (to the right/left of where they cross, if expected inflation is positive/negative). The height of the wedge equals the expected inflation rate. Read nominal i off the LM curve (top of the wedge) and real r off the IS curve (bottom of the wedge).

    "In the monetarist view, the solution to a shortfall in aggregate demand is always more money,..." Remember that both current and expected future money supplies matter. An increase in expected future money (via raising expected inflation) reduces the current demand for money. (Slightly off-topic, but Silvio Gessel's tax on money can be seen as a sort monetarist policy, that also works by reducing the demand for money.)

    Attacking the substance of your good post (though there is much here I agree with):

    1. The upward-sloping (as opposed to vertical) LM curve only makes sense under the assumption that "money" pays an exogenously fixed 0% nominal interest. That is true for currency, but is not generally true. The whole model rests on one very institution-specific assumption. Drop that assumption, and interest rates lose their role as affecting the demand for money.

    2. Let me throw this old post at you:

    1. It's not actually a typo; money demand increases in two cases: when there are direct shocks to the LM curve, and when there is a negative shock to the IS curve. If you substitute the IS equation into the LM equation (M/P = aY - br = aY - b/d(c+Y) = (a - b/d)Y -b/dc), you see this. If c falls (which could be because the government cuts spending, consumers are suddenly up against their borrowing constraints, businesses and household revise their expectations of economic growth down significantly, or some other random reason), then the demand for money at full employment is higher.

      Maybe it would've been better if I posited the money demand curve (all variables in logs) m(t)-p(t) = y(t) - ai(t), and solved it forward for the price level at period t assuming rational expectations and flexible prices (so that y(t) = y and i(t) = r* + pi(t+1)) so that the role of expected permanence in monetary expansions was clear, but I'm skeptical of the extent that rational expectations are consistent with reality and I wanted to keep the math as simple as possible, so I just stuck with static IS-LM.

      Regarding your old post, I agree with you that the consumption Euler equation in the standard NK model is awful. Aside from the indeterminacy issues you mentioned, it's really empirically inaccurate ( In terms of deciding whether to use interest rates or money as indicators of monetary policy, I think it's pretty clear neither does the job exceedingly well; the both r* and money demand fluctuate too much, but I like the idea of having a Taylor Rule quantify monetary policy. Of course you could write a rule for how the monetary base behaves, but it wouldn't be simple and it'd be really hard to justify quadrupling the monetary base no matter what the economic conditions are if you're targeting money. I don't like broader measure either, because central banks don't have direct control over M1, let alone M2 or M3.


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