The Long-Run Effects of Monetary Policy on Interest Rates

After reading Scott Sumner’s recent paper on the Princeton School of Macroeconomics and Zero Lower Bound, I revisited papers of other Princeton economists.[1]Sumner, Scott, The Princeton School and the Zero Lower Bound (October 2021). Mercatus Center Working Paper, https://www.mercatus.org/publications/monetary-policy/princeton-school-and-zero-lower-bound In the second part of the paper, Sumner discussed the Princeton School’s relationship with new schools of thought such as Market Monetarism and NeoFisherianism. In this regard, I examined how the work of the Princeton economists relates to some of the key ideas of market monetarism.

The Princeton School has many economists who have changed the course of macroeconomics. Almost everyone knows most of them today, whether they are familiar with macroeconomics. One of them is Refet Gürkaynak. I think his studies, examining the effects of monetary policy statements on markets and interest rates, should be one of the most significant studies in the field.

Refet S. Gürkaynak, Brian P. Sack, and Eric T. Swanson have a particularly interesting 2005 paper.[2]Gürkaynak, Refet S. and Sack, Brian and Swanson, Eric T., Do Actions Speak Louder Than Words? The Response of Asset Prices to Monetary Policy Actions and Statements, International Journal of Central … Continue reading As they write in the abstract:

We investigate the effects of U.S. monetary policy on asset prices using a high-frequency event-study analysis. We test whether these effects are adequately captured by a single factor—changes in the federal funds rate target—and find that they are not. Instead, we find that two factors are required. These factors have a structural interpretation as a “current federal funds rate target” factor and a “future path of policy” factor, with the latter closely associated with Federal Open Market Committee statements. We measure the effects of these two factors on bond yields and stock prices using a new intraday data set going back to 1990. According to our estimates, both monetary policy actions and statements have important but differing effects on asset prices, with statements having a much greater impact on longer-term Treasury yields.

The perspective that Gürkaynak et al. examine the effects of policy shocks is incredibly useful in evaluating monetary policy statements. Because, as Sumner argued in a recent paper, monetary policy works in two dimensions: by the changing levels of key macro variables and by the changing expected growth paths of these variables.[3]Sumner, Scott, A Critique of Interest Rate–Oriented Monetary Economics (November 2020). Mercatus Center Working Paper, … Continue reading Gürkaynak et al. show that the latter effect mostly comes from policy statements.

In another paper, Gürkaynak, Sack, and Swanson discuss the impact of surprise policy shocks on interest rates in the short and long term.[4]Gürkaynak, Refet S. and Sack, Brian and Swanson, Eric T., The Sensitivity of Long-Term Interest Rates to Economic News: Evidence and Implications for Macroeconomic Models, American Economic Review, … Continue reading The importance of this study is better understood after seeing their findings:

Since the federal funds rate has some persistence, as noted by many authors, tighter policy today leads to expectations that the federal funds rate will remain higher in the near future, thus pushing near-term forward rates in the same direction as the policy surprise. At longer horizons, however, forward rates actually move in the direction opposite to that of the policy surprise, i.e., a surprise policy tightening actually causes long-term forward rates to fall.

In fact, their findings seem consistent with market monetarism’s claim that interest rates can be a misleading indicator of the stance of monetary policy(see image below). The news in the media interpret a cut in the federal-funds target as easy money, and vice versa. Even worse, most of the resources you can find online fall into the fallacy of “reasoning from a price change” when defining monetary policy.

Partly, this mistake seems to stem from confusing the short-term and long-term. When interest rates change today, it simply shows the long-term response of interest rates to earlier actions taken by the Fed. Many of your comments about the monetary policy stance will be wrong if you ignore the long-term effects. A fall in nominal interest rates may indeed indicate easier monetary policy, but it may likewise be falling due to other factors.[5]Scott Sumner, The Money Illusion: Market Monetarism, the Great Recession, and the Future of Monetary Policy, The University of Chicago Press, 2021, 166-168.

It can be enlightening to think about the response of interest rates with the example of the Great Recession. Recall that the ECB tightened its monetary policy by raising interest rates in 2008. This caused the eurozone’s recession to deepen, and the consequences were catastrophic.[6]Politano, Joseph, The Great European Undershoot, Apricitas – an Econ Blog (blog), (August 7, 2021). https://apricitas.substack.com/p/the-great-european-undershoot What were the long-term effects of tight money? Lower income, lower inflation, and lower interest rates. If you want high rates over a long period, you must keep interest rates low for an extended period; the long-term response of interest rates will be the opposite direction, as Gurkaynak et al. have shown.

For the same reason, we can better interpret the Great Recession when we consider the cut in 2008 as the long-term response to the Fed’s previously unreasonable tight monetary policy. That’s what many people confuse: When the Fed cut the interest rates in late 2008, the media looked at it as the Fed eased the policy, not as the long-term effect of earlier tight money. If you think about it that way, it’s easy to believe that the Fed had nothing more to do, and it wasn’t Fed policies that triggered the recession. But when you look at it from a long-term perspective, the Fed should have worsened the financial crisis and triggered the Great Recession.[7]Halperin, Basil, Recessions Are Always and Everywhere Caused by Monetary Policy, Basil Halperin (blog), October 28, 2021. … Continue reading

Consequently, it seems quite misleading to interpret the stance of monetary policy by looking only at the changes in interest rates. Changes in interest rates may be due to other factors, or we may be seeing long-term responses. It’s wrong to draw conclusions about the stance of monetary policy without knowing why exactly rates have changed. That’s an essential point,[8]Sumner, Scott, The Dead Horse I’m Beating Is Very Much Alive, The Money Illusion (blog), October 3, 2021. https://www.themoneyillusion.com/the-dead-horse-im-beating-is-very-much-alive/because underestimating the long-term effects can cause a lot of confusion and mistakes, which has already triggered a recession a decade ago.

References

References
1 Sumner, Scott, The Princeton School and the Zero Lower Bound (October 2021). Mercatus Center Working Paper, https://www.mercatus.org/publications/monetary-policy/princeton-school-and-zero-lower-bound
2 Gürkaynak, Refet S. and Sack, Brian and Swanson, Eric T., Do Actions Speak Louder Than Words? The Response of Asset Prices to Monetary Policy Actions and Statements, International Journal of Central Banking, International Journal of Central Banking, vol. 1(1), (May 2005). https://ideas.repec.org/a/ijc/ijcjou/y2005q2a2.html
3 Sumner, Scott, A Critique of Interest Rate–Oriented Monetary Economics (November 2020). Mercatus Center Working Paper, https://www.mercatus.org/publications/monetary-policy/critique-interest-rate%E2%80%93oriented-monetary-economics-0
4 Gürkaynak, Refet S. and Sack, Brian and Swanson, Eric T., The Sensitivity of Long-Term Interest Rates to Economic News: Evidence and Implications for Macroeconomic Models, American Economic Review, 95 (1): 425-436. (2005). DOI: 10.1257/0002828053828446
5 Scott Sumner, The Money Illusion: Market Monetarism, the Great Recession, and the Future of Monetary Policy, The University of Chicago Press, 2021, 166-168.
6 Politano, Joseph, The Great European Undershoot, Apricitas – an Econ Blog (blog), (August 7, 2021). https://apricitas.substack.com/p/the-great-european-undershoot
7 Halperin, Basil, Recessions Are Always and Everywhere Caused by Monetary Policy, Basil Halperin (blog), October 28, 2021. https://www.basilhalperin.com/essays/recessions-are-always-everywhere-caused-by-monetary-policy.html
8 Sumner, Scott, The Dead Horse I’m Beating Is Very Much Alive, The Money Illusion (blog), October 3, 2021. https://www.themoneyillusion.com/the-dead-horse-im-beating-is-very-much-alive/

Sticky Wages: The Key Problem of Macro

The reason we worry about recessions is mostly involuntary unemployment. Because recessions cause employment fluctuations, and this affects the entire economy. But, why do recessions cause employment fluctuations? Indeed, this question is one of the most important questions at the heart of macroeconomics, and it shows us why nominal variables and wage stickiness is so important in recessions.

A useful way to distinguish shocks that affect the economy is to classify them as nominal and real shocks. Real shocks include the natural employment rate, technology shocks, taxes, and similar types of variables. Real shocks are particularly important when prices and wages are relatively flexible. If we lived in a world where all wages are perfectly flexible, nominal variables would be almost unimportant in this sense, and real variables would be enough to explain business cycles. Alas, that’s not the case, and it’s exactly what makes sticky wages the key problem.

The diagram below is from Scott Sumner’s new book, The Money Illusion.[1]Sumner, S. (2021). The Money Illusion: Market monetarism, the Great recession, and the Future of Monetary Policy. p. 29. The University of Chicago Press. I like to think about business cycles and macroeconomics with this diagram. Because it helps us better understand why changes in nominal variables have real effects.

Money is neutral in the long run but strongly non-neutral in the short run, so monetary shocks affect real wages, output, employment in the short run.[2]Sumner, S. (2021, September 29). Money neutrality, super-neutrality, and non-neutrality. Retrieved October 11, 2021, from https://www.econlib.org/money-neutrality-super-neutrality-and-non-neutrality. Therefore we can talk about the real effects of a change in nominal variables in the short run. However, it’s a little more difficult to explain why a change in nominal variables has real effects. I’ll show you that it’s mostly because of sticky wages. In my opinion, sticky wages are key to understanding business cycles and macroeconomics overall. But Kursad, why? Note that the recessions are caused by sharp declines in NGDP growth. Nevertheless, this itself does not explain why changes in the NGDP growth rate are so important, or why and how it relates to sticky wages. To understand the importance of NGDP shocks, we need to examine the nominal variables; and to understand that, we need to look at sticky wages closely. When economists talk about wage stickiness, what they usually mean is nominal wage stickiness. Because nominal wages are slow to adjust, this affects employment when the economy suffers a shock.

I will first explain why sticky wages matter, then explain why I prefer to focus on sticky wages rather than sticky prices.

Let’s start with a small-scale example to see how sticky wages work. Assume that the demand for refrigerators is unit elastic. For some reason, people are willing to spend more money on refrigerators than in previous years. This shifts the demand curve to the right, but that does not necessarily increase the number of refrigerators sold. In the case of full employment, this only causes wages and employment to rise, and refrigerator manufacturers simply increase the price per unit of the refrigerator. Nevertheless, if NGDP growth rates are low, wages will react to it, and we expect them to be highly sticky. In such a case, refrigerator manufacturers will likely respond to the change in demand by selling more refrigerators. Sticky wages aren’t the only reason for that, but it’s one of the most important reasons.

The evidence that wages are sticky in the short run is so obvious that I’ll take it as given. Instead, let’s look at a few ways to think about sticky wages. The conventional method of thinking about sticky wages is W/P. I think this works well in certain circumstances and not in others. For example, W/P will work well if the refrigerator industry is perfectly competitive. The MC curve shifts upward less than the demand curve, and output increases, so prices will increase, and W/P will fall. This would be a classic sticky wages scenario that leads to countercyclical real wages. But in a monopolistic competitive industry, for example, W/P will not work that well. A scenario in which neither wages nor prices will increase is likely, or both may increase very slightly and at similar rates. In such a case, W/P would be roughly the same, making it very difficult to explain business cycles in terms of W/P.

I think W/NGDP is much more useful than W/P. Nominal hourly wages are sticky, so it’s natural to expect hours worked to fall when nominal spending falls. W/P and W/NGDP are actually unrelated phenomena. Both stickinesses exist, but the key macroeconomic problem is nominal wage stickiness. On the other hand, microfoundations won’t help you beyond this point. The key is aggregate wage stickiness; it would be misleading to think about specific industries or firms. Suppose Saber Steel laid off a large number of workers in a recession. Saber Steel would have done this not because wages were sticky in the steel manufacturing industry but because wages were sticky in other markets or industries. Because wages outside of the steel industry are sticky, a reduction in total labor compensation leads to fewer hours worked. People or firms will buy less steel during a recession, but many everyday purchases will remain roughly the same. Thus, in a recession, for example, Burger King employees or cashiers are less likely to lose their jobs, while steelworkers are more likely to lose their jobs.

So far so good, but even if we agree that wage stickiness is matters and W/NGDP is more useful than W/P, why should we focus on wage stickiness and not price stickiness?

Basil Halperin argues here that it was a big mistake to switch from models of wage stickiness to models of price stickiness:[3]Halperin, B. (2021, June 16). It was a mistake to switch to sticky price models from Sticky Wage Models. Basil Halperin. Retrieved October 11, 2021, from … Continue reading

The history of thought here and how it has changed over time is interesting on its own, but it also suggests a natural conclusion: if you think of involuntary unemployment as being at the heart of recessions, you should start from a sticky wage framework, not a sticky price framework. The original empirical and conceptual critiques of such a framework were misguided.

The debate over wage vs. price stickiness first caught my attention almost five years ago. Although I thought price stickiness was quite important back in those days, I have to admit that I didn’t care much about wage stickiness(but I was a 15-year-old teenager, so it can be forgiven). But after reading the article by Scott Sumner and Steve Silver, my views started to change. Silver and Sumner found in their study that wages are cyclical when the economy is hit by supply shocks, and highly countercyclical when hit by demand shocks.[4]Sumner, S., & Silver, S. (1989). Real Wages, Employment, and the Phillips Curve. Journal of Political Economy, 97(3), 706–720. http://www.jstor.org/stable/1830462.

As I said, I didn’t care about wage stickiness back then. But at some point, I began to question whether inflation was a good variable for our models. A huge part of CPI is rent equivalent, so how can our models explain fluctuations in employment in this way? While there are more issues with the CPI, this was not the main problem that concerned me. NGDP is more of a “real” thing; It’s not just the sum of RGDP and inflation, it has real effects.

Let’s start with a simple question. In the long run, do wages track NGDP/person or inflation? If you think the answer is the latter, you cannot explain the relationship between rising wages and (relatively) low inflation. Despite having a similar inflation rate to the US, China has rapid nominal wage growth. NGDP/person growth drives up wages. And that’s exactly where this problem becomes different from the rest of the economics. We know that NGDP fluctuations are erratic, and nominal wages are slow to adjust; that’s why W/NGDP becomes countercyclical.

Mary Daly and Bart Hobijn created a labor market mathematical model in their work. The assumption lay on the model is that a given fraction of workers are resistant to wage cuts each year. The model also shows that the frequency of zero wage changes is highly correlated with the unemployment rate. Moreover, it explains why the recovery from the Great Recession has been slow. Daly and Hobijn found that productivity growth has the same effect as inflation in the labor market. I think NGDP growth is better than inflation in terms of the benefits of inflation. Here is another reason to prefer W/NGDP as NGDP growth is correlated with productivity growth+inflation.[5]Daly, Mary C, and Bart Hobijn. 2013. “Downward Nominal Wage Rigidities Bend the Phillips Curve,” Federal Reserve Bank of San Francisco Working Paper 2013-08. Available at … Continue reading

Indeed, one of the strongest arguments is the gradual weakening of the relationship between inflation and employment. The Phillips Curve has many weaknesses in this regard and it often misleads economists, as we saw the most recent example in 2019. In contrast, as Joey Politano shows, the Phillips Curve is especially strong from the private sector wages perspective because employment is more associated with wage growth than inflation.

So, what’s my solution? Going back to the basic models such as AS/AD, because it’s much simpler and more useful. Let’s go back to what we were concerned with in the first place, unemployment. The AS/AD model was developed to explain fluctuations in employment. So the first thing we’ll look at is the labor market. And everything becomes clearer when we look at it. Hours worked move in the same direction as NGDP.[6] Sumner, S. (2021). The Money Illusion: Market monetarism, the Great recession, and the Future of Monetary Policy. p. 151-154. The University of Chicago Press.

To summarize, 1) recessions and employment fluctuations are highly correlated, 2) nominal shocks have real effects, 3) hourly wages closely follow NGDP/person, 4) when the economy is hit by a negative nominal shock W/NGDP becomes highly countercyclical because nominal wages are sticky 5) W/NGDP is especially useful in explaining employment fluctuations, hence the recessions.[7]Sumner, S. (2019, January 20). Are recessions about employment?. Retrieved October 3, 2021, from https://www.themoneyillusion.com/are-recessions-about-employment.

All of this may not lead us to NGDP targeting. A framework like GLI targeting is also possible, which is extremely attractive and will stabilize employment fluctuations similarly.[8]Amarnath, S. (2019, May 18). Floor It! Fixing the Fed’s Framework With Paychecks, Not Prices. Retrieved September 23, 2021, from … Continue reading But from a W/NGDP perspective, regardless of policy implication, it’s clear that sticky wages almost always better explain fluctuations in employment.

References

References
1 Sumner, S. (2021). The Money Illusion: Market monetarism, the Great recession, and the Future of Monetary Policy. p. 29. The University of Chicago Press.
2 Sumner, S. (2021, September 29). Money neutrality, super-neutrality, and non-neutrality. Retrieved October 11, 2021, from https://www.econlib.org/money-neutrality-super-neutrality-and-non-neutrality.
3 Halperin, B. (2021, June 16). It was a mistake to switch to sticky price models from Sticky Wage Models. Basil Halperin. Retrieved October 11, 2021, from https://www.basilhalperin.com/essays/sticky-prices-vs-sticky-wages.html.
4 Sumner, S., & Silver, S. (1989). Real Wages, Employment, and the Phillips Curve. Journal of Political Economy, 97(3), 706–720. http://www.jstor.org/stable/1830462.
5 Daly, Mary C, and Bart Hobijn. 2013. “Downward Nominal Wage Rigidities Bend the Phillips Curve,” Federal Reserve Bank of San Francisco Working Paper 2013-08. Available at https://doi.org/10.24148/wp2013-08.
6 Sumner, S. (2021). The Money Illusion: Market monetarism, the Great recession, and the Future of Monetary Policy. p. 151-154. The University of Chicago Press.
7 Sumner, S. (2019, January 20). Are recessions about employment?. Retrieved October 3, 2021, from https://www.themoneyillusion.com/are-recessions-about-employment.
8 Amarnath, S. (2019, May 18). Floor It! Fixing the Fed’s Framework With Paychecks, Not Prices. Retrieved September 23, 2021, from https://medium.com/@skanda_97974/floor-it-fixing-the-feds-framework-with-paychecks-not-prices-78171423e9c1.

IS-LM is not a useful model

I have to admit that I have rarely used the IS-LM model since I became interested in economics. Instead, I find the AD-AS model much more useful. Of course, this does not mean that there is a major theoretical flaw in the IS-LM model. Rather, I think that the inferences that economists make by looking at the model are wrong, and that the model leads both economists and students to “reasoning from a price change.” To be more precise, it leads them to assume that changes in the interest rate are a good indicator of the monetary policy stance.[1]Sumner, Scott. A Critique of Interest Rate–Oriented Monetary Economics. Working Paper, Mercatus Center at George Mason University, November 23rd, … Continue reading But that’s not true. For example, interest rates fell in late 2007 due to the weakening economy, and monetary policy was certainly not expansionary. It is true that a shift in IS could cause this, but I suspect most economists either ignored or failed to see it.

Nor do I find it reasonable to assume that increased savings result in lower demand and output. Whether an increase in hoarding is accommodated by the central bank seems to me a more accurate perspective. [2]Rowe, Nick. The paradox of thrift vs the paradox of hoarding. Worthwile Canadian Initiative, October 01st, 2010. … Continue reading However, when looking at monetary policy through the lens of interest rates, it seems clear that this will hardly be seen. However, when looking at monetary policy through the lens of interest rates, it seems clear that this will hardly be seen. Accordingly, when the propensity to save decreases, the central bank has to reduce the money supply. But the increased desire to save does not affect demand, so there is no reason for an inflation-targeting central bank to reduce the money supply.

Let’s start with interest rates. Theoretically, a doubling of the money supply would almost immediately double the price level. But that’s not the case in the real world – mostly because of sticky wages and prices, although there are other factors. If the price level is not doubling, another variable must double to equate the increasing supply. That variable is the (nominal) interest rates, and they are not sticky – they quickly move the equilibrium rate at which money supply and demand equated. In this example, a fall in the interest rate may be a sign of wage and price stickiness rather than the stance of monetary policy. It need not have an essential role in nominal aggregates.

Someone might say, “But Kursad, the IS-LM model is not about nominal aggregates; it’s about real GDP.” I agree; we can’t get real effects with a perfect wage and price elasticity model. But in the case of wage and price stickiness, we can still get the same kinds of real effects, even if interest rates do not play an essential role: it is possible in the SRAS model. Consequently, a sustained increase in the money supply will proportionally raise the price level, or NGDP. The nominal expense ratio also increases, but to a lesser extent. But I don’t see anything necessary for short-term interest rates to fall in this process. If current rates are held constant, real interest rates will fall as expected inflation increases. Or nominal rates may rise at the same rate as expected inflation, and real rates remain constant. In this case, the opportunity cost of holding cash increases rapidly. We can get real effects when we consider nominal expenditures to rise and wages/prices are sticky. Or suppose nominal rates are falling. I think this would be the case that the IS-LM model would most easily explain. But I don’t understand exactly why it matters whether interest rates fall when the expected future NGDP rises. This puts upward pressure on existing AD and NGDP, and this is true for any commodity. So why are we focusing on interest rates? My conclusion from these scenarios is that monetary policy determines the growth rate in NGDP, which determines the level of nominal interest rates. Interest rates, then, do not determine the stance of monetary policy, because they are not a cause, but rather a result.

But none of this is why I choose not to use IS-LM. Actually, I have purely pragmatic reasons. Basically, I think it’s hard to apply the IS-LM model to the real world, and we have better alternatives instead. I saw this more clearly when I read this passage by Robert King[3]King, Robert G. 1993. “Will the New Keynesian Macroeconomics Resurrect the IS-LM Model?” Journal of Economic Perspectives, 7 (1): 67-82.DOI: 10.1257/jep.7.1.67:

“If changes in the money stock are persistent, then they lead to persistent changes in aggregate demand. With a rational expectations investment function of the neoclassical form, persistent changes in demand for final output lead to quantitatively major shifts in the investment demand schedule at given real interest rates. These effects are generally sufficiently important that real interest rates actually rise with a monetary expansion rather than fall: the IS curve effect outweighs the direct LM curve effect. Further, if persistent changes in the money stock are only gradually translated into price or wage increases, then there are very large additional expected inflation effects on nominal interest rates.”

When I read this, everything actually became clearer. Everything can be interpreted with IS/LM model; still, that doesn’t make it useful. If it’s not intuitively obvious, most people can misunderstand it; and if most people misinterpret it, it’s useless.

While the example I give most of the time relates to the Great Recession, there are many other examples as well. Similar things happened in 1920-21 and 1929-30. In both cases, monetary policy was extremely tight, but if you interpreted it in terms of interest rates, you would think that monetary policy was “appropriate.” Similar situations apply for 1929, 1937, and 2008. However, the IS-LM is not a useful model when thinking about these shocks and seems to mislead most economists.

Between 1926-29, gold reserve rates were increasing at about 2.5% per year. Between October 1929 and 1930, this ratio rose to 9% as central banks increased demand for gold. This naturally changed the future path of NGDP, thus leading to a fall in stock and asset prices. Keynesians saw nominal interest rates fall during this period and assumed that the problem was not monetary policy. I see precisely this kind of reasoning as a bad interpretation of the IS-LM model. Someone might say, “if the problem is not with the model but with the interpreters, you can’t blame the model.” However, I am not blaming IS-LM or claiming it has a theoretical flaw. Rather, I question how useful a model could be that many of the leading economists of the time misinterpreted. If you misdiagnose the disease, your prescription will be useless.

It must be admitted that the IS-LM model works quite well in Great Moderation. However, this seems to me more related to the Taylor Rule. However, the model is not that useful in times when inflation expectations change rapidly. It is more difficult to predict the real interest rate during these periods; For this reason, it is much easier to think that the monetary policy is expansionary in periods such as 1929, 1937, and 2007 when it is actually tight. In a scenario where the Wicksellian equilibrium rate falls more than the policy rate, IS-LM would be misleading. Likewise, traditional monetarism will fail to interpret these periods. Consider a driver who drives well on a straight road, but is more prone to crashes when there are many intersections. This is exactly how I see IS-LM.

All right, so what’s my solution? I prefer to use a more useful and simple model. I prefer to rely on AD/AS, where output changes depending on supply and demand shocks. I believe the interest rate transmission mechanism is confusing and misleading. The AD curve is a rectangular hyperbola (simply NGDP, or nominal expenditures) AS is merely a function that represents short-run output. And finally, OL is a vertical curve that shows the long-run output, i.e., the optimal level of the economy. Since nominal wage stickiness is the underlying assumption of this model, the “Optimal level” will vary depending on the type of wage stickiness and will require us to define nominal shocks in terms of wage stickiness. We could actually add GDP-linked bonds to this model. It would be much easier to model this way, but as we don’t have such a thing for now, we have to make do with what we have.[4]Prasad, Pradyumna. Why you should issue GDP linked bonds, Bretton Goods Substack, July 20th, 2021. https://brettongoods.substack.com/p/why-you-should-issue-gdp-linked-bonds. An unexpected change in AD/NGDP/NE creates a change in hours worked as wages are sticky. The output will returns to OL when wages are fully adjusted. The simple implication of the model is that NGDP shocks affect both production and inflation. I think this model, the “musical chairs”[5]Sumner, Scott. Money and output (The musical chairs model), The Money Illusion Blog, April 06th, 2013. https://www.themoneyillusion.com/money-and-output-the-musical-chairs-model/ interpretation, is much more useful than the interest rate-oriented approach.

P.S. I didn’t originally think of the AD curve as a hyperbola, but as I said here, after seeing Sumner’s model, I decided to tweak it a bit. I think Sumner’s framework has been much more useful.

References

References
1
Sumner, Scott. A Critique of Interest Rate–Oriented Monetary Economics. Working Paper, Mercatus Center at George Mason University, November 23rd, 2020. https://www.mercatus.org/system/files/sumner-critique-interest-rate-mercatus-working-paper-v1.pdf.
2 Rowe, Nick. The paradox of thrift vs the paradox of hoarding. Worthwile Canadian Initiative, October 01st, 2010. https://worthwhile.typepad.com/worthwhile_canadian_initi/2010/10/the-paradox-of-thrift-vs-the-paradox-of-hoarding.html
3 King, Robert G. 1993. “Will the New Keynesian Macroeconomics Resurrect the IS-LM Model?” Journal of Economic Perspectives, 7 (1): 67-82.DOI: 10.1257/jep.7.1.67
4 Prasad, Pradyumna. Why you should issue GDP linked bonds, Bretton Goods Substack, July 20th, 2021. https://brettongoods.substack.com/p/why-you-should-issue-gdp-linked-bonds
5 Sumner, Scott. Money and output (The musical chairs model), The Money Illusion Blog, April 06th, 2013. https://www.themoneyillusion.com/money-and-output-the-musical-chairs-model/

Indicators of A Good Monetary Policy

There has been a heated debate lately about whether inflation is transitory or not. I think I caught this discussion a little late, but for various reasons, it took me quite a while to finalize this post, and I see no reason not to share it now. Note that most of the post was written almost two months ago, and I only made a few additions to it due to a few posts shared recently.

While the US economy is recovering from the recession, we have seen the CPI grown by 0.6%, 0.9%, and 0.5% in the last three months. We’ve seen many pundits seem extremely concerned about persistent inflation. However, we also had many convincing data to think that inflation will be transitory and not worry about it. Despite the many dramatic changes experienced during the pandemic, market and consumer expectations remained quite moderate. The unemployment rate is 5.2%, indicating that the economy still needs to make necessary improvements to reach full employment. It is reasonable and realistic to predict that aggregate demand will decrease (due to the decrease in government support) in 2022, but will reach normal levels once the supply bottleneck is over.

Source: Yes, Inflation is Transitory, Apricitas- An Econ Blog. Graph created by @JosephPolitano

The Fed’s new framework, FAIT, requires short-term above-trend inflation to offset periods of below-trend inflation and maintain a sustainable 2% inflation. However, the Fed has communication problems in explaining its new framework to the public, which created uncertainty about the future path of monetary policy. Moreover, it seems that many pundits still haven’t internalized and understood FAIT. Calls for tightening and doomsday scenarios started flying around as PCE inflation caught the pre-March 2020 trend. In fact, these concerns stem from fundamental confusion: pundits simply do not realize that the inflation we are experiencing is due to the supply shocks from the pandemic.

First of all, I think it’s essential to understand what “transitory inflation” means. According to the generally accepted definition, what we mean by temporary inflation is that inflation, which is higher than the trend, will return to normal level soon. But this seems too obscure to me, and I believe we can make a better definition. It is clear that the Fed is capable of “stopping” both supply-side and demand-side inflation and returning it to normal levels. So the main debate should not be whether the Fed can fix the problem or have something to do, but whether more or less AD would be helpful. The Fed has always had this capability, and we have enough examples not to doubt it. Therefore, whether inflation is transitory depends entirely on what the Fed does in the future. It would be more useful to think of transitory inflation as returning inflation to normal levels without triggering higher unemployment than the current rate. Indeed, this is very similar to the difference between a cold and the flu. If you only have a cold, you can regain your health in a short time if you drink herbal tea, keep yourself warm and rest. But if you have, for example, the flu or pharyngitis, you will have to take antibiotics, and you will suffer from a high fever for a while.

Joey Politano has a fascinating post exactly about that. In here, Joey says:

“In 2007, 2015, and 2018 the Federal Reserve preemptively tightened policy out of misplaced fear of oncoming inflation, only to reverse course later and loosen monetary policy in order to support the economy. If the Federal Reserve does not learn from these prior experiences and stick to their new commitment to create policy-driven transitory inflation they will deal irreparable damage to both their credibility and to the economy. Today’s inflation is transitory, and policymakers should not react to it by pre-emptively tightening monetary policy.”

The Fed is learning from its past mistakes. That’s why we got FAIT last year. It’s not ideal, but it’s a good step in the right direction, and Powell has given us a pretty reasonable policy so far. That’s exactly why the Fed should not make the same mistake.

It is inevitable that “how should a good monetary policy be” arises from all these. In my view, good monetary policy triggers higher employment, leads to a steady increase in nominal wages and income, increases investment and productivity, stabilizes financial and macroeconomic variables, and lowers inequality. But I’m not sure how reasonable it is to target inflation or employment to achieve these. Congress gave the Fed a dual mandate, which can be summarized as maximum employment and stable prices. However, I think that indexing monetary policy to inflation or employment may fail to achieve the above. Of course, it can still do all of these, but I’m not sure that each of them can be reached at an ideal level. Maximum employment is not clearly defined, and we do not have a clear sense of how many jobs can be created by monetary stimulus without destabilizing prices. This does not mean that maximum employment or price stability can be ignored; the Fed should certainly strive to achieve the dual mandate. Rather, it looks like the Fed needs a more precise model to achieve it.

If high inflation is an indicator of excessive AD, then it is more reasonable to focus on NGDP rather than inflation. Similarly, I think the best way to reach maximum employment is to aim for steady growth in NGDP. What could be the definition of maximum employment other than a period when NGDP growth is stable over a long period, and the unemployment rate remains relatively constant over the years? Consequently, in order to achieve dual mandate, the Fed should not target both for monetary policy. The outcomes of a good monetary policy are likewise indicators of whether a monetary policy is good or not.

(4) Joey Politano🐇🚴🌱🕊️ on Twitter: “Now that’s some good tea https://t.co/AwNAxr3OcH” / Twitter