Rethinking Macroeconomics

For a while, I have been trying to systematize my views on macroeconomics. This post will summarize how I approach macroeconomics from my market monetarist framework. However, keep in mind that I am only summarizing the core components. 

First, we need to examine a much more fundamental question: If someone asks why monetary policy is so important, we can talk about the business cycle and financial crises. But what would our answer be if he/she asks how we know that monetary shocks are causing the business cycle?

One of the reasons that market monetarists are a minority in econsphere is that this question is hard to answer. In fact, this question is harder than any other possible question. Because you can’t just say “because of x y z”, you have to put forward a very complex argument carefully. In the first stage, I will try to present the general form of this argument and explain why it is so complex.

First, it is necessary to explain two fundamentally unrelated and unclear points:

1. Why do we think money determines fluctuations?

2. Why do we think that nominal fluctuations create business cycles?

The first question is easier to explain because we need to look at classical economics, the fundamental theory of supply and demand. Since nominal values are measured in currency, changes in the value of money affect all nominal values, and changes in supply and demand for money affect its value. Therefore, it is quite easy to explain how monetary policy can create fluctuations in NGDP. Suffice it to think that the central bank is shifting supply(QE) or demand(IOR) for the monetary base in a way that destabilizes nominal aggregates such as CPI and NGDP.

Still, while these are fundamental things, the person asking why money is important must have internalized this relationship before moving on to the much more difficult question: Why do monetary shocks have real effects? This is because of the money illusion. Even this simple classic argument is difficult for many people to grasp. Most people don’t think of inflation (or NGDP growth) as a drop in value for money.

To make things easier, I’ll split the second question (nominal/real interaction) into two components:

2A. Basic theory and evidence in favor of nominal shocks that create business cycles. Auxiliary

2B. Auxiliary pieces of evidence in favor of nominal shocks that create business cycles.

The main theory and evidence(2A) have four different components that, if combined, strongly cause nominal shocks that create business cycles:

a. Existence of “strange/not obvious” business cycles: unemployment occurs for reasons that are not so obvious. (It should be noted that today we are in a non-strange business cycle. Unlike most cycles, the cause of high unemployment is clear: COVID-19)

b. A clear correlation between nominal shocks and duty cycles known since David Hume.

c. Basic Econ101: price floors and price ceilings that create excess or scarcity

D. Prices and especially sticky wages in the real world.

None of these 4 points are persuasive when taken in the singular form. But together they are incredibly strong. Based on (1), we can see that the contractionary monetary policy can reduce NGDP, and generally, RGDP falls at the same time. This is related to the fact that millions of workers are no longer working, although they wish to work. In a way, it looks like disequilibrium occurring on the price base. That is, the labor supply exceeds the demand for labor. We also know that nominal wages are sticky, so an unexpected drop in NGDP should naturally lead to mass unemployment.

The four parts of this argument fit together like parts of a perfectly working clock.

Indeed, this alone is enough for the basic monetary model of the business cycle. But there are several other auxiliary arguments(2B) that support the same direction:

e. Experiments: What we call monetary policy is difficult to define. However, there are situations where central banks deliberately create monetary shocks, and then we can experience a predicted business cycle effect.

In 1981, the Fed under the Volcker administration began to reduce inflation with its tight monetary policy. Unemployment rose to 10.8%, as expected in the model. One particularly interesting experiment is switching from a stable market to a floating exchange rate regime. If the currency were neutral in the short term, this policy change should not affect real exchange rates. In fact, after the end of Bretton Woods, or when the United States released gold in 1933, real exchange rates became significantly more volatile than the flat rate regime under the floating rate regime. Another interesting experiment is that countries tend to recover from the Great Depression after leaving the gold standard. There is also evidence that countries in Europe perform better, even without the euro, or devalue to increase production.

f. The Natural Rate Hypothesis: Developed by Friedman and Phelps in 1967-68, and the model was later validated by what happened. This model assumes that money is not neutral in the short term. If the model is not correct, then why do subsequent events match the model?

g. I’ll end with a more vague but still interesting piece of evidence. It appears that money is not neutral in the short term, which is believed by a wide variety of people who approach the issue from very different perspectives. Consider central bankers, economists, and investors. Central bankers are making adjustments to monetary policy. This is their job. Then they see the economy react in a way that indicates that money is not neutral. Most economists, on the other hand, believe that money is not neutral for the above reasons. And investors (as a whole) seem to believe in the neutrality of money. Asset prices react to the new poker in a way that supports the theory of market monetarism. This is not surprising; market monetarists think that market responses are the most appropriate signals for the effects of policies. But this also shows that the “crowd” in a sense thinks money is not neutral in the short term.

All in all, it looks like we’ve successfully answered this question. It has 5 parts of the main argument, a nominal model, and 4 theories and evidence supporting real effects. Together, they form a very powerful theory. So we can move on to the important part of the post. 

My view of macroeconomics has several components:

  1. Money matters beyond the impact on interest rates.
  2. NGDP is the single most important variable in macroeconomics; it should be the centerpiece of every macroeconomic system. Unfortunately, it usually doesn’t even appear in models.
  3. NGDP should be used as an indicator of the monetary policy stance instead of the Fed Funds Rate. Some economists talk about the difference between the real and natural rate of interest, but the natural rate is not measurable and therefore not useful.
  4. Interest rates should be excluded from macro models due to the rule of “never reason from a price change.”
  5. NGDP fluctuations are not financial or real shocks; they are nominal shocks. But instead, they do have financial and real effects.
  6. There are welfare effects of changes in trend NGDP growth and also the volatility of NGDP. There are welfare effects from instability in hours worked. Some economists believe the divine coincidence applies to inflation and output; actually, it better applies to NGDP growth and hours worked. Low and stable NGDP growth minimizes the welfare costs of inflation.
  7. The lesson of the Great Recession is that macroeconomists should pay less attention to the financial system.
  8. The New Keynesian/NeoFisherian debate is focused on the wrong set of issues.
  9. Most business cycles occur when NGDP moves unexpectedly in the presence of sticky nominal wages. These shocks cause a fluctuation in the ratio of NGDP to hourly wages, and this leads to fluctuation in total hours worked. Hence, recessions are caused by tight monetary policy, which leads to a sharp slowdown in nominal GDP growth.

(I explained the reasons for 3, 4, 5, 7, 8, and 9 in my previous post.)

If we look at these as a whole, we can easily understand the core components of my market monetarist framework:

It seems to me that market monetarism has two components; the market, and the monetarism. In my view, monetarism is the tradition of economic thought that says changes in money supply and demand drive the most important macro phenomenon, including key nominal variables such as inflation and GDP growth, business cycle movements, and unemployment. More importantly, monetarism argues that other traditions of thought reify various contingent epiphenomena, confusing side effects with core mechanisms. To a monetarist, those epiphenomena are just the side effects of changes in the supply and demand for money, they are not the core mechanism(I mentioned this in the first post of this blog: Recessions are always and everywhere monetary phenomena).

So that’s the core of the “monetarism” of market monetarism. But what about the “market” component of the theory? I believe one of the flaws in the modern macro models is that not all of our models of the efficient market hypothesis are deeply embedded. So when there is a policy initiative like QE, mainstream economists take a “wait and see” approach. They say that after observing a year or two of macro data, we will have a better idea of the effectiveness of the policy. In contrast, a market monetarist says we will learn everything we know about the policy’s effectiveness in 10-15 minutes. Inflation, RGDP, and NGDP futures will be adjusted immediately to reflect the optimal estimate of the policy initiative’s impact. If these markets do not exist, other proxies such as TIPS spreads, exchange rates, commodity prices, and stock prices will tell us everything we know about the policy’s effectiveness.

We argue that the target variable is the most useful measure of market forecasts’ monetary policy stance. Mainstream economists look at a broad variety of epiphenomena, especially interest rates. But the response of interest rates depends on any number of conditional factors and cannot serve as a reliable indicator for easy and tight money. As a result, the only useful definition of easy and tight money is relative to the policy stance expected to achieve the policy goal- is the money too easy or too tight? Again, it is market expectations that will ultimately provide the most appropriate forecast: “The view that markets should guide monetary policy is just one part of a much broader agenda—markets should determine what is true, what is reality.

With this market monetarist perspective, we reinterpret the macroeconomic history, try to focus on the underlying mechanism, and try not to be disturbed by monetary shocks’ various side effects. These side effects are important, but the core message of market monetarism is that these side effects are just side effects.

So we can make the following inferences:

  1. Shocks in money supply and demand drive nominal aggregates.
  2. Unexpected movements in nominal aggregates drive fluctuations in real output and employment. They also contribute to financial instability.
  3. Market prediction of key macro variables provides the most appropriate way to understand what is happening in the economy, predict its future course, evaluate the stance of monetary policy, and set the policy instruments.
  4. As a result, the unstable monetary policy actually causes the cycles.

Again, I remind you that all this is just a summary of the core components. Besides these, the frame has many small/auxiliary components and models. Moreover, even covering each of the core components in detail would be the length of a book. I hope that someday I will be able to explain this whole framework -the core and the auxiliary components and models- in a long and systematic way.

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