I’m not sure that modern models actually have monetary aggregates in them a lot of the time – asset prices come in, but there is normally a “no-ponzi game” assumption that helps to anchor what we are guestimating expectations are.

The key thing is, the model we use depends on the question we are asking. Monetary policy models aren’t supposed to discuss issues with the allocation of assets and investment, as those aren’t policy relevant for monetary policy. As a result, the models used don’t touch on that issue.

In other areas of macroeconomics, they will use other models that are meant to answer those specific questions – and there is potentially a role for such things in terms of the financial stability area of central banks.

The history of economies with “growth” has been filled with bubbles, they should be treated as a element of what occurs but their relevance does depend on what you are trying to “do”. Furthermore, our ability to do something about “expectations” is far from clear – we could change the mix of mood enhancing drugs we put in the water perhaps!

I agree that the ultimate credit constraint is private agents’ expectations but what disturbs me is that the current set of models use constraints (fixed money supply or money multiplier) that simply aren’t justifiable. We don’t know the credit growth boundaries and therefore how far asset bubbles can grow before agents’ expectations “correct”.

Yar, but they are subject to the “expectations of private agents”, which are both unforecastable and unobservable ex-ante.

Economists tend to shy away from assuming preference shifts – but this isn’t because we don’t think they exist, it is because we like to explain as much as possible about the interrelationship between other things, and figure out what measureable variables we should measure, before hopping over to a “trivial preference shift”. It is the reductionists in us.

This is also the reason why:

1) We need to think about “insurance” for the financial system given its exposure to expectations and the systemic risk that entails. This is the reason why the financial system is more regulated than any other.

2) Ways we can create knowledge about preferences, or make them observable, seems pretty useful. Hence the push for research in behavioural and neuroeconomics – the key thing that is missing from them IMO is still the observability issue.

The modelling of expectations is a big area where we could say economists aren’t provide a full description of the world and risks – however, it is something we think about its just that its a very hard issue. The fact that this needs work doesn’t undercut everything else that is models – it just shows that economics is still being “built”.

I think you’re on the right track. The traditional IS/LM “crowding out” stabilisers for preventing over-consumption or -investment aren’t very relevant when there are limited constraints on broad money growth. The risks of unnoticed mal-investment or credit-financed imports causing a systemic event must be very high.

Yes. With inflation expectations anchored and the central bank managing monetary policy in a way consistent with keeping the economy at potential, broad money isn’t necessarily clearly defined. We also need expectations by borrowers to get out asset prices.

In that case, credit growth and asset prices rely heavily on expectations. This is fine, but it is only “welfare relevant” in so far as it does one of two things:

1) Influences movements from potential/inflation (which will then be taken care of by monetary policy). This is the view that asset price inflation can be used to predict future inflation.

2) It risks a systemic event (this is an issue of financial stability).

In this view, we don’t care about any transfers that occur due to bubbles, changes in credit conditions, or the such. We only care about the impact on the broader economy and the risk of a systemic event (which could move us to an “inferiror eqm”).

Now this isn’t to say that the transfers and misallocation of investment aren’t important – just that the central bank doesn’t have a mandate, or necessarily enough ex-ante information, to deal with this type of “second order” issue. Of course, this view may be changing with people discussing active risk weighting management by central banks through their financial stability arms (rather than just setting passive risk weights, they may adjust them based on views of misallocation).

In that case we are essentailly saying we trust the public sector with some issues of the allocation of captial rather than the private sector – we may as well make the assumption clear there!

Still – that rant is sort of how my interpretation of the issues goes 🙂

If borrowers can draw their lines of credit at their discretion (think credit cards for companies not mortgages) but at rates largely set by the CB, then the broad money supply is only very partially under the control of the CB. It is more a function of borrowers’ “animal spirits”, for want of a better term. As long as (CPI) inflation expectations are contained, credit growth is largely unconstrained (by the elements of the standard models, anyway). I think this is very interesting and surely important.

The key thing for me is that we now that, if the central bank can help set the price, in a way that is consistent with their inflation target (which in turn represents underlying economic conditions), then banks will lend to all borrowers that will match that expected price. And as intermediaries they have an incentive to do things such as compete for customers and screen loans.

What other roles can they be seen as having, I’m interested 🙂

Fair enough, it leaves out the interesting bits, but obviously I need to prove that the interesting bits are also relevant! I suspect that it’s important that banks, as manufacturers of credit, act as more than mere mediators between borrowers and lenders. Cheers!

An intermediary in the sense that it is a borrower doing the borrowing and a lender doing the lending, and a banks role is to reduce the information asymmetry between the parties.

If you mean by intermediaries the commonly-held view that banks take existing deposits and lend them to borrowers then that’s not a good assumption.

In reality banks give the borrower the right to swap an IOU from the borrower for one of their own, and when this happens the borrower spends the bank-issued IOU because it is commonly accepted (as money). The borrower chooses the amount to draw and the timing, the bank sets an upper limit. Most limits are only used about 50% so in theory a bank’s balance sheet could double in size overnight. There is no conceivable way that there are deposits sitting ready for this.

The central bank rate doesn’t just affect the marginal cost, but the cost of the back (existing) book of loans as well. All loans, while drawn, need to be funded (but not before).