The last time there was a 50bp increase was May 2000. If you want to understand what was going on there take a look at inflation and the exchange rate during that period – a drop in the dollar was stimulating activity while inflation was high and climbing, so the Bank responded.

The exchange rate isn’t doing that now, but the world (and NZ) opening up post-COVID is filling that role – while core inflation is high, and headline inflation is at levels a lot of people have not seen before. In this way, the Bank is tightening – makes sense, and I trust they’ve worked it all though.

Ok, you have an angle here right – you always complain

Hmmm, there is one thing I was wondering. Tightening isn’t all about the cash rate, in the same way easing wasn’t all about reducing the cash rate – there was quantitative easing so where is the quantitative tightening (QT)?

This is a big issue overseas. The BoE has been signalling about it for a long time and discussing it in minutes, while now undertaking it. The US Fed is also undertaking it.

The RBNZ has announced adjusting their LSAP portfolio (which they’ve also well described here) through sales to NZ Treasury, but it has explicitly said it wants to do it in a way that doesn’t reduce monetary stimulus.

I don’t quite understand this. The BoE noted that it is using cash rate “triggers” to reduce its portfolio – ie. once the cash rate is 0.75 they start easing QT as at that level the liquidity rationale for the balance sheet intervention is largely gone. Once sufficiently unwound they return to increasing cash rates.

There should be some “equivalence” on the monetary stimulus side – where a given path of reductions in the size of portfolio holdings refers to a certain type of adjustment in short-term interest rates. In that way it would be useful to know what the “cash rate offset” associated with QT is, and to communicate that QT is indeed part of tightening monetary policy.

I don’t understand why this is explicitly being ruled out as a way of reducing stimulus – especially when other central banks are saying the opposite. However, this could just be me being dense – so if anyone has an explanation I’d love to hear it

Side note

For economists out there – getting the balance sheet down is important for appropriate central bank independence, both from government and from the financial sector they are regulating.

Monetary policy should be an “offset” to other things hitting aggregate demand, that only has eyes on inflation and other demand related signals – taking more and more influence from government or retail banks about the amazing things they can do and intervene on leads to a situation where policy starts to favour these vested interest groups.

The lack of symmetry about the discussion of QE and QT screams to me that there are specific concerns from either government or New Zealand retail banks that might be influencing policy in a way that varies from this – and the Bank should stand up to that.

Now I have no problem with breaking up monopolies, and I’m a huge fan of clear competition policy. But this isn’t going to deal with the “inflation” problem we are talking about. Let’s chat about it.

An earlier post here on “price controls” discusses a number of specific matters in more detail, but I think a higher level discussion would also be useful. To that end, I thought I’d share a twitter response I made to some bloke going on about corporate greed and inflation:

As you may have noticed in earlier posts, I haven’t given up on the transitory narrative (based on central banks managing expectations), but as Michael Reddell notes the outlook for this narrative does keep worsening:

I did your first year econ course, you said monopolists were price setters, so we need market power to get greed to influence prices – checkmate

Nice, and I hope you enjoyed the course. Sadly you are only remembering the words that we use, not the full nature of the content with that response – sometimes the way economists name things mean they can be misinterpreted.

A “price taking” firm only has the incentive to charge the market price – this does not mean they have to accept some fixed mark-up on cost, it means that market conditions determine the price they are incentivised to sell at!

If overall demand for a product rose, and we were looking at a product where new firms could not enter instantaneously, then this would lead to an increase in the market price – which would then be charged by our little competitive firms. They would earn supernormal profits which should, in time, lead to entry by other firms – this is what drives down the price again (if demand remains high). If there is uncertainty about future demand, then that acts as a additional cost for entry – which implies that higher demand may be met with higher profits in the case of perfect competition.

For a variety of market structures and levels of competition, higher demand would be expected to lead to higher prices and profits – the puzzle often was that, in the case of firms with market power, this was not the case! Instead, we would see their tacit collusion break down, leading to countercyclical margins and less price variability in situations with large oligopolistic firms.

So in other words, we do not need market power to get price and profit change when we have an increase in demand in the economy (relative to productive capacity) – and imperfect competition can actually reduce the relevance of this.

Now, in the current situation we have both significant fiscal spending (government demand) extremely low interest rates and a movement out of lockdown bring consumer spending into the current period (private demand) and disrupted supply chains for goods making the durable items and petrol that people are trying to buy more scarce.

In that situation, it would be good for people to delay purchases a bit – implying higher interest rates, and high prices (relative to future prices) serve that purpose.

But if they just didn’t lift prices there wouldn’t be inflation

No if prices never changed we would never have measured inflation – this also implies wages would never change as well mind.

But what would then happen is that when there is excessive demand the number of products would need to be rationed in some other way – lines, black market activity, empty shelves. Suddenly people that very much value a product would not find that it costs more – they would find that they can’t even buy it.

When demand is insufficient these fixed prices would imply that firms would see their stock building up, and without the ability to cut prices to clear stock they will simply produce much less – implying that larger layoffs and business failures would occur.

This is not to say that the current increase in demand may not propagate through prices in the way firms with market power behave. A clearly communicated “shock” that gives a firm the ability to wink and nod at other firms that it will “lift prices” may allow firms to collude, leading to price increases that would not have been possible with competition. This is the tacit collusion that we chatted about in the prior post, and a million other times here. And the empirical evidence tends to show that this does not occur usually during period of high demand.

And what about changes in relative prices – supply chain disruption is far from even across industry and product types, and so prices need to change to represent that scarcity. If there is less fuel available we want the price of fuel to be higher, so that those with a lower use value of that fuel self ration. Knowing that certain individuals may be in a vulnerable position to changes in fuel prices we may act to support their incomes, but not blunt that price signal.

Now monetary policy does aim to reduce the variability in prices – but it is doing so by reducing the variability in demand, not by telling prices to stay put.

Conclusion

Blaming the current increase in the price level, and the spectre of future inflation, on the greed of someone powerful achieves two things – it makes it a morality play, and it means that we think we can punish the “bad dudes” in order to solve the problem. But these things are not true.

Making a popular boogey man might be good politics – but it doesn’t help the wellbeing of a nations citizens. As Chris Conlon says:

The comments below the article fundamentally think I’m misguided – and that the Bank has dropped the ball more fully. Blanchard also has an excellent post on the US case which may be also be used to be more critical of the policy operation of the RBNZ.

Although I am constantly misguided and wrong, there are two things I would raise here to defend my own position:

1. With external shocks there was always going to be an “income loss” – fiscal and monetary policy determine how this is distributed. The Bank can’t make this type of “cost of living” crisis and related loss go away – it can only ensure that the transition back to their clearly communicated inflation target is “least cost”.
2. Criticising communication is a big critique of the RBNZ – managing inflation expectations is their core job.

There is no point bagging an institution for things that are not their fault – but more transparent and clear communication about monetary policy, instead of every other issue that the Bank seems obsessed with at the moment, is needed. The current lack of communication about narrative/forward looking guidance about how the mandate will be achieved, combined with forecasts that arguably point to a general failure of the mandate, is a problem. If this type of failure doesn’t lead to changes in how monetary policy is communicated in the current environment, or lead to a situation where the responsible people at the RBNZ face consequences for this failure, then inflation expectations are going to become unanchored.

And I would argue that the nature of the comments on my interest.co.nz article indicate that people’s faith in the RBNZ to manage inflation expectations is frayed – and their reaction reinforces the importance of the very communication issue I am pointing to!

If you feel compelled to attack the Bank further or launch into an impassioned defence, then go for it in the comments. I just want good policy communication and evidence-based policy that supports the wellbeing of New Zealanders – something that both the Bank and private sector commentators have a responsibility to up their game on, given the quality of the current discussion of New Zealand’s “cost of living crisis”. (Noting that a number of NZ economists – as shown in the comments of this piece – are trying to clarify what is going on)

Fiscal policy itself matters here, and clearly understanding the trade-offs associated with fiscal policy choices – at a minimum through the necessary monetary policy offset, but also through the distributional implications and consequences on growth and productivity – is another important area for discussion. Let’s leave this for another time though.

The increase in prices in the US over the past year has been generating considerable angst – and comments that “price controls are needed to deal with inflation, due to corporate greed”.  This has led to lots of people saying things on Twitter, with individuals who different people may see as authorities taking very different views on the topic:

Mariana Mazzucato on Twitter: “Excellent by ⁦@IsabellaMWeber⁩ on the real cause of inflation and what to do about it. https://t.co/9epjBGOIpg” / Twitter

Aaron Hedlund on Twitter: “Did I miss the macroeconomics lectures where they teach that antitrust (https://t.co/EWD1CjAOpp) and price controls (https://t.co/oskR2ATzpu) are effective inflation-fighting strategies, or is economic illiteracy just running rampant again in some corners of the popular press?” / Twitter

How about we step back from the name calling to try to think about what these terms mean and what people are saying – as in the end it is likely people are talking a little bit past each other, and when that happens the rest of us can just get confused!

Are we talking about inflation?

To start with, is what we are observing at the moment “inflation”?  This is a point that often gets missed, but it is essential to understanding the distinction between different points of view.

In the United States (where a lot of this discussion is ongoing), the consumer price index has increased by 6.8% between November 2020 and November 2021. There are three things happening here that give us our general context:

• A relative surge in demand for goods while demand for services is more mild
• Supply chain disruption
• Relatively higher price growth in the US than in other countries.

The increase in prices occurred in the face of post-pandemic supply chain disruption and significant fiscal and monetary stimulus – which has supported consumer demand. With some degree of nervousness about using public facing services, relative demand for goods is at an all time high – and so the already interrupted supply chains into and around the US are struggling.

Michael (Asian Century Stocks) on Twitter: “If you’re betting on higher container shipping rates, aren’t you just betting on a continuation of COVID-19? Goods demand is likely to decrease into a recovery https://t.co/bjianLII5m” / Twitter

Given a shortage of goods the increase in demand has translated into higher prices – a mechanism that is common for any type of rationing.

Furthermore, looking through the price categories, pricing pressures exist all across the set of goods and services for sale – yes energy and used car prices have risen by more, but price increases appear to be quite widespread.

This tells us that there has been a generalised increase in prices rather than just an increase  “specific key sectors” as the article suggests. So this indicates that there is likely something increasing “all prices” rather than just the selected prices the article suggests targeting.

Furthermore, the lift in the US is higher than other countries have experienced – suggesting that there is an element of this that is US specific:

 

So that general lift is inflation right?  Well not necessarily – and that is where everyone has been a bit slack.  Inflation is “persistent growth in the level of prices”.  If the supply chain interruption is temporary then this is a one-off price level change – which isn’t what we normally think of when talking about “inflation”. 

This distinction often gets muddied as we care about the change in our ability to purchase goods and services – but the distinction is central if we are to think about the nature and role of monetary policy.

You may have heard of team transitory who are the individuals who believe it is supply chain interruption that is the primary cause of higher prices.  This team does not anticipate future inflation once supply chains begin to function “normally” and in that context, a period of weaker price growth would be likely in the future once that occurs.

However, Elizabeth Warren recently took part of team transitory in another direction – by pointing out that measures of corporate profitability have increased.  How is this relevant – we will get back to this soon I promise – but for now just remember that the view of imposing price controls is partially from this team. 

Furthermore, even those in team transitory that do not believe in price controls are more sympathetic to leaving monetary conditions stimulatory (i.e. bond purchases and lower interest rates) and further government borrowing and stimulus payments.  Why – because it is a temporary supply shock that has pushed up prices, and so allowing higher prices temporarily to prevent a decline in output/unemployment is seen as appropriate.  At the very start of COVID, this was consistent with how Gulnara described the role of monetary policy in the face of such a shock – and a related lift in prices due to the Fed looking through supply chain disruption can be seen as consistent and reasonable.

A supply shock reduces income, and looking through the shock and allowing a one-off increase in prices (as opposed to trying to reduce demand to bring prices down) is seen as a fair way of distributing the shock – at least as far as monetary authorities are responsible for such things.

There is a different team of economists out there who see matters quite differently.  Noting that the quantity of goods sold far exceeds anything seen in the past, this group views the focus on “supply chain disruption” as overstated – instead supply chains are overwhelmed because there is excessive demand.  I see the article uses “team stagnation” which is a dumb name trying to discredit the idea – it is “team permanent”.

If monetary and fiscal conditions remain expansionary in the face of excessive demand, then prices will continue to grow – leading to expectations of future price growth among individuals and firms.  These expectations then filter into price and wage setting behaviour, and become self-fulfilling – generating persistent growth in all prices.  This is inflation.

The feather in team permanents hat is the differential change in inflationary pressures in the US relative to other “similar” countries. If prices are rising more quickly in the US than in other countries with similar supply chain disruption, then the additional price increase may well be due to greater domestic demand – and may be expected to persist generating true inflation and higher inflation expectations.

To this group a portion of the current increase in prices is inflation – as it is the start of a persistent process of rising prices.

Price controls, margins, and the price level

If we are experiencing genuine inflation then price controls are, to be frank, an incredibly dumb suggestion.  Even when Tobin spoke in favour of such controls in 1981 (Economist Tobin on Inflation: How It Started, How to Stop It – The Washington Post) this was based on the view that it was not excessive demand generating the inflation – but the interruption of the oil price shocks.

<iframe src=’https://d3fy651gv2fhd3.cloudfront.net/embed/?s=cpi+yoy&v=202112101416V20200908&d1=19700103&d2=20220103&h=300&w=600′ height=’300′ width=’600′  frameborder=’0′ scrolling=’no’></iframe><br />source: <a href=’https://tradingeconomics.com/united-states/inflation-cpi‘>tradingeconomics.com</a>

There is a point here.  Both of the teams noted above agree that the underlying supply shocks have consequently reduced incomes – and that higher prices are a part of determining who bears the reduction in “productivity” in some sense due to this shock.

A desire to then “control prices” is a wish to avoid the current distributional consequences.  However, it is not costless.

If prices are not allowed to rise to ration the increase in demand, then something else will have to give – fewer goods and services will be available, the relative price anything without a rationed price (i.e. black market sales) will change, the intervention will create uncertainty about voluntary exchange, and finally once the controls are removed prices will simply rebound.  The suggestion that selected prices are frozen is especially disconcerting as it will incentivise firms trying to reclassify products out of scope and lead to pricing pressure leaking out to other products while these products are arbitrarily rationed.

Contrary to the related articles that appear to suggest this isn’t true, we have endless examples of this occurred across the world – Venezuela, Argentina, the United States through the 1970s, New Zealand under Muldoon with freezes occurring between 1976 and 1984 (The wage and price freeze, 1982–1984 – Law and the economy – Te Ara Encyclopedia of New Zealand).

If instead we are viewing this as a one-off price change, then is the argument different? 

If it was, it wouldn’t be the argument in the article linked above – which seemed to ignore the rationing that occurred for years following WWII as a natural part of the same issue, where the supply chain was shifting from significant central direction (to produce war equipment) to the private provision of consumer goods.  The supply chain in the current situation has not had to change what it produced, or have been destroyed by a disaster, it is instead struggling under a mixture of higher costs and high demand.

Higher prices are the rationing mechanism at play given where the balance of supply and demand is – if we fix prices de facto lower the quantity of purchases further, then some individuals who value the goods at a very high price now would not be able to receive them.  So far, no rationale. Furthermore, as the suggestion is to target specific “selected prices” – this will lead to increased demand for substitute products, leading to the pricing pressure leaking to other items.  Given the rationale of targeting products who experience a price increase this is likely to lead to a poorly timed game of whack-a-mole with prices, all while the proximate cause of inflation – excessive aggregate demand – is ignored.

Such price fixing exacerbates the issue at hand – which is that households cannot get the goods and services they want given their real incomes.  If instead of fixing prices we ensure that underlying fiscal policy is appropriately set to set a floor on individuals incomes, and that competitive issues are sufficiently dealt with to allow individuals to have sufficient power when they consume or go to work, then the distributional consequences are likely to be less severe.

If it is demand that is driving up prices, then the rationing functions over time – the high prices now push people who can wait to delay purchases, internalising the fact that supply chains are currently struggling. If prices do not reflect that, then in a rationed environment such products start to be allocated on the basis of luck and other forms of power – it will not reverse out the supply shock, and for some who complain goods are two expensive now it will simply make the goods unavailable.

Power dynamics and corporate profit

The concern about power dynamics is highlighted by the focus on corporate profit and “price gouging”. The idea here may be that producers are using this as a way to collude on higher prices and margins. As a result, there may be a way to undermine this collusion and increase quantity and reduce prices – solely benefiting households.

Now this is likely not an argument about monopoly or heavy concentration itself.  The argument that a monopoly is taking this as an opportunity to charge customers more has to contend with the counter argument – if they could normally charge customers more why don’t they?  Arguments that rely on “gouging” need to explain why this gouging doesn’t normally occur, and if it is a result of current scarcity why the price signal itself isn’t appropriate – after all, not having access to the product is the same as it having an infinite price to the consumer.

If the argument is just that demand is “currently high” then how is that different to stating that we should reduce aggregate demand which is what team permanent is saying?  There is a distinction between their being demand for a specific product due to a crisis – and there being general high demand.  And this article appears to confuse the two.

To try to make the best argument for this view about price fixing we need a coordination issue, we need some idea of oligopolistic firms and price setting.

The Green and Porter (1984) model of price setting among oligopolists may give us a solution here – during states of “high demand” oligopolists may collude and hold up profits, but when general demand falls they are unsure if they are being betrayed or if the economy is slowing.  Given this they are more likely to “punish” by cutting prices when the economy slows.  Here we have clear information of a “high demand” state, and so firms have agreed to collude.

The issue with this model is that is just doesn’t fit the data – rather than being pro-cyclical prices are often found to be counter-cyclical (i.e. Why Don’t Prices Rise During Periods of Peak Demand? Evidence from Scanner Data – American Economic Association (aeaweb.org)).  

This result isn’t just in the annals of economic estimates – it is something you can see all the time by going to the supermarket.  I’ve seen it for Nurofen (Why do supermarkets cut the price of medicine when people are getting ill? – TVHE), during COVID I saw it for toilet paper (Understanding Wellington and toilet paper – TVHE).  Why?

That is where an alternative theory comes in, Rotemberg and Saloner (1986).  If there are “high” demand and “low” demand states then the benefit associated with defecting from collusion is greater when demand is high – as a result, when demand is high and people are fully informed it is high, a price war and lower profitability is likely.

So why are corporate profits high, if our view of an observable demand shock would lead to lower profitability?

One way to do this would be to go back to view this predominantly as a supply shock rather than a demand shock, implying that post-COVID can be viewed as a low demand state.  But that just isn’t consistent with the evidence relating to the quantity of goods being sold.

And that tells me that this IS an interesting puzzle – it isn’t about inflation itself, it is about the magnitude of the increase in corporate profits coming out of a pandemic during a period of elevated demand.

When I see a puzzle the first thing I want to do is look at the data more carefully.

Profit and the national accounts

In such a case the first thing I’d want to look at is what the data is – we are being told this is profit, but I know that national accounts don’t always match up with what we think.  The key item I see here that interests me is the “Expenses exclude deductions for bad debt, depletion, and amortization“ – so bad debts that were written off, and assets and stock that was lost, are not included in expenses … and so form part of profit!  

Inventory valuation adjustment (the IVA mentioned in the profits title) should have captured the majority of this loss as shown in the IVA figures:

Corporate Inventory Valuation Adjustment (CIVA) | FRED | St. Louis Fed (stlouisfed.org)

However, such revaluations tend to be fairly conservative. When combined with non-inventory write-offs in the period, this suggests that some of the increase in profit will only represent these costs to the business. As these are largely fixed costs we may still be surprised that firms have passed them on – however, if the costs were necessary to crystalise in order to being operating in a post-lockdown environment and businesses were liquidity constrained such pass-through may seem plausible.

Furthermore, if the current environment is very risky businesses may be unwilling to take on investment unless they are sufficiently rewarded for taking on the risk of their investment being sunk – which would also lead to higher profit levels.

A disaster that interrupted supply chains and destroyed inventories, and in the aftermath saw corporate profit rise when such losses are not recognised feels as if a major cost and risk parts of the cost shock is not being counted in the corporate profit figures. In an uncertain environment firms will want certainty about cash-flow, and will want to hold liquid assets in case they are faced with another shock – exactly the same way households function in such an uncertain environment.

Now it is useful to ask what else we would see in the data if this was an explanation.  We would expect dividends to not change, while undistributed income and net private savings surges – as the undistributed income is essentially “invested” to pay for the costs noted above.  Sure enough, this is exactly how the data looks:

Net private saving: Domestic business (A127RC1Q027SBEA) | FRED | St. Louis Fed (stlouisfed.org)

Corporate Profits after tax with IVA and CCAdj: Net Dividends (DIVIDEND) | FRED | St. Louis Fed (stlouisfed.org)

However, this does tell us that corporate firms were able to pass on these costs – which itself suggests that there is more going on. To understand this further we need to recognise that it is a bit strange to focus only on corporate profits and not the income of other capital and labour owners.  So let’s take a look at that.

Net value added of corporate business: Compensation of employees (A442RC1Q027SBEA) | FRED | St. Louis Fed (stlouisfed.org)

Nonfinancial corporate business: Profits before tax (without IVA and CCAdj) (A464RC1Q027SBEA) | FRED | St. Louis Fed (stlouisfed.org)

From September 2019 (pre-COVID) corporate profits have risen 29%. Over the same period compensation of employees rose 12%.  These are all in current prices (Q3 2021, Table 1.14. Gross Value Added of Domestic Corporate Business in Current Dollars and Gross Value Added of Nonfinancial Domestic Corporate Business in Current and Chained Dollars: Quarterly | FRED | St. Louis Fed (stlouisfed.org)).  With all incomes increasing and limited capacity to make goods and services this sounds a lot like a general “demand” shock driving up prices – a focus on only one income measure was hiding that!

The 17% percentage point gap between corporate profit growth and compensation of employee growth could plausibly be explained by increased risk in the trading environment, and “missed costs on business” in the national accounts figures that are being investigated.  In this way, when we look at all the numbers as a whole it looks like a smaller puzzle – and more like there is a surge in domestic demand in the United States.

Ok why do I care

The distinction between this being a “supply shock” and a “demand shock” matters for what we would see as appropriate central bank action. If there is truly excess demand then tighter conditions are warranted – if it is mainly about supply disruption and a “price level shock” then there is less need for tighter monetary policy, and more of a need to communicate to manage inflation expectations.

Working through the data, the higher level of corporate profitability – and all incomes – makes the argument that this is a demand shock relatively stronger, rather than weaker.  The argument given for price freezes does not support price freezes, but instead supports the tightening of monetary and fiscal policy the author says is inappropriate.

This is the key with economics – the author recognises this but there are other, unsaid, arguments in the background.

It appears the author is pushing for price freezes believes that there should be more government spending and investment in specific sectors, that the size of government should be larger, and that more resources should be directed by the state – and this is a legitimate position that they can take, and a legitimate position for people to strongly agree or disagree with.  They are not thinking about inflation vs no inflation, but are instead worried about the political economy associated with reducing demand – and it occurring through reduced government spending.

In this world underlying “true” inflation is a tax, and this is a politically expedient way to have a greater tax burden to fund underlying expenditure. I would prefer the author was instead transparent and stated that they want more spending and taxation, rather than arbitrary calls to freeze prices based on corporate greed – but by obfuscating trade-offs they may feel that the world they desire is more likely to happen.

After recent discussions about “negative interest rates” across Australasia I thought it would be useful to talk about how these rates appear mechanically at a high level (in terms of financial system operations).

In class (and Gulnara’s posts here) the motivation of why negative interest rates might be appropriate in a policy sense was raised.  Furthermore, she did a great job of noting that it is unlikely that negative rates will cause additional savings (as some have claimed) and so theoretically we can continue to think about our investment model with negative interest rates.

For this post we will assume that the central bank is trying to influence interest rates towards a level that will “close the output gap” or “push Y to its sustainable level” and achieve their inflation target, and it just happens that this interest rate is negative.

The wrinkle is that we achieve this negative interest rate through a settlement cash mechanism – so we need to ask, how do negative rates in settlement cash accounts translate into lending and actual interest rates?

Negative rates and settlement cash

Let’s take our example from before and assume that the OCR is cut by 400 basis points to -2%.  In this case the borrowing financial institution will “pay” -1.75% and the depositing financial institution “receives” -2.25%.

Why would an institution deposit funds in an account to earn -2.25%?  Why would financial institutions not just ramp up their borrowing at -1.75%?

The reason for that intuition we feel is that we are thinking about money – money yields a nominal interest rate of 0%.  If the banks could just independently hold money at 0% they would borrow endlessly at -1.75% and would never save at -2.25%.  

However, the settlement cash account is designed to include cash holdings for banks.  So if a bank borrows a dollar from settlement cash and tries to hold it as a cash asset, it returns as a deposit in the settlement cash account.  So in this way the system cannot be escaped.

What about interbank lending?  One bank could lend to another bank at 0% and this would be a better return for the lender than -2.25%.  But that bank who is borrowing is paying 0% instead of -1.75% is actually worse off.  As a result, the interbank market will reinforce this dynamic as long as the settlement cash account is determining the opportunity cost of marginal lending.

Given the banks cannot avoid these negative rates in settlement cash accounts, they would then be expected to pass these on to both their depositors and borrowers (in order to achieve the same interest margin) through lower/negative interest rates!

However, they haven’t been. Deposit rates refuse to budge below zero in countries with negative cash rates, and although banks are accepting lower margins they have also reduced lending rates by less than they would have otherwise.

In this situation, there are two ways that banks can turn around and try to avoid these negative rates – and therefore avoid passing on negative rates to depositors and lenders:

1. Investing in instruments that are zero yielding that don’t get captured in settlement cash (eg overpaying tax – e.g. Sweden).  We need to be careful here not to include assets that have an expected negative capital gain (as that equates to a negative yield – such as gold).
2. More carefully ensuring that deposits and loans match on a day-to-day basis.

Both of these have one thing in common – banks are willing to slow down their matching of lending and borrowing, and accept lower liquidity, in order to avoid the cost associated with negative interest rates.

If this is the case, then when rates become negative enough (when they aren’t just representing a small service fee) financial institutions may respond to negative interest rates by being more careful to match their deposits and lending on a day-to-day basis.  Suddenly when you want a loan or to deposit funds the bank will start saying “you meet our criterion, but we have a waiting line for approving loans/deposits and it will occur when you come to the front of that line”.

This would reduce the volatility of money and in turn restrict economic activity.  This is a mechanism that may lead to negative interest rates reducing growth – if the negative interest rates also involve an increase in non-interest restrictions to lending.

But a negative cash rate pays people to lend!

Good point and very consistent with what we’ve done in class. As a result, this discussion requires further explanation.

When cash rates are negative it is true that a financial institution will now be willing to lend at a lower interest rate (given that they can “borrow” from settlement cash at a more attractive rate), so at face value there is no reason to think such negative rates will restrict lending.

But we also need to remember that the borrowing also credits a banks account.  If the person being lent to then deposits the funds in another banks account that other bank will be a bit unhappy about having to pay the negative interest rate on it – and if the person immediately spends it those funds will be deposited.

As a result, banks will want to restrict deposits.  In so far as a bank restricts credit being paid into their account, they can create an issue for loans – which in turn could restrict how quickly loans could take place.

When interest rates are positive you have same issue from lender, but with negative it is the deposit taker that pulls back.  With positive interest rates, lenders are increasingly unwilling to lend as rates go up (due to the uncertain cost of mismatch), with negative rates the deposit taker becomes unwilling to accept funds as rates go down – both break down intermediation, but with positive rates that is the goal – with negative it is not.

Furthermore, even if the loan came back to the same bank as a deposit if the zero lower bound on deposit rates is binding (which it seems to be – with deposits rates in countries with negative cash rates staying at zero) for financial institutions then charging lower interest rates on investment will simply reduce the net interest margin of banks.  With negative spillovers from uncoordinated lending in this sense, tacit collusion between banks might see them agree to cut lending to support margins – making negative rates at best useless and and worst a device that leads to uncompetitive behaviour.

Overall, thinking about how cash rates translate into negative interest rates – and the broader concerns in Eggertson etal 2018 – indicates that negative interest rates may not be as useful as our models in class suggest, where all that mattered was the investment function and the related impulse to investment this suggested.

However, this is an area economists are still trying to understand using data – so hopefully in the future we will have a better idea of what elements are relatively more important!

The main reason for discussing this is to show that, although our models in class are useful – they are not always the whole story. And given unique circumstances it is important to think about other margins that matter. Remember the Joan Robinson quote from the start of the semester – we are learning how to question things, not incontrovertible facts.

In that vein, today we are going to talk about how the central bank does influence the nominal interest rate in New Zealand (as compared to our still useful discussion of bond purchases in class).  By doing so we will also be able to ask about “negative interest rates” in a later post.

It should be noted that none of the content I cover here is assessed – you will be assessed on what we do in class and in the lecture notes and readings. Instead the purpose of this is to add a bit more detail about things for students who are interested.

Cash rates and interest rates

A history of monetary policy implementation in New Zealand is given by the RBNZ here.  However, we will abstract from most of that and just look at where things are right now.  For this the RBNZ provides an excellent teaching resource on settlement cash accounts rate here, and the RBA also provides a nice explanation of the market here.

The corridor described in these pieces refers to the gap between the rate paid to those who deposit funds in the settlement cash account (the ESAS) and the rate changed to those who borrow from the settlement cash account.  There have been significant changes recently in the corridor set around the OCR (due to COVID) – so we will assume our own corridor for simplicity below. 

Across the banking system as a whole we would expect the funds deposited in financial institutions (for simplicity I’ll call them all banks – even though there are many other types of institutions) and the funds lent out to be equal.  We described this process when looking at the money multiplier in class.  However, there will be individual banks who temporarily have deposits that are greater than the loans they’ve written and vice-versa.  The settlement cash account provides a mechanism to help these banks balance the books.

The “cash rate” we are then discussing is the rate that determines these rates from the settlement cash account.  The rate for deposits will be lower than the rate for loans, implying that the central bank earns a “margin” from their settlement activity.  Furthermore, they will lend or borrow as much as necessary at this rate.

This is the background we need to work out how this cash rate influences the lending and deposit rate of banks.  If, at the end of a day, a bank has lent more out than it has brought in with deposits it can borrow the difference from the central bank at the settlement cash lending rate.  If instead they have brought in more in deposits than they have lent out, they can leave the remainder in the settlement cash account and earn the deposit rate.

Given the recent rate corridor changes, let’s use an example where OCR + 25 basis points is charged for someone borrowing from settlement cash, and OCR – 25 basis points is charged for someone lending to settlement cash.  

Take an OCR of 2% (200 basis points), here a bank who is expecting to have to borrow from their settlement account knows that financing will cost 2.25%.  As a result, if a new borrower comes to them they will not charge below a (risk adjusted) 2.25% to lend to that borrower as the cash rate determines their opportunity cost.

Similarly, someone who looks like they are going to have a credit in their settlement cash account may see a new depositor turn up.  They know that they could earn 1.75% putting that money in the settlement cash account and so would not be willing to offer a higher interest rate to that depositor.

Now take things a step further.  One of these banks is lending and one of them is borrowing.  They could essentially transact with each other, through interbank lending, in order to benefit from closing this margin.  For example, the bank that is borrowing from settlement cash could offer 2% to borrow from the other bank that has excess deposits, and the other bank would be keen to take it.

In this way, the settlement cash rate influences the opportunity cost of lending and borrowing for financial institutions, and in turn influences the interest rates they charge lenders, provide to depositors, and choose to interact with each other.

But what happens when the cash rate goes negative?  We will think about that more in a future post.

In the discussion, the RBA outlined the cost side of this tool, namely “They can also encourage people to save more, rather than spend more, so they can be counter-productive from that perspective too.”

I would like to discuss this further as it is contrary to how we often talk about monetary policy, and fleshing it out helps to make some of the assumptions made clearer. 

How do negative interest rates work?

First of all, let’s shed some light on what are negative interest rates and how they work.

I have already discussed negative interest rates as policy here:

“The first solution to this problem is to try to set the interest rate to its appropriate negative neutral level. This isn’t the idea that savers pay lenders – as we aren’t really talking about their interest rate – but it is with regards to the cash rate. The cash rate sets the interest payment/fee for retail banks in their settlement cash accounts.”

By setting the cash rate lower and thereby pushing down interest rates in the economy, the central bank tries to boost demand in the economy – helping to lift both activity and inflation in a situation when both are below target/potential.  Specifically, as interest rates fall households and firm increase their expenditure/demand. This helps to moderate recessions, by cancelling out a drop in expenditure due to some underlying cause (uncertainty, animal spirits).

Assuming that a lower cash rate does lower interest rates, then the increase in expenditure is coming from consumers and firms spending more due to interest rates falling – hence if consumers and firms responded to the change in interest rates by initially saving more (spending less) this would fundamentally undermine the efficacy of the policy change.

Back to the Governor’s saving point…

As a result, it is worth spelling out the logic of how negative rates “…can also encourage people to save more…”.

A change in the interest rate has income and substitution effects – a lower interest rate incentivises spending now, as you receive less in the future from saving $1 (substitution effect). 

However, if you are a saver and have a “target amount” you want in the future, a lower interest rate might incentivise saving now – as you have to save more now to have that amount in the future.  Another way of saying this is that a lower interest rate reduces the lifetime income of a saver – and so that reduces their consumption now (and thereby increases their savings).

Normally we view the substitution effect as dominant in an aggregate economy, as the income effects cancel out between individual savers and borrowers (as the income effect will boost consumption now for a borrower).  However, the RBA may believe that – at a negative interest rate – the responses will be asymmetric. Borrowers will refuse to increase their consumption now, and saver will cut consumption strongly now in order to keep their “target” of future income.  As a result, aggregate savings could rise.

However, is there any evidence for this? And why does this channel only become relevant at a zero interest rate, surely the asymmetric responses of savers and borrowers could be seen as relevant at any interest rate – even very positive interest rates.  

Often we will look past the implications for savings because saving propensities are relatively invariant to the price (interest rate) while lending is responsive – and in turn determines demand.  Why would saving propensities suddenly become so much more responsive when the interest rate becomes zero?

Savers hoarding cash

It is also important to note that this mechanism is different from savers hoarding cash – which is a situation that changes significantly when interest rates near zero.  The savings argument above assumes that negative rates ARE passed through, and that household and firm behaviour is different – but there is an earlier question of whether a negative cash rate is passed on at all.

If savers were to hoard cash instead of accepting negative deposit rates, then that would prevent banks from passing the lower cash rate in terms of borrowing rates.  Why?  Because their inability to cut deposit rates implies that they need to continue charging a higher lending rate to make the same margin.

As a result, hoarding does influence the pass-through of a negative cash rate (and the ability for negative interest rates to practically occur) but it is not related to the idea that saving will rise with negative rates.

Furthermore, with regards to cash hoarding negative rates haven’t been as problematic as was anticipated (at least in the short-term).

This paper from the ECB found no evidence that the negative interest rates incentivises households to hoard cash. While the other evidence shows the opposite relationship, where firms get penalized by cash hoarding, hence why they tend to lend out more.   

Overall, although the RBA piece makes some excellent points I think they oversell the weakness of negative interest rates as a monetary policy tool.

The normal case against negative interest rates on money is that they are impractical. If banks offer a negative interest rate, depositors have an incentive to withdraw their deposits as cash and deposit the cash in safety deposit boxes or hide it in a freezer. Under a fiat monetary system, there is no limit to how much cash people with demand deposits can withdraw, or how much cash governments can produce. 

It seems plausible that interest rates below -1 percent will spark cash withdrawals. Unless the central bank replaces the general public as the holder of the banking systems’ short-term liabilities, these withdrawals will be contractionary rather than expansionary. Since the central bank can be expected to lend cash to banks in response to widespread withdrawals, a negative interest rate policy results in the government paying banks for the privilege of temporarily lending them cash, so that their former customers can withdraw cash and place it in a safety deposit box. It is nice work if you can get it. Of course, this policy could be stimulatory if banks expand their balance sheet by lending to customers who purchase newly produced goods and services to take as much advantage of the government transfer as possible.

However, there is a different case against negative money interest rates that stems from the economics of commodity interest rates. 

Commodity interest rates

What is a commodity interest rate? It is the explicit or implicit interest rate denominated in terms of a commodity (e.g. oil, wheat or gold) when one party explicitly or implicitly borrows or lends a commodity. An example of an explicit commodity interest rate is the interest rate on nuclear grade uranium that is borrowed and lent by nuclear power stations. A power company with a temporary surplus of uranium will lend 1000 grams to another power company, and have a different amount, say 1020 grams  returned at a later date. A common example of an implicit interest is a wheat hedge, where a flour mill may simultaneously buy wheat on the spot market and sell it on the forward market, effectively borrowing wheat until the forward market is due. In this case the wheat interest rate is equal to the spot price divided by the forward price and multiplied by the money interest rate: this formula calculates the kilograms of wheat that are delivered in the future as a function of the kilograms of wheat purchased immediately. Commodity interest rates were extensively analysed by Sraffa and Keynes in the 1930s and have been subject to periodic research ever since. 

When are commodity interest rates negative? Normally when the spot price is less than the forward or future price. Usually this occurs when the spot price falls relative to the future price, and the lower spot prices induces higher consumption of the commodity. Temporarily low spot prices occur if there is a temporary supply glut in the market, or a temporary dearth in demand. A glut that happens every year occurs in the strawberry market: in summer, large quantities of strawberries are produced and sold at low prices, whereas in winter few strawberries are available and the price is high. The implicit negative strawberry interest rate that occurs every summer suggests most people would be willing to swap a kilo of strawberries in summer for 500 grams in winter. More to the point, in commodity markets negative interest rates not only signal higher future prices, but they are also usually associated with temporary price declines.

The same combination – negative real interest rates and temporarily low current prices – is also associated with temporary demand shortfalls. When demand temporarily collapses in a commodity market, the price of the commodity temporarily falls and the implicit commodity interest rates becomes negative. This price decline stimulates additional demand to ensure the quantity demanded is equal to the quantity for sale; consumers get a discount, and although producers suffer lower prices they at least sell their produce. 

Commodity interest rates and money interest rates

This is not the mechanism that is being proposed by those advocating negative money interest rates. Rather, negative interest rates are seen as an alternative to temporary price declines. Most firms spend a lot of time and marketing effort to establish profit-maximising prices, and are reluctant to cut them even in the face of temporary demand declines. From their perspective, it may be better to reduce and output and lay off people rather than cut prices, particularly if they think it will be difficult to raise prices back to normal levels when demand recovers. When lots of firms act in the same manner, reduced demand leads to reduced output rather than lower prices. Negative interest rates on money are proposed as a means of stimulating demand without firms cutting their prices. 

What are the economic consequences of negative nominal interest rates when prices do not fall? We don’t know for sure because empirical evidence is limited. There are not many examples of substantially negative money interest rates because people can withdraw bank deposits as cash. But the idea raises conceptually troubling issues. 

First, negative interest rates punish lenders if they save rather than spend. This is intended to stimulate spending in the same way that temporarily low prices reward spending rather than saving. Unfortunately, there is no good evidence that low price carrots and negative interest sticks have the same effect. A temporary price cut creates substitution and income effects that raise spending: a person buys more not just because the price is temporarily cheap (the substitution effect) but because once they have bought the item they still have left over money which can be spent on other things (the income effect). 

In contrast, negative interest rates change the relative price of current and future consumption without increasing overall purchasing power. A negative interest rate also has distributional consequences that are different from a temporary price cut. When a negative demand shock results in lower prices on commodity markets, buyers gain and producers lose, although the producers do get to sell their goods. If central banks make interest rates negative because firms are reluctant to cut prices, the losses are imposed on lenders rather than producers or borrowers. Perhaps lenders deserve these losses for the “sin” of saving – although in New Zealand, where the prices of so many goods and services are high by international standards, you cannot always blame them for their reluctance to spend. 

From a different perspective, negative interest rates without a spot price declines appear bizarre. An interest rate is merely a short hand summary of a schedule of future payments made from one party to another. Consider vendor finance on a new car. When interest rates are positive, a person can take possession of a car and pay cash immediately, or they can take possession of a car and make a higher payment to the vendor at a later date. Firms offer vendor finance to induce immediate sales to those who expect to receive cash in the future but don’t have it in the present. 

In contrast, a negative interest rate means that a person who purchases a new car today can choose between paying a large amount of cash immediately or a smaller amount if they pay later. Unless cash hoarding is very expensive, people have an incentive to withdraw their deposits in a bank as cash and hoard them in a safe deposit box until the delayed payment falls due. 

But why would a vendor offer such a deal? Why would they prefer to accept a smaller amount of cash in the future that the full amount immediately? Maybe they fear the government plans to confiscate some or all of their cash or bank deposits if they receive payment immediately. Maybe a negative interest allows them to offer a customer a discount without formally reducing the price. 

You can imagine the sales pitch: ‘Have we a deal for you. You can pay the full price now, or if you pay later we will give you a five percent discount and a free set of steak knives. Is the manager crazy or what? You better buy now because the deal can’t last long.’ 

Or maybe negative interest rates are simply a coordination device, allowing all firms to offer implicit discounts without changing their headline prices. Whatever the reason, it is still curious that lenders rather than borrowers are being asked to take a redistributive hit because firms are reluctant to cut prices to induce higher demand. 

Distributional implications

Negative interest rates can be expected to have other effects as well. Loans or delayed payment arrangements can finance asset exchange as well as new activity. If delayed payment makes the purchase of firms or second-hand houses cheaper, there is the risk that negative interest rates will raise the current price of assets. The rationale for doing this when asset prices are near record highs is far from obvious. Negative interest rates on loans used to finance asset exchange also have distributional consequences, favouring people who have previously chosen to purchase assets rather than those who lent money to others. The reason for redistributing wealth to people who have equity rather than debt claims on assets is not particularly clear. 

Is there an alternative to negative money interest rates? If the government is concerned about the decline in output and employment that occurs when firms do not cut prices in the face of temporary adverse demand shocks, it could always try to induce a temporary reduction in prices by another means. One obvious way is to temporarily reduce its GST tax, to reward those who spend now rather than to try and punish those who save by accumulating bank deposits. Clearly this results in temporarily lower revenue, which will need to be offset by higher taxes in later more buoyant times. This policy will also result in a different distribution of income and consumption than the effect of negative interest rates. 

I have no idea about the relative merits of the redistributive effects of negative interest rates and a temporary cut in the consumption taxes. I don’t even know if those advocating negative interest rates have attempted to understand the relative distributive implications of these different policies. I hope they have, because it is not clear that negative money interest rates are an effective substitute for temporary price cuts. This suggests careful thought is in order before attempts are made to crash through the zero bound barrier. As Jerome Powell has argued, there is little evidence that negative interest rates without price falls are a panacea for the problems caused by low demand.

In this post I want to discuss what drives the households to behave in this way, and how this comes into our thinking about economics and monetary policy. 

I have to admit, when the lockdown announcement took place, I was one of those nervous households who decided to cash out money from my bank. My personal reasoning for that was the scars left by defaulting banks during the collapse of the Soveit Union, when my parents lost all their savings because one of the main banks failed. 

However, what are the economic consequences of this behaviour?  We might say that this is saving behaviour – but the people withdrawing their funds were already saving them.  Instead people are hoarding cash for some reason.  This is likely due to fear of bank failure (my reason), but a similar thing can happen even when individuals shift funds from a long-term savings vehicle to near monies (eg a checking account).  Examples of this are:

1. people cash out money or move it to a chequing account due to uncertainty of their employment status in the future
2. people decide to shift allocation of transactions, for instance, waiting until the end of the month to make bulk purchases.

In both cases the increase in demand for cash is also an increase in demand for liquidity.  So what does this mean for our broader economy?

Why are we concerned?

Cash hoarding affects the circular flow of money in the economy. We all know the circular flow diagram, and how real transactions are made between buyers and sellers.  However, these transactions involve a countervailing exchange of money.  So as Matt noted we can think of this both in terms of the money flow (MV) and the nominal income flow (PY). Sudden hoarding will reduce velocity for the same stock of money, thereby leading to a reduction in nominal incomes.  How do we think about this?

The hoarding comes from money demand.  So let’s think about that with a fixed (real) money supply. Here money demand declines with the interest rate as the opportunity cost of money (the return available from illiquid assets) is higher.

Above the change in money demand could be due to: 

1. An increase in output.  It is that shift, where people require greater money balances to facilitate these transactions which defines the traditional LM curve.
2. An increase in precautionary saving held in near monies form (cash, or a chequing account that a bank struggles to use as an effective basis for loans).

Here, with a fixed stock of money, both of these things would push up interest rates.  Hence this forced a movement up the IS curve and a reduction in output.

But this isn’t how a central bank responds to this change – a central bank like the RBNZ accommodates any increase in money demand initially by setting an interest rate peg.  As a result, such a surge in demand for money doesn’t lead to rising interest rates unless the central bank decides not to accommodate it! 

What does it mean for us?

In a broad sense having an interest rate peg instead of a quantity of money peg means that we don’t have drops in output due to tight monetary policy – in a sense.  The central bank accommodates shifts in money demand, thereby automatically meeting any change in the money supply required to meet liquidity needs.

However, the use of QE and other instruments to support liquidity show that this process isn’t always easy – and a fixed interest rate peg doesn’t always translate into sufficient liquid funds to meet this demand for liquidity.  As a result, monetary policy has a very real role trying to ensure that this need is met.

But there is one caveat- the increase in uncertainty associated with something like the current COVID crisis does not just shift that LM curve – it also shifts the IS curve left.  I have discussed this in terms of investment before.

If the central bank is able to manage liquidity issues with its interest rate peg appropriately, then all that matters is the question of whether there is sufficient demand for goods and services – a question that requires different answers (changes in the interest rate, discretionary fiscal policy).  In an IS/LM diagram such monetary policy is represented as a “shift” in that curve.

As a result, the example of people hoarding cash gives us a great insight into the dual roles the RBNZ is playing in both managing money markets and stabilising economic activity – and gives us a framework to consider the two clearly.

This is an issue that I’d cover after discussing Ricardian Equivalence, and think it matters given the increasing relevance of zero-lower bound economics for students in the current environment – and some of the discussion on NBER about multipliers, and HANK vs RANK (heterogeneous vs representative agent models) models of monetary policy.

Note: These non-standard models are cool, and much more “Keynesian” – but I think the more basic description below is important for keeping us humble about our ability to control things.

Now none of this will go into any detail on the more complex models (and ideas of expectations) – it will just ensure that we aren’t “losing money as an asset from our mental model” and should be read as such.

The circular flow (the description ECON141 is all about) describes the flow of funds around the economy, and the key thing is showing that if there is more dollars going around that flow in a period of time there is by definition more nominal activity – be it through higher prices or higher output. This insight can easily get lost in the discussion of individual channels during the course.

Happy with thoughts below – this is likely to be a non-assessed topic for eager students.

The setup

The very idea that the initial MPC relates to the final increase in aggregate expenditure and thereby aggregate demand is incredibly natural – at least in how we’ve outlined it in class.  If higher income leads to households and firms buying more, then that is income for other households and firms, which leads to more expenditure etc etc!  The bigger the impulse the bigger the multiplier is a logical conclusion of the multiplier process.

As a result, a lot of discussion about stimulus is fixated on the ability to boost a specific component of GDP.  Often we hear PY = C + I + G + X – iM and get told that stimulus requires increasing those components to start a multiplier process.  And there is some truth to that.

However, like always it is not the full truth – and it is why Scott Sumner says monetary policy is not aimed at consumption.  And it is why the other identity PY = MV also matters.

Let me explain with a thought experiment.

The thought experiment

Before doing our own thought experiment I wanted to start with the initial story that got me into economics, from a book my brother got me when I was 14.  Lets just use the picture:

Given that, what is our thought experiment:

Say that a helicopter flew out from underneath the central banks building, and deposited $10,000 into every individual’s hands (a very accurate helicopter drop).  And that was only spent on imported goods.  It doesn’t go to the shoemaker, so he doesn’t get the income to spend on the fishmonger, who cannot spend at the butchers etc

This sounds like a failure, a complete leakage from the circular flow. In other words, since the increase in C is met by a lift in iM there is not increase in expenditure on domestic products, and so no increase in domestic incomes, and no multiplier process!

But we haven’t actually finished.  Say the government raised the funds from domestic bondholders who simply flipped these straight to the central bank for the current targeted yield (or even pretend the central bank purchased them directly from the government).  

The increase in import demand based on the extra domestic dollars would increase demand for foreign currency and would drive down the exchange rate, which in turn would increase the incomes of exporters and increase the relative price of imports, which would then lead to increased demand for domestic goods and services.

So if more dollars are generated they either have to be spent on final production in the jurisdiction where those dollar are accepted as legal tender, or be held as an asset by someone (in this case the foreign seller or more likely their bank).

Note: This holds for any mechanism that will generate an increase in money, which as we discussed is a specific liquid type of asset. So the key question is how decisions by fiscal and monetary authorities can influence the amount of money and the role of the private sector (eg private credit creation through banks). A lot of the debates you’ll read come from different views about how this process works – we will leave it to the side here as an important question.

The lack of a central bank counter-reaction to the helicopter drop (total accommodation and so a corresponding increase in the money supply, so an unsterilised drop) implies that we can look at a one-off payment as a true “helicopter money drop”. Another way of saying it is that there are now more domestic dollars, and those dollars can only be held or used to buy domestic goods and services.  Whether they are initially used to buy them is irrelevant!

As a result remember, demand stabilisation isn’t all about picking specific channels and neatly guiding the economy – but ensuring there is sufficient growth in PY to prevent cyclical unemployment.

The Keynes Cross

In class we have defined everything with reference to the Income-Expenditure model, or Keynes Cross diagram. Here the expenditure on domestic products is given with reference to real output Y. Our MPC was considered to be the increase in spending that occurs from a lift in real income, keeping all prices fixed (exchange rates, interest rates, prices themselves).

In the above graph the MPC was less than one. The initial shock reduced expenditure, which then works through that multiplier process above. Now imagine we identify a household that has an MPC of 1 – if we drop the cash on their head will it lead to infinite economic activity … no because:

1. the transmission through other households involves an MPC of below 1
2. Other prices change (interest rates, exchange rates, goods prices, and factor prices)

So when we look at that nice neat graph we know it will be misleading us for two reasons.  i) it should be non-linear given the variabilities in MPCs as a shock transitions through the economy ii) it should be constantly shifting as the other “constant” prices are all changing.

Even though the interest rate is pegged at zero when we are at the zero lower bound there are other channels/prices, and focusing solely on the initial MPC alone misses this.

But if we measure a higher MPC that is probably a higher velocity transaction right – so why split hairs!

I have some sympathy with this as well, and the recent focus on estimating the distribution of these figures suggests it is an issue of interest (here, here, here).  Furthermore, allowing for differences in the types of households in the economy appears to make these responses more salient.

But whenever I start to feel comfortable with that I remember that my PhD supervisor and practicing macroeconomists have told me that things aren’t so simple, and so it is important we are a bit more careful.

A topic we went through in ECON141 which may have seemed “random” is money supply and demand. 

It is a topic that gets critiqued heavily due to the fact that – since monetary policy involves an interest rate peg rather than a quantity of money peg – any shift in credit demand (eg demand for funds for investment) is immediately accommodated.  So we abstract away and simply describe a Taylor Rule without the mechanics for the most part (the Monetary Policy Rule in our IS-MPR model).

However, the MD/MS model (and the LM curve it develops) is still consistent enough with that idea to get insights.  The one I want to use here is to think about money demand motives for a given stock of money.

When we measure an MPC it is for a period of time.  Say a quarter.  We have two identified consumers – one with an MPC of 1 in this quarter, and another with an MPC of 0.5.  They are spending on the same thing (so the transmission going forward is the same) and any marginal savings is expected to completely stall as financial institutions have a shortage of safe assets (so no marginal lending).

Here I can at least rely on the higher MPC right?  Well …….

What happens if that 1 MPC occurs because they spend the whole amount of money at once at the end of the quarter.  But the person with the 0.5 MPC spends it immediately.  If the transmission channel is sufficiently quick at turning over funds (eg spending the entire amount each week) then the lower measured MPC would correspond with a greater stimulus to AE.

If we instead thought in terms of money demand we would see this.  The household with an MPC of 1 has an elevated period of money demand, so the helicopter drop will be hoarded for a period of time.  In the end what matters is how quickly these funds are used – not just the proportion of the funds that will be spent in our defined period of time.  This is our velocity.

This example indicates two things:

1. A higher MPC does not imply a higher initial shock if there is a delay in consumption by the higher MPC household.
2. What matters isn’t the MPC in isolation, but the velocity of the entire funds – how quickly does the helicopter dropped dollar translate into another transaction (and onwards from that), be it spending by a butcher you purchased meat from or spending by a firm that borrows funds from a bank.

Now, no-one knows how these transmission channels work in perfect detail – all we know is that if we drop a dollar on someone it is implicitly hoarded in that instance, and its reintroduction to the circular flow depends on the factors that drive money demand for that individual.  The same thing happens once the funds find their way in another person’s hands – it is marginal VELOCITY of the dollar that determines what happens to expenditure.

Friedman was wrong to state this was a technological constant, but he was right to place emphasis on it.

Sidenote:  This is about expenditure, not prices or output alone

All this discussion is about how a central bank could boost expenditure and how – rather than thinking in terms of C + I + G +X – iM, if we think in terms of M*V the central bank is only impotent if increase in the money stock are met with a corresponding drop in velocity.

Eg the bank performs open market operations (OMO) by buying bonds, knowing that the reduction in the yield will reduce interest rates and provide liquidity and wealth effects that increases consumption.  However, at the ZLB bond holders are indifferent between holding bonds and cash, so there is no interest rate or liquidity effects – and empirically the wealth effect is small.  So wooops, the OMO will increase the money stock by the money will be “hoarded” as an equivalent asset to bonds!

The increase in expenditure here is the goal – but we have no idea whether this will occur through prices or real output without more modelling.  However, if there is insufficient demand then by definition prices and real output are below target – so the question of how expenditure can rise is the key one.