For those who don’t want to listen to a video, we’ve popped the script below.

We’ve chatted about why we care about GDP and the different ways of measuring it – be it through expenditure on final items, the value-added in each industry, or the income paid to those providing a “factor of production” such as work time or capital equipment.

In these chats we established that however we measure it, these measures of “expenditure” “production” and “income” all give us the same result for GDP – and this tells us that the amount we produce, the amount we consume, and the amount of income we have are really all the same thing.

This is a powerful result that has been used to say “Supply creates its own demand” or, as the bloke on my t-shirt says, that “demand creates its own supply”. Behind all of this we always need to model a process to truly understand how the macroeconomy works and what trade-offs there are.

[Gulnara]

However, out of context this result is also misleading – and can lead us to get the wrong impression about how society is progressing or the opportunities available to people.  Even ignoring other attributes that economists like to add in – the distribution of income, environmental change, and non-monetary value stemming from your interaction with your community – this perspective can miss important things even in terms of our narrow understanding of monetary incomes.

In this video we are going to think a little bit about that, and see what other measures we can look at from the national accounts that may give us a wider perspective on incomes.

GDP and income

[Back to Matt]

As we noted in a prior video, GDP can be measured by taking all expenditure on final items, taking all income paid to labour, capital, and through indirect taxes, or by calculating the value added in each industry and adding them up.  And each of these measures will give us the same number!

This measure is amazing at helping us understand the use of society’s scarce factors of production, gives us an insight into economic progress in a country, allows us to understand and compare production and incomes between countries, and provides a useful piece of information for asking about policy trade-offs when we use it with economic models.

However, when it comes to cross-country and time based comparisons we immediately run into an issue – prices change through time, and different countries use different currencies.

If we are looking at one country or countries with the same currency everything is in the same “unit of account” which makes it easy to add up – but how do we add up a New Zealand dollar and a Japanese Yen for building a GDP measure?  

When comparing across countries we need to adjust for the fact that different units of the currency can be exchanged for the same goods.  We can’t just use exchange rates here as they don’t give us the full picture due to non-tradable goods and services. Furthermore,these exchange rates can be excessively volatile and as assets currencies may be valued for reasons other than the strict ability to purchase goods and services. 

We aren’t going to focus on cross-country comparisons and therefore those types of measures right now, but will cover it in a future video.

Our focus here will be on the time based dimension. We know that a New Zealand dollar today cannot buy the same number of chocolate bars as a New Zealand dollar could when I was a kid – sadly. As a result, if we construct GDP just by counting the number of dollars spent on these items, then when comparing GDP numbers over time we will end up with a measure that captures both the increase in the price of goods and services as well as an increase in the actual number of them.

The measure that takes “current prices” to calculate GDP – the equivalent of just adding up the number of dollars spent – is called nominal GDP.  While the measure that adjusts for the fact that prices changed and attempts to measure the volume of GDP over time is called real GDP.

Getting from nominal to real GDP involves figuring out a way to remove the price effect, or what is termed deflating nominal GDP for price growth.  The GDP deflator captures the aggregate price effect through time, and by dividing nominal GDP by this deflator we get our measure of real GDP.

As we often care about the amount of stuff available to buy, rather than the number of New Zealand dollars floating around to spend on it, real GDP is normally the measure we are talking about when we talk about GDP as income.  However, both measures are useful and have their place for asking different questions.

To give this all a bit of context, let’s pull up the data and look at these measures for New Zealand.

[R session]

Here we have pulled some data off the Stats NZ website and made some quick and nasty graphs.  This first one shows us New Zealand GDP in nominal and real terms between 2000 and 2020.

Note how nominal GDP starts below real GDP and then climbs above it.  What does this mean?  Well it means the nominal GDP was growing faster than real GDP, which is what we would expect given that prices were rising!

Furthermore, they are equal during 2009 – implying that we are deflating nominal GDP to get real GDP in 2009 prices.

This is the income of the nation, but as we are looking at incomes we might want to know about the incomes per person – or per capita.  As populations are growing that looks like a second graph here.

This shows a similar trend, but you will notice that the lines are a bit flatter (or that the Y-axis increases by a smaller proportion).  This is because the population was growing during this period, so part of the increase in GDP was associated with there simply being more people.  

The real GDP per capita number tells us that, in New Zealand borders, significantly more output is created per person was created in 2020 than was the case in 2000 – 38% more to be precise!  This opens up a world of questions, are we using more inputs (i.e. working more, using more environmental capital, building up more physical capital) or have we just learned how to use what we have in a more efficient way – what is called multifactor productivity growth.

But we aren’t answering those here. Instead we want to ask, is this income?  Over to you Gully.

What is macroeconomic “income”

[Gulnara]

Thanks again Matt.

Describing GDP and income in the way above is typical for an introductory economics course, and feels very natural. However, it is also misleading. To truly think about income we need to ask what income actually is.

In Hicks 1946, John Hicks stated that income was “the maximum value which [a man] can consume during a week, and still expect to be as well off at the end of the week as he was in the beginning.”.  As one of the founders of the post-war “neo-classical synthesis”, and as a famous welfare economist, it is this definition of income that captures what an economist is thinking about when they say “income”.

It is then the equivalence between consumption + savings (potential consumption) and production at the macro level that leads us to view income as essentially GDP.

Income in this economist’s world is “potential consumption”, as it is this ability to consume final goods and services through time that generates wellbeing and welfare.

GDP on the other hand is a measure of the use of factors of production to generate value added/output – the rationale for looking at this is to understand the utilisation of factors of production, especially workers, in market activities. As noted by Matt above, the focus is also on the number of items. 

In this way, much of GDP is the act of creating some value associated with a final product that is consumed – but there may be cases where the factor of production is instead used in order to “maintain how well off they are” or where the residence of the individual who claims the output differs from the residence of the factors of production.  These differences will lead to a gap between our true concept of income and GDP – so let’s talk about them a bit more.

Maintaining assets

[Matt]

Thanks Gulnara.  The issue I want to talk about a bit more is that of maintenance.  

The “gross” in gross domestic product refers to the fact that ALL investment is included in the measure.

If you own a building and you use it to run a business then that refers to a capital item.  You may invest in that building by adding an extra floor, improving the air conditioning with services like www.newcastleairconditioning.co.uk, painting the building, or replacing the showers.  All this investment activity will be measured at once – however, some part of it refers to maintaining the productive use of the asset while some refers to increasing the productive use of the asset.

Why would we need to maintain anything?  Well, time takes its toll on all of us – especially capital assets.  This depreciation in the usefulness of the capital item is sometimes called “consumption of fixed capital”, and GDP includes investment that is solely about keeping the capital item as productive as it was before.

However, if we imagined someone producing something for themselves the decision to repair something doesn’t constitute a new thing for them to consume – so we wouldn’t view it as part of their “income” or an increase in their ability to consume while maintaining their current position.  Instead, this is an expense that is required to keep themselves in that position!

The measure that tries to adjust for this given estimates of depreciation and measures of the capital stock is Net Domestic Product.

[R session]

We will construct Net Domestic Product from the Stats NZ data and graph it here as well.  For this we have subtracted the Stats NZ estimate of “consumption of fixed capital” from GDP, and then used the same deflator to work out a real value.  True Net Domestic Product will look a little bit different, but this gets us close enough to chat about.

So what is this graph showing?

Net Domestic Product moves in a similar way to GDP, but is lower.  This makes sense as we are subtracting an “expense” that isn’t included in GDP.  By taking away the part of GDP that needs to be used to maintain capital equipment we have a more genuine measure of income relative to the definition Gulnara gave above.

This figure grew by 37.7% – slightly less than the growth in GDP over the same period.  Why is it different?  If the capital stock per person has risen, or the types of assets we hold depreciate more quickly – such as computers – then the amount of maintenance that needs to be paid will rise.  As a result, Net Domestic Product growing by less is also consistent with the changing nature of the economy over the past 20 years.

Opening the borders

[Gulnara]

Things become more complex when we open ourselves up to the rest of the world.

Three things happen when we admit there are other countries:

1. Domestic residents can own assets overseas, and so are able to consume things that are produced overseas – similarly foreign residents can own domestic assets, giving them a claim on some of this domestic production that is measured by GDP.
2. Domestic products might be sold overseas (exports), and foreign products may be purchased and consumed domestically (imports).  Imports are part of consumption, and must be funded to some degree by exports.  If the relative price of exports and imports increases , domestic residents can now consume more for the same amount of production.
3. Transfers, such as charitable giving and intermittences, involves residents in one country sacrificing consumption to provide those opportunities to others overseas.

In this way, GDP remains as a measure of what is “produced” within a country – it measures what is made with factors of production within national boundaries.  But this does not immediately mean that it reflects the claim on products for people who live within those borders!

Gross National Product or GNP is the measure that attempts to adjust for the income of domestic residents overseas, and the income of foreign residents that is generated in the domestic economy.  This is very similar to Gross National Income, or GNI – conceptually they should be the same, but in some accounts the residency definition or definition of primary income (income from factors of production) that are included can vary between the two.

However, secondary income (such as the intermittences noted above) are missing in these measures.  Adding in net transfers from above provides a measure termed GNDI (gross national disposable income) as an aggregate income measure.  By capturing all foreign transactions, the construction of this measure also captures changes in the terms of trade as “income” – in a way that GDP does not. (isi_box1_jun_2015.pdf (banrep.gov.co))

Taking GNDI, we run into the same issue that Matt talked about above – there is some investment that is just about maintaining the stock of capital.  Subtracting this depreciation then leaves us with two other measures that you may hear about, NNI or Net National Income, and NNDI or Net National Disposable Income.

Do all of these adjustments change much?  Let’s look at the New Zealand data with Matt!

[Matt on R part and summing up]

For these figures we are going to stick with the nominal data provided by Stats NZ. This is because real figures are not provided, and trying to back out the appropriate price deflators for these different indices will take a bit of time without necessarily adding much value.

With that out of the way, let’s plot everything from the Stats NZ experimental national accounts.

As we can see here there are potentially a few data issues in this experimental series – so I want us to focus on the relativities rather than the individual series shape over time.

GDP is at the top, with GNI and GDI catching up through time.  GNI and GNDI are also very close to each other.  NDI is then significantly lower than the others – which does make sense.

So why is GNI below GDI in New Zealand? Remember that we get from one to the other by subtracting the domestic production that is claimed by foreign residents and adding in foreign production that is claimed or owned by New Zealand residents. New Zealand on average borrows from the rest of the world, and it is the income flows associated with this that explains the gap!

However, the deflator does matter when we want to think about the key differences between GNDI and GDP – namely changes in the relative price of exports and imports, or the terms of trade.  For this we do want to consider how real measures may look different solely on this basis.

Here we get a much sharper change in the relative value of GDP and GNDI than when we looked at the nominal values.  Why is that?  In this instance New Zealand has seen a very substantial increase in its terms of trade – or the price of exports relative to the price of imports – over this period.  When we deflate the two income series, that terms of trade difference shows up as another part of the change in these measures.

Between 1992 and 2021 real GDP per capita rose 58% while real GNDI per capita rose 77% – as a result this is a very significant difference. So how do we think about which income measure to use?

The fact that New Zealand can now buy a lot more imports from the exports it sells is an increase in income in the GNDI sense – and it is not captured directly by real GDP.  How does this work?  If exports remained fixed and more imports were purchased for consumers to consume, then both C and M would increase in the GDP equation – cancelling each other out.

However, this is real income – having people overseas give New Zealanders more products for the same exports is exactly the same as exports becoming more productive in terms of the amount of goods and services available for New Zealanders to use.  As a result, understanding this change is extremely important!

Conclusion

As we’ve noted above, looking at national accounts to get an idea of material wellbeing can be complex – and MOTU has been undertaking work trying to get a more detailed understanding of this in recent years: Motu-Note-21-Material-Wellbeing-of-NZ-Households.pdf

However, by clearly articulating what GDP is, and how it may measure some things we don’t truly see as “income or potential consumption” we’ve been able to work out some alternative measures that already exist in the data to chat about what is happening.  

These measures give us additional information which may change the way we see New Zealand’s productivity performance, inequality within the country, New Zealand’s wealth and income relative to other countries and a multitude of other narratives that are given in the media and common discussion.  However, we’ll leave it here and we would be eager to hear if this perspective is useful in helping you understand a little more about our beautiful little island.

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.

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.