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Intermediate Spending Booms

(Larry White assisted me in writing this article.)

A number of recent exchanges between Market Monetarists and their critics, and especially those of their critics associated with the Austrian school, have debated the contribution of excessively easy Fed policy toward the housing boom and bust. The issue boils down to this: can monetary policy really be said to have contributed to the housing boom in light of the fact that the NGDP growth rate during the 2003-2007 period was, as the figure below illustrates, only a percentage point or so above its previous 5 percent trend?

Market Monetarists tend to answer, "surely not," while Austrians (and some others, like John Taylor) insist that it is "yes." The difference has to do in part with the very different theoretical frameworks employed by the different sides. For Market Monetarists, like their old-fashioned monetarist predecessors, the framework consists of short- and long-run AS schedules, with the slope of the short run AS schedule reflecting the degree of short-run price and wage stickiness, among other things. AD innovations, including more rapid than usual AD growth, influence real activity by moving the economy along the short-run AS schedule. The stickier prices are, the flatter the schedule, and the greater the change in output.

Like other monetarists Market Monetarists tend to assume that prices and wages exhibit considerably less upward than downward stickiness. That perspective informed Friedman's so-called "plucking model" of the business cycle, according to which the plot of real output resembled a string glued to an incline plane, rising from left to right, that was "plucked" downward here and there owing to slow (or negative) demand growth. According to the plucking model, output drops below its "natural" rate whenever slow spending occurs, because there's a fair degree of downward rigidity in prices and wages. But output seldom rises much above its natural rate, because prices and wages are relatively flexible upwards, so that rapid demand growth tends instead to manifest itself in corresponding upward price movements. A steady rate of NGDP growth avoids the occasional downward “plucking” of output.

To make their case for stable NGDP growth Market Monetarists don't need to refer to interest rates generally or to the federal funds rate as an indicator of the stance of monetary policy–with a low funds rate indicating "loose" money and a high one indicating "tight" money. Indeed, they regard the common tendency to treat the federal funds rate this way as misleading at worst and a distraction at best, and would rather have monetary policy makers pay no attention to interest rates at all, and simply focused on the course of aggregate spending.

To be sure, the Market Monetarists have a point. Nothing could be more naive than the (Keynesian) treatment of interest as the "price" of money, with low rates signifying an abundance of money and high ones signifying a shortage. We can applaud their efforts to put the "money" back into monetary economics and policy, albeit not by drawing attention to the causal role of monetary aggregates but rather by emphasizing M x V or, equivalently, P x y.

But in seeking to free monetary theory and policy from the Keynesian overemphasis on interest rates, the Market Monetarists tend to downplay the extent to which central banks can cause or aggravate unsustainable asset price movements by means of policies that drive interest rates away from their "natural" values. Such distortions can be significant even when they don’t involve exceptionally rapid growth in nominal income, because measures of nominal income, including nominal GDP, do not measure financial activity or activity at early stages of production. When interest rates are below their natural levels, spending is re-directed toward those earlier stages of production, causing total nominal spending (Fisher’s P x T) to expand more than measured nominal income (P x y). Assets prices, which are (appropriately) excluded from both the GDP deflator and the CPI, will also rise disproportionately. It is the possibility that such asset price distortions may significantly misdirect the allocation of financial and production resources that lies at the heart of the "Austrian" theory of boom and bust.

The notion of a "natural" rate of interest comes, of course, from Knut Wicksell, who, starting with the premise that new money is delivered to the economy by way of the credit market, argued that excess money creation would result first in a lowering of interest rates, and only subsequently in a general increase in spending and prices. His approach differs from the naive Keynesian one in treating the interest rate effect of money supply innovations as temporary only, and in allowing that the "natural" rate of interest might itself vary quite independently of monetary conditions. Wicksell's approach ultimately connects the temporary interest rate effects of monetary innovation to nominal income and price level effects. Thus nothing prevents a Market Monetarist from also being a thoroughgoing Wicksellian.

Both Market Monetarists and Wicksell himself differ from the Austrians in paying little if any attention to the direct bearing of short-run interest rate changes on real activity, and especially real activity in asset markets. The Market Monetarists consider interest rate movements an unimportant sideshow without significant knock-on effects, and therefore a distraction from what really matters; Wicksell considered them only as a harbinger of changes in spending. Missing in both perspectives is any attention to the way in which interest rate movements redirect demand from certain markets to others. Monetary policy innovations can, in other words, involve both (nominal) “income” and “substitution” effects.

They needn't do so, of course. "Helicopter" money approximates the case in which monetary innovations boost nominal wealth, and thereby stimulate spending and nominal income, without necessarily involving any particular relative-price changes. The short-run/long-run AS-AD framework tells us all, or almost all, of what we need to know about the potential real consequences of helicopter money drops; and deviations of nominal income from trend supply a reliable indicator of the degree to which monetary policy has been either excessively easy or excessively tight.

But open-market purchases aren't helicopter drops. Instead (as Wicksell took for granted) they initially involve increases in the relative price of the securities being purchased, and corresponding reductions in market-clearing (but not in underlying "natural") interest rates. Lower interest rates in turn encourage a re-orientation of spending toward investment, and especially toward those prospective investment projects whose present values increase most in response to a marginal reduction in the cost of funds. This "substitution" effect of easy money–an effect that depends on real interest rate movements rather than on changes in aggregate spending per se–is the key to unsustainable asset price movements, where “unsustainable” indicates a movement than can only go on while interest rates remain unnaturally low. It is possible, at least in principle, to conceive of a monetary policy that gives rise to large substitution effects–that is, to a substantial increase in the perceived present value of particular investments–while having only a modest ultimate effect on the growth rate of nominal final income. The narrower the initial credit channel through which excess liquidity is injected into the economy before spreading out to the rest of the economy–the further removed we are from helicopter drops–the greater the likely importance of relative-price and substitution effects.

The possibility of substitution effects stemming from “unnatural” (monetary-innovation based) interest rate movements supplies reason for taking even modest innovations to NGDP growth, and upward innovations especially, seriously. The possibility suggests that such deviations are likely to be associated with disproportionate deviations of total spending—that is, of spending on both final and intermediate goods—from its own trend. In so far as money supply innovations tend to drive interest rates either below or above their natural levels, increases in the growth rate of NGDP and other nominal income measures may understate the extent to which monetary policy is excessively easy or excessively tight (and are likely to continue to understate the laxness of monetary policy while a boom persists), because the amplitude of short-run deviations of total spending from trend will be greater than that of nominal income, and because velocity and money multiplier declines that typically accompany the bursting of asset bubbles will suppress the acceleration in nominal income growth that might otherwise be observed once substitution effects have worn off. Just how much this difference in amplitude mattered in any particular case, including that of 2003-2007, is of course, a matter that cries out for further study.

  • The effect of below market interest rates since just after Volcker has brought the velocity to near one. The reason all the printing and spending produces no inflation is because there is no velocity. Velocity is demand for money.

    Even were the Fed to abandon ZIRP, velocity would remain low for decades. If the FED were to do something extreme such as raise the fed funds rate to 8%, it would be 2016 before the velocity increased to a non-robust level of 2.

    Perhaps the only immediate fix would be Gisellian stamp money with a negative interest rate of say 12% per year. People would use it to pay off their debts. Students would dump it on loan creditors. Credit card debtors would pay off their cards. Meanwhile, this high velocity currency would consume the national debt as stamp revenues poured into the US Treasury.

    Velocity would be restored. The Fed would be no more.

    • George Selgin

      "Velocity is demand for money." No: real money demand = y/V; an increase in V is consequently equivalent, holding y constant, to a decline in the demand for real money balances.

      Nor has M2 velocity quite fallen to 1 yet–though it is closer than ever.

      And on what grounds can you, or anyone else, conclude that V will "remain low for decades," or that the Fed (note that, as it isn't an acronym, all caps are inappropriate) would be inclined to raise the funds rate to a whopping 8% unless spending had revived enough to call for such a dramatic increase?

      Finally, the idea of provoking inflation so as to "consume the national debt"–and of thereby effectively swindling a very large number of people out of their hard-earned savings–hardly sounds like my idea of responsible monetary policy. Nor would it mean that "the Fed would be no more."

      • Forgive me if I am mistaken, but I believe that y/V = m = money supply. Demand for money is y/m = V .

        I don't know why you say that negative interest stamp money would provoke inflation. To the contrary, the stamp revenues would pay off the public debt. For example, if the US Treasury simply printed up $1 T in stamp money (without borrowing anything from the Fed), with a negative 12% interest rate, and simply mailed it to student loan debtors, the circulation of this currency would in 100 months retire $1 T of the existing $16 T of national debt.
        It would be austerity with liquidity. Real growth would be tremendous due to the high velocity of this money, as

        r = V(1-u) where u = PV/FV

        Of course, the Fed would have to go as otherwise Congress would spend another $10 T in that 100 months.

        Irving Fisher, after his fall, was a proponent of stamp money and was very grateful to Silvio Gesell for teaching him about velocity.

      • To reply more fully to your comment –

        And on what grounds can you, or anyone else, conclude that V will "remain low for decades," or that the Fed (note that, as it isn't an acronym, all caps are inappropriate) would be inclined to raise the funds rate to a whopping 8% unless spending had revived enough to call for such a dramatic increase?

        – requires a small amount of explanation, to wit:

        The Quantity Theory Of Money (QTOM) equation is

        pQ = mV

        Taking logs on both sides and differentiating w/r to t

        p'/p +Q'/Q = m'/m + V'/V

        In a Say's Law economy, the above is a tautology.

        m'/m is percentage growth of money by interest accrual. m'/m = i, the interest rate;

        Q'/Q is real growth = r ;

        p'/p is the percentage change of price level, also known as inflation/deflation;

        When i = r , the economy is in a state of equilibrium where m'/m = Q'/Q , i.e. percentage growth of money is equal to the percentage growth of salable goods and services brought to market. If i ≠ r for some reason, then i – r = p'/p . Whether or not the economy is in equilibrium, however, the normal state of affairs is that

        V'/V = 0 , which is to say that V is a constant, or at least varies much more slowly than the other variables. At any rate, V'/V = 0 is unaffected by disequilibrium between i and r.

        For a non-Say's Law economy however, the situation is quite different. Here, m'/m = i + g, where g is the amount of money growth due to printing and spending money absent any production of salable goods.

        Regrouping QTOM one can write

        m'/m = p'/p + Q'/Q – V'/V where in light of the foregoing

        i + g = p'/p + r – V'/V and since i = p'/p + r

        g = -V'/V

        Thus, counterfeit money destroys Velocity.


        T0 answer you specifically on the point – And on what grounds can you, or anyone else, conclude that V will "remain low for decades,", – I make theses observations;

        The inflation rate has averaged 4.5% since 1940
        During this entire period of time, except when Volcker spiked the fed funds rate to 18% and velocity shot up from a moribund 2 to over 3.6, the economy has been bleeding velocity. With Reagan, the bleeding resumed.
        Unless the fed funds rate is immediately and sharply raised, the economy will die. Even if it is suddenly raised, it will take more than a decade to revive the economy.
        Public debt is now at $16 T. Until a means of repaying this debt is found, money will be printed to servi
        When V < 1 , hyperinflation will ensue.

        For plots of the variables from my computer model, visit Please be patient, I'm posting them as fast as I can.

  • miguelefe

    Don't you ever get bored with playing with people's patience?
    How can you write so lightly about playing with printed paper as it were totally worthless? I live in Argentina, and have lived , say, more than half of my 59 year life under "monetary ëxperiments". The most visible consequence is the perpetual sensation of living on edge, at the border of civil war. Violence is the main product of irresponsible monetary and credit manipulation.

    North Americans should be very concerned about the possibility of becoming another sudaca country with high inflation , big unemployment and skyrocketing interest rates.

    USA is the last hope for people who believed in freedom and contract accomplishment of any kind.

    • To hold stamp money more than 30 days would require that you purchase a 10 cent stamp to affix to a $10 bill to keep it current.

      I relish the thought of all the student loan debtors showing up at their local banks with wads of the stuff to pay off their loans. Of course, to make money on it, the banks would probably lend it out for 14 days at 1%. It would no doubt be more lucrative than 30 year mortgages. The tremendous circulation would spur real growth. Unemployment would vanish.

  • McKinney

    Nicely done! So why don't you call yourself an Austrian economist?

  • CT

    "The Market Monetarists consider interest rate movements an unimportant sideshow without significant knock-on effects, and therefore a distraction from what really matters;"

    And this a huge part of the problem. Interest rates are incredibly important as they signal what the aggregate of individual time preferences are. It is only severe financial (I won't call it economic) illiteracy to believe that the discount rate applied to investments has no bearing on what type of investments or capital projects people will choose.

    • CT It´s a "side-show" as far as monetary policy is concerned, especially against the conventional view that associates low rates to easy policy and vice versa.

      • CT

        Interest rates are not a side-show. A lower rate of interest is a direct result of either a) new savings, b) new money being introduced via the banking system, or c) a lack of investment demand. NGDP is a side-show. When either new savings or new money is introduced via the banking system, this money gets spent on capital goods which are not counted in NGDP. And since inflation of the money supply results in lower interest rates, investors allocate capital to long term projects which will not show up in NGDP numbers for years. It also explains why commodities such as copper and oil take off when the Fed inflates. In order to evaluate monetary policy, it's the money supply (a correct measure) which must be examined, not NGDP.

      • CT

        Just realized I should probably expand on a particular point. I meant a large part of the money spent on long term projects may not be spent on consumer goods for years …

  • The above argument illustrates the nonsense that is involved in using interest rate adjustments to regulate demand. Borrowing was excessive prior to the crunch, thus interest rates OUGHT TO HAVE RISEN, but they didn’t because demand wasn’t excessive, thus central banks didn’t raise rates.

    Another contributory factor – now I’m entering the lion’s den here – was fractional reserve banking. Under the latter system, the private bank system can create savings out of thin air, and without raising interest rates, so as to supply borrowers with funds. Exactly what happened prior to the crunch. So the solution is thus.

    Full reserve, plus adjust demand by having government and central bank create and spend new money into the economy when stimulus is needed (and/or cut taxes). And the reverse when inflation looms. At least that’s the solution advocated here:

    The use of interest rate adjustments to regulate demand is crazy. For example at the start of a recession, there is a SURPLUS of capital equipment, thus cutting rates so as to encourage investment is nonsene. Second, there is no relationnship between base rates and credit card rates. Third, the idea that there is any relationship between base rates and the actual availability of credit is a joke: UK banks are currently very reluctant to lend to business.

  • George, you say that "distortions can be significant even when they don’t involve exceptionally rapid growth in nominal income, because measures of nominal income, including nominal GDP, do not measure financial activity or activity at early stages of production."

    But GDP calculations include investment, presumably much of which is in the early stages of production. It also includes inventories. Why wouldn't GDP be able to capture an easy monetary policy's effect on investment?

    You point out the MV=PT might be a better indicator of monetary easing since it includes financial transactions. Fair enough. You may find it interesting that Nick Rowe has also made this observation. His reasoning is that MV=PY just includes spending on new stuff – it doesn't include all the spending we do on used and old goods. He suggests that monetarist macroeconomists should scrap MV=PY and replace it with MV=PT.

    You point out that a narrow initial credit channel "through which excess liquidity is injected into the economy" might result in dislocations that don't appear in nominal income measures. I presume these are Cantillon effects you are talking about. But what if monetary policy is conducted in a more democratic manner such that the Fed conducts open market operations not just by buying bonds from primary dealers, but also buying equities on the open market, and buying houses straight from households, and purchasing cars from dealerships, etc etc?

    It seems to me that the differences between you and market monetarists shrink if the target is MV=PT, as Nick has suggested, and if open market operations are actually conducted openly so as to obviate Cantillon effects.

  • johnyuehanlee


    Why do you think it is correct to exclude asset prices from CPI and the GDP deflator?

    Aren't such assets similar to durable goods, many of which are included in t

  • johnyuehanlee


    Why do you think it is correct to exclude asset prices from CPI and the GDP deflator? Aren't such assets similar to durable goods, which are included in the CPI?

    If central banks aim to retain the inflation-targeting approach, how do you think the CPI should be modified?

  • Interesting to see … thank you it's well done 🙂