15 March 2016

Central Banks Can't Control Money Demand!!!!!!!

After posting too many lengthy comments on Scott Sumner's blog a while back, I decided I was going to ignore his claims that high interest rates are "expansionary" because they increase velocity. I tried, but he has crossed the line. He has elevated his already excessive list of central bank abilities to also include the ability to control money demand as well as the money supply.
NGDP = MB*(Base Velocity), where V is positively related to nominal interest rates.
Thus if you cut interest rates without increasing the money supply, then V falls and policy becomes more contractionary.
Read that a few times to get the full point that Sumner is making. His money demand equation is, of course, perfectly fine; you'd have to be ignorant to not understand that velocity is a positive function of nominal interest rates (or, in my preferred terminology, money demand is decreasing in nominal interest rates). The problem comes in when Scott says "if you cut interest rates without increasing the money supply." When you read this, sirens should have begun screeching in your head; Scott's weird partial equilibrium analysis in which there are three things that determine the nominal interest rate (money demand curve, interest rate chosen by central bank, and money supply) may be "monetary economics 101" in his mind, but it's certainly not economics 101, in which a monopoly supplier of something can't control its price and its quantity.

I mean, come on, this should be obvious, but apparently someone with a PhD in economics can make such a mistake without being universally discredited. In Scott's world, all a central bank must do is apparently announce higher nominal interest rates as well as monetary expansion, and NGDP will go up by the desired amount. Well, duh, but the real world doesn't work that way; just because you can force the money demand curve to shift so that a higher money supply means a higher nominal interest rate by making the nominal interest rate and the money supply exogenous in a model doesn't mean that this is actually possible. Seriously, the effective argument that Scott is making here is "thus if you reduce NGDP, then NGDP falls which means that monetary policy has become more contractionary." I'm sorry, but there's seriously no excuse for this; Sumner really needs to start working with general equilibrium sometime before he just skips this misleading line of reasoning and goes straight to "NGDP should have been higher in 2009, if that Fed had simply done this, then a recession wouldn't have happened" (bear with me and pretend Scott hasn't said almost exactly this before).

Of course, a central bank can go about raising the nominal interest rate without changing the current nominal interest rate, but this requires expected increases in the money supply, which Scott never mentions (probably because of previously mentioned attachment to partial equilibrium). That is, if expected money supply growth increases, then so will expected inflation, but this is not the argument that Scott is making, he only talks about the current money supply and the nominal interest rate in his post, and I'm not willing to give him the benefit of the doubt. Beyond that, Sumner was using a one period model to do dynamic analysis (someone explain to me why he's so dedicated to partial equilibrium), which is a sin in and of itself and he would still be guilty of even if he secretly meant to say "thus if you reduce expectations of future money supply growth without increasing the current money supply, then velocity falls [money demand goes up] and policy becomes more contractionary."

The worst part is that I haven't seen anyone complain about this apparent lapse of understanding of basic economics, everyone seems to be obsessed with Sumner's alleged Neo-Fisherism. Everyone, that's not the issue, you don't need to be bothered about Sumner appealing to an extremely basic one period model that you all should agree with, you should be screaming that "central banks can't control money demand!!!!!!!!!!"


  1. "I mean, come on, this should be obvious, but apparently someone with a PhD in economics can make such a mistake without being universally discredited."

    But academics are not taking Scott Sumner seriously.

    It is clear that he does not understand how central banks implement monetary policy and does not understand the theoretical underpinnings (i.e New Keynesian models). And also he is very confused with causal reasoning.

  2. John, I think you're missing at least one "!" in your title. ;)

    1. Maybe I should have put it in all caps too. :P