Wednesday, October 2, 2013

Floating information sources, physical laws and volition


... models of the macroeconomy incorporate monetary policy as just another component of “the economy”, along with the behavior of households and firms. [They] include the reaction functions of monetary authorities as determinate behavioral foundations of how the economy works; there is no corresponding behavioral rule on this fiscal side. 
Back in the days of IS-LM with a fixed money supply (fixed for some unmentioned reason by an almighty central bank), the model consisted of behavioral responses in the money and goods markets, leading to a predicted outcome, equilibrium levels of national income and interest rates. 
... you plugged in a policy choice and it told you how the economy was supposed to respond. 
Now it’s different, at least on the monetary side. In the new versions of IS-LM and AS-AD, as well as the more elaborate models in the professional literature, monetary policy is inside the model. The choices of central bankers are built in. You may have interest rate targeting, inflation targeting or some version of a Taylor Rule, but in all of them the monetary choices themselves are predetermined.

This is effectively the choice between a "floating" information destination and a "constant" information destination (in the market P:NGDP→MB) in the information transfer framework (see here or here). "Floating" means the Fed uses some target or rule, effectively looking to the market like any other business building widgets. "Constant" means it just builds its widgets at some fixed rate. In the former case, the Fed's behavior may be "constrained" (as Dorman says) but it's the kind of constraint that follows from there being lots of dollars (basically, the law of large numbers) and has little to do with volition on the part of the Fed. We don't say an ideal gas is "constrained" from doing what it wants by the ideal gas law. The physical system follows the ideal gas law. These Fed reaction functions are more like Maxwell distributions; Maxwell distributions don't constrain the movements of atoms (which can have any speed) -- they are the result of gazillions of atoms following the laws of physics. These Fed reaction functions don't constrain how the Fed increases the monetary base, they are the result of billions of dollars interacting with the market. The information transfer model with a floating information destination makes minimal assumptions about these functions and just assumes at a fundamental level information in is equal to the information out, or one level up, supply and demand is at work.

In the case of a constant information destination, where the Fed just sets an interest rate or targets a monetary aggregate, the aggregate demand (NDGP) is the only thing doing the reacting. This case generally leads to accelerating inflation.

Why isn't there a government reaction function (asks Dorman)? My best answer in this framework: Because the government (G) is only a piece of aggregate demand NGDP = C + I + G + (X-M). If G were a floating information source then it would just mix in with C, I, X and M as floating information sources leading to NGDP being a floating information source. If G were a constant information source (basically how it is treated), we'd still have C, I, X and M as floating sources that would still allow NGDP to adjust to the monetary base MB.

4 comments:

  1. Jason: re: the accelerating inflation case: Nick Rowe (and others, I think) has said that a fixed interest rate target by the CB could cause either hyperinflation or (hyper?)deflation, depending on where that puts the real interest rate relative to the "Wicksellian" "natural" rate (I think that's how he elaborated on that). Do you agree? It sounds like you may have covered the hyperinflation side of things ("accelerating inflation"), but what about deflation? I think you have covered the deflation possibility elsewhere, haven't you? So I'm going to guess your answer is "yes."

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    1. That is interesting. I think I have to look at the equations to see if I can pull something like a wicksellian rate out of them ...

      I haven't really looked specifically at deflation except in the case of deflation in the "information trap" when the base is large.

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    2. Mark Sadowski presented some evidence that a fixed interest rate target was at least partially responsible for the Weimar hyperinflation in the early 1920s, and Nick Rowe has made some independent statements which I took to be in agreement with that explanation. Specifically Nick has written numerous times that fixed interest rate targeting is a bad idea, but in at least one instance he elaborated saying essentially that Weimar is not an experiment we should run again. The evidence that Sadowski presented was a table showing the interest rate charged by the Reichsbank and the accompanying annual inflation rate over the course of 10 years or so (the data being presented every month). It was almost humorous how the rate stayed steady at 5% while inflation went through some wild ups and downs, but it almost always was at least double digits for 7 years or so until month 6 or so of 1922 (1921?),,. at which point the inflation rate started exploding: the response was that in month 7 (m7 as Sadowski put it), the rate was raised to 5.1% (meanwhile annual inflation was several hundred percent)... this pattern continued over the next year or two (to the end of the hyperinflation), with the interest eventually rising to 90%... but the inflation rate at that point was truly astronomical. Mark said the interest rate increases were probably "symbolic." And I'm not sure Mark explicitly made the argument above, but that was my takeaway: a clear example of what Nick was talking about.

      Later I might try to dig out some links for you... but the specific comments Nick made were in some of the posts he did in response to Steven Williamson's assertions about low rates causing deflation. There were at least two times that Nick, Sumner, etc took issue with Williamson about that: once around December of 2013, and again a few months later (April 2014 maybe?). The "neo-Fisherite" business was what it was called.... at least the 2nd time around. You remember well I'm sure! I'm pretty sure Nick mentioned that fixed interest rate targets lead to hyperinflation or deflation in the second round of that.

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    3. BTW, you might wonder why (if Nick is correct) we don't experience hyperdeflation at the ZLB (since if the Wicksellian natural rate is below the real rate this seems like it should happen). If I was understanding Nick correctly, this is something that he does not have an explanation for. He thinks Krugman has a partial explanation, but he's not entirely happy with what Krugman says:

      http://macromarketmusings.blogspot.com/2014/04/the-cure-for-neo-fisherism-history.html?showComment=1398723933833#c3856755014857782342

      This is not the post I read it in, but it covers the Wicksellian business exactly (2nd paragraph):

      http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/08/taylor-wicksell-fisher.html

      And here's Sadowski, and his Weimar hyperinflation table:

      http://noahpinionblog.blogspot.com/2014/04/the-neo-fisherite-rebellion.html?showComment=1398472777773#c1954688344009492559

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