Friday, July 19, 2013

Insights from the information transfer model?

Here is a list of random thoughts derived from these predictions and these results (i.e. the last three posts):

  • I've had an intuition that the relationship of the MB to NGDP in the information transfer model (ITM) is a bit like the fuel-air mixture. As such, the US and Japan appear to have flooded their engines, reaching a point where monetary policy has little effect on the price level.
  • The situation in Japan may be worse because it appears both deficit spending to boost NGDP as well as monetary policy have been used. Japan has a base of comparable size to GDP and a dept to GDP ratio of over 200%. The path out of the deflationary trap (in the information transfer model) requires a way to boost NGDP (i.e. deficit spending, because markets will panic) while reducing the monetary base ... which could involve a much higher debt to GDP ratio. 
  • It is possible Japan could just reduce its monetary base. The psychological effect (i.e. the standard economic reasoning) will be that tighter money and deflation will result; markets will panic. However, if the ITM is correct, there will be no decrease in the price level -- it should actually increase (specifically, cutting the MB in half should increase the price level by 5%). I have no idea how it would work in practice. The potential panic could upset the entire power stucture and cause the country to collapse. 
  • I will note that there is no conventional economic reasoning that leads to the conclusion that we (or the Japanese) need to decrease the monetary base to create inflation as far as I know. Krugman's liquidity/expectations trap model seems to indicate that expansionary monetary policy has little effect (unless the central bank can effectively "promise to be irresponsible"). This is at least consistent with the ITM predictions where increases in the monetary base have little effect, but I don't think Krugman's model is consistent with the inverted relationship between the money supply and inflation (i.e. where decreasing the base leads to inflation) in the ITM.
  • I will also note that no conventional economic reasoning seems to explain Japan since the 1990s either.
  • The ITM has no conflict with the concept of NGDP targeting; in fact the ITM is a quantity theory of money far from the ridge line (the dashed gray line in the figures here). It would just call for a relabeling of what you mean by expansionary monetary policy when you are near (or over) the ridge (i.e. contraction of the base becomes expansionary).
  • As opposed to the Great Recession, the ITM explanation of the Great Depression is the similar to the standard monetary viewpoint. Money was too tight. The ITM reduces to the quantity theory of money for years before the 1960s. However, boosting NGDP through fiscal policy isn't necessarily offset by tighter monetary policy. They represent two independent dimensions on the price level surface. Therefore the story is not entirely the monetarist story and a complete telling would include part of the Keynesian story (FDR's demand stimulus measures and the effects of WWII).
I may add some points in the future.

2 comments:

  1. The idea that cutting the MB oould raise inflation is entirely counterintuitive. How does the ITM achieve this result?

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    Replies
    1. This is probably one of the reasons I use most to emphasize my doubts about the model.

      The capability to raise inflation by cutting the base arises through the same channel as many of the strange effects in macroeconomics: money is both a unit of account and a medium of exchange. In this case, money is the information destination and the unit of information in the information transfer.

      Mathematically, it comes in through the information transfer index. In normal supply and demand in this model, the information transfer index is constant because it is measured in symbols that communicate information exchange (i.e. money) and not whatever the supply and demand are actually denominated in (e.g. cell phones and humans). The index is In applying the quantity theory of money, the index becomes a function of the aggregate supply (the money supply, actually more like the LM curve in the ISLM model) and aggregate demand.

      I don't know if I have a really good intuitive reasoning for the effect though -- hence my doubts. A negative "money multiplier" is necessary to reconcile Japan and the US with a quantity theory, though. The liquidity trap ( http://en.wikipedia.org/wiki/Liquidity_trap ) explains a similar effect, but there is a key difference. Liquidity traps can happen any time. The effect here only happens when the monetary base is large relative to NGDP and the definition of "large" gets smaller as the size of the economy grows.

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