Tuesday, October 6, 2015

Causing you to do X versus giving you the option to do X

Peter left a comment saying that he didn't believe changes in the monetary base caused anything, and I thought I'd promote my response to a post. I said:
... I disagree that the monetary base doesn't cause anything and a different thought experiment shows how it works. Let's say I give you 900 € (and you live in the EU). You'd do one of three things: nothing, deposit some of it in your bank (which gets lent out), or spend part of it. Since we are all complicated individuals with our own motivations I can't say exactly what you'd do. The least informative prior says you'd spend 300 €, put 300 € in the bank and let 300 € sit in your wallet. On average, you'd do something with it. Very few people would just let the 900 € sit under their mattress. 
Did giving you 900 € cause you to deposit the money or spend it? Well, that's philosophical. Personally, I like to say the 900 € opened up your consumption state space and you took your own path through it ... and on average people do wander through part of it.
[I used € because dollar signs will collide with mathjax.]

The key thing to understand the state space opened up by the 900 €. Does it include higher prices (inflation)? Increased output (NGDP = N)?

This blog says yes to both if the 900 € is physical currency M and the ratio of the naive (least informative prior) information in revealing a dollar of output (log N) to the information in revealing a dollar of physical currency (log M) is greater than one (this is the information transfer index k). [2] If k is close to one (allocating a dollar of output has the same information as allocating a dollar of currency), then there is output growth but not inflation. Inflation measures widget information [1]; money measures widgets. Output is a mix of both.


[1] There's a bit of nuance to that statement, but it's a good elevator pitch version. See here and here for more.

[2] See the draft paper for more.


  1. Thank you for responding.

    I think you are making a fundamental mistake. In your example it is not the fact that the base increased that cause GDP to go up, but the fact that incomes, or assets, of the private sector increased. To argue it is the base, you would have to prove that if I was given $900 in Treasuries things would have been entirely different. They wouldn't. I could just sell the Treasuries with the Fed being the ultimate buyer.

    You are describing a fiscal operation which would indeed work, obviously. But monetary policy afficionados like Sumner don't get that the Fed can't do those type of operations: if it fiddles with the base it is increasing it while decreasing the other private assets, it would be a swap of $900 Treasuries for $900 reserves. That is like swapping someone's savings account for a checking account. It doesn't matter. All Fed ops are like this, they don't change the private sector Net Financial Assets: the balance sheet impact is nil. These ops change the relative price of bonds vs reserves a.k.a as the yield curve. The Fed is not allowed to perform helicopter drops, only asset swaps and loans. QE is just an asset swap.

    To get the accounting right please see:





    1. Sure the balance sheet impact is nil, but that doesn't mean prices (for example) can't be affected. Take two extreme cases, neither of which is either a direct injection of nor a direct removal of assets (not helicopter money nor the opposite of helicopter money):

      1. The Fed completely unwinds it's balance sheet, refuses to sell anymore dollars and raises reserve requirements to 100% afterwards: literally withdrawing almost all dollars from the economy. You don't think prices would go down?

      2. The Fed eliminates it's reserve requirements, sets a negative interest rate on reserves and then attempts to purchase everything there is to buy in the world expanding its balance sheet many many times over. You don't think dollar denominated prices would go up?

    2. I see we have moved the goalposts from "the monetary base doesn't cause anything" to " increasing [base] while decreasing the other private assets ... doesn't matter". However, in my example I never said where that 900 € came from ... and it doesn't matter. If I bought your lamp from you for 900 € you'd still either spend it, put it in your checking account or do nothing (or more likely some combination of all three). The least informative prior is that you'd spend 300 €, save 300 € and keep the other 300 € in your wallet.

      Yes, how the Fed actually operates is through buying (selling) short term securities with electronic money it creates and approving exchanges of reserves for physical currency printed up by the treasury. The former (open market) operation creates a direct link between the monetary base and short term interest rates. And because the latter operation has banks as gatekeepers (and due to the storage limitations of physical currency), we don't have true helicopter drops of physical cash. But the lack of helicopter drops does not imply that an increased exchange of reserves for physical cash wouldn't cause anything. Just because it doesn't happen doesn't mean it doesn't do anything.

      So increasing the base while decreasing short term securities does lower short term interest rates -- and therefore the monetary base does cause something.

    3. Jason,

      "We" are not moving the goalposts, you are :)

      To talk about the base impact you need to keep all else constant. So no fiscal injections. Actually the example you mentioned has zero base impact: the govt would print $900, inject into the banking system as reserves instructing the bank to mark up my account by $900 and the sell $900 in bonds to soak up the newly created reserves. Zero impact on base. Please see my first link above. I hope you didn't mean that i was given the $900 by a private person - this leaves the base unchanged, our banks swap reserves. So these examples are not examples showing anything about the impact of the monetary base size. In the real world experiments which change the base while "all else is equal" are the CB OMOs - they do very little, *unless they change relative prices* by a lot. But again, you can change rates without much base change, so this is again a bad example of the base in itself impacting anything. Interest rate impact on economy is ambiguous at best - some impact on the housing channel, almost none on corporate investment.

    4. We've come a long way from base money not causing anything. If given €900, an economic agent will react. He could buy something. He could deposit the money.

      It doesn't matter where that €900 came from, whether it was newly printed or from a private individual. Nine €100 notes placed in that agent's hand resulted in that agent doing something different. He went to the bank or the store when he otherwise wouldn't have. That is base money causing an economic agent to do something.

      Now it is possible that adding up the effect of adding €900,000,000 to the aggregate monetary base -- all the actions of millions of agents given on average a couple hundred Euros each (or several firms given millions) -- could sum to zero. That all that changes is the MB and no other macro observable. But that has to be shown with a model.

      Now the dominant macro models say that base money causes inflation, unless:
      1. It is expected to be taken away, in which case it does nothing. You sum up the aggregate agents and get money that just sits in banks.
      2. You are in a liquidity trap, in which case agents don't see a difference between short term treasuries and base money.

      In both of these cases, there is a reason for the agent who gets the €900 to do nothing with it. He doesn't want to put it in the bank or spend it (because it could be taken away and interest rates don't pay enough to be worth the trip to the bank). But it doesn't have to do with the detailed accounting of who got the money -- because at the aggregate level, after integrating over agents, that doesn't matter too much.

      In order to figure out why an agent chooses to do nothing with €900, we need a model that aggregates the actions of agents.

    5. We have come a long way, because you changed the subject. Again, being given $900 by a private person or the govt does not involve a change in the monetary base. So if any effects follow they show us nada about monetary base possibly influencing anything. For that you would need an operation that changes the base and not prices and balance sheets. A $900 ain't it.

    6. I have not.

      Base money in an economic agent's hand causes that agent to buy something or deposit it in the bank.

      Increasing the aggregate monetary base causes short term interest rates to fall (see here).

      Monetary base in micro influences people per the hot potato effect, monetary base in macro influences short interest rates. Ergo, the monetary base does cause something.

      Your statement was, letting q(x) = "the monetary base influences x":

      ∀x : ¬q(x)

      I showed

      ∃ x : q(x)

      Base money causes people to spend or deposit it; therefore q(x) is true for x = micro agents . Also if x = short term interest rates, then lower rates are caused by a larger base, ceteris paribus.


  2. 1. The Fed cannot refuse to sell dollars, it would make solvent banks insolvent.
    2. In Canada they have such system, not much difference from the US which shows that the size of the MB is irrelevant. The Fed can't buy "everything", the fiscal agent can.

    Sure you can impact prices by changing the MB, you can impact prices w/o changing the MB (most rate changes don't require a change in MB, an announcement is enough - nobody is going to "fight the Fed"), the point is it is the price change that has an impact, not MB size change, like Warren Mosler says: "it is about price, not quantity".

    In any case the original example in the post was not a monetary operation but a fiscal operation: injection of Net Financial Assets.

    1. "1. The Fed cannot refuse to sell dollars, it would make solvent banks insolvent."

      Is this true? I think banks request X dollars in physical cash and the Fed can approve X - ɛ to be sent on to the Treasury for printing. The Treasury in turn may be able to turn around and say they only want to print X - ɛ - δ.

      Unless you're talking about repurchase agreements and electronic reserves ... in which case the Fed can take back electronic money it has sent out via a repo. That is functionally equivalent to refusing to sell dollars.

    2. PeterP, you write:

      "But monetary policy afficionados like Sumner don't get that the Fed can't do those type of operations: if it fiddles with the base it is increasing it while decreasing the other private assets, it would be a swap of $900 Treasuries for $900 reserves."

      I actually do think he understands how OMOs work. It's been a while since I read this, but I think that post makes it clear that Nick Rowe understands OMOs and how they affect balance sheets, and he and Sumner are mostly on the same page regarding banks and money. They just don't agree with you (and Mosler) that OMOs (being an asset swap) don't matter.

      What evidence would convince you that you and/or Mosler are wrong on this? I'm not saying you are wrong (or that Scott, Nick, Jason, or anybody else are right). I ask everybody this question, including Jason. What do you think of this for example? Jason addressed that here (and in a few follow on posts).

      I'm a fan of a lot of different macro blogs, but IMO one of the things that's especially nice about this blog is that Jason can tell you (last time I checked anyway) what evidence would convince him to abandon the ITM, and he regularly puts the ITM to the test by making forecasts with models derived from it. I'd love to see more of that on macro blogs. How are we ever going to eliminate candidates without putting them on the line with respect to the evidence?

    3. Tom,
      Evidence that would persuade me I am wrong:

      1) If monetary base (in absence of rate impacts, so with rates already at zero) caused inflation, opposite from what we saw in US, Sweden and Japan when huge base injections coincided with inflation going *down*.

      2) Econometric studies that show any impact. Those that were done show the opposite:

      Does the quantity of central bank money carry any information?


      3) If bankers said they look at reserves when lending, the opposite of what they say:

      4) if any studies existed that would show that people can sense the movements of the monetary base. This info cannot be transferred by balance sheets, because banks doing swaps with the Fed doesn't impact the deposits.

    4. PeterP,

      Thanks for the reply and the links. I took a look through the fed paper in particular. I'm pretty sure I've looked at that one before.

      The 1st link I provided above is a concluding post from a series of 11 prior posts looking at Granger causality between MB and a host of other macro measures in the "age of ZIRP." (specifically in the US from Dec 2008 to 2015). There are links at the bottom of that posts to the other 11 posts. Offhand I didn't see a contradiction between those and the Fed econometric study you linked to.

      As I mentioned above, my 2nd link in my previous comment is the 1st of a series of posts Jason did on those 12 original posts with lots of comments between Jason and the author in the comments section. There's a lot they don't agree on, but you can take a look for yourself. Here's another one in the series Jason did which includes a handy summary of what the 11 original posts examine (reproduced below):

      monetary base → price level
      monetary base → industrial production index
      monetary base → TIPS (5-year breakeven)
      monetary base → DJIA
      monetary base → ten-year rate
      ten-year rate → industrial production index
      monetary base → exchange rates
      monetary base → deposits
      monetary base → credit

      I found the whole thing (comments and all) to be interesting. You might want to take a look. I read all 12 of the posts the author presented and all Jason's posts and all the commentary between them. I'm an amateur fan of this sort of thing, so I found the following post by econometrician Dave Giles very helpful in understanding the 12 original posts:

      I notice that Dave has another on that subject up now (his latest post):

      I'd be very curious to know what you think.

    5. ... keep in mind, that all 11+1 of the original econometric study posts would fall under the condition that Jason mentioned in his comment above since they're focused on the "age of ZIRP," namely:

      "Now the dominant macro models say that base money causes inflation, unless: ...
      2. You are in a liquidity trap, in which case agents don't see a difference between short term treasuries and base money."

      But from your above comment, that's precisely what you were looking for (in terms of evidence) it sounds like.

      The question is, in spite of ZIRP is there evidence that changes in MB can cause changes in what I listed above. Nick Rowe addressed the author in the comments asking for a "tl;dr" summary. Here's Nick summarizing the author's response to his question::

      "So, basically a 10% increase in MB leads to a bit less than 1% increase in NGDP."

      Agree? Disagree? Do you share Jason's thoughts on it? Thanks.

    6. Also, I think Jason makes an interesting statement in the comments below regarding monetarist (& other) models for what's happened during ZIRP.

  3. Jason,

    If ‘you’ give me €900 the question I would ask is who are 'you'?

    You are not a household. Households can’t create money so the money options you give to me are offset by the same options lost to you.

    You are not a commercial bank. Commercial banks can create money but they want that money paid back plus interest. That means they give money options today at a cost of losing even more options in future.

    You are not the central bank. Central banks can create money but they use that money mostly to buy existing assets such as government bonds or gold so they don’t provide something for nothing.

    You are not the government. Governments can create government bonds which are a type of money. However, they sell the bonds for money so that they can spend the money.

    You are not a business. Businesses can create corporate bonds which are, at a stretch, a type of money. However, they sell the bonds for money so that they can spend the money.

    The problem is that I don’t think that the money donor in your example exists in the real world!

    The nearest real world equivalent to your scenario would involve multiple parties cooperating as follows:

    1. Jason saves €900 in a pension fund. Now the pension fund has the €900 and Jason has a promise of a future pension payment.
    2. The pension fund looks for opportunities to speculate with the €900. The government decides to run a deficit. It creates 900 bonds and sells them to the pension fund. The government now has the €900 which it proceeds to spend. The pension fund now has the 900 bonds including an entitlement to interest payments on the bonds.
    3. The central bank prints money and offers to buy the pension fund’s bonds. The pension fund wants more than €900 for the bonds as it would forego the interest payments if it sold the bonds. Assume that the central bank prints €950 which the pension fund accepts for the bonds. Now the central bank has the 900 bonds and the pension fund has €950 which is €50 more than it had before it purchased the bonds.
    4. The central bank returns future interest payments on the bonds to the government.


    1. The above example does not depend on where I got the money from (so it doesn't matter who I am) or what I exchanged it for (in my reply to Peter above, I bought a lamp).

      If you now have €900 in cash (or bonds or a personal check) you might do nothing. But given I have no idea as the macro theorist what a specific agent might do, I have to take it as unknown and average over possibilities. I do know that given the €900, you will only do at most €900 of actions with it (a budget constraint).

      At this point, we're back to this argument:


  4. If you stand back from this scenario and summarise the net changes, you see the following picture:

    1. In bond terms, the central bank now owns 900 bonds issued by the government on which the government pays no effective interest. As both the central bank and the government are part of the same public sector, the bond holding and liability can be cancelled out until the central bank sells the bonds back to another pension fund or equivalent.
    2. In monetary terms, the central bank has printed €950 and effectively given €50 to the pension fund and €900 to the government.
    3. The pension fund will either sit on the €50 gain and the €900 original capital or use them to buy further assets which will just push up asset prices. If it buys more assets, someone else must sell the assets, so the other party will now have the money. However, people only buy and sell existing financial assets as savings vehicles so they will probably just sit on the money or use it to buy further existing assets as well.
    4. The government spends the €900 and stimulates the economy (or not, depending on your political views). It spends the money after it sells the bonds, not when the central bank buys the bonds.
    5. The stimulus effect of the €900 depends on how the government spends the money e.g. tax cuts, transfer payments or infrastructure spending, and on the propensity to spend of the recipients of the government’s spending.

    The pension fund has been used as a conduit by the central bank and the government to allow the central bank to give the government €900 interest-free money to fund its deficit. The fund has received €50 for its cooperation. This is an equivalent to your scenario.

    This process can happen only because BOTH the government and the central bank agree to play their parts. Economists often talk about helicopter money as a variant of this type of arrangement. However, from what I can see, either an unwilling central bank OR an unwilling government can prevent any variant from taking place as long as they are independent of each other. The government could override an unwilling central bank by removing central bank independence and /or the management of the central bank. However, that would be a pretty drastic step. A national central bank cannot override an unwilling government.

  5. "Did giving you 900 € cause you to deposit the money or spend it? Well, that's philosophical."

    And it is a question that Aristotle addressed. The money is a material cause, he stuff with which something may be done. To do something with it requires at least an efficient cause, with which physics is mainly concerned, and, in human affairs, a final cause, the purpose of what is done.

  6. A few general comments:

    1. The Fed doesn't control M0 (the supply of $ banknotes and coin) in any meaningful way. Bank demand deposits and M0 are freely convertible. An esoteric example of this is investor Kyle Bass who exchanged $1mm into twenty million nickels (as an investment). This was accommodated by his bank and the Fed:

    2. The Fed controls the supply of bank reserves, but only in a narrow sense. Its ability to adjust the quantity of bank reserves depends on the willingness of banks (technically dealers) to do business with the Fed. And if it wishes to purchase long-term assets (treasuries, MBS), there have to be buyers (pension funds, insurance firms, banks, ...) on the other side.

    Theoretically, the private sector (banks, households, corporations) could disconnect itself completely from the Fed, by using bitcoins (or some other private currency) to facilitate its transactions. Interest rates would then be determined entirely by the market. This is the way things worked before the Fed came into existence.

    3. Regarding the thought exercise involving €900: From what I understand, Jason's arguments refer to the so-called wealth effect (https://en.wikipedia.org/wiki/Wealth_effect). There has been some research about the relation between asset (stocks, houses) prices and households' consumption patterns. So far I haven't been convinced that this effect has significant implications for the macro-economy. To think that the new owner of the €900 would use 33.3% percent of the money for immediate consumption seems awfully optimistic to me.

    1. Regarding #1, the Fed and Treasury did call up, though. It didn't just go through without question, so there is some capability there. Also a million in nickels is a tiny fraction of (currency) base ... less than 0.0001%.

      Regarding #3, I originally left out what the €900 was for and it doesn't matter. I could have bought a €1000 bond from you (in which case your wealth has gone down). You'd still do something with the €900. It's not wealth effect -- which would mean you'd more likely use it for immediate consumption.

      The 33% figure comes from a two-period economy with two explicit options (save in one asset, spend on one good) and one implicit (do nothing). In reality we have many periods and many different consumption and saving options, so there would be some consumption smoothing.

      But you will do something with it. A billionaire might set it on fire to light a cigar, but that's not typical.

      If the world ends tomorrow, 33% actually seems kind of low -- you'd probably spend 100% of it ... if anyone still used money in that economy :)

    2. Then the question is "Why am I selling you the bond?". Unless I wanted to have the money to buy some good in the first place, why not just stay invested (or invest in some other bond)?

    3. I mean, you could go into the market today and buy $100k worth of Apple stock. Whoever sells it to you would then have $100k in money. Would he use some of that for immediate consumption? Probably not. Most likely the seller is a high-frequency trading program.

      All money is eventually used for consumption (or set on fire by billionaires :) ) , but "eventually" can be a very long time.

    4. Regarding the why of selling the bond, that is not really important. What is important is that you have physical cash or a check. That causes you to go to the bank to deposit it (so it is lent out) or spend it. Few people sit on cash or a check.

      The HFT program would probably immediately invest it again. Again, few people (and fewer HFT programs) would take physical cash and sit on it.

      This is micro-level causality. There is a question of aggregating the effects -- but that requires a model. In the ZLB liquidity trap, agents will sit on cash because interest rates are zero. In the monetarist version, agents will sit on cash because they expect it to go away (QE will be unwound in the future). These are the micro mechanisms that lead to approximately zero consumption (or investment).


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