In recent years Nick Rowe has come up with a clever set of metaphors to describe a central puzzle of monetary economics—the fact that easy money both lowers and raises interest rates. Here’s the punchline of his latest:
According to that theory: if the central bank wants to lower the real interest rate on paper money (because it thinks there’s a danger the real interest rate on paper money will rise above target unless it does something) it needs to lower the nominal interest rate on electronic money. The central bank calls this the “short run” part of its theory.
But, according to that same theory: if the central bank’s target for the real interest rate on paper money were lower, the nominal interest rate on electronic money would need to be higher. The central bank calls this the “long run” part of its theory.
Very few people understand the central bank’s theory. Even some very good monetary economists don’t get the short run part, and think that if the central bank wants to lower the real interest rate on paper money, all it needs to do is raise the nominal interest rate on electronic money.
Just in case you haven’t figured it out yet: this is not an imaginary world. It’s the real world. But it definitely is weird. Only a finance theorist could have dreamed up a world this weird.
This is a bit unfair to Nick, like quoting just the last stanza of a poem. Please read the whole thing. Here I’d like to talk a bit more about the money/interest rate puzzle—what drives it, and why it’s so important.
Let’s start with a simple flexible price world, where the central bank decides to increase the trend growth rate of zero interest fiat money. Most monetary models would predict superneutrality, which means that the inflation rate and the NGDP growth rate and the nominal interest rate would rise in proportion to the rise in the money supply growth rate. We will call this assumption A. I’m going to try to amend this example with two other assumptions, to see if they can cause this result to “flip,” so that easy money makes nominal rates fall. Neither will work.
B. Now assume that prices are sticky. What happens if the money supply growth rate increases? Most likely rates will still rise over time. They might even rise immediately. This is something like what occurred during the “Great Inflation.” And nominal rates rose during that episode. Trend rates by definition involve long periods of time, and prices are flexible over long periods of time.
C. Now go back to the flexible price assumption, but change the example from an increase in the growth rate of M to a one time increase in the money supply. With flexible prices money should be neutral even in the short run (technically you also need flexible debt payments, i.e. indexed mortgages.) If money is neutral then P and NGDP immediately rise in proportion to the rise in money, and nominal interest rates are unchanged. This is what happens during a “currency reform.”
So we still have not reversed the results. We still don’t have a clear and unambiguous example of easy money lowering nominal rates. Sticky prices didn’t do the job, nor did switching to a one-time change in M. But now let’s see what happens if we try both assumption B and assumption C at the same time:
D. Assume a sticky price world and a one-time rise in M. Now we have short run disequilibrium in the sense that the supply of money exceeds the demand for money, and since prices are sticky the price level has not risen enough to restore equilibrium. But nominal interest rates can immediately fall, and this lowers the opportunity cost of holding cash and electronic reserves. So we do reach an equilibrium in one sense, nominal rates adjust to equilibrate the supply and demand for money. Then in the long run prices adjust and nominal rates return to their original level. Money is neutral in the long run. We have a more comprehensive macroeconomic equilibrium in the long run, whereas we only reach a monetary equilibrium with the adjustments in nominal rates.
Thus to reverse the Kocherlakota/Williamson result that inflation and nominal rates move in the same direction, we need not one but two assumptions—a onetime rise in M and sticky prices. That’s why it seems like such a perplexing puzzle, the resolution is not simple. And I think the reason Nick and the rest of us MMs keep harping on this issue is that it seems really important. Consider a few facts:
1. The declines in NGDP during 1929-33 and 2008-09 seemed to be lose-lose events. Almost everyone lost money, from the poor to the banksters. Hard to believe that special interest politics would have led Fed officials to intentionally engineer such catastrophes.
2. Easier money would have prevented or at least greatly moderated these two disasters.
3. One reason that money wasn’t made easier is that almost everyone (wrongly) assumed money was already incredibly easy. If nominal rates had been 8% during 1930 or 2008, the Fed would have cut them sharply.
4. Their assumption was wrong because very few people understand Nick’s nice little parable.
As so we must suffer.
PS. Nick needs to collect all his little stories into a book. I’m imagining the monetary equivalent of Italo Calvino’s Invisible Cities. Something like “Imaginary Economies.”