OPERATIONAL CONSTRAINTS
HOLMES
73
The opening of the discount window,on the other hand,runs the
risk that reserves acquired at the initiative of the commercial banks
would be used to expand the total supply of money and credit and
not solely to meet the ebb and flow of reserves through movement of
market factors. As a result, the Federal Reserve would have to
institute the same controls-in decentralized fashion-at the various
discount windows to limit the supply of reserves that are now
provided in a more impersonal way through open market operations
Consequently, it would appear wise to disassociate the debate over
money supply from the problem of so-called defensive open market
operations. There seems to be no reason why a seasonal movement of
currency, a random movement of float,or a temporary bulge in
Federal Reserve foreign currency holdings should automatically be
allowed to affect the money market or bank reserve
would seem to be no point in consciously reducing our efficient and
integrated money and capital markets to the status of primitive
market where the central bank lacks the means and/or the ability to
prevent sharp fluctuations in the availability of reserves-in the
misguided attempt to hold "steady" the central bank's provision of
reserves.
а
positions. There
But the point remains that the ebb and flow of reserves through
market factors is very large. While defensive operations are generally
successful in smoothing out the impact of these movements on
reserves, even a 3 percent margin of error in judging these movements
would exceed a $20 million injection in many weeks. Hence
the small, regular injection of reserves, week by week, is not really a
very practical approach.
The idea of a regular injection of reserves-in some approaches at
least-also suffers from a naive assumption that the banking system
only expands loans after the System (or market factors) have put
reserves in the banking system. In the real world, banks extend
credit, creating deposits in the process, and look for the reserves
later. The question then becomes one of whether and how the
Federal Reserve will accommodate the demand for reserves. In the
very short run, the Federal Reserve has little or no choice about
accommodating that demand; Over time, its influence can obviously
be felt.
In any given statement week, the reserves required to be main-
tained by the banking system are predetermined by the level of
deposits existing two weeks earlier. Since excess reserves in the
banking system normally run at frictional levels-exceptions relate
IS-LM Framework – Part 6
Operational Contraints on the Stabilization of Money Supply Growth ...
（Adobe PDF）
Operational Contraints on the Stabilization of Money Supply Gr01vth. ALAN R. HOLMES. The debate over whether
Operational Contraints
on the Stabilization
of Money Supply Growth
ALAN R. HOLMES
The debate over whether the Federal Reserve should rely exclu-
sively
target of monetary policy,
debate has shed some
indicator
the money stock-somehow defined-a
s an
or a
on
both, continues unabated. While the
on the role of money in monetary policy
and the role of monetary policy in the overall mix of policies that
much heat as
or
light
affect the real economy, there has been perhaps
as
light. And the light that is being generated from the many research
studies that have stemmed from the debate is very often dim indeed
This paper does not attempt to contribute to the controversy.
Instead it tries to sketch out briefly current practices of the FOMC in
establishing guidelines for the conduct of open market operations
guidelines that involve
aggregates. It then turns to the operational constraints and problems
that would be involved if the Federal Reserve were to rely exclu-
sively
operations
The approach taken in the paper is
theoretical. The views expressed should be taken
author, and not as
will probably not come as much of a
conclusions find much in favor of current FOMC practices and
procedures
blend of interest rates and monetary
the money supply
the guideline for day-to-day
on
as
essentially practical rather than
those of the
as
representative of the Federal Reserve System. It
surprise, however, that the
Сurrent FOMС Practices
The Federal Reserve has frequently been accused of money
market myopia. This is a
affected in some
false charge usually made by economists
peculiar myopia of their own. The
degree by
charge stems, or so it seems to me, in the first instance from
confusion between monetary policy decisions per
se and the oper-
Mr. Holmes is Senior Vice President, Federal Reserve Bank of New York.
65
My response to a German critic of MMT – Part 1
Makroskop is a relatively new media publication in Germany edited by Heiner Flassbeck and Paul Steinhardt. It brings some of the ideas from Modern Monetary Theory (MMT) and other analysis to German-language readers. It is not entirely sympathetic to MMT, differing on the importance of exchange rates. But it is mostly sympathetic. I declined to be a regular contributor when invited at the time they were starting the publication not because I objected to their mission (which I laud) but because their ‘business model’ was a subscription-based service and I consider my work to be open source and available to all, irrespective of whether one has the capacity or the willingness to pay. But I have agreed to contribute occasionally if the material is made open source, an exception to their usual material. Recently, the editors approached me to respond to an article they published from a German political scientist – Modern Monetary Theory: Einwände eines wohlwollenden Zweiflers or in English: Modern Monetary Theory – Questions from a Friendly Critic. The article constitutes the first serious engagement with MMT by German academics and thus warrants attention. Even if you cannot read German you will still be able to glean what the main issues raised in the German article were by the way I have written the English response. The issues raised are of general interest and allow some key principles of MMT to be explicated, which explains why I have taken the time to write a three-part response. Today is Part 1.
The so-called “Friendly Critic” of MMT (self-styled) was Martin Höpner, who is a political scientist associated with the Max-Planck-Institut für Gesellschaftsforschung (Max Planck Institute for Social Research – MPIfG) in Cologne.
The original article (in German) was published on March 20, 2018.
Here is guidance on why Martin Höpner’s contribution is interesting but essentially flawed. To ensure these blog posts do not become too long, I decided not to quote his original German.
So, when I quote Martin Höpner using quotation marks “”, I am providing my translation, and, given my German to English is not perfect, nuanced errors in translation and interpretation (usage) are possible.
Martin Höpner considers MMT to be “one of the most exciting, if not the most exciting theoretical developments of the present day” which is a good start.
But he considers himself to be a “friendly critic”, the meaning of which is hard to interpret. Does that mean he is attracted to MMT but has some quibbles or wants to be attracted but cannot bring himself to accept the basic precepts of MMT? Or something else?
Whatever, his essay raises a series of questions which seem define his skepticism and I am not sure I would place them in the realm of friendship, which in English would suggest a concern for the welfare thereof.
I decided to accept the invitation to respond because the issues he raises are mostly reasonable – (with an exception as you will see in Part 2) and they are issues that many interested readers raise when they first encounter Modern Monetary Theory (MMT).
As an aside, he mentions my name among MMT contributors to Makroscop and suggests I “maintain critical distance to MMT”, which is clearly not correct in my case, given I am one of the founders to this approach to macroeconomics. MMT is central to what I see as one of my academic contributions. I am far from ‘distant’.
An aside though.
Martin Höpner initially summarises what he considers to be the “cornerstones” of MMT, which he correctly acknowledges builds on a range of previous economic approaches (“Keynesianism, Chartalism, and the functional finance approach”).
We could quibble about the “Keynesianism” reference. In fact, I would say it was the work of Keynes not what followed that is of more influence on some of the original developers of MMT, although in my case, it is the work of Marx through to Kalecki that has more influence than Keynes’ General Theory. But that is another aside.
Please read my blog post – Those bad Keynesians are to blame – for more discussion on this point.
The summary points which Martin Höpner uses to set his critique of MMT up are:
1. There is a difference between the currency-issuer and the currency-user, such that the former has no intrinsic financial constraints on its spending. Such a government can always meet any liabilities that are denominated in the currency it issues.
And, if I may extrapolate further, this also means that such a government can purchase anything that is for sale in the currency it issues, including all idle labour.
Which means that the government chooses the unemployment rate. An elevated unemployment rate is always a political decision rather than anything that is forced on a nation by ‘market forces’ or the choice of individuals/households.
2. The governments ability to spend is prior to any revenue it might receive in the form of taxation. Taxation revenue comes from just funds that the government has already spent into existence.
Martin Höpner says: “Decisive is the order: Government expenditures are the condition of the collection of taxes, not vice versa.”
3. Central banks are monopoly creators of “central bank money”, while commercial banks create “bank money” out of thin air – through “balance sheet extension”.
Central banks set the interest rate but cannot control the broad money supply or the volume of “central bank money” in circulation.
This might seem a little confused. On the one hand, the government is a monopoly issuer of its own currency but then cannot control the volume in circulation.
The way to understand it is to realise that the central bank has no choice but to ensure there are enough bank reserves available given its charter is to maintain financial stability.
If cheques start bouncing because of a shortage of reserves then financial panic would follow.
4. “All considerations of deficits and debts must be made from a balance-theoretic perspective”, which means in the language of MMT that context is everything.
A government deficit (surplus) equals dollar-for-dollar a non-government surplus (deficit). This is the ‘balance-theoretic’ that Martin Höpner is referring to.
The non-government sector is comprised of the external and private domestic sectors. If the external sector is in deficit and the private domestic sector desires to save overall, then the government sector has to be in deficit and national income changes will ensure that occurs.
The aim of fiscal policy is not to deliver a particular fiscal outcome (surplus or deficit). Rather, it is to ensure that the discretionary government policy position is sufficient to ensure full employment and price stability, given the spending and saving decisions of the non-government sector.
If from a particular level of national income, the private domestic sector, for example, desires to save more overall and cuts its spending accordingly, then unless there is more net export spending coming in, the government will have to increase its deficit to avoid rising unemployment and a recession.
There is no particular significance in any fiscal outcome. Context is everything.
At this stage, Martin Höpner is in agreement – “Everything indicates that MMT provides the current best descriptive theory of money and credit creation with these points”.
So he believes that the proponents of MMT provide the best understanding of how the monetary systems we live within operate and the capacities that currency-issuing governments maintain.
Where he departs is when we start talking about “prescriptive” (policy) matters.
Here, he considers the policy implications of MMT to be “politically explosive”:
It reaches conclusions that seem contradictory to everything that was previously thought to be known about the room governments have to implement fiscal and monetary policy.
Martin Höpner is worried about some of the practical statements that MMT proponents make.
Which are?
First, he is worried about the advocacy of flexible exchange rates, which MMT proponents (like me) argue maximises the policy space for government to pursue domestic objectives.
That point is a fact.
Once a nation adopts a currency peg of any description (fixed exchange rate, dollarisation, currency board, etc) it loses its full currency sovereignty and compromises domestic policy aspirations in order to maintain that exchange rate rigidity.
It is not about giving reign to free markets but maximising the sovereignty of the currency-issuer that underpins our advocacy of flexible exchange rates.
It is about removing constraints on policy that compromise the capacity of government to maintain full employment and price stability and deliver equitable outcomes to all.
Martin Höpner’s objection appears to be that MMT proponents present what he considers to be a:
Remarkable … juxtaposition of non-liberal and liberal principles.
“Remarkable” carrying a pejorative inference in this case.
Apparently advocating flexible exchange rates places MMT proponents in the ‘liberal’ camp where the market is dominant. But then, we allegedly adopt non-market policy positions on other matters. That is inconsistent in Martin Höpner’s view.
But at this point, while Martin Höpner more or less accuses MMT proponents of being hypocritical, he reveals he hasn’t fully understood the difference between MMT as a lens, which allow one to see the true workings of fiat monetary systems, and particular value systems that proponents might apply to that understanding.
His first error is to assert that:
MMT propagates state interference to an extent that most citizens find unimaginable.
No it doesn’t.
This is his “non-liberal” allegation.
I have stated this point often but it still seems to escape the attention of many critics (and second-generation MMTers, for that matter).
MMT is not a regime that you ‘apply’ or ‘switch to’ or ‘introduce’.
Rather, MMT is a lens which allows us to see the true (intrinsic) workings of the fiat monetary system.
It helps us better understand the choices available to a currency-issuing government.
It is not a regime but an accurate perspective on reality.
It lifts the veil imposed by neo-liberal ideology and forces the real questions and choices out in the open.
In that sense, MMT is neither right-wing nor left-wing – liberal or non-liberal – or whatever other description of value-systems that you care to deploy.
I mean by that, that while MMT provides a clear lens for viewing the system, to advance specific policy platforms, one has impose a value system (an ideology) onto that understanding.
So, while I, personally, advocate the state resuming its historical responsibility under the Post World War 2 social democratic consensus for sustaining full employment, because my values tell me that the ability to have a job is a key element of a sophisticated society and a starting point for social inclusion and equity, others might consider mass unemployment to be of use.
For example, they would see mass unemployment as advancing the interests of capital by suppressing the capacity of workers to share in productivity growth and maintain real wages.
But they would not be able to say the ‘state has run out money and cannot provide work for all’. They would be forced to justify the state not taking responsibility to eliminate mass unemployment via direct public sector job creation in terms of more venal motives.
So a person who claimed an understanding of the principles of MMT and used that as a lens to explicate the consequences of their policy prescriptions could easily support a very ‘liberal’ set of interventions or a very small ‘state’ footprint totally in accord with neoliberal type conceptions.
But, given that, what one cannot escape are the constraints imposed via national income changes on the fiscal balance as a result of non-government spending and saving decisions.
Even if one opts for a very small government footprint in terms of the proportion of available real resources that the public sector commands to advance public policy initiatives, it would still be the case that that government would have to run fiscal deficits should the non-government sector desire to save overall.
That is inescapable.
Trying to run fiscal surpluses in the face of a non-government sector desire to achieve a surplus itself will just result in a major recession and a fiscal deficit via the automatic stabilisers (as the tax base shrinks, for a start).
That sort of fiscal deficit is what I call a ‘bad’ deficit because it is associated with a rise in unemployment and a loss of national income (as a result of the recession).
The same ‘small’ government should, instead, run a ‘good’ deficit, by allowing their net spending to accommodate – to ‘fund’ – the desire of the non-government sector to save overall.
It would not mean the government was ‘large’ – deficits do not imply anything in particular about the overall ‘size’ of government.
But if the non-government sector enforces a desire to save overall (via its spending actions) then the government has no choice but to fund that via a fiscal deficit or accept recession as the inevitable consequence.
All of this is quite apart from the debate as to whether the dominant neoliberal paradigm is, in fact, ‘liberal’.
As Thomas Fazi and I explain in our new book – Reclaiming the State: A Progressive Vision of Sovereignty for a Post-Neoliberal World (Pluto Books, September 2017) – the claim that neoliberalism is ‘pro-market’ is a misnomer.
In fact, it just deploys the capacities of the state in different ways to advance the interests of capital at the expense of other claimants on national income.
When state interference is required to protect profits and shareholder capital, the lobbyists will be working night and day to ensure that fiscal or regulative support is achieved.
A far better juxtaposition is between the neoliberal regime that ‘privatises the returns and socialises the losses’ against a progressive policy framework that advances the well-being of all citizens and doesn’t privilege capital in any particular way.
Having clarified those issues, we move on to the next misconception in Martin Höpner concern about flexible exchange rates.
While he asserts the falsehood that MMT is about extensive state intervention, he then claims (thanks to BastaFari for a better translation of this sentence):
[Note Tuesday morning: as a result of the more accurate translation I have edited the following section up to the +++++ demarcation point].On the other hand, MMT trusts in the ability of markets to find the right value for the most important price in capitalist economies after the wage: the exchange rate.
I have dealt extensively with questions of the exchange rate and the open economy in relation to MMT previously. For example:
1. The capacity of the state and the open economy – Part 1 (February 8, 2016).
2. Is exchange rate depreciation inflationary? (February 9, 2016).
3. Balance of payments constraints (February 10, 2016).
4. Ultimately, real resource availability constrains prosperity (February 11, 2016).
The issues usually relate to the inflationary effects of depreciation including the erosion of living standards, trade competitiveness, and the destabilising impacts of currency speculation.
Taken together these concerns are bundled under a heading – ‘balance of payments constraints’.
So, while MMT proponents argue that the currency-issuing state has no financial constraints, critics argue that the capacity of a nation to increase domestic employment using fiscal deficits is limited by the external sector.
And they argue that these constraints have become more severe in this age of multinational firms with their global supply chains and the increased volume of global capital flows.
These critics erroneously believe that fixed exchange rates provide financial stability and insulate nations from imported inflation, while flexible exchange rates undermine stability.
The long-standing claim is that government deficits, designed to reduce unemployment will not only render a nation uncompetitive as unions took advantage of the higher employment to press ever-increasing wage demands, but the rising income would push out imports, leading to a balance of payments crisis and exchange rate depreciation.
The argument then contends that the Government has to step in and introduce contractionary fiscal policy and/or tighter monetary policy to suppress the wage pressures, reduce import demand and attract higher levels of capital inflow.
It is argued that under these conditions a nation is forced to follow a ‘stop-go’ growth path, where periods of stimulus and growth push the economy up against the balance of payments constraint, which then necessitates an economic downturn (not recession) to restore balance.
While the ‘stop-go’ terminology was really born in the period of fixed exchange rates (Bretton Woods period), it is survived into the flexible exchange rate era.
The first problem these critics find with flexible exchange rates is that nations can ‘import’ inflation from other nations, which negate real income gains made through domestic expansionary policy.
The exchange rate does influence the real value of the nominal incomes that a nation generates via its impact on import prices.
The purchasing value of nominal incomes depends on what the translation of the monetary value into real value is – that is, what is the volume of real goods and services that an income recipient can purchase.
Ostensibly, that depends on the prices of goods and services, some of which will be more influenced by movements in exchange rates than others.
Non-tradable goods and services will be much less influenced by exchange rate movements than direct imports. In many cases, these goods and services will have negligible exposure to exchange rate movements.
The provision of many services, for example, will have little variability to exchange rate fluctuations.
So, movements in the domestic price level are what really matters for the ‘real wage’ and the extent to which those movements are influenced by shifts in import prices arising from exchange rate movements depends on the degree of ‘pass through’ and the importance of imported goods and services to the overall basket that determines the workers’ material living standards.
Imagine a nation (A) that imports good X from nation B, which uses $B.
Say that good X costs nation A, $B5 and the exchange rate is at parity ($A1 = $B1). That means good X costs $A5 per unit.
Then if the currency of A depreciates, say by 20 per cent, such that $A1.20 = $B1, then good X which still costs $B5 will now cost $A6, if the full impacts of the depreciation are included in the local import price.
That situation would represent a ‘pass through’ of 100 per cent.
But suppose local importers decide to defend market share (against say an import competitive product) and take some of the depreciation impact via reducing their margin.
So, for example, the local price might only rise to $A5.20 rather than to $A6.
In this case, the 20 per cent depreciation has led to a 4 per cent rise in local price of imported good X and the ‘pass through’ would be 4/20 or 0.20.
This says that for every 1 per cent in currency depreciation, the local import price of a good will be 20 cents, a relatively low ‘pass through’.
The research evidence is clear – ‘pass through’ estimates are highly variable and depend on many factors including how much spare capacity there is in the economy, the degree of import competition, etc.
But that isn’t the end of the matter.
The second impact depends on how changes in overall consumer price inflation respond to changes in import prices. So ‘pass through’ might be high and rapid but the second impact low and drawn out, making the overall impact inconsequential.
So if imports are a relatively small proportion of goods and services included in the inflation measure, even if the ‘pass through’ is high, the overall impact on the domestic inflation rate will be small.
There is also the question of time lags – how long these separate effects take to impact. In many studies, the sum of the two impacts can take years to manifest.
It is also very difficult to come up with unambiguous estimates of these separate effects.
Estimates for Australia, for example, indicate (Source):
… that exchange rate changes are usually passed through quickly and to a large extent to import prices … [but] … the pass-through of exchange rate changes to overall consumer prices occurs gradually over an extended period … a 10 per cent exchange rate appreciation can typically be expected to result in a reduction in overall consumer prices … of around 1 per cent, spread over around three years.
That is a very small and drawn out effect, hardly justifying the assertion by Martin Höpner the exchange rate is the “most important price” in determining the purchasing power of workers’ wages.
The coherent empirical research on this question suggests that in the real world tells us that the ERPT is weak in most nations for which coherent empirical research has been conducted.
This blog post – Is exchange rate depreciation inflationary? (February 9, 2016) – discusses ‘pass through’ and the impact of exchange rate changes on inflation rates in more detail.
End of Tuesday Edit
+++++++++++++++++++
Moreover, the history of fixed exchange rates tell us that the operations designed to defend the agreed parities across nations severely restrict the capacity of the government in nations that run external deficits to advance the well-being of the citizenry.
External deficit countries in nations that peg their currencies are prone to recession-bias, as they must restrict fiscal policy stimulus and run higher than otherwise interest rate regimes, the former being more damaging than the latter.
The result, which history has documented time and time again, is elevated levels of mass unemployment and all the costs that come with that degree of labour wastage.
While Germany has historically, at least in the last several decades before adopting the euro, been managing upward pressure on its currency – due to its trading strength and the deliberate policy positions adopted by the Bundesbank (interest rate management), most other nations have had to contend with recessionary biases due to their current account positions.
Their experience is that fixed exchange rates are very damaging.
These costs tend to dwarf all other costs including fluctuations in price levels that might be sourced in exchange rate variability.
Australia is a very open economy that has historically endured large swings in its exchange rate. Between February 29. 1984 and July 31, 1986, the Australian dollar depreciated by 36 per cent against the US dollar – quite a shift.
By January 31, 1989, the exchange rate had appreciated by 48.6 per cent against the US dollar – again, quite a shift in the opposite direction. This is a familiar pattern to citizens of Australia, a primary commodity producer.
Over the first period, Real net national disposable income rose just 3.3 per cent (per capita measure fell by 0.2 per cent), while real GDP rose 8.4 per cent and GDP per capita rose 4.7 per cent.
So even with a massive exchange rate depreciation, which followed major declines in our terms of trade, real per capita living standards barely fell using the Real net national disposable income measure and rose using the GDP per capita measure.
Three years later, Real net national disposable income had risen by 17 per cent (per capita measure rose by 12.2 per cent), while real GDP rose 12.6 per cent and GDP per capita rose 8.1 per cent.
It is also the case that the distributional impacts of those shifts are uneven. Buyers of expensive imported (luxury) cars suffer more than those who purchase the lower-margin cars. Those who take overseas ski holidays at expensive resorts face higher costs. The rest of us go camping up the coast!
Australia regularly goes through these sorts of exchange rate swings but manages to be classified as among the richest per capita nations in the world.
It is simply untrue that a flexible exchange rate system severely compromises the material living standards of workers.
Second, it is false to think that a flexible exchange rate regime is more prone to speculative attacks on a nation’s currency.
If anything, the reverse is true.
When currency traders form the view that a government will have to eventually devalue a fixed peg parity to stem the consequences that accompany a chronic current account deficit they can easily hasten that decision by short-selling. It becomes a self-fulfilling inevitability.
And, in this context, it is also untrue to assert that MMT proponents such as myself advocate total market determined exchange rates when we advocate flexible exchange rates.
I have repeatedly noted that the nation state has the capacity to impose capital controls if there are destabilising financial flows present.
Iceland has demonstrated the effectiveness of using capital controls to stop the financial sector undermining currency stability through speculative capital outflows. Similarly, unproductive capital inflows can be subjected to direct legislative controls.
We outline how this is done in some detail in our new book – Reclaiming the State: A Progressive Vision of Sovereignty for a Post-Neoliberal World (Pluto Books, September 2017).
Conclusion
That ends Part 1.
In Part 2 we will address criticisms about interest rate management and bond yields.
In Part 3 – and yes, it was a German raising these issues – we will discuss his fear that the political class will go wild once they realise that taxes and bond sales no longer fund government spending and generate … wait for it … uncontrollable inflation.
That is enough for today!
(c) Copyright 2018 William Mitchell. All Rights Reserved.
IS-LM Framework – Part 6
I am now using Friday’s blog space to provide draft versions of the Modern Monetary Theory textbook that I am writing with my colleague and friend Randy Wray. We expect to complete the text during 2013 (to be ready in draft form for second semester teaching). Comments are always welcome. Remember this is a textbook aimed at undergraduate students and so the writing will be different from my usual blog free-for-all. Note also that the text I post is just the work I am doing by way of the first draft so the material posted will not represent the complete text. Further it will change once the two of us have edited it.
Previous Parts to this Chapter:
- The IS-LM Framework – Part 1
- The IS-LM Framework – Part 2
- The IS-LM Framework – Part 3
- The IS-LM Framework – Part 4
- The IS-LM Framework – Part 5
Chapter 16 – The IS-LM Framework
[PREVIOUS MATERIAL HERE IN PARTS 1 to 5]16.6 Introducing the price level – the Keynes and Pigou effects
[CONTINUING FROM LAST WEEK – WITH REVISED DIAGRAM AND PIGOU EFFECT ADDED]Figure 16.10 depicts a family of LM curves with each individual curve corresponding to a different price levels (P0 is the highest price and P3 is the lowest price).
The introduction of the price level now means that the interest rate-income equilibrium is now contingent on the price level. If there is a different price level, the equilibrium changes as noted.
This means that within this framework, the national income equilibrium can shift without any change in monetary or fiscal policy settings if the price level changes.
Figure 16.10 The Keynes Effect
This observation was central to the debates between Keynes and the classical economists during the 1930s, which we examined in detail in Chapter 15.
Assume that the economy is currently at Point A, where the interest-rate is i0 and national income is Y0. The general price level is P0.
The full employment output level is at YFE, so that the current equilibrium corresponds to what Keynes would refer to as a underemployment equilibrium.
At Point A, the product and money markets are in equilibrium but there is an output gap and there would be mass unemployment in the labour market as a consequence.
Keynes considered this to be the general case for a monetary economy and depicted the neo-classical model as a special case in which the equilibrium that emerged was also consistent with full employment. For Keynes, a monetary economy could be in equilibrium at any level of national income.
The neo-classical response to this was that unless we impose fixed wages on the model, the persistent mass unemployment would eventually lead to falling nominal wages and prices.
While this might not lead to a fall in the real wage (if nominal wages and prices fall proportionately), which would negate the traditional neo-classical route to full employment via marginal productivity theory, the fact remains that the lower price level increases real balances in the economy.
The reasoning that follows is that the reduction in prices leads to a decline in the transactions demand for money at every level of income because goods and services are now cheaper.
With the nominal stock of money fixed, the expansion of real balances combined with a decline in the demand for liquidity, results in a decline in the rate of interest.
As long as future expectations of returns are not affected adversely by the deflationary environment, the reduction in the rate of interest, stimulates investment spending, which leads to increased aggregate output and income via the multiplier effect.
As long as there is an output gap, deflation will continue and the interest rate will continue to fall until the economy is at full employment.
The link between real balances and the interest rate was referred to as the Keynes effect.
In terms of Figure 16.10, the LM curve shifts outwards as the price level falls and the rising investment is depicted as a movement along the IS curve.
For example, if the price level fell to P1, the LM curve would shift and a new IS-LM equilibrium would result at Point B, with the interest rate at i1 and national income is Y1. Under the circumstances depicted this is not a full employment level of national income.
As a result of this observation, the neo-classical economists argued that an underemployment equilibrium was a special case when wages and prices were fixed given that flexible prices could reduce the output gap and unemployment via LM curve shifts.
The view that Keynes’ underemployment equilibrium was a special case of the more general flexible price model became known as the Neo-classical synthesis. This approach recognised that aggregate demand drove income and employment (the so-called Keynesian contribution) but that the economy would tend to full employment if wages and prices were flexible (the Classical contribution).
Note that the capacity of the Keynes effect to deliver output and employment gains is limited. If there is a liquidity trap (iLT) then the maximum expansion in national income that is possible via falling prices would be YL at Point C (where the IS curve intersects with the flat segment of the LM curve.
At that point, there would still be unemployment and if wages and prices were flexible and behaved according to the Classical labour market dynamics, the price level would continue to fall, say to P3.
The LM curve would continue to shift out but there would be no further expansion in national income beyond YL because the increase in real balances would not reduce the interest rate below iLT.
The classical route to full employment thus would require the full employment level of national income to lie at a point where the intersection of the IS-LM curves produced an equilibrium interest that that was equal to or above iLT.
The Keynes effect is so-named because the expansion that follows a reduction in the price level occurs through a rise in aggregate demand – first, through the interest=rate stimulus to investment, and, second, through the standard expenditure multiplier inducing higher consumption expenditure.
However, as we learned in Chapter 15, Keynes did not support wage and price cuts as a way to achieve full employment. He considered the social consequences of wage cuts to be unacceptable and instead advocated increasing the nominal money supply as the way to increase real balances.
But the limits to expansion posed by the possible existence of a liquidity trap dissuaded Keynes from considering the Keynes effect to being a plausible route to full employment.
There are several other arguments that militate against a reliance on the Keynes effect for achieving full employment.
Keynes’ General Theory, – Chapter 19 – which is devoted to the impacts of money wage changes on aggregate demand – presented several such arguments.
Among other impacts, Keynes argued that lower money wages and prices will lead to a redistribution of real income (FIND PAGE NUMBERS):
(a) from wage-earners to other factors entering into marginal prime cost whose remuneration has not been reduced, and (b) from entrepreneurs to rentiers to whom a certain income fixed in terms of money has been guaranteed.
He concluded that the impact of “this redistribution on the propensity to consume for the community as a whole” would probably be more “adverse than favourable”.
Moreover, falling money wages will have a (FIND PAGE NUMBERS):
… depressing influence on entrepreneurs of their greater burden of debt may partly offset any cheerful reactions from the reduction of wages. Indeed if the fall of wages and prices goes far, the embarrassment of those entrepreneurs who are heavily indebted may soon reach the point of insolvency, — with severely adverse effects on investment.
Overall, Keynes concluded that there was “no ground for the belief that a flexible wage policy is capable of maintaining a state of continuous full employment”.
The debt-deflation argument was also recognised by other economists such as Irving Fisher in 1933, Michal Kalecki in 1944 and Hyman Minsky in 1982).
The Classical view proposed an additional mechanism that could generate full employment as long as wages and prices were flexible.
The so-called – Pigou effect – was named after Keynes’ principal antagonist at Cambridge University, Arthur Pigou, whose work exemplified the Treasury View during the Great Depression. The Pigou effect is also known as the Real Balance effect.
While the Keynes effect worked via interest rate responses to changing real money balances then stimulating investment, the Pigou effect was based on the view that falling prices would stimulate consumption expenditure.
It was argued that the real value of household wealth rose as prices fell and this reduced the need to save. As a result the consumption function shifted upwards (higher levels of consumption at each income level) and this would shift the IS curve outwards.
Figure 16.11 captures the Pigou effect. Note we abstract from any impacts on the LM curve of the falling price level to highlight the shifting IS curve.
If we start from an initial underemployment equilibrium at i0 and Y0 with the price level at P0. The argument is that wage and price levels would fall given the output gap (Y0 < YFE) and this would increase real wealth balances and stimulate consumption, thus pushing the IS curve outwards and leading to an expansion in national income.
Eventually, if prices were sufficiently downwardly flexible, the economy would achieve full employment at i2 and YFE, with the lower price level, P2.
You will note that unlike the Keynes effect, whose effectiveness was limited by the possibility of encountering a liquidity trap, the expansionary possibilities of the Pigou effect are unlimited.
Figure 16.11 The Pigou Effect
The introduction of the Pigou effect provided a theoretical device to combat Keynes’ argument that when aggregate demand was deficient (relative to the full employment level), wage and price flexibility would not guarantee full employment.
However, studies have rejected its practical importance. Wealth effects, where identified in the empirical research literature, have been shown to be small and insufficient to resolve a major recession.
16.7 Why we do not use the IS-LM framework
There have been many critiques of the IS-LM framework over the years. Many have concentrated on whether the approach is a faithful representation of Keynes’ General Theory, as was its initial purpose. Even its originator John Hicks accepted that it was not a valid depiction of Keynes’ theories (see box).
Other critiques have concentrated on issues relation to its static nature and the fact that it can tell us nothing about what happens when the economy is no in equilibrium.
A third focus of objection relates to its denial of the realities of central bank operations and the way in which the commercial banks function.
In this section, we focus on the last two of these lines of attack.
The endogeneity of the money supply
The supply side is the simpler of the two since the money supply is regarded as fixed by some external agent (the ‘policymaker’) and independent of the rate of interest.
First, the IS-LM analysis relies on the assumption that the money supply is “exogenous”, that is, controlled by the central bank and, thus, independent of the demand for funds.
The underlying theory supporting this assumption centres on the money multiplier, which we examine in detail in Chapter 20. The assumption is that the central bank is in control of the so-called monetary base (MB) (the sum of bank reserves and currency at issue) and the money multiplier m transmits changes from the base into changes in the money supply (M).
By setting the size of the monetary base, it is thus asserted that the central bank controls the money supply, as is depicted in the derivation of the LM curve.
As we will learn in Chapter 20, this conceptualisation of the monetary operations of the system are not remotely applicable to the real world.
A senior official in the US Federal Reserve Bank of New York, A.D. Holmes identified what he called “operational problems in stabilising the money supply” as far back as 1969:
[Reference: Holmes, A (1969) ‘Operational Constraints on the Stabilization of Money Supply Growth. In Controlling Monetary Aggregates’, Federal Reserve Bank of Boston, 65-77]The idea of a regular injection of reserves … suffers from a naive assumption that the banking system only expands loans after the System (or market factors) have put reserves in the banking system. In the real world, banks extend credit, creating deposits in the process, and look for the reserves later. The question then becomes one of whether and how the Federal Reserve will accommodate the demand for reserves. In the very short run, the Federal Reserve has little or no choice about accommodating that demand; over time, its influence can obviously be felt.
The reality, which we will analyse in detail in Chapter 20, is that the central bank sets the so-called official, policy or target interest rate. This is the rate at which they are prepared to provide funds to the banking system on an overnight basis.
This rate then determines the interbank rate that banks apply a margin to, which determines the cost of loans. The interbank rate is just the rate that banks lend to each other to ensure the payments system is stable on a daily basis.
The cost of loans influences the demand for them from private borrowers. Banks then lend to credit-worthy borrowers by creating deposits. The banks then seek the necessary reserves to ensure the withdrawals from the deposits are honoured by the payments system.
While the banks can get the necessary reserves from alternative sources, the central bank supplies reserves on demand to ensure there is financial stability and that they can maintain control of their policy interest rate.
If there is a shortage of reserves, then the competition in the interbank market between the banks for funds will drive up the short-term interest rate above the policy rate and the central bank would lose control of its policy rate. In these cases, the central bank will always supply reserves at the policy rate to maintain control over its policy settings.
Alternatively if there are excess reserves, the banks will try to loan them to other banks at discounted rates and the short-term interest rate would drop to zero. Hence the central bank will either drain the excess by selling interest-bearing government debt or it will pay a return on the excess reserves that eliminates the interbank competition.
These operations tell us that:
- Bank loans create deposits – that is, banks react to the demand for credit from borrowers rather than on-lend deposits.
- The demand for credit depends on the state of economic activity and the level of confidence in the future.
- Bank lending is not constrained by reserve holdings. The reserves are added on demand by the central bank where needed.
- Rather than driving the money supply, the monetary base responses to the expansion of credit by the banks.
- This process means the money supply is endogenously determined and the central bank has no real capacity to maintain any quantity-targets.
The fact that the money supply is endogenously determined means that the LM will be horizontal at the policy interest rate. All shifts in the interest rates are thus set by the central bank and funds are supply on demand elastically at that rate. In this case, shifts in the IS curve would not impact on interest rates.
From a policy perspective this means the simple notion that the central bank can solve unemployment by increasing the money supply is flawed.
If the central bank tries to increase reserves in a discretionary manner this would only result in excess reserve holdings and push the overnight interest rate to zero without actually increasing the money supply. To avoid this the central bank would have pay the policy rate on those excess reserves.
Unemployment is typically the result of a high liquidity preference – people want to hold cash rather than spend it – given uncertainties about the future. In those cases the demand for loans collapses and the banks become more cautious in who they will loan funds to for fear of losses. Under these conditions, there is no way for the central bank to simply increase the supply of money to raise aggregate demand.
In the global financial crisis, central banks have been adding massive volumes of reserves to the banking system via the so-called quantitative easing programs, which we analyse in detail in Chapter 20. The demand for funds was so subdued that credit expansion also slowed dramatically and the banks were content to hold vast quantities of low-interest bearing reserves.
Expectations and Time
[TO BE CONTINUED IN PART 7]Conclusion
PART 7 next week – FINALISE CRITIQUE OF FRAMEWORK.
Saturday Quiz
The Saturday Quiz will be back again tomorrow. It will be of an appropriate order of difficulty (-:
That is enough for today!
(c) Copyright 2013 Bill Mitchell. All Rights Reserved.
16.7なぜ私たちはIS-LMフレームワークを使わないのか
長年にわたり、IS-LMフレームワークについて多くの批判がありました。当初の目的と同様に、アプローチがケインズの一般理論の忠実な表現であるかどうかに多くの人が集中してきました。その創始者ジョン・ヒックスでさえ、それはケインズの理論の有効な描写ではないと認めた（ボックス参照）。
他の批評は、その静的な性質とそれが経済が均衡に達していないとき何が起こるかについて私たちに何も伝えられないという事実に関係する問題に集中しました。
異議の第3の焦点は、中央銀行業務の現実の否定と商業銀行の機能の仕方に関係しています。
このセクションでは、これらの攻撃の最後の2つに焦点を当てます。
マネーサプライの内生性
マネーサプライは何らかの外部エージェント（「政策立案者」）によって固定されており、金利とは無関係であると見なされるため、供給側は2つのうちのどちらか単純です。
第一に、IS-LM分析は、貨幣供給が「外因性」である、すなわち中央銀行によって支配され、したがって資金需要とは無関係であるという仮定に依存している。
この仮定を支持する根底にある理論は、第20章で詳細に検討する貨幣乗数を中心としている。仮定は、中央銀行がいわゆるマネタリーベース（MB）（銀行の準備金と通貨の合計）の管理下にあるということである。そして貨幣乗数mは基底からの変化を貨幣供給量の変化（M）に伝達する。
マネタリーベースのサイズを設定することによって、LM曲線の導出に示されているように、中央銀行がマネーサプライを管理することが主張される。
第20章で学ぶように、システムの金銭的操作のこの概念化は現実世界には遠隔的には適用できません。
1969年にまでさかのぼるが、ニューヨークの米連邦準備銀行、A。D。ホームズの高官は、彼が「マネーサプライを安定させる上での運用上の問題」と呼んでいたものを確認した。
定期的に準備金を注入するという考えは、システム（または市場要因）が準備金を銀行システムに入れた後にのみ、銀行システムがローンを拡大するという単純な仮定に苦しんでいます。現実の世界では、銀行は信用を拡大し、その過程で預金を生み出し、後で準備金を探します。その場合の問題は、連邦準備制度が準備金の需要に対応するかどうか、またその方法にどう対処するかということです。非常に短期的には、連邦準備制度理事会はその需要に対応することについてほとんどあるいは全く選択肢がありません。時間が経つにつれて、その影響は明らかに感じることができます。
[参考文献：Holmes、A（1969）、「マネーサプライの成長の安定化に対する運用上の制約」。 「貨幣総計の管理」のボストン連邦準備銀行、65-77]
第20章で詳細に分析する現実は、中央銀行がいわゆる公式、政策、または目標金利を設定するということです。これは、一晩で銀行システムに資金を提供する準備ができている割合です。
このレートは銀行が証拠金を適用する銀行間金利を決定し、それがローンのコストを決定します。銀行間金利は、支払いシステムが日々安定していることを保証するために銀行が互いに貸し合う金利です。
ローンのコストは、民間の借り手からの彼らの需要に影響を与えます。銀行はその後、預金を創出することによって、信用に値する借り手に貸し付けます。次に銀行は、預金からの引き出しが支払いシステムによって確実に遵守されるように、必要な準備金を求めます。
銀行は必要な準備金を他の資金源から得ることができますが、中央銀行は金融の安定性を確保し、政策金利の管理を維持できるように準備金をオンデマンドで供給します。
準備金が不足している場合、銀行間の銀行間の資金調達競争により、政策金利を上回る短期金利が上昇し、中央銀行は政策金利の支配を失うことになります。このような場合、中央銀行は常に政策金利で準備金を供給し、その政策設定に対する管理を維持します。
あるいは、余剰準備金がある場合、銀行は他の銀行に割引金利でそれらを貸し付けようとし、短期金利はゼロに低下します。したがって、中央銀行は有利子国債を売って超過分を流出させるか、超過準備金に返済して銀行間競争を排除します。
これらの操作は私達にそれを教えてくれます：
銀行ローンは預金を生み出します - つまり、銀行は、貸出預金ではなく、借り手からの信用の需要に反応します。
信用の需要は、経済活動の状況と将来への信頼の度合いによって異なります。
銀行の貸付は、準備金の保有に制約されていません。引当金は必要に応じて中央銀行により要求に応じて追加される。
マネーサプライを推進するのではなく、マネタリーベースは銀行による信用の拡大に反応する。
このプロセスは、マネーサプライが内生的に決定され、中央銀行には維持するための実質的な能力がないことを意味します。
どの数量ターゲットでも。
貨幣供給が内生的に決定されているという事実は、LMが政策金利に対して水平になることを意味する。したがって、金利の変動はすべて中央銀行によって設定され、資金はその金利で弾力的に需要に応じて供給されます。この場合、IS曲線の変化は金利に影響を与えません。
政策的見地から、これは中央銀行がマネーサプライを増やすことによって失業を解決することができるという単純な概念に欠陥があることを意味します。
中央銀行が任意の方法で準備金を増やそうとすると、実際にマネーサプライを増やすことなく、過剰な準備金を保有し、翌日物金利をゼロにするだけです。これを避けるためには、中央銀行はそれらの超過準備に対する政策金利を支払わなければならないでしょう。
失業は一般的に高い流動性の好みの結果です - 人々は将来についての不確実性を考えると、現金を使うよりも現金を保持したいのです。そのような場合、ローンの需要は崩壊し、銀行は損失を恐れて資金を誰に貸すかについてより慎重になります。このような状況下では、中央銀行が総需要を引き上げるために単に資金の供給を増やすことはできません。
世界的な金融危機において、中央銀行はいわゆる量的緩和プログラムを通じて、大量の準備金を銀行システムに追加しています。これについては、第20章で詳しく分析します。資金需要も大幅に抑制され、信用拡大も劇的に減速しましたそして、銀行は膨大な量の低利子準備を保有することに満足していました。
期待と時間
[第7部に続く]
結論
第7部来週 - フレームワークの批評を完成させる。
サタデークイズ
サタデークイズは明日また戻ってきます。それは難易度の適切な程度でしょう（ - ：
今日はこれで十分です！
（c）著作権2013 Bill Mitchell。全著作権所有。
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