This post was motivated by a conversation with Eric Lonergan. It began with a simple question: what should be the interest rate paid on reserves? I answered that according to theories I’m familiar with, reserves should earn the "natural" rate of interest, which I defined as the sum of population and productivity growth. So, assuming 2% "real" growth and 2% inflation, reserves (and government debt more generally) should be yielding around 4%. I think it’s fair to say most people did not find my answer very satisfying. So I thought I’d take a moment to explain how I arrived at it. I want to do so in the context of a model economy. Let me describe the model first. We can discuss its limitations and possible extensions later on. Consider an economy where people live for two periods; they areRead More »
Articles by David Andolfatto
The title of this post alludes to a paper written by Tom Sargent and Neil Wallace 40 years ago "Some Unpleasant Monetarist Arithmetic." The startling conclusion of this paper is that a central bank (limited to interest rate policy and/or open market operations) does not have unilateral control over the long-run rate of inflation. The result is made all the more powerful by the fact that it relies mostly on arithmetic and only minimally on theory. So, what’s the basic idea? First, begin with the fact that monetary and fiscal policy are inextricably linked via a consolidated government budget constraint. This implies that monetary policy will have fiscal consequences. In particular, interest-rate policy affects the interest expense associated with rolling over any given amount of governmentRead More »
I’ve been thinking a bit lately about theories of the business cycle (a lot of time for reflection in these days of COVID-19). At least, I’ve been thinking of the way some of these theories have evolved over my lifetime and from the perspective of my own training in the field. From my (very narrow) perspective as a researcher and advisor at a central bank, the journey beginning c. 1960 seems like it’s taken the following steps: (1) Phillips Curve and some Natural Rate Hypothesis; (2) Real Business Cycle (RBC) theory; (3) New Keynesian theory. It seems like we might be ready to take the next step. I’ll offer some thoughts on this at the end, for whatever they’re worth. There’s no easy way to summarize the state of macroeconomic thinking, of course. But it seems clear that, at any givenRead More »
Yesterday, I posted a reply to John Cochrane’s Sept 4 post on the national debt. John alerted me to his Sept 6 update, which I somehow missed. Given this update (together with some personal correspondence), let me offer my own update. John begins with an equation describing the flow of government revenue and expenditure. With a debt/GDP ratio of one, the sustainable (primary) deficit/GDP ratio is given by g – r, where g = growth rate of NGDP and r = nominal interest rate on government debt (I include Federal Reserve liabilities and currency in this measure). John assumed g – r = 1% (so about $200B). In a post I published last year, I assumed g – r = 3% (so about $600B); see here: Is the U.S. Budget Deficit Sustainable? Two things to take away from these calculations. First, thisRead More »
The stock of national debt is now larger than our annual national income in the United States. Is this something to worry about? Does it matter how big the debt-to-GDP ratio gets? Is there any limit to how large it can grow and, if so, what is it this limit and what factors determine it? A lot of people have been asking these questions lately. John Cochrane is the latest to opine on these questions here: Debt Matters. I’m not even sure where to begin. I suppose we can start with the famous debt clock pictured on the right. Whenever I look at the debt clock, I’m reminded of James Tobin who, in 1949 remarked: The peace of mind of a conscientious American must be disturbed every time he is reminded that his government is 250 billion dollars in debt. He must be shocked by the frequentRead More »
I was invited recently to take part on a panel discussion
on Modernizing Liquidity Provision as part of a conference hosted jointly by CATO and the Mercatus Center entitled A Fed for Next Time: Ideas for a Crisis-Ready Central Bank. My post today is basically a transcript of the presentation I gave in my session. I’d like to thank George Selgin and David Beckworth for inviting me to speak on why the Fed should create a standing repo facility, an idea that Jane Ihrig and I promoted early last year in a pair of St. Louis Fed blog posts here and here.In those posts, Jane I argued that the Fed should create a standing repo facility that would be prepared to lend against U.S. Treasury securities and possibly other high quality liquid assets (HQLAs). We distinguished the facility we
Michal Kalecki 1899 – 1970Sam Levey reminded me of Kalecki’s 1943 article on the political aspects of full employment. This a very interesting and thought-provoking paper. I enjoyed it enough to offer my critique of it.The paper starts by taking as given what Kalecki calls the doctrine of full employment. The basic idea is that the private sector, left to its own devices, is prone to Keynesian aggregate demand failures (see here for game-theoretic interpretation). The remedy for these spontaneously-occurring "coordination failures," is a government spending program that acts, or stands ready to act, as private demand begins to falter.Kalecki starts his paper off by asserting that by 1943, the doctrine was widely accepted by most economists. It seems clear that Kalecki views the doctrineRead More »
There are a lot of moving parts to the MMT program. I want to focus on one of these parts today: the relation between monetary and fiscal policy.
One thing I find appealing about MMT scholars is their attention to monetary history and
institutional details. I’ve learned a lot from them in this regard.
But as is often the case with details, one has to worry about whether they help
shed light on a specific question of interest, or whether they sometimes let us not see
the forest for the trees. And in terms of the broader picture, since I grew up
in that branch of macroeconomics that tries to take money, banking, and debt
seriously (i.e., not standard NK theory), I sometimes have a hard time understanding what all the fuss is
about. Much of standard monetary theory (SMT) seems perfectly
In case you missed it, there’s an interesting (and slightly wonkish) debate going on between Olivier Blanchard and Roger Farmer concerning the theoretical relevance of the Phillips curve. Roger fired the opening salvo by presenting a macroeconomic model he claims fits the data well and yet makes no use of the Phillips curve. Farmer, in Laplace-like fashion, declared "he had no use for that hypothesis." Blanchard predictably, and understandably, came to the defense of the orthodoxy:
On Farmer. One cannot just ignore an equation (the Phillips curve), and replace it by another. ? Does anybody doubt that if the Fed decreased u rate down to 1%, it would not lead to more inflation? P curve relation is complex and shifting, but it is there. Sorry Roger… https://t.co/ewy09sTg7i
There’s been much talk about the Phillips curve lately, especially in the wake of Jay Powell’s recent testimony before Congress. Many people are proclaiming the death of the Phillips curve. I think that many people making these proclamations are probably wrong–or, more likely–they are correct, but for the wrong reasons.What exactly is being proclaimed dead here? Are people referring to the absence of any statistical correlation between inflation and unemployment? Or are they referring to the theory that the unemployment rate (beyond some "natural" rate) causes inflation? These are two conceptually different notions of the Phillips curve. The fact that the Phillips curve is "flat" does not in itself negate the Phillips curve theory of inflation. This is because monetary policy and otherRead More »
The Phillips curve can mean one of two conceptually distinct things (which are sometimes confused). First, the Phillips curve may simply refer to a statistical property of the data–for example, what is the correlation between inflation and unemployment (either unconditionally, or controlling for a set of factors)? Second, the Phillips curve may refer to a theoretical mechanism–why does inflation and unemployment exhibit the statistical properties it does?The presumption among many is that statistical Phillips curves tend to be negatively sloped, suggesting a trade-off between inflation and unemployment. A standard theoretical interpretation of this negative relationship is that a high level of unemployment means that aggregate demand is low, so that firms feel less inclined to increaseRead More »
The U.S. federal budget deficit for 2018 came in just shy of $800 billion, or about 4% of the gross domestic product (the primary deficit, which excludes the interest expense of the debt, was about 3% of GDP).
As the figure above shows, the present level of deficit spending (as a ratio of GDP) is not too far off from where has been in the 1970s and 1980s. It’s also not too far off from where it was in the early 2000s (although, the peaks back then were associated with recessions).Of course, the question people are asking is whether deficits of this magnitude can be sustained into the foreseeable future without economic consequences (like higher inflation). In this post, I suggest that the answer to this question is yes, but just barely. If I am correct, then any new governmentRead More »
The so-called zero-lower-bound (ZLB) plays a prominent role in modern (and even older) macroeconomic theories. It is often introduced in a paper or at conference as a fact of life — an unavoidable property of the physical environment, like gravity. But is it correct to view it in this way? Or is the ZLB better thought of as legal constraint–something that can potentially be circumvented by policy?The Financial Services Regulatory Relief Act of 2006 allows the U.S. Federal Reserve (the Fed) to pay interest on reserve accounts that private banks hold at the Fed. Specifically, the Act states that:
Balances maintained at a Federal Reserve bank by or on behalf of a depository institution may receive earnings to be paid by the Federal Reserve bank at least once each calendar quarter, at a
I want to say a few things about Chicago Booth’s recent survey questions posed to a set of economists; see here. The survey asked how strongly one believes in the following two statements:
Question A: Countries that borrow in their own currency should not worry about government deficits because they can always create money to finance their debt.
Question B: Countries that borrow in their own currency can finance as much real government spending as they want by creating money.
Not surprisingly, most economists surveyed disagreed with both statements. Fine. But, not fine, actually. Because the survey prefaced the two questions with
Modern Monetary Theory
as if the the two statements constitute some core belief of MMT.
Was any MMT proponent included in the survey? Don’t beRead More »
There’s been much welcome discussion of late concerning the sustainability of government budget deficits and whether the size of the public debt is anything to worry about. I’m not going to answer this question for you here today. But what I would like to do is describe a framework that economists frequently employ to help organize their thinking on the matter. I want to begin with some simple arithmetic and then move on to a bit of theory. I’ll let you judge whether the framework has any merit.Let’s start with some standard definitions.
G(t) = government spending (purchases and transfers) in year t.
T(t) = government tax revenue in year t.
R(t) = gross nominal interest rate on government debt paid in year t+1.
D(t) = nominal government debt in year t (including interest-bearing central
According to my friend and former colleague Steve Williamson, inflation is low in Japan because of the Bank of Japan’s policy of keeping its policy rate low. Accordingly, if the BOJ wants to hit its 2% inflation target, it should raise its policy rate and keep it persistently higher. This is what I’ve called the NeoFisherian proposition. It’s a provocative idea because it flies in the face of conventional wisdom. But is it correct? Does it serve as a practical guide for monetary policy? My feeling is that the answers to these questions are "no" and "no." In what follows, I explain why.At some point in their undergraduate career, students of macroeconomics are introduced to the Fisher equation. The Fisher equation usually stated as R = r + π or, in words:
Nominal Rate of Interest = Real
Contrary to popular belief, standard economic theory does not provide a theoretical foundation for the notion that "competition is everywhere and always good." It turns out that legislation that promotes competition among producers may improve consumer welfare. Or it may not. As so many things in economics (and in life), it all depends.I recently came across an interesting paper demonstrating this idea by Ben Lester, Ali Shourideh, Venky Venkateswaran, and Ariel Zetlin-Jones with the title "Screening and Adverse Selection in Frictional Markets," forthcoming in the Journal of Political Economy.The paper is written in the standard trade language. Like any trade language, it’s difficult to understand if you’re not in the trade! But I thought the idea sufficiently important that I asked BenRead More »
This post is motivated by Eshe Nelson’s column "The Dismal Cost of Economics’ Lack of Racial Diversity." I was especially struck by this data — out of the 539 economics doctorates awarded to U.S. citizens and permanent residents (by U.S. institutions), only 18 of the recipients were African-American.
I thought it would be of some interest to see what the data looks like more broadly over other groups and over a longer period of time. I thank my research assistant, Andrew Spewak, for gathering this data (from the National Science Foundation). Let’s start with the raw numbers first. The data is aggregated into 5-year bins beginning in 1965 and up to 2014. The orange bars represent the number of econ PhDs awarded to U.S. citizens and permanent residents (by U.S. institutions) over aRead More »
It’s well-known that the Fed has been undershooting its inflation 2% target every year since 2012 (ironically, the year it formally adopted a 2% inflation target). This has led some to speculate whether 2% is being viewed more as a ceiling, rather than a target, as it is with the ECB. The Fed, however, continues to insist that not only is 2% a target, it is a symmetric target. But what does this mean, exactly? And how can we judge whether the Fed has a symmetric inflation target or not?These questions came to me while listening to Jay Powell’s recent press conference following the FOMC’s decision to follow through with a widely anticipated rate hike. At the 16:15 mark, reporter Binyamin Appelbaum (NY Times) asked Powell the following question:
BA: You’re about to undershoot your
I had an interested chat with a colleague of mine the other day about the labor market. In the course of conversation, he mentioned that he used to teach a class in labor economics. Naturally, an important lesson included the theory of labor supply. Pretty much the first question asked is how the supply of labor can be expected to change in response to a change in the return to labor (the real wage). My colleague said that for years he would preface the theoretical discussion with a poll. He would turn to the class and ask them to imagine themselves employed at some job. Then imagine having your wage doubled for a short period of time. How many of you would work more? (The majority of the class would raise their hands.) How many of you would not change your hours worked? (A minority ofRead More »
David Beckworth has a new post up suggesting that the Fed’s floor system has discouraged bank lending by making interest-bearing reserves a relatively more attractive investment; see here. I’ve been hearing this story a lot lately, but I can’t say it makes a whole lot of sense to me.Here’s how I think about it. Consider the pre-2008 "corridor" system where the Fed targeted the federal funds rate. The effective federal funds rate (FFR) traded between the upper and lower bounds of the corridor–the upper bound given by the discount rate and the lower bound given by the zero interest-on-reserves (IOR) rate. The Fed achieved its target FFR by managing the supply of reserves through open-market operations involving short-term treasury debt.Consider a given target interest rate equal to (say)Read More »
Book of Smart Contracts 1959
In his 1959 classic Theory of Value, Gerard Debreu takes a deep dive into general (Walrasian) equilibrium theory. (Yes, I know, but please try to stay awake for at least a few more paragraphs.)He studies a very stark hypothetical scenario where people are imagined to gather at the beginning of time and formulate trading plans for a given vector of market prices (called out by some mysterious auctioneer). Commodities can take the form of different goods, like apples and oranges. But they can also be made time-contingent and state-contingent. An apple delivered tomorrow is different commodity than an apple delivered today. An orange delivered tomorrow in the event of rain is different commodity than an orange delivered tomorrow in the event of sunshine. And so
It’s well-known that in the United States, recessions are often preceded by an inversion of the yield curve. Is there any economic rationale for why this should be the case? Most yield curve analysis makes reference to nominal interest rates. Economic theory, however, stresses the relevance of real (inflation-adjusted) interest rates. (The distinction does not matter much for the U.S in recent decades, as inflation has remained low and stable). According to standard asset-pricing theory (which, unfortunately for present purposes, abstracts from liquidity premia), the real interest rate measures the rate at which consumption (a broad measure of material living standards) is expected to grow over a given horizon. A high 1-year yield signals that growth is expected to be high over aRead More »
I came across a presentation of Bitcoin the other day called The Trust Machine: The Story of Bitcoin. I thought it was very nice and I encourage anyone who’s interested in Bitcoin to view it (less than 25 minutes). What I offer below are questions and comments that came to my mind as I listened to the narrative. I’d recommend listening to the entire presentation first and then reading my comments below. The bold numbers represent the corresponding time in the video to which the remark pertains.
1:04 Before Bitcoin, the only way to make electronic payments over the Internet was via your bank. However, over 2 billion people in the world do not have access to a bank account.
Sure, but why is Bitcoin the best solution for this problem? Nobody was connected to their bank accounts
In my previous post (Inflation and Unemployment), I reviewed what I thought was a fair characterization of the way the Federal Reserve Board staff organize their thinking about inflation and unemployment, as well as how this view of the world was at least partly responsible for the "hawkish" overtone of current Fed policy. I also suggested that the inflation and unemployment dynamic might be better understood through the lens of an alternative theory that emphasized the supply and demand for money (broadly defined to include U.S. treasury debt).I want to thank Paul Krugman for taking the time to critique my post and draw attention to an important issue that concerns U.S. monetary policy makers today (see: Immaculate Inflation Strikes Again). I was only a little disappointed to learn thatRead More »
The FOMC decided on March 21 to increase the target band for the federal funds rate by 25 basis points, to a range of 1.50-1.75%. This despite inflation running persistently below the Fed’s 2% target, only moderate wage growth, and inflation expectations firmly anchored.
What is the FOMC thinking here? To be more precise, what is the dominant view within the FOMC that is driving the present tightening cycle? Remember, the FOMC is made up of 12 regional bank presidents plus 7 board of governors (at full strength) possessing a variety of views which are somehow aggregated into a policy rate decision. I think it’s fair to say that the dominant view, especially among Board members, is heavily influenced by the Board’s staff economists. So, maybe what I’m really asking is: what is the BoardRead More »
Conventional wisdom is that a central bank can anchor the long-run rate of inflation to a target of its own choosing. This belief is evident where ever a government has charged its central bank with a "price stability" mandate (commonly interpreted nowadays as keeping a consumer price index growing on average at around 2% per annum over long periods of time).
What exactly is the mechanism by which a central bank is supposed to control the long-run rate of inflation (the growth rate of the price-level)? And is it really the case that a central bank can defend its preferred inflation target without any degree of fiscal support?
Asking these questions reminds me of the old joke of an economist as someone who sees something work in practice and then asks whether it might also work in theory.
I admit this is a rather strange title for a post, but bear with me. Every once in a while I reflect back on the so-called "taper tantrum" event in the summer of 2013 when Fed Chair Ben Bernanke made an off-the-cuff remark that the FOMC was thinking of maybe slowing down the pace QE3 asset purchases (see here). The stock market had a temporary sell-off, which turned out to be no big deal. What I find more interesting is how long bond yields rose sharply and persistently. Even more interesting, real bond yields behaved in this manner–see the figure below.
OK, so maybe the initial sell-off of bonds could be interpreted as the market being surprised that QE3 (an open-ended program) might terminate earlier than expected. But I just can’t believe that QE programs can have such persistentRead More »
One way to decompose the GDP is in terms of its expenditure components, Y ≡ C + I + G + NX. I like to write "≡" instead of "=" to remind myself that this decomposition is measurement, not theory.
In what follows, consumption is measured in terms of nondurables and services only–I add consumer durables with private investment. The data is inflation-adjusted, quarterly, and I report year-over-year percent changes. I’ll start with recent history (since 2010) and then later look at a longer sample (beginning in 1960).
Let me begin with GDP and consumption. I like to study consumption dynamics because I have some notion of Milton Friedman’s "permanent income hypothesis" in the back of my mind. The idea is that individuals base their expenditures on nondurable goods and services moreRead More »
This post is me thinking out loud about how fiscal considerations may influence the price-level. The question of what determines the price-level is an old one. It’s a question that economists struggle with to this day.
To begin, what do we mean by the price-level? Loosely, the price-level refers to the "cost-of-living," where cost is measured in units of money. Living refers to the flow of services consumed (destroyed) for the purpose of survival/enjoyment. (Note that the cost-of-living might alternatively be measured as the amount of labor one must expend per unit of consumption, but this would require a separate discussion.)
Measuring aggregate material living standards is challenging for two reasons. First, people consume a variety of goods and services. Suppose that the price of