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Silas Barta and I have a long ongoing debate (part 1, 2,3 part 2 actually comes before part 1) about monetary economics, 2008 recession policy and the views of mainstream macro-economists. This post summarizes the progress of the debate:

Theoretical issues

I think I’ve convinced Silas of a couple of things: I’ve clarified the mechanism by which monetary disequilibrium works. I’ve convinced Silas that the non-monetary impacts of conducting monetary policy, meaning buying and selling financial assets with newly created money, are not large. I have convinced Silas that having the Fed try to adjust the quantity of money to accommodate changes in the demand for money is not a terrible policy, though I don’t think I’ve convinced him it’s a good policy.

Silas has convinced me that the possibility of a decrease in the demand for money due to a decrease in market activity (for example, a shift towards consuming leisure instead of consumer goods) should be taken seriously. I think the evidence strongly indicates that’s not what’s going on right now, but a good monetary system should be able to handle such a change. I am not sure what kind of rule would deal well with this case as well as more conventional cases.

2008 recession policy

Silas and I still disagree about whether the evidence suggests that a high demand for money relative to the quantity of money has been a major problem over the last ~2 years. I haven’t convinced Silas that TARP and similar policies are basically independent of monetary policy, meaning not recommended (or disrecommended) by standard macro as well as implementable independently of monetary policy. Silas and I also disagree about how bad TARP and similar policies were. I claim that they were not terrible but not great. Silas seems to think they were terrible, but I am not clear on why.

Mainstream macro-economist’s view of the world

Silas and I still disagree about whether mainstream macro-economists see surface level economic statistics (inflation, GDP, spending, loans, interest rates, unemployment etc.) as ends in themselves, rather than being indicative of the state of the economy. I say it is obvious that mainstream macro-economists understand this distinction, while Silas maintains he doesn’t see any evidence they do. Silas and I do agree that many mainstream macro-economists have a poor understanding of monetary economics, so that even if they do understand the surface level statistics/ actual welfare distinction much of their advice will be bad.

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Previously, I discussed the features which distinguish money from other goods (Money as a good), why you should view most money as a branded product, and how that affects the perspective you should take on central bank actions (Money as a product). I showed that it makes sense to talk about the best quantity of a particular money in the economy. Now I want to discuss one important process that affects what the best quantity of money is.

This process is called “monetary disequilibrium”, “excess cash balances mechanism” and probably some other things as well. The Keynesian concept of the “Paradox Of Thrift” is related, though less well developed. I will first describe the process informally. In later posts I will describe it more formally. My intent here is to give an intuitive explanation of the basics of monetary disequilibrium.

The real quantity of money that people would like to hold in equilibrium can change over time. Because prices are sticky this can have real effects in the economy. To see how, consider an economy initially at equilibrium with a fixed quantity of money and prices that adjust to changes only after some time (sticky prices). Some people in the economy decide they want to hold higher money balances than they had in the past:

When people hold less money than they would like, they try to increase their holdings of money in two ways: 1) try to reduce their spending 2) try to increase their income. The quantity of money is fixed, so if one person holds a higher nominal quantity of money than before, all others must hold a lower quantity of money than before in aggregate. Prices are fixed, so this is also true for the real quantity of money. When one person reduces their spending, they reduce the income of all others in aggregate. Unless those others desire to hold less money than before, they now hold less money than they would like. Now those others also try to increase their money holdings by the same means. This is a vicious circle and aggregate spending and incomes decline. The circle ends when people no longer want to cut their their spending to achieve higher money balances.

There are two effects which determine how far this process proceeds. 1) The quantity that people want to hold is positively related to the quantity people expect to spend, so as people expect to spend less they will need to hold somewhat less money. 2) As people reduce their spending, those reductions become more painful, so will be more reluctant to trade off consumption for increased money balances.

This process reduces the real quantity of market transactions below it’s equilibrium level. The real quantity of market transactions can only return to normal when prices have adjusted to the new equilibrium, so that people can hold higher real money balances given the fixed nominal quantity of money.

This is the foundational insight of money-based macroeconomics. For some reason this process is not explained in introductory macroeconomics classes, nor commonly discussed by mainstream macro-economists. I believe understanding this logic is critical for understanding the effect of money in the economy and for understanding macroeconomic fluctuations.


Arnold Kling constantly says things that give me the impression that he does not really grok the money-based macro theories he criticizes. For example, he once stated

Pretty much everything in AS/AD is riding on the hypothesis that labor supply is highly elastic at the nominal wage and labor demand is reasonably elastic at the real wage.

Depending on what exactly he meant, this is either false or very misleading.  There are certainly people who think it works this way, macro-economists even, but as Nick Rowe as explained, explanations that rely on the first order effects of real prices do not make sense. The only foundations for AS/AD-like models that make any sense is some kind of monetary-disequilibrium theory. In a monetary disequilibrium theory (Sumner calls it excess cash balances mechanism), if people hold lower real money balances than they would like, they try to accumulate higher money balances by reducing their spending or trying to increase their sales. Since one person’s spending is another’s income, an overall increase in the demand for money without an increase in the supply of money will lead to a decrease in overall spending (you can also call this a decrease in AD, though I don’t see the use).

The latest example is here (#2) (I was a tad too rude in the comments, and I apologize for that)

Yesterday in my high school econ class, I found myself trying to explain why having a separate currency that could depreciate would enable the PIIGS to live happily ever after. I made the textbook argument, but I found myself not so convinced. OK, so maybe you can tell a story where one country that has a recession and a large fiscal deficit would be better off with devaluation. But there are so many countries in that position right now, and they cannot all devalue.

Speaking of “cannot all devalue,” doesn’t the impact of the PIIGS crisis completely nullify QE2? If the dollar appreciates 10 percent and the foreign sector is 10 percent of the economy, then that represents 1 percent disinflation, which probably more than wipes out any inflationary impact of the Fed’s new bond buying program.

To me this just screams “missing the point”. Exchange rate effects are not how coherent money-based macro. Neither are the traditional income/substitution effects (unless you mean substitution towards holding money). It’s monetary disequilibrium.