...the main proximate effect of monetary policy on AD is via Tobin's q -- when the price of existing assets rises relative to the marginal cost of producing new assets, firms will move along their MC curves and produce more new assets. Investment increases, in other words, and investment is a component of AD. And when the price of existing assets rises relative to the price of newly-produced consumption goods, both the income (wealth) and substitution effects lead households to increase their demand for newly produced consumption goods, and consumption is also a component of AD.This is such a good explanation of the fundamental mechanism of monetary policy that I virtually had to sit at my computer and applaud.
Greg Random responds in the comments:
Altering the flow and size of money streams changes the relative valuations of different asset classes, throwing the economy into discoordination, creating recalculation problems.
Think of housing assets and housing related financial assets.While I don't necessarily agree with him, it made me think about a couple of questions:
- Presumably the relative valuations of different assets change naturally anyway, no matter what the central bank does. Is this also discoordination? It's an ugly word for a natural and unavoidable process (indeed even if we could stop the relative price changes happening, it would be a terrible idea to do so).
- Is it part of the central bank's (or the fiscal authorities') job to smooth these changes so that employees have time to transfer out of one investment industry into another, reducing disutility from unemployment? Welfare can certainly be increased if people have more warning of future changes which are going to happen anyway. But in this case the way to get that warning is by deliberately delaying the change...and the negative welfare effect of the delay might outweigh the positive effect of the warning signal.
- How does this work with consumption goods? Their relative price changes too. Should authorities intervene in that (either to delay, or to help it along)? What is the difference between consumption goods and assets anyway? One can be converted into the other, in some cases by physical transformation, or alternatively by trading your expectations of the future benefits of an asset for the present benefits of a consumption good.
- Is the difference between assets (or investment) and consumption analogous to the difference between individual, one-off exchanges and ongoing economic relationships? Does this tell us anything about whether there should be any protection or "property rights" in an ongoing economic relationship, as there is for an investment asset? Models of markets are generally based on simple exchanges, but many (most?) trades are part of a long-term series: an employment contract, or a rental payment, or the purchase of a sandwich from the same cafe I have been visiting for the last three years. Perhaps these are qualitatively different from a single, one-off trade of oil for gold on a commodities exchange.
Any of these questions would be easier to answer if illuminated by a Nickrovian thought experiment.
Related but not the same: this Marginal Revolution post asking about the composition of the economy and where declines in demand are happening.