Knowing and Making

As often happens, Nick Rowe has communicated something tricky and difficult to understand in a limpid and revelatory way : ...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, thro...

Nick Rowe has come up recently with a couple of nice analogies for monetary policy: the pole balancer and the farmboy . And for those of you not reading the other economics blogs, there's a bit of an uproar right now about Narayana Kocherlakota, president of the Minnesota Federal Reserve, and his claim that long-term  low  interest rates will lead to deflation , when surely every schoolboy knows low rates lead to inflation . I've been trying to work out why Kocherlakota's argument is so intuitively wrong and yet theoretically consistent with standard monetary models. I think I've got it, with a bit of inspiration from Nick, Karl Smith , Andy Harless and Scott Sumner . So here's my contribution to the monetary analogy industry: You're driving a truck, one of those big articulated lorries with a trailer full of goods and services. There are three main variables which determine the truck's acceleration: how much you push the gas pedal (let's call...

In an intriguing example of pricing an externality, Barack Obama has announced a plan to tax American banks based on their reliance on the wholesale finance markets. On a related subject, Nick Rowe has a neat analysis of finance as magic - the magic of borrowing short and lending long, sharing risk and creating liquidity. To make this magic work in a more stable fashion, it's understandable that governments would want to encourage banks to move from wholesale to deposit finance. Assuming it works, what are the effects of this move likely to be? The coordination game between multiple owners of capital will work better, for two reasons. First, because no individual will have as much power as they do now. Second, because the more finance is provided by millions of depositors (instead of a few hundred managers of wholesale capital) the more statistically predictable their behaviour is likely to be. Even when there are herd changes in depositor behaviour, the movement of a larger...

The Economist has a Global Public Debt Clock on their site now, along similar lines to the American and Irish debt clocks but monitoring the total public debt of the whole world. But lots of people are concerned by the buildup of private, consumer and corporate, debt as well as debt incurred by governments. So, inspired by previous conversations with Nick Rowe , I decided to extend it to show the net total of ALL debt in the world - public and private. The clock will automatically update to the correct figures in real time. Here it is - enjoy:

What trouble it causes in life when you can't just act directly on your preferences but need to signal indirectly. Chief example at the moment: tomorrow's vote at Marks and Spencer . The shareholders don't really want to get rid of Stuart Rose - he's done a good job - but they do want to tell the M&S directors to stop messing around with corporate governance. So there's a proposal to get him to step down as chairman (not chief executive); but if it passes, or gets significant votes, it's likely to be interpreted as a vote of no confidence in Rose himself. What else? A debate over on Worthwhile Canadian Initiative about the bluntness of the interest rate tool as a way of controlling inflation. If inflation is low anyway, for other reasons, but interest rates are kept low to boost economic activity, price pressures can leak over into asset prices - causing a house price bubble for example. A tool, when not designed directly to address the problem it is meant ...

If you have clicked onto this article just from reading the title, then I may disappoint you slightly. I am not (yet) going to propound a behavioural theory of money, though I think there's one coming in the future. But I will point to a couple of results which may indicate where to get one. The first is a quote from John Moore and Nobu Kiyotaki of LSE, in the beautifully titled lecture Evil Is The Root Of All Money . "Money is the medium of exchange. Notice that for this argument to hold together, there has to be a set of mutually-sustaining beliefs, stretching off to infinity. I was willing to hold money yesterday because I believed the dentist would accept it today. She is willing to hold money today because she believes someone else will accept it tomorrow. And so on. If there were a known end-point to history, the entire structure of beliefs would collapse back from the end." This, as they point out, is the conventional view among microeconomists about the existence ...

I don't often do link lists but they seem to be quite the thing for bloggers. Here's one: Tim Harford's article in Forbes about what credit does to our brains . A clear and simple model showing one way to think about toxic bank assets from Mark Thoma The US is following the UK again: the administration has a plan to improve small business access to credit, just like Alistair Darling; a guest post on Econbrowser  has some interesting microeconomic analysis of the rationale. Nick Rowe is always good value: here is a discussion of how liquidity can be factored into the value of a financial (or other) asset. A very nice summary (PDF) from Tyler Cowen of different definitions of rationality used in economics (somewhat technical, so you'll need a bit of economics vocabulary, but not much mathematics) That will do for now. Given the results of this week's zeitgeist, perhaps I should include something about AIG. But I find it difficult to care.

I've posted the following over at Worthwhile Canadian Initiatives : JKH: I'll have a go at that (no doubt Nick will add more insight too). The multiplier effect depends on the extent to which Ricardian equivalence holds. If it holds perfectly - i.e. people expect all increase in income to be eaten up by future tax increases - then the multiplier effect should in theory be zero. However, the truth of Ricardian equivalence also depends on the multiplier effect! Full Ricardian equivalence is based on the idea that national income will not be affected by a stimulus. If instead the stimulus does increase income, then future tax revenues will be increased automatically, partly offsetting the marginal tax rises that are expected. And does the stimulus increase income? Well, that depends on the multiplier effect! Although I haven't worked out the mathematics, I expect there would be at least two stable equilibria: one where Ricardian equivalence is complete and self-fulfilling, an...

Nick Rowe responds with some feedback on my posting : Three thoughts on your variant of the proposal: Remember the classical dichotomy, between nominal (measured in $) and real (measured in physical, or inflation-adjusted units), and the (long-run) neutrality of money. Monetary policy cannot determine any real variable in the long run. The attempt to do so would cause accelerating inflation or deflation. (The attempt to peg employment with a vertical LR Phillips Curve was one example of this). So REAL investment won't work as a target, but NOMINAL investment might. It is VERY hard to measure investment (even gross investment, let alone net investment). Where do you draw the line between consumption and investment; current expenses and business investment? Human capital? Home improvements? Cars? It's also noisy, on a monthly basis. Somebody buys a big order of airplanes, and up it goes. (Depends on size of country, but a guy at the bank of Canada once told me that US is a big en...