Nick Rowe argues that the “natural rate of interest” in modern New Keynesian economics is no better than the “velocity” in monetarist models, and quite possibly worse:
The Old Keynesians have been replaced by New Keynesians. And the Old Monetarists have been replaced by….umm…mostly New Keynesians too. (Us “quasi monetarists” are too few and too lacking in influence to really count). So the old debate is now moot. But velocity isn’t totally dead as a concept…
So now I’m going to respond with “Y tu mama tambien!”.
Very very crudely, and over-simplifying massively, New Keynesians replace PY=MV with delta(PY)=(natural rate of interest – actual rate of interest). If the central bank sets the actual rate of interest below (above) the natural rate of interest, then nominal income will rise (fall)…
So. Neither is constant. Which is more stable? Velocity, or the natural rate of interest?
At least velocity never goes negative, which is more than you would say yourselves about your natural rate of interest. And your mother wears army boots!
“Stability” isn’t the right criterion. Consider this: over the past 50 years, the ratio of GDP to government spending has been remarkably consistent, always confined between 4 and 6, and staying within even narrower intervals over the medium term. That’s more stable than velocity! If I were a fanatical Old Keynesian, I might use this as evidence that we should really be looking at the government expenditure multiplier as the key to policy.
Of course, this would be silly. Government expenditure doesn’t create all other activity in the economy through some “multiplier” process. Instead, it’s relatively consistent with respect to GDP because voters and politicians want it that way: their preferences over taxes and government services are such that they’ve sought a government that accounts for somewhere between one-sixth and one-fourth of the economy. In other words, the causation runs from GDP to government spending, not the other way around.
Is velocity any different? I doubt it. To the extent that velocity is “stable”, what’s actually happening is that consumers want to hold money balances as a relatively consistent fraction of nominal income. Sure, the ratio is stable, but the denominator causes the numerator, not the reverse.
This is tough to verify, of course—if the relationship actually is stable, then without auxiliary assumptions we can’t say where the causation lies. But some historical episodes offer hope. Consider, for instance, the savage recession of the early 80s, which is near-universally acknowledged as the result of Volcker’s fight against inflation. Can we identify a change in the monetary base that matches the magnitude of the recession, or even comes close? Not at all; it’s barely a blip. What about a higher-level monetary aggregate like M2? Again, nothing. Compare that to the obvious slump in nominal GDP. When it mattered, velocity wasn’t so stable after all.
Why? It’s easy to interpret with the right theory. Consumers desire money balances roughly in proportion to their nominal income, with some adjustments made for the nominal interest rate. Consumers are also sluggish in reoptimizing their portfolios. When the Fed contracts the supply of base money even slightly, slow reoptimization means that a dramatic increase in the nominal interest rate is necessary to clear the market. Since interest rates are now well above the “natural rate”, we see recession and disinflation.
Does velocity-centric monetarism offer any similarly coherent account of the Volcker recession? I don’t see it. What made velocity collapse between mid-1981 and 1983?
Ultimately, velocity is just a residual, one without much practical role in monetary policy.