The dark, dark era of money demand

Did you know that Greg Mankiw and Larry Summers once wrote a paper showing that tax cuts are probably contractionary?

Neither did I.

Of course, in an effort to be sensationalist, I’m being unfair to Mankiw and Summers. I doubt either of them has ever actually believed that tax cuts depress the economy. Mankiw, after all, has some innovative ideas about how paycheck-to-paycheck consumers might make tax cuts effective as a tool to boost aggregate demand. As high-ranking economic advisers, both Mankiw and Summers presided over large tax cuts intended as stimulus.

Yet for some reason, they wrote a paper in 1986 whose working title was “Are Tax Cuts Really Expansionary?” They concluded the answer was quite possibly no:

In this paper, we re-examine the standard analysis of the short-run effect of a personal tax cut. If consumer spending generates more money demand than other components of GNP, then tax cuts may, by increasing the demand for money, depress aggregate demand. We examine a variety of evidence and conclude that the necessary condition for contractionary tax cuts is probably satisfied for the U.S. economy. (emphasis mine)

I can’t think of a better demonstration of how “money demand” once warped economists’ minds.

Mankiw and Summers, you see, were following up on a long literature that used the IS-LM model to analyze the effects of fiscal policy. In that literature, debt-financed transfers stimulated the economy: with more money in their pockets, consumers spent more. (Needless to say, this literature didn’t bother with Ricardian equivalence—but that’s another story.)

Now, there was some feedback from the “LM curve”. As consumption rose, there was greater demand for the (fixed) quantity of money, leading to higher interest rates and a partially offsetting drop in consumption and output. But this could only be a partial offset. After all, interest rates only rose because output rose: if output stagnated or fell, there’d be no dampening effect from interest rates, and nothing to offset the positive effect from the transfer, meaning that output would have to rise after all. (Contradiction!)

In IS-LM lingo, an upward movement in the “IS” curve would inevitably boost the value of “Y”:

Mankiw and Summers challenged this result with a simple observation. Maybe money demand doesn’t depend on output in the aggregate—instead, it depends separately on different components of output, like consumption and investment. In particular, Mankiw and Summers argued that money demand was influenced mainly by consumption—households hold a lot of money for consumption purposes, but they don’t need nearly as much for durable goods purchases, and businesses don’t use much cash for investment.

This slight modification of the IS-LM model makes it possible for tax cuts to be contractionary. Here’s the logic: tax cuts boost consumption, which dramatically increases money demand and forces up interest rates. Higher interest rates put such a damper on investment that the overall movement in output is negative.

Interesting story. But it misses the obvious question: why does the Fed stand by, complacently, and keep the money supply exactly the same as such clearly unintended consequences play themselves out? And assuming the Fed will never anything so crazy, why do we care about a thought experiment where it does? If it’s even just following an interest rate rule, the paper’s entire chain of reasoning is meaningless.

To be fair, Mankiw and Summers recognized these issues:

Second, our analysis considers the effect of tax cuts assuming a constant path of some monetary aggregate. Depending on the Fed’s reaction function, a wide range of alternate outcomes is possible.

But, for some reason, they still found it to be a worthwhile exercise:

Our assumption that the money stock is held constant in the face of tax changes, however, is a natural and conventional benchmark

A natural benchmark? Really? A constant money stock is natural? If this is your framework for policy analysis, you might as well conclude that the War on Drugs is the most contractionary economic program in the United States: after all, it creates a tremendous demand for cash in illicit transactions, one that quite plausibly swamps any short-term variation due to fiscal policy. If Mexican drug lords could safely wire their money around, there wouldn’t be any need for so many $100 bills. Holding the money stock constant, interest rates would plummet, investment would soar, and we’d experience a massive investment boom.

But I shouldn’t be too hard on circa-1986 Mankiw and Summers: after all, they were prisoners of their time. A constant money stock in the face of policy changes has never been a “natural” benchmark, but it certainly was conventional. Everybody used it. The Fed even toyed for a few years with its own form of monetarism—the only policy rule under which the Mankiw-Summers result (and all its IS-LM precursors) might have had a grain of truth.

This is one of those historical episodes that makes you realize how far economics has come. Somehow, in 1986, it seemed perfectly natural to write a paper on the obscure properties of the money demand function—even to two economists as sharp as Mankiw and Summers. (They don’t come much sharper than that.) Today, thanks to Michael Woodford and fellow travelers, we realize that the money part of monetary policy isn’t really so important, and that the perverse feedbacks of the old model are little more than intellectual curiosities—unless, of course, you have a central bank crazy enough to implement a money supply rule, which we fortunately do not.

And this is liberating! Macroeconomics is hard enough without having to worry about how every single policy might interact with money demand. (For instance, in extreme cases we need to discuss changes in liquidity demand; a related concept, but one with very different policy implications.) Let’s be glad that the era of money demand is over—hopefully for good.



Filed under macro

16 responses to “The dark, dark era of money demand

  1. Matt

    I’m not sure I understand – what does modelling a fixed money supply have to do with thinking about money demand? If there’s a weakness in the way the Fed’s reaction function is visualized, how does that invalidate thinking about endogenous money demand?

    Wouldn’t a Nick Rowe say that this almost exactly proves his way of thinking about the economy – a fixed money supply Fed is, in effect, raising interest rates to offset (or more than offset) the expansionary effects of the tax cuts.

    Or, equivalently (I think), that interest rates are an ‘epiphenomenon’ and what matters is the endogenous money demand and the exogenous money supply.

    Please do correct me if I’m wrong.

  2. I read that paper when it first came out, back when I was first starting to study macroeconomics. It actually didn’t sound so crazy at the time, because (1) we had recently lived through the experience where the passage of the Reagan tax cut was followed by a major recession and (2) the Fed had recently been explicitly (at least officially) following a policy of targeting monetary aggregates and was still paying lip service to the idea. In retrospect, I think it’s a big stretch to believe that what the paper describes was actually happened during the early Reagan administration, but it’s not beyond the realm of possibility (since the Fed was really big on aggregate targeting in 1981-82), and at the time it conformed to the intuition that I had about the events in question before having studied macroeconomics.

    • I had always conceived the Fed’s “monetarist” phase as mostly a ploy to justify the tight policy and ensuing recession needed to combat inflation—and perhaps a way to signal, in a world without Taylor rules, that the Fed had a reaction function conducive to price stability. Since there was still some ambiguity about which monetary aggregate to target (and how to implement that target), the Fed had a fair amount of freedom in the day-to-day operation of monetary policy. But you’re right—the insanely volatile path of the Fed funds rate around 1981-82 strongly suggests that the Fed was at least briefly committed to quantity targeting (though it dropped that commitment when it ceased being useful), and in such a world the Mankiw-Summers phenomenon might actually occur.

      I still think that the “higher consumption demand => higher money demand => higher rates => lower investment” channel is bizarre enough that, at the very least, it suggests something is clearly wrong with a money supply rule. This presumably why (almost) no one today argues for an rule that explicitly specifies the money supply—rather, we get similar but more robust alternatives like NGDP targets.

  3. Matt:

    The claims about the irrelevancy of money demand seem a bit premature to me. The only reason Woodford and others reach that conclusion is because of their modeling assumptions. The standard way money is put into models–either through money in the utility function or cash in advance constraint–simply assumes way the difficulties of transaction and search costs so that money is almost assumed to be unimportant. Thus, when the results of the model without money turn out to be roughly equivalent to those with money, the conclusion they reach is that money (and money demand) is unimportant rather than realizing the modeling assumption isn’t useful.

    The only folks who don’t trivialize money in their models are the New Monetarist. This is one place where I agree with wholeheartedly with Stephen Williamson. From the first paragraph of Lagos and Wright (2005):
    “Existing monetary models in macroeconomics are reduced-form models. By this we mean they make assumptions, such as putting money in the utility function or imposing cash-in-advance constraints, that are meant to stand in for some role of money that is not made explicit–say, that it helps overcome spatial, temporal, or informational frictions.”

    • I guess I’m happy to “trivialize” money, at least in the sense that I think that the explicit details of monetary frictions are insignificant when compared with the massive effect of interest rates on the real economy. This is particularly true for the monetary frictions that distinguish base money from nearly equivalent alternatives like T-bills. At the margin, the only relevant frictions here are (1) sometimes you need to pay for things in paper currency, and (if you can even call this a “friction”) (2) there is a legal requirement that 10% of transactions deposits, themselves a very small fraction of overall liquid assets, be held in the form of base money.

      Suppose that inflation rises substantially and equilibrium nominal interest rates go up to 10% a year. If I have $100 in my pocket at all times, I’m now losing $10 a year. That’s not zero, but it’s also incredibly trivial compared to (1) the welfare costs of inflation that arise for non-frictional reasons, i.e. tax complications, (2) my spending on cash goods, (3) my overall spending, and (4) any reasonable estimate of the other effects of monetary policy.

      The calibration exercise in the Lagos-Wright paper is an extremely good example of how one can get carried away when trying to model monetary frictions. They identify the following novel cost of inflation: when inflation is higher, whoever I meet in the “decentralized market” has greater power over me, since they know that if I have to wait until next period to make a purchase, I’ll lose some of the value of my money due to inflation. Since the sellers in the DM get a disproportionate share of the surplus, I am less willing to hold money until the DM in the first place. This amplifies the usual distortion created by inflation.

      This does not strike me as a remotely plausible story, at least at the magnitudes that Lagos & Wright calculate. Certainly I have never planned to make some big purchase, met a unique counterparty in some kind of decentralized market, and then thought “rats! if I don’t buy from this guy, I’ll need to keep $5000 in cash in my pocket for the next several months even as it loses value due to inflation”. If I did, I’d take the cash back to the ATM so that it didn’t lose value due to inflation. (Except, of course, due to our poorly designed tax code, and perhaps the 10% reserve requirement if I felt the need to hold it in a transaction account.) I don’t see what possible circumstances would force me to keep holding the money in the form of paper currency, which is what Lagos & Wright posit.

      And this is arguably the leading work in the literature on monetary frictions…

      • David Beckworth

        Money that is used as medium of exchange is more than just base money. The Fed may not directly control broader measures of money assets directly, but it can strongly influence the demand for them and the endogenous creation of them by how it sets expectations. The use of these other money assets is not trivial to broader macroeconomic activity. Imagine if everyone woke up tomorrow and suddenly had a desire to rebalance their portfolios toward more money assets (i.e. an increased in money demand). The fact that these money assets are used on every other market as the medium of exchange means such a sharp spike in money demand would be devastating for the economy.

        I do think, though, that excess money demand is equivalent to the natural interest rate being lower than the actual market rate. I think where we differ is that you see everything through the changes in the expected path of interest rates where I see that the path itself could also be changed a exogenous shock to money demand.

  4. Matt: good to see this post. You lay out the opposing view well. I disagree, of course.

    The Bank of Canada *did*, in the late 1970’s, target the money stock. I don’t think it is alone. But I don’t know of any central bank that targets a nominal interest rate. Can’t be done anyway, in any natural rate model, like New Keynesian models, for example. Most target inflation.

    But how exactly do central banks target inflation? Mightn’t it have something to do with the fact that their liabilities are money, and other monies are convertible on demand into that money? The only thing a central bank can ultimately control is its own balance sheet, and the liability side of that balance sheet is the only thing that special. So the supply and demand for central bank monetary liabilities is at the root of central banks’ ability to target inflation?

    After all, the Bank of Montreal can set interest rates at which it is willing to borrow and lend, just like the Bank of Canada. I don’t see anything in Mike Woodford’s model which explains why the Bank of Montreal, rather than the Bank of Canada, can’t choose Canada’s inflation rate.

    • I’m not sure we’re very far apart here. I agree that money supply and demand are conceptually important, as the mechanisms through which the central bank ultimately must conduct its operations—I just think that their importance ends there. (Though we have to be careful: a central bank can arguably implement policy just as effectively through IOR, and that doesn’t need to involve changing money supply or demand at all.)

      It is better to say (1) the bank implements inflation targeting by following an interest rate rule, and (2) the bank is generally able to implement its intermediate target for the interest rate by moving money supply relative to demand, but this is a very erratic and complicated process (see a graph of reserves?) whose technicalities are irrelevant for the macroeconomic impact.

  5. Ok now I’m really confused. Nick, I thought you would not have seen this post as a challenge to your views at all.

    If I’m understanding this at all, the issue is with the modelling of a constant money supply. If the *money supply ‘reaction function’* has been modelled incorrectly, how does that invalidate the conceptual importance of the money *demand*?

    • Ritwik: I don’t have any problems with running the ISLM with different money supply functions. But I do have a problem with leaving money demand and money supply out altogether.

      To a first approximation, if I wanted to draw the LM curve in {r,Y} space, I would draw it vertical, for an inflation targeting central bank like Canada. The Bank adjusts the supply of money to try to keep output at (what it thinks is) potential output.

      • Exactly. At least I understand you alright!

        So I summarise Matt’s argument as ‘money supply was modelled horrendously –> thinking about money supply and demand is not helpful’.

        And I don’t see how the conclusion follows from the premise.

      • Ritwik, in the IS-LM model, money only affects the economy because it affects real interest rates, which change the incentives for investment and other kinds of spending. If the Fed’s near-term policy rule is an interest rate target, adding the precise details of money supply and demand to the picture is a needless complication—you can directly look at the effect of interest rate choices on output using the diagram (or a more sophisticated model of your choice).

        Moreover, the fact that money demand is erratic and unpredictable, combined with the fact that virtually all the real economic effect happens through interest rates, strongly suggests that we should use interest rates as an intermediate target*—if you use an kind of money supply rule instead, you’re subjecting yourself to all kinds of weird, unintended fluctuations, like the Mankiw-Summers effect.

        So my syllogism here is a little more complicated than the one you describe. It’s more like “the interaction of a money supply rule and money demand produces bizarre results that could not conceivably be optimal => for this reason, you should not use a money supply rule, and should instead use interest rates as the intermediate target, since they’re the mechanism through which real economic effects happen => conditional on this kind of rule, the details of money demand are irrelevant (though the existence of a money demand function is theoretically important)”.

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  7. merijnknibbe

    “unless, of course, you have a central bank crazy enough to implement a money supply rule, which we fortunately do not.”

    The European Central Banks explicitely aims at an on average 4,5% a year increase of M3 in the medium run (8 years):

    “reference value for monetary growth
    In order to assess monetary developments, the Governing Council has announced a reference value for the growth of the broad monetary aggregate M3. This reference value refers to the rate of M3 growth that is deemed to be compatible with price stability over the medium term. The reference value is derived in a manner that is consistent with and serves the achievement of the Governing Council’s definition of price stability on the basis of medium-term assumptions regarding trend real GDP growth and the trend in the velocity of circulation of M3. Substantial or prolonged deviations of M3 growth from the reference value would, under normal circumstances, signal risks to price stability over the medium term. However, monetary policy does not react mechanically to deviations of M3 growth from the reference value. At present, this reference value is 4½%. ”

    Needless to say that actual M3 growth has been substantially below the target for a prolonged time… the rise to a 2% annual increase triggered the interest rate hikes of this year.

    • I’m aware that the ECB supposedly bases policy in part on measurements of M3—though as you say, it hasn’t hit the target very much in recent times. (If you ask me, this is a bizarre policy—basically a nonsensical vestige of monetarism. Suppose that there is a large increase in demand for time deposits, one that the banking sector is able to satisfy. Does this mean that the ECB should tighten policy, because M3 is growing too quickly? If the banking sector is overextended, that’s another story, but it seems like there are vastly better measurements of a troubled banking sector than M3.)

      I am very interested to hear you draw a connection between changes in M3 growth and the ECB’s recent interest rate hikes. Are there media accounts documenting this connection? I would be fascinated to see any if they are available—I had assumed that the ECB was mainly concerned about high headline inflation, but this presents an additional possible rationale.

  8. John

    (Needless to say, this literature didn’t bother with Ricardian equivalence—but that’s another story.)

    First the FT just ran a whole series of essays commenting on such being false, as I am sure you know.

    There is no such thing—if prices are going up, consumers will buy now (example: light bulbs), for the asset will rise in value with an internal rate of return at least equal to inflation

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