Tag Archives: history

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