Elves and Helicopters
Could the central bank hit a 20,000% nominal growth target, plus or minus 1000%?
No. Certainly not next quarter. Maybe it come close if it aimed for such a target in 2014.
Consider two thought-experiments, one involving elves and one involving helicopters.The elves change money as the unit of account. They sneak in one night and add a zero to every price, contract, and asset in the economy. You wake up and instead of being paid $30 an hour, you are paid $300 an hour. A gallon of gas costs $25 instead of $2.50. Your $20 bill is now a $200 bill. Your $100,000 stock portfolio is now a $1 million stock portfolio.
The unit of account change is purely neutral. No one’s wealth has changed. No one’s income has changed. No relative prices have changed. This is the same economy as yesterday, merely with another zero in all of these places.
The helicopters change money as a store of value. They drop a huge amount of money in the economy, and it lands in proportion to where it was held before. Let’s say that the helicopters double the money supply, measured as cash plus checking account balances. If I was carrying $100 in cash and had $1500 in my checking account before the helicopter drop, then after the helicopter drop I have $200 in cash and $3000 in my checking account.
In classical monetary theory, the helicopters have the same sort of effect as the elves (at least in the “long run”). Relative prices will be unchanged, real economic activity will be unchanged. Only the price level will be different.
However, in my view, classical monetary theory is wrong. The change in the store of value is not neutral. The helicopter drop will disrupt people’s habitual behavior. Initially, with prices unchanged, some people will feel wealthier. However, that will change as they realize that prices are rising. As they see prices rising, people will realize that money is depreciating faster than it was before, and they will try to economize on cash balances. All sorts of relative wealth effects and relative price changes will take place. We will not end up with the same real activity as before.
Let me return this discussion to Scott Sumner’s thesis. As I understand it, he wants to say that the Fed should have looked around in the second half of 2008, seen that nominal GDP was looking bad, concluded that velocity was falling, and sent the helicopters out to drop money in order to offset this. I am willing to grant that a big helicopter drop would eventually have raised prices above what they otherwise would have been. But my guess is that it would have had very little effect on near-term nominal GDP, and I am not sure whether it would have any positive effect at all on near-term real GDP.
Again, I am pursuing what Bryan calls my bizarre monetary theory. If you were brought up on either saltwater or freshwater economics, you will find it quite strange.
Am I a believer in real business cycles? To me, what was called real business cycle theory in recent decades was an attempt to describe a change in the marginal product of labor. You get a productivity shock or a tax increase that reduces labor demand. Instead, I want to talk about the need to Recalculate, that is to make major changes in the allocation of resources across firms and across industries. Because the Recalculation story does not attribute macroeconomic fluctuations to changes in M or V, it is a non-monetary story, and I suppose you can call it a real business cycle if you like.
During a Recalculation, we have to observe a drop in V. Obviously, if we keep M and P constant and lower Y, then V goes down. However, I do not see the drop in V as a playing a causal role. Nor do I see an increase in M as solving the problem. In the short run, raising M will mostly result in lowering V. In the longer run, P will be higher. Along the way, what happens to Y is not clear. If the helicopters help the economy Recalculate (for example, by surreptitiously lowering real wage rates in a helpful way), then Y will be higher. If instead they simply make things more confusing and disrupt the Recalculation, then Y will be lower.