Marshall's scissors and the Law of Reflux
By Scott Sumner
I don’t generally get into debates over monetary “disequilibrium,” as I don’t find the concept to be particularly useful. It’s too vague. But against my better judgment I’m going to take a stab at the debate between David Glasner and Nick Rowe. Nick says that an increase in bank money (deposits) will lead to an excess supply of money, which will boost NGDP. David argues that this sort of excess supply would be rapidly eliminated as asset prices adjusted and people exchanged unwanted bank deposits for other assets. He cites Tobin’s famous 1963 paper in support, but unless I’m mistaken the paper actually supports Nick’s argument.
Let’s start with the basics. There is the familiar supply and demand for money diagram with the base on the horizontal axis and nominal interest rates on the vertical axis. The supply is assumed vertical, and thus an increase in supply (shift right) in some sense “forces” people and banks to hold more base money. Is this “excess supply?” Yes and no. Interest rates and other financial asset prices adjust immediately, so in that sense people are holding as much cash as they prefer. On the other hand there is excess supply relative to the current (sticky) wage and price level. Excess supply in terms of the goods market. For long run equilibrium to occur you need an increase in prices. When that happens real cash balances return to their desired level, as do nominal interest rates.
Now consider a different sort of money supply increase. Suppose technological improvements cause the banking system to become more efficient. Or suppose banks increase the supply of bank money for some other reason, like deregulation. Now bank deposits become a larger share of M1 and M2 than before. Is there an excess supply of bank deposits? I’d say yes and no, in exactly the same two senses that applied to the monetary base.
Unless I’m mistaken David is arguing the banking case is different. That if banks tried to create more deposit money than the public wanted to hold, then asset prices would adjust and the public would exchange their unwanted bank deposits for other assets—the Law of Reflux. It seems to me that this is sort of assuming a vertical demand curve. That is, an attempt by banks to increase the supply of bank money results in a zero net increase, after the Law of Reflux.
David cites Tobin’s 1963 paper, but it seems to me that the argument by Tobin cuts both ways, against an absolutist position vis-a-vis either money supply or money demand:
Marshall’s scissors of supply and demand apply to the output of the banking industry, no less than to other financial and nonfinancial industries.
Tobin’s central message is that everything is flexible. There are no rigid multipliers. A change in any one part of the system will have some impact on all other parts of the system, but less than if there were no countervailing forces. If the supply of bank money shifts right by a billion dollars, the equilibrium amount of bank money will shift right by $400 million, or $600 million, or whatever.
At a micro level the Law of Reflux seems to eliminate excess supplies of bank money. But that’s equally true of base money–as a fall in nominal interest rates makes people willing hold larger real cash balances. But at a macro level this doesn’t really solve the problem, as there is still excess supply in terms of goods and services. NGDP still must adjust.
As I read the back and forth of the debate, I see people slipping back and forth between one sense of “disequilibrium” and another, which makes it hard (for me) to follow. Thus it’s quite possible that this post has misinterpreted one or both parties.
PS. In my view the debate would be easier to follow if people made claims that X or Y behavior by banks or the central bank would or would not shift NGDP (for a given base), after the Law of Reflux had played itself out.
That which has no practical implications, has no theoretical implications.