How should we teach monetary policy?
A new paper by Jane Ihrig and Scott Wolla makes some recommendations for changing the way we teach monetary policy in intro economics courses. These include:
1. Dropping coverage of the money multiplier.
2. De-emphasizing open market operations (OMOs), and focusing most heavily on the Fed’s interest on reserves (IOR) policy tool.
I have long favored dropping coverage of the money multiplier, but I’d be opposed to de-emphasizing OMOs. Control of the monetary base has been an important part of Fed policy over the past 100 years, and is likely to remain so for the foreseeable future.
It is not even clear that IOR will be the Fed’s primary policy tool going forward. During periods of zero interest rates, the Fed uses open market operations to control the size of the monetary base and influence the price level. Interest rates have been near zero for most of the past decade, and are likely to remain there for years to come. OMOs will remain an important policy tool, perhaps the dominant tool.
But even if we operated in a positive rate environment I’d still be opposed to de-emphasizing OMOs, for several reasons.
First, Peter Ireland has shown that open market operations continue to have a long run impact on the price level, even when the Fed pays IOR.
Second, students need to understand the process of inflation in many different contexts. It’s important to cover IOR, but that won’t explain why inflation rose dramatically when the US switched from a gold standard to fiat money, nor does it explain why inflation rates in some countries are much higher than in other countries.
When we teach a topic to students, we need to provide a framework that will remain useful in a wide variety of settings. During the 1980s, my students probably thought I was wasting their time with coverage of episodes of deflation and zero interest rates. They probably thought, “We’ll never see that again!” I hope that years later at least a few of them remembered what I had taught them, after they got out and started working on Wall Street.
We should also try to use a framework with which they are already somewhat familiar, such as supply and demand.
And the framework should also directly connect with the goals of monetary policy, such as 2% inflation.
The most general and robust framework for discussing monetary policy is a supply and demand diagram for base money, with the value of money (1/price level) on the vertical axis. In this framework, monetary policy can either shift the supply of base money (OMOs) or the demand for base money (IOR).
We can then explain to students that the Fed adjusts both the supply of money (OMOs, aka “QE”) and the demand for money (IOR) with the goal of keeping inflation near 2%.
The danger of focusing mostly on IOR is that students might begin to engage in the fallacy of reasoning from a price change, assuming that a low interest rate policy is a easy money policy and a high interest rate policy is a tight money policy. The NeoFisherians are not correct in arguing the exact opposite, but they are surely correct in criticizing the naive view that holding nominal interest rates at zero for many decades is an expansionary monetary policy.
One of the most important goals of teaching supply and demand is to stop students from reasoning from a price change. If we start equating interest rates and monetary policy, then students might also assume that a change in the exchange rate will have a predictable effect on the trade balance, or that a change in oil prices will have a predictable effect on oil output. In fact, the impact of high oil prices on oil output depends on whether high oil prices are caused by less supply or more demand, and the impact of a strong currency on the trade balance depends on whether a strong currency is caused by more demand for our exports or more demand for our financial assets. Similarly, the impact of higher interest rates depends on whether the interest rate increase is caused by an expansionary monetary policy or a contractionary monetary policy.
Whenever I present this argument for using the supply and demand for base money, someone will invariably say, “But look, we did all this QE and inflation barely rose.” I could just as well retort, “Look, we cut interest rates to zero and inflation hardly rose.” Or I could respond “Look, we ran trillions of dollars in budget deficits and inflation hardly rose.”
Yes, policy changes are often partly endogenous, responding to shifts in the demand for money, credit and other variables. In that case they seem to have little effect. But that doesn’t mean that a permanent and exogenous change in the monetary base will not increase the price level by the same proportion in the long run, even in a world with IOR.