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.
READER COMMENTS
Thomas Hutcheson
Nov 2 2020 at 7:06am
It ought to, that is one of it’s mandates along with maximum employment. But does it? Surely the teaching ought to include something on Fed’s actual behavior.
That however would require someone with expertise in political science and psychology as well as behavioral economics and public choice to try to unravel this mystery.
[Since the readership does not overlap completely I think you should cross post your Econlog pieces like this one to Money Illusion]
Philo
Nov 2 2020 at 10:30am
“[Since the readership does not overlap completely I think you should cross post your Econlog pieces like this one to Money Illusion]” Nah, don’t bother: Scott Sumner fans know where to go!
Michael Pettengill
Nov 2 2020 at 11:25am
The most important topic is how money gets in the pockets of consumers who buy production.
Does the Fed deposit money in consumer bank accounts for consumer to spend buying production within 30 days or the money is taken back?
Does the Fed pay the wages of consumers working for businesses so businesses don’t need to fund consumption spending out of business revenue?
Does the Fed order Congress to distribute x amount of money to consumers who must pay for consumption?
Does the Fed give money to Congress knowing Congress will use more than every dollar in revenue paying workers who use their pay to buy production?
No production occurs for long without consumers paying more than labor costs of production to consume it. The Fed can only increase national production, aka GDP, by ensuring the increased production is paid for by consumers. Ultimately, consumers are always individuals. Government is merely an agent for a collection of individuals, so government is merely buying production as collective individual consumption. Even government buying gold bars or 100,000 nuclear warheads that sit in government warehouses is individuals collectively buying production. Circa 1930, very little gold was mined because the price paid by US government for gold was less than mining labor costs. When the Fed created money to enable paying $35 instead of $20, twice as many miners were employed to produce new gold sold to US Treasury, and all other ultimately individual gold consumers.
Richard Burden
Nov 2 2020 at 12:51pm
I read every article on monetary policy that I find, I am yet to find one that addresses our particular brand of capitalism.
Correct me if I am wrong but the biggest problem is that once the money from whatever source, rises to the top, it then too often stays there instead of recirculating. Inflation control would be on both ends. After all one Definition of an economy is the carful management of available resources.
If we were to use taxes to bring the money back into circulation. We could control the total supply on the high end. Put the money back into the bottom of the economy by funding infraestructura for the common good. Increasing total employment, raising wages to a level that allowed everyone to have a stable, comfortable living with education, healthcare and retirement.
Colin Haller
Nov 2 2020 at 5:00pm
What does “supply” even mean where fiat currency is concerned?
Scott Sumner
Nov 3 2020 at 11:27am
Colin, The “supply curve” of base money is basically a vertical line, determined by the Fed.
Kurt Schuler
Nov 2 2020 at 6:22pm
You should be a little more precise in your language. The Fed does not “adjust” demand with interest on reserves. The Fed tries to influence demand with interest on reserves, but it may or may not be successful in moving the public’s demand in the direction it wants.
Scott Sumner
Nov 3 2020 at 11:24am
Fair point. “Influence” is more accurate than “adjust”.
Brian
Nov 2 2020 at 6:54pm
I have a definitions concern. You say “OMO, aka QE”. Right now, and also now, Wikipedia’s description of OMO does not include QE other than in the “see also” section. That leaves the impression that OMO mainly affects short term rates because the the preferred solution (according to Wikipedia) is repurchase agreements and those agreements are a form of short term borrowing.
Scott Sumner
Nov 3 2020 at 11:26am
QE is the purchase of large quantities of bonds by the Fed. It’s clearly the dominant form of OMO in recent years.
Garrett
Nov 5 2020 at 5:17pm
In my experience the hardest thing to explain to people is that a central bank with a fiat currency mainly influences the path of inflation by signaling what they will do if their targets are not met. So the public’s expectation of future Ms affects current Md. Large increases in Ms (rightward shifts) sometimes lead to no increase in inflation rate (decrease in money value) because they are expected to be temporary, so Md shifts outward and the public is comfortable increasing their excess cash holdings.
An example of this is when a central bank does not accelerate open market purchases, or decelerates them, even though the central bank publishes or references forecasts for inflation to be below target.
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