Tim Peach directed me to a graph in Paul Krugman’s International Economics textbook (coauthored with Maurice Obstfeld and Marc J. Melitz.) It’s a very elegant display of the long run effect of an acceleration in the money supply growth rate (and roughly describes the US economy from 1963-73):

Here’s how to read these graphs.  Graph A shows the money growth rate increasing, say from 5%/year to 8%/year (a steeper slope to the line).  Graph C shows that the growth rate of the price level also increases due to the quantity theory of money.  Prices take a sudden jump at time=0, which we’ll consider later.

In Graph B you see the nominal interest rate jump up at time=0 due to the Fisher effect—higher inflation leads to higher nominal interest rates.  Because the nominal interest rate is the opportunity cost of holding money, this causes money demand to fall at time=0, or if you prefer it causes velocity to rise.  Going back to graph C, this drop in money demand explains the sudden jump in the price level at time=0.  The bottom line is that when money growth accelerates, prices rise even faster than the money supply, as there’s less demand to hold zero interest money.  Both the growing money supply and falling money demand push prices higher.

And in Graph D we see the exchange rate follow the price level, due to purchasing power parity.  BTW, an increase in the price of euros means the dollar is actually depreciating.

This is roughly what happened during 1963-73, and the analysis is right out of Milton Friedman’s monetarism.  Money growth accelerated, inflation accelerated, nominal interest rates rose, and the dollar depreciated.  The process was less smooth than you see here, because in the real world prices are sticky and hence the price level does not jump discontinuously when money growth accelerates.

This exercise helps us to understand the difference between New Keynesians like Krugman and MMTers.  Both groups tend to agree on policy at zero interest rates, favoring fiscal stimulus and not worrying about crowding out.  Both are skeptical of the efficacy of monetary policy at zero rates (although MMTers are even a bit more skeptical than New Keynesians.)

It is when nominal interest rates are positive that the two schools of thought sharply diverge.  When I try to explain the views of MMTers I get shot down.  But that’s never stopped me before, and so I’ll try again here.  I believe that MMTers would start by claiming that the Fed can’t increase the money supply growth rate, as money is “endogenous”.  If you insisted that they consider what would happen if the Fed persevered in trying to force more reserves into the economy, they’d argue that this would drive rates to zero.  Krugman is arguing that faster money growth raises interest rates in the long run.  This difference helps to explain why Krugman differs from MMTers on the existence of a “money multiplier”.

MMTers would claim that driving interest rates to zero would cause banks to hoard most of the new money, and thus it would not have a multiplier effect.  They’d also suggest that it would have relatively little impact on the price level, as aggregate demand is determined by spending, not the stock of bank reserves.

Both New Keynesians and monetarists argue that the Fisher effect is very important when thinking about the long run effect of a change in the money growth rate.  In contrast, MMTers seem to pretty much ignore the Fisher and income effects, and view interest rates as being set by the central bank via the liquidity effect.  An exogenous increase in the money supply growth rate would lead to lower interest rates, in their view.  Because central banks target interest rates, MMTers assume money is endogenous.  They basically ignore the vast empirical literature on the “superneutrality of money” when the money growth rate changes.

To be a good macroeconomist, you need to hold two models in your head simultaneously.  One is the long run flexible price classical model, such as Krugman illustrates in the graph above.  The other is the short run sticky price model, which has special characteristics at zero interest rates.   Krugman’s a brilliant macroeconomist, and thus is not attracted to MMT models that have no tools for evaluating the long run impact of changing money supply growth rates.