Hey John, I know this is doubtlessly a silly question, but here it is anyway. How does the Fed control interest rates without controlling the money supply? Because I am not a macro economist and am not up to speed on current macro economic modeling, and because I know your math is well and truly done, I accept every word in your paper. But I did have that one question.
Short answer, banks have accounts at the Fed, "reserves" The fed just decides how much interest to pay on reserves. Other interest rates adjust to this opportunity.
Yes, of course. But other interest rates don’t adjust magically without excess supply or demand for loanable funds, do they? Wouldn’t the interest the Fed pays on reserves have to be in the ball park of interest banks can get by expanding or contracting the money supply through loans? I’m trying to get some intuition about why M*V=P*Y is not a useful framework, and I’m failing so far.
Two answers, really. First, the Fed doesn't limit the quantity of M. We have essentially a flat money supply. There are no reserve requirements any more. Even more true of the ECB which offers any amount of reserves at a fixed price. So it's M = PY/V -- determines the quantity of M, not P. Second, it's really M V(i) = PY, with i = the interest cost of holding money. Velocity is not a fixed number. And we are now in the "abundant reserves" regime in which reserves pay the same interest as other overnight loans, and the same or even more than short-term treasuries. That means banks are indifferent between "money" and "bonds." Exchanging money for bonds is like taking green M&Ms and giving red M&Ms in return. Velocity is PY / green M&Ms only. M V(0) = PY is not a function, it's a correspondence. Any amount of M is consistent with the equation. Velocity adjusts. It's really V(0) = PY/M.
Thank you for the useful explanation. I have a few more questions. MV=PY is an accounting identity, of course. V is not a constant, it is definitely a function of other variables, of course. What do you mean by V(0) and "correspondence"? Is the the word "correspondence" a technical term, such as the word "correlation"? Again, please excuse my ignorance, which is abundant, because I do not keep up with current macro economic modeling or literature.
Any amount of M is consistent with the equation, of course, and I have long though that V is elastic in the short run, but not so much in the long run. What do you think? I'm thinking V is sloppily bounded between zero and some common sense upper limit.
Is saying that V(0) = PY/M saying that nominal GDP divided by some measure of M determines velocity? If so, what measure of M and over what time frame?
I have other questions, but perhaps this is not the venue for them.
Thank you, John. Your explanation is certainly helpful. I am reading your book about FTPL soon. Just got to get through this semester full of provost search and teaching 4 classes. 😊 I think I get it. Is it fair to say that FTPL makes government behavior the central factor for P, which is not hard to swallow?
Central bank should set neither interest rate nor money supply targets. They should set real income-maximizing inflation rate targets, the average level of the target determined by the normal range and frequency of shocks and the degree of downward price stickiness. = AIT [Expectations affect the stickiness of prices.]
Moreover, they should be flexible enough to engineer temporarily over-target inflation to facilitate adjustment to extraordinary shocks. = FAIT
I write mainly about US monetary policy, US fiscal policy, trade/industrial policy, and climate change policy.
I have my opinions about which US political party is by far the least bad and they are not hard to figure out, but I try to keep my analysis of the issues non-partisan.
Keynes said, “Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”
Hey John, I know this is doubtlessly a silly question, but here it is anyway. How does the Fed control interest rates without controlling the money supply? Because I am not a macro economist and am not up to speed on current macro economic modeling, and because I know your math is well and truly done, I accept every word in your paper. But I did have that one question.
Short answer, banks have accounts at the Fed, "reserves" The fed just decides how much interest to pay on reserves. Other interest rates adjust to this opportunity.
Yes, of course. But other interest rates don’t adjust magically without excess supply or demand for loanable funds, do they? Wouldn’t the interest the Fed pays on reserves have to be in the ball park of interest banks can get by expanding or contracting the money supply through loans? I’m trying to get some intuition about why M*V=P*Y is not a useful framework, and I’m failing so far.
Two answers, really. First, the Fed doesn't limit the quantity of M. We have essentially a flat money supply. There are no reserve requirements any more. Even more true of the ECB which offers any amount of reserves at a fixed price. So it's M = PY/V -- determines the quantity of M, not P. Second, it's really M V(i) = PY, with i = the interest cost of holding money. Velocity is not a fixed number. And we are now in the "abundant reserves" regime in which reserves pay the same interest as other overnight loans, and the same or even more than short-term treasuries. That means banks are indifferent between "money" and "bonds." Exchanging money for bonds is like taking green M&Ms and giving red M&Ms in return. Velocity is PY / green M&Ms only. M V(0) = PY is not a function, it's a correspondence. Any amount of M is consistent with the equation. Velocity adjusts. It's really V(0) = PY/M.
Thank you for the useful explanation. I have a few more questions. MV=PY is an accounting identity, of course. V is not a constant, it is definitely a function of other variables, of course. What do you mean by V(0) and "correspondence"? Is the the word "correspondence" a technical term, such as the word "correlation"? Again, please excuse my ignorance, which is abundant, because I do not keep up with current macro economic modeling or literature.
Any amount of M is consistent with the equation, of course, and I have long though that V is elastic in the short run, but not so much in the long run. What do you think? I'm thinking V is sloppily bounded between zero and some common sense upper limit.
Is saying that V(0) = PY/M saying that nominal GDP divided by some measure of M determines velocity? If so, what measure of M and over what time frame?
I have other questions, but perhaps this is not the venue for them.
Thank you, John. Your explanation is certainly helpful. I am reading your book about FTPL soon. Just got to get through this semester full of provost search and teaching 4 classes. 😊 I think I get it. Is it fair to say that FTPL makes government behavior the central factor for P, which is not hard to swallow?
Central bank should set neither interest rate nor money supply targets. They should set real income-maximizing inflation rate targets, the average level of the target determined by the normal range and frequency of shocks and the degree of downward price stickiness. = AIT [Expectations affect the stickiness of prices.]
Moreover, they should be flexible enough to engineer temporarily over-target inflation to facilitate adjustment to extraordinary shocks. = FAIT
Sorry abut the spam under your name. :(
Hi
As you are not already a subscriber, may I invite you to subscribe (for free) to my substack, "Radical Centrist?"
https://thomaslhutcheson.substack.com/
I write mainly about US monetary policy, US fiscal policy, trade/industrial policy, and climate change policy.
I have my opinions about which US political party is by far the least bad and they are not hard to figure out, but I try to keep my analysis of the issues non-partisan.
Keynes said, “Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”
I want to be that scribbler.
Thanks,