Delong’s Peculiar Definition of ‘Monetary Policy’

Keynesians often live in a sort of alternative universe from me. One that reminds me of my daughter’s “Opposite Day” at school. For them, low interest rates mean easy money, for me it indicates money has been tight. Michael Woodford likes to envision a monetary system without money, where monetary policy is all about interest rates. I like to envision a monetary system without interest rates, to show how changes in the money supply are the essence of monetary policy. And now Brad Delong argues that a policy of targeting future inflation isn’t really monetary policy:

You can call Federal Reserve policies aimed at the sending of signals that alter the expected rate of future inflation “monetary policy” if you want, but then you lose analytical clarity–because the way such policies work (if they work) is not the “normal” way that “normal” monetary policy works. Normal monetary policy works by shifting the private sector’s asset holdings toward assets that people spend more readily and rapidly, thus boosting spending. Quantitative easing at the zero bound does not do that: it simply exchanges one zero-yield government asset for another. What is does do is to change bond prices, rather by raising the safe short-term nominal interest rate and thus giving people an incentive to spend the money they already have more quickly.

In contrast, I regard policies that change the expected track of the money supply and inflation to be the only reasonable definition of monetary policy.

Before I explain why, let me emphasize that I am not the only one who takes a forward-looking approach to monetary policy. In the bible of new Keynesianism, Woodford argues that what matters is not current changes in the policy instrument, but rather changes in the expected future path of that instrument. He uses interest rates, but the same applies to the money supply. Of course in the long run money and inflation go hand in hand, a higher future expected money supply implies a higher future expected inflation rate, and vice versa. Maybe Delong doesn’t buy into these newfangled new Keynesian models, so let me illustrate the point with a couple very simple thought experiments:

Consider two hypothetical experiments. In one case the monetary base is doubled, and is expected to remain at the higher level. In the second, the monetary base is doubled, but people expect the money to be pulled back out of circulation one year later. Let’s look at these hypotheticals first from a monetarist perspective, then a Keynesian perspective. (BTW, I’m not sure the second example is that hypothetical, given recent hawkish statements from the Fed it seems close to current policy.)

Now consider the impact on the price level. Monetarists would argue that the first case, a permanent doubling of the monetary supply, would eventually lead to a doubling of the price level. Indeed these sorts of one-time, permanent changes in the money supply are the bread and butter of textbook examples of the Quantity Theory of Money. As we’ll see, there’s a reason why they make this assumption.

Now consider the temporary currency injection. We know that the long run price level doesn’t change. Once the money supply returns to the original level (a year later) prices should also return to the original level. At first you might assume that monetarists would claim that the price level would double, and then fall in half. But consider the real interest rate. Monetarists typically assume that real variables like the real interest rate aren’t much affected by monetary shocks. But if prices doubled, and then were expected to fall in half, the expected real return on currency would be 100% in year two. That is, the purchasing power of money would be expected to double in year two. More likely, almost all of the temporary currency injection would be hoarded and prices would rise by just one or two percent—the risk free real rate of return.

Astute readers might notice that this thought experiment is quite close to the model Krugman used to explain the liquidity trap in Japan. But this shows much more than that; it shows that even in normal times, even when the real rate is slightly positive, it is still approximately true that only permanent changes in the money supply have a significant impact on the price level. Furthermore, I can slightly tweak the model to get even closer to Krugman. Let’s now adopt the Keynesian assumption that easy money temporarily depresses the real interest rate. In that case it’s not hard to imagine a massive and temporary currency injection driving risk free real rates close to zero. And then there would be little or no impact on the price level. Any impact would be washed out by the noise from other types of shocks.

To summarize, it is now true and it has always been true that the monetarist story about monetary shocks assumes those shocks are expected to permanently impact the money supply and the price level. It is hard to draw up any model where monetary policy can significantly impact the current price level without also impacting the expected future price level. And this isn’t just me saying this; Michael Woodford says the same thing.

So here is what Delong has done. He has defined monetary policy to exclude any policies that can only be effective if they are able to move the expected future price level. By doing so, he has defined monetary policy in such a way that it excludes any policy that might actually be effective. I can see why an old-style Keynesian like Delong would be attracted to a definition of ‘monetary policy’ that excluded any effective monetary stimulus. If you define monetary policy in such a way that only ineffective policy actions count, then monetary policy will be ineffective. And what’s left? Fiscal policy—big government.

How does he end up so far off course? Look at how he defines “normal” monetary policy. It’s all about swapping one asset for another. No discussion of expectations, although most explanations of really powerful monetary shocks (liquidity traps, currency devaluation, hyperinflation, etc) are heavily dependent on expectations. In fact, monetary policy is not about swapping currency for T-bills. It is about changes in the future path of currency (relative to demand.) Because money doesn’t affect interest rates in the long run, those changes lead (through the excess cash balance mechanism) to a change in the future expected price level. And that has an immediate effect on all sorts of asset prices; including stocks, commodities, and real estate. And if wages are sticky (and they are) this also has an immediate impact on employment.

Expectations are the key to the transmission mechanism. They are what monetary policy is all about.

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