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Macro is basically composed of three fields:

1. Long run RGDP growth.

2. Nominal macro variables in the long run (P, NGDP, i, E, etc)

3. Business cycles.

Money is all of part two, and half of part three. That means monetary economics is half of macro. It’s also far and away the more interesting half. The real side is a long, boring and random list of factors that affect RGDP (capital, labor, technology, good governance, natural disasters, etc. Monetary economics is an interesting, counterintuitive and elegant structure that fits together wonderfully, using concepts like money neutrality and superneutrality to generate the QTM, the Fisher Effect, PPP and lots of other models filled with beautiful symmetries.

A work study student helped me create a couple of graphs that form my “model” of the macroeconomy. I’ll use them to explain a few issues. First a model of NGDP determination:

This is similar to the regular model of money supply and demand in Mankiw’s textbook, except that the value of money is defined as 1/NGDP, not 1/P. I.e., the value of money is defined as the share of NGDP that can be bought with a single dollar. As with the traditional model, the demand curve is a rectangular hyperbola. In this case the area of a rectangle under any given point on the demand curve is M* (1/NGDP), or M/NGDP, not M/P as on the traditional graph. Thus a given demand for money is defined as a given “Cambridge k” (which is the inverse of velocity.)

Market monetarists differ from traditional monetarists in that we see monetary policy as shifting both money supply and money demand. As in traditional monetarism, any one-time and permanent increase in the monetary base increases NGDP in proportion. That would be like a shift from point A to point C. (Note that 1/NGDP falls at point C, hence NGDP rises.) On the other hand setting a higher NGDP growth target would raise NGDP by reducing the demand for base money–shifting the demand curve to the left. Ditto for a lower IOR.

If NGDP is slow to adjust to a permanent rise in the base, interest rates may fall in the short run (the liquidity effect) and you initially go to point B as the lower interest rates cause the demand for money to rise. Then over time NGDP starts rising, and you gradually move from point B to point C. Actually that’s not quite right, as even in the very short run NGDP will respond somewhat to monetary stimulus. After all, some prices (like food, metals and crude oil) are highly flexible. So the short run equilibrium is actually slightly below point B. NGDP rises immediately, by a small amount.

If the monetary stimulus is not expected to be permanent then you will see interest rates fall and you would go to point B in the short run. That’s what happened in Japan between 2003 and 2006. Then in 2006 the MB was reduced by 20% and Japan went back toward point A.

OK, so that’s my model for explaining one third of macro; inflation, NGDP, nominal interest rates, nominal exchange rates, etc. It’s a monetary model. Then we add the assumption that nominal wages are sticky in the short run:

This one is kind of tricky to explain. I’ve assumed the long run supply of labor is perfectly inelastic, but nothing of importance would change if you made it slightly positively sloped, or even backward bending. The key assumption here is that, unlike in the money market, we are usually not at equilibrium. Let’s start with the case where the Fed reduces NGDP unexpectedly, causing W/NGDP to rise unexpectedly to point B. We assume that employment is demand-determined when we are above equilibrium. Lots of people want to work at that wage, but employers determine how many actually get jobs. The gap between supply and demand is cyclical unemployment, which is currently about 2.6% in the US. The other 5.6% is the natural rate of unemployment, and occurs even if we are at an equilibrium relative wage rate. In terms of hours, unemployment is even higher, as many who want to work full time are working part time, or so discouraged they leave the labor force.

If monetary policy pushes NGDP above expectations (from when labor contracts were signed), then we have an overheating economy. In this case the actual level of excess hours worked is not necessarily equal to the gap between supply and demand, as there may be a labor shortage at point C. In that case the level of hours worked would lie somewhere between the supply and demand curve, but the qualitative results would be the same—too much employment. In a richer and more realistic model employment would depend on more than just unexpected NGDP shocks; because of money illusion workers may be reluctant to accept nominal wage cuts.

One problem with the preceding model is that it implies that equilibrium is “best” and that the public suffers if there is either too much employment or too little. And yet it doesn’t seem that way in the real world. It seems like boom periods are much better than recession periods. And they are! That’s because this simple model abstracts from all sorts of real world policy distortions. The vast majority of government intervention tends to discourage employment (minimum wages, marginal tax rates, welfare, unemployment comp., occupational licensing laws, etc, etc.) Thus when we are on the long run labor supply curve the level of hours worked is actually far too low, even in the US. It’s even worse in Europe, which explains why Europeans are less happy than Americans (see if that gets some comments.)

So there’s a reason why booms feel like good times, even though the simple model says we are working too much. The stickiness of wages temporarily pushes us toward the socially optimal level of hours worked. We produce more goodies, and collectively we consume more as well. We are happier. Alas, we can’t stay there, as wages adjust and we go back to the long run equilibrium. Even worse, attempts to use monetary policy to create booms tends to end up creating more business cycles, which makes people less happy. Better to do as the Aussies do and throw Schumpeter in the trash can. End business cycles with stable NGDP growth, or at least level targeting if there are unavoidable short term blips like 2009.

I agree with Matt Yglesias about 99% of the time on monetary policy. The one area I slightly disagree is that I think he’s too inclined to view the Great Moderation as being a period of excessively tight monetary policy. That might be slightly true, as inflation and NGDP growth did decline very gradually during that period. But the decline was so slight it doesn’t seem to me that it mattered much, until 2008. I wonder if he isn’t relying on his intuition that it’s better to err on the side of higher inflation. In the short run that’s true, but only because of all the other policy distortions. This is actually a very counterintuitive point, and is similar to a policy debate I occasionally have with Karl Smith. I insist that there is no first order income effect for tax changes, and hence that only the substitution effect matters. That means taxes unambiguously reduce hours worked. It’s really hard to see at the individual level, because the average American feels that higher taxes make him worse off, even as a first order effect. But that can’t be true, as the tax money is not just destroyed. Similarly, if wage stickiness is making you work harder than you’d prefer, it seems like it would be making you worse off. But what you don’t see is that the average person working harder also gives more tax money to the government, and that at least some of this money comes back to you (you the average American) in the form of Social Security, better schools for your kids, or better roads.

Booms feel good. It’s a nice example of the fallacy of composition.

PS. Mark Sadowski sent me the following graph of unemployment (red) and nominal wages divided by per capita NGDP:

It breaks my heart to think about all the garbage we force our students to learn in macro. Is inflation good or bad for growth? They leave the course not having a clue. If only we’d teach a simple monetary model of NGDP determination, and then a simple W/NGDP model of business cycles, using the sticky wage assumption. They might actually be able to understand that model. Of course if our politicians understood the model then they never would have allowed the Fed and ECB to create the Great Recession. No more macro. Economics would become a one semester course, and we’d loose lots of teaching jobs.

PS. Matt Yglesias has a great post on why non-sticky wage models of unemployment (such as a loss of wealth) are a dead end. They can’t explain why people would work less:

It is both true that we are not as wealthy as we thought we were and that there’s a lot of joblessness in the United States, but I struggle to grasp a model in which the former causes the latter. Imagine a reverse situation. A town full of working class people sees its unemployment rate suddenly shoot up from 11 percent to 27 percent. Concurrently, it turns out that the town’s residents were much wealthier than they thought they were””each one of them actually had a check for $1 million sitting in their pockets. We might say it’s pretty clear what’s happened here. These folks are wealthier than they thought they were so they raised their reserve wage. But then suppose it turns out the checks were fraudulent and they all bounce. The reserve wage should fall and joblessness should decline. That it seems to me is the supply-side story about the relationship between wealth and employment.

Exactly.

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This entry was posted on July 17th, 2012 and is filed under Misc., Monetary Theory. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



