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There’s an easy way to tell whether or not you understand monetary economics. If you understand why all of the following seemingly contradictory sentences are true, and can clearly explain why using graphs showing the time path of interest rates and NGDP in response to both one-time changes in the monetary base, and permanent changes in the growth rate of the base, then you are all set.

1. The bigger the monetary base, the more expansionary the monetary policy.

2. The bigger the base/GDP ratio, the more contractionary the monetary policy.

3. A move to a more expansionary monetary policy lowers short-term interest rates.

4. In general, the higher the level of short-term rates, the more expansionary the monetary policy.

5. The more expansionary the monetary policy the faster the growth in NGDP.

6. The faster the growth in NGDP the more expansionary the monetary policy.

Many people, including pundits, policymakers and academics, never really grasp the intuition behind the seemingly contradictory statements 1 through 4. They may understand them at some level, but have not internalized the concepts.

Statements 5 and 6 are not at all contradictory. There is no puzzling paradox to wrestle with. No conundrum. It’s simple, clear and straightforward.

One can argue that the Great Recession was largely caused by the general tendency to think of monetary policy in terms of money and interest rates, not NGDP growth. Because these policy indicators are simply too confusing for the vast majority of influential pundits, policymakers and academics to work with, policy went tragically off course.

PS. All of this was well understood long ago. I studied these ideas in the 1970s. But they have never really been internalized, as Milton Friedman discovered in 1997.

PPS. Nick Rowe gets it.

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This entry was posted on October 25th, 2013 and is filed under 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.



