Future money and today's NGDP By Garett Jones

In times of trouble, I often turn for comfort to the Cagan

money demand model. Philip Cagan, who passed

away in June of this year, was a monetarist who moved the ball down the

court. Back in the 50’s, he gave us a new

and better set of reasons for thinking that future monetary policy impacts

today’s economy.

Here’s his story: Today’s demand for real, liquid buying

power (the money supply divided by the level of prices, M/P) depends partly on

inflation in the near future. If

inflation’s high, you want to hold less money–you’d rather hold real assets

that won’t lose value in an inflation.

Sure, you as one person can dump your money holdings by

selling (!) them to someone else. But

for the economy as a whole, the money supply is pinned down by government (and

some other stuff I’m leaving out–remember, you never

want to see everything in perspective). So if there’s inflation in the future, the only way people can reduce their real buying

power today is for the price level to

rise. Future inflation causes a price increase today.

But here’s the thing: Cagan doesn’t just assume that inflation is caused by money

growth—he proves it. There’s a little

arithmetic to it, but the story is this: Today’s price level depends partly

on today’s money supply, and partly on tomorrow’s price level.

But tomorrow’s

price level depends on both tomorrow’s money supply and the price level in the even

more distant future, which depends partly on money in the still more distant

future. And so onward, forever.

The result? Today’s price level depends mostly on the future supply of money.

So if word gets out that the money supply will be higher than

expected two years from now, in Cagan’s story that pushes up prices today.

And longer-lasting increases in future money have a bigger impact on

prices than one-off increases (like the burst

of money printed around Y2K).

Economists have a lot of stories about why expectations

matter, how beliefs about future government policy influence things today. But Cagan’s money demand model did more than

that: It gave us a new reason to think that a credible Federal Reserve—one

that makes their future intentions clear, and sticks to those plans–creates macro

stability today.

Implication: Countries that seriously

debate big changes in their monetary policy–even for the better–create macro

instability right now.

And the Cagan model is a great starting point for thinking

about why the Fed’s new

monetary policy rule will start pushing up nominal GDP fairly soon…even if it

takes years for the mortgage purchases to add up to much of anything. Expected money matters today.

Coda:

Congratulations to Scott Sumner on his deserved and underacknowledged victory.