10/21/10 7:46 PMWhat Is This "Demand for Money" of Which You Speak? - Grasping Reality with Both Hands

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Grasping Reality with Both HandsThe Semi-Daily Journal of Economist J. Bradford DeLong: Fair, Balanced, Reality-Based, and Even-HandedDepartment of Economics, U.C. Berkeley #3880, Berkeley, CA 94720-3880; 925 7080467; delong@econ.berkeley.edu.

Economics 210aWeblog ArchivesDeLong Hot on GoogleDeLong Hot on Google BlogsearchSeptember 30, 2010

What Is This "Demand for Money" of Which You Speak?

If our big macroeconomic problemof deficient demand for currently-produced goods and services werethe result of a deficient supply ofliquid cash money--the stuff youkeep in your pockets and use forclearing and functions as a mediumof exchange--then the prices of allalternatives to money would be verylow: people would be trying todump their holdings of other assetsto build up their stocks of liquidcash money, and only very lowprices of and very high expectedrates of return on those alternativescould check that desire. Thus we would expect a downturn caused by a shortage ofliquid cash money to be accompanied by very high interest rates on, say, governmentbonds--which share the safety characteristics of money and serve also as savingsvehicles to carry purchasing power forward into the future, but which are not liquidcash media of exchange.

Nevertheless, David Beckworth writes:

Macro and Other Market Musings: Martin Wolf, the Paradox of Thrift, and theExcess Demand for Money: Martin Wolf concludes more borrowing may be justwhat the economy currently needs.... [His] paradox of thrift idea is really nothing

Dashboard Blog Stats Edit Post

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more than another way of saying there is a monetary disequilibrium created by anexcess demand for money. And, of course, an excess demand for money is bestsolved by increasing the quantity of money. The painful alternative is to let theexcess money demand lead to a decline in total current dollar spending anddeflation until money demand equals money supply... the paradox of thriftrequires the Fed to be asleep on the job.

Let me explain why the Paradox of Thrift is really just an excess demand formoney problem.... [I]ndividual households can save... by cutting back onconsumer spending and hoarding money... by spending income on stocks, bonds,or real estate and... by paying down debt.... [I]ncreas[ing] their holdings of moneyby cutting back on expenditures... will create an excess demand for it and a painfuladjustment process will occur. If, on the other hand, the Fed adjusts the moneysupply to match the increased money demand then the painful adjustment isavoided.... In the latter two cases where assets are bought and debt is paid downthe money is passed on to the seller of the assets or to the creditor. Here, the onlyway to generate the painful adjustment is for the seller or creditor--or any otherparty down the money exchange line--to hoard the money. If the creditor or sellerdoes not hoard the money then it continues to support spending and price stability. All is well. Increased austerity, then, only becomes an economy-wideproblem when it leads to an excess demand for money.... The fundamentalproposition of monetary theory is that an individual household can adjust itsmoney stock to the amount demanded, but the economy as a whole cannot...

The hole in David's argument is, I think, where he says "the Fed adjusts the moneysupply" without saying how. Suppose that we have a situation--like we have today--where people are trying to cut back on their expenditure on currently-produced goodsand services in order to build up their stocks of safe assets: places where they can parktheir wealth and be confident it will not melt away when their back is turned. Theyswitch spending away from currently-produced goods and services and try to build uptheir stocks of safe assets--extremely senior and well-collateralized private bonds,government securities, and liquid cash money. Now suppose that the Federal Reserveincreases the money supply by buying government securities for cash. It has altered thesupply of money, yes. But it interest rates are already very low on short-termgovernment paper--if the value of money comes not from its liquidity but from itssafety--then households and businesses will still feel themselves short of safe assetsand still cut back on their spending on currently-produced goods and services and theexpansion of the money supply will have no effect on anything. The rise in the moneystock will be offset by a fall in velocity. The transactions-fueling balances of theeconomy will not change because the extra money created by the Federal Reserve willbe sopped up by an additional precautionary demand for money induced by the fall inthe stock of the other safe assets that households and businesses wanted to hold.

So, yes, Beckworth is right in saying that there is an excess demand for money. But heis wrong in saying that the Federal Reserve can resolve it easily by merely "adjust[ing]the money supply. The problem is that--when the underlying problem is that the full-employment planned demand for safe assets is greater than the supply--each increasein the money supply created by open-market operations is offset by an equal increasein money demand as people who used to hold government bonds as their safe assetsfind that they have been taken away and increase their demand for liquid cash moneyto hold as a safe asset instead.

Increasing the money supply can help--but only if the Federal Reserve does it without

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its policies keeping the supply of safe assets constant. Print up some extra cash andhave the government spend it. Drop extra cash from helicopters. Have the governmentspend and. by borrowing to finance it, create additional safe assets in the form ofadditional government debt. Guarantee private bonds and make them safe. Conductopen market operations not in short-term safe Treasuries but in other, risky assets andso have your open market operations not hold the economy's stock of safe assetsconstant but increase it instead.

These are all ways of increasing the money supply or of decreasing the effectivedemand for money by shifting some of the precautionary demand for money-not-as-liquid-but-as-safe-asset over to newly-created other safe assets.

These are all ways that ought to work, the Lord willing and the creek don't rise.

But to say that the problem is an excess demand for money is, I think, misleading, forit suggests that the standard way of increasing the money stock--open marketoperations that swap liquid cash for other assets while holding the total stock of safeassets in the economy constant--will also work. And by this point I think we have abunch of evidence that it does not.

And to describe these other policy moves--printing up some extra cash and having thegovernment spend it; dropping extra cash from helicopters; having the governmentspend and. by borrowing to finance it, create additional safe assets in the form ofadditional government debt; guaranteeing private bonds and making them safe;conducting open market operations not in short-term safe Treasuries but in other,risky assets and so having your open market operations not hold the economy's stockof safe assets constant but increase it instead--as "monetary policy" seems likely to meto add to the general confusion. When the excess demand for liquid cash money isitself the result of a spillover from a more fundamental excess of (planned) savingsover investment or of (planned) safe asset holdings over supply, standard open marketoperations that are designed to hold the stock of safe assets and the stock of savingsvehicles constant are unlikely to work. And when Federal Reserve monetary expansionsdo work, it is likely to be because they not only increased the supply of money butmore important increased the supply of safe assets or increased the supply of savingsvehicles.

The point, I think, is that liquid cash money is not only a medium of exchange but it isalso a store of value--a savings vehicle--and a hedge--a place of safety that you hold inyour portfolio to satisfy your precautionary demand, and so the transactions demandfor money is only part of the whole. But because other assets are stores of value andhedges a well, to focus exclusively on the supply and demand for money is to missmuch of the action in times like these.

I am still frustrated that all of this seems so clear to me and is to opaque to so manyother smart people. Personally, I blame Olivier Blanchard for making us spend threeweeks on Lloyd Metzler's "Wealth, Saving, and the Rate of Interest" in my first year ofgraduate school...

UPDATE: Nick Rowe comments on David Beckworth:

Yes! There is no paradox of thrift. There is a paradox of hoarding the medium ofexchange. That's because there are two ways to buy more money: sell more otherthings; buy less other things. One of those two options is always open to theindividual, but not to everyone.

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The only case where Say's Law is wrong is when there is an excess demand (orsupply) of money, the medium of exchange.

Could I make Nick Rowe happy by saying that there is too a "paradox of thrift," in thissense:

When there is an excess of (planned) savings over investment, savers will beunable to find enough bonds to satisfy their demand and will park the excessdemand in liquid cash money instead, which they will hoard. They will thusdiminish the supply of money available to meet the transactions demand formoney and that imbalance creates the excess demand that breaks Say's Law. Thuseven though the problem as an excess demand for money, standard open-marketoperations will not resolve it: they will increase the money supply, yes, but bydiminishing the supply of other savings vehicles they will also increase the amountof the money stock not available for transactions purposes because it is being heldas a savings (or a safety) vehicle

?

Does that make anything clear, or just deepen the darkness?

Brad DeLong on September 30, 2010 at 10:01 AM in Economics, Economics: FederalReserve | Permalink

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Comments

Joe Gagnon said...Hi Brad,

Good column. I agree with the substance of your analysis. But to continue aterminological debate we had about 6 months ago, I would like to propose definingmonetary policy as printing money to buy assets and fiscal policy as selling assets tobuy goods or make transfers. Thus, helicopter drops are just monetary + fiscal policy.

Away from the zero bound, monetary policy can stick to buying safe short-term assetsbecause money yields zero and all other assets have a positive yield. At the zero bound,as you note, for monetary policy to have any effect it must buy other types of assetsthat do not have zero yield. But in both regimes the way monetary policy works is bypushing down the rates of return on financial assets. That is quite distinct from fiscalpolicy which works by increasing demand directly, albeit at the expense of higher rates

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of return on financial assets. And of course, helicopter drops increase demand directlywithout increasing rates of return on financial assets.

Reply September 30, 2010 at 12:54 PMBob Athay said...> Does that make anything clear, or just deepen the darkness?

*I* think so, but I've been following your blog on a daily basis for some time now.With enough repetition, even quantum mechanics starts to become intuitive. Nokidding. So does underwater acoustics, combinatorial optimization, integrated circuitmanufacturing and a bunch of other things that are a lot more arcane than anythingyou've posted here. So far, so good...

By the way, how's your book coming?

Reply September 30, 2010 at 12:55 PMGS said...Great column. But is that an endorsement of Metzler's work or not?

Reply September 30, 2010 at 01:47 PMBernard Yomtov said..."Does that make anything clear, or just deepen the darkness?"

I go for (a).

Reply September 30, 2010 at 02:10 PMjcb said...Deepens the darkness for me, I'm afraid.

Most families are consuming less and trying to pay off debt. How does that translateinto any incentive to "hoard money" or search for safe assets? You are talking mostlyabout the relatively few wealthy individuals and institutions that have no place to parkmoney in excess of their own consumption. I suspect that the recent increased rate ofsavings largely pertains to them -- and that they formerly spent the money they nowhoard as safe assets, in part, by inflating the bubble that has recently burst (a practiceformerly know as "investing").

Your whole discussion seems to monetarize the meaning fiscal policy. So, more moneyis circulated; so, more safe assets are created. So what? It's the distribution that counts,and the demand that is created. Otherwise, these policy prescriptions seem simply toshift greater quantities of liquid and safe assets into different accounts in differentbanks.

Your fallback position seems to accept the impossibility of more direct deficit spendingto produce jobs and effective demand (instead of classes of "assets"). So, it's trickle-down investment economics all over. Wasn't that TARP?

Have I missed something?

Reply September 30, 2010 at 02:17 PMToo Much Fed said..."They will thus diminish the supply of money available to meet the transactionsdemand for money and that imbalance creates the excess demand that breaks Say'sLaw."

If "money" is currency or the demand deposits created from debt, is one solution tocreate more currency or create more debt?

Since the fed believes that most if not all shocks are aggregate demand, do they choose

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to lower interest rate(s) to create more demand deposits from more debt?

If there is an aggregate supply shock, should the fed price inflate with currency?

Reply September 30, 2010 at 02:19 PMMin said..."If our big macroeconomic problem of deficient demand for currently-produced goodsand services were the result of a deficient supply of liquid cash money--the stuff youkeep in your pockets and use for clearing and functions as a medium of exchange--then the prices of all alternatives to money would be very low: people would be tryingto dump their holdings of other assets to build up their stocks of liquid cash money,and only very low prices of and very high expected rates of return on those alternativescould check that desire."

But what if the people who do not have enough liquid cash also do not have otherassets to dump for money? The recession officially ended over a year ago, yetunemployment continues to be high and poverty is growing. Does that not indicate atwo-tier or multi-tier economy? The people towards the top are not generating enoughdemand by themselves, but not from their own lack of liquidity. The need for cash iselsewhere, at the bottom. If more people were employed and out of poverty, they wouldspend money, if only because they need to.

Reply September 30, 2010 at 02:41 PMNick Rowe said...There's not much difference between us.

"When there is an excess of (planned) savings over investment, savers will be unable tofind enough bonds to satisfy their demand and will park the excess demand in liquidcash money instead, which they will hoard. They will thus diminish the supply ofmoney available to meet the transactions demand for money and that imbalancecreates the excess demand that breaks Say's Law."

I basically agree with that. I would just say it a little differently. The *proximate* causeof a violation of Say's Law is always an excess demand for the medium of exchange. Anexcess demand for any other non-newly produced good, like bonds, land (Keynes waswrong when arguing with Gessell), or antique furniture, cannot cause a general glut,*unless* it spillsover into an excess demand for the medium of exchange (which it maydo).

"Thus even though the problem as an excess demand for money, standard open-market operations will not resolve it: they will increase the money supply, yes, but bydiminishing the supply of other savings vehicles they will also increase the amount ofthe money stock not available for transactions purposes because it is being held as asavings (or a safety) vehicle"

In "normal" times, an increased supply of money, no matter how it's brought about,will solve the problem, by eliminating the excess demand for money. But right now, inthis particular recession, you may very well be right, in that a purely *temporary* OpenMarket Operation in money and Tbills will have little or no effect, for the very reasonsyou describe. But I would just describe it differently, by saying that a reduction in thesupply of Tbills may cause an increase in the demand for money. Which is one of thereasons I would want some more radical monetary policy, so that the demand formoney would actually fall when the Fed increased the supply.

(As an aside, I'm also worried that Tbills may actually have become money, in theliteral sense of being used as a medium of exchange, but I'm still trying to get my head

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fully around that.)

We just have to remember: recessions are always and everywhere a monetary (mediumof exchange) phenomenon!

Reply September 30, 2010 at 02:48 PMDavid Beckworth said...Brad,

Those are fair points and I agree that something beyond a standard OMO is needed toalleviate this excess money demand. I should have been more explicit on this point inmy original post. Thanks for being so civil in applying the famed Brad DeLongSmackdown on me!

Reply September 30, 2010 at 03:00 PMBrad DeLong said in reply to Nick Rowe...Re: Nick Rowe: I would just describe it differently, by saying that a reduction in thesupply of Tbills may cause an increase in the demand for money. Which is one of thereasons I would want some more radical monetary policy, so that the demand formoney would actually fall when the Fed increased the supply...

And I would then say that a whole bunch of things--having the government spend and.by borrowing to finance it, creating additional safe assets in the form of additionalgovernment debt; guaranteeing private bonds and making them safe assets; etc.--thatdont look like monetary policy also reduce demand for money right now, and so aremuch more effective in circumstances like this (and standard OMO much less) thanMilton Friedmans standard strictures on the relative power of fiscal and monetarypolicy would suggest...

Reply September 30, 2010 at 03:44 PMLord said...I tend to distinguish these as excess demand as cause, due to fear for example, andexcess demand as result, say of insufficient investment alternatives. The result is thesame but the solution may not be due to the difficulty of addressing it.

Reply September 30, 2010 at 05:33 PMEllen1910 said..."I'm also worried that Tbills may actually have become money . . . ." Nick Rowe

Everything has "become money," fool -- well, maybe not old Dutch masters. What dothink credit default, interest rate, and currency swaps are there for, eh?

Reply September 30, 2010 at 05:58 PMTravisA said...Brad,

Do you consider 10 year or 30 year US govt bonds 'safe assets' in this situation? Ireally find it hard to believe that the desire to hold safe assets would remain constant ifthe Fed announced that it is going to buy $5 trillion of US govt debt.

It's really not that hard to cause inflation. There doesn't have to be any helicopterdrops, govt spending, or purchase of risky assets. Just let the Fed set a public pricelevel target and keep buying US govt bonds until the target is achieved. I am not surewhy you and Krugman think that it is so complicated...

Reply September 30, 2010 at 06:09 PMMr. E said in reply to David Beckworth...He knows you are one of the good guys and amenable to reasonable back and forth.

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I read your stuff all the time so maybe have a more detailed understanding of yourentire idea that Brad does. Lets note for the record that you believe that all of thethings Brad mentioned would be effective and that you've mentioned them asbeneficial in other posts.

Reply September 30, 2010 at 08:18 PMMr. E said in reply to Brad DeLong...RE: spending and creating safe assets. Govt spending don't look like monetary policybecause it is fiscal policy. This is one way to create more money - government spending

Re: all the other ways you mentioned to create money. They are also fiscal policy. Justbecause they may be undertaken by the fed doesn't change the essential differencebetween these actions and traditional fed actions.

Traditional fed actions only impacts the relative price of various levels of liquidity.During normal times, changing that price matters.

During times where short term interest rates are near zero, these actions have littleimpact when applied to the short end of the curve because the relative differen ce inboth liquidity and the price of that liqidity is small.

But each of the other actions you named are fiscal policy.

1. Giving money away without getting anything in return (helicopter drop) 2. overpaying for assets (insuring non-government debt, presumably at no cost)3. Buying other risky assets and issuing debt (straight fiscal policy)4. Spending money without borrowing (even writing this! Bravo! Bravo!)

So lets just call it all fiscal policy, no matter who does it, because it all involvesspending and not exchanging money for term money.

Now, to your point on "Store of Value". You need to be pounding the table that weshould strive to make money a moderately poor store of value compared to other assetsright now. You are, but in such a "professorly" way that Andrea Mitchell might notunderstand you the first time.

Why?

1. It seems quite clear to me that the unit of account and medium of exchangefunctions create the store of value property. Note we use paper and magnetic fields torepresent money now - things without value - so the "value" part must result from theother properties of money. This is common to nearly everything - value results fromother properties.

But unit of account and medium of exchange are what scoreboards do and tradingdoes.

If "store of value" means "I can trade this for something valuable in the future" - and Ithink that it does - then why should the idea of a trading pit with a scoreboardattached be a better store of value than a physical car or factory?

We need to lower the price of money in assets, it is too dear. Until this is done, oureconomy will remain broken.

Reply September 30, 2010 at 09:16 PMRalph Musgrave said...DeLong claims in his first sentence that people short of cash will sell the nearestequivalent, e.g. bonds. The flaw here is that the large majority of those who are short of

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cash just don’t have bonds to sell. To illustrate, about 99% of U.K. national debt is inthe hands of institutions, not individuals. And even to the extent that governmentbonds ARE in the hands of individuals, I guess these will mostly be high net worthindividuals: not the sort of people who will cut their spending because of a mere creditcrunch.

That is much the point made by JCB above, but I thought I’d put it in my words.

Reply October 01, 2010 at 02:55 AMStatsGuy said...

1) Yes to Joe Gagnon's observations. I have yet to read something he's written that Idisagree with. Note that the real foes here, the pop-Austrians, no longer distinguishbetween Keynesians and Monetarists, or QE and printing physical currency.

2) I do wish the academic debate would move beyond the purely domestic policyquestions and focus more on the questions that are driving the markets - which areinternational. What happens, for instance, when there is an exogenous fixed long termincrease in demand for finite supply commodities/resources due topopulation/standard of living growth in developing countries? In such an environment,it seems that it's quite possible for pure QE (with long term but not permanentinjections of money/credit) to generate inflation via commodity-driven carry tradeseven in a Keynesian model - it's simply not the kind of inflation we all want, nor doesit necessarily support investment in value added economic activity. It does, however,create strong incentives to spend effort to redeploy commodities as economic stores ofvalue.

Reply October 01, 2010 at 08:14 AMAuOso said...So, who has some helicopters? We need to do something NOW.

Reply October 01, 2010 at 02:28 PMFrank Moraes said...I had to read this column a few times before I understood it. Part of this was due tomy general lack of intelligence. Part of this was due to the material, which _was_challenging--even, I suspect, for someone really smart. And part of this was due toyour use of dashes.

I too am a lover of the dash; I use it all the time. And you are to be complimented forstanding firm against the forces that would put spaces before and after the lovelies: the_New York Times_ comes to mind. However, I think maybe you're over-doing thedashes; commas are nice sometimes, too. This isn't a complaint--just something toconsider.

Also, as much as I love the engine-caboose construct of "--," the properly typeset m-dash has a poetry that makes my heart sing. You are thinking and writing and thedouble-hyphen just comes naturally. I understand. But is it really _that_ hard to type"& mdash;"? (Without the space.) Again, just a thought.

I hope you take these suggestions in the filial way in which they were intended--one(lesser) dash lover to another (greater).

PS: Comments don't allow _me_ to format my dashes as I would like.

Reply October 01, 2010 at 08:12 PMDon the libertarian Democrat said..."Thus, helicopter drops are just monetary + fiscal policy."

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That's called The Chicago Plan of 1933.

Reply October 01, 2010 at 09:14 PMThe Money Demand blog said...Short response: after Lehman the relative price of very safe but less liquid assets suchas TIPS has crashed.

Long response here: http://themoneydemand.blogspot.com/2010/10/brad-delong-and-flight-to-safety.html

Reply October 02, 2010 at 07:03 AMComment below or sign in with TypePad Facebook Twitter and more...

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Economists Debate The Philosophy Behind British Budget CutsNPR (blog) - 12 hours agoBrad de Long, an economist at UC Berkeley, and a prolific blogger, is quoted in theTimes as mourning the dismissal of Keynes. ...Related Articles » « Previous Next »

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Me: Economists:

PaulKrugmanMark ThomaCowen andTabarrokChinn andHamiltonBrad Setser

Juicebox

Mafia:

Ezra KleinMatthewYglesiasSpencerAckermanDanaGoldsteinDanFroomkin

Moral

Philosophers:

Hilzoy andFriendsCrookedTimber ofHumanityMarkKleiman andFriendsEricRauchwayand FriendsJohn Holboand Friends

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