Just Do It: One Approach To Monetary Policy

There are a wide variety of ways of thinking about monetary policy. In this post, I’ll use some graphs to illustrate various policy options, with the goal of shedding light on some of the major debates of the past decade.

Let’s start with a shift from a zero percent target path for inflation to a 2% path. Let’s also assume that the Quantity Theory (QT) holds in the long run, in the sense that prices move in proportion to changes in the money supply, other things equal. But in the short run, money demand is negatively correlated with nominal interest rates. (Don’t worry if you don’t like the QT, this example will have anti-QT implications.)

Let’s assume that it is Japan that switches from a zero percent inflation path to a 2% inflation path. Also, assume that the new path pushes nominal interest rates up from 0% to 2%. (I.e. assume a zero real rate of interest, for simplicity.) And finally, let’s assume that that demand for base money in Japan is 100% of GDP at zero interest rates and 10% of GDP at 2% nominal interest rates. (Not implausible assumptions, BTW.)

In the following graph, path A shows the path of the money supply that would push inflation from 0% to 2%, without any discontinuous change in the price level at the point where the policy change occurs.

(Click on image to enlarge)

Even though the money supply plunges by 90% at time=0, the price level does not show any immediate change. The Japanese suddenly prefer to hold much smaller cash balances, because the opportunity cost of holding base money has risen from zero to 2%/year.

Once money demand has fallen by 90%, it levels off. From that point forward, the BOJ must raise the money supply at 2%/year in order to generate 2% annual inflation. It takes 72 years for the price level to quadruple, but even then the money supply remains 60% below the level just before the change in policy.

So far I’m assuming that everything works smoothly. The policy change is credible and is expected to persist forever. The Japanese attitude toward money changes immediately, to become more like the Australian attitude. Japanese salarymen suddenly start refusing overtime, and instead go home and put on shorts, throw a few shrimp on the backyard barbie, and make rude jokes about Sheilas.

That’s already a pretty heavy lift, but it gets much worse. Let’s suppose that the money supply follows path A for 72 years, and then is expected to level off (as in path B). What then?

In that case, everything changes even today, at time=0. The hypothesis that the BOJ could reduce the money supply by 90% and at the same time start on a path of 2% inflation is entirely dependent on the public believing that this new policy will last forever. If it lasts for “only” 72 years, the effect will be radically different.

Under path A, the price level is four times higher after 72 years. Under path B, it is 60% lower than at time=0. That’s because path B leads to zero money growth and zero inflation in the long run. That means that 72 years from today, real money demand will be just as high as before the t=0 policy shift, and since the money supply is assumed to be 60% lower, the price level will also be 60% lower. The path of prices over that 72 year period will also be vastly different, but I’m not smart enough to show exactly how different.

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