Mainstream Economists Completely Incoherent on the Effects of Monetary Policy

Confused Thoughts1

Bill Mitchell has a post up on his blog today criticising Mankiw’s textbook which apparently has a new edition coming out. Basically Mankiw is stuck in monetarist-land telling students that “banks control the money supply” and all that other nonsense that should have been done away with  years ago.

Mitchell’s critique is perfectly salient. But on one point I think that he drops the ball. Indeed, moving into the future I don’t think that criticisms will aim at New Monetarists like Mankiw because the profession is gradually giving up the old fashioned Friedman-esque doctrines. The point at which Mitchell makes a mistake is when he discusses the work of Wendy Carlin who is in charge of INET’s CORE curriculum reform committee. He suggests that she will likely be flogging the New Monetarist stuff when he writes:

Even so-called progressives who think they are on top of the situation like the iNET sponsored Wendy Carlin have embedded in their so-called – The 3-Equation New Keynesian Model — a Graphical Exposition – the view that savers provide the funds that the banks lend out for profit.

Well, the paper that Mitchell has linked to does not contain New Monetarist doctrines. Rather it substitutes for the LM-curve a central bank reaction curve that suggests central banks set an interest-rate target — a Taylor Rule. Thus the model recognises that central banks set the interest rate and do not seek to control the money supply.

Other mainstream textbooks have already integrated this insight. Although Paul Krugman has shown time and again that he does not remotely understand how the modern banking system works, his textbook Macroeconomics actually does contain an interest rate target rather than a money supply target (p351). This is not to say that this chapter of the textbook is not confused — it is, Krugman and his co-author flip-flop this way and that on the issue by providing a money multiplier at another point in the chapter (p331) — but they do provide the student with the idea that the central bank sets the interest rate.

The mainstream are a bit of a mess on this one. They still teach the money multiplier but they also teach interest rate targeting. Of course, the Bank of England has, as Mitchell points out, stated clearly that these two theoretical conceptions are mutually exclusive. But this is just more evidence that the mainstream don’t really understand their own theories: they just learn them by rote.

Nevertheless, if interest rate-targeting is the way of the future we must be clear that the criticisms of this approach lie elsewhere. Mitchell gives us some hints on this when he alludes to the fact that such theories are fallacious insofar as they assume instantaneous adjustment (logical time) rather than a realistic portrayal of the investment process (i.e. one embedded in historical time). He writes:

Essentially they claimed that if consumption spending fell as saving rose, more funds would be made available to the loanable funds market. The higher saving would drive down interest rates because there would be an oversupply of funds to the market relative to the current investment level.

The lower interest rates would stimulate higher investment and eventually the saving and investment changes would become equal at some lower rate than before and the spending lost to consumption would be made up by the higher investment spending. Therefore there could never be any deficiency in demand.

You will read that with a certain amount of incredulity I am sure as I did when I studied the rubbish. Basic first question – How does a firm that produces consumption goods suddenly become an investment (capital) goods producer? What about sectoral imbalances? What happens when the dynamic is the opposite?

These are important points. But the key criticism lies elsewhere: there is no natural rate of interest because, as Keynes showed us well, investment decisions are undertaken based on subjective expectations. Keynes assumed that interest rates did have an effect on investment but that these could be ‘drowned out’ by the lowered expectations of the investment community. Ultimately Keynes thought, quite rightly, that it was the expectations that were more important than the interest rate.

In fact, empirical work done since then has shown that interest rates seem to play little or no role in how businessmen and businesswomen decide on how much to invest. This is generally recognised today as Frederic Mishkin shows in his paper The Channels of Monetary Transmission: Lessons for Monetary Policy. He says that the general consensus is that the manner in which changes in policy interest rates have their effects are through the following channels:

1. Exchange rate effects — a fall in interest rates will (sometimes) lead to a weakening of the currency. This will boost exports and curtail imports.

2. Equity prices — a fall in interest rates might lead to rising stock prices which might stimulate investment and may also lead to a ‘wealth effect’ that raises consumption.

3. House prices — a fall in interest rates might lead to a pick up in house prices and thus to new investment in this sector.

4. Balance sheets — a fall in interest rates will cause financial instruments to become more valuable and this will strengthen balance sheets which may encourage borrowing/lending.

Note carefully that these affects might occur. It is by no means assured that they will occur. But even leaving this aside this is no longer a very straightforward question. In the textbook fairytale a fall in the rate of interest leads to higher investment. Thus there is some sort of nice equilibrium balancing going on. But if Mishkin is correct that the channels through which it actually works (when it works) are the above ones this does not fit nicely into the abstract fairytale model.

The above effects also do not suggest that the economy will move toward equilibrium. In the fairytale story the economy re-equilibrates through the assumed adjustment mechanism. But the above channels more so suggest that the economy will, at best, get a simple one-off boost. This is what Post-Keynesians like Joan Robinson, Nicholas Kaldor and Michal Kalecki said years ago. They never bought into the equilibration story because they were fundamentally dynamic economists (even though their theories occasionally didn’t reflect this) and they saw lowering interest rates as the equivalent of eating a sugary snack on an empty stomach: it might work once, for a few hours, but soon you’ll need another sugary snack or you’ll crash.

The history of the era of interest rate targeting bears this interpretation out too. We can basically date interest rate targeting in the US to around 1984 when monetarism and money supply controls were thoroughly abandoned. After this the interest rate was on a slippery slope downward until it hit the zero-lower bound. The following chart shows the real overnight interest rate in the US from that period (i.e. the nominal overnight rate minus the rate of inflation).

REALinterest rates

After 2008 the central bank basically ran out of sugary snacks and the economy slipped into a diabetic coma. (A similar story can be told for the UK although the monetarist era ended slightly later).

The empirical work done by the mainstream today suggests that there is no such thing as a natural rate of interest. Yet the modellers still assume that this does exist. This is yet more evidence of the incoherence in the mainstream that I have noted on this blog before. In this case it is because the modellers want to keep their equilibrium tools intact even though they do not fit the material that they are trying to use them on. This should also provide a serious warning for Post-Keynesian economists who have slipped into using comparative static tools to undertake what needs to be dynamic analysis.

Update: On the Krugman front Dirk Ehnts did a nice job last year showing how the good doctor flip-flops on this issue. When I read Krugman and Wells’ macroeconomic textbook I got the distinct impression that Krugman probably didn’t write the section on money creation and interest rates. If I’m wrong and he did then that is even worse because it means that he was cutting and pasting rather than understanding the material that he was putting together for students.

One point on which I would correct Ehnts is that the demand for loans can actually affect interest rates, just not in the way that Krugman thinks (i.e. not in the ‘loanable funds’ way). Interest rates in the economy gravitate toward the overnight central bank rate but the spread between this rate and other interest rates is determined by risk perceptions of the market (Keynes’ ‘liquidity preference’). So, if lots of people demand loans in theory the market could price in the fact that since more people are borrowing these peoples’ risk levels are higher because they are borrowing more.

But this is only one of many possibilities because risk perceptions are not what economists call ‘rational’. Rather they are set in line with subjective expectations. In a period of very buoyant borrowing risk perceptions will probably — ala Minsky — become far more accommodating. This is certainly what we saw in the run-up to 2008 and we have also seen it after the Fed’s easy money policies did their magic and dragged the economy out of a liquidity trap in 2009-2010 (yes, stop listening to Krugman about almost everything monetary; we are out of the liquidity trap for now). So, in contrast to what Krugman thinks at a time of very high borrowing it is quite likely that interest rates will actually fall as the good feelings and gnarly vibes work their way through that rather ridiculous hall of mirrors known as the financial market.


About pilkingtonphil

Philip Pilkington is a macroeconomist and investment professional. Writing about all things macro and investment. Views my own.You can follow him on Twitter at @philippilk.
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8 Responses to Mainstream Economists Completely Incoherent on the Effects of Monetary Policy

  1. helsworth says:

    Shouldn’t that “natural” rate of interest be zero, since we’re talking about fiat money? But I guess you were talking about people who think that governments and CBs are “manipulating” the interest rate – as if God/the Market had some default setting on this question. The again, these sort of people look at the fiscal deficit as something the government controls to “ruin/subjugate” the economy – rather than looking at it as the effect of private sector’s behavior. All welfare workers and welfare recipients should get a leaflet explaining the role of the automatic stabilizers.

  2. NeilW says:

    I still wonder why we are still talking about monetary policy? It’s like driving a car by ignoring the steering wheel and throwing your weight from left to right trying to find the right position to get the wheels to move.

    I cannot find a reason to use interest rate changes to drive an economy that doesn’t rely upon metaphysical beliefs and religious objections to elected governments intervening on behalf of the citizens they represent.

    Park the interest rate (probably at zero) and leave it there.

    Then grab the steering wheel.

    Enhance the auto-stabilisers to allow the vehicle to maintain a course throughout the business cycle and then set discretionary policy within parliament to choose a course.

    There seems to be a glossing over the simple fact that for monetary policy to do anything somebody has to borrow money and come up with a way of paying it back. There are a limited number of circumstances where that is a sensible idea given an alternative.

    • helsworth says:

      That’s because the magicians (mainstream economists) don’t tell us that monetary policy is a swap operation – nrs changing between the securities account to the reserve account. And the politicians are even worse, since they demonize government spending every day – yet, ironically, they’re the ones pleading people to come out and vote them into office. The most tragic thing, in my opinion, is the fact that even the citizens are reluctant to ask for more spending in key sectors or less taxes – because they’re afraid they will leave their children indebted. Or that they are simply eating more cake now, and there will be no cake (more taxes/no money in their pockets) tomorrow.
      This has got to stop. I find it easy to explain the sectoral balance accounting identity to 12 year olds; but that’s because they’ve not been indoctrinated by conventional wisdom.
      Btw, more bad news for my country (Romania). Basescu is pushing us into shrinking the fiscal deficit from where it is now (at 2% of GDP) to 1%. Luckily, the trade balance has improved a little – it’s almost neutral.
      With the right taking once again control in the EU, we’re in much trouble.
      I like how the clueless deficit hawks talk about “debt-induced prosperity”… They’ve no idea that their other kind of “prosperity” is linked with being slave producers to others; making us trade away positive net wealth in exchange for high unemployment, smaller living standards, more social unrest, more violence, and fueling racist/xenophobic tensions.

  3. philippe101 says:


    this paper might interest you:

    The insensitivity of investment to interest rates: Evidence from a survey of CFOs (2014)


    A fundamental tenet of investment theory and the traditional theory of monetary policy
    transmission is that investment expenditures by businesses are negatively affected by
    interest rates. Yet, a large body of empirical research offer mixed evidence, at best, for a
    substantial interest-rate effect on investment. In this paper, we examine the sensitivity of
    investment plans to interest rates using a set of special questions asked of CFOs in the
    Global Business Outlook Survey conducted in the third quarter of 2012. Among the
    more than 500 responses to the special questions, we find that most firms claim to be
    quite insensitive to decreases in interest rates, and only mildly more responsive to interest
    rate increases. Most CFOs cited ample cash or the low level of interest rates, as
    explanations for their own insensitivity. We also find that sensitivity to interest rate
    changes tends to be lower among firms that do not report being concerned about working
    capital management as well as those that do not expect to borrow over the coming year.
    Perhaps more surprisingly, we find that investment is also less interest sensitive among
    firms expecting greater revenue growth. These findings seem to be corroborated by a
    cursory meta-analysis of average hurdle rates drawn from firm-level surveys at different
    times over the past 30 years, which exhibit no apparent relation to market interest rates.

    Click to access 201402pap.pdf

    • helsworth says:

      That ought to give pause for austrians to rethink their belief that the CB gives bad signals to the market via its manipulation (whatever that means) of the interest rate. In our modern monetary system, the “market God” didn’t set a default on it. ^_^

  4. philippe101 says:


    “central banks set the interest rate and do not seek to control the money supply”

    what about QE? The cb is deirectly expanding the base money supply in that case, not just setting an interest rate.

    Also, if the CB pays interest on reserves, then it seems that it can both set the interest rate and control the base money supply at the same time.

    Mainstream types would also usually say that the central bank targets inflation, not that it targets interest rates.

    • They can’t control the base money supply unless they flood the system.

      As to trying to target monetary aggregates in QE I think you’re right that this was a hangover from the New Monetarist rot. You can read this rubbish in Bernanke’s papers and books. Friedman had a huge impact on this generation. Pity the policies didn’t work. Anyway, the money supply control stuff is off the books in the Fed and the BoE. It’s on the way out at the ECB.

  5. Lincoln's economics says:

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