I meant to link this last week… but such is life when trying to convince your advisors you’re ready for the job market.
I went after Prof. Delong for having an abnormal view of how normal monetary policy works but I didn’t tell you what the actual non-abnormal normal view was. Prof. Sumner does:
Now consider [a] temporary currency injection. We know that the long run price level doesn’t change. Once the money supply returns to the original level (a year later) prices should also return to the original level. At first you might assume that monetarists would claim that the price level would double, and then fall in half. But consider the real interest rate. Monetarists typically assume that real variables like the real interest rate aren’t much affected by monetary shocks. But if prices doubled, and then were expected to fall in half, the expected real return on currency would be 100% in year two. That is, the purchasing power of money would be expected to double in year two. More likely, almost all of the temporary currency injection would be hoarded and prices would rise by just one or two percent—the risk free real rate of return.
Astute readers might notice that this thought experiment is quite close to the model Krugman used to explain the liquidity trap in Japan…. In fact, monetary policy is not about swapping currency for T-bills. It is about changes in the future path of currency (relative to demand.) Because money doesn’t affect interest rates in the long run, those changes lead… to a change in the future expected price level. And that has an immediate effect on all sorts of asset prices; including stocks, commodities, and real estate. And if wages are sticky (and they are) this also has an immediate impact on employment.
In retrospect, the surprise about the stimulus debate, to me, was that there’s a big chunk of economists that doesn’t seem to understand how monetary policy works, at least from the perspective of research over the last 30 years. In a sense, big chunks of economists were speaking different languages; those speaking modern macro and those speaking… umm… 70’s macro. The frustration in the debate, the heat generated, was derived from the fact that both chunks of economists didn’t realize they were speaking different languages.
Which begs the question: what the hell chunk did Krugman belong to?