June 30, 2003

A Correspondent Asks...

"Why do you say that it is so foolish for Lawrence Kudlow to compare May-June to March-April rates of growth of the monetary base and to conclude that monetary policy is becoming more restrictive?"

The answer is that month-to-month monetary base growth rates are very, very noisy. Banks' demands for reserves and public demand for currency fluctuates a lot on a month-to-month basis, especially if you express changes as annual growth rates (which Kudlow does). For example, take a look at the month-to-month changes in the monetary base since the start of 2000:

But does this bounciness mean that monetary policy is extraordinarily restrictive one month and extraordinary expansionary another? No. It just means that the demand for high-powered money is noisy, and thus that a central bank that wants to stabilize short-term interest rates (or any of the broader measures of the money stock) will find that it has to make the monetary base bounce around considerably from month to month.

Why, then, does Kudlow think that comparing March-April to May-June growth rates is an interesting number? I have no idea. I've never met any monetary economist who understands why either.

Posted by DeLong at June 30, 2003 05:58 PM | TrackBack


We should have learned these kinds of old tricks of the trade from the neo-con boosters a long time ago. It's pure simple propaganda, always has been, including the celebrated 'Laffer curve'.
The method is simplicity itself:

1.) Pick a dull little used and 'long ignored' stat. It need not show much, but be able to be esily manipulated in order to prove your pet theories. It is therefore USEFUL in being 'noisy' and well nigh 'uninterpretable'.

2.) Claim to have 're-discovered' said series of stats. and their critical importance to the sector you desire to affect. Reinterpret said stat. to 'show' how this one or series has behaved as you desired in the far or recent past, and making a leap of logic, insist that it can only or generally do 'X' given your good graces and the prospect of a 'good' economy or a number of obscure circumstances that only you and/or your cronies are able to discern.

3.) The very zenith of you art will come in a new
millennium when you can thus pronounce 'down' is 'up' economically to the bewildered public and have very little opposition in doing so. Illogic and news-speak having taken the land by storm via the <6 main media conglomerates, there is no longer any real 'negative news', (not for long) and the job's much easier still. Your flunkies will now be reduced to forever claiming that their pet obscure 'indicators' are always on the rise. Before, during and after the bubble you'll be able to do this all day long, because no one is paying too close attention.
(See: Wag the dog scenario #1- 7)

So the answer lies not in the numbers, it's in how you play the numbers before the rubes. (See : CNBC broadcasts 1997-2002) You play well, and you go home richer, and the rubes loose. You play poorly and you go home a little less richer [perhaps], but the rubes loose worse. Until someone comes out and says: 'Gee Larry, this is quite some career of BS you've managed to make a fortune on', you'll never know how it might work out. I'm betting anyone serious enough to do so persistently, (and IF ever given the chance), will be offered a piece of the franchise. That's the way it works in the modern media. Facts no longer matter. Reality long ago was banished from the stage as being too depressing to the rubes, it too easily frightens the crowds.

Posted by: VJ on June 30, 2003 11:09 PM

I was reading an argument a while ago about whether or not the fed targets the money supply. As shown by DeLong, the interest rate is targeted at some level i*, and the money supply is the instrument that you must adjust (very frequently) to reach that target interest rate. The reason why you have to adjust the money supply so much is that demand for money fluctuates or, almost same thing, that the short run velocity of money is not constant.

This is how I understand it so far:

So we have the quantity of money identity


which implies that their growth rates are

m + v = p + y

I'm also going to assume sticky prices in the short run, and ignore supply shocks, so the growth rate of P (p which is inflation) is the same. If the short run velocity of money (I'm not sure which aggregate I'm talking about here) V = PY/M = Y/L(Y,i) were constant, and if the fed chose a steady growth rate of nominal money supply that would equal the growth rate of nominal output, these would be the growth rates.

m + v = p + y

m + 0 = p + y = m

Since velocity is constant we know

Also v = y - l = 0
and hence
l = y

since we know that
m = p + y


Therefore the growth rate of the supply of real balances (m-p) and the growth rate of the demand of real balances (l) both = y

which implies that if M/P = L(Y,i) it will continue to do so under this monetary growth rule.

But what if velocity is volatile in the short run?

this implies that although m - p = y under the fed's monetary growth rule

v = y - l does not = 0

and therefore this could not keep PY or i the same

Let's say that v is temporarily greater than 0

which implies that y is greater than l

therefore m-p = y but l is less than y

and hence soon M/P is greater than L(Y,i). In the money market i must decrease. A smaller i increases investment and consumption (if substitution effects are greater than income effects) in the goods market which increases Y, which offsets the decrease of money demand a little bit. The short run result is greater Y and smaller i.

Let's say that v is temporarily less than 0

which implies that y is less than l

therefore m-p = y but l is greater than y

and hence soon M/P is less than L(Y,i). In the money market i must increase. A greater i decreases investment and consumption (if substitution effects are greater than income effects) in the goods market which decreases Y, which offsets the increase of money demand a little bit. The short run result is less Y and more i.

Therefore this monetary growth rule does not keep i the same.

I guess that the general nominal monetary growth "rule" that keeps nominal output the same should be (though v is not readily observable):

m = p + y - v

so the real money supply grows at

m - p = y - v

since v = y - l
we know that it is always true that
l = y - v

So both M/P and L(Y,i) grow at y - v and hence M/P = L(Y,i) continues to be true under this monetary growth rule.

But I'm guessing that even this monetary growth rule will not keep the interest rate the same if IS curve shifts occur, although it will keep PY the same. . . .

Posted by: Bobby on July 1, 2003 02:35 AM


You lost track of what you were trying to do while going through the math. Let's start with V= Y/L(Y,i). Why is this? Well, it comes from the eqaution of exchange: V=PY/M and money demand: Md/P=L(Y,i). Assuming demand equals supply (Md/P=M/P): V=Y/L(Y,i). So your result goes back to the assumption of M/P=Md/P=L(Y,i).

So what you have is that the money supply should change in response to money demand changes. This gets back to whether money growth targets will work. Under a monetarist view, the Friedman money demand is of the form Md/P=L(Y) leading to a velocity of V=Y/L(Y). And since Y is fairly predictable in the long run at least and price level is determined by past money growth, an relatively easy money target can be established.

Now if we take a Keynesian style money demand of Md/P=L(Y,i)and base it on a more fully developed model of the economy things get complicated really quickly. The reason being is that M,P, Y, and i and not independant variables. A change in one can affect others, For example, and increase in Y can lead to higher price level as well as higher i. A chnage in M affects the other three, making the correct target very difficult to determine.

Posted by: Rob on July 1, 2003 09:03 AM

"That's the way it works in [much of] the modern media. Facts no longer matter. Reality long ago was banished from the stage as being too depressing to the rubes, it too easily frightens the crowds."

Do I ever agree. Forget the propaganda of Fox, PBS News is pablum.

Posted by: lise on July 1, 2003 09:49 AM

Washington Post

Lawrence Kudlow is an economist, contributing editor of National Review magazine and frequent guest on "The McLaughlin Group," where he often argues in favor of deep tax cuts. He is also a recovering alcoholic and cocaine addict.

Kudlow attributes his bout with drug and alcohol abuse partly to the pressure he felt when he was chief economist and senior managing director of Bear, Stearns & Co., a Wall Street investment firm....

Posted by: Who on July 1, 2003 10:57 AM

I actually shook Larry Kudlow's hand once on a plane to D.C. When I asked, "Are you Larry Kudlow? . . . Can I shake your hand?" he looked terrified but did stick out his hand sheepishly -- it was an odd experience.

Rob. I apologize. Could you please rephrase what you were saying in your post. As it reads, I am not quite sure what you are trying to say. I've only known the MV=PY equation for about a month now, since they didn't teach it in my undergrad intermediate macro class -- it is puzzling to me. I was really trying to put the argument that growing money supply at a constant rate does not imply a constant i. The reason is that money demand shifts which shift the LM curve and change the nominal interest rate. I was trying to translate this into quantity theory language. I figured that V = PY/M = Y/L(Y,i) would allow me to do this, but apparently I failed.

Posted by: Bobby on July 1, 2003 12:12 PM

rather a reason. IS curve shifts also change i and so do supply shocks even under a constant growth rate of M

Posted by: Bobby on July 1, 2003 12:15 PM

This might be made a little simpler if people understood that when the Fed targets interest rates it gives up all control of the money supply. When it targets a money aggregate it gives up all control of interest rates. This was explained quite simply by Poole (currently a Fed governor) in a 1970 article. Essentially to maintain a certain interest rate the supply of money must be made perfectly elastic. In order to target a monetary aggregate the money supply becomes perfectly inelastic. This explains a number of things:
1) Why the monetary aggrgates, including high powered money seem so noisy. The Fed shovels out and takes back huge amounts of money in its open market operations edahc day.
2) Why Kudlow is soo idiotic-Here you have a guy reading tea leaves in a coffee cup. He is observing a variable, explaining a variable and doesn't have a clue that maybe the variable is made meaningless by a certain policy.

Posted by: Lawrence on July 1, 2003 05:40 PM
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