July 07, 2003

The Long Dark Night of the Soul of the Monetary Economist: A Platonic Dialogue

Glaucon: You want to get really disturbed?

Admetos: No!

Glaucon: Too bad! How large an intervention does the Federal Reserve typically have to make to change the Federal Funds rate by 0.25 percentage points? And to change other interest rates in proportion--the one-year note rate by 0.10 percentage points, the seven-year note rate by 0.05 percentage points, and so forth?

Admetos: Sometimes nothing... sometimes its in the hundreds of millions... sometimes more...

Glaucon: OK. Let's take the case of a $100 million open market operation. So to raise interest rates the Federal Reserve sells $100 million worth of three-month Treasury bills for cash. Afterwards the private sector has $100 million more less of reserve deposits in its collective accounts at the Federal Reserve on the asset side of its balance sheet. Afterwards the private sector has $100 million more of interest-earning government bonds on the asset side of its balance sheet.

Admetos: Yes. And because of the government purchase, the supply of bonds has risen. So by supply and demand, the prices of bonds fall--and that means that interest rates rise.

Glaucon: And what are the total financial assets of the U.S. economy?

Admetos: back of the envelope? $11 trillion in annual GDP. Perhaps some $35 trillion in the total capital stock. Most of that is securitized and tradeable one way or another. Perhaps $20 trillion of net financial asset wealth--counting in intermediaries would produce a much bigger figure, of course.

Glaucon: And what proportion of $20 trillion is $100 million?

Admetos: Five-ten-thousandths of one percent. Why?

Glaucon: And Treasury bills and reserve deposits are assets with very similar properties, are they not?

Admetos: Yes...

Glaucon: So you are telling me that when the central bank takes steps to alter the gross composition of the private sector's asset portfolio by five-ten-thousands of one percent--and to alter the net composition by much less, for these assets are very close substitutes--this shakes the entire intertemporal price system? That supply and demand elasticities are such that the future one year hence drops in price relative to the present by one-tenth of one percent? Doesn't that imply a cross-elasticity of demand for liquid spending power one year hence of 200? Even in the case when a $1 billion intervention is required, that's a cross-elasticity of 20. And when there is no intervention required, the cross-elasticity is infinite... Aren't these numbers a little... high?

Admetos: But if everyone expects today's open market operation to be followed by a whole sequence of operations in the same direction in the future...

Glaucon: But they don't, do they?

Admetos: But if everybody expects the Federal Reserve to do what it needs to do to make its policy effective...

Glaucon: They will front-run in advance to try to profit, and so change their own desired portfolios. But we no longer have a well-defined private-sector asset demand curve as a function of risk, return, and asset quantities, do we? Instead we have herd behavior coordinated by a single large actor in the marketplace, don't we?

Admetos: It would seem so...

Glaucon: Is this what we teach our students?

Admetos: No...

Glaucon: Are you disturbed? This was the late Fischer Black's argument that monetary policy could not have the effects attributed to it--that the changes in asset portfolios were simply too small...

Admetos: And the answer is?

Glaucon: There is no answer--at least, none that I know.

Admetos: Yes. I'm now looking forward to the long dark night of the soul of the monetary economist... Posted by DeLong at July 7, 2003 06:03 PM | TrackBack


Uh...so is the answer that Alan Greenspan acts in the World of Forms, where his actions are intelligible, but that his forms cast vast shadows because his plane is so far above hours and is closely backlit by really, really powerful spotlights? And that the shadows in our world are, of course, imperfect and noisy, so even though Greenspan's actions are clear and bell-toned, our markets are chaotic and noisy?

Posted by: Jonathan King on July 7, 2003 07:50 PM

"[S]everal economists have suggested that open market operations may not be necessary for controlling the funds rate. Rather, they suggest that the Fed controls the funds rate through open mouth operations. The Fed merely indicates its desire to change the funds rate and the market does the rest.

"This paper investigates the extent to which the close relationship between the federal funds rate and the federal funds rate target is due to open market or open mouth operations...."

And it considers a third possibility too.


Posted by: Jim Glass on July 7, 2003 08:12 PM

Thanks, Brad.

Posted by: Faith Witryol on July 8, 2003 12:51 AM


One seeming monetarist has woken up from the Long Dark Night ...


Double bubble of Fed's own making
By Melvyn Krauss
Financial Times: July 7 2003

"Moreover, the US bond bubble was creating an unwanted European bond bubble as well.

Suffice it to say that the Fed's credibility suffered a significant blow when, at the June FOMC meeting, it opted to economise on its scarce supply of conventional bullets rather than push the new frontiers of monetary policy. " ...

"The unpleasant truth is that Mr Greenspan and his colleagues first created the bond bubble with their radical rhetoric, then burst it with their conventional actions." ...

Mr Greenspan is the "double bubble" man - not Mr Duisenberg. The Fed's fall from grace is valuable if only for putting the achievements - and shortcomings - of the ECB and Mr Duisenberg into proper perspective.

Posted by: Faith Witryol on July 8, 2003 01:18 AM

If you can, I would suggest getting hold of an old research discussion paper from the Reserve Bank of Australia: Bob Rankin, "The Cash Market in Australia", RDP 9214. The Australian cash market is the equivalent of the Fed Funds market.

The market for Fed Funds is demand driven, with the clearing banks on one side and the Fed on the other. The desired level of Fed Funds is the amount of liquidity that is needed for the market to function smoothly in transferring payments between banks. The central bank supplies whatever the market needs, at the target rate.

As for changing the rate, it is like a 'credible threat'. The Fed doesn't have to change supply to force a rate change, simply because is CAN change the supply. Better for the market to accommodate the rate change, rather tham have its collective arm twisted by the Fed. When there is some supply change, this is possibly the Fed doing a little bit of arm-twisting to bring recalcitrant market participants into line.

Posted by: Mark on July 8, 2003 01:19 AM

Having just done a course in graduate macro, I was depressed to discover that the theory largely still thinks the money supply is what it's all about.

Posted by: Mark on July 8, 2003 01:26 AM

Not any worse than talking with a free trader, makes you want to turn into a salmon so you can swim upstream and die.

Posted by: northernLights on July 8, 2003 03:26 PM
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