Evan Soltas
Feb 8, 2012

Dollars and Sense?

Smart people saying dumb things about monetary policy


I see that Mark Perry of Carpediem, for whom I have the highest respect, re-posted an article by Mark Calabria of Cato--the argument, apparently, is that monetary policy is wholly ineffective, and that all it does is transfer income.

...Are you kidding me?

Let me provide you the key quotes, and then I'll go through, point-by-point, to show where they are wrong:

[L]ow interest rates involve a transfer of wealth from net savers to net borrowers, but no net increase in wealth. Conversely, when contractionary monetary policy raises short-term interest rates, it's great for savers but bad for borrowers and transfers wealth from net borrowers to net savers, with an overall net wealth effect of zero...the overall net effect on the economy has to be zero...We should stop pretending that monetary policy that lowers interest rates is good for the overall entire economy, and recognize that it's only good for 50% of the economy and bad for the other 50%.
Perry and Calabria contend that an expansionary monetary policy redistributes income (they write "wealth," but the graph they use is of income). This is incorrect. Monetary policy is redistributive insofar as actual inflation differs from expected inflation, because then the ex ante real interest rate does not equal the ex post interest rate.

For a simple example, if you take out a car loan at a nominal interest rate of 7%, anticipating inflation of 4%, then your ex ante real interest rate is 3%. But if inflation is actually 6%, then your ex post real interest rate -- the one you actually pay in real terms -- is only 1%. That would represent a transfer of expected income from lender to debtor, just as unexpectedly low inflation would transfer income from the debtor to the lender. The key here, however, is that the change in inflation is unexpected. If it is fully anticipated by both parties, then the debtor pays what he/she expected to pay, and the lender receives what he/she expected to receive, in real terms. No transfer of income involved.

Whether Fed policy caused unexpected inflation or disinflation not the argument Perry and Calabria are making--although it is worth noting that this recession saw a sharp and unexpected drop in inflation, which would have, as shown above, transferred income to lenders. I don't see a strong argument that the currently "highly accommodative" monetary policy is unexpected; in fact, the Fed's been significantly more transparent and careful to calibrate expectations than ever before.

(I want to add a quick caveat here to the counterargument I have just made. In the real world, increases in the money supply are injected into credit markets, which to some degree reach certain people before others, increasing the purchasing power of their income temporarily over others, according to research by Oliver Ledoit at the University of Zurich.)

The second contention--that monetary policy has "no net increase in [output or income]...the overall net effect on the economy has to be zero"--of Perry and Calabria is even sillier. (I have replaced the word "wealth" again because in the context of the article, it is clear they are thinking about output or income.)

The problem with their reasoning is they assume that the supply of loanable funds remains constant. That's false. The entire point of monetary accommodation is to boost the supply of loanable funds in the short run and drive down interest rates in that time frame as a stabilization policy. Using the IS-LM model above (see an explanation here), we can see how monetary policy, in the short run, will boost output, and not just depress interest rates. The low interest rates and larger supply of loanable funds directly stimulates investment and has indirect positive effects on consumption and exports. We see this as as the shift from A to B on the IS curve, created by the shift of the LM curve.

What's strange is that Perry seems to recognize this in his other online writings:

"Unexpected expansionary (contractionary) monetary policy will temporarily increase (decrease) output and employment...Expansionary monetary policy will stimulate an economy in recession toward full employment."
That is the correct answer.

(PS. Perry also mentions briefly the problem of the zero lower bound, but the reference and why it matters to his distributive analysis is obscure. In fact, if the nominal interest rate is zero, then expansionary monetary policy cannot push the short-term nominal interest rate any lower, so of course there can be no nominal change in income between debtor and lender. In other words, the LM curve is flat when i = 0, so obviously shifting the LM curve to the right--a monetary expansion--will have no effect on the short-term interest rate when the intersection of IS and LM already occurs at i = 0.)