Thursday, May 05, 2011

Why Money Isn't Irrelevant

Matt Rognlie attacks monetarism and more broadly the belief that money matters, which Austrians also believe indeed, even more so than the so-called monetarists. I am more of an Austrian than a Friedmanite, so I feel no need to defend Friedman's theories, but I do want to defend the idea that money matters.

In his first paragraph he argues that the traditional monetarist accounting identity MV=PY, where M is money supply, V is "velocity" and PY is nominal output, is a tautology. That is sort of true since V is defined as PY/M, or in other words the number you get when you divide nominal output with money supply, and the equation is then created by multiplying both V and PY with M. However, to the extent it highlights that money demand and money supply both influence inflation and growth, it is more than just a tautology.

In his second paragraph he claims that because V isn't entirely stable since money supply growth and nominal GDP growth sometimes differ, nominal GDP growth "does its own thing" which I assume means that neither money supply nor money demand influences. But that doesn't follow at all. All it shows is that M=PY would be an incorrect assumption, and that money demand also matters. The reason why there is V is in fact because M is not equal to PY. If V had been stable by contrast, it would have been more useful to formulate it as M=PY, but since it's not, we formulate it as MV=PY.

He later argues that nominal interest rates is sufficient in considering whether monetary conditions are "easy" or "tight". But that is not true because nominal interest rates can be low for very different reasons, including:

1) Low inflationary expectations (including expectations of deflation).
2) High savings rate
3) Low investment demand
4) Falling demand for money
5) Higher supply of money

This is very relevant since this illustrates the difference between the low nominal interest rates that we saw in the U.S. during the housing bubble, which was a result of factors 4 and 5, and the low nominal interest rates that we saw in Japan during that same period which was a result of factors 1 and 3. In the cases of 4 and 5, the result is as we saw in the U.S. price inflation, including asset price inflation, in the cases of 1,2 3 by contrast there will not be any price inflation, as we saw in Japan.