Thursday, November 6, 2014

The Neo-Fisherian Question

On the "Neo-Fisherian" idea that maybe raising interest rates raises inflation, Nick Rowe asks an important question. What about the impression, most recently in a host of countries that seemed to raise rates "too early" and then backed off, that raising interest rates lowers inflation? (And thanks to commenter Edward for the pointer.)

Partly in answer, and partly just in mulling it over, I think I can boil down the issue to this question:

If the central bank pegs the nominal rate at a fixed value, is the economy eventually stable, converging to the interest rate peg minus the real rate? Or is it unstable, careening off to hyperinflation or deflationary spiral?

Here are some possibilities to consider. At left is what we might call the pure neo-Fisherian view. Raise interest rates, and inflation will come.

I guess there is a super-pure view which would say that expected inflation rises right away. But that's not necessary. The plot in Monetary Policy with Interest on Reserves worked out a simple sticky price model. In that model, dynamics were pretty much as I have graphed to the left: real rates rise for the period of price stickiness, then inflation sets in.

Now,  here is a possibility that I think might satisfy  Neo-Fisherism, Nick, and a lot of people's intuition:

In response to the interest rate rise, indeed in the short run inflation declines. But if the central bank were to persist, and just leave the target alone, the economy really is stable, and eventually inflation would give up and return to the Fisher relation fold. (I was trying to get the model of "Interest on Reserves" to produce this result, but couldn't do it. Maybe fancier price stickiness, habits, adjustment costs...?)

This view would account for the Swedish and other experience.

We don't see the Fisher prediction because central banks never leave interest rates resolutely pegged. Instead, they pursue short-run pushing inflation around.

And there's nothing really wrong with that if they know what they're doing. If you have a system with this kind of short run dynamics, you can get inflation where you want it faster by pushing the short run dynamics around, rather than pegging interest rates and just waiting for the long run to arrive. Lower rates, which pushes inflation up in the short run, then follow inflation up, with a quick burst of high rates to stop inflation, then back to normal.

I think the revival of Neo-Fisherism occurs by watching our period of zero rates, in which central banks can't push rates down any more. If you held the last view,  raising rates and waiting for the long run seems like a possible strategy.

But these dynamics are not the standard view. The standard view is that the economy is inherently unstable. If the central bank were to raise rates and leave them there, the economy would spiral off to never ending deflation. Conversely, a too low interest rate peg would send the economy off to spiraling inflation.

Now, we don't see such spirals. But that is because central banks don't peg interest rates.

In the standard view, a central bank would soon see inflation spiraling down, would quickly lower interest rates to push it back up again. Upside down, this might be a stylized view of the 1970s and 1980s.

Alas, central banks pushing short-run dynamics around in my second neo-Fisherian view graph would lead to time series and impulse responses that look like this as well.

So in normal times it would be devilishly hard to tell long run stability from long run instability by looking at time series of inflation and interest rates. (Most impulse response functions do feature interest rates with interesting dynamics after a shock. So we can't really tell if the resulting inflation path is due to the initial shock or to the subsequent behavior of interest rates)

We can put the issue more generally as, if the central bank does nothing to interest rates, is the economy stable or unstable following a shock to inflation?

For the next set of graphs, I imagine a shock to inflation, illustrated as the little upward sloping arrow on the left. Usually, the Fed responds by raising interest rates. What if it doesn't?  A pure neo-Fisherian view would say inflation will come back on its own.
Again, we don't have to be that pure.

 The milder view allows there may be some short run dynamics; the lower real rates might lead to some persistence in inflation. But even if the Fed does nothing, eventually real interest rates have to settle down to their "natural" level, and inflation will come back. Mabye not as fast as it would if the Fed had aggressively tamed it, but eventually.

By contrast, the standard view says that inflation is unstable. If the Fed does not raise rates, inflation will eventually careen off following the shock.

We don't see that outcome in the data, because even if not right away (as the Taylor rule recommends), eventually central banks wise up, raise rates, and bring inflation back again.

Which brings us to the current moment.

The last 5 years have brought us a delicious opportunity for measurement. Once we hit the zero bound, interest rates can't move any more. So the whole problem of empirically verifying long run dynamics is a lot easier.

What happened when the Fed kept interest rates at zero for 5 years? Pretty much nothing! OK, you see inflation going up and down, but look at the left hand scale -- one percentage point. Given the colossal scale of other events in the economy, that's nothing. Japan has been at it even longer, with similar results.

We seem to have in front of us a pretty clear measurement that long run dynamics are stable.

"Nothing" is astounding. This dog that did not bark has demolished a lot of macroeconomic beliefs:

  • MV = PY. Sorry, we loved you. But when reserves go from $50 billion to $3 trillion and nothing at all happens to inflation -- or at most we're arguing about percentage points -- it has to go out the window. 
  • Keynesian deflationary spirals. Just as much as monetarists worried about hyperinflation, Keyensians' forecast of a deflationary spiral just didn't happen. 
  • The Philips curve. Unemployment went to levels not seen since the great depression; the output gap went to 10 percent and ... inflation moved less than one percent. Adieu. (Actually, Phillips curve lovers turn this on its head, to proclaim that all we need is 1% more inflation to bring the economy roaring back, but you can see how tortured that one is.) 
  • Fiscal stimulus... well, we'll take that up another day

So, I bring you the question, which is not so obvious as Nick makes it sound.

If the Fed completely and permanently pegs interest rates, is inflation in the long run stable or unstable?

In response to shocks (left arrows) and after a period of short-run dynamics (squiggly path), will inflation eventually return to the Fisher relation?

Or, will inflation eventually diverge -- until the Fed gives up on the target?

Think of holding a broom upside down. That's the standard view of interest rates (on the broom handle) and inflation (the broom). Anytime the Fed sees inflation moving, it needs to quickly move interest rates even more to keep inflation from toppling over -- the Taylor rule. To raise inflation, the Fed needs first to lower interest rates, get the broom to start toppling in the inflation direction, then swiftly raise rates, finally raising them even more to re-stabilize the broom.

The neo-Fisherian view says the Fed is  holding the broom right side up, though perhaps in a gale. To move the bottom to the left, move the top to the left, and wait.  But alas, the broom sweeper has thought it was unstable all these years, so has been moving the handle around a lot.

Theories: Both monetarist and old Keynesian theories are of the unstable sort.

For Keynesian models, I like very much John Taylor 1999 Journal of Monetary Economics This paper (or at least my reading of it starting p. 601 here) shows that old-Keynesian models with fixed interest rate targets are unstable, with explosive eigenvalues. Adopting a Taylor rule with inflation coefficient greater than one makes the economy stable -- the Taylor rule says, move the broom handle more than the top of the upside-down broom is moving, and you'll keep it balanced.

For monetarism, read (re-read!) Milton Friedman's "Role of monetary policy" starting on p. 5 regarding interest rate pegs.

Adaptive expectations are, I think, the key features that make these models unstable. By contrast, new-Keynesian models, with rational forward-looking expectations produce stability with interest rate pegs. They produce too much stability, and thus multiple equilibria. (Stephanie Schmitt-Grohe' and Martin Uribe's papers on this topic are a good place to look.)  Fiscal theory removes the indeterminacy, so seems to give a determinate Neo-Fisherian answer. And it empahsizes, that what will happen both in the short and long run depends on fiscal policy.

At the cost of repeating myself (this means you, Nick!) the issue is the long run stability of inflation under an interest rate peg (and appropriate fiscal policy!), not short-run dynamics. And it's not so easy to tease out of the data, though certainly worth the challenge. A clever VAR, noting periods of forced pegging due to the zero bound, might help.


  1. Hi Professor Cochrane,

    Just wanted to say as a student of macro (mostly from a NK perspective, of course), this is the clearest and most lucid explanation of the Neo-Fisherite position I've read. Thanks for writing it up.

  2. John,

    What about the experiences of Germany in the early 1920s when it pegged its interest rate or the Fed when it pegged rates in the 1940s-1950s? In both cases inflation eventually takes off. Here is a post on wrote a while back that shows the time series graphs for these experiences:

  3. "MV = PY. Sorry, we loved you. But when reserves go from $50 billion to $3 trillion and nothing at all happens to inflation -- or at most we're arguing about percentage points -- it has to go out the window."

    Are you assuming M = monetary base? If so, what about demand deposits?

    1. Fed Up:

      I think John is making an exaggeration here. There is nothing in MV = PY that predicts that the inflation rate will move in lockstep with the money growth rate. For that you need to make some assumptions.

      The derivation is this:

      M * V = P * Q

      dM/dt * 1/M + dV/dt * 1/V = dP/dt * 1/P + dQ/dt * 1/Q

      I think Milton Friedman made the postulation that velocity is relatively stable ( dV/dt is approximately zero ).

      dM/dt * 1/M = dP/dt * 1/P + dQ/dt * 1/Q
      dM/M = dP/P + dQ/Q

      Assuming a stable real growth rate (dQ/Q), then the inflation rate (dP/P) is roughly proportional to the money growth rate (dM/M).

      Get rid of the assumptions of a stable money velocity and real growth rate and you start with:

      dM/M + dV/V = dP/P + dQ/Q

      Any chance that increase in the money growth rate (dM/M) could lead to a decrease in the velocity change rate (dV/V) so that monetary policy has no affect on either real growth or inflation?

    2. Hello Frank Restly,

      First, you are correct that Dr. Friedman assumed that velocity was stable[1]. However even this is not assumed the Fisher Equation can still work well.

      Between the 1st Quarter of 2008 and the First Quarter of 2014 the volume of M2 increased by 34% (3,550 to 4,725 BUSD / Ratio of 1Q 2008 to 1Q2014 = 1.34). The velocity of M2 money fell in same period by 21% (1.940 to 1.533 / Ratio of 1Q 2008 to 1Q2014 = 0.79). If the values are multiplied M2*V2 the change over this same periods is 6% (6893 BUSD to 7243 BUSD / Ratio of 1Q 2008 to 1Q2014 = 1.06).

      So the massive increase in the volume of money slightly offset the massive fall in velocity. Prices increased during this period about 10% as measured by the Personal Consumption Expenditure Chain Type Index 100 = 2009 (99.14 to 108.2 / Ratio of 1Q 2008 to 1Q2014 = 1.10). Gross Domestic Product increased by about 8% (14,890 BUSD to 15,832 BUSD / Ratio of 1Q 2008 to 1Q2014 = 1.08).

      So [delta]M2*V2 = [delta]P*y is approximately correct. Of course only the Federal Reserve Bank (FRB) has no control over V, P, or Q and only limited control over M2. The FRB can control the total amount of currency (i.e. Federal Reserve Notes and coins) and the size of bank reserves but that is only a small portion of the total volume of money.

      Nonetheless, the FRB was able through monetary policy to counter the strong deflationary pressures indicated by falling velocity by a equal increase in the size of the volume of money.

      [1] “The relative stability of monetary velocity and the investment multiplier in the United States, 1897 – 1958″ by Friedman, M. and Meiselman, D. (1963) in Stabilization Policies. Prentice Hall

    3. David,

      "So the massive increase in the volume of money slightly offset the massive fall in velocity."

      Did the massive increase in volume of money offset the fall in velocity or did it in part cause the fall in velocity? What I am asking for is proof / disproof of causality, and if causality exists, which direction does it operate?

    4. Hello Frank Restly,

      M2 velocity has been falling for years now. It peaked in 1997 and has been falling since, although it did revive a bit in the mid-2000's. It resumed its decline in 2007 and then went into a free fall in 2008. The Quantitative Easing Policy did not stop the decline of velocity, it merely prevent prices from falling as well.

  4. "Keynesian deflationary spirals. Just as much as monetarists worried about hyperinflation, Keyensians' forecast of a deflationary spiral just didn't happen."

    What about all the gov't debt that basically replaced a lot of private debt, bank bailouts, and backstopping the money market funds after the Reserve Fund "broke the buck"?

  5. I think that this may be missing one important detail with the focus on interest rates, and that is the growth rate of the money supply.

    In an interest-on-money model, the money supply increases exclusively through interest paid on money. 0% interest here would be roughly equivalent to a gold standard, and that period was indeed historically characterized by a relatively stable price level.

    However, the modern 0% period is clearly not associated with zero growth of the money supply, either of base money or of M2 money.

    Looking at the growth of M2 compared to the federal funds rate, both nominal and real ( we can see periods where both the Fisher-type relationship held (the 80s and 90s), and where it was exactly violated (the 70s). The correlation for the 2000s-today period seems not particularly strong with either model.

    1. Majormax,

      " a gold standard, and that period was indeed historically characterized by a relatively stable price level."

      Not really.

      Inflation rates of 20%+ from June of 1917 thru June of 1920 despite the U. S. being on a "gold standard" - unless you are referring to a non-fractional reserve gold standard.

    2. I was thinking more "super-long-term", like from 1700-1920, but thank you very much for the contradictory data.

      I think widespread fractional reserve banking ends up breaking any sort of neat relationship between inflation and quantity of base money and inflation. That's not to call it bad, but when private banks can issue circulating money in this manner it means we can't be indifferent to their operation in analyses like this one.

    3. Majormax,

      "0% interest here would be roughly equivalent to a gold standard, and that period was indeed historically characterized by a relatively stable price level."

      And so it wasn't the "gold standard" that led to a relatively stable price level, but instead a period where fractional reserve banking did not exist.

  6. John: thanks! I'm coming back to this. Right now my head is full of Stephanie Schmitt-Grohe and Martin Uribe.

  7. sorry guys..respectfully .. I think you are giving to much power to interest rates as a prime mover to an economy in any circumstance..seems to favor theoretical against actual..

    if you take an over-levered ..over indebted economy with huge unfunded liabilities..compounded with bad trade policies..and declining wage growth for last 30 yrs ..a byzantine tax system..and manipulated govt data.. first off what are we actually measuring and controlling?

    we are probably asking to much of the blunt instrument "interest rates" manipulated by CB b-crats w no real economic experience to draw from

    for a real world example of discounting the power of interest rates as prime mover - take Brasil

    1. brasil61, I am Brazilian as well, it looks to me that aggregate demand in Brazil is too dependent on the fiscal stance of government, so rates go up in Brazil to force government cut spending, given the financing constraint...

  8. I like this post. Some random thoughts:

    1. Yes, the macroeconomy is much less unstable than theory says it should be, in a world where central banks set a nominal interest rate, especially at the ZLB. Theory says that black holes are theoretically possible, yet we do not observe them. Why?

    But there are really two puzzles here:

    a) why did inflation not spiral down, given the apparent output gap? (It did in the 1930's, despite the peg to gold providing a nominal anchor setting a floor under the price level.) It seems that inflation was much stickier than I thought it would be. Maybe the history of (implicit or explicit) inflation targeting had anchored expectations even more than we thought it would, so that 2% inflation just became a focal point.

    b) Why didn't output spiral down, given an apparent gap between the actual and natural rate of interest? Maybe the Mr Micawber effect: "something will turn up, and we will return to full employment". Sort of like a Peso Problem, where there is always a positive probability of a big jump up in output.

    But yes, monetary economies are less unstable than regular theory says they should be, given central banks setting nominal interest rates. I don't know why.

    2. I like the broomstick metaphor ("inverted pendulum" in engineer-speak). (Steve Williamson did not like it at all, when I tried to use it with him!) But inverted pendulums don't become right way up all by themselves. We need to change central banks' operating procedures, to make them the right way up.

    3. And expectations don't coordinate themselves either. There's a reason they have a conductor of an orchestra, and a coxswain on a racing eight. Only the conductor and coxswain can get them all to increase the tempo at the same time. Or all change our clocks back one hour at the same time. And I can imagine a central bank coordinating expectations of inflation in much the same way, by calling out a higher inflation target and a higher nominal interest rate at the same time. But without that announced higher inflation target, people could equally well be convinced that the central banker who raises the nominal rate is malevolent, and wants to coordinate everyone on a deflationary spiral.

    4. OK, a model where the central bank setting a higher nominal rate causes inflation first to fall, then rise, is possible. But nobody has built such a model, even in sketch. And it doesn't seem to fit the German hyperinflation, where inflation just rose and rose.

    5. I have now got my head around your model ("Interest on reserves"). A 2 for 1 stock split halves the value of each stock. A continuous 1.05 for 1 stock split, every year, causes the stock to depreciate at 5% per year. But that is exactly the same as setting the money growth rate at 5%, paying the new money as interest on old money, and seeing 5% annual inflation. Your model makes logical sense, but it has exactly the same implications as an old monetarist model, when you see that "raising the rate of interest" means "raising the money supply growth rate", given the institutional setup. But I have not yet got my head around the Schmitt-Grohe Uribe paper. I am deeply suspicious. At first I thought the intuition was the same as paying new money as interest on old money. But now I think they are just implicitly assuming a coxswain to coordinate expectations. "Either Neo-Fisherian result is right, or the economy spirals into a black hole, but the shape of the utility function means the black hole isn't an equilibrium, therefore we must all expect the Neo-Fisherian outcome". Stick a bit of inflation inertia in their model (like you did with your 4-period overlapping price setting), and that wouldn't work so well.

    Still thinking.

    1. But the underlying problem, of all Neo-Wicksellian models (like the Schmitt-Grohe Uribe model, or the Woodfordian model) is that they are models of monetary exchange without money. When central banks hit the ZLB, they didn't just throw up their hands in despair. They can still control the money base, whether or not they are at the ZLB. The economy won't spiral into a black hole, unless the money base spirals into a black hole too. And central banks did not let the money base spiral into a black hole. They did the opposite.

      And once you start thinking about what central banks are doing with the money base, you have to also start thinking about whether any increase in the money base is expected to be temporary of permanent. Because it matters a lot, especially when nominal interest rates are low, so the interest-elasticity is high. And nobody expects the US increase in money base to be anything like permanent. Because as soon as the economy recovers, and inflation starts to rise, the Fed will reduce it again. Which is why it takes such a massively large increase in the money base to do anything.

      So the lesson I have learned from the last few years is that we need to stop thinking about central banks as setting interest rates.

    2. Hi Nick, I wonder whether one thing that helps stabilize the economy is that a lot of spending is very insensitive to income and interest rates in the short to medium term. This helps keep hot potato money flowing in a downturn, and slows the economy’s slide into a deflationary spiral.

      For example, imagine someone who spends money on food, housing and consumer durables. With an output gap of zero, she spends on all three items. In a recession, she might cut back on consumer durables, but will keep spending on food and rent. This keeps hot potato money circulating to the benefit of other people in the economy. Now let’s say the recession turns to a depression, she loses her job and moves in with her parents. She then ceases to spend on both rent and consumer durables. But her parents might then have to use their savings to buy her food, sustaining some economic activity. It would take a long time for deficient demand to kill her, terminating all consumption and finally reaching the theoretical black hole.

      This inertia might mean it takes a long time for GDP to fall significantly - perhaps 5 years for GDP to fall 30%. This gives some time for policymakers to respond and for prices to adjust. I think the key thing is that that the marginal propensity to consume varies significantly with income (adaptive expectations about income could drive this) and a lot of spending is insensitive to interest rates.

    3. Anonymous: that might be part of it. But I think I would put most of my faith in money. If it spirals down deep enough into a black hole, I could buy the whole world with a $1 coin. And I would, before anyone else beat me to it. Work backwards from there.

    4. Great comment Nick Rowe, as a money manger it surprises me that central bankers still believe that they have some kind of newtonian joystick that controls everything (remember Paul Krugman boasting inflation would be whatever the FED wanted plus minus 0,1%), when in fact they don't. I know it will be hard, but keep pushing that idea, it is importante people realize that.

  9. John, here's how it works out in the bank of Canada's large and fancy New Keynesian DSGE policy model. The relevant part is the response of the economy to a change in the inflation target, section 4.4.3 on page 76. This model has the usual combo of backward and forward inflation in its Phillips curve. Imperfect credibility case is more backward looking, in perfect credibility case the bank of Canada would move the interest rate from the start in the same direction as the desired inflation target change.

  10. Central banks at the lower bound haven't been doing nothing for the past 6 years. First, they've been pushing medium term rates up and down with forward guidance (medium term rates are arguably more important for economic activity than short term rates). Second, QE might have been helping to stabilize the economy (to the extent that QE had any significant effect).

  11. The Bank of England pegged the base interest rate for over a century:

    1. But the gold standard provided a nominal anchor.

  12. This approach is something completely new to me. If I understood it right, this line of thought is based on the idea that there is a strong connection between interest rates and inflation and in the idea that the filed for experimentation in economics is very limited once people are not lab rats. What is still completely obscure to me is whether we are talking about correlation or causality. Are there studies on this issue?

    1. Somewhat off-topic but your comment resonated with a thought I had while reading the post and comments. The empirical evidence cited for and against occurred against different backdrops and simply focusing on a couple of variables in a complex system shouldn't be expected to provide any insights. Economics as a "science" suffers from the impossibility of running any scenario again to see if it's reproducible nor can any scenario be re-run changing only one variable. There's simply no way to apply the traditional scientific method here. I don't see how there can be "studies".

      In my experience in hard science lab rats, under carefully controlled conditions, behave as they damn well please. People are even worse.

  13. Great Post John!
    I presented this model of short-run effects and long-run effects back in May. The video at that post uses system dynamics to show what you show above.

    In the case of Sweden, they did not let their interest rate stay up long enough to start seeing the rise in inflation. They dropped the interest rate while inflation was still reacting to the short-run effects.
    But there is still a deeper issue in all this... The business cycle.
    In the business cycle, the nominal rate will rise from recession to peak, so will the real rate. The real rate will want to return to it natural level.
    If you keep the nominal rate stable throughout the business cycle, the real rate will want to rise, which would make inflation start out high and then fall towards the peak of the biz cycle. Now take the ZLB. It forces the real rate lower than its natural level with expectations that nominal rates will return to their natural level. So you end up with mild disinflation as the biz cycle heads towards its peak. We are seeing that.
    If it starts to become clear that the Fed rate will not start moving up toward a natural rate, then expectations will change to a much lower Fed rate at the natural level of the economy. In this case, we would see inflation decline much more.
    My sense is that we will start to see inflation and its expectations decline much more over the next 6 months as it becomes clear that the Fed rate is stuck... really stuck.
    And if we go into a contraction, then inflation can drop even more.
    In short, Sweden should have stood the ground and kept the interest rate higher for longer to show that 2 years are needed to raise inflation with the Fisher Effect.
    Once again... great post here John!

  14. Dr. Cochran,

    The difficulty with your argument is his claim that "Just as much as monetarists worried about hyperinflation, Keyensians' forecast of a deflationary spiral just didn't happen." This is a strawman argument, few serious economist's argued that hyperinflation was just around the corner. Further, the deflation that the Federal Reserve Bank (FRB) worried so much about actually did occur. Prices did indeed see downward pressure but the Deflationary Spiral never matured because of the actions of the FRB, i.e. Quantitative Easing Policy (QEP).

    The FRB did indeed "print money", (i.e. had the United States Treasury Bureau of Engraving and Printing print money), quite a bit. The supply of M1 Currency (Federal Reserve Notes (FRNs) and coins) increased from 800 BUSD to 1200 BUSD between 2008 and 2012 [1], a 50% increase, which quite significant. During the same period the size of the M2 Money Stock increased dramatically as well, from 7,600 BUSD to 11.500 BUSD, a 40% increase. Of course the size of the Monetary Base rose by a staggering 400% [3] in the same period. Increasing the size of the money stock did indeed create inflationary pressures, the "monetarists" that you reference were correct about that.

    Where they were wrong however was in thinking that those inflationary pressures are the only pressures on prices. During the same period monetary velocity was falling, also quite dramatically, as was industrial utilization capacity, and rates of capital formation[4][5]. These represented deflationary pressures. The inflationary pressures created by the monetary policy of the FRB countered the deflationary pressures of the US economy, producing a small amount price increase.

    The "Keynesians" that you reference were correct, deflationary pressures did arise but prices fell very little, if at all. The Deflationary Spiral never occurred because of the anti-deflationary policies of the FRB, i.e. QEP. Your argument comes done to that of the man who lived down stream of a dam, he complained that dam did no good because since there was never any flooding.






    1. Interesting read. It staggers me how many people I come across, some quite well educated, who think that the only thing that causes prices to rise and fall is the quantity of money! Is this the return of Monetarism with a vengeance?

    2. Hello Anonymous,

      You are correct it is a common misconception that every increase in the volume of money eo ipso results in an increase in prices. That is not to say that there are not specific conditions where this can occur. Dr. Friedman, a very prominent Monetarist has an excellent quote on the subject, to wit: "Inflation is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output." So rather than a universal position, it is conditional on the quantity of money increasing faster than the out put of goods and services. Using the MV = PQ equation, Dr. Friedman's quote only applies if delta M is greater than delta Q and if V is stable, as he assumed it was [1]. However the current economic climate is dominated by a declining velocity [2] so Dr. Friedman's quote in not apropos.

      It never ceases to amaze me how few people actually believe that prices of commodities are controlled by the dynamics of supply and demand. Obviously when supply and demand are at equilibrium, the price of a commodity is driven the costs to produce the commodity and distribution. When demand exceed supply the price raises above this equilibrium point and when the reverse is true, prices drop below that equilibrium point.

      If prices rises, inflation, it is because the cost of production and distribution have risen or the balance of supply and demand have shifted in favor of demand over supply. Is there any reason for to suppose that this is going to occur? What forces would be driving up prices? Is the economy expanding sufficiently that suppliers of goods and services can no longer meet demand? That seems unlikely as capacity utilization is low and has been declining for several years [3]. Further, with low levels of capital investment, why would demand for durable goods increase. Unemployment is still high so there will be little upward pressure on wages.

      We live in deflationary conditions and the Federal Reserve Bank needs to adopt policies appropriate to those conditions.

      [1] "The relative stability of monetary velocity and the investment multiplier in the United States, 1897 - 1958" by Friedman, M. and Meiselman, D. (1963) in Stabilization Policies. Prentice Hall .



    3. David de los Angeles,

      I think you're confusing the price level and relative prices. Quantity of money matters for the price level whereas production costs matter for relative prices.

    4. Hello Math. Bo.,

      I have been using the Personal Consumption Expenditure Price Index - Chain Type which is the price level appropriate to the Fisher Equation. My discussion was directed at market prices not production costs.

  15. John,

    I've been coming to many of the same conclusions you have here through an entirely different approach -- however, there is a difference that allows "quantity theory" economies to exist as a particular limit (high inflation) whereas "neo-Fisherite" economies tend to have low inflation (and a large monetary base relative to NGDP):

  16. If this is true, what Cochran says, then the Fed should hold interest rates at zero and conduct $500 billion dollars of quantitative easing every year. We will have no inflation and a decreasing national debt.

    1. Yes must say this an idea that could only function in a narrow band of interest rates. It seems like pegging the interest rate very high or very low would not result in the inflation rate following along. If we had allowed interest rates to go negative is Cochrane trying to argue we would have had outright deflation?

  17. And my post in response!

  18. The trick here is the straw man: "Or is it unstable, careening off to hyperinflation or deflationary spiral?"

    The real question you're asking is: if the central bank pegs the interest rate at a fixed value, will growth be slowed below potential by excessive inflation when credit demand is high and slowed below potential by overly tight credit when credit demand is low, as standard macro teaches, or will growth and inflation be high when credit access is tight and low when credit access is easy, as my strange interpretation of the Fisher equation seems to suggest?

  19. I think the model is too simple to be useful, and is not tested by recent events, because of expectations. No investor would ever expect the Fed to hold an interest rate peg.

  20. I should add, still an interesting post, though. It's just that investors want to know what inflation will do to their nominal returns, not what the Fed will do with interest rates.

  21. Hi Prof Cochrane,

    I've been reading your posts on the neo-Frisherian hypothesis with great interest, as I find to be a very interesting idea, but before going much further, you might want to look to the historical evidence, such as David Beckworth's nice summary of some episodes, that are, seemingly, inconsistent with the hypothesis:

    Look forward to how you respond to these cases.

    1. Examples 1 and 2 (Germany WWI US 1950) are classics of the Fiscal Theory of the Price Level. If you look at "monetary policy with interest on reserves" you find that the precondition for determinacy with a fixed interest rate target is fiscal backing. That's exactly what was missing in Germany WWI (Sargent and Wallace, "ends of hyperinflations") and dissapeared in the Korean War in the US (Woodford, "fiscal foundations of price stability"). The third episode (canada) strikes me as just like the Sweden I was responding to: short run dynamics may well go the other way. The issue is long run dynamics, and hence how do you escape when interest rates can't go any lower.

    2. Prof,

      thank you for your response. I'm not completely sure if I agree with your interpretations of these historical events, particularly with what would constitute short-run dynamics as opposed to long-run ones, but you've clearly given this a lot of careful thought and if I'm not necessarily agreeing with your interpretations, I can certainly see why you come about them.

      I guess I need to think about this some more. But, again, greatly appreciate you sharing your thoughts, thanks.

  22. Hi Prof Cochrane,

    How do you know there's not another parameter which determines if an economy is an NK/Monetarist regime vs a neo-Fisherite regime. For example, the size of the economy relative to some other factor. This concept would (perhaps) allow economies to slowly evolve over decades from one regime to the other as they grew.

    Such a model does not necessarily have to be more complicated. In fact, it's possible it can be less complicated on the whole (fewer parameters overall).

  23. The problem is that as you lower interest rates you lower velocity, see Hussman and my stuff here:

    So on the way down everything seems easy. You have more money but lower velocity, so not much inflation, for awhile.

    The trouble comes as you try to return interest rates to normal or if you stay too long making money too long. As you raise rates you also raise velocity. So it is possible for things to spiral into hyperinflation. But the longer you go without getting back to normal the greater the danger of an eventual spiral. See more on that here:

    Using the equation of exchange I can simulate hyperinflation here:

    After interest rates are back to normal levels we can talk about what we learned from this extreme monetary experiment. But for now this is still an ongoing experiment, so it is too early to say what the experimental results are. Don't throw out the equation of exchange just yet, and least not from this ongoing experiment.


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