Arnold Kling has been promoting a macroeconomic theory he calls "Recalculation" which takes a controversial view on the efficacy of monetary policy. You can read his discussion of recalculation macro here
, and here
. Within these discussions he summarizes his view of monetary policy as follows:
In the short run, the economy is going its own way, regardless of monetary policy. Higher M leads to lower V, and vice-versa. In the long run, a significant change in the rate of money creation causes a similar change in the rate of inflation. However, the lag is long and the effect on the rate of Recalculation is small and of indeterminate sign[.]
As this and other passages from his postings show, Kling makes three controversial assertions about monetary policy in his recalculation macro theory. They are as follows:
(1) Monetary policy has no effect on expectations in the short-run. Bill Woolsey
(2) Monetary policy has no effect on nominal economic activity in the short run.
(3) Monetary policy has no effect on real economic activity in the short run.
has been all over Kling's case for making these assertions and the assumptions behind them. I will speak in a moment to Woolsey's critique but for now I want to see what the data says about the assertions (1) - (3).
Number (1) touches on an important question: can the Fed influence expectations about the future in such a way as to shape current economic behavior? Standard macro theory says yes--it is the reasoning behind the current arguments for why the Fed should be explicitly targeting some positive rate of inflation now. Kling, however, does not buy it
. In order to test this question empirically, I took the monthly expected inflation series implied by the difference between the nominal 10-year Treasury yield and the 10-year TIPs yield and put it in a vector autoregression (VAR) along with the monthly GDP series from macroeconomic advisers
. Nominal GDP was turned into an annualized monthly growth rate and the data used runs from 1999:1 through 2007:9. More data would have been helpful, but TIPs only start in the late 1990s. (Technical note: both series were in rates so no unit root problems, 13 lags were used to eliminate serial correlation, and corporate bond spreads were included as a control variable for the financial crisis). The two figures below show what the typical responses of expected inflation and nominal GDP to the typical sudden change or shock to expected inflation over the sample. The solid line shows the point estimate while the dashed lines show two standard deviations around the point estimate. Upon impact, the shock causes expected inflation to jump 16 basis points and occurs as the level of nominal GDP increases by 1.16 percent. In other words, a sudden positive change in expected inflation is associated with an increase in current nominal spending. Both effects persist but eventually become insignificant about 14-15 months later. (Click on figures to enlarge.)
Now presumably the change in 10-year expected inflation comes from a expected change in monetary policy, but just to be sure and to fully address (2) and (3) I have posted below some figures from another VAR I did that looks at the effect of unexpected changes or shocks to the monetary base for the period 1960:3 - 2008:2. This is a larger VAR that controls for more things. (This figure is actually an excerpt from a series of VARs
I did in response to Nick Rowe's post
on monetary policy and debt.) Here, the monetary base is shocked 1%. Note how all the real variables increase on impact. In other words, an unexpected positive increase in the monetary base historically has led to an increase in the short run
of real economic variables. As predicted by theory, the effect of the monetary base shock eventually wears out--money becomes neutral. (Note that the price level is implicitly in these figures too: it is difference between real money and money. Here, there is a permanent effect)
So the assertions (1), (2), and (3) are empirically falsified. Of course we did not need my VARs to know this. There is already a lot of empirical evidence out there that reaches a similar conclusion. Moreover, Bryan Caplan notes
numbers (1) and (2) fly in the face of everything we know from hyperinflation experiences. So why make such assertions? Bill Woolsely explains
that Kling's assertions can work if prices are sticky in the short run, real income is determined by productive capacity, and real money demand is not affected by real income. As Bill Woolsely notes, this last assumptions is incredibly wrong, as many empirical studies have demonstrated over the past 50 years.
In light of the evidence I say it is time for Arnold Kling to join the ranks of the monetary disequilibrium bloggers.Update
1:Here are some definitions to add clarity to the figures above. The real stock price series is the real S&P 500, the debt series is financial sector debt to GDP, the money supply is the monetary base, and the real money balance series is the monetary base divided by the CPI.Update 2
: Josh Hendrickson provides a nice follow up
to the issues raised here while Arnold Kling assails
my use of the "Dark Age Macroeconomic"-based VAR.