Open Market Operations and Non-Neutralities of Money

Matt Rognlie and I are having a conversation in the comment thread of this previous post, which I'm sure most of you have lost track of. Here's a summary of the basic issues: One of my complaints with New Keynesian economics is that it skirts around most of what is interesting for me about monetary policy and how it works. In mainstream monetary models, e.g. standard representative agent models with cash-in-advance constraints, non-neutralities of money are restricted to the effects of unanticipated money and inflation. Monetary policy matters due to distortions in intertemporal prices, for example the anticipation of higher money growth and higher inflation acts as a tax on labor supply and reduces output. Further, the nominal interest rate increases due to a Fisher effect. Mike Woodford looked at those effects and thought that they did not matter much in practice, or that they had the wrong signs, and he wrote down models where he could dispense with those types of intertemporal distortions entirely. In basic New Keynesian models we do not worry about the details of monetary exchange, it is assumed that the central bank can choose the short-term nominal interest rate at will, and monetary policy has real effects because of relative price distortions due to sticky prices and wages.

My contention is that one cannot analyze monetary policy without modeling the role of central bank liabilities and other assets in exchange, and the role of the central bank as a financial intermediary. This need not involve substituting for New Keynesian-type effects. One can easily take the approach of being explicit about exchange, the central bank balance sheet, and central bank intermediation activity, and include the sticky prices and wages if one really can't live without them.

In this paper, one of the results I get is a particular non-neutrality of money. Prices are flexible, so it's certainly not a New Keynesian effect, and it's different from what you get in mainstream monetary models. There are essentially two classes of assets - currency and various other assets (government bonds, loans) which may be fundamentally illiquid but are made liquid (though not as liquid as currency) by financial intermediaries. A standard open market purchase (think of this as normal times) will ultimately increase the stock of currency in nominal terms, with no change in the real stock of currency, but the real stock of other assets declines, those assets become more scarce, the real interest rate falls, and lending increases. Essentially, this is an illiquidity effect.

In reply to Matt's last set of comments:

1. [Here he's discussing the effect of the open market operation]

But ultimately I have severe doubts that this channel makes much of a quantitative difference. When the Fed adjusts policy through open market operations, over the short to medium term it's making purchases in the tens of billions of dollars; maybe $100 billion at the very most. Meanwhile, the MZM money stock is $10 trillion, and that's an underestimate of the true size of the universe of liquid assets. Fiscal shocks happen all the time that adjust the quantity of liquid government debt by much more than Fed operations normally do; if you're positing that this an important channel for the effects of Fed policy, it follows that the Fed is at most a minor sideshow next to the Treasury. That doesn't ring empirically true to me.

First, in my model, there is not an increase in the yield spread "between government debt and other liquid securities." To keep things simple, I put assets into two classes. In the second class there is everything that is not currency, and I assumed that all that stuff (government interest-bearing debt and loans) could be intermediated in the same way. In a more elaborate model, one might imagine assets with different degrees of liquidity, but liquidity will be priced according to how assets are intermediated. For example, we might think of a house as highly illiquid, but a mortgage-backed security (MBS) can be highly-liquid, and the MBS is essentially backed by the houses that act as collateral for the mortgage debt that gets chopped up and put into the MBS.

Second, Matt has hit on something interesting in the latter part of the above paragraph, relating to fiscal policy. The Treasury could indeed be more important than the Fed, as it can bring about changes in the total quantity of consolidated government debt outstanding; the Fed can only change the composition. In fact, under current circumstances, the changes in the composition of outstanding debt the Fed can accomplish are irrelevant. Matt seems to think that these things don't "ring empirically true." I say run with the idea.

Matt goes on to discuss how New Keynesian effects work, and how he thinks they are empirically more relevant than what I'm after. You can read the details in the comment thread in the previous post. Two comments:

1. In terms of current events, my model might tell you that our current problem is that liquid assets (the second class of assets - the intermediated non-currency assets) are too scarce, and the real interest rate is too low. New Keynesians tell us the real rate is too high. If we take the New Keynesian line, we have to take a stand on what the "natural" real rate of interest is. That would be the real rate if wages and prices were perfectly flexible. To determine what that rate is we have to determine what the shock was that was driving the recession (and the financial crisis) presumably. I'm not sure what the New Keynesians have in mind there. Also, at first glance, real rates (based on current inflation, current short nominal rates, TIPS yields) look pretty low to me.

2. Some of Matt's arguments are in terms of back-of-the-envelope reasoning about the quantities of government debt and currency relative to other liquid assets. But we know that, through the shadow banking sector, a small quantity of assets, used as collateral, can support a very large quantity of credit activity. This is part of what Gary Gorton has written about. One might not think that things going haywire with a relatively small quantity of mortgage debt could cause such a big problem, but it did. Similarly, small changes in the quantity of interest-bearing government debt outstanding, through the process of rehypothecation, can give potentially very large effects in asset markets. Collateral and rehypothecation are not in my model, but if one were to take it to the data, that might be part of what one would want to include.