Monday, March 12, 2012
Running on MMT
I’m going to regret this, but here is a short reaction to the Modern Monetary Theory (MMT) uprising, occasioned by reading (after some hesitation) Philip Pilkington’s MMT-inspired attack on IS-LM models over at Naked Capitalism.
1. I agree with the fundamental complaint MMTers have about the LM curve: it assumes a fixed money supply, so that changes in the speculative demand for money (due to i) have to be offset by changes in the transaction demand (due to Y): hence the upward slope. (The slope is flat during a liquidity trap.) But the money supply is not fixed; it has a substantial endogenous component. Note the word “substantial”.
2. But MMT jumps from one corner solution to another. After rejecting the implausible notion that the money supply is fixed, always at a level determined by the money multiplier times the monetary base, it leaps to the equally implausible notion that the monetary base is completely decoupled from the money supply. On this view, infusions or withdrawals of liquidity by the central bank influence only interest rates, and the banking system alters its credit creation to meet money demand at the policy-determined price. Thus the volume of economic activity need have no bearing at all on interest rates; the central bank has a completely free hand. Do I have this right?
My view is that corner solutions are usually wrong; at least they should be regarded with fierce skepticism. It would take a lot to convince me that monetary aggregates are completely decoupled from central bank liquidity provision, just as I doubt they can be controlled by monetary policy. Surely there are limits to credit creation, which we see in a raw form during those episodes in which reserve requirements are reset. What’s wrong with saying that the money supply is jointly created by the central bank and the private sector as the latter responds to perceived lending (and other asset acquisition) opportunities?
(Note: this post is about just one issue in IS-LM modeling. There are others, but I am saving them for a day when there is really nothing better to do.)