Thursday, April 19, 2007

Splain Me

Update This post is getting a few hits from non-regulars so I'll give a little background. My question was around this idea:

It seems to me that in the absence of price increases an increase in the money supply should theoretically increase the demand for durables but not non-durables. This is because without an increase in prices more money represents an increase in transitory income.

However, if there is no increase in the demand for non-durables there is no reason to raise their prices.

Therefore, the common neutrality argument has a chicken and the egg problem. Why does nominal demand for non-durables increase in the absence of price changes? Why does the price of non-durables change in the absence of an increase in nominal demand?

Unless the problem is answered then it would seem that money should increase the real demand for durables. This is at odds with the common neutrality result from theory.


In response to my question on the money supply commenter writes

If you're committed to market clearing as a modeling strategy then you need something like the Lucas islands model or some sort of stickiness to get short-term non-neutrality.

In Hume's account of long-run neutrality and short-run non-neutrality, the new money worked its way through the economy, pushing prices up as it went round and round. His story was credible because people didn't observe the increase in the monetary mass.


OK so this is the common assertion. However, and I recognize that I must be missing something, I don't see why observing the increase in the money supply matters.

For example, suppose I am the proprietor of a McDonald's. Tomorrow the money supply doubles. This is great. However, the nominal demand for my product is not going to double. In fact, the real demand will likely fall.

I won't experience a decrease in demand, but what I will experience, over time, is lots of my employees quiting to take jobs in construction because of the housing boom that just occurred.

How is it in my interest to raise prices? It won't be until I actually have to start paying my workers more. I have to wait for the increase in money to work its way to my cost structure before I begin to raise prices.

It seems to me this should be true for everyone whose product demand doesn't depend on the interest rate.

Products whose demand does depend on the interest rate will experience the opposite phenomenon. They will see a nominal and real increase in the demand for their product.

In other words an increase in money should shift demand towards durables and away from non-durables. But it should do it in a two-step fashion. First, real durable demand goes up, then wages and input prices go up, creating an effective real decline in demand for non-durables.

This doesn't depend on myopia, islands or any other non-market clearing devices. \

So I ask again, where do I have it wrong.

19 comments:

Ryan said...

Is it possible that the prospect of physical dollars soon becoming half as valuable will encourage people to rush out and spend them on whatever they can? I imagine there would be newspaper articles and TV reports by economists and those "wealth management" sorts, warning people to go out and do just that before it's too late.

Gabriel Mihalache said...

Let me detail...

In a Rational Expectations model, the agents know the "true" model fo the economy. They're also in a reflexive equilibrium: I expect that you'll expect that I'll expect...

If they observe the change in the money supply, they know the economy will look at the new equilibrium and they'll adjust their actions to match the new equilibrium (this is their Nash dominant strategy).

In such models, there's no adjustment. The economy jumps to the new equilibrium. This is a feature, not a bug. It allows you to study some phenomena but not other.

To deviate from this world of perfect jumps, you need to make people either unware of some feature or another of the economy, or of the shocks or constrain them in nominal contracts.

Something closer to what you want is a Friedman-like story of sloped short-run aggregate supply and long-run vertical agg. supply when an increase in the money supply will cause a temporary increase in activity but will only result in inflation in the long-run.

Only relative prices matter when it comes to welfare and rational choice. So maybe you're looking for a way to show that changes in the money supply change these ratios...

What you're looking for, it seems to me, are the microfoundations of monetary economics, and pretty much no one can explain that at this point. Maybe someone can.

Search-and-matching models might help but textbook examples are not complex enough to satisfactorly answer your question...

Karl Smith said...

If they observe the change in the money supply, they know the economy will look at the new equilibrium and they'll adjust their actions to match the new equilibrium (this is their Nash dominant strategy).

This is exactly what seems wrong. It does not seems to be a dominate strategy to adjust your actions to match the new equilibria.

If at the momement a monetary action were taken, McDonalds raised prices unilaterly, they would suffer a loss in profit.

In fact precisely my point is that it is in no one's indivdual interest to move towards equilibrium.

Perhaps I should build a model around this, but I worry about wasting too much time on what is likely a dead end.

GVV said...

gabriel mihalache,

"Economy jumps to a new equilibrium"

All these models treat only flow equilibrium, the stock dimension of factors are not discussed-they are based on logical time analysis.
Instead, the historical time method of the PKS views (as Prof.Robinson says) today as "an ever moving break from a known past and an unknown future" so that economic actors operate under complete uncertainty.

Anonymous said...

"In fact precisely my point is that it is in no one's indivdual interest to move towards equilibrium."

wouldn't social welfare be at a maximum when at the equilibrium?

JD said...

karl,

can you post your thoughts on the following paper? it is really interesting.

http://d.repec.org/n?u=RePEc:fip:fedmsr:388&r=dge

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