Wednesday, September 29, 2010

Message to the Fed: this is the modern monetary theory (MMT) transmission mechanism.

It seems a number of Fed and ex-Fed people have at last tumbled to the fact that there are serious problems with traditional ideas on money supply transmission mechanisms.

This Fed paper to which Warren Mosler draws attention points to the fact that there has been a 2,173% rise in bank reserves in the last two years, with (contrary to text book predictions) almost no effect. Yes you read that right: 2,173%.

The authors of the Fed paper also say “if the quantity of reserves is relevant for the transmission of monetary policy, a different mechanism must be found.”

And then there is Arnold Kling, who worked for a time as an economist for the Fed. He says “I am having an equally hard time understanding modern monetary theory.”

In view of the above, it might be helpful to set out the MMT transmission mechanism. It is very simple and it’s thus (as I see it).

1. The government-central bank machine net spends in a recession. Assuming government wants the relative sizes of public and private sectors to remain constant, some of the money will be spent on hiring extra public sector workers and/or making sure that tax shortfalls don’t result in public sector workers being sacked. That creates employment.

2. There is a multiplier effect from “1”, that is, part of the above additional payroll costs will be spent, which in turn employs more people.

3. The above additional public sector workers will probably save some of their income. That boosts private sector savings. Those savings will not expand for ever. The point will come where the private sector thinks it has enough by way of savings, at which point it will cease saving and will spend, or try to spend all its income. That employs yet more people.

4. While the above boost for the public sector boosts the private sector INDIRECTLY, it is probably desirable to give the private sector a DIRECT boost as well. That can be done by, for example, reducing payroll taxes or income tax. That boosts employees’ take home pay, which in turn will boost their spending, which employs more people.

Doubtless some of the above private sector increase in take home pay, will be saved. The consequences are exactly the same as with the above public sector employees. That is, savings will rise to the point where no more savings are required, etc, etc.

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