We are all in Scott Sumner’s debt for teaching (or reminding) us never, ever to reason from a price change. The reason is simple. You can’t just posit a price change and then start making inferences from the price change, because price changes don’t just happen spontaneously. If there’s a price change, it’s because something else has caused price to change. Maybe demand has increased; maybe supply has decreased; maybe neither supply nor demand has changed, but the market was in disequilibrium before and is in equilibrium now at the new price; maybe neither supply nor demand has changed, but the market was in equilibrium before and is in disequilibrium now. There could be other scenarios as well, but unless you specify at least one of them, you can’t reason sensibly about the implications of the price change.
There’s another important piece of advice for anyone trying to do economics: never mistake a change in quantity demanded for a change in demand. A change in demand means that the willingness of people to pay for something has changed, so that, everything else held constant, the price has to change. If for some reason, the price of something goes up, the willingness of people to pay for not having changed, then the quantity of the thing that they demand will go down. But here’s the important point: their demand for that something – their willingness to pay for it – has not gone down; the change in the amount demanded is simply a response to the increased price of that something. In other words, a change in the price of something cannot be the cause of a change in the demand for that something; it can only cause a change in the quantity demanded. A change in demand can be caused only by change in something other than price – maybe a change in wealth, or in fashion, or in taste, or in the season, or in the weather.
Why am I engaging in this bit of pedantry? Well, in a recent post, Scott responded to the following question from Dustin in the comment section to one of his posts.
An elementary question on the topic of interest rates that I’ve been unable to resolve via google:
Regarding Fed actions, I understand that reduced interest rates are thought to be expansionary because the resulting decrease in cost of capital induces greater investment. But I also understand that reduced interest rates are thought to be contractionary because the resulting decrease in opportunity cost of holding money increases demand for money.
To which Scott responded as follows:
It’s not at all clear that lower interest rates boost investment (never reason from a price change.) And even if they did boost investment it is not at all clear that they would boost GDP.
Scott is correct to question the relationship between interest rates and investment. The relationship in the Keynesian model is based on the idea that a reduced interest rate, by reducing the rate at which expected future cash flows are discounted, increases the value of durable assets, so that the optimal size of the capital stock increases, implying a speed up in the rate of capital accumulation (investment). There are a couple of steps missing in the chain of reasoning that goes from a reduced rate of discount to a speed up in the rate of accumulation, but, in the olden days at any rate, economists have usually been willing to rely on their intuition that an increase in the size of the optimal capital stock would translate into an increased rate of capital accumulation.
Alternatively, in the Hawtreyan scheme of things, a reduced rate of interest would increase the optimal size of inventories held by traders and middlemen, causing an increase in orders to manufacturers, and a cycle of rising output and income generated by the attempt to increase inventories. Notice that in the Hawtreyan view, the reduced short-term interest is, in part, a positive supply shock (reducing the costs borne by middlemen and traders of holding inventories financed by short-term borrowing) as long as there are unused resources that can be employed if desired inventories increase in size.
That said, I’m not sure what Scott, in questioning whether a reduction in interesting rates raises investment, meant by his parenthetical remark about reasoning from a price change. Scott was asked about the effect of a Fed policy to reduce interest rates. Why is that reasoning from a price change? And furthermore, if we do posit that investment rises, why is it unclear whether GDP would rise?
Scott continues:
However it’s surprisingly hard to explain why OMPs boost NGDP using the mechanism of interest rates. Dustin is right that lower interest rates increase the demand for money. They also reduce velocity. Higher money demand and lower velocity will, ceteris paribus, reduce NGDP. So why does everyone think that a cut in interest rates increases NGDP? Is it possible that Steve Williamson is right after all?
Sorry, Scott. Lower interest rates don’t increase the demand for money; lower interest rates increase the amount of money demanded. What’s the difference? If an interest-rate reduction increased the demand for money, it would mean that the demand curve had shifted, and the size of that shift would be theoretically unspecified. If that were the case, we would be comparing an unknown increase in investment on the one hand to an unknown increase in money demand on the other hand, the net effect being indeterminate. That’s the argument that Scott seems to be making.
But that’s not, repeat not, what’s going on here. What we have is an interest-rate reduction that triggers an increase investment and also in the amount of money demanded. But there is no shift in the demand curve for money, just a movement along an unchanging demand curve. That imposes a limit on the range of possibilities. What is the limit? It’s the extreme case of a demand curve for money that is perfectly elastic at the current rate of interest — in other words a liquidity trap — so that the slightest reduction in interest rates causes an unlimited increase in the amount of money demanded. But that means that the rate of interest can’t fall, so that investment can’t rise. If the demand for money is less than perfectly elastic, then the rate of interest can in fact be reduced, implying that investment, and therefore NGDP, will increase. The quantity of money demanded increases as well — velocity goes down — but not enough to prevent investment and NGDP from increasing.
So, there’s no ambiguity about the correct answer to Dustin’s question. If Steve Williamson is right, it’s because he has introduced some new analytical element not contained in the old-fashioned macroeconomic analysis. (Note that I use the term “old-fashioned” only as an identifier, not as an expression of preference in either direction.) A policy-induced reduction in the rate of interest must, under standard assumption in the old-fashioned macroeconomics, increase nominal GDP, though the size of the increase depends on specific assumptions about empirical magnitudes. I don’t disagree with Scott’s analysis in terms of the monetary base, I just don’t see a substantive difference between that analysis and the one that I just went through in terms of the interest-rate policy instrument.
Just to offer a non-controversial example, it is possible to reason through the effect of a restriction on imports in terms of a per unit tariff on imports or in terms of a numerical quota on imports. For any per unit tariff, there is a corresponding quota on imports that gives you the same solution. MMT guys often fail to see the symmetry between setting the quantity and the price of bank reserves; in this instance Scott seems to have overlooked the symmetry between the quantity and price of base money.
