Confessions of a Supply-Side Liberal

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Is Monetary Policy Thinking in Thrall to Wallace Neutrality?

Economics (or even just the combination of stabilization policy and macro public finance that I laid out as a core focus for this blog in its original Prospectus, "What is a Supply-Side Liberal?") is too vast for me to have the crystallized intelligence necessary to do this blog with the care it deserves on my own.  So I need your help.  And I spent some time yesterday working with my daughter Diana Kimball to set up comments with disqus to get your help directly on this blog.  

Currently, I am trying to prepare for more posts on monetary policy.  Following @justinwolfers and @tylercowen on twitter yesterday, including clicking on Brad DeLong’s post A Fragment on the Interaction of Expansionary Monetary and Fiscal Policy at the Zero Nominal Lower Bound to Interest Rates, I was struck again by how dominant the view is that Wallace neutrality as defined by Noah Smith is descriptive of the real world.  Let me try setting out a definition of Wallace neutrality to see if you think the definition is a fair one.  Also, I want to see if you think Wallace neutrality is an appropriate name.

Wallace neutrality:  a property of monetary economic models in which differences in the government’s overall balance sheet at moments in time when the nominal interest rate is zero have no general equilibrium effect on interest rates, prices, or non-financial economic activity, as long as the pattern of government purchases and marginal tax rates is held fixed.  

The first question I am asking readers of this blog is “Do you see a flaw in this definition?”

As Noah points out in his post Does Steve Williamson think printing money can’t cause inflation? the blogosphere has been calling Wallace neutrality the Modigliani-Miller theorem.  And there is no question that it is a Modigliani-Miller-like result, since the proof relies on private agents adjusting their portfolios in a way that counteracts any change in the government’s balance sheet.  But I think it will clarify things a great deal to follow Noah (subliminal message alert) in calling this Wallace neutrality.  

One reason I think that Wallace neutrality deserves its own name is that we find it useful to call Ricardian neutrality “Ricardian neutrality” instead of “the Modigliani-Miller theorem” even though (I think) Ricardian neutrality is more or less an application of the Modigliani-Miller theorem.  In Ricardian neutrality results, the government is typically exchanging bonds (a receive-interest-payments-and-principal-later asset) for cash on the one hand and exchanging an implicit receive-tax-payments-now asset for a receive-tax-payments-later asset.  So it seems like an application of the Modigliani-Miller theorem to me.  

With that definition of Wallace neutrality in hand, or with whatever modified definition you think is the right one, here are my other questions:

  • Is it correct to say that Ben Bernanke does not believe that Wallace neutrality is a good description of the real world?
  • Aside from Ben Bernanke, Noah Smith, and yours truly, who else does not seem to believe that Wallace neutrality is an adequate description of the real world to guide the conduct of monetary policy in our current situation?  
  • What do you think are the best monetary models out there (where “best” includes both technical virtues and real-world plausibility of mechanisms) that exhibit departures from Wallace neutrality that could be used to get oomph from monetary policy in the current economic situation?  When I say “get oomph from monetary policy in the current situation” I mean the kind of thing I was talking about in my posts "Balance Sheet Monetary Policy: A Primer" and "Trillions and Trillions: Getting Used to Balance Sheet Monetary Policy."
  • Is it accurate to say that almost all of the formal models of optimal monetary policy by Michael Woodford and Lars Svensson and their students exhibit Wallace neutrality?   What are the exceptions?  What about formal models of optimal monetary policy by other authors?

Use the comment window at the bottom of this post to reply if you feel you have an answer to one of these questions.   (It will not show up on the blog right away because I need to approve comments for them to appear.)  I appreciate the help.  3696 heads are smarter than one.

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