Ed Nelson on Money, its Role within Monetary Policy and the Monetarist Legacy

In life, Milton Friedman had a massive influence on monetary policy, but in what ways does he continue to influence decision making within the Fed?

Ed Nelson is a senior advisor in the monetary affairs division of the Board of Governors of the Federal Reserve System. Ed has also spent time at the St. Louis Federal Reserve Bank, the Bank of England, and has worked as a professor. Ed joins the Macro Musings podcast to discuss his research on money and its role in Monetary Policy.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected]

David Beckworth: Ed, thanks for joining the show.

Ed Nelson:  Thank you David. It's a pleasure to be here.

Beckworth: It's a real treat to have you on. So, tell us, how did you get into macro economics?

Nelson: Well, I'm originally from Australia, Sydney, Australia and the high school system, certainly when I was a student in the late 80s actually has a pretty decent economics program in the last two years that you can take if you want to take it.

Nelson:  And it's very policy oriented. It wasn't deep theory or anything, but it was, gave you some of the bare bones of economics as well as the current economic policy issues as were in Australia and tried to analyze them in economic terms.

Nelson: And so, I got very interested in that. I got more sort of exposure to economics by newspaper coverage. Then I went to a process of hanging around secondhand bookshops, finding books on economics and gradually decided I wanted to do that as a career.

Nelson: And I know the economics I learned at the high school involved a lot of things that I would not subscribe to today. There was a lot of emphasis on wage pushes, the cause of inflation, income policy, divide inflation. It's right, it didn't have a very centralized wage system in those days. So, that was-

Beckworth: Interesting.

Nelson: ... a very much a live issue then. There wasn't really much talk about the supply side. It was very much a mechanical sort of textbook view of how fiscal policy multiplies work. And we also were very much taught the current account deficit was a major problem.

Nelson:  So, those are the things that with over time I've moved away from. But it was a good interaction, and then I got into an undergraduate economics University of Sydney. Again, I wouldn't say that necessarily the posture taken by the teachers was necessarily that I eventually adopted, one of the teachers we had in both in first and second year for microeconomics was Yanis the Greek-

Beckworth: Oh, really?

Nelson: Yeah.

Beckworth: Very colorful figure.

Nelson: That's right. So, he was very open. I mean, he has said publicly that he taught his economics course as a critique of textbook economics. So, that's kind of a strange way to get an introduction to economics. But it made me interested and I took monetary economics courses.

Nelson: And obviously I had exposure to some of the major textbooks. I particularly like the Dornbusch and Fisher textbook, which is sort of even today something I look back at, look up as the occasion demands. And so, I got into economics from that background in Australia.

Nelson: And then, I worked at Macquarie University in Australia for a while, sort of helping out at a small business school there and trying to introduce myself a little bit to economic research. And I knew some macro economists who were very prominent in monetary economics in Australia and you picked R.G. who was a formerly IMF and who sadly died while I was at Macquarie University, but I knew him and Bill Knowlton was my employer at Macquarie University.

Nelson: He'd been the head of the RBA research department. I think it was. I knew some people at the RBA. I knew Glen Stevens. He was kind enough to give me a lot of time when I wanted to talk to him about monetary issues.

Nelson: So, I got exposure through Australia into both the policy side and to some extent the analytical side of economics. And then I went to Carnegie Mellon and obviously that was my PhD education. And so, Carnegie Mellon's always had a very small monetary economics sort of cell within the overall economics group and the business school there. But it's always been a strong, vibrant little cells.

Nelson: So, in the '70s, it was Alan Meltzer and Bob Lucas in the 80s, I guess it was Allen Meltzer and Ben McCallum and Marty Eichenbaum. And when I was there, it was basically down to Ben and Allen, although there obviously are other major macro people there including Fin Katelyn, Stan Zinn and Kathy Shore who later became a member of Clinton's CA, Tom Torrey.

Nelson: So, I got a lot of exposure to monetary economics even before I went to Carnegie Mellon. It was really Carnegie Mellon, it was kind of my education in economics, we think of the PhD is really where you learn things all over again and then that suddenly was what happened in my case.

Beckworth: Okay. Just for our listeners, I know most of them know this, but RBA is the Central Bank, right?

Nelson: The Reserve Bank of Australia. So, the Australian economy has really done so well over the last 25 years that the Australian economy is kind of the envy and the admiration of the world. And so the RBA-

Beckworth: Yes it is.

Nelson: ... can take a lot of credit for that.

Beckworth: No, I've often pointed to Australia as a good example of what Monetary Policy should have been during the great recession across the world. And it's fascinating, I know Australia is a little bit different. They have commodities in terms of trade shocks that we don't have to deal with, but with that said, Australia had huge household debt levels.

Beckworth: They were lots of leverage issues. Some of the similar arguments given for why we went into great recession. They had the same problem. It didn't seem to cause them to have any major contractions, but no contractions since the early '90s. Is that right?

Nelson: I think that's correct, yes.

Beckworth: So, they've had this massive ongoing expansion. There's all this recent talk about in the U.S. and about do expansions die of old age and it's probably in Australia, very foreign conversation to have because it's just goes and goes and goes and goes, and largely to get it to central bank there. Right?

Nelson: I think that certainly the RBA deserves enormous amount of credit, because they have not been sort of asleep at the switch. They've done a lot of changes in policy when the offload changed and they have a very well trained staff for a lot of my friends work there.

Nelson: Including, I know a particular guy developed a deputy governor there, is an old friend. So, they have a lot of very smart economists there. But I think that the sort of publicity in Australia during the financial crisis was on the fiscal policy stimulus, but the Monetary Policy side of things really doesn't have a lot of credit too, I think.

Beckworth: Yeah. Now, going into it, I've looked a little bit and pry enough to be dangerous. You can correct me where I'm wrong, but going into the crisis, they had higher inflation trend. Trend inflation was a little higher in Australia, which gave the bank more room to cut rates.

Beckworth: So, they didn't actually get to the zero lower bound, where in other places it seemed like we kept and wasn't enough. So, is that part of the story? They never really hit the zero lower bound mark?

Nelson: I think that certainly a big part, because I haven't had to do QA, but I think over and above that, there's the fact that the real natural rate of interest seems to be on the high side of Australia.

Nelson: Certainly, if you like the spread over of riskless rates in Australia over those in the U.S. tends to be positive. So, that gives an extra buffer. That in some ways that's seen as a disadvantage. It's sort of showing that, saying that foreigners have to be paid an extra bit of cash to lend to Australia. But on the other hand it has this, you feel like bonus in making Monetary Policy more straightforward when you have a negative shock.

Beckworth: Okay. Very interesting. Yeah. So, there's a lot to learn from them. And someday I want to sit down and do a paper because again, they have these huge leverage household balance sheets and yet they didn't have the great recession, which kind of goes against the grain of one of the standard interpretations of a crisis here.

Beckworth: All right, let's go back to your career. So, you went and study under Bennett McCollum and as listeners of this show know I'm a big fan of Nominal GDP targeting and he was a big advocate of it. And you wrote many papers with him.

Beckworth: In fact, I as a grad student and even as a young professor, I read a lot of your work trying to figure out these models and how they apply to Nominal GDP targeting. So, would you consider yourself a fan of Nominal GDP targeting or was that just more Bennet's preference?

Nelson: I'm certainly willing to go to bat phenomenally and come tog. I wouldn't say I'm somebody who sort of goes around saying this is the open sesame to a better stabilization policy. But I have a lot of appreciation through working with Ben and through work I've done on the reading literature of the benefits of nominal income targeting.

Nelson: I guess, one aspect that Ben really emphasized perhaps is less prominent these days is, he really emphasized it's something that's robust to different specifications to biogrid supply. Biogris supply I mean, the price wage setting sector of the economy.

Nelson: So, you have to remember that Ben was really developing the normal, his own advocacy of normal income tolerating, obviously always other people with different angles arguing for different variants of Normal Income Targeting like Bob Gordon and James Tobin. But Ben, I think really started in on his interest in Normal Income Targeting.

Nelson: I think his first pipe going in that direction was one, he presented to the AA in I think December '93 because it was the same session as a pipe Milton Friedman gave actually, and Ben Freedmans on that session too.

Nelson: And over the next four years he really made concrete his nominal income targeting proposal. And I think it was really based on the idea that we want a policy that would be robust even if the aggregate supply side was a real business cycle model.

Nelson: Even if it was an acceleration as Phillips curve, even if it was a forward looking type Phillips' curve, although the forward looking type Phillips' curve was really although they've been in some sides of development, the eighties came on really lighter as a major in focus with the research literature.

Nelson: So, he was saying we don't want to a rule that requires knowledge of the level of the output gap because there's too much uncertainty about that. We don't want a rule that requires knowledge of what's happening to the economy today. We want something that what he called operational.

Nelson: And another thing that eventually sort of marked him out or us out a bit more over the years was, he wanted it to be in a cycle instrument rule, that is to be specified in terms of a left hand side variable that the Central Bank can control and right hand side variables to which it responds.

Nelson: So, the big contrast with let's say Bob Gordon's version of nominal income curve is Bob Gordon I think had more of a optimal control version of normally targeting.

Nelson: So, I've been really emphasized operationality and also robustness. So, it's obviously his well known as well known paper in the '80s on these issues was for I think Allan H. Meltzer, of that the kind of care Rochester Held.

Nelson: I think it was in late '87. The paper is actually published '88 on robustness properties with Normal Income Targetinng. So, he was very much emphasizing, let's get away from fragile estimates of the output gap. Let's get away from, the environment which he was working was one in which the IBC model was on the ascendance.

Nelson: So, for him, I think Caitlin was his next door neighbor and for many years in the office complex at Carnegie Mellon, at GSI and Tepper school.

Beckworth: So, you had to answer to him?

Nelson: Yes, exactly. So, obviously your surrounding shape what you perceive as the so intellectual environment. So, the RBC model was on the rise. So, he wanted a rule that would work in a flexible price model. These days there would be less emphasis on that as a criteria and people would, I think of people who work in monetary issues with some exceptions tend not to think that the RBC model is a good baseline for how the actual price setting sector operates.

Nelson: So, he really emphasized those factors operationality and robustness these days the emphasis on Normal Income Targeting is more emphasizing the forward looking and the promise keeping aspects of Normal Income Targeting as robustness in the face of things like the zero balance and interest rate.

Nelson: So, those were things that I suppose consistent with his approach. But when were they emphasized, I'll certainly want modern modified his approach.

Beckworth: Well, I think that's important that this whole argument, if I understand you correctly, the nominal income targeting rule is robust to supply shocks that are unknown size and occurrence in a real time.

Beckworth: There's this knowledge problem. And I have a paper where I look at the output Everly's often his work on the 1970s where he says, "Look, the Fed was following a Taylor rule. It's just his knowledge of the output gap was flawed and therefore led to bad policy prescriptions."

Beckworth: And if you go and look at the Fed stuffs real time estimates of the output gap, you find these unit rules, you find that there's persistent myths. And then Josh Hendrickson and I've looked at the same forecast for the nominal income level for the current period or the growth rate, excuse me. And there is no unit in that.

Beckworth: So the Fed is, does a decent job of forecasting current period, Nominal GDP growth. So, even if Nominal GDP gets revised, the Fed does a good enough job estimating what it actually is, that it could do Nominal Income Targeting without suffering from this data revision problem.

Beckworth: I know you and Ben also spoke to that one of your papers as well, because that is one of the critiques, right? That there's a data revision but you think there's ways around that, right?

Nelson: Yeah. So, the references on growth rates in Ben McCallum's version of the Nominal Income Targeting was, if you like anticipating some of these issues because often in his work for the most part is focusing on the uncertain estimates of level of the apple gap.

Nelson: A lot of the era differences away. So, if you have a policy rule that is counting on potential output to grow at a certain rate that might be more robust to a rule that assumes a certain equally a sudden level of potential output.

Nelson: In the case of Ben, he was going further than that because he was essentially not using even the change in the potential output and the rule. He's just basically using the changing normal incoming as the criterion and see, he had to assume average growth rate of potential or an average growth rate over the long run of the economy, but not really, he didn't have to take a stand on the period to period movements of potential output.

Beckworth: Right. And I think that's one of the appeals of this, whereas you mentioned day, the other pill is it's forward looking nature and helps guide expectations. Okay. You've also spent some time in addition to working with Bennett McCollum doing a lot of research on Milton Friedman's work. His influence on Monetary Policy his monetarism. How influential has Milton Friedman been on the profession?

Nelson: I would make the case that he's had a very substantial influence. The main case against that is the fact that monetary targeting was tried and monetary targeting stopped being used. But the more enduring aspects of his framework I think have continued to influence policy and continue to permeate research, what it's gotten a lot of publicity in the last few months with a slew of papers including one from me on the 50th anniversary.

Nelson: It's the 50th anniversary of his presidential address, so-called, although AR 1968 paper on the role of Monetary Policy that has several aspects to it, one of which is recommendation of a constant money growth rule. But over and above that he argues that the level of real variables are not determined by Monetary Policy in the long run.

Nelson: And I think that's something that policy makers since let's say the late '70s, have really taken on board in their thinking quite separate from what they may think about money.

Nelson: Another very important aspect of Friedman's work, which I really feel has been underestimated, particularly in the United States, is simply the idea that Monetary Policy is what is the bail and endo ultimately inflation.

Nelson: So, the Monetary Policy can set the long run inflation right, it has a lot to do with the basic costs of inflation even over the medium term. That's such a commonplace now that people tend to be a bit reluctant even attributing that to Milton Friedman.

Nelson: So, what got me going to some extent on my work on Milton Friedman was the view that if Central Banks around the world abandoned monetary targeting, which they did, that meant that Friedman influence on policy making was done.

Nelson: And I would say that, the consensus that inflation on monetary phenomenon, it can be controlled by Monetary Policy, should be targeted by Monetary Policy. And that I think that's a very enduring part of Friedman's influence.

Nelson: The respect in which he has not been influential is the output gap stabilization. He really wants to indirect ways of stabilizing the apple gap where there's monetary targeting or some other emphasis on nominal variables and if you like through the back door, providing conditions in which the apple gap would be stable. He was not very confident about policies that actually responded directly to estimates of the apple gap or to other estimates of resource slack.

Nelson: Policymakers in practice have been much more inclined to estimate the output gap and using their best estimate to set policy perhaps responding to that or responding to some other real variables.

Nelson: So, real stabilization is a much more explicit part of policymaking than it was in Friedman's recommendations. But in terms of the ultimate emphasis on nominal variables and the basic assignments of Monetary Policy, I think he's been very influential.

Beckworth: Yeah. Modern central banking has a large Milton Friedman fingerprint on it seems to me. Absolutely. Let me ask you about his monetary target. So, that is one that seems to draw a lot of the disdain or contempt for Friedman.

Beckworth: And he did advocate that, but he also didn't he change his mind later in life or more open because I know in monitoring mischief, he brings up the possibility of targeting break even inflation.

Nelson: Yeah. So, I had a bit of correspondence with him around the time he was writing that. And I think even that correspondence and suddenly in the book, I think in both, he credited that to Robert Hetzel. And I think his view was that he was, he thought the Hetzel proposal was a good first start that it was going in the direction of a more direct responsibility of policymakers for inflation.

Nelson: I'm not sure that he ever entirely recruited monetary targeting. I've seen many people say that he did. Partly on the basis of an interview he gave in the Financial Times in 2003, in which there was some of throwaway line to the effect of monetary cognitives targets clearly haven't made a success.

Nelson: I don't put a great deal of weight on that because even in the '70s, he was saying, "Well, monetary targets I thought would be when they were introduced, I thought that that'd be a watershed," but policymakers have found ways of following or at least announcing monetary targets and then doing what they want.

Nelson: So, you have to keep in mind that he thought a public monetary target would be a very significant turning point. And he was disappointed on that even by the late '70s, and certainly by the mid '80s.

Nelson: So, I have a paper in the St. Louis review in 2007 which I tried to be careful about going through his various comments late in life. And certainly he was much more accepting of the fact that Central Banks in practice has been able to do better than monetary targeting.

Nelson: But I think he retained sort of soft spot for monetary targeting and was not willing to say it couldn't be done, or that even necessarily it shouldn't be done.

Nelson: He wrote a sort of farewell for Alan Greenspan, when Alan Greenspan was finishing his time at the afimacy on the board in which he sort of said, suddenly Alan Greenspan has done better than Birol would have, but he was not necessarily saying that other policymakers would have. So, even in 2005, 2006, he was not quite sort of casting aside the constant money growth rule.

Beckworth: Okay. So, he was open, but he was still in spirit with money supply target notion. Are there any monetarists left that you would say any vestiges of monetarism and I've been called a market monetarist because I advocate Nominal GDP targeting.

Beckworth: And some people will even Michael Woodford has said in his Jackson Hole speech, he could look at Nominal GDP targeting as velocity adjusted months of money supply targeting. And there's other ways to look at it, but do you see explicit monetarist around? Or maybe monetarism is the mainstream, maybe new Keynesian is modern version of monetarism.

Nelson: I think what you've just said is a large part of the story that I think the number of self identifying monetarists is small. But the pressed against the wall, a lot of economists would admit subscribing to a number of the propositions in the '60s were specifically associated with monetarism.

Nelson: You have to remember that even when Friedman was emphasizing the Fisher distinction between real and nominal interest rates, that was perceived as a monetarist view, that was not perceived as common sense statement of real versus nominal interest rates. That was seen as something that was a challenge to the '60s brand of Keynesianism.

Nelson: So, there are a number of things that have just been absorbed and therefore having been absorbed. People who believe in when necessarily say the monetarists. In so far as you define monetarism as actually saying, let's go to monetary base as the instrument with money aggregate target is the immediate target.

Nelson: I think there are very few who would actually that would be their first preference. So, on the policy recommendation side, I think that there are very few monetarists even Anna Schwartz by the time that I really got to work with her, she was not pushing for money targeting or anything like that, but obviously Ann Schwartz was still a monetarist.

Nelson: So, it's very hard to judge on the basis of policy recommendations. Whether somebody is a monetarist, is really I would say the analytical framework or the doctrine. Some people don't like the word doctrine because it sounds like a sort of religious thing that you're always believed.

Nelson: By doctrine I mean the framework underlying your strategy or your approach to policy analysis. So, I would not be offended by people calling me a monetarist, but on the other hand, I don't go around saying let's overhaul operating procedures to make it a monetary base control.

Nelson: So, I'm not a monetarist by that criteria. But in terms of thinking, Friedman's very important in thinking, there's a lot of lessons in Friedman's work and Allan Meltzers work, Karl Brenda's work, Ann Schwartz's work that we can learn from and that have been absorbed in, it should be absorbed.

Nelson: I'm certainly a monetarist in that sentence and I have quite good monetarist credentials I suppose, because Allan Meltzers, was on my thesis committee, and Ben McCallum by some counts is a monetarist.

Nelson: Certainly the Dornbusch and Fisher textbook counted him as a monetarist. In terms of other monetarist out there, I'd say I think Peter Ireland is one of the more active, he's really being passionately I would say, diligently continuing work on Montreal aggregates.

Nelson: And I haven't followed work by others as closely as I should have. But I think that there are plenty of people still interested in money, but far fewer people who are really saying that interesting money, the crawler of that should be monetary targeting.

Beckworth: Okay. Now, you work at the board of governors. In fact, maybe you should tell us a little bit about your position, but it'd be interesting to hear your perspective on how people think inside the Fed.

Beckworth: I mean, no one's said that Fed is a monetarist, but as you said, many of the ideas are incorporated in center practice. But tell us briefly about your position at the board of governors.

Nelson: Well, I'm a cycled senior advisor at the division of Monetary Affairs at the Federal Reserve Board. So, I'm particularly affiliated with what's called the FOMC secretariat, part of the division of monetary affairs.

Nelson: The FOMC secretary it's heavily involved in the machinery of the FOMC meetings by which I mean the agenda for the meeting, making sure that documents are circulated to the reserve banks, writing the minutes for the meeting, supervising the creation and accuracy of the transcript of the meeting, pushing out the transcripts onto the public website after five years, pushing out key memos after five years, those are sorts of things with which the FOMC secretariat is involved.

Nelson: The way I've just described it sounds very mechanical, but actually these are very important tasks, and there's a lot of economics involved in them as well. So, that's what to my responsibility is. But over and above that there's a lot of interaction with colleagues on areas of mutual interest. And I feel I can be helpful on the writing or discussion of matters and I try to be helpful.

Beckworth: Now, you have a position that many market watchers would love to have an inside look at, because the minutes before they come out, you help write the minutes. So, you have a sense how markets are going to look at this, and what they're going to take away from it. So, you're the person who actually writes them, right? You take turns…

Nelson: I would say yes. I'm one of the people who writes them. That's a very different thing from knowing how the markets will react. There're far wide heads of the board than me on those sorts of issues.

Beckworth: Okay. Well anyways, moving on to the... again, the discussion at hand about monetarism. Is there any form of that left at the board of governors when you do research with your colleagues when you sit down? Any discussions of monetary aggregates?

Nelson: Oh, absolutely.

Beckworth: Okay.

Nelson: So, I think David Lopez Lido would have a very good prospect of being named the sort of leading researcher at the board. He's really had an absolutely amazing in Stella Research Career and worked with some of the top people in the profession, including Mako Osler and Jody Golly.

Nelson: And he's an exceptionally close friend of mine, we often discuss monetary aggregates. I know he's a very avid follower of Peter Ireland's work in particular, and he had a paper with several colleagues at the Federal Reserve Board, including Ed HubSpot and Chris Gust that was published in the AI that I think used some of Peter's work not necessarily the work of money but work on Monetary Policy that built on that work in analyzing zero bond issues.

Nelson: So, I think that he and I, because of career long admirers of Peter Ireland in particular, and I've often discussed issues concerning Friedman and other figures with him. And one person I really miss at the Federal Reserve Board, although he deserves a very long retirement because he's had an enormously productive influential career at Stan Fischer.

Nelson: And of course, Stan was a colleague of Milton Friedman's. So, my authenticity as an expert on Friedman was constantly on the challenge I felt, not anything invert, but because Stan's firsthand interaction with Friedman was second to none among really people living in the profession, active in the profession.

Nelson: So, he would be another example of somebody who would often talk about Friedman. I'm not saying it was something that he would necessarily put at the center of a conversation, but there would be offhand things. And when I'm talking to people about credit or spreads and that sort of thing, I often talk to them about what Friedman and Schwartz would have said about when I say would've said, I'm not trying to put words into their mouth, but they did say about some this or that issue.

Nelson: So, I think that no one economist is really going to be part of the everyday conversation at the board. There's much more emphasis on current issues and on topics as opposed to personalities. But Friedman is suddenly a name that comes up in discussions.

Beckworth: All right. And we want to come back to Peter Ireland in a minute. When we get to, does money still matter empirically before we get to the empirics of whether money still matters, let's ask the more general question. Does money still matter?

Beckworth: And I'm just going to lay out some observations which you've touched on, but in general, money plays very little if any role in monetary policies today. So, several banks no longer look to the quantities of money as an indicator or an intermediate target, you don't have.

Beckworth: I'm not aware of any central bank that actually uses the monetary base as the instrument, the left hand side of a reaction function. In fact, the Feds floor system, there's been one paper that talked about divorcing money from Monetary Policy. The floor system allows you to adjust the quantity, the size of the balance sheet, independent of interest rates.

Beckworth: So, everything that you seem to look at in terms of the operations of Monetary Policy has kind of separated money from what is done. Even you Keynesian models, kind of the workhorse of modern macro, that my demand equation is often dropped off. Money's completely endogenous, short run, long run in between.

Beckworth: So, there's this question, does money still matter? It's very bleak kind of assessment. And let's begin with a theoretical argument. Is there still a role for money theoretically?

Nelson: I think certainly there's nothing invalid about having a money demand equation in a model. So, the circled cashless work of Woodford has talked about limiting cases in which you might have money and you might still have securities, but we're not in that world.

Nelson: So, in so far as you want to look at, money, you can certainly include a money demand function that can be derived in Keynesian model with money and the ability functional, some other motivation. So, there's no problem with getting money in there in the model.

Nelson: The question is, having gotten in the model, does it have a meaningful role or is it just as you said, just an extra equation in there? I would say that what has to be very careful about whether the new Keynesian model is breaking with historical models in a straight bit of money. And I would say that it really isn't very much.

Nelson: Provided you have a single interest rate, it's almost truism that the... and if you have an interest rate as the policy instruments, it's almost a truism that the money demand function will then be "Redundant," that you will be able to solve for inflation approach interest rates without looking at the money demand function.

Nelson: That's not something that new Keynesian model brought into the world, and thereby changed the mindset, that was something that was in old eyes, Ellen models provided you have interest rate instrument, and you don't have the interest rate responding to money. You do have this reclusiveness result as far as the dynamic equations are concerned.

Nelson: So, what's interesting is that this is not something that monetarists in the '70s took offense side. I mean, a lot of the early pioneering work on interest rate rules and being able to solve a model coherently with interest rate rules was done by monetarists like Bill Poole, and Karl Brunner and Ben McCallum.

Nelson: So, it's really the fact that you have a single interest rate is that's a key factor in making the money amount equation redundant. If you have a second interest rate and if that second interest rate in some way depends on it's spread in relation to the other interest rate in some way, depending on quantities. And you have money back in the system.

Beckworth: System.

Nelson: In terms of the long run, that's a different question. So, you could ask is it the case that you can still think of the long run level of inflation, the steady state level inflation as essentially set in, its core set by what the central bank policies are and what those policies do to them to the money stock.

Nelson: I would argue that you can't still think of the steady state inflation rate is fixed by the money growth, the steady state money growth rate. That was an area in which I sort of took issue with the Mike Woodford approach.

Nelson: Mike and I don't disagree at all on what the long run steady state equations are, is if you'd like a question of when you're staring at these equations, how do they work in long run? So, I would say that in the long run, the central bank can't control interest rates because the interest rate is ultimately a real variable since percent terms.

Nelson: The way you control it is by influencing a real quantity, the real money stock. And in the long run you can only control the long influence the nominal money stock. So, I would say that the nominal interest rate in the long run, it has to be regarded as something that central bank can't directly set.

Nelson: It can influence it because it influences the expected inflation term in the Fisher equation. But that begs the question, how does it affect the expected inflation term? And so I would say they do it by following whatever Monetary Policy they follow and long run that'll implies certain money growth rate and you would look at the steady state money demand equation to work out the implied inflation rate.

Beckworth: If you had a paper with Ben McCallum that was published in the handbook of Monetary Economics 2011. The title was Money and Inflation, some critical issues. And you do both empirics and you go over theory in there.

Beckworth: And I believe one of the arguments you make in that is that, lurking in the background of these new Keynesian models is this long run relationship, right?

Nelson: Yes.

Beckworth: That inflation is ultimately grounded by anchored by growth and money. And so, in other words, the quantity theory money is still implicit in these models even if they don't say so. It's still implicitly there.

Nelson: It's implicitly there and comes to the fore in the long run. There can't be easily written in terms of an interest rate policy in the long run. I didn't think until the exchange with Woodward, I didn't think that was a particularly controversial point, because it could be found in early papers by Mark Gutler and I thought it was implied by some of the things that Ben Bernanke had said in his writings.

Nelson: Namely that the Phillips' curve suddenly describes the inflation dynamics and there's no direct role for money if anything matters indirectly through interest rates, which in turn matter for the demand, which in turn matter for the inflation dynamics by the Phillips' curve.

Nelson: But I thought that it was less controversial than in the long run. The model becomes simpler and becomes one in which the Phillips' curve drops out. And money growth comes to the floor is what central banks influence and what then determines inflation.

Beckworth: The reason this comes up at all is because in the short run money is endogenous, right? Just because the Fed says an interest rate target, and then money supply. Well, the monetary base adjust to money demand shocks. Is that right?

Nelson: I'll get partway with that. So, I would be nervous about saying that the unimportance of money is because money is not targeted by the central bank, because by that logic even if you can establish hyper-inflations in which the central banks were concerned about money growth or if the central bank thought our job is to provide money growth to accommodate this, to provide the purchasing power for these high prices.

Nelson: Either of those, either ignoring money growth or thinking that the central bank's function is to provide money in the face of inflation. Either of those could be seen as policies in which you're making money endogenous but nevertheless money would be very useful to say the least in understanding why those equations.

Beckworth: Matters immensely.

Nelson: Yes.

Beckworth: Okay. Well, maybe rephrase it. In advanced economies with low inflation levels, in the short to medium run, the monetary base is largely endogenous. Right?

Nelson: Yeah.

Beckworth: And so, maybe people don't think carefully about it. They don't think carefully about the long run relationships because in the short run, what they kind of see day to day is an endogenous relationship.

Nelson: I think that's right. I think that particularly because the monetary base consists or consisted very heavily of currency, and it's absolutely true that the no central bank that I'm aware of has tried to regulate the volume of currency.

Nelson: That in that sense it was very obvious and tempting to see the monetary base is not a very useful variable and as "Determined by output not determined by normal income not the other way around."

Nelson: But as I say, one has to be a bit careful because whatever, it's one thing to say the central bank sets the interest rate therefore, the monetary base is endogenous. I completely agree with that. I've heard some people try to go further and say something like therefore the monetary base is not a reflection of what's happening to Monetary Policy.

Nelson: Now, different interest rate policies will imply different paths for the monetary base. In fact, one of the things I'm proud of from my time in the bank of England, while I was pretty junior, when I started that in late '90s, was that, we the staff but especially the senior staff were involved, so I was not one of the senior staff obviously.

Nelson: I was involved in writing a booklet on the transition mechanism Monetary Policy, which ultimately the NPC would review, revise, and then Monetary Policy committee of the Bank of England would review, revise and release under it's own name.

Nelson: And the initial draft was a little bit, I thought too much in the direction of saying it's clear that the interest rate is what policy makers set. Therefore, we can't really think of the money supply or the monetary base as variables that Monetary Policy variables.

Nelson: I would say because for any decision by the Monetary Policy committee, there's an implied path for the monetary base some of the money stock. It's still meaningful to think of the money, the cost of money as reflecting decisions by the monetary authorities.

Nelson: So, one way I would characterize it is that the central bank doesn't determine money supply, but influences the money supply and it's decisions are crucial for the path of money supply.

Beckworth: Yes. It's the macroeconomic environment, which then in turn drives broader monetary aggregate growth. But in general, this kind of wrap up our theoretical discussion, the quantity theory money is still binding.

Beckworth: You mentioned the currency demand growth, which is kind of a secular phenomenon. There's a certain demand of currency demand growth, which was before the crisis, the largest part of the monetary base. And maybe in the future it will be again, looking forward it is a balance sheet strength.

Beckworth: But the quantity theory might even say, look, if the Federal Reserve decided to exogenously or increase the monetary base above and beyond the growth of that currency demand, there would be some long term effect on the price level. Right?

Nelson: That's right. That's right. If nothing else was happening, if it wasn't just accommodating some surge in reserve demand or something like reserves demand or some surge in public demand for money. If like a willful increase in the money stock on the part of the central bank, then that would have-

Beckworth: A permanent one-

Nelson: Yeah.

Beckworth: ... it would lead to permanent change in the.

Nelson: Mm-hmm (affirmative).

Beckworth: Okay. Let's move on to the empiric stand. So, is there still a role for money empirically and we've touched on this, theoretically the Quantity Theory still holds even in these models, even if folks are reluctant to acknowledge it.

Beckworth: And let's maybe break this down by, does the monetary base still matter versus do broader monetary aggregates? And you mentioned Peter Arlen's. Let's go there first. He's looked at both, but he's looked in particular at broad monetary aggregates using the divisia measures of money.

Beckworth: And one of the takeaways from his work, Mike Balonegeo, Joss Hendrickson, is that some of the concerns in the 70s and 80s about money supply targeting or at least using them as an indicator variable was, there was the missing money or real money demand relationships were unstable.

Beckworth: And I think one of the implications of their work is that well if you properly measure money, some of those problems go away. Is that one takeaway from their research?

Nelson: I think suddenly they have a better short run relationships-

Beckworth: Short run relationships, okay.

Nelson: ... I think that even in the '70s and '80s, the long run relationships were actually not bad. So, the missing money period in the '70s as I understand it was really a problem with the shorter run money demand equation that Steve Gold felt in particular had been estimated for a couple of papers for the bookings panel.

Nelson: And he had found a short run money demand equation, that is a money demand equation trying to explain the quarter to quarter variations as well as long on variation of money or real money balances for M1.

Nelson: And he'd found it was a really nice fit up to about 1973. Then there was almost as soon as he published the paper, which of course seems to happen, there was a breakdown, and this is the cycle period of missing money in which M1 growth was low in relation to real and nominal and M1 growth were low in relation to what the equation would predict.

Nelson: My understanding is that subsequent research, particularly by Bob Lucas has suggested that the long run M1 demand relationship will stable it through let's say the end of the '80s and this has been backed up by later work using co-integration techniques and so forth by people like Jim Stock and Mark Watson.

Nelson: That in fact what may have happened was that Golfad, was trying to be too ambitious in fitting these period to period movements in M1. It may well be that the Visio work has found a better way of accounting for the short run movements in money in a way that the long run, in a way that the research using standard monetary aggregates was not able to do.

Beckworth: Okay. Yeah. I mean, I've had bill Barnett on the show and he's very vocal as you know about the proper use, the scientific use, Proper Aggregation Theory, Index Theory. And that you get better results when you use the Visio.

Beckworth: Okay. What about then the monetary base, because I know you've done work where you've looked at real money balances as an indicator variable that has an information above and beyond just the interest rate. Also, you had a very ethic clever approach where you looked at the Domestic Monetary Base.

Beckworth: So, we know a lot of the currencies held outside the U.S. you'll get the monetary base within the U.S. There's a recent paper on recent 2014 by John Tatum where he looks at the monetary base in the context of the QA period where he says, the monetary base is still useful if you subtract out excess reserves.

Beckworth: And then I would say we'll also subtract that maybe foreign component, do you think the monetary base itself is still useful in the current regime? The system that we're in?

Nelson: I would always be interested in looking at the monetary base. There are a lot of things going on as you don't to say the least. The last decade affecting the monetary base and effecting the Federal Reserve's balance sheet in relation to the monetary base, because there've been growth in non reserves, non currency liabilities in particular, reverse free power liabilities of the Federal Reserve.

Nelson: So, what I would ultimately like to see in my dream world of research is somebody who picks up the pieces of the Karl Brunner elementary research of trying to link the monetary base and broad monetary aggregates. Peter Ireland has done work in that direction.

Nelson: And it sounds like there's a promising work by others you just mentioned. But there's an awful lot of slippage between the monetary base and monetary aggregates at the best of times. And the last 10 years have really compounded that because you have an interest on reserves, you've had the non, as I just said, the non reserved liabilities expand.

Nelson: You've also had the really traumatic experience of the financial crisis, which I don't think it should be underestimated in terms of so long run effects. The wholesale banking market pre 2007, it was working so smoothly that if an individual bank felt short of funds, it could tap the wholesale market very quickly, very reliably.

Nelson: The 2007, 2008, period was very traumatic because you had obviously, freezing up of that market. You had big spreads, you had a lot of problems with that market, which happily have been smoothed over. But I think that experience since the experience, all of the financial crisis left a permanent mark and probably raised permanently the demand for reserves.

Nelson: So banks, even if they weren't being paid interest on reserves, I think would have a precautionary demand for reserves that would be larger than pre 2007. So, anytime you're talking about demand for reserves, you're really talking about something that would cause slippage between the monetary base and monetary aggregates.

Nelson: So, what I would like to say, this is not something that I feel it's a bit sort of off the track as far as the way my own research has gone. But what I would like to say is people trying to sort of recover and understand the relationship between the monetary base and other aggregates, because the monetary base will always be with us because Anna Schwartz used to say the function of a central bank is to provide the monetary base.

Nelson: They're the ultimate creator of liquidity. And so, it's not as though whatever economists may think of the monetary base, the monetary base will somehow cease to be a variable in monetary analysis. It's here to stay, whether it has steady relationships with other aggregates be they monetary aggregates or the economy's a different question in the last decade hasn't been very particularly encouraging.

Nelson: But there are reasons that there's been instability in that relationship. It's not as though we don't understand some of the reasons for the instability of that relationship. But I would like to see research that tries to quantify the, if you'd like the modern day relationship between the monetary base and board monetary aggregates.

Beckworth: Yeah. I think my way of thinking about this at least is you've got to get at the right measure of the monetary base, just like the Visio advocates would say, "Hey, you've got to get the right measure, the money supply."

Beckworth: I think you need to get at the right measure of the monetary base in that, as you mentioned, reserves, now there's demand for reserves that didn't exist before, because it's on excess reserves, but also new regulatory burdens on banks. The liquidity ratios and things like that.

Beckworth: So, I think that you're absolutely right. So, this kind of goes back to what is truly the high powered money today. Where you don't have interest paid on it and that'd maybe the currency component. And I'm just wondering, I'm thinking out loud, should you take maybe that portion, subtract out the foreign component of it.

Beckworth: And I've looked at it, you don't see a mass, it's fairly like linear trendish looking. And I wonder if there's any relationship between that and like nominal income. There's a relationship there.

Nelson: I think that it would be very interesting if there was a relationship between currency and the rest of the economy. I think extracting the foreign component is very important, and I'm happy to say a couple of my colleagues at the St. Louis Fed were very active in that area Bob Rash was unfortunately deceased. But also Dick Anderson who was a very vibrant advocate of monetary statistics.

Nelson: And at the bullet there's Ruth Johnson who's really been a tireless worker on the adjusting for foreign holdings of currency. So, excluding foreign holdings of currency I think is a no brainer You would want to do that.

Beckworth: Okay.

Nelson: Whether looking at currency per se is going to get you back to a variable that is if you like a modern day version of what let's say Bernard Meltzer and looked to the monetary base that I think is possible in one sense, but maybe it's going away from Brunner and Meltzer on another sense.

Nelson: In the sense that it is valid, the currency just could be a very good indicator of money demand, of transactions in the economy but also of maybe of variables and metaphor, aggregate demand because if currency is interest sensitive, then it's responding to interest rates.

Nelson: Sometimes interest rates might be very hard to measure. So, the currency in Bernard Meltzer monetarists type of spirit might be a very good stand in for important asset prices in the economy. The sense in which may be looking at currency alone would get you away from the Brunner and Meltzer approach is, that they are really emphasized that the monetary basis, particularly if you adjust it for reserve requirement changes consolidated all the quantitative actions of the central bank.

Nelson: So, obviously open market operations affect the monetary base, but they tend predominantly to affect the reserves component of the monetary base. So you would not be getting that aspect of central banking policy.

Nelson: So, in so far as the monetary base is really a measure of central bank money or central bank actions, then you maybe would want to include reserves aggregate in there, reserve-

Beckworth: So, to the extent currency component would reflect the broader idea you just mentioned, which in the past was reserves and currency maybe you can get to that. But the problem of course with including reserves is there's these new pressures, new demand pressures on them.

Nelson: Yes.

Beckworth: Well, that's a nice segue into... I want to talk about QE, what QE did over the past decade. I know you've written on this, you've mentioned your colleague, you and David López-

Nelson: Mm-hmm (affirmative), Salido?

Beckworth: ... Salido thank you. And you guys have written on the large scale asset purchases and I believe you've approached them from the kind of the segmented market story perspective, portfolio balance channel. That's how Bernanke kind of advocated.

Beckworth: I know there's also some signaling channels, but I think the main argument has been given put forth is a segmented market story that the QE is all about the asset side of the Fed's balance sheet. It's not about the reserves growth of the monetary base, it's a byproduct. It's about the composition, the mix of assets and how that can affect spreads and interest rates.

Beckworth: And that's kind of the Tobin story. I think the Modigliani straight going back, the monitor's perspective would be, we need to think more about the liability side. Is that right? Or would monetarists be okay with looking at the assets side at large?

Nelson: I think the later, this is a bit of an open question. So, John Cochran and I have had some good nitrate disagreement about this, because I think he really associates monetarism specifically we're thinking the liabilities side matters for asset price reactions.

Nelson: I would not quite put it that way. In the work that as you mentioned that David López-Salido and Havi Andres and I did on trying to put segmented market type effects into a new Keynesian model. We did emphasize the asset composition as what matters for yields, for spreads and the reaction of the time spread to Monetary Policy actions.

Nelson: But the actual position that the reason that aggregate demand reacts to Monetary Policy over and above what Monetary Policy does to the short term interest rate, that the reason Monetary Policy has these effects as of course affects asset prices and spreads.

Nelson: That is something I think is common to Tobin and to the monetarists, whether it's Friedman, Schwartz in mostly verbal accounts or Bernard Meltzer in, well, they tried to be more formal modeling frameworks, although they would not be considered very modern models today.

Nelson: So, Brunner and Meltzer, I think in particular, we're not really saying that there's something inherent about an injection of reserves that creates reactions of asset prices. I think that they lay emphasize the monetary base and reserves I believe because they were pretty confident about the reaction of the overall money stock to injections of reserves.

Nelson: Although they didn't have a mechanical money multiplier approach, they provided a modeling approach that rationalized a fairly mechanical money multiplier operation as the default setting for the way in which open market operations affect the economy.

Nelson: There are certainly circumstances in which the money multiplier approach is actually a very good way of looking at things, not that the zero lower boundary and other circumstances. So, that thing, the case, a change in the monetary base may be a very reliable indication of what's going to happen to a broader measure of money.

Nelson: If you believe that changes in the base can reliably translate into changes in let's say an M1 or an M2 type aggregate, then you can look at changes in the base and see and view the basis a proxy for the true measure of money stock for bank deposits plus currency.

Nelson: And so, I think once you look at the monetary base that way, you're not really saying the liabilities or reserves per se are important. You are saying that they are a good indication of what's going to happen to the overall money stock.

Nelson: Once you look at the money stock, you looking back at about assets because from the public's point of view, from the private sector point of view, the money is an asset. So, you do get these portfolio balance. The portfolio balance channel becomes a legitimate way of describing how the spending and asset prices react to the economy.

Beckworth: So, even though the focus on the asset side you're saying the liability side is still important, has information at least?

Nelson: That's right. Exactly.

Beckworth: Okay. Well, so my critique of QE and it's emerged early on I was a big advocate of QE and I still think it had some effect. I think the literature shows that had some effect on yields, modest effect on yields and I think there's still some debate about the overall magnitude on the real economy.

Beckworth: My takeaway, and you correct me if I'm wrong, QE one I think it probably mattered a lot. I think there's more discussion about QE 2, QE 3 but I guess where I would be critical the most of QE, and this is the monetarists to me, the part that likes the monetary base is that the liability side of the Fed's balance sheet, the expansion is largely signaled to be temporary.

Beckworth: So, there was never going to be a permanent expansion of the monetary base and anything that was permanent was going to be sterilized by interest and excess reserve. So, there was an increase in reserves. Because as you mentioned earlier, banks are hoarding those for regulatory reasons or because it was just an excess reserves, there wasn't this exogenous increase in the monetary base.

Beckworth: So, Paul Krugman's worked, he talks about a lot of his literature on the zero lower bound talks about a permanent expansion of the monetary base and even Brunner and Meltzer have some pieces they talk about there's a difference between a temporary injection versus a permanent injection.

Beckworth: So, am I right to be worried that while QE may have some effects that it loses a big punch because it doesn't allow for permanent expansions of the monetary base?

Nelson: It's certainly true that QE was not framed in terms of changes in the monetary base. It implied movements in the monetary base. But the way in which the policy was articulated was in terms of putting pressure on longterm interest rates and so forth.

Nelson: However, I think that the QE policy was not one that had a demand for reserves that canceled the increase in supply of reserves. All that canceled the... and it canceled any meaningful stimulus.

Nelson: You had factors rising the demand for reserves but you had in the form of QE factors rising the supply of reserves. And you particularly the way that reserves were created was by purchases of longterm securities, which as the Bank of England in particular has stressed.

Nelson: Is something that's more likely than orthodox conventional short term security purchases more likely to expand the money stock, because the sellers of bonds tend to be outside the commercial banking system.

Nelson: So, QE, I don't think that it was something that was so self canceling or anything like that. And one also has to take into account even if once emphasizing quantities, the prediction of people who emphasize quantities, there's nevertheless that QE would put downward pressure on asset prices and stimulate spending.

Nelson: And certainly there's evidence that QE produced reactions of asset brought downward reactions of asset prices and corresponding, I shouldn't say downward, I say upward pressure on asset prices downward pressure on yields, the perennial problem getting the signs right.

Nelson: It boosted asset prices, and put downward pressure on the term premium put on longterm rates. And it really wouldn't have done that if it wasn't a stimulative action on net. I think if something was perceived goes completely temporary, the question arises, why is even the term premium reacting in the short run?

Nelson: So, while I think there's something to the idea of a temporary permanent distinction. I would say that the QE purchases we're not self-defeating.

Beckworth: Yeah, I want to be clear. I think QE had some effect. I agree some, but if you look at the pace of recovery, right?

Nelson: Mm-hmm (affirmative).

Beckworth: ... it wasn't the most robust by historical standards. I mean, and you could maybe make other... there's other reasons for that maybe structural reasons, it's a financial crisis. But let me play this counterfactual out.

Beckworth: We know the Fed is shrinking its balance sheet and we're going to be careful here because you can't comment on certain things but just let's say the Fed for the sake of argument shrinks its balance sheet to the point where it's a small balance sheet and they go to a corridor system. So, right now it's a floor system, large balance sheet.

Beckworth: We know the Fed's been very clear, the speed of the balance sheet shrinkage, but the destination is still a little unclear. We're not sure yet at the federal end up in a floor or a corridor. If it ends up at a corridor system, we kind of go back to what we had before the crisis.

Beckworth: And if that's the case, most of those excess reserves will be gone other than West demand for regulatory reasons. The level of the monetary base will be hired just due to currency growth. But it's almost as if all of that injection access will have been kind of either taken out through currency growth or through shrinking of the balance sheet. So, in that sense, we don't know whether those injections had been temporary?

Nelson: I don't say that's necessarily an implication. I'm really talking about whether there is stimulus on it rather than what the ultimate, close to the monetary base is.

Nelson: I don't think one can say because of the monetary base in let's say 2025 is a certain level that allows us to pass a verdict on whether policy is made into 2010 or 2011 were effective or permanent.Because, some of the responses of the economy might be ones in which the commercial banking system became more confident and wanted to expand the money multiplier.

Nelson: And therefore, supported a larger deposit and loans base on a small monetary base. So, that would be a case in which, let's say the monetary became relatively smaller and yet that would be resulting from stimulus and confidence. So, I think these are questions that will be we weren't going to resolve this afternoon, but I think that-

Beckworth: Want to avoid.

Nelson: ... one has to say in 2010, the Phillips curve, the acceleration in Phillips curve equations were saying there was going to be deflation in 2010 and there wasn't. So, there was some underpinning of the nominal spending of the economy from-

Beckworth: No, I completely agree. I agree, we didn't have the great depression all over again, it definitely did something, but it never allowed a robust growth and nominal demand or you never saw a fall, you didn't even see a bounce back. You didn't see any kind of inflation overshoot.

Beckworth: And I wonder to what extent the way the QE was designed influenced it. But let me move on to one last question. We are out of time, going back to the monetary aggregates. So, we talked about there is a theoretical and empirical case for them. Which monetary aggregate do you think is the most relevant one today?

Beckworth: So let's say you believe in the Visio, like Bill Burnett has the Visio and one and two and three and four, you're getting an M3 three going into these institutional money assets as well as retail.

Beckworth: What do you think is more informative if you're looking to that? So, if central bank chair comes to you, Jay Powell says, "Hey, I buy your arguments, which measures should I be looking at?" What would you say?

Nelson: Well, speaking as a researcher rather than anything to do with policy, I would say, I'm very well disposed to an M2 type monetary aggregate. I have sort of the background of the Ben McCallum emphasis with me that what you're really interested in is sort of transactions aggregate.

Nelson: And I think that the distinction between non M1, M2 and M1 has become so porous. So, nebulous that it's worthwhile looking at M2 rather than M1 on that ground. As between divisia and non-divisia, I accept the theoretical arguments for divisia, so I'm very open to looking at divisia aggregates.

Nelson: I would draw the line I think at retail versus wholesale. So, I guess divisia M2, I'd prefer to divisia M3 and M4. Once you start putting in wholesale aggregates, you're getting into the issue of, can we motivate this money demand or will this monetary aggregate in terms of underlying theory of household money demand.

Nelson: If you think that the underlying theory of money demand is essentially household based money, the hoodie function type model, then that would strongly motivate emphasis on retail at deposits.

Nelson: Also, partly from my background of having studied the UK experience, I'm a little bit nervous about saying in the modern world, we need to go to wider and wider aggregates. That strikes me a little bit like the Radcliffe Report and from a liquidity approach.

Nelson: So, I would try to draw the line of retail aggregate exclude treasury bills, exclude liabilities that commercial banks offer to market participants as opposed to their retail customers.

Beckworth: All right, well, this has been a very fascinating conversation. Our guest today has been Ed Nelson. Ed, thank you for coming on the show.

Nelson: Thank you very much David.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.