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Thursday, March 03, 2011

Long and Variable Lags in Monetary Policy

I am between classes and in a rush, so I don't have time to say much about Scott Sumner's latest misrepresentation of what I've said (I tried to clear it up here, e.g. for just one example, he turns the statement "it would be very unusual for monetary policy to work that fast" into my saying it couldn't possible have happened -- that's not what I said). However, on one point -- the lags in monetary policy -- since Scott claims (based upon his own work on the Great Depression) that "I don’t see any long and variable lags there," and uses this to try to refute my claim about policy lags, and since he makes it sound like I am relying solely on "modern macro" to draw this conclusion, let me quote Milton Friedman as an authority on monetary policy in the Great Depression (and outside of it for that matter). Here's what Friedman said to me on policy lags in a letter on one of my papers:

...Turning to your mathematization of the idea, I am struck that it is extremely ingenious and I have no comments to make on that. In re the conclusions, I am not greatly disturbed that positive money growth shocks do not have a large impact on inflation when the economy is operating at maximum level. We have consistently found that changes in money lead changes in inflation by about two years, and there is no reason why that lag should not be just as operative at upper turning points as elsewhere. You include, as I understand it, a lag of at most six months. True, the impulse response functions implicitly extend the lag, but I suspect that is not the same as allowing for a very much longer lag. Changes in money tend to affect output after something like about six to nine months, and inflation only after another 18 months, by which time the effect on output is negative rather than positive. Hence, it is not surprising that the short-term reaction is on interest rates rather than on inflation. In a frictionless world in which money was completely neutral, the impact of monetary growth would always be solely on inflation. In the real world, given the lags that I have described and taking for granted that positive money growth is not reflected in inflation for a considerable period, it must be reflected somewhere. The obvious candidates are output, interest rates, and buffer money stocks. When the economy is operating below capacity, it is easy for part of the impact to be taken up by real output and a lesser part by interest rates or by buffer stocks. But when the economy is operating at full capacity, it cannot be taken up by output. It will therefore have to have a stronger influence on the two other components. ...

The claim that there are lags before policy takes effect is not at all controversial. I can understand the inclination to argue otherwise when you need short lags -- no lags essentially in this case -- to justify the story you've been telling about policy. But saying it, and acting quite assured in doing so, does not make it true. So, once again, to restate the claim I made, there are long and variable lags in policy. Finding significant employment effects so soon after the QEII policy was announced -- essentially within a quarter, four months at the most -- is difficult to believe given that employment is even slower to respond than output. As I said initially, we don't have the data to sort this out yet, it's too soon to know for sure, but a lag that short would be "unusual."

[Update: I probably should have also clarified what it was that I responded to in the initial post long ago. Scott claimed in a post, without any qualification I can recall, that fiscal policy had failed. Period. No question about it. My point was a simple one -- we don't have the evidence to come to that conclusion yet (and the evidence that does exist points in both directions -- you can support whatever you want by choosing the right study), and due to the timing of various policies, it will be difficult even when we do have all the data we need to do the tests properly. When monetary and fiscal policies are implemented at nearly the same time, as they were, and when they come at or near the trough of cycles, as both QEII and the recent tax cuts did, it is hard to identify them separately. And it will also be hard to separate the effects of policy from the natural recovery. The part about QEII working so soon, or not, drew the most reaction, but it was not the main point being made.]

    Posted by on Thursday, March 3, 2011 at 02:07 PM in Economics, Monetary Policy | Permalink  Comments (26)


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