1. A unprofessional trader cannot make much money, even he understands many things. Because small little detail kills. For example, the lot size of option trading, and the discount caused by liquidity of ETF.
2. Trading can be very distractive. It is costly to human capital.
3. Never use money that you will need in 5 years to trade. It creates fear, and fear makes you a poor trader.
4. Never use more than 10% of your wealth to trade. It creates fear, and fear makes you a poor trader.
5. Never use leverage.
Thursday, July 9, 2015
Thursday, July 10, 2014
Does Taylor rule pin down inflation?
The U.S. Congress is going to introduce a legislation which ties the hands of Federal Reserve. Basically, the idea is that instead of giving full discretion for the Fed to set nominal interest rate, now the Fed has to follow a Taylor rule. The Fed chairman has to explain any policy difference from the rule to the often hostile partisan Congress. The inventor of Taylor rule, John Taylor, will testify to the Congress. Needless to say, the Fed and their friends in Congress will fight back fiercely.
So let us see what is this rule: “The term ‘Reference Policy Rule’ means a calculation of the nominal Federal funds rate as equal to the sum of the following: (A) The rate of inflation over the previous four quarters. (B) One-half of the percentage deviation of the real GDP from an estimate of potential GDP. (C) One-half of the difference between the rate of inflation over the previous four quarters and two. (D) Two.
It may be an encouraging news for the New Keynesian academics, who witness their theory of monetary policy becomes orthodox. However, a scrutiny on the rule may horrify them, since this version of Taylor will cause exploding inflation according their theory.
So let us see what is this rule: “The term ‘Reference Policy Rule’ means a calculation of the nominal Federal funds rate as equal to the sum of the following: (A) The rate of inflation over the previous four quarters. (B) One-half of the percentage deviation of the real GDP from an estimate of potential GDP. (C) One-half of the difference between the rate of inflation over the previous four quarters and two. (D) Two.
Part (B) basically says, nominal interest rate should rate less than one for one to inflation. In fact, it is one half.
Tuesday, June 24, 2014
How does the central bank control interest rate?
How does the central bank control interest rate? Anyone who is slightly familiar with history knows that it is notoriously hard to control price. For example, many governments have dictated a price floor for gasoline, the result would always be a queue in the gas station. Central banks are not even able to dictate interest rates. They have to do it trough market by buying or selling Treasury bills. But a hedge fund can buy or sell Treasury bill as well, and it can be larger than the Fed (post crisis Fed is definitely larger). Benjamin Friedman argues that Fed's action can influence the interest rate because it changes the amount of bank reserves, of which Fed monopolizes the supply. However, reserve requirement is becoming less relevant. (Many countries have no requirement for any banks. In the U.S., shadow banks do not have reserve requirement. Many types of commercial bank liability also does not have reserve requirement.) Now, how do central banks control interest rates if it is not able to control the price of gasoline?
It seems that there is a fundamental difference between gasoline and money. Central banks cannot create gasoline out of nothing, but they can create money. Bank reserve, the liability of central bank to commercial banks, is the so called high power money. Neglecting other inside money, central bank can change money supply by borrowing more or less. If central bank wants to borrow more, it can just buy real assets from commercial banks with bank reserves, which the central bank can costlessly add; if the central bank wants to borrow less, it can just sell the real assets and repay the liability. But does the change of quantity of money always link to interest rate?
Let us illustrate how it works. Suppose now the market equilibrium interest is 5%, and the Fed wants 10%. So it announces that "The interest rate should be 10%". It starts to sell Treasuries to suck up bank reserves. We assume that there is no shortage of reserves, or no required reserves, or Treasury bills are so liquid which functions essentially as reserves. In this world, there would be no effect if the Fed merely changes the composition of Treasury and bank reserves. In fact, now bank reserves start to pay interest, it is hard to conceive any intrinsic difference between reserves and Treasuries. The Fed has to increases the interest on reserves, which set a floor for interest rate, since no one would lend lower if they can deposit to central bank and get 10%. It is also the ceiling, since reserve is not special, so no one would borrow reserve higher than 10%, which is already higher than the original 5%.
But wait, wouldn't a interest rate higher than equilibrium creates over-supply of credit? Does central bank need to absorb all the extra credit? Let us start with the simplest world where there is only real assets called apple, but no money. Now the central bank promises a 10% return if you lend your apple to someone. 100 people want to lend at this rate, only 60 want to borrow (each has one apple), so the central bank has to borrow the extra 40. So the central bank get the 40 apples, and issue 40 IOUs to lenders. The central bank can collect apples only through tax. Now the central bank promises a 0% return for the apple. 100 people want to borrow, but only 60 want to lend, so the central bank has to lend the extra 40. How? The central bank need to get apple by tax.
Important conclusion: in a world without money, the only way that the central bank can control the interest rate without causing shortage or excess supply is fiscal policy.
Now suppose households have money in their utility function. Central bank liability is money. It can exchange apples with money which can be costlessly supplied. Now suppose 10% case where the central bank has to accommodative excessive supply for credit. The central bank borrowed the 40 apples, and issue 40 IOUs to lenders. Money supply increases. But wait, should high interest rate be associated with low money supply?
There is a flaw in the above argument. The market for money should also cleared by interest rate. 10% definitely causes over supply of credit in terms of money in this market. So central bank has to accommodative the excess 40 supply of money, by issuing 40 IOUs. But, IOU is money, so central bank is replacing IOUs by IOUs, effectively doing nothing!
The contradictory result comes from the fact that we do not have Treasuries here. It seems essential to have an asset, which is an IOU issued by the government/central bank, but differs in liquidity from money. And more importantly, the liquidity difference matters for interest rate.
Can liquidity really affect interest rate? The amount of liquidity should only affect liquidity premium, i.e. the difference between return on liquid liability claims and illiquid liability claims. Central bank can affect the composition of liquid and illiquid claims, which will affects liquidity premium. But can it affect the return of illiquid liability claims, which is the true interest rate? In another words, does change of liquidity composition change the demand and supply for credit? How can one price (the interest rate) clear both money market and credit market?
Another way to formulate the question is: Suppose the liquid claims pay zero interest. If the central bank replace all the illiquid claims by liquid claims, can it bring down the interest rate (return on illiquid claim) to zero? Maybe not. There can be excessive credit demand at very low interest rate.
So we have come back to the claim that I made above:"It seems essential to have an asset, which is an IOU issued by the government/central bank, but differs in liquidity from money." In a world where there is no special thing about bank reserve as against Treasury, (e.g. no reserve requirement), the central bank can still control interest rate. It is not only theoretical possible, it also works in reality. New Zealand has no reserve requirement, but the bank of New Zealand can still control interest rate. How does it work? The central bank can just announce a rate, at which it is willing to borrow and lend at any amount. Since the central bank can always costly create the liability (by printing money) or eliminate the liability (selling assets, if not enough, by taxation), the central bank can always achieve the interest rate target. Therefore, to reconcile with the discussion between money and Treasury, changing liquidity premium is just one way to change interest rate, the central bank can always use other ways to change interest rate, (e.g. simply dictating the rate).
However, it is still not clear how central bank can change the rate that people borrow and lend apples by printing money. Do we have to go back to the moneyless model where the rate control is effectively through the fiscal policy? If so, how to map the printing money action to fiscal policy?
The fundamental misconception here is the distinction between nominal and real interest rate. The rate that people borrow and lend apples is real interest rate. The rate that people/central bank borrow and lend dollars is nominal interest rate. The central bank can control nominal rate, but it does not mean that it can also affect real rate. Continue our thought experiment. We add money in the apple economy, but people do not really need money. We call this the "parallel economy" since there is no interaction between nominal and real. The central bank can do what it wants on the returns on the money. But the real interest rate on apple is still 5%. An empirical analogy is Bit-coin. It can assign whatever interest on the Bit-coin, but it would not affect the interest rate of the economy since (almost) no one is using it.
So the real question is: when central bank changes nominal interest rate, does it change the real interest rate? To answer this question, we first note that the difference is inflation. In the parallel economy, the real rate is always constant. An increase of nominal rate mechanically means that the inflation rate will go up (quite unintuitively if one believes high nominal rate means monetary tightening and disinflation). In an economy where inflation is rigid, an increase nominal rate will lead to an increase of real rate. This is basically what New Keynesian framework is: central bank controls nominal rate directly, and inflation is sticky. They do not need to specify how the interest rate target is achieved, they do not pay any attention to the quantity of money or the size of balance sheet of the central bank, because it is almost tautological that central bank can control nominal rate. What they do is to model why inflation is sticky.
Now the question left is that when the central bank tries to control nominal interest rate, will it end up with a gigantic balance sheet? In the parallel economy, since money has no use, central bank's action will have no effect on the size of balance sheet (in terms of apples), since it is constant zero. In the other extreme, where inflation is fixed, the central bank's action causes real rate to vary, but how?
Suppose the price of apple is fixed, so inflation is zero. Now central bank raises the nominal rate to 10%, which means the real rate also becomes 10%. More people want to lend than borrow. So central bank accept the excess credit supply, either in terms of money or apple. In a second scenario, the central bank reduces the nominal rate to 0%. So the central bank has to accommodate the excess demand, either in terms of money or apple. If the central bank lends apple out, it has to tax apple in the first place. This thought experiment seems to show that the central bank's action, if it really changes the term that people borrow and lend the real good, will cause substantial variation of the size of central bank balance sheets, and very likely involves fiscal policy.
This points to the curious feature of New Keynesian model, in which the size of central bank balance sheet or fiscal policy does not show up explicitly. We need to resort to fiscal theory to address this mystery.
It seems that there is a fundamental difference between gasoline and money. Central banks cannot create gasoline out of nothing, but they can create money. Bank reserve, the liability of central bank to commercial banks, is the so called high power money. Neglecting other inside money, central bank can change money supply by borrowing more or less. If central bank wants to borrow more, it can just buy real assets from commercial banks with bank reserves, which the central bank can costlessly add; if the central bank wants to borrow less, it can just sell the real assets and repay the liability. But does the change of quantity of money always link to interest rate?
Let us illustrate how it works. Suppose now the market equilibrium interest is 5%, and the Fed wants 10%. So it announces that "The interest rate should be 10%". It starts to sell Treasuries to suck up bank reserves. We assume that there is no shortage of reserves, or no required reserves, or Treasury bills are so liquid which functions essentially as reserves. In this world, there would be no effect if the Fed merely changes the composition of Treasury and bank reserves. In fact, now bank reserves start to pay interest, it is hard to conceive any intrinsic difference between reserves and Treasuries. The Fed has to increases the interest on reserves, which set a floor for interest rate, since no one would lend lower if they can deposit to central bank and get 10%. It is also the ceiling, since reserve is not special, so no one would borrow reserve higher than 10%, which is already higher than the original 5%.
But wait, wouldn't a interest rate higher than equilibrium creates over-supply of credit? Does central bank need to absorb all the extra credit? Let us start with the simplest world where there is only real assets called apple, but no money. Now the central bank promises a 10% return if you lend your apple to someone. 100 people want to lend at this rate, only 60 want to borrow (each has one apple), so the central bank has to borrow the extra 40. So the central bank get the 40 apples, and issue 40 IOUs to lenders. The central bank can collect apples only through tax. Now the central bank promises a 0% return for the apple. 100 people want to borrow, but only 60 want to lend, so the central bank has to lend the extra 40. How? The central bank need to get apple by tax.
Important conclusion: in a world without money, the only way that the central bank can control the interest rate without causing shortage or excess supply is fiscal policy.
Now suppose households have money in their utility function. Central bank liability is money. It can exchange apples with money which can be costlessly supplied. Now suppose 10% case where the central bank has to accommodative excessive supply for credit. The central bank borrowed the 40 apples, and issue 40 IOUs to lenders. Money supply increases. But wait, should high interest rate be associated with low money supply?
There is a flaw in the above argument. The market for money should also cleared by interest rate. 10% definitely causes over supply of credit in terms of money in this market. So central bank has to accommodative the excess 40 supply of money, by issuing 40 IOUs. But, IOU is money, so central bank is replacing IOUs by IOUs, effectively doing nothing!
The contradictory result comes from the fact that we do not have Treasuries here. It seems essential to have an asset, which is an IOU issued by the government/central bank, but differs in liquidity from money. And more importantly, the liquidity difference matters for interest rate.
Can liquidity really affect interest rate? The amount of liquidity should only affect liquidity premium, i.e. the difference between return on liquid liability claims and illiquid liability claims. Central bank can affect the composition of liquid and illiquid claims, which will affects liquidity premium. But can it affect the return of illiquid liability claims, which is the true interest rate? In another words, does change of liquidity composition change the demand and supply for credit? How can one price (the interest rate) clear both money market and credit market?
Another way to formulate the question is: Suppose the liquid claims pay zero interest. If the central bank replace all the illiquid claims by liquid claims, can it bring down the interest rate (return on illiquid claim) to zero? Maybe not. There can be excessive credit demand at very low interest rate.
So we have come back to the claim that I made above:"It seems essential to have an asset, which is an IOU issued by the government/central bank, but differs in liquidity from money." In a world where there is no special thing about bank reserve as against Treasury, (e.g. no reserve requirement), the central bank can still control interest rate. It is not only theoretical possible, it also works in reality. New Zealand has no reserve requirement, but the bank of New Zealand can still control interest rate. How does it work? The central bank can just announce a rate, at which it is willing to borrow and lend at any amount. Since the central bank can always costly create the liability (by printing money) or eliminate the liability (selling assets, if not enough, by taxation), the central bank can always achieve the interest rate target. Therefore, to reconcile with the discussion between money and Treasury, changing liquidity premium is just one way to change interest rate, the central bank can always use other ways to change interest rate, (e.g. simply dictating the rate).
However, it is still not clear how central bank can change the rate that people borrow and lend apples by printing money. Do we have to go back to the moneyless model where the rate control is effectively through the fiscal policy? If so, how to map the printing money action to fiscal policy?
The fundamental misconception here is the distinction between nominal and real interest rate. The rate that people borrow and lend apples is real interest rate. The rate that people/central bank borrow and lend dollars is nominal interest rate. The central bank can control nominal rate, but it does not mean that it can also affect real rate. Continue our thought experiment. We add money in the apple economy, but people do not really need money. We call this the "parallel economy" since there is no interaction between nominal and real. The central bank can do what it wants on the returns on the money. But the real interest rate on apple is still 5%. An empirical analogy is Bit-coin. It can assign whatever interest on the Bit-coin, but it would not affect the interest rate of the economy since (almost) no one is using it.
So the real question is: when central bank changes nominal interest rate, does it change the real interest rate? To answer this question, we first note that the difference is inflation. In the parallel economy, the real rate is always constant. An increase of nominal rate mechanically means that the inflation rate will go up (quite unintuitively if one believes high nominal rate means monetary tightening and disinflation). In an economy where inflation is rigid, an increase nominal rate will lead to an increase of real rate. This is basically what New Keynesian framework is: central bank controls nominal rate directly, and inflation is sticky. They do not need to specify how the interest rate target is achieved, they do not pay any attention to the quantity of money or the size of balance sheet of the central bank, because it is almost tautological that central bank can control nominal rate. What they do is to model why inflation is sticky.
Now the question left is that when the central bank tries to control nominal interest rate, will it end up with a gigantic balance sheet? In the parallel economy, since money has no use, central bank's action will have no effect on the size of balance sheet (in terms of apples), since it is constant zero. In the other extreme, where inflation is fixed, the central bank's action causes real rate to vary, but how?
Suppose the price of apple is fixed, so inflation is zero. Now central bank raises the nominal rate to 10%, which means the real rate also becomes 10%. More people want to lend than borrow. So central bank accept the excess credit supply, either in terms of money or apple. In a second scenario, the central bank reduces the nominal rate to 0%. So the central bank has to accommodate the excess demand, either in terms of money or apple. If the central bank lends apple out, it has to tax apple in the first place. This thought experiment seems to show that the central bank's action, if it really changes the term that people borrow and lend the real good, will cause substantial variation of the size of central bank balance sheets, and very likely involves fiscal policy.
This points to the curious feature of New Keynesian model, in which the size of central bank balance sheet or fiscal policy does not show up explicitly. We need to resort to fiscal theory to address this mystery.
By the Old Keynesian's and the New
How does monetary policy affect the real economy in the New Keynesian models? To answer this question, we need to understand how monetary policy pins down inflation. I didn't recognize these two questions can be pursued separately until I read Cochrane's "Determinacy and Identification with Taylor Rules". The key is to recognize that we can have money as unit of count in a frictionless economy. New Keynesian models are examples of cashless economy, and money is the unit of count, and nominal variables are well-defined in absence of price stickiness.
Therefore, to understand how monetary policy pins down inflation, the New Keynesian Phillips Curve (NKPC) is not essential. Gali (2008) claims that:"The NKPC determines inflation given a path for the output gap, whereas the DIS equation determines the output gap given a path for the (exogenous) natural rate and the actual real rate. In order to close the model, supplement those two equations with one or more equations determining how the nominal interest rate i evolves over time, i.e., with a description of how monetary policy is conducted." However, the key point is that three differential equations do not uniquely pin down three processes. "Determinacy in the new-Keynesian model does not fundamentally reply on frictions". The fundamental source of indeterminacy is the absence of initial condition.
The key insight of Cochrane's critique is that New Keynsian model selects a certain initial condition (or boundary condition, or expectation) such that the inflation does not go to infinity as time goes by. Economically, it sounds odd. It means that the agents will choose a current inflation such that it will not explode in the future. In reality, inflation as a nominal variable does explode. In a model with price stickiness, exploding inflation will lead to exploding real variables, which seems to violate transversality condition. However, this is not a result. It is merely an assumption that price will always be sticky even if inflation is exploding. This assumption is not realistic since we do see price becomes more and flexible when inflation explodes, and we do see a currency is abandoned when inflation goes out of control, which basically means perfect price flexibility. In the real world, exploding nominal variables do happen, and it never leads to exploding real variables. So ruling out exploding paths is not sensible.
Exploding paths are not only sensible, they are also interesting to study. Exploding path does not necessarily leads to exploding inflation. The central bank can revert to a non-exploding path half way. The Fed in the 70s definitely allows inflation to grow out of bound, and then Volker reverted it. I feel this is a more accurate description than Fed under Volker chooses a Taylor rule such that the current inflation has to be certain value, otherwise it will explode. It was exploding before Volker, and Volker stopped the explosion.
So what pins down the initial condition? Cochrane suggests fiscal theory of price level. From the experience of Volker disinflation, it seems to be the right answer. How does Volker disinflation happen? Volker refused to monetize government bond (printing money to buy bond to keep price high and interest low), so nominal interest rate sky-rocketed. High interest rate generated political pressure to cut deficit. Inflation decreased as a result. Suppose the congress did not cut deficit, will disinflation still happen? Following Cochrane, let us think in the perfect foresight friction-less framework, without ruling the explosive equilibria. In this framework, real rate is exogenously pinned down by endowment processes, and current inflation is pinned down by nominal rate from the Fisher equation. Face current high inflation, Fed unexpectedly hikes nominal rate, which leads to higher inflation, which in turn leads to even higher nominal rate. Inflation explodes rather than recedes. Current New Keynesian's approach will tell you a very different story: "Agents realize the inflation has to go down to certain level, otherwise the inflation will explode." The inflation was exploding before Volker. He cannot threaten the economy by make it explode.
Fiscal theory assumes an exogenous path of real prime surplus and current nominal bond level. This pins down the current price level. The government can choose a future nominal bond level, which pins down future price level. The change of two dates pins down inflation and nominal interest rate. In essence, choosing nominal bond level and choosing nominal interest rate is equivalent, given exogenous real surplus. So we can still think the central bank is following an interest rate rule. The only difference is that it uniquely pins down inflation. Comparing fiscal theory and Taylor rule-New Keynesian equilibrium determination, the only difference is that fiscal theory specifies the path of real prime surplus(Specifying nominal bond level is equivalent to specifying nominal interest rate). Therefore, it is all too transparent to understand why Taylor rule does not uniquely pin down the price and inflation: given a path of nominal rate(or how nominal rate react to inflation), there are many ways that the government can vary its a path of real prime surplus. Those path where inflation goes out of bound could simply because that the government issues too much nominal debt without backing by increase of real surplus. A key point for empirical research: Government does not need to run deficit to set off an inflation. Government only needs to sell too many nominal bonds. In fiscal theory, nominal government debt is unit of count. If you have too many, the unit will change. Nominal interest rate is the spread in which the total amount of debt grows: A higher nominal rate seems to help to fuel an inflation, since high nominal rate increases refinancing cost, so the next period nominal bond level goes even higher. Paradoxically, a low nominal rate seems to stop inflation. Less controversially, a low real deficit also stop inflation.
Mathematically, fiscal theory is an interest rate rule with the initial conditions. So the dichotomy of monetary dominance and fiscal dominance is not hard to distinguish mathematically. If one believes Taylor rule alone does not pin down equilibrium, then one always need fiscal theory. Whether i. the congress chooses real surplus and nominal debt level, and let the market to sort out nominal rate, or ii. the Fed chooses nominal debt level and nominal rate, and force the congress to choose real surplus to avoid default, or iii. the congress chooses real surplus and Fed chooses nominal rate, let the market to sort out nominal debt level is hard to distinguish mathematically. Empirically, we can assume that congress does not want cut spending, so a cut means it was dominated by the Fed.
The new Keynesian's intuition is quite different from old in selecting equilibrium. In old Keynesian models, today's inflation is pinned down by yesterday's inflation and output. Old Keynesian needs nominal rate to over-react to inflation, so that today's output falls to cancel the shock to the inflation process (which is unit root). Otherwise, the equilibrium path will be exploding. In New Keynesian models, today's inflation depends on expectation of tomorrow's inflation. An over-reacting monetary policy will send the inflation to infinity, except the current inflation is exactly at the saddle point. By the old Keynesian and the new, I have to say that these two intuitions cannot be more different.
Therefore, to understand how monetary policy pins down inflation, the New Keynesian Phillips Curve (NKPC) is not essential. Gali (2008) claims that:"The NKPC determines inflation given a path for the output gap, whereas the DIS equation determines the output gap given a path for the (exogenous) natural rate and the actual real rate. In order to close the model, supplement those two equations with one or more equations determining how the nominal interest rate i evolves over time, i.e., with a description of how monetary policy is conducted." However, the key point is that three differential equations do not uniquely pin down three processes. "Determinacy in the new-Keynesian model does not fundamentally reply on frictions". The fundamental source of indeterminacy is the absence of initial condition.
The key insight of Cochrane's critique is that New Keynsian model selects a certain initial condition (or boundary condition, or expectation) such that the inflation does not go to infinity as time goes by. Economically, it sounds odd. It means that the agents will choose a current inflation such that it will not explode in the future. In reality, inflation as a nominal variable does explode. In a model with price stickiness, exploding inflation will lead to exploding real variables, which seems to violate transversality condition. However, this is not a result. It is merely an assumption that price will always be sticky even if inflation is exploding. This assumption is not realistic since we do see price becomes more and flexible when inflation explodes, and we do see a currency is abandoned when inflation goes out of control, which basically means perfect price flexibility. In the real world, exploding nominal variables do happen, and it never leads to exploding real variables. So ruling out exploding paths is not sensible.
Exploding paths are not only sensible, they are also interesting to study. Exploding path does not necessarily leads to exploding inflation. The central bank can revert to a non-exploding path half way. The Fed in the 70s definitely allows inflation to grow out of bound, and then Volker reverted it. I feel this is a more accurate description than Fed under Volker chooses a Taylor rule such that the current inflation has to be certain value, otherwise it will explode. It was exploding before Volker, and Volker stopped the explosion.
So what pins down the initial condition? Cochrane suggests fiscal theory of price level. From the experience of Volker disinflation, it seems to be the right answer. How does Volker disinflation happen? Volker refused to monetize government bond (printing money to buy bond to keep price high and interest low), so nominal interest rate sky-rocketed. High interest rate generated political pressure to cut deficit. Inflation decreased as a result. Suppose the congress did not cut deficit, will disinflation still happen? Following Cochrane, let us think in the perfect foresight friction-less framework, without ruling the explosive equilibria. In this framework, real rate is exogenously pinned down by endowment processes, and current inflation is pinned down by nominal rate from the Fisher equation. Face current high inflation, Fed unexpectedly hikes nominal rate, which leads to higher inflation, which in turn leads to even higher nominal rate. Inflation explodes rather than recedes. Current New Keynesian's approach will tell you a very different story: "Agents realize the inflation has to go down to certain level, otherwise the inflation will explode." The inflation was exploding before Volker. He cannot threaten the economy by make it explode.
Fiscal theory assumes an exogenous path of real prime surplus and current nominal bond level. This pins down the current price level. The government can choose a future nominal bond level, which pins down future price level. The change of two dates pins down inflation and nominal interest rate. In essence, choosing nominal bond level and choosing nominal interest rate is equivalent, given exogenous real surplus. So we can still think the central bank is following an interest rate rule. The only difference is that it uniquely pins down inflation. Comparing fiscal theory and Taylor rule-New Keynesian equilibrium determination, the only difference is that fiscal theory specifies the path of real prime surplus(Specifying nominal bond level is equivalent to specifying nominal interest rate). Therefore, it is all too transparent to understand why Taylor rule does not uniquely pin down the price and inflation: given a path of nominal rate(or how nominal rate react to inflation), there are many ways that the government can vary its a path of real prime surplus. Those path where inflation goes out of bound could simply because that the government issues too much nominal debt without backing by increase of real surplus. A key point for empirical research: Government does not need to run deficit to set off an inflation. Government only needs to sell too many nominal bonds. In fiscal theory, nominal government debt is unit of count. If you have too many, the unit will change. Nominal interest rate is the spread in which the total amount of debt grows: A higher nominal rate seems to help to fuel an inflation, since high nominal rate increases refinancing cost, so the next period nominal bond level goes even higher. Paradoxically, a low nominal rate seems to stop inflation. Less controversially, a low real deficit also stop inflation.
Mathematically, fiscal theory is an interest rate rule with the initial conditions. So the dichotomy of monetary dominance and fiscal dominance is not hard to distinguish mathematically. If one believes Taylor rule alone does not pin down equilibrium, then one always need fiscal theory. Whether i. the congress chooses real surplus and nominal debt level, and let the market to sort out nominal rate, or ii. the Fed chooses nominal debt level and nominal rate, and force the congress to choose real surplus to avoid default, or iii. the congress chooses real surplus and Fed chooses nominal rate, let the market to sort out nominal debt level is hard to distinguish mathematically. Empirically, we can assume that congress does not want cut spending, so a cut means it was dominated by the Fed.
The new Keynesian's intuition is quite different from old in selecting equilibrium. In old Keynesian models, today's inflation is pinned down by yesterday's inflation and output. Old Keynesian needs nominal rate to over-react to inflation, so that today's output falls to cancel the shock to the inflation process (which is unit root). Otherwise, the equilibrium path will be exploding. In New Keynesian models, today's inflation depends on expectation of tomorrow's inflation. An over-reacting monetary policy will send the inflation to infinity, except the current inflation is exactly at the saddle point. By the old Keynesian and the new, I have to say that these two intuitions cannot be more different.
(the above graph is a simulation of King(2000) with the initial inflation and output slightly deviate from the saddle point (0,0). As shown, it leads to explosion.)
Wednesday, June 18, 2014
Dangerous Money
"Monetary theory is a dangerous thing", he smiled and continued, "Many researchers are sucked into it, but never get out: they never produce anything." Such is the warning from one of the smartest theorist in the department.
Money is always intriguing. Economists spent decades to understand why people exchange real goods for a piece of paper with no intrinsic value. Now it seems that we have a rough ideas: money arises to solve the problem of double coincidence of wants: I have something that you want but you don't have something that I want, so you give me money so I can buy it from a third person. But "it is a theory for money one hundred years ago". He exclaimed. "We now have credit cards, bank accounts, stock mutual funds. We are in an essentially cash-less economy."
I agree. Modern monetary policy suggests that a record keeping device, say a computer, can also solve the problem of double coincidence of want. In Kocherlakota's words, "Money is memory". In other words, anything has memory can be money. Instead you give me money, the computer debits your account balance and credits mine. No money changed hands.
So economists in the 20th century have to include bank deposit as money, which their ancestors in 19th century were quite hesitant to do. Now, technology advance allows you to buy coffee with your mutual funds (Although it has to be a special type of funds call money market funds). Do you count mutual funds, stocks, bonds and even houses as money?
This is not a purely philosophical question out of pure curiosity. It is practical. Understanding how money works is the first step to understand how monetary policy works. The central question is how the central bank controls interest rate. It is notoriously hard to control price, let alone the most important price in the economy, interest rate.
"Money is beyond any single man's comprehension." He concluded. But I disagree. Economics is a not a rocket science. It is a worldly philosophy. There is nothing deep here: people make simple decisions based on cost and benefit. That is it. I believe with careful thinking and rigorous reasoning, one can come up with a theory, like David Hume's "Of Money" and "Of Interest". Moreover, we have the bless of modern information technology. It would not be hard to test our theories with plethora of data.
Let me end with a quote from Hume. It refutes money agnosticism by its power of reasoning:
"Were all the gold in England annihilated at once, and one and twenty shillings substituted in the place of every guinea, would money be more plentiful or interest lower? No surely: We should only use silver instead of gold. Were gold rendered as common as silver, and silver as common as copper, would money be more plentiful or interest lower? We may assuredly give the same answer. Our shillings would then be yellow, and
our halfpence white, and we should have no guineas. No other difference would ever be observed, no alteration on commerce, manufactures, navigation, or interest, unless we imagine that the color of money is of any consequence.”
Tuesday, June 17, 2014
Richard M. Nixon: A Life in Full
"The author is a crook." A political science professor said this to me when I was half way through the book, "but he writes good biographies". I was intrigued. I googled the author of the book, Conrad Black, and found that he was sentenced to prison because of inside trading. True story.
"The book tries to justify Nixon's legacy", a review criticized. "Conrad Black and Nixon both have the ability to convince themselves that imaginative facts are real", a friend in history commented sarcastically. How biased is the book? Should I stop reading it? I asked myself.
Maybe it is good to have someone like Black to write Nixon. as observed by Franklin D. Roosevelt: "It takes a thief to catch a thief". Reading the book, one can clearly tell Black identifies with Nixon. He was thinking in Nixon's shoes, pondering each hard decision as if it is his own decision to make, essentially relived Nixon's life as if it was his own.
So it is a great book. The best part is how the author interpret Nixon's political calculations in his way to power. Nixon as an underdog exhibits the incredible political skills in forming alliance, attacking enemies, give and take, shock and awe. In "the Great Train Robbery", Nixon shows his ruthless Machiavellian skill by selling out his old ally to the powerful new boss, Eisenhower. In the "fund crisis" when Eisenhower wanted to ditch a rumour inflicted Nixon, Nixon took his enemies by surprise: he directly reached to the general public, gave his "checkers speech" in TV, refuted the rumour, won the support from the people, and had a full come-back. Black made all of these episodes alive.
Nixon also exhibits an incredible perseverance. When he lost his first bid for presidency to John F. Kennedy, and two years later, governorship of California to some unknown candidates. Everyone thought he's over. In politics, much depends on perceptions. Quote George R.R. Martin, "Power resides where men believe it resides. No more and no less." It is hard to imagine someone who has lost the perception could come back. Yet he did come back eight years later, as the president of the United States. This contrasts to the sad story of Lyndon B. Johnson, the president before Nixon. LBJ made a huge mistake in plunging the U.S. into Vietnam war. Unlike Nixon, he never came out of it. He didn't run for re-election, gave up fighting, and smoke heavily, and became over-weight. According to his intimate friend, "He basically waited to die." He died at an age of 65, four years after his presidency. In comparison, despite all the ridicules and criticism after Watergate, Nixon lived to 82. He told Chou Enlai on this defeat and come-back: "hope when my life is over, I’ll have one more victory than defeat."
Despite of his astonishing intelligence and endurance, it is hard to like Nixon as a person always neurotic, awkward, cynical and ungracious. Although Black tries to minimize the Watergate controversy, it is a hard sell. His downfall reveals the flaws of his character: he never commands the magnanimity of a president. His humble background may explain his insecurity facing the hostility of the establishment, but cannot justify his nasty way to deal with it. As the political science professor said, "Many presidents came from humble backgrounds: Clinton's father died before Clinton's born, and the step father is an alcoholic who almost killed Clinton's mother. Obama does not even have a father. Lincoln's mother died when Lincoln was 9. But... they all rise above it."
"The book tries to justify Nixon's legacy", a review criticized. "Conrad Black and Nixon both have the ability to convince themselves that imaginative facts are real", a friend in history commented sarcastically. How biased is the book? Should I stop reading it? I asked myself.
Maybe it is good to have someone like Black to write Nixon. as observed by Franklin D. Roosevelt: "It takes a thief to catch a thief". Reading the book, one can clearly tell Black identifies with Nixon. He was thinking in Nixon's shoes, pondering each hard decision as if it is his own decision to make, essentially relived Nixon's life as if it was his own.
So it is a great book. The best part is how the author interpret Nixon's political calculations in his way to power. Nixon as an underdog exhibits the incredible political skills in forming alliance, attacking enemies, give and take, shock and awe. In "the Great Train Robbery", Nixon shows his ruthless Machiavellian skill by selling out his old ally to the powerful new boss, Eisenhower. In the "fund crisis" when Eisenhower wanted to ditch a rumour inflicted Nixon, Nixon took his enemies by surprise: he directly reached to the general public, gave his "checkers speech" in TV, refuted the rumour, won the support from the people, and had a full come-back. Black made all of these episodes alive.
Nixon also exhibits an incredible perseverance. When he lost his first bid for presidency to John F. Kennedy, and two years later, governorship of California to some unknown candidates. Everyone thought he's over. In politics, much depends on perceptions. Quote George R.R. Martin, "Power resides where men believe it resides. No more and no less." It is hard to imagine someone who has lost the perception could come back. Yet he did come back eight years later, as the president of the United States. This contrasts to the sad story of Lyndon B. Johnson, the president before Nixon. LBJ made a huge mistake in plunging the U.S. into Vietnam war. Unlike Nixon, he never came out of it. He didn't run for re-election, gave up fighting, and smoke heavily, and became over-weight. According to his intimate friend, "He basically waited to die." He died at an age of 65, four years after his presidency. In comparison, despite all the ridicules and criticism after Watergate, Nixon lived to 82. He told Chou Enlai on this defeat and come-back: "hope when my life is over, I’ll have one more victory than defeat."
Despite of his astonishing intelligence and endurance, it is hard to like Nixon as a person always neurotic, awkward, cynical and ungracious. Although Black tries to minimize the Watergate controversy, it is a hard sell. His downfall reveals the flaws of his character: he never commands the magnanimity of a president. His humble background may explain his insecurity facing the hostility of the establishment, but cannot justify his nasty way to deal with it. As the political science professor said, "Many presidents came from humble backgrounds: Clinton's father died before Clinton's born, and the step father is an alcoholic who almost killed Clinton's mother. Obama does not even have a father. Lincoln's mother died when Lincoln was 9. But... they all rise above it."
Tuesday, February 25, 2014
Team of Rivals
The word used again and again to describe Lincoln's personality is "Magnanimity". It is the character with which Lincoln could transcend personal feelings, to do what he needed to do.
Politics is an art of possibilities. I was surprised by all the political tactics employed by Lincoln to secure votes for the thirteenth amendment to abolish slavery. As his famous words:"I am the president of the United States of America, clothed immense power, you will procure me these votes". Lincoln actually tried to influence the congress election after his Emancipation Proclamation, since the result of the election will be viewed as a public judgement on his policy. He had to win, so he used all possible ways to make sure that he would win.
A man with super ability will never be buried. Who can anticipate a self educated man who lost in his bid for congress and senate several times would rise to become the president of the United States? I remember what Lincoln said after the he lost the senate, he said, I slipped, I didn't fall.
Politics is an art of possibilities. I was surprised by all the political tactics employed by Lincoln to secure votes for the thirteenth amendment to abolish slavery. As his famous words:"I am the president of the United States of America, clothed immense power, you will procure me these votes". Lincoln actually tried to influence the congress election after his Emancipation Proclamation, since the result of the election will be viewed as a public judgement on his policy. He had to win, so he used all possible ways to make sure that he would win.
A man with super ability will never be buried. Who can anticipate a self educated man who lost in his bid for congress and senate several times would rise to become the president of the United States? I remember what Lincoln said after the he lost the senate, he said, I slipped, I didn't fall.
Subscribe to:
Posts (Atom)