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December 2, 2011

Money and Ships

I was going to post about a crisis of confidence among monetarists, but on the way I had a crisis of confidence. So I thought that I would write about some of my thoughts regarding monetary policy and ships. You might wonder if you do something a little bit and get a result how it could be that if you do it a lot the result is not more of the previous result. Now comes the ship metaphor. If a ship is moving and you turn the wheel slightly, the ship changes course . . . admittedly with some lag. But if you turn the wheel all the way over so that he rudder is perpendicular to the length of the ship, the ship slows. The implication is that if you increase the rate of money growth from 2% to 6% we would call that an expansionary monetary policy posture. But if you double or triple the money supply, the result may not be a hugely expansionary or even inflationary impact.

What is going on here? In order to be effective in turning the ship, the rudder must produce lift (not just drag) as water passes around it. There must be a connection between the rudder and the water that speeds up along the side opposite to the direction of turn. In order to be effective in turning the economy, there must be a link between monetary base and money. If excess reserves grow seemingly without limit, you can forget about the effectiveness of monetary policy.

This is not to say that you can forget about money. The Fed has created a tinderbox of inflation that could be set off by a recovery.

Now getting back to confidence, we should all be a bit modest with our predictions and advice. There are no historical parallels to our current mess. The money stock suggests that nobody’s models are calibrated to handle the current situation. Anybody who asserts that their model predicts something has no sense of the concept of prediction errors.

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