Sunday, January 27, 2008

What is a stimulus

At the request of fellow commenter Robert D. Feinman, I’m expanding a comment from Economist’s View into a full blog post. Apropos of Paul Krugman’s column on the fiscal stimulus plan, Robert posted a comment asking:
What is "savings"? I understanding taking the check over to Walmart.

If I take the check and deposit it in my local bank what then? The bank loans out the money or buys notes from the Treasury (lending to the government). The money is then spent by the recipient. The difference is that in one case I determine how the money is "spent", in the other I delegate the spending to some one else. Why is one a stimulus and the other not?
In a later comment, I answered:
When you deposit the money in the bank, it doesn't actually get loaned out; it gets withdrawn by the Fed. That's an oversimplification, but it's roughly what happens. If you deposit money in the bank, it makes more money available in the banking system, which tends to push down the federal funds rate; but the Fed has a policy of controlling the federal funds rate, so it will act to offset your deposit by selling treasury bills (or, more precisely, probably, by buying fewer treasury bills than it otherwise would).

This raises the question of why we would need a fiscal stimulus in the first place, because if it wanted to, the Fed could just put more money in the banking system (causing the federal funds rate to fall), and there would be more loans and more purchases and we'd get the same stimulus. And the reason has to be something bad about low interest rates, but it's not clear exactly what. Maybe we're worried that low interest rates would weaken the dollar too much and cause an import price shock. Or maybe we're worried that interest rates will go down to zero (as they did in Japan), in which case banks might be unwilling to lend out the money that the Fed creates (since they wouldn't be taking any loss by just holding it, and the risks of lending might be too high).
I could add here that I think both of these considerations are things we should be worrying about right now.

Now that I think about it, though, the reason doesn’t have to be something bad about low interest rates; it could be, for example, the lag in effectiveness: one may imagine that tax rebates will be spent (if they are spent at all) more or less immediately, whereas if the money is in the banking system, it takes time to lend out, and it takes time for the borrowers to spend it.

When I actually say it, that argument doesn't sound very convincing, so I'll go back to "something bad about low interest rates," but I'll note that the "something bad" may also relate to policy lags. For example, if the "something bad" is an excessive housing boom, that also has a delayed economic stimulus effect, so that's a reason that the Fed can't do as big an initial stimulus with monetary policy as the government could do with fiscal policy.

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27 Comments:

Blogger Robert D Feinman said...

Thanks for taking up my challenge.

I've expanded my comments to a diary as well:
What is Savings? What is Spending?

The site is frequented by those from Europe and they may have some other views on economic theory. So far, no comments.

I see two issues, one of timeliness (which you also mention) and one of Puritanism disguised as economic theory.

I still fail to understand this comment of yours:
"When you deposit the money in the bank, it doesn't actually get loaned out; it gets withdrawn by the Fed."

Taken to its logical conclusion banks would have no money to lend...

Once banks have met their reserve requirement I don't see why added deposits don't lead to increased lending. If banks chose to lend to the Treasury then we would need to examine whether this leads to any economic activity. After all the source of the tax rebate is the Treasury to begin with.

So there may be something special about conditions at this moment, but the argument over spending vs saving is a continuing one in economic circles. If there is something unique right now then those pushing for a given policy should be able to explain exactly what this is.

Sun Jan 27, 11:43:00 AM EST  
Blogger knzn said...

If the supply of base money were fixed, then (assuming that banks' desire to hold excess reserves is not affected by your deposit) the process you describe would work, and your deposit would be matched one-for-one by loans, which would presumably be spent (though with a time lag and maybe not entirely, because borrowers may wish to hold some of their borrowings for working capital or in anticipation of future purchases, e.g., they might borrow in a single chunk and spend it on uncertain expenditures over the course of several years).

But the supply of base money is adjusted constantly by the Fed, and the Fed will respond to your deposit by reducing the supply of base money, in order to keep the interest rate constant.

You might ask why the Fed would do this instead of holding the supply of base money constant and letting the stimulus work. The answer is that, through various historical experiences, they have learned that controlling interest rates is a better way to conduct policy than controlling the supply of base money. The particular relevant experience is the 1930s, in which the Fed more or less tried to control the supply of base money, but banks would sometimes become more conservative and stop lending it out, which was (according to one way of looking at things, anyhow) essentially the reason for both the initial fall into depression in 1930 and the subsequent second dip in 1937. The other relevant experience is 1979-82, when they tried to adjust the base so as to keep the total amount of money (essentially base plus bank loans) constant, thus hoping to correct for both the time lags and the changes in banks' preferences with respect to excess reserves (and also theoretically for changes customers' preferences with respect to holding currency instead of deposits, although I think they pretty much ignored that aspect). They had a devil of a time trying to do that and eventually gave up and went back to targeting interest rates, which is pretty much the consensus today of how central banks should operate.

Sun Jan 27, 03:49:00 PM EST  
Blogger Robert D Feinman said...

I guess my ignorance is showing but I don't see how "the supply of base money is adjusted constantly by the Fed".

The Fed can choose not to lend to banks, but other than that they would have to change the reserve requirements, something which happens rarely. The current effort at throwing money at banks (secretly) is not the way things operate normally.

If they refuse to lend to the banks and the bank gets my deposit then it would have all the more reason to lend it out, assuming a steady reserve requirement and a reasonably constant demand for loans.

What seems to be happening to me is that the checks to taxpayers are going to covered by printing money. This will cause inflation which the Fed will then try to tamp down. One hand working at odds with the other.

By your analysis if we had a higher saving rate then there would be less money available to lend to enterprises, that just doesn't seem right.

Sun Jan 27, 06:23:00 PM EST  
Blogger knzn said...

I'm saying the Fed will respond to your deposit by choosing not to lend to banks. So the banks will lend out your deposit, but they'll end up with less other money to lend out, and the net effect on lending will be nothing.

I think you're right that the checks will, in effect, be covered by printing money (actually only in part by printing money; the rest is covered by the additional money that banks lend out when you print new money, since whoever borrows the printed money will deposit it in a bank, which can then lend it out -- minus a reserve requirement -- to somebody who will deposit it in another bank, and so on). Essentially, by holding the interest rate constant, the Fed is promising to print whatever money is necessary to keep the interest rate there. On the other hand, assuming the stimulus doesn't turn out to be too much, the money would have been printed eventually anyhow, because the Fed would cut interest rates again if the fiscal stimulus hadn't happened.

Of course the hope is that the amount of money printed will be enough to prevent a recession but not enough to produce a significant increase in inflation. (Actually, I should say, not enough to prevent a significant decrease in inflation, because most people expect the inflation rate to fall as commodity prices stabilize.) It's theoretically possible to get things just right, though in practice, the Fed often misses the mark on one side or the other, and sometimes there is no middle ground, just stagflation.


Finally, "By your analysis if we had a higher saving rate then there would be less money available to lend to enterprises, that just doesn't seem right."

What I'm saying, roughly, is that there would be exactly the same amount of money available to lend, because the Fed would offset the behavior of savers.

But that's only in the very short run. If people suddenly increase their saving, the Fed will initially offset the effect on the banking system by supplying less base money. But then, since people are buying less, the Fed will notice that the economy is weakening, and it will cut interest rates, and it will do so by supplying more base money. Ultimately, this subsequent increase in base money should roughly offset the earlier decrease in base money, so with the new savings from individuals, there will be more money available for enterprises to borrow.

Sun Jan 27, 08:17:00 PM EST  
Anonymous Anonymous said...

Saving is voluntarily spending less than is earned (consume less than is produced). The difference can be used for business expansion (or gov programs).

If the Fed creates money out of thin air to expand business (or gov), they are forcing those whose income goes up slower than inflation (or assets that grow slower than inflation) to consume less. There are limits to how much the lower end can be "forced" to consume less (rich people tend to have inflation resistant income and assets). So we borrow from foreign workers who consume less than they produce.

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Anonymous Anonymous said...

I have heard some arguments that a stimulus package bill will be funded thru borrowing from foreign creditors or governments. How does a stimulus is being funded? Can you please give some insight to this? Thank you.

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