(Larry White assisted me in writing this article.)

A number of recent exchanges between Market Monetarists and their critics, and especially those of their critics associated with the Austrian school, have debated the contribution of excessively easy Fed policy toward the housing boom and bust. The issue boils down to this: can monetary policy really be said to have contributed to the housing boom in light of the fact that the NGDP growth rate during the 2003–2007 period was, as the figure below illustrates, only a percentage point or so above its previous 5 percent trend?

Market Monetarists tend to answer, “surely not,” while Austrians (and some others, like John Taylor) insist that it is “yes.” The difference has to do in part with the very different theoretical frameworks employed by the different sides. For Market Monetarists, like their old-fashioned monetarist predecessors, the framework consists of short- and long-run AS schedules, with the slope of the short run AS schedule reflecting the degree of short-run price and wage stickiness, among other things. AD innovations, including more rapid than usual AD growth, influence real activity by moving the economy along the short-run AS schedule. The stickier prices are, the flatter the schedule, and the greater the change in output.

Like other monetarists Market Monetarists tend to assume that prices and wages exhibit considerably less upward than downward stickiness. That perspective informed Friedman’s so-called “plucking model” of the business cycle, according to which the plot of real output resembled a string glued to an incline plane, rising from left to right, that was “plucked” downward here and there owing to slow (or negative) demand growth. According to the plucking model, output drops below its “natural” rate whenever slow spending occurs, because there’s a fair degree of downward rigidity in prices and wages. But output seldom rises much above its natural rate, because prices and wages are relatively flexible upwards, so that rapid demand growth tends instead to manifest itself in corresponding upward price movements. A steady rate of NGDP growth avoids the occasional downward “plucking” of output.

To make their case for stable NGDP growth Market Monetarists don’t need to refer to interest rates generally or to the federal funds rate as an indicator of the stance of monetary policy–with a low funds rate indicating “loose” money and a high one indicating “tight” money. Indeed, they regard the common tendency to treat the federal funds rate this way as misleading at worst and a distraction at best, and would rather have monetary policy makers pay no attention to interest rates at all, and simply focused on the course of aggregate spending.

To be sure, the Market Monetarists have a point. Nothing could be more naive than the (Keynesian) treatment of interest as the “price” of money, with low rates signifying an abundance of money and high ones signifying a shortage. We can applaud their efforts to put the “money” back into monetary economics and policy, albeit not by drawing attention to the causal role of monetary aggregates but rather by emphasizing M x V or, equivalently, P x y.

But in seeking to free monetary theory and policy from the Keynesian overemphasis on interest rates, the Market Monetarists tend to downplay the extent to which central banks can cause or aggravate unsustainable asset price movements by means of policies that drive interest rates away from their “natural” values. Such distortions can be significant even when they don’t involve exceptionally rapid growth in nominal income, because measures of nominal income, including nominal GDP, do not measure financial activity or activity at early stages of production. When interest rates are below their natural levels, spending is re-directed toward those earlier stages of production, causing total nominal spending (Fisher’s P x T) to expand more than measured nominal income (P x y). Assets prices, which are (appropriately) excluded from both the GDP deflator and the CPI, will also rise disproportionately. It is the possibility that such asset price distortions may significantly misdirect the allocation of financial and production resources that lies at the heart of the “Austrian” theory of boom and bust.

The notion of a “natural” rate of interest comes, of course, from Knut Wicksell, who, starting with the premise that new money is delivered to the economy by way of the credit market, argued that excess money creation would result first in a lowering of interest rates, and only subsequently in a general increase in spending and prices. His approach differs from the naive Keynesian one in treating the interest rate effect of money supply innovations as temporary only, and in allowing that the “natural” rate of interest might itself vary quite independently of monetary conditions. Wicksell’s approach ultimately connects the temporary interest rate effects of monetary innovation to nominal income and price level effects. Thus nothing prevents a Market Monetarist from also being a thoroughgoing Wicksellian.

Both Market Monetarists and Wicksell himself differ from the Austrians in paying little if any attention to the direct bearing of short-run interest rate changes on real activity, and especially real activity in asset markets. The Market Monetarists consider interest rate movements an unimportant sideshow without significant knock-on effects, and therefore a distraction from what really matters; Wicksell considered them only as a harbinger of changes in spending. Missing in both perspectives is any attention to the way in which interest rate movements redirect demand from certain markets to others. Monetary policy innovations can, in other words, involve both (nominal) “income” and “substitution” effects.

They needn’t do so, of course. “Helicopter” money approximates the case in which monetary innovations boost nominal wealth, and thereby stimulate spending and nominal income, without necessarily involving any particular relative-price changes. The short-run/long-run AS-AD framework tells us all, or almost all, of what we need to know about the potential real consequences of helicopter money drops; and deviations of nominal income from trend supply a reliable indicator of the degree to which monetary policy has been either excessively easy or excessively tight.

But open-market purchases aren’t helicopter drops. Instead (as Wicksell took for granted) they initially involve increases in the relative price of the securities being purchased, and corresponding reductions in market-clearing (but not in underlying “natural”) interest rates. Lower interest rates in turn encourage a re-orientation of spending toward investment, and especially toward those prospective investment projects whose present values increase most in response to a marginal reduction in the cost of funds. This “substitution” effect of easy money–an effect that depends on real interest rate movements rather than on changes in aggregate spending per se–is the key to unsustainable asset price movements, where “unsustainable” indicates a movement than can only go on while interest rates remain unnaturally low. It is possible, at least in principle, to conceive of a monetary policy that gives rise to large substitution effects–that is, to a substantial increase in the perceived present value of particular investments–while having only a modest ultimate effect on the growth rate of nominal final income. The narrower the initial credit channel through which excess liquidity is injected into the economy before spreading out to the rest of the economy–the further removed we are from helicopter drops–the greater the likely importance of relative-price and substitution effects.

The possibility of substitution effects stemming from “unnatural” (monetary-innovation based) interest rate movements supplies reason for taking even modest innovations to NGDP growth, and upward innovations especially, seriously. The possibility suggests that such deviations are likely to be associated with disproportionate deviations of total spending—that is, of spending on both final and intermediate goods—from its own trend. In so far as money supply innovations tend to drive interest rates either below or above their natural levels, increases in the growth rate of NGDP and other nominal income measures may understate the extent to which monetary policy is excessively easy or excessively tight (and are likely to continue to understate the laxness of monetary policy while a boom persists), because the amplitude of short-run deviations of total spending from trend will be greater than that of nominal income, and because velocity and money multiplier declines that typically accompany the bursting of asset bubbles will suppress the acceleration in nominal income growth that might otherwise be observed once substitution effects have worn off. Just how much this difference in amplitude mattered in any particular case, including that of 2003–2007, is of course, a matter that cries out for further study.