A great misunderstanding

Mark Carney has been appointed the next governor of Bank of England. Some people believe that BOC's policy under Carney has been so expansive that he has built the way to destruction.  I doubt it. As far as I know BOC's policy was classic counter-cyclical monetary policy. This is what the Bank of Canada has done  to its monetary base during his term:

The Bank expanded its balance sheet through 2009 and the early 2010 but it contracted through the mid 2010 and the first half of 2011 and has steadily increased the monetary base as the NGDP grows, (whether or not in intended). The information is from CANSIM.

It is not what you can expect from an expansionary central banker. The information is from FRED. The problem of housing bubble is probably not from low interest rate. Plus the low interest rate is not from the BOC's loose money. That is generally from the weak recovery in the U.S. economy and the low velocity of money in Canada, which represents low money demand. The information is from FRED and CANSIM.

Long Run Economic Growth and Constant Monetary Growth

I have recently started thinking about this issue while speculating on the relationship between IS-LM model and AD-AS model. Of course, the IS-LM is a short-run model and may not be adequate to think about the long run. However....

First, assume that prices are sticky in the short run. All of sudden, productivity is expected to be improved and potential output increases. Then LRAS curve will shift right while the SRAS curve stays the same. There is no output gain because prices of goods and services do not fall as the supply increases: the consumers cannot purchase them because their wages are so sticky that they do not rise as potential output increases; their bosses insist they will raise wages only if their goods are really sold. As a result, there is no change in the money market; there is no change in the goods market. The IS-LM curves stay the same.

Second, assume that prices are flexible. The SRAS curve is upward sloping. As much as the previous model, the LRAS curve shifts right as productivity is enhanced. Unlike the previous model, however, the SRAS curve shifts right too. Even though the firms cannot expect their absolute input costs not to go down, their relative input costs to output will go down. If they lower prices, then more goods and services at lower prices. As a result, output will really grow while the price level falls. Since the price level goes down, the real money supply will increase, lowering interest rate. Then the LM curve will shift right; since the low price level induces the great consumption, the IS curve will shift right, too.

The Single Transferable Voting System

Today, Justin Trudeau made very interesting remark on the Canadian election system. He would like to reform the current fast-past-the-post system into preferential voting system or single transferrable voting system.

Let's imagine a constituency of 100 voters. There are four candidates, A, B, C and D. Instead of choosing one of them in the ballot, a voter rank them from the most preferred to the least preferred. When the ballot box opens, it turns out A won 35; B: 30: C: 25; and D:10. D is eliminated. Then the D voters' second preferences are counted. A won 4; B: 5; C: 1. Those numbers are added to A, B, and C's the first preference votes'. Now A scores 39; B: 35; C: 26. C is eliminated. Then the C voters' next preferences will be counted. I.e., C voters' second preferences, and the third preferences if a vote's second preference is D, are counted Among 26 votes, A wins 10 and B wins 16. Eventually B wins the election in 51 to 49.

A strength of this system is that every vote really counts. Even if a voters's first preferred candidate is eliminated, her second and third preference will still matter. Then it restrains the parties from becoming radical because they will have to conform with the demand of, at least the voters in the middle.

Another strength of this system is that it does not prevent a politician from running independently. Russia has a full party list proportional representation system with 7% of threshold. It indeed favours Putin and his supporters' parties. Even if the system is more open like Germany's mixed part list proportional representation system with 5% of threshold, it might be considered a barrier to independent politicians and small parties.

Of course, there could be some problems. If voters are not well aware of the system, they may just mark the ballots nily-wily.

I was glad that Mr. Trudeau clearly had an agenda for election system reform.

Why it is not the case that the commercial banks would not lend because of the low interest rate.

I have seen some people argue that lending activities by the commercial banks have been weak because the central banks are pushing the interest rate low. Indeed, lending activities have been weak although they are bouncing back now.

The question is why they have been so weak and not been returning to the pre-crisis level despite the historically low interest rate. Does it imply that the banks do not want to lend because of the low interest rate? Some people misunderstand what is happening in the world, for example, Denmark's negative interest rate policy. This is what many people get wrong. The interest rates close to or below zero are policy rates such as the target for overnight interest rate or central bank funds rate. Those rates are the interest rates that the central bank offers the commercial banks under its charter. As long as the commercial banks are allowed to lend money higher than those rates, they can make comparable amount of profits to the pre-crisis level and this is what is happening:

The U.S. commercial banks can still make profit of 3% on the top of its federal funds rate from each lending activity even though the federal funds rate is very close to zero. That's the rate of profit even before the crisis. The interest rate is not now rising despite growing lending activities since the mid 2010 simply because zero federal funds rate is not low enough yet. That is why the actual monetary aggregate growth is relatively low even though massive increase in monetary base.

Even though the MZM growth rate is about 10%, it is actually not high enough given the fact that the economy is annually growing by 2% and the annual inflation rate is between 2-3%. Don't forget the velocity of money is historically low; in other words, people rather sit on cash or put it in the bank than spending it. It is not the case that the banks do not want to lend because of low interest rate; it is low investment demand and low money demand.      

What Shinzo Abe would do...

The next will-be PM of Japan Shinzo Abe of the Liberal Democrats said:

"Money will be forced to go out to the market by (the government) having the BOJ buy construction bonds directly if possible...[I] would like to choose someone who supports the inflation target."(http://online.wsj.com/article/BT-CO-20121117-700066.html)

Now, some people apparently misunderstand the concept of central bank's independence and Abe's approach is against it. His speech may sound like a violation of central bank's independence. However, it is not independent from the government in terms of policy goal. Abe is stating the next Japanese government's goal here and calling for BOJ's coordination with it.

By no means, the LDPJ is my favourite because historically it has too many figures in it that defend Japan's war crime during the WWII. However, I believe Abe's approach would be basically good and help the Japanese economy end the Lost Decades. 

Of course, here is some Austrian style complaint: http://seekingalpha.com/article/1010651-shinzo-abe-i-come-to-bury-the-yen

However, the truth in Japanese inflation rate is:

I clearly see a deflationary spiral here. Simply, those who believe in the stuff like central bank printing money nothing but raises price level do not understand the relationship between price level and money supply.

What some people have got wrong with price level.

Obviously there is a conspiracy that the central banks and government stat authorities manipulate CPI down and quite a few people believe that. Therefore, it might be better to use the GDP deflator to measure our inflation. the GDP deflator should be better if you do not trust the CPI since it includes all the goods and services domestically produced.

Are you still seeing a run-away inflation? Much milder than the inflation rate measured in the CPI, isn't it? Unless the GDP deflator is manipulated as well...

Stagflation concerns?

I really don't know if Israel really will strike Iran. If so, then it will be disastrous. However, I doubt oil price will really likely rise at this moment.

It is more likely that crude oil price is stabilized around $90/barrel and the percentage change is very low now.

Where many people get it wrong on money supply and price level

I have recently heard some people saying expansionary monetary policy causes inflation. In most cases, that happens. However, it does not happen all the time, and this is the time when it is not happening. Consider the following graph:

The initial money supply is MS1 and money demand is MD2. All of sudden, the unemployment rate rises and income falls. As a result, the money demand falls from MD2 to MD1. Since P=(MV)/Y, the price level will fall as income falls. To restore the full employment output, the quantity of money required is M2. The central bank tries to expand money supply by lowering the nominal interest rate and purchasing bonds. However, it is not willing to lower the interest rate below zero. Then, actually, the quantity of money in the economy is only M3. As much as M2-M3, the economy lacks in the quantity of money. Since the actual quantity of money is smaller than M2, the price level rises only as much as M3-M1. Then, the price level does not change so much or the inflation rate will be very low. Now look at the U.S. inflation rate using the CPI for urban consumers.  

Whenever the Fed QE kicked in, the inflation rate rose and that was it. Then, the inflation rate stopped growing and fell. We really do not see a run-away inflation.