Deciphering MMT (wonkish)

One of the most interesting debates blowing up the econ blogosphere is between mainstream macro and modern monetary theory (MMT) (see here, here, here, and here). MMT seems to flip the conventional wisdom surrounding money, banking, and monetary and fiscal policy on its head—the federal government, as the monopoly issuer of the currency, has no budget constraint; budget deficits lower interest rates instead of raising them; and fiscal policy should be the primary tool used to achieve full employment.

It’s an interesting theory, and I find some elements of it useful in explaining how modern banking works. But I also find it to be an enigma; how MMTers model the short-run macroeconomy feels like a mystery. Paul Krugman accuses MMTers of playing Calvinball, and maybe he’s right. Nevertheless, here’s my attempt to decipher MMT.

Before I begin, let me say that this is not an attempt to affirm or refute MMT, it is simply an attempt to understand it (or at least part of it).

Start with the model Krugman presents in this post. This is the New Keynesian IS-LM model, typically taught in undergraduate macro courses:

In this model, planned investment is a function of the interest rate, and because the interest rate is the cost of borrowing to finance investment, higher interest rates reduce planned investment and vice versa. So, the investment function slopes down. But because higher interest rates reduce planned expenditure, income also falls. Put these together, and you get the IS curve. Where the IS curve crosses the “full employment” line determines the natural rate of interest. 

Not shown in the figure above, but implicit to the model, is the LM curve. The LM curve tells us the interest rate that equilibrates the money market at any level of income. A rise in income increases the demand for money, which leads to rising interest rates, and vice versa. So, the LM curve slopes upward. In practice, the central bank simply chooses the interest rate, making the LM curve horizontal. 

Suppose the economy is in recession and the central bank has set the interest rate above the natural rate. The solution is simply for the central bank to lower the LM curve down until the interest rate equals the natural rate. In practice, the central bank does this by reducing the fed funds rate and/or the interest it pays on reserves. Alternatively, fiscal policy can be used to shift the IS curve to the right, raising the natural rate to match the interest rate set by the central bank.

One implication of this model is that the short-run aggregate demand curve is vertical. So, if the central bank wants to prevent inflation or deflation, it must adjust the interest rate to do so. If the interest rate is too high (above the natural rate), we’ll get deflation, and if it’s too low, we’ll get inflation. 

O.K., now, what do MMTers say?

One thing they say is that the interest rate has very little, if any, effect on savings and investment. In other words, savings and investment are interest-inelastic. If that’s the case, then the IS curve would be vertical. 

What then, is the natural rate of interest? Well, if the IS curve is vertical, there isn’t one. That is, there is no unique interest rate that equilibrates the supply and demand for savings at full employment. Actually, MMTers argue that there isn’t a market for loanable funds at all. So, if we happen to be at full employment, any interest rate will do.

MMTers agree, I think, that the short-run aggregate demand curve is vertical. But because they also (seem to) believe the IS curve is vertical, adjusting interest rates has no effect on aggregate demand. So, monetary policy can’t affect demand—it’s “weak tea”—which means fiscal policy must be used to achieve full employment output.

O.K. Suppose we start relying on fiscal policy to reach full employment output. Won’t we run up too much debt?

Not to worry, say the MMTers. As long as the interest rate remains below the GDP growth rate, snowballing debt can’t happen. And if the central bank can set whatever interest rate it wants, it can simply choose a rate below the GDP growth rate. In fact, it may as well choose zero. So, the government faces no budget constraint, at least in the long-term. The only constraint is accelerating inflation—that is, a vertical IS curve to the right of full employment output.

O.K., I think this is (mostly) right. I realize this doesn’t showcase the interaction between the Treasury, central bank, and financial system that MMTers insist is so important, and yes, I know MMTers aren’t fond of IS-LM, but I think this helps clarify a lot of their thinking.