Brad: "And come 2008-2009 everything collapsed. Construction collapsed, business investment collapsed--that’s what the spike in interest rates did. ... Then came 2008, which was a John Stuart Millian process: surprising losses in finance, a panic, everybody tries to run and shift their portfolio into something cashlike..." That's the bit where my own (not as good as yours) talk last week to my students fell apart as well. The US (and world) economy was doing fine 2005-2008. What happened in 2008? What caused the surprise? Did the panic cause the drop in expected AD? Or did the expected drop in AD cause the panic? My brain is mush nowadays.

Ritwik: "What does the LM curve look like in a nominal Y (where Y is the path of nominal GDP rather than level) and real r world?" If we put nominal GDP on the horizontal axis, then if the BoC were targeting NGDP, the LM curve would be vertical, and it would never shift (more strictly, it would shift rightwards at a fixed 5% per year). If the BoC were targeting inflation, then it would still be vertical, but changes in AS would cause the division of PY into P and Y to change, and would cause the LM to shift right or left. You lost me on the 45 degree stuff. K: "1) It's not a problem so long as the system is meta stable by virtue of central bank interest rate policy." Possibly correct. But even then, if the central bank changes the interest rate "target" in response to what happens, it's no longer a target. 2. It doesn't matter how tiny the demand for money is. It is the fact that everything else is bought and sold for the medium of exchange (plus it's the medium of account) that makes money important. 3. If the price of peanuts were perfectly flexible, it would also be always possible to buy or sell money for peanuts. Does that make the price of peanuts the macroeconomically significant price, in addition to the (a) rate of interest?

Where are all the PK's, Neo-Wicksellians, and MMTers? Should (could?) I have made this post even more provocative?

Doc Why: I fished it out anyway, to try to train the spam filter not to make mistakes like that.

I'm stuck in spam! (Feminist spam filter!)

genauer: mind your manners please. And you are wrong, regardless of whether Simon or I is the one who is right on this. Hi Simon! 1. I think the horizontal LM curve is a fantasy (for any period longer than 6 weeks in Canada). Because the BoC adjusts the overnight rate target every 6 weeks to try to keep the output gap closed and try to keep inflation at the 2% target. A much better approximation to reality would be to draw the LM curve vertical, at that level of Y which the BoC thinks is potential output. Because the Mundell Fleming model (and ISLM too) was designed for short run analysis, and anything less than 6 weeks is very very short run indeed, where the economy can't hope to get anywhere near the IS curve (or even the LM curve, for that matter). 2. Even if you reject my vertical LM model, I think it would be closer to reality to say that central banks in a SOE with PCM choose the real exchange rate, rather than the real interest rate. (Of course, the BoC would never describe itself as doing that, because it would upset the Americans! But we don't have to buy into the same social construction of reality that central banks use to describe what they are doing.) 3. I wouldn't go to the wall on the question of whether the real exchange rate is a random walk or reverts to mean. I can see the merits of your way of doing it. I know it can't be a true random walk, because if it did then its long run variance would be infinite, and PPP wouldn't work any better than a random guess, and PPP does work better than a random guess. But *some* shocks will be permanent. And even if they aren't strictly permanent, it is possible for the shocks to increase over time, at least initially. And even if the shocks do decay over time, the rate of decay might be very slow, relative to the time period over which the MF model is useful, so a random walk might be a good approximation to reality. If I remember the empirical literature (Stephen did a post on this some time back) it is very hard to reject the random walk assumption over any moderate length of data.

123: I have read reviews of that book. I think it would be too depressing to read. Doctor Why: in answer to your (much) earlier question, about diversified economies and flexible exchange rates. Suppose you had a very diversified economy. There would be less chance of a shock hitting all your sectors at once. And if a shock did hit, and have macro effects, a small change in the real exchange rate might be enough to reallocate demand and resources towards those that survive. If you have only two sectors (banking and tourism) you have a bigger chance that one might get wiped out, and you would need a bigger fall in the real exchange rate to reallocate demand and resources towards the other. That real exchange rate adjustment has to happen somehow, even if you wish you could keep on earning the same old income at the same old real exchange rate. Under fixed exchange rates, the only way it can happen is through deflation, which is slow and painful. Under flexible exchange rates it can happen through exchange rate depreciation, which is fast and not quite so painful.

genauer: Google is your friend. Giovanni: you lost me a little there. What would your "benchmark" open economy macro model look like, if you were ignoring UIP for simplicity? Vertical BP curve?

Yep. Bob Smith is stuck in spam, 2 hours ago.

pcle: saying "the exchange rate is indeterminate" isn't a very good answer to give to a student who asks "what makes the exchange rate go up or down?" Especially since I have already proved to the students, with the help of one international student volunteer, that even Purchasing Power Parity, while not a perfect theory, is a lot better theory than "it's indeterminate". JW: Thanks! But I confess I'm having some second thoughts. Simon's way of teaching it *is* very simple, even though it does make RE implicit. One nice thing about ISLMBP (whether or not we call it "Mundell-Fleming") is that it's very easy to make the BP curve upward-sloping, if we want to relax the small open economy + perfect capital mobility assumption. (Or relax Simon's assumption that the central bank sets the real interest rate).

JV: agreed. But this comment thread has now been derailed into a discussion about Germany (which perhaps I too should not have joined in). So: no more comments about Germany per se. This post is about monetary theory, exchange controls, and fixed vs flexible exchange rates. BTW, did I leave it too implicit? My "Cunning Plan" was nothing more than the reinvention of flexible exchange rates with national currencies. Or was that sufficiently obvious?

If the Bank of Canada is targeting 2% inflation, that determines a finite stream of seigniorage revenue, which creates the Bank of Canada's profits, which it gives to the government. That's a couple of billion per year. That will grow over time if the economy grows, but will fall over time if the use of 0% interest currency falls over time. That seigniorage revenue needs to be included in the government budget constraint. It does not mean the government has no budget constraint.

david: yep. But there are two things that money resolves: trust is the first; getting 3 (or more) people to all meet at once to do a 3-way exchange is the second (the coincidence of wants gets resolved either by money or by all 3 people doing a simultaneous 3-way deal). I wanted to get both of those ideas in.

Thanks Stephen.

K: the mechanism I see for transfer payments, in Taylor's model, is that if transfers decline, that reduces long run distorting taxes, which increases future Y and C, which increases current C via consumption smoothing. I ignored that mechanism in this post, because I wanted to concentrate on the future G mechanism. Admittedly, what I'm saying is just a (informed, I hope) *conjecture* about what's driving the results in his model. But at the end of PK's first post, he says something like he can't see what's driving JT's results. And what I'm doing is putting forward my explanation of what's driving his results, and trying to reconcile JT's results with PK's intuition (or vice versa). Like PK, whenever I see a math model I ask myself "OK, what's *really* going on here?". Like PK, I never trust a math model, unless I can *understand* where the results are coming from, because you never know what's been slipped in without anyone noticing (including the modeller, in many cases). (I'm the exact opposite of Determinant, in other words.) Kevin: we are on the same page, except: "But of course that’s not the NK consumption-smoothing mechanism." Yep, and I think it's important to note that's what's driving the results. Because it's exactly the same mechanism that PK himself pointed to in some old posts of his about why a temporary increase in G works in NK models. "At the end of the day, the big difference is that OK models allow for involuntary unemployment and NK models do not." Yes and no. NK models can sorta have involuntary unemployment in Keynes' (strict peculiar) sense. Plus, if you add sticky wages to a NK model, you simply convert the voluntary unemployment into involuntary unemployment without otherwise (much) affecting the results. So I don't think that is a big difference.

Greg: "The apple we store for eating in March is superior to the apple we didn't eat in September in order to store. Menger, Menger, Menger." Of course. But we live in a world where relative prices coordinate the plans of those who store apples and those who produce and consume apples. If the real interest rate on apples (= nominal interest rate minus expected rate of inflation on apples) is negative, it will be profitable to store apples. Irving Fisher diagram. (Not that there is anything in that diagram an Austrian would object to, apart from its possible overs-simplification through having only 2 periods). Determinant: as I said before, adding the ZLB as a binding constraint to John Taylor's model would only strengthen the results he is talking about. That's because: making Gdot negative raises the natural rate r*, and raising r* is expansionary unless the Fed raises actual r by an equal amount, and if the ZLB is a binding constraint the Fed would not raise actual r by an equal amount. You need to actually understand the model, not fly blind by the math. Kevin: but G2 (expected future G) either doesn't play any role in Old Keynesian models, or plays the opposite role to what we have here. A cut in G2, holding G1 constant, would be expansionary in a NK model, and equal increases in G1 and G2 would have no effect, while it would be expansionary in an OK model. (Thanks for the info on PK's post.) Thanks for the links Ritwik. Yep, I have mu own doubts about ISLM, that I think are sort of similar to Leijonhufvud's. I think we observe points off both the IS and LM.

All: simmer down a little please.

My take on it: http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/03/fiscal-policy-with-old-and-new-keynesian-is-curves.html

It seems the Cyprus Parliament has rejected the plan. Now what? Will Cyprus be able to reopen the banks? If they do, without some other plan, then there will be a very big bank run. And if the banks stay closed, well, I wonder what that effectively does to the money supply, and the ability of people to buy and sell things? Recessions are always and everywhere a monetary phenomenon.

Bob: two hypotheses: 1. What Doctor Why says in comments above: "Third, if the haircut (conversion to equity) was limited to uninsured deposits, that would most likely give control over the banking system to non-residents (some would say money-launderers) - and nobody in the Eurozone would be happy about that." 2. Cyprus needs a loan from Putin, and doesn't want to piss him off too much. But I don't know.

hix: I'm not very familiar with the use of neighbourhood proxies, but here's how I think it's supposed to work: You take average income in a neighbourhood as a proxy for the income of a family living in that neighbourhood. (And average education as a proxy for education.) Obviously (unless all families in a neighbourhood have the same income) the proxy will be imperfect. And this means that the estimated coefficient on income will be smaller than the true coefficient, because of the errors in variables bias. But as long as the proxy is correlated with the true income, the estimated coefficient should still have the right sign. The danger is if the errors in the proxy are correlated with some other variables in the regression, because that would bias the estimated coefficients on those other variables. Interesting hunch on mental illness/males.

Frances: I see via email the university econometrician has been very quick to test that. Looks to me like the "8.30am effect" is roughly the same on both males and females! Or maybe just slightly worse for males. K: Hmm. Fair point. Maybe. (Catfish taste very good to me, btw.)

Determinant: it did. Which proves there's a Liberal plot to control the media!

Ooops!

Frances: thanks! That sample selection/imperfect proxy stuff is what I was trying (and failing) to get my head around yesterday. I was also trying to get my head around what would happen if students have some information on their own ability at university that is not captured in high-school grades ("Was I slacking off at school and will I work harder at university?"). So we had two sorts of sample-selection effects interacting. But it was too hard for me to think about. The fishing trips you suggest might be interesting. My hunch would be on number of assignments vs exams though. And yes, lots of different fish may be in the river, and the outside job opportunities is probably a big one. But the fish I would go hunting would only be the fish we could eat. If there is no policy that could reasonably be implemented to do something about it, there's no point in catching it. (Except for scientific curiosity, of course, which is fine, but I've got to think with my policy hat on nowadays.)