Sexy new model could shed light on the Great Recession

Market Monetarists like myself claim that the Great Recession mostly was caused by the fact that the Federal Reserve and other central banks failed to meet a sharp increase in the demand for dollars. Hence, what we saw is what David Beckworth has termed a “passive” tightening of monetary policy.

I have come across a (rather) new paper that might be able to shed more light on what impact the increase in money demand had in the Great Recession.

Te paper by Irina A. Telyukova and Ludo Visschers presents a rather sexy model (that’s an economic model…), but has a rather unsexy title “Precautionary Demand for Money in a Monetary Business Cycle Model”. Here is the abstract:

“We investigate quantitative implications of precautionary demand for money for business cycle dynamics of velocity and other nominal aggregates. Accounting for such dynamics is a standing challenge in monetary macroeconomics: standard business cycle models that have incorporated money have failed to generate realistic predictions in this regard. In those models, the only uncertainty affecting money demand is aggregate. We investigate a model with uninsurable idiosyncratic uncertainty about liquidity need and find that the resulting precautionary motive for holding money produces substantial qualitative and quantitative improvements in accounting for business cycle behavior of nominal variables, at no cost to real variables.”

Hence, Telyukova and Visschers incorporate shocks to money velocity from increases in what they call “precautionary demand for money” into a dynamic business cycle model. The model is yielding rather interesting results, but it is also a rather technical paper so it might be hard to understand if you are a none-technical economist.
Anyway, the conclusion is relatively clear:

“By incorporating this idiosyncratic risk into a standard monetary model with aggregate risk, and by carefully calibrating the idiosyncratic shocks to data, we find that the model matches many dynamic moments of nominal variables well, and greatly improves on the performance of existing monetary models that do not incorporate such idiosyncratic shocks. We show that our results are robust to multiple possible ways of calibrating the model. We show also that omitting precautionary demand while targeting, in calibration, data properties of money demand – a standard calibration practice produces inferior performance in terms of matching the data, potentially misleading implications for parameters of the model, and may therefore adversely affect the model’s policy implications as well.”

The paper was first written back in June 2008 (talk about good timing) and then later updated in March 2011. Oddly enough the paper does not make any reference to the Great Recession! This is typical of this kind of technical papers – even though the results are highly relevant the authors fail to notice that (or ignore it). That does not, however, change the fact that Telyukova’s and Visschers’ paper could clearly shed new light on the Great Recession.

As I see it the Telyukova-Visschers model could be used in two ways which would be directly relevant for monetary policy making. 1) Use the model to simulate the Great Recession. Can the increase in precautionary demand for money account for the Great Recession? 2) The model can be used to test how different policy rules (NGDP targeting, price level, inflation targeting, a McCallum rule, Taylor rule etc.) will work and react to shocks to money demand. I hope that is the direction that Telyukova and Visschers will take their research in the future.

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4 Comments

  1. Alex Salter

     /  October 17, 2011

    I have to admit I’m not very impressed by modeling of this kind. One of the big advantages MM has over other schools is its belief in simple models as opposed to the highly technical stuff which dominated the theory journals pre-crisis. It’s partly that sort of methodology, and the associated mindset, which got us into this mess in the first place. The more complicated the model, the more assumptions you have to make about behavior and background conditions which may or may not be valid. Simple models combined with robust empirical evidence, econometric or otherwise, is the key.

    Reply
  2. Alex, I to some extent agree. We don’t need super technical models and a lot of math to understand monetary policy and theory. That said, it is interesting that this model actually would have something interesting to say about the Great Recession – even though the model unfortunately is not used in that fashion in the paper.

    Reply
  3. Lars: that’s an important result. Makes sense intuitively and empirically. Money demand may depend positively on income in normal times, but negatively on income during recessions. The more income falls in a recession, the bigger the demand for money.

    Reply
  4. talldave2

     /  May 10, 2013

    I agree, would love to see the authors do a follow-up where they look at TGR specifically.

    Reply

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