Month: July 2010

I am happy to see Paul Krugman address the question.  He writes:

So why not forget about open-market operations, and just drop the stuff
from helicopters? Well, remember that at this point cash and short-term
bonds are equivalent. So a helicopter drop is just like a temporary
lump-sum tax cut. And we would expect people to save much or most of
such a tax cut – all of it, if you believe in full Ricardian
equivalence.

I hold a different opinion for two reasons.  First, cash and short-term bonds may be near-substitutes but they are not literally, strictly equivalent.  The nominal rate on T-bills is not exactly zero and furthermore you can't use a T-bill for every retail purchase.  The demand curve for real cash need slope down only slightly for a quantity theory result to hold.  After everyone spends the new cash balances, and prices rise, people end up with the quantity of real balances which they initially desired.  These equilibria have "knife-edge" properties, where "identical to T-Bills" and "nearly identical to T-Bills" do not bring the same results.  Tsiang showed this in a very good JMCB article on Friedman's optimum quantity of money, in the early 1970s and you might regard it as implicit in Bewley's Econometrica article on Friedman.

Second, after a helicopter drop no one need expect future taxes to be raised to retire the money (although maybe a sufficiently credible government could create such an expectation).  So there is no Ricardian motive to save the new cash, as Brad DeLong points out.  Indeed, if you think there is some chance that others will spend the money, raising the price level, you will want to spend your new cash soon, so as to preserve its value against forthcoming price inflation.  The resulting game-theoretic equilibrium, applying dominant strategies, again leads to higher prices, higher aggregate demand, and the desired quantity of real cash balances held.

Those are not the only possible cases (see the work of Fischer Black) but I take them to be the most sensible default cases.  Both indicate that a helicopter drop of cash will work fine in boosting aggregate demand.

The most likely scenario for no positive AD effect is simply that the helicopter drop is so small that no one expects a price level rise and thus no one expects an inflationary tax on the new cash, people (for bounded rationality reasons) treat the new cash as a transfer purely to themselves, the precautionary motive for saving is strong, and so the new money is simply held.  A larger helicopter drop should overcome that inertia, if need be.

Maybe these arguments are incorrect but they date from a consensus established in the mid- to late 1960s and early 1970s, much of it springing from Patinkin's book on money and the subsequent discussions thereof.  Krugman suggests this perspective is wrong, but he hasn't yet given me — or others — a reason to budge from it.

In May 2010, DNA
Consultants began offering a test called the Neanderthal Index.  Priced at USD $90.00, the test
purports to “estimate how much Neanderthal is in your ancestry.” 

There is much more here.

Ian Ayres writes (source, with further explanation, here):

In our risk-reducing implementation, we want people to borrow to invest more when young and then invest less when older. The lifetime exposure to stocks is held constant. Compare the following two investment paths:

Option 1

Year 1 Invest $1

Year 2 Invest $2

Year 3 Invest $3

Option 2

Year 1 Invest $2

Year 2 Invest $2

Year 3 Invest $2

Our view is that option 2 is the safer bet.

That is a simple comparison, but I am still puzzled. 

First, under option one, the investor faces more price risk, given that share prices will move between period two and period three.  But price risk is not quantity risk, and a traditionally risk-averse investor, in the Arrow-Pratt sense, need not mind price risk on net.  If you tell me I can buy into Microsoft at p = 50, or accept a lottery with 0.5 (p = 100), 0.5 (p = 0), I might prefer the latter, noting that we live in an equity premium scenario and sometimes share price understates fundamental value.  

Second, under option one the investor buys less equity in the first period.  Let's assume that same investor holds T-Bills instead, or perhaps avoids debt.  There is nothing in the so-called "mutual fund theorem" which tells us what the T-Bills/equity ratio should be.  Maybe Ayres and Nalbuff think it should be higher — and maybe they're right — but that's an argument distinct from the "smoothing purchases over time" argument.

Is there a "smoothing equity purchases over time" argument which does not collapse into the "it's better to have a longer total exposure to the market" argument?  Or not?  Do Ayres and Nalebuff think it is OK if the "smoothing" argument boils down to an "there is actually an equity premium, so seek greater total market exposure over time" argument. (For instance, what if option one is the non-smoothed, but highly exposed sequence "3, 2, 1" instead of the specified non-smoothed but lesser exposed "1, 2, 3"?

I am very willing to admit that the confusion here is mine, but confused I am.  Here is my previous post on the book.

Addendum: Andrew Gelman comments.