Consider this to be thinking out loud and not a series of positive claims asserted to be necessarily true:
1. Money is non-neutral and monetary expansion helps correct for negative AD shocks.
2. At the same time, monetary expansion itself has non-neutral real effects. Imagine that the Fed conducts all open market operations on ice cream cones.
3. As the economy recovers, there are two options.
4. First, the Fed can keep buying lots of ice cream cones forever. Eventually the economy ends up producing too much ice cream. Note that in the early days of the purchases, however, the economy was producing suboptimal levels of ice cream, so this was not initially much of a distortion, if it was any distortion at all.
5. The second option is that the Fed can back off its ice cream purchases now. This will hurt AD and it also will hurt the ice cream market, although it may pre-empt a more serious blow to the ice cream market later on. Either the Fed finds it politically impossible to buy lots of ice cream forever, or the Fed minds the eventual distortion of the ice cream market.
6. Recently the Fed suggested it might back off ice cream purchases, to see what the price of ice cream would do, so as to learn more about the market. We observed both a negative AD effect and a severe negative price effect in the ice cream market. Some Fed officials then tried to talk those markets back up, just as they had been talked back down. The talk-backs failed, reflecting the wisdom of the market.
7. We now all know that slowing down the rate of ice cream purchases will be harder than we had thought.
8. This parable assumes that injection effects are important, namely where the new money goes first. This Austrian-like view is unfashionable, has weak theoretical foundations, and violates the Modigliani-Miller theorem, but at the moment markets seem to believe it. Should we believe it too?
8b. But wait, you Austrians shouldn’t get too gleeful. The implied theory of the market is anti-Wicksteed, anti “supply is the inverse of the demand to hold, and vice versa,” and “flows only,” a bit like some of the early Keynesians had argued. Uh-oh. (Or maybe the Austrians and the early Keynesians had a bit more in common than they like to let on.)
9. You will note that the demand for ice cream also spills over into cookies, cupcakes, and kulfi.