This paper explores the aggregation of micro-agents’ borrowing and saving decisions. The critical insight is that banking and the exogenously-supplied monetary base may prevent income growth expectations by micro-agents from properly aggregating into macro interest rates. Such imperfect aggregation results in ex-ante disequilibrium between desired savings and borrowings, which causes cyclical fluctuations in nominal incomes, inflation and asset prices. I define the aggregation error as the measure of such disequilibrium and find that it is equal to the difference between the monetary base and asset money demand. Asset money demand represents long-term savings held in the form of money by agents who expect declining or stagnant incomes. The aggregation error causes the economy to either over or under-perform compared to expectations. Such variance between actual and expected outcomes exerts a re-enforcing influence back on expectations thus closing the feedback loop at the heart of the business cycle.
Another way of describing this framework is to consider time preference as a measure of income growth expectations, asset money demand as a measure of uncertainty and fear and the aggregation error as a measure of disequilibrium in money markets. Economic booms and busts are not caused by random fluctuations, sticky prices/wages, output shocks or irrational agents whose spirits sway back and forth between exuberance and fear. Rather, as banks interface independently with borrowers and savers and savers have the option to save by holding base money, there is not ex-ante requirement that desired savings should equal desired borrowings. As a result, the time preferences of micro-agents do not accurately aggregate into macro interest rates and ex-ante money supply and demand are in disequilibrium.
The paper proposes that the velocity of money is a proxy for monetary disequilibrium. Short-term fluctuations in M2 velocity are caused by changes in asset money demand while fluctuations in the velocity of bank money (M2 less Monetary Base) are caused by the aggregation error. Accordingly, such observed velocities can be used to derive asset money demand and the aggregation error. This new understanding of velocity re-interprets the Quantity of Money Equation whereby velocity is a measure of ex-ante money demand and the causality in the ex-post QP=MV identity flows from MV with prices and employment being the residuals.
The idea that ex-ante monetary disequilibrium drives the business cycle is consistent with Keynes’ insight from the General Theory. However, this framework departs from mainstream ideas in several important ways:
- There is no endogenous process driving the economy toward equilibrium at full employment. Instead, the main driver of economic performance are ex-ante income expectations and net desired borrowings as determined by time preferences and interest rates. More importantly, such expectations do not have to be consistent with full employment. In other words, the economy is subject to a bootstrapping problem as incomes have to be anticipated ex-ante to be generated ex-post (Chart 1) (here more on bootstrapping).
- Money is not
neutral. It represents the critical link between micro decisions and macro outcomes. Furthermore, it is money as created by banks or exogenously supplied by the central bank that facilitates ex-ante disequilibrium between desired savings and borrowings and by extension, money supply and demand.
- Velocity is
a measure of ex-ante money demand. The causality in the ex-post identity
QP=MV flows from MV with prices and employment being the residuals.
- There is no
trade-off between inflation and unemployment as both are residuals of ex-ante
money supply and demand. The observed
Phillips Curve is determined by the monetary regime. Nor are prices and wages sticky. The degree of stickiness is also determined
by the monetary regime.
expectations have no bearing on future prices.
The Future is unknowable. Expectations are just another dimension
describing the present whereby income growth expectations are reduced by
inflation expectations to determine time preferences in the current
- The true source of inflation is two-fold. If Say's Law holds there will be no change in prices. However, desired borrowings in excess of desired savings bootstrap demand above ex-ante income expectations. As capital is fixed ex-ante, suppliers can respond to such change in demand only by raising prices and/or increasing employment. The reverse occurs if there is a shortage of desired borrowings - prices and employment decline. To sum up, ex-ante disequilibrium between desired savings and borrowings causes the break-down of Say's Law. The second source of inflation is domestic capital flight. In other words, domestic agents do not recognize domestic currency as monetary reserve, hence they seek to satisfy their asset money demand by fleeing into FX or money-like commodities such as gold. Such phenomenon gives rise to stagflation, which accurately describes the 1970s and emerging/developing markets today.
- Asset booms
and busts are caused by neither irrational agents nor swings in
fundamentals. Only relative prices
change due to changing fundamentals and the subjective preferences of private
agents. The general price level, on the
other hand, is determined by the value of money. As money is denominated in itself, its price
is infinitely sticky. An ex-ante
disequilibrium between money supply and demand will induce changes in consumer prices and the prices of financial assets.
- Utility is
not an abstract measure of satisfaction described by a curve that’s ever
increasing albeit at a declining rate. Rather, utility is the maximum price an agent is willing to pay for a
certain level of consumption.
Accordingly, the utility curve approaches infinity at zero consumption and the 45-degree line as spending increases since the maximum price and agent is willing to pay can never fall below the actual level of spending. Furthermore, agents attempt to maximize their utility gains as opposed
to the absolute level of utility.
Utility gains stand for the difference between such maximum price and
the price actually paid. This is similar to the notion that firms attempt to maximize profits as opposed to the absolute level of revenue.
- Time preference is not an exogenous, always-positive input into the Euler Equation that discounts future consumption into the present. As the utility of consumption is a function of incomes, time preference is endogenously determined by the income expectations of private agents. Accordingly, if private agents expect declining incomes, their time preferences will be negative. In other words, they will value consumption tomorrow more than consumption today, which is the proverbial "saving money for a rainy day".
Expansionary monetary policy by the Federal Reserve in the 1960s in the face of declining stocks of monetary gold led to the collapse of Bretton Woods. In the 1970s, domestic agents continued to seek the safety of gold to satisfy their asset money demand which gave rise to stagflation. In the mid-1980s, the US Dollar severed the link to gold and re-gained its role as a monetary reserve capable of satisfying asset money demand. This ended the stagflation pattern of the prior decade but also put the US monetary base in position to affect asset prices. As predicted by the model, there is compelling evidence that the asset bubbles in the 1990s and 2000s were caused by large positive aggregation error resulting from inflation-targeting monetary policy by the Federal Reserve.
Inflation-targeting central banks spur growth by lowering interest rates below time preferences. This boosts private borrowings and asset prices. However, in the long-term, time preferences become depressed as excess private liabilities cannot be passed onto the next generation and higher asset prices raise the risk of bubbles. This inexorably sets inflation-targeting central banks on a path toward the zero lower bound. At the zero lower bound, economies can experience prolonged stagnation despite monetary base expansion by the central bank as agents with negative or zero time preferences are indifferent between holding money or financial assets.
As to fiscal policy, the aggregation error framework predicts that unless the central bank is in position to peg interest rates, fiscal deficits and surpluses cannot offset shortfalls or excesses in private activity. I find strong statistical evidence to that effect by regressing the private aggregation error against fiscal deficits (Chart 2). Prior to 2008, co-efficient of negative 2.07 suggests that fiscal policy had little effect on short-term economic fluctuations as fiscal deficits did not fully offset the private aggregation error since central banks actively managed interest rates during the period. However, a co-efficient of negative 1.18 shows that fiscal policy has been much more effective since 2008 as interest rates have been naturally pegged by the zero lower bound.
According to these findings, central banks should adopt a money-demand-targeting rule which can achieve stable economic growth with neither inflation nor asset bubbles. Banks should be required to duration-match their assets and liabilities and the inflation target should be lowered to zero. In order to deal with depressed expectations not consistent with full employment, central banks should also be vested with new tools in the form of temporary consumption and investment tax credits. Such credits can directly impact the time preferences of private agents thus affording central banks direct control over money demand and by extension, the velocity of money.
Such proposal brings particular benefits to the Eurozone as Money Demand Targeting can eliminate constraints due to the zero lower bound and one-fits-all monetary policy. Furthermore, it can act as a substitute for fiscal union without being predicated on further political integration, fiscal transfers and public risk-sharing. Last but not least, by funding the tax credits with ECB-guaranteed bonds, the ECB can help sever the link between the Euro and overly-indebted member-states.
 Under the gold standard, base money was exogenously determined by the available supplies of gold. Under fiat-money, central banks supply base money according to an exogenously-set interest rate target. Such target may or may not take into account all endogenous processes taking place in the economy.
 This assumes that bank assets and liabilities are perfectly duration-matched.
 Since capital is fixed ex-ante, the supply curve is also fixed. Accordingly, businesses can respond to change in demand in the current period only by changing prices and employment.
 If domestic agents accept domestic currency as a monetary reserve capable of satisfying their asset money demand, the Phillips Curve will show a negative correlation between inflation and unemployment away from ZLB and no correlation at ZLB. If domestic agents seek the safety of gold or foreign reserves to satisfy their asset money demand, the Phillips Curve will show a positive correlation between inflation and unemployment.
 Price can be considered a measure of the opportunity cost associated with forgoing the utility of all other possible consumption baskets.