So I’m slow and it had to stew around in my brain a little while before I understood what Scott Sumner was saying when he answered the following question:

An elementary question on the topic of interest rates that I’ve been unable to resolve via google: Regarding Fed actions, I understand that reduced interest rates are thought to be expansionary because the resulting decrease in cost of capital induces greater investment. But I also understand that reduced interest rates are thought to be contractionary because the resulting decrease in opportunity cost of holding money increases demand for money.

One? Neither? Both? Little of each? Depends?

His answer was roundabout, but not ambiguous as it seemed to me at the time, which was:

 Here’s what people forget.  The Fed doesn’t wave a magic wand and reduce interest rates.  They do so via a boost in the monetary base.  Now let’s think about the effect of a sudden and instantaneous 1% boost in the monetary base. Contrary to most macro models, there is an immediate impact on NGDP, although almost certainly less than 1%.  The instantaneous impact on NGDP comes from the fact that the OMP immediately boosts commodity prices, and hence the gold and oil flowing out of the ground in America has a higher nominal value.  But that’s nowhere near enough to instantly boost NGDP by 1%.  Instead interest rates must fall by enough so that Americans are willing to hold extra non-interest bearing base money.  The lower interest rates reduce velocity in the short run.  So NGDP might rise by 0.2%, and V might fall by 0.8%, within seconds.

In the very long run money is neutral, V is unchanged, and NGDP rises by 1%.

The medium term is the most complicated.  There may well be a period when velocity goes up, especially if inflation rises and real growth is strong.

So the correct answer is that the lower interest rates tend to reduce NGDP, but the thing that causes lower interest rates may increase NGDP by more than the reduction caused by lower V.  At least if that “thing” is OMPs. Yes, easy money often makes rates fall in the short run, but it’s the larger money supply that does the “heavy lifting” of boosting NGDP.

The thing that confused me was the framing of the question which Sumner followed along with instead of clearing up the issue of consequence of OMOs, as in being at a secondary effect. Geez, talk about having to turn my brain inside out to understand this. If it were not for David Glasner stepping through the use of interest rates in usual and ordinary analysis, I probably wouldn’t have caught on that the answer here is basically the same as I imagined – that the Fed can passively tighten by doing nothing as the demand for money increased and interest rates would plummet along with NGDP.

So I am now with the program and I owe Sumner a huge apology. I am sorry that I misunderstood.

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