RIP Professor Goodfriend

In a rather unfortunate turn of events, Professor Marvin Goodfriend passed away on December 5^th, 2019. This is The Buylyst’s tribute to him.

I took Professor Goodfreind’s class on Monetary Policy at Carnegie Mellon in 2011. Back then, I had only a superficial knowledge of Monetary Policy and its connection to my reality, my surroundings. Initially, his class was hard. I thought I knew Economics pretty well, having done my bachelor’s degree in it and having worked on Wall Street for 7 years, but I was wrong. I had preconceived notions about Economics and the Fed. They were based on superficial commentary and analyses in popular financial newspapers.

In a nutshell, what Goodfriend taught me was this:

1. Monetary Policy is an on-going experiment.
2. Monetary Policy is “Macro” Economics, but it deals with variables that are decidedly “Micro” Economics. The two branches are closely intertwined. (This connection may seem obvious to you but when you study Economics formally, you lose sight of it.)
3. The present incarnation of Monetary Policy in the US and most major economies is a laissez-faire system that combines both Supply Side and Demand Side Economics.
4. The system has evolved over the years through multiple crises to become more robust. But it still has flaws. It’s still fragile. We take it for granted.

At the heart of this momentous semester in my life was his “Primer” on Monetary Policy, which he had written in 2002 while he was at The Federal Reserve of Richmond. This paper was the basis of his popular class at Carnegie Mellon. At the time, in 2011, I didn’t understand it deeply. But over the years, as I went back to Wall Street to hone my skills as an investor, I understood his teachings viscerally.

This article – I hope – helps you understand the Federal Reserve and how our money works, viscerally. If you do, you’ll have a better understanding of how our economy works and, consequently, how our world works.

The Landscape: What you need to know.

In October this year, I spent almost 3 weeks on The Buylyst Fed Papers (links to which you will find in the Related Worldviews section on right if you’re reading on a desktop, or at the bottom if you’re on Mobile). I had drawn on a lot of theoretical underpinnings from Goodfriend’s Primer. The point of The Buylyst Papers was to describe how our monetary system has evolved, where it is now, and why Cryptocurrencies need to deliver something BETTER (not just different and cool because, you know, F*** the Govt.) to replace or even augment our current system. Goodfriend’s Primer describes the theory the practice behind the primary dashboard of the Federal Reserve: INFLATION. I went over the concept of Inflation Targeting in What the F*D Part 3 in some detail, but obviously Goodfriend does it better. In this article, I will try to summarize his Primer in plain language, without equations and numbers, in my attempt to spread his legacy beyond the confines of Carnegie Mellon, Monetary Economists and Wall Street. I hope I do justice to it.

Here’s how Goodfriend set up his Primer:

1. He talks about the Core Real Business Cycle (RBC). This is his description of how things ought to be in a modern economy.
2. He then describes what he calls the New Neoclassical Synthesis (NNS). This is where he takes the RBC and gives it a shot of reality. He introduces some Keynesianism into the predominantly “Supply Side” worldview of the RBC.
3. He then describes the role of Price Stability and Inflation Targeting in an NNS economy, keeping in mind (in his words) a “Welfare” objective: Maximum Employment.
4. He goes on to talk about potential flaws in the NNS model.

In describing the RBC, the NNS, Price Stability and Flaws, Goodfriend splits up the economy into two logical buckets:

1. Households
2. Firms

And while he does that, he also splits consumption by Households and Firms into two generic time-periods:

1. Current
2. Future

He describes the state of the world using these 4 vantage points, first in a utopic RBC scenario, and then in a more realistic NNS scenario. Like I said, over time he helped me see the connection between:

1. Macroeconomics and Microeconomics
2. Supply Side Economics and Demand Side Economics
3. Production and Consumption
4. Business and Labor

To me, it was a sort of “theory of everything” in Economics. It helped me make more sense of the world than any other Economics course I had ever taken. I ask you to not think of this article as an Economics paper. If you can, think of it as a Sociological paper – one that makes sense of how our world works. For the remaining sections, my intention is to put Goodfriend’s ideas in plain language without data or equations. The idea is to come out at the end of it with a better understanding of how our economy works and how our money works.

The Core Real Business Cycle is idealistic.

Remember that Goodfriend split the economy into two big groups: Households and Firms. We start with Household Consumption – this is why businesses produce goods. But the decision to consume – among households – has one important variable: Time. How much should a household consume now vs. in the future. Or should a household borrow from the future and consumer more than his/her income today? These are real-life decisions we make almost every day.

Now, to consume stuff, households need Income. For that, households need to work. For the most part, it is firms that hire them. And firms pay households wages for their time and effort. For households, it’s important to decide how much they want to work and for what level of wages. This is more of psychological decision, rather than an empirical one. Households don’t usually have all the data and information to analyze this decision. They go by “their gut”. And this gut decision has 3 main implications:

1. If we hold wages constant, Household Labor Supply is assumed to be inversely related to Household Consumption. More consumption means more leisure, which means a lower propensity to work more.
2. But if we hold consumption constant, Labor Supply rises if wages rise. Obviously, if people get paid more, they’d be willing to work more.
3. And it both wages and consumption rise by roughly the same amount, there is no material effect on Labor Supply.

Now we move on to Labor Demand. What is the Firm’s point of view (I use the term “firm” here to represent the aggregate number of businesses in an economy)? Goodfriend makes 3 key assumptions about firms:

1. They have some pricing power – meaning their products are differentiated enough that they can set prices instead of taking prices.
2. They all have a fixed goal for Profit Margin.
3. To maintain their profit margin, firms can move around prices freely.

All 3 assumptions are idealistic. But this is how Economics is studied – we start with an idealistic world and then we peel the layers towards reality. So, what do these idealistic assumptions have to do with labor supply and demand? Well, it’s easy to see that wages make up a large part of a firm’s cost structure (they should). So, higher wages cut into a firm’s pre-determined profit margin. And then to maintain that margin, firms will raise prices on their goods.

There is one other variable that Goodfriend introduces at this point: Productivity. This is where things get slightly complicated. Think of productivity as technological progress. If productivity increases, labor can produce more in the same number of hours. Remember, we’re assuming that firms hold their profit margin fixed, and move prices around freely to maintain the margin. As productivity increases, supply of goods increases. But so does the aggregate level of wages. Households consume more because they can. But this happens up to a point. Eventually, the combination of higher wages and lower prices (because of increased supply of goods), profit margins get squeezed. So, firms stop producing more.

This is a key point: Goodfriend uses a lot of utility functions and equations (like a true economist) to make this point: The natural level of employment depends on the Markup – the Profit Margin – and not on Productivity. Wages depend on productivity, but the level of employment rate depends on the profit margin.  

Putting it all together: The RBC scenario above is a utopian. The perspective is almost entirely “supply-side”. The assumption is that firms determine their profit margin, and everything revolves around that. Based on their profit margin, they set out a certain level of production. But what about demand? Remember that in this RBC model, demand for goods is independent of supply. Households decide whether they want to consume more now or in the future. That decision depends on current income prospects and future income prospects. Income (Wages) depends on productivity. If productivity keeps increasing (as it usually does), households would be more incentivized to borrow from their future income to consume more now. That means more people borrow more money in the credit markets (bank loans etc.). But as more people join the bandwagon, interest rates move up. And as that moves up, borrowing decreases again.

Interest Rates act like regulators in this model. Interest Rates match demand to fit the supply volume of goods that firms have produced in their relentless attempt to maintain their sacrosanct profit margin. Interest Rates incentivize and dis-incentivize households just enough to consume roughly what profit-maximizing output firms have imposed on them. And so, interest rates perform 2 “market-clearing” roles:

1. Clearing the credit-markets.
2. Clearing the goods markets.

So, markets for credit and markets for goods take care of everything. No intervention is needed, and employment levels are always stable. Perfect. In short, interest rates conform demand to available supply. And as a result, employment is always at full capacity. As you’ve no doubt guessed, this is not how the real-world works. Goodfriend makes that quite clear.

The New Neoclassical Synthesis Model is closer to reality.

Goodfriend introduced one change to the RBC model: remove the assumption that firms always maintain their profit markup by continuously changing prices. Removing this assumption changes everything. He called this model of sticky prices and flexible markup the New Neoclassical Synthesis model (NNS). That’s because it takes the RBC model and introduces a dose of Keynesianism to it. 

In the NNS world, employment is driven by aggregate demand, not the aggregate profit margin. If demand drops, firms can’t immediately drop prices to increase demand and maintain their profit margin. Prices remain sticky for a while UNLESS firms believe that the decrease in demand will be long-lasting. Then firms go ahead and change their prices to reflect their prognosis. The same goes for increases in input costs. If a firm believes that input costs will increase over the long-term, they will need to go through the expensive process of changing prices to try and maintain their optimal profit margin.

Remember that the flexible-prices feature acts like an escape valve that allows firms to always produce at it profit-maximizing level and thereby ensuring full employment. That escape valve doesn’t exist in the NNS. Profit margins get squeezed because a firm can’t change prices all the time to reflect, say, rising input costs. If that happens, the response is usually to cut controllable variable costs. And laying off people is often one such move. This exacerbates the problem economy-wide. Aggregate demand drops, and profit margins get squeezed even more. At some point, firms bite the bullet and decrease prices to induce more demand. This can turn into a whirlpool of misery very quickly. I discussed this in What the F*d Part 1 – a deflationary spiral was a major symptom of the Great Depression.

The opposite can happen too. If input costs go down, firms will see higher profit margins. And maybe they pay their employees more to get back to their optimal profit margin. This is unusual these days, but it can happen. Aggregate wages across the economy increase. Demand goes up. Households feel confident about their future income prospects. They borrow more. Demand goes up even more. Firms finally raise prices because they expect this cycle to continue for a long time. Inflation becomes palpable. Eventually, there is a mismatch between price and demand. 

The point is this: In the RBC model, firms held on to their profit margin by constantly changing prices to absorb either changes in input costs or changes in aggregate demand. In the NNS model, shocks caused by changes in demand or input costs are absorbed by the firm in the short run. And this can cause fluctuations in employment. 

In the RBC model, aggregate demand increases if wages increase. Wages increase because of productivity and nothing else. Increase in wages increases demand. Firms absorb this increase in demand by raising prices – because they can. Remember, firms want to maintain their profit margin. At the same time, however, households borrow because they see their income prospects improve. As more people borrow, interest rates rise. Rising interest rates act as a regulator to demand. At some point, firms stop borrowing and demand reduces again. Firms lower prices accordingly to maintain their profit margins. As long as profit margin is maintained, employment remains steady.

In the NNS model, aggregate demand increases employment and wages. More demand induces firms to produce more. So, they attract more labor by paying higher wages. And more wages – economy-wide – increases demand even more. Just like households in the RBC world, households in the NNS world also borrow to abet their consumption because they believe their future income prospects are even better. Interest rates rise again as borrowing increases. And when interest rates rise enough, borrowing starts cooling down soon after. Aggregate demand decreases from its giddy highs. Again, in the NNS world, firms a hesitant to change prices to induce more demand. But now they’ve hired so many people because they expected high demand for the foreseeable future. So, their wage and overhead costs are high. Now their profit margin gets squeezed again. What do they do? They close offices and lay off people. And the downward spiral starts again. 

In the NNS world, there is no escape valve. Firms react to squeezes in profit margins by reducing employment. But firms change prices IF they believe that good economic times or bad economic times will persist. This is a subjective decision.

The Fed steps in.

Aggregate demand has two drivers: 

1. Wages
2. Borrowing cost or Interest Rate.

In the NNS world of sticky prices and flexible profit margins, wages and employment take the heat if aggregate demand fluctuates. The cycles can get violent and frequent. So, the Fed steps in to ease those scary cycles using its influence on the other driver: interest rates. I had discussed in What the F*D Part 3 that the Fed’s policy objectives are: Maximum Employment and Price Stability. We’ve just seen that the two objectives go hand in hand. 

In the NNS world, prices change only if firms expect aggregate demand to be persistently strong or weak. But in reality, increase in aggregate demand cannot exceed increase in wages. And the RBC world tells us that over the long-term, wages increase because of increases in productivity. As technological progress helps firms increase scale and speed, there is a proportionate distribution of its economic impact to wages (we can argue whether that actually happens these days but that’s a separate discussion).

In the RBC world, prices adjust real-time and that makes market-driven changes in interest rates effective in matching supply and demand. 

In the NNS world, prices don’t adjust in real-time, which creates long-lasting mismatches in supply and demand, which interest rates – without intervention – cannot correct. 

The Fed’s policy is to make sure that firms and households don’t overborrow or under-borrow to a level that’s severely disconnected with the economic reality. How do they know what economic reality is? By keeping an eye on Inflation. If prices in general are rising too fast – in a way that’s disconnected from increases in productivity and wages – the Fed knows that the economy is too optimistic. It intervenes by raising rates. 

At the end of the day, the Fed wants to prevent long-lasting cycles of mass-unemployment. That – as Goodfriend calls it – is the Fed’s “Welfare” Policy. 

Goodfriend was a giant in his field. His Primer was an attempt to help us mere mortals understand Economics a little bit better. My attempt here has been the same, but by standing on his shoulders. As Newton said, If I have seen further, it is by standing upon the shoulders of giants”. I’m no Newton, but if I can see at all, it’s because of giants like Goodfriend.