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Federal Reserve Bank of Chicago

An Interview with Neil Wallace
David Altig and Ed Nosal

November 2013
WP 2013-25

An Interview with Neil Wallace
David Altig
Federal Reserve Bank of Atlanta

Ed Nosal
Federal Reserve Bank of Chicago

November 2013

Abstract
A few years ago we sat down with Neil Wallace and had two lengthy, free-ranging
conversations about his career and, generally speaking, his views on economics. What
follows is a distillation of these conversations.

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Introduction

The lore of the Cleveland Fed research department famously includes (maybe even starts
with) an episode in the late 1980s when Neil Wallace participated in a conference on money
demand, organized and hosted by the Bank. At the time, like many other Federal Reserve
research departments, the Cleveland group was in full-trot transition from a team devoted
largely to business conditions analysis to one focused on policy-related research that could
stand up to the highest professional standards and scrutiny. As a member of the pioneering
research out…t at the Minneapolis Fed, and a founding father of the rational expectations
revolution (which at the time still felt quite young), Neil Wallace was the honored guest at
the conference.
Be…tting his status, Neil was seated at the head table for the conference dinner, along
with the president Lee Hoskins and the research director John Davis. In the course of the
evening’s conversation, Neil was asked what policies he would be pursuing if he was in charge
of the Fed. His …rst response (of course) was that he would never take such a job. But his
hosts pressed on, insisting that he suspend disbelief and deliver a policy conclusion.
The views expressed here do not necessarily represent those of the Federal Reserve Banks of Atlanta and
Chicago or the Board of Governors of the Federal Reserve System.

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“Well,” Neil eventually replied, “I guess I would set the money supply as a constant
fraction of the government debt.” After a few seconds, his table companions pressed him
further on why that would be his preferred course.
“Well,” Neil even more eventually replied, “It turns out some models are easier to solve
with that assumption.”
When we reminded Neil of this story during the course of our interviews, he responded
…rst with a silent bemused look, then entered his silent tilted-head/raised-eyebrows/I’mthinking mode. After quite a few moments of this – Neil likes to note that people have
told him even his pauses have pauses –he began to describe to us the class of models and
problems he was working on at the time, and why a constant money-debt ratio seemed like
a plausible policy.
You will read a lot of that sort of thought process in this interview. What stands out to
us in this conversation, as with every one we have ever had with Neil, is how clearly each idea
emerges from the intellectual platform on which it is built. As Neil describes his career you
will recognize the tale of a serious scholar, someone not just doing the work but continuously
thinking through how the work ought to be done.
There is an old joke that asks how many economists it takes to change a light bulb. The
punchline is that economists don’t change light bulbs. They screw one in during graduate
school, and when it burns out they just sit there in the dark. You will …nd none of that in
what follows, which is a distillation of two lengthy, free-ranging conversations that we had
with Neil at the Federal Reserve Bank of Chicago several years back. The time devoted to
these talks re‡ect both Neil’s incredible generosity and the unwillingness of the interviewers to cut short any opportunity to learn from a man that we both, with some amount of
self-‡attery, consider a mentor.
Very few people have a truly coherent view of their own intellectual history, and the
capacity to articulate their mind’s journey. Fewer still have lived that history in such a
remarkably consequential period for their chosen …eld. Neil Wallace is one of those few.

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2

Graduate School

I went to Columbia as an undergraduate and then the University of Chicago as a graduate
student. I began my …rst job when I was 24 at the University of Minnesota in 1963. A lot
has happened since then. For the things that I think about, there have been two main developments over this time. One is the development of rational expectations equilibrium and
the other, more generally, is the notion that we ought to build models in macroeconomics
and monetary theory in a coherent way.
As a graduate student, did you have a feeling that something along these lines was about to
happen?
In my …rst year at Chicago, Harry Johnson taught us macro, and it was pretty strange. I
remember Harry coming into each class with these voluminous handwritten notes, and reading to us. The course met twice a week in two-hour sessions, and I don’t recall a break during
the two hours. So we were sort of sitting there, listening. I remember that Harry almost
never used the blackboard. His approach was the history of thought of macro. I don’t know
how far back we went, but I can certainly remember trying to read some of Irving Fisher.
Toward the end of the course, we read Franco Modigliani’s 1944 Econometrica paper. I can
still remember my feeling that this paper was the “Promised Land.” I got to know a few
graduate students when I was an undergraduate at Columbia, and I remember going back
when I was on vacation from Chicago, and running into some of them. They were still trying
to do macro using the equation of exchange as their framework, while I had Modigliani’s
framework. It was an eye opener for me at the time.
Can you remember exactly what it was? What conception of macro did you have before
Modigliani?
Well, I really had no conception. You know what the history of macro is like. Prominent
economists, like John Stuart Mill, wrote a micro book and a macro book. If you pick up the
micro book, you sort of recognize what is going on, even though it’s very primitive. You pick
up the macro book, and you don’t know what’s going on. Alfred Marshall was the big exception. And it wasn’t an accident. According to what I heard— maybe from George Stigler
in a graduate course in the history of thought or from Milton Friedman— Marshall had the
view that macro was not well enough developed to call for an exposition like the principles
of macro. So when people want Marshall’s views on money, they read his testimony about
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the Indian monetary system before various commissions or rely on reports from those who
attended his lectures. After looking at this early unrecognizable macro stu¤, in Modigliani
you see equations whose number is equal to that of the unknowns, and the equations seem
to allow you to talk about things the way people still do today. So it was a real eye opener.
One of the best things I learned at the University of Chicago was some econometrics.
I can’t remember who taught us this course, but the book was by Theil, and it wasn’t an
econometrics text. The book had a huge appendix, with the …rst exposition of two-stage
least squares. So, somehow, IS-LM, macroeconomics and econometrics, were …tting together.
That’s where I was at in graduate school.

3

Moving from Modigliani to Modern Macroeconomics

Can you remember when dissatisfaction with the Modigliani program started to bubble up for
you?
It wasn’t until I saw a working paper version of Lucas’s “Expectations and the Neutrality
of Money.”Before that, Tom Sargent and I were trying to build models which were elaborations of IS-LM. I won’t speak for Tom, but I was stuck in a static mode. We had the view
that things depend on people’s expectations of in‡ation, and we wanted to endogenize the
expectations. Our approach was to be clear about stocks and ‡ows in IS-LM. But when you
start thinking about that, you’re naturally led to think about some kind of dynamics. At the
time, I was also working with John Kareken and Tom Muench. Muench was a good operations researcher, so to him the idea that an equilibrium condition is a di¤erence or di¤erential
equation didn’t seem strange. But to me, that was just way out there. So although we were
thinking about dynamics, it was in a very static way. Then I saw this paper by Lucas; I
don’t know why I read it, or tried to read it. In part, I did because Bob had been a classmate
at Chicago and I had a high opinion of him. I picked up the paper, and it’s talking about
people, two-period lived people. What’s that? There are no people in macroeconomics! I
pretty much saw that the Phillip’s curve ideas that Sargent and I had been working on were
a dead end. That paper (Lucas ‘72) raised the standard, and there was no turning back.
The Lucas ’72 paper had a huge in‡uence on me in all sorts of respects. First of all,
in terms of style and a way of theorizing, that pretty much marked a break for me. And
the paper made me think about what money was doing in that model. That’s probably my
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…rst substantive, what I would call serious, thinking about money. So it was hugely in‡uential. Recently, I was at a little conference in Phoenix, and Lucas gave a keynote address.
In talking about the recent …nancial crisis he, in part, used the equation of exchange as a
framework. He said, “The profession is struggling with trying to …gure out how a change
in nominal income is split between prices and real income,”and that “I wasted 10 years on
that problem.” I don’t know who was sitting next to me in the audience, but I said “Well,
maybe, but he got a Nobel for it.” But anyway, that really is the way he feels. He wasn’t
joking when he said, “I wasted 10 years on this.”
Do you still think it’s an interesting problem?
Yes. I’m not ready to dismiss outright the ideas that are in Lucas’s ‘72 paper. The idea
that it is unreasonable to have lags in seeing the money supply because you can look up the
St Louis Fed’s estimate of it is, I think, a misguided criticism. Lucas’s paper is a model of
aggregate demand shocks and how they impinge on the world. The St. Louis Fed numbers
are only part of the story about last quarter’s aggregate demand shock. So I think some of
the ideas in the Lucas paper shouldn’t be dismissed.
So the bell went o¤ after you read the Lucas paper. You obviously had a stockpile of things
that you were working on. Were you in con‡ict for three or four years trying to …nish up
these (pre-Lucas ‘72) papers?
I don’t think I was in much of a con‡ict. I sort of abandoned that stu¤. In 1975, Tom
and I published a well-known paper. That was Tom’s e¤ort to get a little something out of
a failed research e¤ort. But I was done. Lucas’s paper got me thinking about money, and,
for the most part, abandoning directly thinking about business cycles. Since money was the
only asset in Lucas ’72, there was no issue about why it was held.
What was your thinking at the time about what would be a good way to think about money?
For a while there, I thought the overlapping-generations model was going to be the model
of money. My attitude was to try to put that model to work in a number of applications.
A classic problem in monetary economics, identi…ed by Hicks back in 1935, is why money
exists when there are higher return assets around. I had this idea that if we legally inhibit
intermediation, then rate of return dominance would emerge. I wrote a couple of papers
about that using an overlapping-generations model. In retrospect, I think the profession was
right to reject that view of money.

5

Because it didn’t deliver on Hicks’s central question?
I don’t think it dealt with Hicks’s question very well. But the overlapping-generations
model really failed miserably in explaining why economies have money in the following sense.
People have had in mind for, I think, a couple of thousand years that something like money is
a useful thing. It helps an economy achieve outcomes that it couldn’t achieve in its absence.
So it’s natural to have as a goal of monetary theory to invent settings where that is the
case. How are you going to do that? There are two versions of answering this question. One
version has money as one of a number of devices for achieving allocations, and it’s not the
unique one. I have as a goal the second and more ambitious version. I want money to be
the unique way to achieve allocations. People looked at Samuelson’s overlapping generations
model, and gave the …rst answer. Money was one way to achieve the allocation. But it was
hard to make the claim that it was a unique way to do it. In the early 90’s, Kandori wrote
a paper about implementing allocations in overlapping-generations models. In his paper,
he said that if we can remember what people did when they were young and reward them
when they are old contingent on what they did as young people, then we don’t need money.
We can achieve everything that you could achieve with money. This record-keeping idea is
much older. I attribute it, mainly, to Joe Ostroy in his thesis and in some papers that he
published in the mid-70’s. Even though I had discussed Ostroy’s papers in classes, I didn’t
see their signi…cance. Although Ostroy, a paper by Townsend in the 80’s, and Kandori’s
work pre-date Narayana’s paper entitled Money is Memory, that paper brought home the
idea that money is a way to record past actions.
This seems to me to be a great idea, and something we ought to be working on. It
…ts within economics in general. When I teach undergraduates money and banking, I say,
suppose you’re in class and you don’t have a pencil. So you turn to your neighbor, and what
are you going to say? You might say, “Do you have a spare pencil?”Suppose the person has
a spare pencil. Do you o¤er to buy it? Or do you say, “lend me a pencil.”I think you would
say, “lend me a pencil,” because you’re in a continuing relationship with this person. The
idea is that we use money with strangers, and we don’t with people we know.
I guess some of us have tried to hire our kids and to give them allowances to get them
to behave. But by and large we don’t use money in the family. You don’t use money in a
small Amish community or in a kibbutz. We know what people have done. Maybe we don’t
use money in the same way in an organization either. So I think it’s a big idea, and a good
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idea. It just wasn’t in the overlapping-generations model.

4

Deviations from Arrow-Debreu Model

Obviously, the notion of hidden trading histories seems very natural. But, given technological
advances, it seems to be becoming increasingly less natural to think in those terms. Money
is becoming less important. So do you have thoughts about this?
Sure. I think that idea should push us is in the direction of thinking about payments
instruments in terms of the informational requirements needed to support them. We use
credit and debit cards most of the time. There’s an information structure that supports
that. And that idea is related to what we should take to be the base for the in‡ation tax.
It ought to be currency, not some broad notion of money. It may be true that your checking
account has a low interest rate, but there are lots of reasons why that might be. An obvious
one is that the payment of explicit interest would be part of your income for tax purposes,
and giving you payment services for free is something you don’t have to claim as income.
One of the best models we have of demand deposits, the Diamond-Dybvig model, says
that you’re sacri…cing some rate of return for the right to spend early if you want. This model
predicts that demand deposits will have a low rate of return in exactly the circumstances
under which the equilibrium looks like an illiquid banking system. So, when we think about
in‡ation taxes, we’re thinking about currency. And once we think about currency, where
does that push us? Well, obviously, it pushes us to thinking about the underground-economy
role of currency.
All of this goes along with the idea about trading histories. Certainly we can imagine
the world going cashless. Is a cashless world going to be the Arrow-Debreu model? Well,
for lots of reasons, maybe not. In particular, these ideas about circumstances under which
money is essential always assume that people are not committing to future actions. That’s
always there in the background, as it probably should be in everything we think about. But
that’s not the Arrow-Debreu model.
In a world without cash, what would monetary theory be about?
A few years ago, I started out a graduate course in monetary theory by handing out a table
of GDP by sector of origin. I asked the students “which of these sectors …t comfortably as an

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activity or an industry or a good in the Arrow-Debreu model?”You can do the Arrow-Debreu
model very crudely, and maybe shove many things into it, but not very easily. One sector
which does not …t into it is FIRE: …nance, insurance, and real estate. Retailing is another
such sector. We need new models for those sectors and, perhaps, when we have them, we will
see a relationship to monetary theory. By the way, I wonder whether Greenspan, who probably was a big believer in some version of the …rst welfare theorem, recognized that he was presiding over a …nancial system which doesn’t exist in the model to which the theorem applies.
You just argued a little while ago that incomplete trading histories is the best story we’ve
got to describe the frictions that give rise to money. But maybe it is only a piece of this big
non-Arrow-Debreu world?
I don’t know whether this imperfect monitoring idea is the whole idea, but I think it’s a big
idea in thinking about how we transact. But your question brings to mind another question:
what is the role of pairwise meetings in monetary economics and elsewhere in economics. I
like pairwise meetings. In some ways, they certainly …t well with imperfect monitoring—
you don’t know about things occurring across the street right now because you’re not there.
There are a lot of things in the past that you don’t know about because you weren’t there and
haven’t been told about. The idea that we’re not all costlessly and immediately connected
has a lot to do with those big non-Arrow-Debreu sectors of the economy. I’ve done some applications of pairwise meetings models where this lack of connection is a big deal. One of my
favorite papers is something called “Float on a Note”, written with Tao Zhu, which takes up a
seeming paradox related to the pro…tability of bank note issuing in private banking systems.
In a very general way, ‡oat in the …nancial system is about people not being connected.

5

Teaching

How do these ideas about money, informational frictions and Arrow-Debreu in‡uence your
views on teaching economics?
If we were to construct an economics curriculum, independent of where we’ve come from,
then what would it look like? The …rst physics I ever saw was in high school. I went to the
Bronx High School of Science, so you might think they would have had some good physics
there. The year I took it somebody was on sabbatical, and I was taught physics by someone
who was a Latin instructor. He was struggling along with us. I can vaguely remember some8

thing about frictionless inclined planes, and stu¤ like that. So that’s what a …rst physics
course is; it’s Newtonian mechanics. So what do we have in economics that’s the analogue of
Newtonian mechanics? I would say it’s the Arrow-Debreu general competitive model. So that
might be a starting point. At the undergraduate level, do we ever actually teach that model?
That means that you would not talk about money in your …rst course.
That’s right. Suppose we taught the Arrow-Debreu model. Then at the end we’d have
to say that this model has certain shortcomings. First of all, the equilibrium concept is a
little hokey. It’s not a game, which is to say there are no outcomes associated with other
than equilibrium choices. And second, where do the prices come from? You’d want to point
out that the prices in the Arrow-Debreu model are not the prices you see in the supermarket
because there’s no one in the model writing down the prices. That might take you to strategic models of trade. You would also want to point out that there are a lot of serious things
in the world that we think we see that aren’t in the model: unemployment, money, and (an
interesting notion of) …rms aren’t in the Arrow-Debreu model. What else? Investing in innovation, which is critical to growth, isn’t in that model. Neither is asymmetric information.
The curriculum, after this grounding in the analogue of Newtonian mechanics— which is the
Arrow-Debreu model— would go into these other things. It would talk about departures
from that theory to deal with such things; and it would describe unsolved problems.
So that’s a vision of a curriculum. Where would macro be? One way to think about macro
is in terms of substantive issues. From that point of view, most of us would say macro is about
business cycles and growth. Viewed in terms of the curriculum I outlined, business cycles
and growth would be among the areas that are not in the Arrow-Debreu model. You can talk
about attempts to shove them in the model, and why they fall short, and what else you can do.
Another aspect of macro is some special tools used to analyze inter-temporal models.
At Penn State, the beginning part of the graduate macroeconomics curriculum is essentially
only that. In some programs, there may be a mixture of tools and substantive issues.
My vision of a curriculum di¤ers a bit from the parallel treatment of micro and macro
that we see at all levels of the economics curriculum. That parallel treatment is a bad idea.
The substantive issues in macro— business cycles and growth— should be what are called
…eld courses, parallel to courses in industrial organization and international trade.
I can remember a little debate we had in the Minnesota economics department in the

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1970’s. We had principles of economics courses, and one of the courses had the number 1,
and the other had the number 2. There was no prerequisite ordering over these courses, but
one had the number 1 and the other had the number 2. At the time I got there, macro was
number 1 and micro was number 2. I was among those who said, “even though we’re not willing to put a prerequisite ordering on these courses, why don’t we switch the numbers?”to at
least give some hint that a little background in micro might be helpful background for macro.
Not everyone liked this idea of switching the numbers. It was noted that the then current
labeling was adopted to encourage interest in economics by having them take macro …rst.
As part of the discussion, we talked about how you don’t need micro to do the quantity
theory of money, IS-LM, and so on. That’s the argument for teaching micro and macro as
parallel o¤erings. I don’t think that’s the impression that we want to impart to students.
Just because business cycles and growth are important doesn’t mean you start out with
discussions of them. Cancer is important, but it’s not the …rst biology course.
It sounds as if you’re going to tell the students, “this is medicine, you have to take it, and
then you’ll get to appreciate the economy through economics.”
This goes to issues in the philosophy of science. It goes to issues like, are there facts that
are distinct from theories, or are there just theories? I don’t think we’re doing students a
service by, say, teaching beginning students supply and demand and not pointing out the
sense in which this is a theory. It’s not truth, it’s a theory. There are these old debates in
economics about whether supply/demand is empty, but it’s not empty. Supply/demand is
the general competitive equilibrium model, with its …rst welfare theorem, and so on. It’s not
empty, but to teach it as if it’s the truth is in every sense a bad idea. Yes, students want to
know about the economy, but somehow, at some point, you have to dispel the notion that
you’re up there dispensing truth.

6

Theory and Policy

You seem to believe that theory informs us about some practical things. For example,
Diamond-Dybvig appeals to you as more than just a nice theoretical construct. It appeals
to you because it addresses something that is pertinent. So what is it?
Adam Smith wrote a chapter on banking. In it, he said that banks should try to match

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the maturities of their liabilities to the maturities of their assets. In modern language, he
would have been saying banks shouldn’t take on term-structure risk. Friedman advocated
100% reserve banking. Today, there are advocates of narrow banking, which is much the
same thing. Is there a theory underlying those claims?
I think not and I think that Diamond-Dybvig throws light on that policy issue. It comes
out on the side of those who say that it’s the function of banks to borrow short and lend
long. In a dramatic way, the model provides new insights into that issue.
This gets back to your earlier argument that maybe we should just be thinking of macro as a
set of substantive questions.
Right, I think policy decisions both at the individual level and government level are, in
a general way, a good entry into motivating what should be taught. So, for example, you
can motivate a …nance course, or at least some of it, by saying “Well, you guys out there
and your parents are making some portfolio decisions. Let’s think about the elements that
go into that.”
Do you think economists as a group have made a prominent or useful contribution to public
policy?
I don’t know. Some time ago, I read a book of essays by Lewis Thomas, a very wellknown biological medical researcher. In one of his essays, he says that he rarely picks up
an issue of the journal Nature in which he doesn’t come across some article that completely
changes his mind about some natural phenomenon. If we pick up an issue of a leading
economics journal, it’s a little hard to say something analogous. But I think we have made
some progress. I remember reading some articles from the 60’s by some well-known people
discussing Ricardian equivalence issues. I think the profession is much clearer about that
today than it was 40 or 50 years ago. Also, you would be hard pressed to …nd an economist
that believed in a permanent in‡ation-unemployment trade-o¤ today.
It would be nice to be able to point out the big discoveries in economics which you might
put side by side with a list of big discoveries in biology, medicine, physics, or chemistry. It’s
not so easy to make that prominent list for economics.
Is this because the problems in economics are just a lot less signi…cant than in other areas?
Or are answers just a lot less certain in economics?
So here’s an issue. Michele Boldrin and David Levine have been working on a big en11

deavor for a number of years. They advocate that we eliminate patents. I really applaud
them for taking up this issue. We’ve had studies going way back which suggest that most of
growth is attributable to innovation as opposed to changes in inputs of labor and capital. So
you’d think that …nding would lead people to turn to the question: How does a society organize to achieve innovation? Most economists have not addressed the question, but Boldrin
and Levine have.
They’re two very smart guys. They started out trying to argue that they discovered a
‡aw in the theory that defended patents, and that unfettered competition might lead to
innovation. I think they’ve backed o¤ that claim. Now they seem to have adopted the view
that whether patents are desirable is an empirical issue. They have a book that largely looks
at case studies and says that there’s enough advantage to being the …rst mover that you
don’t need patents.
How society should organize to achieve the right amount of innovation or the best bang
for the buck is a hard question. It’s an instance of an important question that is an economics question, and one that we’re not very far along in answering. Nailing that question
would be analogous to discovering penicillin. But can we imagine nailing it? Maybe, but
I’m not sure. In any case, there are questions in economics that if answered in a convincing
way would rank with major discoveries in other …elds.
If you were a policy maker how you would think about policy? We’ve observed that you have
been kind of silent about speci…c recommendations. Why is that?
This is sort of related to things we’ve been talking about. I have no desire to be a policy
maker. To have a desire to be a policy maker would be to say something like, “Well, if I
had been in Bernanke’s situation I would have done things very di¤erently for the following
reasons, and things would be much better had I been in that position.”I have no feelings in
that direction. It’s very hard to make policy decisions given our current state of knowledge,
and I have no desire to try.
Do you …nd any irony in that fact you’ve been so closely attached to many Federal Reserve
banks throughout your career, prominently in Minneapolis of course, but even afterwards?
Not really. This is delicate on a number of grounds. I’ve been working in monetary
theory for all this time, and I think it’s a fun and exciting area to work in. I look at received
theory, and see a hole in it regarding money. If you can help …ll it in a way that provides

12

some insights on policy issues, then that’s a big contribution.
To what extent should the Federal Reserve System be engaged in such research?
In my years in association with the Federal Reserve Bank in Minneapolis, there have been
a few times when my research was directly inspired by some policy issue that the Bank wanted
to address. One was some work in the 60’s on so-called intermediate policy targets; the other
was related to bank failures and deposit insurance issues that …rst came up in the mid 70’s.
You wouldn’t pick unpleasant monetarist arithmetic?
Right, I wouldn’t. We were thinking a little about current events, but it’s not that the
Bank president posed the question.
Wasn’t your work on deposit insurance directly motivated by a real time policy question?
It was. At the time, John Kareken was an economic advisor to the Bank president and
we became interested in the way the Fed and the FDIC handled the failure of Franklin National. But in most other respects, the research questions that have inspired me have just
been there and have been there for a long time.

7

Kareken and Wallace Indeterminacy

One of things that the Minneapolis Fed was prominent in advocating for a while was …xed
exchange rate regimes, which we’d always gathered was highly in‡uenced by your work.
I can’t recall what exactly inspired it, but I can remember some things about it. This
was about the time when I was going from model building by just slapping down some
demand function for money to wanting to do something more fundamental— maybe, using
overlapping-generations to do it. But it was in a quite early stage of doing that. I’m not
sure what our thinking was, but we decided we would write down an overlapping-generations
model with two countries and two monies, and we’d think about the possibility of currency
substitution in that world. As I remember, we were surprised by the result that if we didn’t
have some extraneous rules— residents of one country are not allowed to hold the other countries’money or something related— then we couldn’t get well de…ned demands for individual
monies.
At the time when we …rst got this result, it was pretty disturbing to me. I felt like we

13

were heading into some completely unknown area. Luckily for me, Kareken was willing to
be adventurous. He wanted to take this wherever it went: if it’s a little disturbing, …ne. He
had in mind that it was a good thing to look for serious micro foundations. So we wrote
this little paper. I’m not sure what we called it, but it came be labeled “indeterminacy of
exchange rates.”This is the only Quarterly Journal of Economics publication I’ve ever had.1
At the time, the Minneapolis Fed had a quarterly review, and it was always a struggle
to …ll it. I can remember thinking, maybe I should write a quarterly review article about
indeterminacy of exchange rates. I’m Jewish by background, and knew a bit about Passover.
Part of it is a meal at which one of the children asks what are called the four questions.
And one of these questions, or maybe the general overriding question, is “why is this night
di¤erent from other nights?” I was driving home from work one day and I thought of a
title for a potential Quarterly Review piece; namely, why markets in foreign exchange are
di¤erent from other markets. Because I liked the title, I decided I would write the paper.
And I think it’s the only one of my Quarterly Review articles that doesn’t have a symbol
in it. The article was picked up in a couple of books of readings because Federal Reserve
papers can be freely reprinted and because it was all words.
But I did like the question— why markets in foreign exchange are di¤erent from other
markets— because it relates back to some fundamental issues. I can …nd in writing Milton
Friedman saying that if markets can price cars, then they can price German marks in terms
of dollars. So what does it mean that markets can price cars? That’s an allusion to the …rst
welfare theorem. There’s something good about markets pricing cars, but dollars and other
currencies are not in the model. So this analogy is not valid in several senses. That’s partly
the theme that I pursued. And, yes, I’ve been skeptical of ‡oating exchange rates on those
grounds. Floating exchange rates is not just an application of free markets. It has to rest
on other grounds.
In fairness to Friedman, his main argument for ‡exible exchange rates was not the …rst
welfare theorem. It’s actually Philip’s curve stu¤: it’s easy to get price adjustments through
an exchange rate rather than from price levels. It was a story about some prices being more
‡exible than others. But at the time, these sorts of in‡exible nominal price models were not
the things we were pushing in Minneapolis, so where was the case for ‡oating exchange rates?
1

Well, not quite. Neil has a forthcoming paper in the Quarterly Journal of Economics, “Optimal
money-creation in ‘pure-currency’economies: a conjecture.”

14

If I was taking up this issue today, my analysis might be somewhat di¤erent. However,
I’d still have a tough time defending the view that the Canadian dollar should ‡oat against
the US dollar.

7.1

Re‡ections on Own Research

Staying with the topic of your research, you are known to be one of your own toughest critics.
But over your career there’s got to be some stu¤ that you really like. What papers do you
still like and why?
In one sense I’ve been fortunate. There are people who do their best work as their …rst
work. Consider Kenneth Arrow and his work on social choice theory. I think most people
would put that work up there among the best things that he’s ever done. I’ve talked about
how I came from doing old style macro, where you build models one equation at a time, and
you don’t think about the underlying behavior very much. So I’ve sort of made a painful
conversion from being that kind of economist to learning a little economic theory. And along
with learning a little economic theory, I learned a little mathematics. I still have holes, substantial holes, in my mathematical knowledge. But I’m in this somewhat happy position of
thinking that I’m writing my best papers now— certainly relative to what I’ve done in the
past, and even, relative to what other economists are doing now.
I think I’ve mentioned that I like the paper that Tao Zhu and I wrote, called “Float on a
Note.”It took this issue, not the biggest deal in the world, and provided a nice insight about
it. And I liked the little paper we and Manjong Lee did on denomination structures. It’s
about how we think about what are good denomination structures, in the following sense:
should you have $5’s, $7’s, and $20’s or something else. It’s a small question and it’s easy
to master the small literature on it. Our paper couldn’t have been written without the
background work on models in which people meet in pairs to trade. The same is true of the
paper on ‡oat. Both papers are on small questions, but represent substantial advances on
the existing literature on those questions. Most important, they take an existing group of
models and apply them in new areas.
I’m not just picking those things out because they’re recent. If I put them up against
things I’m better known for— unpleasant monetarist arithmetic or the work on deposit
insurance— the recent things are more innovative. That’s my judgment. I think I’ve be-

15

come a better economist, mainly because I couldn’t help but get better.
You don’t have anything that you would say, “I got it about right.”
I don’t think so. I think what I got right, since about the mid 70’s, is telling graduate
students that monetary theory is quite undeveloped. There are some real voids to …ll there,
so we should try to …ll them. I haven’t been the only one saying that by any means. But I’ve
probably been saying it longer than a lot of people. But in terms of actually making contributions that might stand some test of time, I don’t think that earlier stu¤ will meet the test.
Don’t you think new ideas help even if they don’t stand the test of time? You’ve already discussed how the OLG framework was really the …rst attempt to get at the deeper foundations
of monetary economics. Ok, so it didn’t quite pan out, but the question got asked. . .
Yes, perhaps that’s so. By the way, I like the work I’ve done with Ricardo Cavalcanti on
inside and outside money. (We would do it better if we were writing that paper now, but that
paper with Ricardo is one that I like a lot.) When I compare that work to a cash-in-advance
model, or a model in which money is in the utility function, our work is much better and
takes up a real issue. Should we allow people to issue private monies? It’s a long-standing
question. What do you do with that question if your theory of money is cash-in-advance?
It’s a dead end. It’s a conversation stopper. You’re either going to say, well, the private
money is the cash in the cash-in-advance model or it’s not. That’s the end.

8

Importance of Heterogeneity

Could you expand on that? What is the right approach to building monetary models?
The right way to integrate money into economic theory is to try to build models from
the ground up; try to build models in which money has a role. That pushes you in a certain
direction. If you like models in which people meet in pairs, then any kind of idiosyncratic
shocks that occur— such as health shocks, tastes shocks or some people are running into
trading opportunities and others not— will lead to a situation of diverse outcomes. This
gives rise to heterogeneous-agent models.
The di¢ culty is having a state variable which is a distribution. Except in very special
cases, you do not get closed-form solutions. By the way, outside of monetary economics,
people are not really shying away from this. In any case, the issue is whether you can you
16

innocently simplify the model and get away from this heterogeneity?
Lagos-Wright thought of a way of doing this. They had the vision that the economy has
some decentralized trade in the economy and some trade that looks more like competitive
markets. This, perhaps, seems reasonable. Then they assume quasi-linear preferences in
the part of the model where there’s competitive trade. That assumption has far-reaching
consequences. When you think about quasi-linear preferences in microeconomics, it’s used
to do partial equilibrium analysis in a somewhat rigorous way; that is, it allows you to talk
about one market at a time. It’s widely used in microeconomics and is sometimes called
transferable utility. It simpli…es things by getting rid of income e¤ects. It was clever for
Lagos and Wright to see that this hugely simplify matching models.
So then the question is: What are you getting through this assumption (of quasi-linear
preferences), and what are you giving up? Well, you’re getting a huge amount of tractability,
the ability to get closed-form solutions. But you have to ask yourself, what’s the price of
this? I do not think that is not being addressed. Related to this, when matching models
began to be used, it was standard to assume that money holdings were either zero or one
indivisible unit. And, there too, it is important to ask whether the answers are sensitive to
that assumption, an assumption which is made only for the sake of tractability.
So what about quasi-linearity? By now, we know some qualitative things about this. We
know if you could support the taxation required to have the Friedman rule in that model,
it would give us the …rst best allocation. But we also know that if we had a departure
from quasi-linearity, in terms of preferences in this competitive part of the model, then we
wouldn’t want to have the Friedman rule. We’d want to have less de‡ation, or a lower rate of
return on money. So this particular assumption of quasi-linearity gives a particular answer
which is not general and is not indicative of the general policy prescription.
So I think we ought to be careful about treating this quasi-linearity as if it’s some normal
case. When you look at the way these models work, what they say is that if you think about
them in terms of the propensity to save, at some wealth level below some critical value, the
marginal propensity to save is unity and above some critical value, it’s zero. So this is a
pretty special thing. You have to decide for what issues quasi-linearity is somewhat innocent
and for what issues it’s not. It should not be the default model.
Beyond tractability, one argument for the Lagos-Wright approach is that it eliminates hetero-

17

geneity that is not an essential characteristic of a model that would be useful for answering
many questions about monetary economies. Do you think this argument is wrong?
Well, what are those questions? They seem to be questions about the Friedman rule and
the welfare costs of in‡ation. As I said before, I believe that currency is the base for the
in‡ation tax. Once you look at currency, you have to really shut your eyes to treat in‡ation
as a representative-agent tax. We may or may not want to tax currency, but to imagine
that the holdings are spread approximately evenly and are unrelated to other things in the
economy seems silly.

9

Wrapping Up

The real business cycle model was a representative agent model and this was a big revolution
in macro. Is seems like you didn’t really participate in that research program. Is that because
you think representative agent framework cannot answer important questions?
When Prescott started real business cycle theory, I viewed it as having a qualitative
message. The idea was to make the point that innocent settings, settings in which there are
obviously no departures from optimality, can give rise to qualitative observations which had
been viewed as puzzling— mainly, that investment ‡uctuates a lot relative to consumption.
That was a worthwhile message.
The message that optimal outcomes could generate ‡uctuations and, therefore, don’t call
for interventions, is not intrinsically connected with a representative agent. Nor is the idea
that exogenous technology shocks account for most ‡uctuations. However, if real business
cycle theory turns into a theory in which TFP is an empty box into which you can shove
anything, a view which Prescott seemed to espouse in the Ely lecture he gave a number of
years ago, then it becomes a much less interesting theory.
Given the very strong sentiment you expressed about heterogeneity being at the center of some
of the questions we really want to answer, do you think that the place we really ought to be
moving on the frontier is on methods for handling heterogeneity and distributional issues?
Is the big piece of this now a math problem?
Maybe it is, or maybe it is just a programming problem. If I had a really good model
whose implications were really going to tell me something important, I do not think it would

18

be hard to get a big grant to do a lot of intensive computing. People don’t do that because
they cannot make the case that the answer is important enough. Either the question being
posed isn’t interesting enough, or the way it’s being addressed does not merit that kind of
e¤ort.
You’ve spent a huge amount of your time working in monetary economics. Some people out
there would say this is useful so we can help central banks get a handle on the welfare costs
of in‡ation. Is this the big question or would you propose other big questions in monetary
theory?
One nice thing about doing research is that you build models which do some things, and
then you see that you can use them to address other questions. I don’t start out wanting to
improve monetary theory in order to get better estimates of the welfare costs of in‡ation.
I start out to do monetary theory to try to put in place some building blocks that we’re
happy with. Better estimates of the welfare costs of in‡ation may be part of the output, but
I don’t think it’s the only one by any means.
For example, quite a few years ago at the Federal Reserve Bank of Minneapolis, an
economist there and I had a few brief discussions about Federal Reserve ‡oat. The Federal
Reserve has rules about how it credits depositing banks and debits banks on which checks
are written. Other countries have di¤erent rules. The question was: can we appraise those
di¤erent rules? At the time, I decided we weren’t ready to do it. We didn’t have a model
of transactions or of ‡oat. Now, we have such models. Although I haven’t returned to that
question, if I did I would have at least some inkling about how to begin.

10

Referenced Materials

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Boldrin, M. and D. Levine (2008) Against intellectual monopoly. Cambridge, UK: Cambridge University Press.
Cavalcanti, R. and N. Wallace (1999) A model of private bank-note issue. Review of
Economic Dynamics, 2, 104-136.
Cavalcanti, R. and N. Wallace (1999) Inside and outside money as alternative media of
exchange. Journal of Money, Credit and Banking 31, 443-457.
19

Diamond, W. and P. Dybvig (1983) Bank runs, deposit insurance, and liquidity. Journal
Political Economy 91, 401-419.
Friedman, M. (1951) A Program for Monetary Stability. New York City, NY: Fordham
University Press.
Hicks, J. (1935) A suggestion for simplifying the theory of money. Economica 2, 1-19.
Hu, T., J. Kennan, and N. Wallace (2009) Coalition-proof trade and the Friedman rule
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Kandori, M. (1992) Repeated games played by overlapping generations of players. Review
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Kareken, J. (1983) Deposit insurance reform; or, deregulation is the cart, not the horse.
Federal Reserve Bank of Minneapolis Quarterly Review, 7:2, 1-9.
Kareken, J. and Wallace N. (1981) On the indeterminacy of equilibrium exchange rates.
The Quarterly Journal of Economics 96, 207-222.
Kockerlakota, N (1998) Money is memory. Journal of Economic Theory 81, 232-251.
Lagos, R. and R. Wright (2005) A uni…ed framework for monetary theory and policy
analysis. Journal of Political Economy, 113, 463-484.
Lucas, R. (1972) Expectations and neutrality of money. Journal of Economic Theory 4,
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Prescott, E. (2002) Richard T. Ely lecture: prosperity and depression. American Economic Review 92, 1-15.
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Sargent, T. and N. Wallace (1975) “Rational” expectations, the optimal monetary instrument, and the optimal money supply rule. Journal of Political Economy 83, 241-254.

20

Sargent, T. and N. Wallace (1981) Some unpleasant monetarist arithmetic. Federal Reserve Bank of Minneapolis Quarterly Review, 5:3, 1-7.
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229-246.

21

Working Paper Series
A series of research studies on regional economic issues relating to the Seventh Federal
Reserve District, and on financial and economic topics.
Comment on “Letting Different Views about Business Cycles Compete”
Jonas D.M. Fisher

WP-10-01

Macroeconomic Implications of Agglomeration
Morris A. Davis, Jonas D.M. Fisher and Toni M. Whited

WP-10-02

Accounting for non-annuitization
Svetlana Pashchenko

WP-10-03

Robustness and Macroeconomic Policy
Gadi Barlevy

WP-10-04

Benefits of Relationship Banking: Evidence from Consumer Credit Markets
Sumit Agarwal, Souphala Chomsisengphet, Chunlin Liu, and Nicholas S. Souleles

WP-10-05

The Effect of Sales Tax Holidays on Household Consumption Patterns
Nathan Marwell and Leslie McGranahan

WP-10-06

Gathering Insights on the Forest from the Trees: A New Metric for Financial Conditions
Scott Brave and R. Andrew Butters

WP-10-07

Identification of Models of the Labor Market
Eric French and Christopher Taber

WP-10-08

Public Pensions and Labor Supply Over the Life Cycle
Eric French and John Jones

WP-10-09

Explaining Asset Pricing Puzzles Associated with the 1987 Market Crash
Luca Benzoni, Pierre Collin-Dufresne, and Robert S. Goldstein

WP-10-10

Prenatal Sex Selection and Girls’ Well‐Being: Evidence from India
Luojia Hu and Analía Schlosser

WP-10-11

Mortgage Choices and Housing Speculation
Gadi Barlevy and Jonas D.M. Fisher

WP-10-12

Did Adhering to the Gold Standard Reduce the Cost of Capital?
Ron Alquist and Benjamin Chabot

WP-10-13

Introduction to the Macroeconomic Dynamics:
Special issues on money, credit, and liquidity
Ed Nosal, Christopher Waller, and Randall Wright

WP-10-14

Summer Workshop on Money, Banking, Payments and Finance: An Overview
Ed Nosal and Randall Wright

WP-10-15

Cognitive Abilities and Household Financial Decision Making
Sumit Agarwal and Bhashkar Mazumder

WP-10-16

1

Working Paper Series (continued)
Complex Mortgages
Gene Amromin, Jennifer Huang, Clemens Sialm, and Edward Zhong

WP-10-17

The Role of Housing in Labor Reallocation
Morris Davis, Jonas Fisher, and Marcelo Veracierto

WP-10-18

Why Do Banks Reward their Customers to Use their Credit Cards?
Sumit Agarwal, Sujit Chakravorti, and Anna Lunn

WP-10-19

The impact of the originate-to-distribute model on banks
before and during the financial crisis
Richard J. Rosen

WP-10-20

Simple Markov-Perfect Industry Dynamics
Jaap H. Abbring, Jeffrey R. Campbell, and Nan Yang

WP-10-21

Commodity Money with Frequent Search
Ezra Oberfield and Nicholas Trachter

WP-10-22

Corporate Average Fuel Economy Standards and the Market for New Vehicles
Thomas Klier and Joshua Linn

WP-11-01

The Role of Securitization in Mortgage Renegotiation
Sumit Agarwal, Gene Amromin, Itzhak Ben-David, Souphala Chomsisengphet,
and Douglas D. Evanoff

WP-11-02

Market-Based Loss Mitigation Practices for Troubled Mortgages
Following the Financial Crisis
Sumit Agarwal, Gene Amromin, Itzhak Ben-David, Souphala Chomsisengphet,
and Douglas D. Evanoff

WP-11-03

Federal Reserve Policies and Financial Market Conditions During the Crisis
Scott A. Brave and Hesna Genay

WP-11-04

The Financial Labor Supply Accelerator
Jeffrey R. Campbell and Zvi Hercowitz

WP-11-05

Survival and long-run dynamics with heterogeneous beliefs under recursive preferences
Jaroslav Borovička

WP-11-06

A Leverage-based Model of Speculative Bubbles (Revised)
Gadi Barlevy

WP-11-07

Estimation of Panel Data Regression Models with Two-Sided Censoring or Truncation
Sule Alan, Bo E. Honoré, Luojia Hu, and Søren Leth–Petersen

WP-11-08

Fertility Transitions Along the Extensive and Intensive Margins
Daniel Aaronson, Fabian Lange, and Bhashkar Mazumder

WP-11-09

Black-White Differences in Intergenerational Economic Mobility in the US
Bhashkar Mazumder

WP-11-10

2

Working Paper Series (continued)
Can Standard Preferences Explain the Prices of Out-of-the-Money S&P 500 Put Options?
Luca Benzoni, Pierre Collin-Dufresne, and Robert S. Goldstein
Business Networks, Production Chains, and Productivity:
A Theory of Input-Output Architecture
Ezra Oberfield

WP-11-11

WP-11-12

Equilibrium Bank Runs Revisited
Ed Nosal

WP-11-13

Are Covered Bonds a Substitute for Mortgage-Backed Securities?
Santiago Carbó-Valverde, Richard J. Rosen, and Francisco Rodríguez-Fernández

WP-11-14

The Cost of Banking Panics in an Age before “Too Big to Fail”
Benjamin Chabot

WP-11-15

Import Protection, Business Cycles, and Exchange Rates:
Evidence from the Great Recession
Chad P. Bown and Meredith A. Crowley

WP-11-16

Examining Macroeconomic Models through the Lens of Asset Pricing
Jaroslav Borovička and Lars Peter Hansen

WP-12-01

The Chicago Fed DSGE Model
Scott A. Brave, Jeffrey R. Campbell, Jonas D.M. Fisher, and Alejandro Justiniano

WP-12-02

Macroeconomic Effects of Federal Reserve Forward Guidance
Jeffrey R. Campbell, Charles L. Evans, Jonas D.M. Fisher, and Alejandro Justiniano

WP-12-03

Modeling Credit Contagion via the Updating of Fragile Beliefs
Luca Benzoni, Pierre Collin-Dufresne, Robert S. Goldstein, and Jean Helwege

WP-12-04

Signaling Effects of Monetary Policy
Leonardo Melosi

WP-12-05

Empirical Research on Sovereign Debt and Default
Michael Tomz and Mark L. J. Wright

WP-12-06

Credit Risk and Disaster Risk
François Gourio

WP-12-07

From the Horse’s Mouth: How do Investor Expectations of Risk and Return
Vary with Economic Conditions?
Gene Amromin and Steven A. Sharpe

WP-12-08

Using Vehicle Taxes To Reduce Carbon Dioxide Emissions Rates of
New Passenger Vehicles: Evidence from France, Germany, and Sweden
Thomas Klier and Joshua Linn

WP-12-09

Spending Responses to State Sales Tax Holidays
Sumit Agarwal and Leslie McGranahan

WP-12-10

3

Working Paper Series (continued)
Micro Data and Macro Technology
Ezra Oberfield and Devesh Raval

WP-12-11

The Effect of Disability Insurance Receipt on Labor Supply: A Dynamic Analysis
Eric French and Jae Song

WP-12-12

Medicaid Insurance in Old Age
Mariacristina De Nardi, Eric French, and John Bailey Jones

WP-12-13

Fetal Origins and Parental Responses
Douglas Almond and Bhashkar Mazumder

WP-12-14

Repos, Fire Sales, and Bankruptcy Policy
Gaetano Antinolfi, Francesca Carapella, Charles Kahn, Antoine Martin,
David Mills, and Ed Nosal

WP-12-15

Speculative Runs on Interest Rate Pegs
The Frictionless Case
Marco Bassetto and Christopher Phelan

WP-12-16

Institutions, the Cost of Capital, and Long-Run Economic Growth:
Evidence from the 19th Century Capital Market
Ron Alquist and Ben Chabot

WP-12-17

Emerging Economies, Trade Policy, and Macroeconomic Shocks
Chad P. Bown and Meredith A. Crowley

WP-12-18

The Urban Density Premium across Establishments
R. Jason Faberman and Matthew Freedman

WP-13-01

Why Do Borrowers Make Mortgage Refinancing Mistakes?
Sumit Agarwal, Richard J. Rosen, and Vincent Yao

WP-13-02

Bank Panics, Government Guarantees, and the Long-Run Size of the Financial Sector:
Evidence from Free-Banking America
Benjamin Chabot and Charles C. Moul

WP-13-03

Fiscal Consequences of Paying Interest on Reserves
Marco Bassetto and Todd Messer

WP-13-04

Properties of the Vacancy Statistic in the Discrete Circle Covering Problem
Gadi Barlevy and H. N. Nagaraja

WP-13-05

Credit Crunches and Credit Allocation in a Model of Entrepreneurship
Marco Bassetto, Marco Cagetti, and Mariacristina De Nardi

WP-13-06

4

Working Paper Series (continued)
Financial Incentives and Educational Investment:
The Impact of Performance-Based Scholarships on Student Time Use
Lisa Barrow and Cecilia Elena Rouse

WP-13-07

The Global Welfare Impact of China: Trade Integration and Technological Change
Julian di Giovanni, Andrei A. Levchenko, and Jing Zhang

WP-13-08

Structural Change in an Open Economy
Timothy Uy, Kei-Mu Yi, and Jing Zhang

WP-13-09

The Global Labor Market Impact of Emerging Giants: a Quantitative Assessment
Andrei A. Levchenko and Jing Zhang

WP-13-10

Size-Dependent Regulations, Firm Size Distribution, and Reallocation
François Gourio and Nicolas Roys

WP-13-11

Modeling the Evolution of Expectations and Uncertainty in General Equilibrium
Francesco Bianchi and Leonardo Melosi

WP-13-12

Rushing into American Dream? House Prices, Timing of Homeownership,
and Adjustment of Consumer Credit
Sumit Agarwal, Luojia Hu, and Xing Huang

WP-13-13

The Earned Income Tax Credit and Food Consumption Patterns
Leslie McGranahan and Diane W. Schanzenbach

WP-13-14

Agglomeration in the European automobile supplier industry
Thomas Klier and Dan McMillen

WP-13-15

Human Capital and Long-Run Labor Income Risk
Luca Benzoni and Olena Chyruk

WP-13-16

The Effects of the Saving and Banking Glut on the U.S. Economy
Alejandro Justiniano, Giorgio E. Primiceri, and Andrea Tambalotti

WP-13-17

A Portfolio-Balance Approach to the Nominal Term Structure
Thomas B. King

WP-13-18

Gross Migration, Housing and Urban Population Dynamics
Morris A. Davis, Jonas D.M. Fisher, and Marcelo Veracierto

WP-13-19

Very Simple Markov-Perfect Industry Dynamics
Jaap H. Abbring, Jeffrey R. Campbell, Jan Tilly, and Nan Yang

WP-13-20

Bubbles and Leverage: A Simple and Unified Approach
Robert Barsky and Theodore Bogusz

WP-13-21

5

Working Paper Series (continued)
The scarcity value of Treasury collateral:
Repo market effects of security-specific supply and demand factors
Stefania D'Amico, Roger Fan, and Yuriy Kitsul
Gambling for Dollars: Strategic Hedge Fund Manager Investment
Dan Bernhardt and Ed Nosal
Cash-in-the-Market Pricing in a Model with Money and
Over-the-Counter Financial Markets
Fabrizio Mattesini and Ed Nosal
An Interview with Neil Wallace
David Altig and Ed Nosal

WP-13-22

WP-13-23

WP-13-24

WP-13-25

6