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It occurred to me that perhaps much of what I have been discussing recently is a bit too esoteric for normal people who don’t live and breathe Woodfordian monetary theory. So today I’m going to try to explain the basic ideas in a very simple way. Then in part 2. I’ll try to explain how I can use the same Woodfordian model that people like Thoma and Krugman use, and reach different conclusions.

I’ll start where Nick Rowe left off yesterday. Nick spent a lot of time discussing all the perplexities of trying to control the economy by controlling real interest rates. Unfortunately my brain is not wired properly to understand monetary policy based on manipulating real interest rates. I see the new Keynesians as taking a peripheral stylized fact (prices are sticky), exaggerating to the point of inaccuracy (prices don’t change at all in the short run), and then making it centerpiece of their model. But Nick ends on a more hopeful note, which is where I’ll pick up:

Tinkerbell and framing aside, this reveals another critique of our thinking about monetary policy as setting interest rates. Why did we ever think that cutting real interest rates would increase demand permanently, as Old Keynesian models suggest? Cutting real interest rates merely shifts demand towards the present, and away from the future. That won’t work if both present and future demand are too low. Maybe monetary policy is about the supply and demand for money?

I’ll start with the last line of Nick’s post. The only knowledge I am going to assume that you have is an understanding of the Quantity Theory of Money—the idea that if you double the money supply, the price level will also double over time, leaving every real variable in the economy unchanged.

I want you to imagine that everyone understands and believes in the QTM. Imagine you live in a country where a typical 3 bedroom ranch house sells for $200,000. Also assume the money supply has been stable for years. Now the Fed suddenly doubles the money supply. What will happen to the price of that house? Keynesians will say “nothing”; prices are sticky. If they are right, I plan to buy up as many houses as I can, right after the money supply doubles. And then sell them again when the house prices double later on. But I actually think it more likely that the sellers will also understand this implication of the doubled money supply, and won’t hand me a $200,000 profit on a silver platter. They’ll immediately demand higher prices. The Keynesians are right that in the real world many prices rise more slowly, but in any case they do eventually rise.

So far there is nothing controversial in my application of the QTM. But now let’s assume that as the Fed doubles the money supply, they announce that 4 months later they plan to withdraw the extra money from circulation. Does the price level still double in that case? Or, if you are a sticky-price Keynesian, does the expected future price level still double? If we think about that $200,000 house, I think the answer is clear. Who in their right mind would pay $400,000 for a house expected to be worth only $200,000 very soon, after the monetary injection is withdrawn in 4 months? Indeed we would expect almost no increase in the price of the house, despite the doubling of the money supply. And the reason is simple, the efficient markets hypothesis is far more fundamental than the QTM. It’s simply not plausible that house prices would rise from $200,000 to $400,000, if people expected them to return back to $200,000 in the near future.

So let’s review. If you double the money supply, and the increase is expected to be permanent, speculators will rapidly bid up the prices of houses. And even the prices of sticky goods will be expected to rise as their prices are readjusted over time. But if you double the money supply, and the monetary injections are expected to be withdrawn in the near future, then house prices will barely budge, and sticky prices won’t be expected to eventually rise upward. This is an incredibly powerful insight.

What does this all mean? It means that the effect of changes in current monetary policy on current aggregate demand and prices is utterly trivial compared to the effect of changes in the future path of monetary policy on AD and prices. Change the current money supply and leave all future money supplies unchanged, and almost nothing happens. Leave the current money supply unchanged and change all future money supplies for year 2, 3, 4, etc, and you have a powerful and immediate effect on AD and prices. The current price level basically depends on the future expected path of monetary policy. Woodford didn’t discover this idea, but it forms the centerpiece of his model.

OK, but how does all this relate to the “Tinkerbell principle?” And why do we only hear about this principle during “liquidity traps?” The reasons are complicated. One reason is that Keynesians like Woodford and Krugman think of monetary policy in terms of the path of interest rates. This leads to very different assumptions from using the money supply as your policy instrument.

Let’s redo the previous example with interest rates. The Fed cuts the interest rate this year, but leaves all future expected interest rates unchanged. Unlike with the monetary base, the expansionary effect of today’s action is not completely negated by the fact that future monetary policy is unchanged. Those who trust me can skip the next paragraph.

[You can think of this in two ways. Assume the current expansionary cut in rates boosts the economy this year. Because AD is higher at the end of the year, even an unchanged level of future interest rates means an effectively lower policy rate in the Wicksellian sense. The rate has fallen relative to the natural right (which is higher in a stronger economy.) If this makes no sense here is another explanation. To cut rates this year the Fed must increase the monetary base. This boosts NGDP. If they plan to keep all future rates unchanged, then they must keep a higher monetary base at the end of the year when interest rates return to their normal level. This is because with more spending in the economy, you have more demand for base money, and hence must supply more base money to keep rates at the predetermined level. So a one-time cut in short term rates leads to a permanent rise in the monetary base. That’s why even temporary monetary policy changes can have an effect if you use interest rates as your policy tool. but even there, future expected changes are far more powerful.]

What about the “liquidity trap?” Recall that Keynesians think that monetary policy becomes ineffective once rates hit zero. (Modern Keynesians use short term rates, but Michael Belongia reminded me that Keynes actually was thinking in terms of long rates. So we aren’t actually in a Keynesian liquidity trap, as the Fed’s QE in March 2009 did substantially affect long rates.) You might wonder; “Why don’t the Keynesians think a permanent doubling of the monetary base would raise prices, even if interest rates were zero today?” After all, my initial example with the $200,000 house and doubled money supply seems very straightforward. The answer is that smart Keynesians like Woodford and Krugman and Thoma do understand that a permanent doubling of the money supply would raise prices. Their argument is different from Keynes’s original liquidity trap argument. They fear that any monetary injection would not be expected to be permanent. More specifically, they fear that the Fed would not be able to convince the public that the increase would be permanent. And if they can’t do that, then they can’t convince them that the price rise would be permanent. And if that $200,000 house is only expected to temporarily rise to $400,000, then it will never rise in price in the first place. So to create current inflation you have to believe the inflation will be permanent. “If we believe we can inflate, then we can inflate.” That’s Tinkerbell.

Part 2.

So far I agree, but now let’s look where I disagree with the standard Woodfordian approach to monetary policy traps. To do that we need to think more about what the Fed is really doing. Recall that the most important thing the Fed does is not to set the current value of the money supply (or interest rates), but rather to signal intentions about future policy. But how do they do this? There are many ways. They could change the monetary base, and let the public guess what that meant. They could announce permanent changes in the money supply. They could adjust the exchange rate. They could announce that they are targeting the expected inflation rate in the TIPS markets. And so on. In practice, most central banks send signals by changing short term nominal interest rates.

Unlike all the other options that I mentioned, nominal interest rates have an Achilles heel. They might need to go significantly below zero, but cannot. This means that if rates fall to zero, and the Fed wants them to be lower, and the Fed is incapable of communicating with the public in any way other than interest rate changes, then the Fed becomes literally dumb (in the sense of speechless, although I’d argue that slang for ‘stupid’ also applies here.)

[Note, here and in a few other places I am shamelessly stealing ideas from Nick Rowe’s brilliant “social construction of monetary policy” post.]

So the markets look to the Fed for direction, and they have nothing to say. During the first 10 days of October, 2008, the markets saw that the short term rate needed to go well below zero to prevent a severe recession. They looked to the Fed for some signal that it was switching out of interest rate “talk” and into some other language like price level targeting. But like most big bureaucracies, the Fed is not as nimble and quick as Tinkerbell. They remained mute—and the asset markets understood that this meant future monetary policy would be constrained by the zero rate bound on short rates, and would be far too contractionary. Asset prices crashed.

Modern central banks don’t just have one language, they have two. In addition to signaling short term intentions with interest rates, they signal long term policy goals with inflation targets. So even when rates hit zero, the Fed could have signaled a higher inflation target. Indeed Krugman and Woodford both recommended this. This would be a signal that once we exited the liquidity trap, the Fed would keep monetary policy more expansionary than usual, so that prices could rise by more than the normal 2%. Here’s where the expectations trap comes in. Once we have exited the liquidity trap, the Fed might not want the high inflation to actually occur. It makes sense to promise inflation, as that will lower real interest rates today and help us recover. But once the deflation and recession have ended the Fed might renege on this promise, because they are conservative central bankers who don’t like high inflation.

Here’s an analogy. A mom promises a child that she’ll get a lollipop if she finishes her homework. After homework is finished, the mom reneges on her promise, because lollipops are bad for the child’s teeth. And after all, the homework is done so the inducement has achieved its purpose–even if it was all a lie. I hope you can see the problem here. This sort of thing almost never happens. Moms do give the lollipop, and for two very good reasons:

1. Moms are not evil witches.

2. Moms may have to promise lollipops in the future.

So although the “expectations trap” is a nice clever theory, it almost certainly has no implications for the real world. If the central bank publicly promised a certain inflation or price level path in an emergency, they would almost certainly carry through with the promise. Why then was this silly theory developed? Because I think people gave far too much respect to the Bank of Japan protestations of innocence in the 1990s, and focused far too little on the fact that the BOJ was unwilling to actually promise inflation. So it looked like the BOJ was stuck, unable to move AD and prices, when in fact they weren’t really trying. Even worse, the BOJ actually did eventually do a temporary currency injection somewhere around 2001-02, and then withdrew the money in 2006. And remember, the whole expectations trap idea is based on the insight that temporary currency injections have almost no effect. So when the temporary currency injection had almost no effect, it seemed to support the model. It does support the model that temporary currency injections don’t have much effect, but doesn’t support the assumption that the central bank can’t signal inflation. After all, they never tried to signal inflation.

So why does the Woodford model seem to suggest that fiscal policy can work when monetary policy is stuck in an expectations trap? This is very complicated, as (I am pretty sure) it rests on two dubious assumptions:

1. The Fed can only signal short term policy by targeting short term rates.

2. The Fed targets inflation at 2%, come hell or high water.

If you buy both assumptions, then it is indeed true that when short term rates are zero, the Fed can do nothing. They can’t cut short rates and they won’t change their long run 2% inflation target. And it’s also assumed that if they did promise higher inflation, no one would believe them.

Here’s my problem with that view. The term ‘trap’ suggests there is nothing they can do. But in fact this “trap” is completely self-inflicted. They can target some other variable, such as the money supply, or long term interest rates, or exchange rates, or TIPs spreads, and signal a more expansionary policy in that way. They aren’t dumb (well, at least in the “mute” sense.) And even Woodford himself has argued that if they are at the zero rate bound, their long run target should be the price level, not inflation. Either changing the short run policy indicator or changing the long run policy goal would allow them to boost AD.

A skeptic might say: “But you haven’t really addressed the expectations trap. Suppose they set a higher price level target, and no one believes them? Then we are still stuck.” I have three problems with this view:

1. They would be believed.

2. Even if they weren’t they can use other short term tools like currency depreciation or TIPS spread targeting.

3. If there is still a problem it is even more applicable to fiscal policy.

And now we have come full circle to my post that raised such a fuss. I argued that if you take the Woodfordian view that future expected monetary policy has a far greater impact than changes in current monetary policy (which I accept) then it is equally true that changes in future expected monetary policy can have far more effect than changes in the current stance of fiscal policy.

And if you go on to assume that heartless future monetary policymakers will sabotage current attempts by the Fed to boost the future expected price level, then they would be even more likely to sabotage current fiscal policymakers, for whom that have a far greater distaste. So why didn’t Woodford get this result?

In the Woodford model once rates hit zero the monetary authority is literally speechless, except if they can signal changes in the future path of interest rates, i.e. promise to hold them at zero for an “extended period of time.” (Sound familiar?) But if they have a 2% inflation target (which is assumed) they have no incentive to do this after they have exited a liquidity trap. And the public understands this and hence doesn’t believe Fed promises to inflate.

Fiscal policy is different. They can do something meaningful right now. Even if short term rates stay at zero, fiscal expansion can boost AD in the normal Keynesian way (or by boosting velocity in the monetarist approach.) The fact that the inflation target stays at 2% in the long run doesn’t sabotage current fiscal policymakers, as current fiscal expansion it least is able to get you out of the deflation much sooner, and back on to that long run 2% inflation track.

So what’s wrong with this approach. Technically, there is nothing wrong with it. But it’s not what I consider an expectations trap. Monetary policymakers (especially Bernanke) know all this. They know that if they want to escape the liquidity trap quickly, they need to target the price level, not inflation. Bernanke said as much when he recommended that Japan do this. Woodford recently recommended a price level targeting approach. So at a minimum, a Fed that really wanted to be more expansionary would adopt a price level target, aka ‘level targeting’. They would promise to catch up for shortfalls. But if this is their promise, and they are assumed to renege on the promise, and sabotage current monetary policy, then fiscal policy is equally screwed.

If fiscal policy is to work, then it must raise AD, and hence the future expected price level. If the Fed won’t let them do that, then it won’t work. It doesn’t even matter if the short term rate is stuck at zero right now, and there is nothing the Fed can do right now to sabotage fiscal policy. Just the expectation that in the future they will act to prevent the price level from rising as the fiscal authorities hope, is enough to sabotage current fiscal policy. That’s why I started this entire overlong essay with the thought experiment about house prices, to try to convince you that what drives current assets prices, and current AD, is future expected monetary policy.

To summarize; future expected monetary policy is what drives AD. Fiscal policy may be effective, but only of the future Fed is expected to allow it to be. Current monetary policy may be effective at the zero rate, but only if the future Fed is expected to allow it to be. And there is almost no reason to expect that a future Fed (probably headed by Ben Bernanke) would try to sabotage and humiliate a current Fed that made a very public and explicit price level target in the midst of a severe crisis. Won’t happen. Period. End of story.

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This entry was posted on June 08th, 2010 and is filed under Fiscal policy, Monetary Policy, Monetary Theory. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



