I am honored to have David Andolfatto discuss my proposal for eliminating the zero lower bound in his post “Are negative interest rates really the solution?” David asks what model I have in mind when I write, for example, in “America’s Big Monetary Policy Mistake: How Negative Interest Rates Could Have Stopped the Great Recession in Its Tracks,"
Even without the ZLB [the zero lower bound on nominal interest rates], there would have been some hit from the financial crisis that ensued with the bankruptcy of Lehman Brothers on Sept. 15, 2008, but negative interest rates in the neighborhood of 4% below zero would have brought robust recovery by the end of 2009.
This post gives that model.
One thing I will not try to do in this post is to talk about how we have actually been crawling out of the hole left by the great recession using the low-power, but not powerless tool of quantitative easing. Among instruments of monetary policy, this post considers only the current short-run safe interest rate. (I discuss some of the downsides of quantitative easing relative to negative interest rates in my ”Breaking Through the Zero Lower Bound" Powerpoint file.)
Related Work
It is a model that I have taught in my advanced undergraduate course “Business Cycles” since the mid-90’s (see scans of student notes for two different years 1, 2), building on my academic papers
(My “Business Cycles” course is Economics 418 at the University of Michigan. Masao Ogaki has also arranged for me to teach it at Keio University in Tokyo, in August 2014.)
I am currently working on a formal treatment of the kind of issues I will address here with Bob Barsky and Rudi Bachmann. Blogging has brought home to me the policy importance of pushing that paper through to completion. We do not have a full draft yet, but if you want to see the kind of model it is, here is a mathematical appendix I put together early on in our process of writing that paper.
But to understand what I am going to say, you don’t need to read the academic papers I flag above. The only indispensable prerequisite for understanding what I am going to say beyond a general background in economics is to read my post “The Medium-Run Natural Interest Rate and the Short-Run Natural Interest Rate,” where I discuss why I reject the IS-LM model on theoretical grounds, using instead the soundly micro-founded KE-MP model.
The Argument for Sticky Prices, Sticky Wages or Sticky Information or Sticky Information Processing Relevant to Prices and Wages
I am claiming that the KE-MP model is soundly “micro-founded,” but “micro-founded” is of course always a matter of degree. The Arrow-Debreu model is not fully micro-founded because it does not explain how the contracts at its heart are enforced! In the case of the KE-MP model, the place where the micro-foundations do not go as deep as one might wish is in explaining why prices are determined in the way they are. I consider the evidence of substantial monetary nonneutrality (from Friedman and Schwartz, from Romer and Romer, from vector auto-regressions, from the experience of central bankers even after allowing for some of the likely psychological biases, etc.) very persuasive. Despite many attempts, models without sticky prices, sticky wages or some kind of sticky information or sticky information processing relevant for prices and wages have not been very successful at explaining substantial monetary nonneutrality. (In saying this, I am leaving aside models that, in their totally real versions, have multiple equilibria; it is of course easy to have nominal things help select among multiple real equilibria.) Thus, regardless of the qualms one might have about why prices might be sticky (or wages, or information relevant to prices and wages), it is appropriate to assume something that is the moral equivalent of sticky prices in the broad sense.
Many people do not realize that there is another very powerful strand of evidence for something like sticky prices: the observed response of the economy to technology shocks. In “Are Technology Improvements Contractionary?”Susanto Basu, John Fernald and I make a careful, extensive, and I believe persuasive, argument that the observed response of the economy to technology shocks is very hard to square empirically with models that lack something like sticky prices, sticky wages or sticky information or sticky information processing relevant to prices and wages. I have been disappointed in the years since it was published that this aspect of our paper–this argument for sticky prices or the like–has had as little influence as it has. (Of the many citations the paper has, the bulk appear to be from economists who are simply eager to use our measure of technology shocks.)
As for the empirical evidence behind "Are Technology Improvements Contractionary?“, it is nice to know that our evidence based on purifying Solow Residuals of variable capital and labor utilization and increasing returns to scale to identify technology shocks is backed up by the very different methodology of structural vector autoregressions of aggregate hours and output, beginning especially with Jordi Gali’s paper ”Technology, Employment, and the Business Cycle: Do Technology Shocks Explain Aggregate Fluctuations?“ (which was actually contemporaneous with our work in ”Are Technology Improvements Contractionary?“ in its inception, but was completed much more quickly than our paper), and ably defended by John Fernald in his paper Trend Breaks, Long-Run Restrictions, and Contractionary Technology Improvements.
One of the important contributions of ”Are Technology Improvements Contractionary?“ is to focus on the evidence that technology improvements are contractionary for business investment as well as for labor hours. That evidence for a contractionary effect on business investment of immediate permanent technology shocks, is actually much more decisive as evidence for something like sticky prices than the evidence of a contractionary effect on hours. (Note that if technology improvements are anticipated in advance, in a real business cycle model they should make both investment and hours increase at the moment when the technology actually improves. But both investment and hours decline when the technology is observed to improve.)
I should mention in passing that the response of the economy to technology shocks only provides evidence for sticky prices because the monetary policy response to technology shocks is suboptimal. An optimal monetary policy response to technology shocks should strive to make the economy behave like the real business cycle model corresponding to perfectly flexible prices. (In my column "Show Me the Money” I discuss the importance of monetary policy responses to tax policy changes as well as technology shocks.)
Sluggish Inflation
In the graphs I present below, I will treat inflation as being relatively sticky and unchanging. I was clued into the importance of sluggishly changing inflation by Michael Kiley’s job talk at the University of Michigan in 1995 and presented my own (never published) model to generate that kind of behavior at a seminar at Harvard in May, 2000. But given the premium on actually publishing things in academic journals, I gave this account of those ideas in my post “Trillions and Trillions: Getting Used to Balance Sheet Monetary Policy”:
I take the idea that inflation adjusts gradually from my main graduate school advisor Greg Mankiw, one of the most eminent New Keynesians: both from his textbook where he gives his view of the facts and from his theoretical 2002 paper with Ricardo Reis trying to explain those facts: “Sticky Information Versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips Curve.”Michael Kiley anticipated Mankiw and Reis in his 1995 job market paper. He used the nice phrase “sluggish inflation” to describe what he was explaining with his model.
The thing I emphasize to my graduate students is that if inflation is sticky, as distinct from the price level being sticky, that some kind of imperfect information processing must be involved. Why? Let’s think of a continuous-time model–or it is good enough to think of a model with 365 periods per year–for clarity. Inflation yesterday was generated by the firms that changed their prices yesterday. But with staggered price setting, the firms that were changing their price yesterday are different firms than the one that are changing their prices today. So, other than having a similar information environment, there is nothing connecting inflation yesterday to inflation today. If firms are optimally using all available information, and something big happens between yesterday and today, then inflation should jump, since the optimal price to change to today should generally be different than the optimal price to change to yesterday. (I am assuming that the old price firms are changing from is changing gradually at that juncture.) To make inflation not jump when something important happens requires firms today somehow not fully using that new information. That is, there has to be some form of imperfect information processing. Mankiw and Reis model the imperfect information processing as firms being asleep relative to new information and making up price changes based on old information much of the time, then periodically updating the information set they are using in full
The key evidence for sluggish inflation is how costly it seems to be to reduce inflation. Paul Krugman gives a nice (though as usual, combatively framed) description of the relevant historical episode in his very interesting post “Fighting the Last Macro War?”:
So, what were the macro wars of the last few decades? First there was stagflation — and that did indeed knock Keynesians back for a while, even as it gave freshwater macro some credibility. As I’ve already indicated, the freshwater guys then stopped there. And I mean really, really stopped there: in many ways they seem to be forever living in 1979.
In particular, they never reacted at all to the second macro war, the disinflation of the 1980s. The point there was that disinflation was very costly, with protracted high unemployment — which shouldn’t have happened if freshwater macro were at all right. This reality, as much as clever new models, drove the Keynesian revival …
What Paul doesn’t say there, but I think would agree with, is that costly disinflation is not only evidence for monetary nonneutrality, but also evidence against something as simple as the usual Calvo model of price setting, which has sticky prices, but jumping inflation. Indeed, Larry Ball among others pointed out that the Calvo model implies that disinflation brought on by a gradual reduction in the growth rate of the money supply should cause a boom if price setting were as in the usual Calvo model of price setting.
In any case, though the usual Calvo model might be OK for some pedagogical purposes, it is seriously flawed as a representation of reality in any context in which it might matter whether inflation is sluggish or not. For a recent, brief discussion of evidence for sluggish inflation in the context of the Great Recession, see Bob Hall’s strong words in “The Routes into and out of the Zero Lower Bound”:
The historical pattern is that a rise in unemployment generates a transitory decline in inflation, but the rise wears off quite quickly, and an extended period of high unemployment|as in the U.S. since 2007 has no effect on inflation.
(Note: I am not persuaded by Bob Hall’s story for why inflation has not fallen faster during the Great Recession.)
The KE-MP Model
