Matt Rognlie has a number of new posts that are quite good. Here he emphasizes the importance of monetary stimulus:
In failing to understand this core logic, most commentary about “deleveraging” is rather bizarre. At some level, it’s the same cluelessness that we once saw from central planners: they’d trip over themselves in the complexity of fixing a shortage in one market or a glut in another, never quite realizing that the price mechanism would do their work for them. Right now, historically low inflation expectations and below-potential output are prima facie evidence that real interest rates are too high. That’s what every macro model tells us is associated with contractionary policy by the Fed. Yet we see pundits lost in all kinds of complicated, small-bore proposals to stimulate the economy—when the fundamental, overriding dilemma is getting the price (in this case, the interest rate) right.
. . .
The Fed’s failure to use all the tools at its disposal—in particular, its failure to make a conditional commitment like the one proposed by Chicago Fed President Charles Evans—is by far the most serious failure of economic policy today.
And here he explains why the argument for monetary stimulus doesn’t go away just because we face a “balance sheet recession.”
Even households drowning in debt tend to have some assets: a house, and maybe a 401(k) or IRA. All else equal, low interest rates place upward pressure on home prices (since they bring down the cost of financing for those who can obtain it) and make both equities and long-term bonds much more valuable (since lower rates increase the discounted value of an asset’s payout). This can actually help fix household balance sheets: it brings them out from underwater on their mortgages (or, at least, makes them less underwater than they otherwise would be) and increases the value of their other financial assets. In this light, it’s entirely conceivable that crippled balance sheets make monetary policy more effective, not less. Although the “wealth effect” from higher equity and bond prices matters most for the richest Americans, it’s useful for a much broader group.
In this post his criticizes the IS-LM and AS/AD models:
This is nothing, of course, compared to the abomination that is the AD/AS model, also included in undergraduate textbooks. AD slopes down for the same outdated reason that LM slopes up: given a constant money supply rule, lower prices imply higher real money balances and therefore lower real interest rates, which lead to higher demand. (It can also be justified using real balance effects, which are quantitatively irrelevant, or fixed exchange rates, which only exist in a few cases.) This has absolutely nothing to do with monetary policy as it’s currently implemented. Yet the simple AS and AD curves, made appealing by the apparent (but false) analogy to ordinary supply and demand, lurk somewhere in the minds of countless former economics students. This leads to all kinds of bad intuition—like the notion that sticky prices are problematic because they prevent the adjustment to equilibrium on the AD/AS diagram. (Wrong. Under current Fed policy, the price decrease -> lower interest rate -> improvement in demand mechanism is no longer operative, unless deflation combines with the Taylor rule to force a policy that the Fed should have chosen anyway. Certainly this is no use at the zero lower bound, where price flexibility is actually harmful, because it leads to more deflation and higher real interest rates.)
I entirely agree with Matt’s argument that the AS/AD model he describes (the standard Keynesian one) is an abomination, and that AS/AD has nothing to do with supply and demand (and hence is misnamed.)
But I actually like a different AS/AD model; indeed it is the model I use to take a first pass at macro issues. The version I like uses an AD curve that represents a given level of aggregate expenditure, or NGDP. Thus it’s drawn as a rectangular hyperbola. Last time I posted on AS/AD some commenters assumed the rectangular shape had something to do with the Quantity Theory. It doesn’t, so please don’t make that assumption. It’s an arbitrary definition, and like all definitions it’s not a theory.
Is it a useful definition? I think so. I view monetary policy as the force that (actively or passively) determines the path of NGDP. Then we use the SRAS to describe how shifts in nominal spending are partitioned between prices and output in the short run, and the LRAS to explain how spending shifts are partitioned in the long run.
I don’t agree with Matt’s assumption that increased price flexibility is destabilizing, under any conditions. Under a gold standard the future expected real value of gold puts a floor under deflation. Under fiat money regimes the floor comes from the fact that most debts are nominal, and it’s politically impossible to deflate very fast. In that case the faster wages and prices fall to the appropriate equilibrium, the quicker the economy can recover. We recovered very fast from the severe 1921 deflation, precisely because wages and prices adjusted very quickly in the relatively laissez-faire policy environment of the Harding years. That’s not to say 1921 wasn’t a severe recession. It was severe, but if wages had been artificially prevented from falling fast (as in 1929-30) the damage would probably have been even greater.
I think it’s also a mistake to assume that increased price flexibility makes the real interest rate rise more sharply during an adverse demand shock. Prices do fall much faster, but expected inflation doesn’t necessarily fall, at least over the sort of time frame that is relevant for business cycles. Again, because there is a floor on how much prices can fall, a quick downward adjustment in commodity and asset prices (which are the prices most relevant for the Fisher equation), means real rates can more quickly regain their natural rate. Even during 1929-32 there is evidence that the deflation was unexpected, and hence real rates weren’t particularly high.
The preceding should not be misconstrued as implying I “favor deflation.” I don’t, I favor monetary policies that allow for steady NGDP growth. But if the monetary authority screws up and lets NGDP fall by X%, it’s better that wages and prices quickly adjust to reflect the X% lower NGDP. That’s the implication of AS/AD, and it’s a correct implication.