Fiscal expectations traps: Reply to Woolsey

Bill Woolsey has a response to my fiscal expectations trap idea.  I agree with most of what he has to say, but want to respond to a few points:

Krugman’s argument needs to be that even if money expenditures were expected to remain growing at trend, the natural interest rate would remain more negative than the expected inflation rate. The only way to get the market interest rate that negative is to raise the expected growth path of nominal expenditures and so the expected inflation rate. Central banks won’t do that, and so, fiscal policy is the only option.

More precisely, future monetary policymakers (it is alleged) hint that monetary injections are temporary, so don’t you go bidding up asset prices.  I agree, in principle.  In other words they could sabotage current monetary policymakers who want to promote recovery, by winking to the public that those money injections are only temporary.  But in that case, why would they allow current fiscal policymakers to boost AD, and hence the NGDP growth path?  It makes no sense.  You say they wouldn’t dare try to sabotage Congress?  They already are doing it, all this talk of exit strategies is slowly grinding core inflation down to sub 1% levels.  Woolsey continues:

Sumner’s argument is reasonable. Krugman has responded. The government will actually employ people regardless of expectations. Sumner’s counter argument is that the private sector will contract to offset that effect due to expectations of the central bank’s future contractionary actions.

First, part of the reason why Sumner and his critics appear to talk past one another is the monetary transmission mechanism. Sumner argues that sooner or later, an excess supply of money results in higher monetary expenditures. The new Keynesians assume that monetary policy can only increase real expenditures through a decrease in the real interest rate. Fiscal policy, on the other hand, can expand real expenditure without decreasing the real interest rate:

Yes, the new Keynesians think in terms of interest rates, but they also assume that the quantity theory holds in the long run.  Thus a permanent monetary injection will raise the expected future price level, and this will lower current (real) long term interest rates.  Bill addresses this next:

From a new Keynesian perspective, the normal way that monetary policy impacts real interest rates is by changing short and safe nominal interest rates–the federal funds rate. Once “the” nominal interest rate is zero, real interest rates can only fall through a higher expected inflation rate. If the central bank is truly committed to never increasing the inflation rate, this possibility is out of bounds as well. If no one believes that the central bank will allow higher inflation, the real interest rate cannot fall if the nominal interest rate is already at zero. And so, real interest rates cannot fall. And so monetary policy cannot expand real expenditures.

Fiscal policy doesn’t have this problem because it expands real expenditures without lowering the real interest rate.

Yes, that nicely describes the monetary expectations trap.  But if the central bank is truly opposed to higher inflation (and here’s where I think the price level can clarify our thinking) or a higher price level, why would they allow the fiscal authorities to raise the price level?  How can they stop them, as fiscal policy will (allegedly) raise NGDP for any given level of real interest rates?  Easy, just reduce the expected inflation rate enough to raise real interest rates to a level that negates the fiscal stimulus.

Once again, I am not saying it is likely that a future central bank would try to sabotage a fiscal authority in any sort of blatant way.  But I think it even less likely that they would want to sabotage the current central bank.  Bernanke will probably be head of the Fed for a long time.  If the Fed announced a clear price level target path, level targeting, I think it highly unlikely that in 5 years Bernanke would stick out his tongue and say; “Nah nah, I fooled all you people who went long on stocks, commodities, and real estate.  You should have known I was tricking you, and bought 30 years T-bonds.”  (BTW, this last sarcastic comment isn’t directed at Woolsey’s post, I’m just trying to head off some implausible arguments in the comment section.)

Tags:

This entry was posted on June 05th, 2010 and is filed under Misc., 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.