Woolsey on Eggertsson on liquidity traps.
Bill Woolsey has a very good post on what is now the standard new Keynesian view of liquidity traps:
According to Eggertsson, monetary policy is setting short term interest rates. The variable representing the nominal interest rate has a side constraint–greater than or equal to zero.. . .Monetary policy, (setting the short term interest rate,) is assumed to be aimed at avoiding output gaps or deviations of inflation from target. The “modern” liquidity trap exists because the central bank cannot credibly promise to keep interest rates at a low level after a deflationary shock passes and generate an inflationary boom. Real output collapses and price deflation results because no one believes that the central bank will allow real output to rise above target and prices to rise faster than the long run trend during future periods.. . .These models fail. Or maybe they describe the behavior of a blind and foolish central bank.Suppose that the central bank targets a growth path of nominal expenditure. There are implications for the output gap and inflation, of course. But with that goal, there is no reason for the central bank to prevent whatever inflation that results from a return of nominal expenditure to its targeted growth path.The liquidity trap described by Eggertsson, (as best I can tell) is that the assumed deflationary shocks push the price level down. For some reason, the central bank wants the price level to grow from that low level at a targeted rate. Why?. . .In my view, Eggertsson’s version of the liquidity trap is really a story about a model–a class of models. Did we suffer a Great Recession because central bankers pay too much attention to these models?
The answer is yes. We suffered a “Great Recession” because the Fed failed to have a NGDP target in 2008, level targeting. It’s that simple.
BTW, Eggertsson is wrong in arguing that monetary policy is changes in short term rates. Changing short term rates are just one of many effects of monetary policy.
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2. January 2010 at 12:50
When Eggertson and Woodford write about liquidity traps they explicitly ignore non-interest rate monetary policy (i.e. they say things like “I’m going to ignore other policies available to the central bank because those policies are studied elsewhere”). So these papers should be seen as analyzing the effects of a blind Fed. These authors are explicit about this so their papers should be read as cautionary tales.
If the Fed had read and internalized these tales, we wouldn’t have seen the mistakes that turned a recession into a Great Recession. Given this, I don’t see how these papers or the models they study are failures.
2. January 2010 at 13:24
pushmedia1, I partly agree with you, but partly disagree. I think both Eggertsson and Woodford focus too much on interest rates as both the instrument of monetary policy and the indicator of the stance of monetary policy. I see that as one of the major defects with modern monetary economics, and I believe it led to the current crisis. I have argued that NGDP growth expectations are the proper indicator of policy. I don’t think that they support targeting the forecast.
I do agree that they have showed the risks of using interest rates as a policy instrument, and also the need for price level targeting in a liquidity trap. I regret if I left the wrong impression.
2. January 2010 at 19:45
Bah, “Bill Woolsey has a very good post” is redundant. I almost always find the quality of his posts exceptionally good.
3. January 2010 at 11:24
Doc, I agree.
4. January 2010 at 11:15
“Monetary policy, (setting the short term interest rate,) is assumed […] prices to rise faster than the long run trend during future periods.”
Krugman has pointed out, that there is a credibility problem which a central bank faces when an economy is in a liquidity trap. This idea bases upon the old time inconsistency problem of monetary policy, where a central bank cannot credibly promise to keep inflation low. Here is a different problem. The modern central banks have targeted to keep inflation low, but now inflation is needed to push the real interest rates down to get out of the slump.
The other way is to keep the intetest rate on the lower bound. But if the economy faces deflation, the real interest rate is to high to close the output gap. So we need inflations expectations to push the real rate down. The inflations expectations have to be higher than the normal target. And here comes the problem.
No one believes that the central bank will accept higher inflation in the long run.
“The liquidity trap described by Eggertsson, (as best I can tell) is that the assumed deflationary shocks push the price level down. For some reason, the central bank wants the price level to grow from that low level at a targeted rate. Why?”
Because inflations expectations are needed to get out of the liquidity trap. The main instrument, the short interest rate is out of the match. The real interest rate is the key to get out of the slump. Pushing down the real rate means rising inflation.
“In my view, Eggertsson’s version of the liquidity trap is really a story about a model-a class of models. Did we suffer a Great Recession because central bankers pay too much attention to these models?”
I think we suffered this resession because Bernanke and others focussed on credit easing and not on a history-dependent price-level-targeting (like Eggertsson and Woodford). Pushing down long interest rates and risk premia weren´t enough, so we are still looking in the eye of the crisis.
“The answer is yes. We suffered a “Great Recession” because the Fed failed to have a NGDP target in 2008, level targeting. It’s that simple.”
In a way you are right. I prefer the idea of Wood ford and Eggertsson, but we will never know who is right.
@Bill: Sorry for the comments in Scotts blog, but C&P didn´t work in your blog.
Greetings from Germany
Tobias
6. January 2010 at 12:45
Tobias, Yes, I am familiar with his time inconsistency theory, but I don’t find it at all plausible. First of all the central bank should not target the rate of change in prices or NGDP, they should target the level. If they spell out a target trajectory for P or NGDP, I see no reason why it wouldn’t be credible. And if it weren’t, I have published numerous papers showing how any time inconsistency problem could be overcome by pegging the price of NGDP futures contracts. I know of no example in all of world history where a central bank failed in its attempt to inflate because people didn’t believe them. Krugman thought Japan fit his model, but it doesn’t even come close.
I do agree with your comment on Eggertsson and Woodford’s price level targeting idea. NGDP would be even better, but a price level target would have made the recession much smaller.
Good to have readers in Germany.