Krugman 1998 . . . Sumner 1993

Paul Krugman and I both use a similar framework to analyze monetary policy.  Temporary monetary injections don’t have much effect; stimulus comes from injections that are expected to be permanent.  I thought it might be interesting to review just how similar our views are, given the small but important differences in how we interpret this framework.

This is from Krugman’s justifiably famous 1998 paper “It’s Baaack“:

One often hears, for example, that the real problem is that Japan’s banks are troubled, and hence that the Bank of Japan cannot increase monetary aggregates; but outside money is still supposed to raise prices, regardless of the details of the transmission mechanism. In addition to the problem of bad loans, one often hears that corporations have too much debt, that the service sector is overregulated and inefficient, and so on. All of this may be true, and may depress the economy for any given monetary base – but it does not explain why increases in the monetary base should fail to raise prices and/or output. One way to say this is to remember that the neutrality of money is not a conditional proposition; money isn’t neutral “if your banks are in good financial shape” or “if your service sector is competitive” or “if corporations haven’t taken on too much debt”. Money (which is to say outside money) is supposed to be just plain neutral.

So how is a liquidity trap possible? The answer lies in a little-noticed escape clause in the standard argument for monetary neutrality: an increase in the money supply in the current and all future periods will raise prices in the same proportion. There is no corresponding argument that says that a rise in the money supply that is not expected to be sustained will raise prices equiproportionally – or indeed at all.

.  .  .

Suppose that we start with a [flexible price] economy . . .  and then imagine an initial open-market operation that increases the first-period money supply.  (Throughout we imagine that the money supply from period 2 onwards remains unchanged – or equivalently that the central bank will do whatever is necessary to keep the post-2 price level stable). Initially, as we have already seen, this operation will increase the price level and reduce the interest rate. . . . But what happens if the money supply is increased still further – so that the intersection of MM and CC is at a point like 3, with a negative nominal interest rate?

The answer is clearly that the interest rate cannot go negative, because then money would dominate bonds as an asset. What must therefore happen is that any increase in the money supply beyond the level that would push the interest rate to zero is simply substituted for zero-interest bonds in individual portfolios (with the bonds being purchased by the central bank in its openmarket operation!), with no further effect on either the price level or the interest rate. . . .

A good way to think about what happens when money becomes irrelevant here is to bear in mind that we are holding the long-run money supply fixed at M*, and therefore also the long-run price level at P*. So when the central bank increases the current money supply, it is lowering the expected rate of money growth M*/M, and also – if it does succeed in raising the price level – the expected rate of inflation P*/P. Now what we know is that in this full employment model the economy will have the same real interest rate whatever the central bank does. Since the nominal interest rate cannot become negative, however, the economy has a minimum rate of inflation or maximum rate of deflation.

Now suppose that the central bank in effect tries to impose a rate of deflation that exceeds this minimum – which it does by making the current money supply M large relative to the future supply M*. What will happen is that the economy will simply cease to be cash-constrained, and any excess money will have no effect: the rate of deflation will be the maximum consistent with a zero nominal rate, and no more.

Great stuff.  In a 1993 paper on colonial American currency, I developed a similar idea.  Here’s a few passages from that paper:

[note (1=r)n and (1+r)x are meant to be (1+r) raised to the power of n or x.]

For example, suppose that at time=zero there is a nonpermanent currency injection that is expected to be retired at time=x.  Then, if the real return from holding currency has an upper bound of r, the ratio of the current to the end-period price level (Px-n/Px) cannot exceed (1 + r)n.  Furthermore, if real output is stable, it would not be expected that Px would be any different from Po.  Both price levels would be determined by the supply and demand for money as in the quantity theory.  The existence of a maximum anticipated rate of deflation (r) has the effect of placing a limit on the size of the initial increase in the price level.  No matter how large the original currency injection, the price level at the time of the currency injection cannot increase by more than a factor of (1+r)x.  Furthermore, these restrictions on the time path of prices can be established solely on the basis of the future time path of the quantity of money, without any reference to fiscal policy.  It is this quantity-theory model that is applicable to the colonial episodes of massive and nonpermanent currency injections. . . .

The impact of U.S. monetary policy during the period from 1938 to 1945 provides a good illustration of the preceding hypothesis.  Between 1938 and 1945 the currency stock increased by 368 percent while prices (the GNP deflator) increased by only 37 percent.  There was no depreciation in the dollar (in terms of gold.)  Although real output grew substantially, the ratio of currency to nominal GNP increased from .062 to .132.  Why was the public willing to hold such large real balances?

Although the U.S. did not experience deflation following World War II (as it had following previous wars), surveys indicate that deflation was anticipated.  During the entire period from 1938 to 1946, the three-month Treasury Bill yield never rose above 1/2 percent.  The fact that massive currency injections (associated with expectations of future deflation) were able to drive the nominal interest rate down close to zero, is at least consistent with the modern quantity-theory model I have described.

In both our papers the equilibrium real interest rate sets the maximum rate of expected deflation.  Krugman recognized that the equilibrium real interest rate might be negative (and thus we might have a liquidity trap at positive expected rates of inflation.)  Oh, and although my paper came first, his is 100 times better.

In future posts I’ll discuss why we interpret this framework differently.  But at least we agree that the quantity of money drives the price level in the long run.

And just so you won’t think there’s anything new under the sun, here’s some Congressional testimony from 1932 involving New York Fed President Harrison and Representative Goldsborough (proposing a price level targeting bill.)  Notice how it weirdly echoes Krugman’s discussion of Japan:

Harrison: [T]hat pressure [excess reserves] does not work and will not work in a period where you have bank failures, where you have panicky depositors, where you have a threat of huge foreign withdrawals, and where you have other disconcerting factors such as you have now in various sorts of legislative proposals which, however wise, the bankers feel may not be wise. You then have, in spite of the excess reserve, a resistance to its use which the reserve system can not overcome.

Goldsborough: [I]n anything like normal times, specific directions to the Federal reserve system to use its power to maintain a given price level will tend to decrease very greatly these periods, or stop these periods of expansion and these periods of deflation which so destroy confidence and produce the very mental condition that you are talking about…. I do not think in the condition the country is in now we can rely upon the action of the Federal reserve system without the announcement of a policy. A banker may look at his bulletin on Saturday or on Monday morning and see that the Federal Reserve system has during the previous week purchased $25,000,000 worth of Government securities. But that does not restore his confidence under present conditions because he does not know what the board is going to do next week…. If this legislation…were passed, the Federal Reserve Board could call in the newspaper reporters and say that Congress has given us legislative directions to raise the price level to a certain point, and to use all our powers to that purpose, and we want you to announce to banks and public men at large that we propose to go into the market with the enormous reserves we now have available under the Glass-Steagall Act and buy $25,000,000 of Governments every day until the price approaches the level of that of 1926…. [I]f the bankers and business men knew that was going to be the policy of the Federal reserve system,…it would restore confidence immediately….and the wheels of business would turn [italics supplied].

Note that FDR adopted price level targeting in 1933.

The entire quotation (including italics) is taken from an unpublished manuscript by Robert Hetzel.  You will be hearing a lot more about Hetzel’s work in the future.  I regard it as the definitive account of the Great Recession, comparable to Friedman and Schwartz’s Monetary History.



9 Responses to “Krugman 1998 . . . Sumner 1993”

  1. Gravatar of Bill Woolsey Bill Woolsey
    6. July 2011 at 02:56

    Why is the equilibrium real interest rate the maximum rate of deflation?

  2. Gravatar of Fed Up Fed Up
    6. July 2011 at 08:48

    “Note that FDR adopted price level targeting in 1933.”

    How about the accounting for leaving the gold standard?

  3. Gravatar of ssumner ssumner
    6. July 2011 at 10:44

    Bill, The real rate is the maximum rate of expected deflation, in an economy where money is assumed to be neutral. The idea is that the QTM holds in the long run. Hence if the money supply rises and then falls back to the original level, prices will also rise and fall back to the original level. But no matter how much prices rise, they can’t be expected to fall at a rate faster than the real interest rate. Otherwise the real return from holding cash would exceed the equilibrium real interest rate. But in that case the real interest rate would rise above equilibrium, and money would no longer be neutral.

    Thought experiment. The Fed doubles the money supply in year one, then cuts it in half in year two. If the QTM holds, then prices double, and are expected to fall in half. Thus the real return from holding currency in year two is 100%. But then people would hoard currency in year one, in hopes of getting that 100% return. This money hoarding would prevent prices from rising (very much) in the first place.

    Fed up, FDR used the price of gold as the policy instrument, which of course forced him to leave the gold standard (temporarily.) He returned the US to gold in 1934. This was important, because without the return to gold there would be much less incentive for people in 1933 to view the rising price of gold as a signal of future monetary stimulus. And that’s why rising gold prices today don’t cause inflation.

  4. Gravatar of Bill Woolsey Bill Woolsey
    6. July 2011 at 15:08

    Suppose the Fed targets the inflation rate at -10%. Is this impossible if the initial real interest rate was 2%?

    I don’t think the QTM holds in the face of sufficient deflation.

    I think a monetary system based upon zero nominal interest rate currency is not neutral in the face of deflation greater than the natural interest rate. The monetary system interfers with intertemporal coordination.

  5. Gravatar of Bill Woolsey Bill Woolsey
    6. July 2011 at 15:16

    P.S. I see how in the thought experiment that concerns you, the price level cannot rise now more than an amount consistent with a deflation rate equal to the equilibrium real interest rate.

    Also, there is a similar process that causes the price level to fall immediately to a level such that its expected future rate of decrease is no greater than the real interest rate. But, this is very much based upon assuming constant shrinkage rates of currency. Suppose the target isn’t a rate of currency shrinkage, but a rate of price (or NGDP) decrease. With zero interest currency, neutrality is not a good assumption.

  6. Gravatar of Scott Sumner Scott Sumner
    7. July 2011 at 08:22

    Bill Woolsey, This is a difficult area. Your second comment addresses one point I was going to make in response to your first point. My focus was on how much prices could rise in equilibrium, if expected to later fall.

    In addition, the goods that are closest substitutes for financial assets are commodities, and their prices are flexible. So if 10% a year deflation is expected for 5 years, the prices of commodities and homes will immediately fall by 50%, and then sticky prices will fall gradually. Because it’s not easy to invest in goods with sticky prices, the real interest rate becomes hard to define.

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