Krugman vs. Eggertsson

I am getting whiplash trying to keep up with Krugman.  Four days after insisted in a NYT Op-ed that monetary policy was our only hope, and endorsed a major program of QE, he has again reverted to the view that monetary policy is ineffective once rates hit zero.  Seems my “vindication” was too good to be true.  We’ll get to monetary policy eventually, but first I’d like to examine the way that Krugman interprets a recent study by Eggertsson.

Gauti Eggertsson is in the process of presenting a new paper on fiscal policy; the paper is here. In his presentation “” though not in the paper “” he offers great phrase: the “paradox of toil.”

According to his paper, when you’re in the liquidity trap, certain kinds of tax cuts have perverse effects. Cutting taxes on capital income, for example, encourages more saving “” which is a bad thing, because we’re suffering from the paradox of thrift. In fact, reduced taxes on capital income actually end up reducing investment.

So what’s the paradox of toil? If you cut taxes on labor income, this expands labor supply “” which puts downward pressure on wages and leads to expectations of deflation, which increases the real interest rate, which leads to lower output and employment.

I am going to skip over the so-called paradox of thrift, which as all good monetary economists know is really about an increase in the demand for money, not saving.  Let’s focus on the assertion that a cut in the payroll tax can increase labor supply, and thus shift SRAS to the right, and yet still decrease employment.  How is that possible?  It is possible because Gauti Eggertsson assumes the AD curve is upward sloping when rates are stuck at zero.   Could something like this happen?  I suppose anything is possible.  But if you look closely at Eggertsson’s paper, it isn’t very likely.  And if you look at the evidence from when interest rates actually were near zero, there is overwhelming support for downward sloping AD curves.  But first, let’s see what makes Eggertsson’s model tick:

Figure 5 clarifies the intuition for why labor tax cuts become contractionary at zero interest rates while being expansionary under normal circumstances. The key is aggregate demand. At positive interest rates the AD curve is downward-sloping in inflation. The reason is that as inflation decreases, the central bank will cut the nominal interest rate more than 1 to 1 with inflation (i.e., φπ > 1, which is the Taylor principle; see equation 6). Similarly, if inflation increases, the central bank will increase the nominal interest rate more than 1 to 1 with inflation, thus causing an output contraction with higher inflation. As a consequence, the real interest rate will decrease with deflationary pressures and expanding output, because any reduction in inflation will be met by a more than proportional change in the nominal interest rate. This, however, is no longer the case at zero interest rates, because interest rates can no longer be cut. This means that the central bank will no longer be able to offset deflationary pressures with aggressive interest rate cuts, shifting the AD curve from downward-sloping to upward-sloping in (YL,πL) space, as shown in Figure 5. The reason is that lower inflation will now mean a higher real rate, because the reduction in inflation can no longer be offset by interest rate cuts.
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