Coping with the Zero Nominal Bound

Transcription

1 Economics 196 Spring 2012 David Romer Coping with the Zero Nominal Bound April 3, 2012

2 A Couple of Ground Rules No electronic devices. I expect you to participate.

3 I. INTRODUCTION

4 Unemployment has been very high for more than 3 years. It is falling, but only slowly, and it is still far above its pre-crisis level.

5 Percent Federal Funds Rate 2006:1 to 2010:12 July 2007 February 2008 December The Federal Reserve s key policy interest rate has been virtually zero since late 2008.

6 II. THE IS-MP-IA MODEL EXTENDED

7 The IS Curve: E = C + I + G + NX E = The Baseline IS-MP-IA Model When r falls, I rises (and C and NX may rise as well) C depends positively on (and I may as well). So:

8 The IS Curve r IS

9 The Baseline IS-MP-IA Model (2) The MP Curve: The central bank conducts policy so that r = r(,π) r(,π) is increasing in both arguments Thus, for a given π, r depends positively on So:

10 The IS-MP Diagram: The Determination of r and at a given π r MP 0 r 0 IS 0 0

11 The Baseline IS-MP-IA Model (3): The AD Curve r MP 0 r 0 IS 0 π 0 π 0 0

12 The Baseline IS-MP-IA Model (3, cont.): The AD Curve r MP 0 r 0 MP 1 IS 0 π 0 1 π 0 π 1 0 1

13 The Baseline IS-MP-IA Model (3, cont.): The AD Curve π AD

14 The IA Curve: The Baseline IS-MP-IA Model (4) At a point in time, the inflation rate is given and does not respond to the state of the economy. Let denote the economy s normal or potential level of output. If >, inflation is rising. If < is falling. If =, inflation is steady.

15 The AD-IA Diagram: The Determination of and π π π 0 IA 0 AD 0 0

16 The Baseline IS-MP-IA Model : Long-Run Equilibrium r MP 0 r 0 IS 0 π 0 (= ) π 0 0 (= )

17 Changes to the Baseline Model (1) The nominal interest rate cannot be negative The central bank would like to set r = r(,π). Since the real interest rate, r, equals i π e, this means that r cannot be less than 0 π e. e Thus: r(, π) if r(, π) + π r = e 0 π otherwise 0

18 Changes to the Baseline Model (2) In the baseline model, expected inflation follows actual inflation That is, π e = π. (An alternative would be π e = π e (π), with the function increasing.)

19 Where We Are Headed: The Aggregate Demand Curve Accounting for the Zero Lower Bound π AD

20 The IS and MP Curves Accounting for the Zero Lower Bound: Step 1 r r(,π) 0 π e IS

21 The IS and MP Curves Accounting for the Zero Lower Bound: Step 2 r MP 0 π IS

22 r Deriving the AD Curve MP(π 0 ) -π 0 π π 0 IS 0 0

23 r Deriving the AD Curve MP(π 0 ) MP(π 1 ) MP(π 2 ) -π 2 -π 1 -π 0 π π 0 π 1 π 2 IS 0 π 0 > π 1 > π

24 Deriving the AD Curve (continued) r MP(π 2 ) -π 2 π IS 0 π 2 2

25 Deriving the AD Curve (continued) r -π 3 -π 2 MP(π 2 ) MP(π 3 ) π IS 0 π 2 π 3 π 2 > π 3 3 2

26 Deriving the Aggregate Demand Curve: Conclusion π AD

27 III. EXAMPLES

28 Example: A Large, Long-Lasting Fall in Planned Expenditure r MP 0 -π 0 IS 0 π AD 0 0 (= ) π 0 IA 0 0 (= )

29 Example: A Large, Long-Lasting Fall in Planned Expenditure r MP 0, MP 1 -π 0 π AD 1 IS 1 AD 1 0 (= ) 0 IS 0 π 0, π 1 IA 0, IA (= )

30 A Large, Long-Lasting Fall in Planned Expenditure (cont.) r MP(π 1 ) -π 1 π AD 1 IS 1 π 1 IA 1 1

31 A Large, Long-Lasting Fall in Planned Expenditure (cont.) r MP(π 1 ) MP(π 2 ) -π 2 -π 1 π AD 1 IS 1 π 1 IA 1 π 2 IA 2 2 1

32 The Effects of a Large Rebound in Planned Expenditure r -π 2 MP(π 2 ) IS 1 IS 3 π AD 1 π2 IA 2 2 AD 3 4

33 How Seriously Should We Take This? The main message: When the economy is at the zero lower bound, a key force keeping the economy stable is inoperative.

34 Saving our Ammunition : The Initial Situation r MP 0 -π 0 IS 0 π AD 0 π 0 IA 0 0

35 Saving our Ammunition: The Dynamics of the Economy π AD 0 π 0 IA π 0 2 IA π 2 3 IA π 3 4 IA

36 Using our Ammunition r MP 0 MP 1 -π 0 IS 0 π AD 0 AD 1 π 0 IA 0, IA 1 0 1

37 Using our Ammunition (cont.) r MP 0 MP 1 -π 0 IS 0 π AD 0 AD 1 π LR IA LR π 0 IA 0, IA 1 0 1

38 INTERMISSION

39 Plan for the second part of the lecture Discuss strategies for escaping from a liquidity trap at a general level. Japanese experience in the 1990s and 2000s. U.S. experience in the 1930s. U.S. experience since 2008.

40 IV. STRATEGIES FOR DEALING WITH THE ZERO LOWER BOUND

41 Suppose we are at the zero lower bound because of a collapse of IS: r MP 0 0 π e 0 IS 0 0

42 Solution 1: Expansionary Fiscal Policy r MP 0 0 π e 0 IS 0 IS 1 0 1

43 Quantitative Easing Non-standard open market operations. Central bank usually buys short-term government bonds. Could buy long-term government bonds, mortgage-backed securities, private bonds, etc. Typically done with the short-term policy rate is at zero.

44 Effects of Quantitative Easing Raise the price of assets being purchased. This will likely have a wealth or balance sheet effect. Lower longer-term interest rates. Flatten the yield curve. Typically done with the short-term policy rate is at zero. Raise expected inflation.

45 Solution 2: Lower Long-Term Rates through Quantitative Easing r MP 0 0 π e 0 IS 0 IS 1 0 1

46 Communications Policy Central bank commits itself to certain actions. For example, it might promise to keep shortterm rates low for longer than it normally would. This could lower long-term rates through the expectations theory of the term structure. It could also change expectations of future inflation and future real growth.

47 Currency Depreciation A specific kind of non-standard open market operation. Central bank buys foreign currency. Shifts out IS by increasing net exports.

48 Solution 3: Raise Expected Inflation π e 1 > π e 0 r MP 0 0 π e 0 0 π e 1 IS MP 1 0 1

49 How can we raise expected inflation? Communications policy. Inflation or price-level target. Regime change. Rapid money growth.

50 Raising Expected Inflation to Escape from a Liquidity Trap: A Complication It may be that policymakers want expected inflation to rise, but do not want actual inflation to rise. Thus, they may be tempted to renege on their statements about future policy.

51 Same methods may raise expectations of future growth. Expected future growth could raise spending today. This could increase investment as firms gear up to produce more. Consumer spending might rise as people feel their jobs and incomes are more secure.

52 Solution 4: Raise Expected Future Growth r MP 0 0 π e 0 IS IS 1 0 1

53 Evans s Idea: Targeting a Price Level Path

54 V. JAPAN IN THE 1990S AND 2000S

55 Source: Ben Bernanke, Japanese Monetary Policy: A Case of Self-Induced Paralysis?

56 Peak in stock prices was in 1989; real estate peak was a little later.

57 Bernanke s Critique of Bank of Japan s Policy Too slow to act. Communications policy vague and ineffective. Afraid to create inflationary expectations. Refused to depreciate the en.

58 Japan Overnight LIBOR Percent /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/2010 Bank of Japan was slow to cut rates, and then raised rates in both and

59 13.4 Japanese Real GDP Logarithms GDP leveled off in 1990 and growth has remained anemic.

60 VI. UNITED STATES IN THE 1930S

61 Real GDP growth was both fast and slow in the recovery from the Great Depression. Source: Christina Romer, What Ended the Great Depression?, Journal of Economic History, It was fast in an absolute sense, but slow relative to the recovery needed.

62 Safe interest rates have been approximately zero two times: the mid- and late 1930s and today.

63 Roosevelt s Regime Shift A regime shift is an abrupt and dramatic change in government economic policy. Roosevelt replaced Hoover s fiscal and monetary austerity with expansionary policy. Most obvious signal of the regime shift was abandoning the gold standard.

64 Price of Cotton and the Exchange Rate, Exchange Rate (Dollars per British Pound) Price of Cotton (in Dollars) Source: Temin and Wigmore, The End of One Big Deflation, Explorations in Economic History, Devaluation raised the price of tradable goods, especially agricultural products, and hence farm incomes.

65 Source: Temin and Wigmore, The End of One Big Deflation, Explorations in Economic History, Auto and steel production took off after devaluation.

66 36.5 Stock Prices, Monthly S&P Stock Price Index Jan 1927 Jul 1927 Jan 1928 Jul 1928 Jan 1929 Jul 1929 Jan 1930 Jul 1930 Jan 1931 Jul 1931 Jan 1932 Jul 1932 Jan 1933 Jul 1933 Jan 1934 Jul 1934 Jan 1935 Jul 1935 Jan 1936 Jul 1936 Jump in stock prices could be a sign of a change in expectations.

67 Investment and Consumption Spending, Consumption Investment Source: Temin and Wigmore, The End of One Big Deflation, Explorations in Economic History, Investment spending rises almost exactly when the U.S. suspends the gold standard.

68 Industrial Production and Steel Production, Investment Consumption Industrial Production Steel Source: Temin and Wigmore, The End of One Big Deflation, Explorations in Economic History, Steel rose so much, Temin and Wigmore say it must reflect a big change in expectations of future demand.

69 Source: Christina Romer, What Ended the Great Depression?, Journal of Economic History, Money growth was very rapid in the mid-1930s.

70 4500 Gold Inflows to the U.S. Millions of Dollars Gold inflows surged starting in 1934, and were a key source of monetary expansion.

71 Source: Christina Romer, What Ended the Great Depression?, Journal of Economic History, Expected inflation rose and real interest rates fell beginning in 1933.

72 Interest-sensitive spending recovered quickly in Source: Christina Romer, What Ended the Great Depression?, Journal of Economic History, Movements in spending appear to be correlated with real interest rate changes.

73 VII. UNITED STATES SINCE 2008

74 Percent Federal Funds Rate 2006:1 to 2010:12 July 2007 February 2008 December Funds rate target was 0 to.25% starting in December 2008.

75 Where would the Fed have liked to set the nominal rate?

76 How did the Fed try to deal with the zero bound? Large-scale asset purchases Communications policy

77 First Round of Quantitative Easing (QE1) Source: Gagnon, Raskin, Remache, and Sack, International Journal of Central Banking, In all, the Fed bought about $1.7 trillion of assets.

78 Identify news events. Event Study Approach Look at the response of interest rates on the day of the news. What are the benefits and pitfalls of this approach?

79 Five of Eight Key Announcement Dates

80 Source: Gagnon, Raskin, Remache, and Sack, International Journal of Central Banking, 2011.

81 Effect of QE1 Source: Gagnon, Raskin, Remache, and Sack, International Journal of Central Banking, 2011.

82 Effect of QE1 Source: Gagnon, Raskin, Remache, and Sack, International Journal of Central Banking, 2011.

83 Inflation target Forward guidance Communications Policy

84 Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, January 2012 The longer-run forecasts are supposed to give an indication of where the Fed would like inflation to be.

85 Fed isn t promising to keep rates low even if output is back to normal; they are saying they expect to want to keep rates low because output will be low. Their statements about future interest rates are Delphic, not Odyssean.

86 Where would the Fed have liked to set the nominal rate?