UNIVERSITY OF CALIFORNIA Economics 134 DEPARTMENT OF ECONOMICS Spring 2018 Professor David Romer LECTURE 11

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1 UNIVERSITY OF CALIFORNIA Economics 134 DEPARTMENT OF ECONOMICS Spring 2018 Professor David Romer LECTURE 11 THE ZERO LOWER BOUND IN PRACTICE FEBRUARY 26, 2018 I. INTRODUCTION II. TWO EPISODES AT THE ZERO LOWER BOUND A. Japan since the 1990s B. A little bit on the United States, III. POLICIES TO STIMULATE AN ECONOMY AT THE ZERO LOWER BOUND A. Bernanke s assessment of the performance of the Bank of Japan B. Overview of possible policies 1. IS 2. MP C. Possible policies to shift the IS curve D. Possible policies to shift the MP curve E. Discussion IV. EVIDENCE ON THE EFFECTS OF LARGE-SCALE ASSET PURCHASES (QUANTITATIVE EASING) A. What is quantitative easing? B. Possible impacts C. Empirical evidence about impact on long-term interest rates 1. Difficulties 2. event study approach 3. Gagnon s et al. s evidence. D. A little on Federal Reserve communications policy

2 Economics 134 Spring 2018 David Romer LECTURE 11 The Zero Lower Bound in Practice February 26, 2018

3 Problem Set 2: Announcements Due at the beginning of lecture next time (Feb. 28). Optional problem set work session: Today (Monday, Feb. 26), 6:45 8:15, in 597 Evans Hall. Midterm: Wednesday, March 7, in class. I will discuss it at the start of class next time.

4 Economics 134 Spring 2018 David Romer LECTURE 10 The Zero Lower Bound in the IS-MP- IA Framework (concluded)

5 How the Zero Lower Bound Affects IS-MP Diagram and AD Curve r 0 π e (π 0 ) MP(π 0 ) π IS 0 Y π 0 AD 0 Y 0 Y

6 Example 2: Anchored Expectations Inflation fell less in the Great Recession (and the subsequent period of continued high unemployment) than in previous recessions.

7 A Model of Anchored Expectations Two influences on inflation: As usual, below-normal output acts to make firms raise price and wages by less than before. This works to push inflation down. Firms expectations of inflation act to move inflation toward π*. When actual inflation is below π*, this works to push inflation up.

8 Revisiting a Large, Long-Lasting Fall in Planned Expenditure r MP(π*) 0 π e (π*) π AD 1 IS 1 AD Y 1 Y 0 (= Y) Y 0 IS 0 π* IA 0, IA 1 Y 1 Y 0 (= Y) Y

9 A Large, Long-Lasting Fall in Planned Expenditure (cont.) r MP(π*) MP(π LR ) 0 π e (π LR ) 0 π e (π*) π AD 1 IS 1 Y π* π LR IA 1 IA LR Y LR Y 1 Y Y

10 A Large, Long-Lasting Fall in Planned Expenditure (concluded) With anchored expectations, inflation can stabilize at a level below π* where the upward _ pull from π* and the downward pull from Y Y < 0 balance.

11 Economics 134 Spring 2018 David Romer LECTURE 11 The Zero Lower Bound in Practice

12 I. INTRODUCTION

13 II. TWO EPISODES AT THE ZERO LOWER BOUND

14 15.4 Japanese Real GDP Growth Logarithms After growing rapidly for decades, GDP leveled off around 1990, and growth was anemic for the next two decades.

15 What Is Bernanke s Evidence that Japan Was Suffering from an Aggregate Demand Deficiency? Inflation had fallen and was very low. Output was well below most estimates of potential output.

16 Peak in stock prices was in 1989; real estate peak was a bit later.

17 What happened in Japan in an IS-MP framework r MP 0 0 π e (π 0 ) Y 1 IS 0 IS 1 Y Y Collapse in wealth and financial distress reduced C and I.

18 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

19 Inflation Rate in Japan Inflation fell after 1990 and was often negative (deflation) after 1998.

20 AD decline with ZLB and Anchored Expectations π AD 0 π* IA 0 π LR IA LR Y LR Y 0 Y Y

21 U.S. real GDP fell sharply in the Great Recession and did not bounce back.

22 Funds rate target was 0 to 0.25% from Dec to Dec

23 The period that the federal funds rate stayed near zero lasted much longer than almost anyone expected.

24 III. POLICIES TO STIMULATE AN ECONOMY AT THE ZERO LOWER BOUND

25 Bernanke s Assessment of the Performance the Bank of Japan Feckless ( weak, ineffective, worthless, irresponsible ).

26 Policies to Stimulate an Economy at the Zero Lower Bound Overview r MP 0 0 π e (π 0 ) IS 0 Y 0 Y

27 r Shifting the IS Curve MP 0 0 π e (π 0 ) IS 0 IS 1 IS 1 Y 0 Y 1 Y 1 Shifting the IS curve right raises Y. (The shift may or may not be large enough to lead to i > 0.) Y

28 r Shifting the MP Curve 0 π e (π 0 ) r 1 * r 1 * MP 0 MP 1 MP 1 IS 0 * denotes: Explanation coming soon! Shifting the flat part of the MP curve down raises Y. (The shift may or may not be large enough to lead to i > 0.) Y 0 Y 1 Y 1 Y

29 r Shifting the MP Curve (cont.) MP 0 MP 1 0 π e (π 0 ) Y 0,Y 1 IS 0 Shifting the upward-sloping part of the MP curve down does not affect Y. Y

30 Examples of Possible Policies to Shift the IS Curve Fiscal stimulus. Policies to improve the functioning of the financial system or credit availability. Policies to lower interest rates that are still above 0. Policies to lower expectations of future interest rates ( forward guidance ). Steps to improve confidence or raise expectations of future output. Policies that cause the exchange rate to depreciate. Redistribution to individuals with high MPCs.

31 Possible Policies to Shift the Flat Part of the MP curve Down General r = i π e, so the possibilities are: Lower i (to below zero). Change expected inflation, so that π e at a given π is higher than before.

32 Shifting the MP Curve (Revisited) r 0 π 0 e (π 0 ) i 1 π 1 e (π 0 ) MP 0 MP 1 IS 0 The flat part of the MP curve can be shifted down either by lowering i below 0 or by raising π e at a given inflation rate. Y 0 Y 1 Y

33 Possible Policies to Raise Expected Inflation Adopt a higher inflation target. Aim for inflation temporarily above the target. (Possible example: Targeting a price level path.) Perhaps: Anything that stimulates the economy today or creates expectations of future stimulus. Perhaps: A conventional expansionary openmarket operation at the zero lower bound.

34 Discussion

35 IV. QUANTITATIVE EASING

36 Quantitative Easing and Its Possible Effects Large-scale asset purchases: Fed buys a lot of long-term government bonds or mortgagebacked securities. Should drive up the price of these assets (and so increase wealth). Could shift IS. Should drive down their interest rate. Could shift IS. Could affect expectations. Could shift MP.

37 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.

38 Difficulties in Identifying the Impact of QE Interest rates might move before asset purchases based on news. Other things might be going on that move longer-term interest rates. For example, economic data releases, other government policies, etc.

39 Identify news events. Event Study Approach Look at the behavior of interest rates in a short period around the time of the news. What are the benefits and pitfalls of this approach?

40 Five of Eight Key Announcement Dates

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

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

43 Does It Matter How Forward Guidance Is Framed? Example 1: The Committee anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period (FOMC statement, 3/18/2009). Example 2: [T]he Committee anticipates that [the] exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored (FOMC statement, 12/12/2012).