Policy in the Great Recession

Transcription

1 Policy in the Great Recession Pedro Serôdio July 25, 2016

2 In the 1930s, Keynes and Hicks argued that during a depression, monetary policy is completely ineffective at influencing the level of activity, since the nominal interest rate cannot be reduced below zero.

3 In the 1930s, Keynes and Hicks argued that during a depression, monetary policy is completely ineffective at influencing the level of activity, since the nominal interest rate cannot be reduced below zero. When inflation is low, an economy might hit that zero lower bound to nominal interest rates (ZLB). Fisher relation: r = i π.

4 In the 1930s, Keynes and Hicks argued that during a depression, monetary policy is completely ineffective at influencing the level of activity, since the nominal interest rate cannot be reduced below zero. When inflation is low, an economy might hit that zero lower bound to nominal interest rates (ZLB). Fisher relation: r = i π. In a liquidity trap, the equilibrium real interest rate that policymakers would presumably like to achieve is negative.

5 In the 1930s, Keynes and Hicks argued that during a depression, monetary policy is completely ineffective at influencing the level of activity, since the nominal interest rate cannot be reduced below zero. When inflation is low, an economy might hit that zero lower bound to nominal interest rates (ZLB). Fisher relation: r = i π. In a liquidity trap, the equilibrium real interest rate that policymakers would presumably like to achieve is negative. MP is approximately horizontal at approximately-zero nominal interest rates (for a given inflation rate).

6 In the 1930s, Keynes and Hicks argued that during a depression, monetary policy is completely ineffective at influencing the level of activity, since the nominal interest rate cannot be reduced below zero. When inflation is low, an economy might hit that zero lower bound to nominal interest rates (ZLB). Fisher relation: r = i π. In a liquidity trap, the equilibrium real interest rate that policymakers would presumably like to achieve is negative. MP is approximately horizontal at approximately-zero nominal interest rates (for a given inflation rate). For some time, it was thought that the liquidity trap and the zero lower bound were interesting theoretical special cases, but no longer practically relevant.

7 The historical record suggests that this was indeed not a practically relevant case for the UK. Interest rates in the aftermath of the great recession hovered marginally above 0%, a value which they hadn t reached in the preceding century.

8 In fact, these rates are historically unprecedented in the history of the Bank of England.

9 Liquidity saturation In a liquidity trap, traditional monetary policy cannot get the economy out of the recession.

10 Liquidity saturation In a liquidity trap, traditional monetary policy cannot get the economy out of the recession. In a liquidity trap, there is already liquidity saturation:

11 Liquidity saturation In a liquidity trap, traditional monetary policy cannot get the economy out of the recession. In a liquidity trap, there is already liquidity saturation: ) s > L(i, Y ) ( M P

12 Liquidity saturation In a liquidity trap, traditional monetary policy cannot get the economy out of the recession. In a liquidity trap, there is already liquidity saturation: ) s > L(i, Y ) ( M P If the authorities raise M S in an effort to reduce i (and r), individuals will simply hold on to the extra money, since income has not risen to induce people to spend more.

13 Liquidity saturation In a liquidity trap, traditional monetary policy cannot get the economy out of the recession. In a liquidity trap, there is already liquidity saturation: ) s > L(i, Y ) ( M P If the authorities raise M S in an effort to reduce i (and r), individuals will simply hold on to the extra money, since income has not risen to induce people to spend more. There is no incentive to switch into bonds, so there will be no downward pressure on interest rates (which could hardly fall anyway).

14 r MP r 0 = i min π e y DIS

15 Recall that the slope of the AD schedule in the IS-MP model is given by: π y = 1 c + dφ y dφ π

16 Recall that the slope of the AD schedule in the IS-MP model is given by: π y = 1 c + dφ y dφ π Looking at the expression for the slope, note that φ y = 0 in a liquidity trap.

17 Recall that the slope of the AD schedule in the IS-MP model is given by: π y = 1 c + dφ y dφ π Looking at the expression for the slope, note that φ y = 0 in a liquidity trap. In a liquidity trap, the MP curve is horizontal at the minimum nominal interest rate.

18 r MP 0 MP 1 r 1 = i min π e 1 r 0 = i min π e 0 y 1 y DIS

19 For a given nominal interest rate, r increases?autonomously? if inflation expectations fall (expected disinflation), so MP shifts up.

20 For a given nominal interest rate, r increases?autonomously? if inflation expectations fall (expected disinflation), so MP shifts up. This causes a reduction in AD.

21 For a given nominal interest rate, r increases?autonomously? if inflation expectations fall (expected disinflation), so MP shifts up. This causes a reduction in AD. In normal circumstances, policymakers would choose φ π > 0, and nominal interest rates would be reduced so that target real rate < r 0, thereby y, p.

22 For a given nominal interest rate, r increases?autonomously? if inflation expectations fall (expected disinflation), so MP shifts up. This causes a reduction in AD. In normal circumstances, policymakers would choose φ π > 0, and nominal interest rates would be reduced so that target real rate < r 0, thereby y, p. In a liquidity trap, nominal interest rates cannot fall.

23 For a given nominal interest rate, r increases?autonomously? if inflation expectations fall (expected disinflation), so MP shifts up. This causes a reduction in AD. In normal circumstances, policymakers would choose φ π > 0, and nominal interest rates would be reduced so that target real rate < r 0, thereby y, p. In a liquidity trap, nominal interest rates cannot fall. A delay in consumption, so IS shifts left. This causes a further reduction in AD.

24 Escaping the liquidity trap How to escape a liquidity trap: A. Fiscal expansion

25 Escaping the liquidity trap How to escape a liquidity trap: A. Fiscal expansion Fiscal policy can be effective: a massive deficit-financed fiscal expansion could shift IS outwards

26 Escaping the liquidity trap r MP r 1 DIS 1 r 0 = i min π e y 1 y DIS 0

27 Escaping the liquidity trap How to escape a liquidity trap: A. Generate expected inflation

28 Escaping the liquidity trap How to escape a liquidity trap: A. Generate expected inflation If the central bank can effectively communicate that inflation is going to be higher in the future, that lowers the real interest rate faced by private agents.

29 Escaping the liquidity trap How to escape a liquidity trap: A. Generate expected inflation If the central bank can effectively communicate that inflation is going to be higher in the future, that lowers the real interest rate faced by private agents. The full set of equilibrium conditions is given by: DIS: y t = g t + (yt e gt e ) 1 (r r) σ

30 Escaping the liquidity trap How to escape a liquidity trap: A. Generate expected inflation If the central bank can effectively communicate that inflation is going to be higher in the future, that lowers the real interest rate faced by private agents. The full set of equilibrium conditions is given by: DIS: y t = g t + (yt e gt e ) 1 (r r) σ MP curve shifts down in (r, Y ) space if πt+1 e rises, for given i. Generating expected inflation reduces the real interest rate and shifts MP downwards.

31 r MP 0 MP 1 r 0 = i min π e 0 y 1 y r 1 = i min π e 1 DIS 0 DIS 1

32 Escaping the liquidity trap How to make a promise of future inflation credible?

33 Escaping the liquidity trap How to make a promise of future inflation credible? Prof Paul Krugman suggested buying so much debt that people would be convinced of future inflation.

34 Escaping the liquidity trap How to make a promise of future inflation credible? Prof Paul Krugman suggested buying so much debt that people would be convinced of future inflation. Or the CB could try to make a credible commitment to future monetary expansion by announcing a positive long-run inflation target, e.g. 4% for 15 years.

35 Escaping the liquidity trap How to make a promise of future inflation credible? Prof Paul Krugman suggested buying so much debt that people would be convinced of future inflation. Or the CB could try to make a credible commitment to future monetary expansion by announcing a positive long-run inflation target, e.g. 4% for 15 years. Or,as suggested by Prof Lars Svensson, the CB could announce a price-level target.