Scott Sumner  

The zero bound isn't interest rate pegging

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Saturos directed me to a new paper by John Cochrane:

This long period of quiet inflation at the zero bound - and Japan's longer period - poses a deep challenge to monetary economics. Old-Keynesian models (including Milton Friedman's 1968 AEA address) predict inflation is unstable under a peg. They predict a deflation spiral, which did not happen.
I don't believe this is accurate. Friedman believed that an interest rate peg would be destabilizing when changes in the money supply were being used to keep interest rates fixed. That does not describe recent policies in developed countries.

Friedman was concerned about the following scenario. Suppose the economy strengthened (higher NGDP growth.) That puts upward pressure on interest rates. The Fed injects more money to hold interest rates at the peg. But the extra money causes even faster NGDP growth, which puts even more upward pressure on interest rates. The Fed injects even more money, etc. etc. In a few years you've become Zimbabwe.

Of course central banks never do this, as it would be foolish. Even the Zimbabwe hyperinflation was done for unrelated (fiscal) reasons.

The zero bound is quite different from an interest rate peg. Instead of using changes in the money supply to keep interest rates fixed, they rely on the inability of rates to fall (very far) below zero. Rather than using interest rate targeting, central banks target the inflation rate by adjusting the money supply. The BOJ moved the money supply up and down to keep inflation close to its target of 0% from the mid-1990s to 2012. Inflation rose to about 2% over the next few years, after Japan raised its inflation target to 2%. (But inflation has recently fallen back to zero, as the BOJ seems to have given up about a year ago.)

Macroeconomists keep insisting that recent events are inconsistent with modern macro models. If so, then maybe they are looking at the wrong models. I don't see any mysteries that need explaining. Recent events are easily explained within the market monetarist framework.


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COMMENTS (5 to date)
marcus nunes writes:

"Recent events are easily explained within the market monetarist framework."
They sure are:
http://ngdpadvisers.co.uk/2016/10/11/great-moderation-transformed/

marcus nunes writes:

The same can be seen for less recent events:
https://thefaintofheart.wordpress.com/2012/09/18/50-years-of-us-growth-and-inflation-history-from-a-market-monetarist-perspective/

Jose writes:

The model that Cochrane comments on is yet another move from new-Keynesian do plain keynesian model.
This time it is not rentiers and speculators that make real interest rates too high in their search for liquidity, it is consumers that are myopic because they don't see the deficit spending now will force new taxes in the future, so they don't fully compensate for future taxes by saving now, and Ricardian Equivalence doesn't hold. Therefore fiscal stimulus now is the recipe that works. I believe that what caught Cochrane's attention here is that the model has a neat form, and delivers closed form single solution under certain conditions, in addition to provide a neo-fisherian result in the long run, something that he has posted about many times recently ... I think is funny that the authors have called agents "myopic", as opposed to "irrational". It is funny too to call this feature of the model a "behavioral" component, but, at this point, I can't stop thinking about theoretical detours in economic research that derail the evolution of our undertanding of economics by decades ...

Andrew_FL writes:

They use myopic because that's the correct term for the assumed behavior. What's more surprising is that they didn't misuse "irrational" as many so called economists are oft want to do.

Jose writes:

No, the correct term for the assumed behavior is blind, which actually is not even a behavioral carachteristic. If one is myopic she can overenphasize defict spending, saving much more than enough to compensate future taxes, therefore producing an effect that is the exact opposite of what was intended, but somehow this is not in the studies. They intended blind or irrational, since most interventionists don't believe in the ability of markets to price uncertainty. They used myopic because irrational or blind would bring about a lot of criticism ...

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