A Question I Can Answer: Why Is the Speed Limit on Deflation so Low? - Grasping Reality with Both Hands
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Grasping Reality with Both Hands The Semi-Daily Journal of Economist J. Bradford DeLong: Fair, Balanced, RealityBased, and Even-Handed Department of Economics, U.C. Berkeley #3880, Berkeley, CA 94720-3880; 925 708 0467; delong@econ.berkeley.edu.
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A Question I Can Answer: Why Is the Speed Limit on Deflation so Low? Nick Rowe asks: Worthwhile Canadian Initiative: Re-learning the New Keynesian IS curve: [A]n empirical puzzle for New Keynesian macroeconomists. If macroeconomic black holes of deflationary spirals exist, and if bad monetary policy can cause economies to fall into one, why haven't we ever observed this happening? Does somebody up there like us? (At least, until now). Or is something wrong with the model? The Akerlof-Yellen answer--which I think is correct--is that the expectational Phillips Curve model of pricing is wrong. Cutting nominal wages substantially has such devastating effects on worker morale that employers simply do not do it in large numbers--even with enormous amounts of slack in the labor market. Thus the dynamic system has two basins that converge to two attractors: a basin that converges to "normal" with employment near full, the nominal interest rate equal to inflation plus the warranted natural real rate of interest, and inflation near the central bank's target; and a basin that converges to "Japan" with nominal interest rates at their floor and deflation proceeding at its (slow) speed limit. That, at least, is what you have to think the right model is, if you think Japan's experience over the past two decades has something to tell us about how the other North Atlantic economies work... And let me, to please Rajiv, reprint my draft comment on Bullard... Extremely rough: A note on James Bullard (2010), "Seven Faces of 'The Peril'" http://research.stlouisfed.org/econ/bullard/pdf/SevenFacesFinalJul28.pdf...
http://delong.typepad.com/sdj/2010/09/a-question-i-can-answer-why-is-the-speed-limit-on-deflation-so-low.html
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Here is the graph:
Bullard: In this paper I discuss the possibility that the U.S. economy may become enmeshed in a Japanese-style, deflationary outcome within the next several years. To frame the discussion, I rely on an analysis that emphasizes two possible longrun outcomes (steady states) for the economy, one which is consistent with monetary policy as it has typically been implemented in the U.S. in recent years, and one which is consistent with the low nominal interest rate, deรกationary regime observed in Japan during the same period.... When the line describing the Taylortype policy rule crosses the Fisher relation [i.e., Wicksellian Balance], we say there is a steady state at which the policymaker no longer wishes to raise or lower the policy rate, and, simultaneously, the private sector expects the current rate of inรกation to prevail in the future.... In the right-hand side of the Figure, short-term nominal interest rates are adjusted up and down in order to keep inflation low and stable. [Point A]... [A]s we move to the left... the two lines cross again, creating a second steady state [at Point B].... The policy rate cannot be lowered below zero, and there is no reason to increase the policy rate since well, inflation is already "too low." This logic seems to have kept Japan locked into the low nominal interest rate steady state. Benhabib, et al., sometimes call this the "unintended" steady state... Let's graph this, with the nominal interest rate on the vertical axis and the inflation rate on the horizontal axis... As I understand this model, the "Policy Rule" line shows what the Federal Reserve wishes it had set its policy nominal interest rate i--the Federal Runds rate--given the rate of inflation ฯ . When i lies above the policy rule line, monetary policy is "too tight" and the Federal Reserve will reduce i. When i lies below the policy rule line, monetary policy is "too loose" and the Federal Reserve will raise i. As the vertical arrows in the version below show, i is falling everywhere above the policy rule line and rising http://delong.typepad.com/sdj/2010/09/a-question-i-can-answer-why-is-the-speed-limit-on-deflation-so-low.html
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everywhere below it. The "Wicksellian Balance" line is what Bullard (and Benhabib et al.) call the "Fisher Relationship." I prefer to think of it in Hicksian IS or Wicksellian terms: for aggregate demand Y to be equal to potential output Y*, the market real interest rate r must be equal to the natural real interest rate re. When the market real rate r exceeds the natural real rate re, investment spending is too low for aggregate demand to match potential output and there is downward pressure on the rate of change of prices. If the market rate r is less than the natural real rate re, investment spending is too high for aggregate demand to match potential output and there is upward pressure on the rate of change of prices. Above the Wicksellian Balance line, there is downward pressure and so inflation is falling. Below the line, there is upward pressure and so inflation is rising. Complicating the dynamics further is the zero-bound requirement: i cannot fall below zero. Complicating the dynamics still further is downward price stickiness: π cannot become large and negative (although we see hyperinflation in the real world, we have never seen hyperdeflation with governments adding zeroes to the denomination of their currency). Just as i cannot fall below zero, π cannot fall below the vertical line starting at point C.
The natural dynamics of this model separates the graph into two regions. The first region consists of a subset of those points above the Wicksellian Balance line and to the right of the Policy Rule line for which the economy's dynamics lead it to eventually hit the X-axis to the left of point B, and then converge to point C. The economy starts out with monetary policy "too tight" and with aggregate demand below potential output, hence both inflation π and the policy interest rate i fall until the economy hits the x-axis. Then i stops falling--it can't fall any further--and inflation π continues to fall until the economy reaches its sticky-price deflationary speed limit at Point C. There the economy sits. http://delong.typepad.com/sdj/2010/09/a-question-i-can-answer-why-is-the-speed-limit-on-deflation-so-low.html
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The second region consists of all those points that generate paths that at some point fall below the Wicksellian Balance line--that at some point produce situations in which aggregate demand is higher than potential output. Those paths then spiral into the stable equilibrium at point A. There the economy sits.
Note, under these dynamics, that point B is not of especial interest. It is not an attractor of any kind for any basin. Rather, it merely marks the bottom of the curve that is the boundary between the two regions: the region of states that ultimately converges to the good equilibrium A and the region of states that converge to the absorbing deflationary-Japan equilibrium C. If the economy is sitting at point B, we do not expect it to stay there. A small downward shock to aggregate demand or a small upward shock to the policy interest rate would throw the economy into the zone that converges to C. A small upward shock to aggregate demand would throw the economy into the converge-to-point A zone. Bullard suggests two possible policies to deal with the danger of convergence to Japanstyle chronic deflation a la point C. (1) His first policy suggestion is to engage in a policy of quantitative easing if deflation threatend: have the Federal Reserve expand its balance sheet even after pushing its policy interest rate i to the floor and take duration, systemic, and possibly default risk onto its own books. In this model, such a policy of quantitative easing can be interpreted as changing the position of the "Wicksellian Balance" line when inflation is very low. With more risk of various kinds taken onto the government's books in response to threatening deflation, firms are more willing to invest at higher real interest rates. Thus the "natural" real interest rate falls, and falls discontinuously if the quantitative easing program is switched on discontinuously when, say, inflation falls below zero. The effect is to change the model to:
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When inflation hits zero and the quantitative easing program begins, the policy interest rate i consistent with Wicksellian balance rises--points lying below the nowdiscontinuous blue line produce upward pressure on inflation. The effect on the dynamics is to eliminate the zone that converged to point C, and thus to eliminate the danger of a Japan-style chronic deflation. (2) A second policy suggestion is for the Federal Reserve to contract rather than expand its assets when deflation begins: to engage not in quantitative easing but rather in contractionary open-market operations to raise the policy interest rate i away from zero to some higher level, like so:
http://delong.typepad.com/sdj/2010/09/a-question-i-can-answer-why-is-the-speed-limit-on-deflation-so-low.html
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Bullard's thought is that this would eliminate the danger of an adverse outcome by eliminating the point B where the red and the blue curves cross. If point A is the good stable equilibrium and point B is thought of as a bad alternative equilibrium, adopting a monetary policy that keeps the curves from crossing at point B and so eliminates point B entirely might help the sitaution. A little investigation, however, shows that under these dynamics the correct conclusion is otherwise. The problem is not the existence of point B. Rather, the problem is the existence of a zone within which the dynamics of the system drive it to the absorbing point C. This second policy suggestion increases the size of that unfortunate region. The dynamics of our new system are given by:
Tracing paths through these dynamics, we see that the boundary between those states that converge to C and those that converge back to normal affairs at A has shifted from the green curve to the orange curve. Basically, almost every path that ends in any deflation at all now converges to point C--only those where the pace of deflation is trivial and is accompanied by aggregate demand well above potential output escape the black hole at point C:
http://delong.typepad.com/sdj/2010/09/a-question-i-can-answer-why-is-the-speed-limit-on-deflation-so-low.html
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Even though the point B at which the curves crossed is indeed eliminated, raising interest rates if the economy actually goes into deflation does not diminish but rather increases the peril of a bad outcome. This should not be surprising: if expanding the money stock via quantitative easing helps, how can contracting the money stock-which is what raising the policy interest rate is--fail to hurt? To recap: I think Bullard has been led astray in part of his analysis. I think the flaw is in his conceptualization of point B--where the curves cross--as an equilibrium at which the economy might sit. The actual equilibria in his model are, I think, point A-where active monetary policy keeps inflation near its target and aggregate demand near potential output--and point C--where the policy rate i is at its zero bound and where the deflation rate π is at its lower bound as determined by the economy's resistance to nominal wage declines. Thus Bullard thinks in terms of eliminating point B where the curves cross, when he ought to be thinking of how to eliminate the zone of initial conditions that converge to point C. He--correctly--concludes that policies of quantitative easing can help eliminate 'The Peril." But he also, I think incorrectly, concludes that policies that reduce the set of states in which very low interest rates are pursued (or that shorten the duration of very low interest rates) can help. However, if my analysis is correct, such contractionary policies would oly hurt. True, they eliminate the point B where the curves cross. But we are interested in where the curves cross only when those points are where dynamic trajectories end. And that is not the case here: here eliminating point B via raising policy interest rates in deflation states increases rather than decreases the zone that converges to the bad equilibrium C. Jess Benhabib et al. (2001), "The Perils of Taylor Rules," Journal of Economic Theory http://www.columbia.edu/~mu2166/perils.pdf James Bullard (2010), "Seven Faces of 'The Peril'" http://research.stlouisfed.org/econ/bullard/pdf/SevenFacesFinalJul28.pdf
http://delong.typepad.com/sdj/2010/09/a-question-i-can-answer-why-is-the-speed-limit-on-deflation-so-low.html
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Brad DeLong on September 04, 2010 at 08:22 AM in Economics, Economics: Macro | Permalink Favorite
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Comments chrismealy said... Bonus points for using skitch. Reply September 04, 2010 at 11:29 AM Alex said... Presumably, hyperdeflation would correspond to an environment where everyone expected a massive downward price shock, and anticipated it by hugely increasing their net financial balances (interestingly, for a lot of possibilities, the asset they might choose to hold would be cash - like a surge in liquidity-preference, driven by the precautionary demand for money). I'm thinking of an immediate pre-war panic anything I could buy might be destroyed at any moment. Perhaps the typical conditions that might give rise to hyperdeflation are so closely associated with the typical conditions that give rise to hyperinflation that it never arises? Reply September 04, 2010 at 12:18 PM Deamiter said... Great explanation! If I may be allowed to nit pick, in hyper-deflation, wouldn't governments be REMOVING zeros from their currency? Reply September 04, 2010 at 01:06 PM Richard Careaga said... Employers may hesitate to reduce __nominal__ wages, but they have no hesitation at all in reducing __effective__ wages through overloading. While this is limited by wage and hour laws and union contract, exempt employees are fair game. Since the speed at which it is possible to attend meetings is a constant, and the speed at which it is possible to answer email and prepare reports declines as a function of context switching, the inevitable result is longer hours for the same wage. Reply September 04, 2010 at 05:19 PM Thomas T, Schweitzer said...
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Deamiter, to pick your nit, in hyper-inflation governments add zeros to the left of the decimal point of their currency; in hyper-inflation they would add zeros to the right of the decimal point. Reply September 04, 2010 at 05:37 PM Robert Waldmann said... I think that for some Taylor rules there is a third basin with hyperinflation. Also didn't the economy fall into the deflationary black hole in the great depression ? Reply September 04, 2010 at 07:08 PM Nick Rowe said... I wasn't sure how to interpret Bullard. He seemed to be saying what you interpret him to be saying. But at the same time he seemed familiar with stuff like George Evans' analysis. If you are right in your interpretation of what he was saying, then your criticism is right. God help us! I think you are half right in your response to my question (and thanks for the response). There are two potentially destabilising positive feedback loops: 1. Low demand leads to falling inflation leads to falling expected inflation leads to rising real interest rates leads to falling demand. 2. Low demand leads to low income leads to low expected future income leads to low demand. (This was the feedback loop I was exploring in my blog post). Your argument, if correct (it may be) puts a stop on 1. But it still leaves 2 wide open to do some very nasty stuff. As far as I can see, it is quite possible, if the real rate is stuck permanently above the natural rate, even if the gap between the two rates is constant, for output to fall *without limit*. In fact, if you have homothetic preferences, and if consumption is the only type of demand (investment is too hard for me to think about), then I think (I'm not 100% sure) that this *must* happen. Intuitively, because of homothetic preferences, everything is proportionate to permanent income. A 1% drop in permanent income leads to a 1% drop in consumption, which leads to a 1% drop in output, which leads, via learning, to a 1% drop in permanent income. Like having an mpc=1. The long-run multiplier is infinite. The economy spirals to zero, even if you stop deflation. Reply September 04, 2010 at 07:10 PM Nick Rowe said... Output wouldn't spiral down to zero in an Old Keynesian model, because the Old Keynesian IS curve has a finite slope. Stop the real rate from rising, by stopping deflation, and output stops falling. It's just low, like in Japan, or the 1930's US. But the New Keynesian IS curve is different. The gap between current planned consumption demand and permanent income is (under homothetic preferences) proportional to the gap between the real rate and the natural rate. There's zero autonomous expenditure, to put it in Old Keynesian terms, in the long run. So output spirals to zero, at the same speed that agents learn to revise their beliefs about permanent income. Now, you would probably argue that Government expenditure plays the role of autonomous expenditure. And that is what has stopped Japan spiralling to zero. But can G play this role indefinitely? That implies an indefinitely growing stock of money+bonds. Is that possible? Well, the trouble is that money and bonds do not appear explicitly in the NK model. So it cannot even address this question.
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Back to some sort of variant on monetarism? We can't ignore what is happening to the stock of money, and promises to pay money. Reply September 04, 2010 at 07:27 PM Other Peter T said... Isn't there a stop to the downside of the deflationary spiral set by the real economy? You can add any amount of zeros to left of the zero - the limit is set by the size of the piece of paper. But the real economy -that is, people actually living in houses, cooking food, making things - has some lower bound of activity (while there are people alive). In short, money can become worthless, but it can't be of infinite worth. Reply September 05, 2010 at 03:16 AM bakho said... Bankruptcy protection from creditors is also an important backstop to deflation. Competition of workers and information are important in addition to morale issues. Organizations invest a lot of money in workforce training. Untrained workers are not perfect substitutes for trained workers. Poaching workers trained by another organization eliminates training costs AND can provide the winning bidder with inside information on the competitor. Institutional memory is important. Imagine the impact if your entire secretarial support staff was gone tomorrow and replaced by temps?? Would anything get done? Workplace dynamics and institutional memory (sunk training costs) are more important than morale.w Reply September 05, 2010 at 07:02 AM Indigenous Centurion said in reply to Thomas T, Schweitzer... " hyper-inflation governments add zeros to the left of the decimal point of their currency; in hyper-inflation " ~~ Thomas T, Schweitzer~ Hyper-Inflation Vs. Hyper-Inflation Ask not where you could do zero for Your Country, but ask where is Your Country's Decimal Point with respect to your significant figures. And watch your figures, Fatso People! 2200000000.0000000 Zimbav Dollars 0.0000000002200000 Zimbav Dollars ^ | | ^ Add zeros here, Zoro! Grazia ! But where is the Robert's Radius of deflationary unity point on the event horizon? Additionally, what is the critical neutron mass for super-nova hyper-inflationary bang for our Zim Buck, Tutu? http://delong.typepad.com/sdj/2010/09/a-question-i-can-answer-why-is-the-speed-limit-on-deflation-so-low.html
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But if the psychological devastation of pay cut has all the zeros drained from its magnitude when the employee is paid in gold bullion, the worker will see his gold appreciate in spite of inflation as it has doubled in value twice since it was recently worth only a quarter length shadow of its new self. This then begs the question of extant deflation when gold price is doubling so rapidly. Have wages lost strength merely because of recent distortions in their previous true value, distortions rooted in Capitol Hill? Will you find a reasonable answer by writing your Congressional Nancy? Got a pencil ? Reply September 05, 2010 at 11:13 AM Indigent Centurion said in reply to Indigenous Centurion... 2200000000.0000000 Zimbav Dollars 0.0000000002200000 Zimbav Dollars ~~~~^ ~~~~| ~~~~| ~~~~^ Add zeros here, Zoro! My hex20 spaces hit the bit-bucket. Not enough security cameras. Reply September 05, 2010 at 11:47 AM Comments on this post are closed.
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