What I Hope Is the Last Word on Stephen Williamson... - 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.
Economics 210a Weblog Archives DeLong Hot on Google DeLong Hot on Google Blogsearch August 29, 2010
What I Hope Is the Last Word on Stephen Williamson... A question from the floor: Stephen Williamson Makes His Play for the Second Stupidest Man AliveTM Crown: Andy writes: As I understand Kocherlakota and Williamson, theyre saying that in the long run, fundamentals determine the real return, r (ie monetary neutrality). The Fed then can choose i or pi and the other is then pegged. So low interest rates lead to deflation.... I thought the Fisher equation is a (long-run) noarbitrage condition. In that sense, theres no reason to talk about causality. We choose i or pi and the other one is set by fundamentals (ie, r) and noarbitrage... I reply: Yes, you are confused. The Federal Reserve chooses pi by choosing the rate of growth of the money stock. If i is then below pi + r, you can make profits by borrowing in nominal dollars and investing in physical capital that yields the real return r. You do so. The supply of bonds goes way way up as bond issuers make money hand over first, and that enormous flood of the supply of bonds pushes the interest rate i up until it is equal to r + pi. Now suppose the Federal Reserve sets i, and once again i is below pi plus r--i minus r is less than pi. You can still make money by issuing bonds. But when you issue bonds that has no effect on i--remember, the Fed is pegging it. So you issue more bonds. And then you take the bonds and use them to buy up factors of production in order to make more physical capital. And the increased demand for factors of production increases
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What I Hope Is the Last Word on Stephen Williamson... - Grasping Reality with Both Hands
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wages and prices, so pi rises as well. And the gap between i and r + pi is now bigger. And so you issue even more bonds. When the Federal Reserve pegs the money stock growth rate, the arbitrage trade drives i to r + pi. When the Federal Reserve pegs the interest rate, the arbitrage trade drives pi away from i - r. In one case, arbitrage gets you to the rational expectations equilibrium. In the other case, arbitrage pushes you away from it--thus it is hard to see how you would ever get to the rational expectations equilibrium at all. All of this is, I think, said better in Howitt (1992)... And we have Andy Harless and Rajiv Sethi in comments: Stephen Williamson Makes His Play for the Second Stupidest Man AliveTM Crown: Andy Harless writes: Basically, it all depends on how pi^e (expected inflation) responds to changes in i. It's reasonable to think that, if the Fed raises i, pi^e will rise too, because the increase in i probably reflects higher inflation expectations on the part of the Fed, and private agents will take that into account in making their own forecasts. In order for Kocherlakota's argument to be valid (i.e., in order to get a system that converges to the rational expectations equilibrium at a constant value of i) the change in pi^e has to be at least one-for-one (in the same direction) with the change in i. That seems highly improbable to me. If I'm expecting 0% inflation, and the fed raises the funds rate by 50 basis points, I will not start to expect 0.5% inflation. Rajiv Sethi said in reply to Andy Harless... Andy, the thing is, in an RE model the extent to which expectations respond to changes in interest rates is not a behavioral parameter - it's determined endogenously in equilibrium. And one can set up very standard, currently mainstream models with or without sticky prices that give you an equilibrium response that is strong enough for Narayana's claim to be valid (Jesus Fernandez-Villaverde has convinced me of this in email correspondence over the past couple of days). The question, then, is whether the models themselves are robust to departures from RE, for instance with respect to learning. This is what Howitt's paper addresses so nicely. And I say, crossing with Rajiv's comment: I would add to the requirements. I would say it has to be (a) a robust equilibrium that (b) people can find via some normal learning process. Now, as Robert Waldmann points out, we have run the natural experiment: the Reichsbank pegged its discount rate at 3.5% nominal after World War I. The outcome was not price stability or slow deflation, but rather hyperinflation. Brad DeLong on August 29, 2010 at 08:04 PM in Economics, Economics: Federal Reserve, Economics: Macro, Economics: Theory | Permalink
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What I Hope Is the Last Word on Stephen Williamson... - Grasping Reality with Both Hands
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Comments christofay said... Just as the U. S. regularly kills the Al Quaeda # 3, there are lots of contenders for the 2nd most stupidest man. Larry Summers still is the smartest guy in the room. If I remember correctly Greenspan and Bernanke, central planners, have been setting the fed rate regularly, usually lower, and we are in a ditch. If Greenspan and Bernanke reset the fed rate lower again, the economy is going to get out of the ditch or we just handed off the benefit to big finserv again Reply August 29, 2010 at 09:14 PM Michael E Sullivan said... This is why Nick Rowe's analogy is so perfect -- trying to peg the interest rate is like balancing a long heavy pole on your hand. If you want to move the pole left, you can't just move your hand left, you have to move it right, wait for the pole's disequilibrium to push the top to the left, and then rebalance under it when it gets to the right spot. So if you want to raise the natural interest rate (i.e. get the money supply to grow) and the only tool you have is an interest rate peg, you have to first lower the interest rate peg to below the natural rate, and then, after the supply has moved to where you want it, raise the interest rate to the equilibrium point. But of course, if the natural interest rate is already at zero and you want to raise it, this trick doesn't work anymore, unless you are willing to pay people to borrow money from you or can find a way to penalize them for not borrowing. It's like having your hand up against a wall trying to balance a pole that is tipping over the wall at a point higher than you can reach. Which is why the fed should probably start trying to find new ways to control money growth that aren't dependent on this bass-ackwards disequilibrium process. Reply August 30, 2010 at 08:29 AM Simon van Norden said... The Reichsbank was also confused about causality (if memory serves.) The Chancellor argued that they were forced to keep increasing the money supply to keep up with ever
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What I Hope Is the Last Word on Stephen Williamson... - Grasping Reality with Both Hands
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higher demand for currency. Reply August 30, 2010 at 12:18 PM Bob Athay said... First of all, thanks to everyone contributed their insights. This is one of the most informative discussions I've read online. But I do have one question: under what conditions would we believe that the system is stable (in a mathematical sense) in the vicinity of an equilibrium point? Balancing a pole (vertically) on your hand is basically unstable: you can actively correct for small disturbances, but it's a dynamic process that works ony if (1) the pole doesn't reshape itself (at least, not faster than you can learn how it responds to your motion) and (2) external disturbances have relatively little effect. Reply August 30, 2010 at 02:24 PM Comments on this post are closed.
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What I Hope Is the Last Word on Stephen Williamson... - Grasping Reality with Both Hands
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What I Hope Is the Last Word on Stephen Williamson... - Grasping Reality with Both Hands
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