Sunday, August 29, 2010

Reply to Mark Thoma

Yes, I can picture you out there drumming your fingers on the desk. I thought I had said my piece and was ready to move on. However, I'll take a stab at this if you promise to be nice.

(i) Kocherlakota says this:
Monetary policy does affect the real return on safe investments over short periods of time.
This seems uncontroversial. He is recognizing that there are short-run nonneutralities of money - tight monetary policy can make the real rate of interest go up. Then he says:
But over the long run, money is, as we economists like to say, neutral. This means that no matter what the inflation rate is and no matter what the FOMC does, the real return on safe short-term investments averages about 1-2 percent over the long run.
Again, uncontroversial. You can quibble about super-nonneutralities here, but I think the consensus is that, for the types of changes in rates of long-run inflation we are talking about here, those effects are small. Then he says:
Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative.
This seems to be what set everyone off. This is a statement about the long run. My interpretation of this is that this is just Irving Fisher. What does it mean to "maintain the fed funds rate at its current level?" Some people seem to think the Fed can't do this. Krugman and a number of other people cite Wicksell, and argue that it's impossible. My reading of the implications of Wicksell (and remember that Wicksell expressed himself in words, not math, so he's hard to interpret) is that the Fed cannot peg the real rate forever. Friedman said something like this too, but I don't have the quote. I know that there are issues about nominal interest rate policy rules and determinacy. However, Woodford thinks he solved those problems. I replied to most of the comments I had time for, or could understand. Some people had what I thought were confused notions of equilibrium. In other cases, as in the link you mention, there are people concerned about disequilibrium phenomena. These approaches are or were popular in Europe - I looked up Benassy and he is still hard at work. However, most of the mainstream - and here I'm including New Keynesians - sticks to equilibrium economics. New Keynesian models may have some stuck prices and wages, but those models don't have to depart much from standard competitive equilibrium (or, if you like, competitive equilibrium with monopolistic competition). In those models, you have to determine what a firm with a stuck price produces, and that is where the big leap is. However, in terms of determining everything mathematically, it's not a big deal. Equilibrium economics is hard enough as it is, without having to deal with the lack of discipline associated with "disequilibrium." In equilibrium economics, particularly monetary equilibrium economics, we have all the equilibria (and more) we can handle, thanks.

Anything else I can do for you?

53 comments:

  1. Yes, you could answer the question instead of saying it is too hard:

    "Equilibrium economics is hard enough as it is, without having to deal with the lack of discipline associated with 'disequilibrium.'"

    That is what the controversy is about. Simply blowing it off by saying the mainstream also ignores these issues isn't much of a response.

    Interesting that you chose to leave out the links to Rajiv and others. He says:

    "But while Williamson and Fernandez-Villaverde interpret the consistency of Kocherlakota's claim with the modern theory as a vindication of the claim, others might be tempted to view it as an indictment of the theory. Specifically, one could argue that equilibrium analysis unsupported by a serious exploration of disequilibrium dynamics could lead to some very peculiar and misleading conclusions. I have made this point in a couple of earlier posts, but the argument is by no means original. In fact, as David Andolfatto helpfully pointed out in a comment on Williamson's blog, the same point was made very elegantly and persuasively in a 1992 paper by Peter Howitt."

    He also says:

    "The problem arises when one examines the stability of this equilibrium. Any attempt by the bank to shift to a lower nominal interest rate leads not to a new equilibrium with lower inflation, but to accelerating inflation instead. The remainder of Howitt's paper is dedicated to showing that this instability, which is easily seen in the simple old-fashioned model with adaptive expectations, is in fact a robust insight and holds even if one moves to a "microfounded" model with intertemporal optimization and flexible prices, and even if one allows for a broad range of learning dynamics. The only circumstance in which a lower nominal rate results in lower inflation is if individuals are assumed to be "capable of forming rational expectations ab ovo"."

    What is your answer to Howitt's criticism? Why doesn't it hold in this instance?

    And what's with all the attitude?

    ReplyDelete
  2. Sometimes theories are just wacky, and not deserving of attention. What more can I say? You're welcome to that stuff if you like it. I wouldn't try to explain it to the business people in Marquette Wisconsin, though, as I'm sure their eyes would glaze over. The attitude is about the fact that I don't think you guys are really interested in sorting out the economics. I think you have decided that Kocherlakota is a bad guy (one of your people from the dark side, I think), and you're now looking for evidence to convince people that he doesn't know what he is talking about. Good luck.

    ReplyDelete
  3. Some theories are wacky.

    Such as the theory that a model which applies only at equilibrium can be affected by an exogenous variable.

    Or the theory that the relationship between inflation and interest rates is commutative.

    ReplyDelete
  4. Steve,

    I know both you & Narayana. I know that you're both extremely smart. I don't think that either of you is a "bad guy" or from the "dark side."

    But I do think Mark (whom I've never met) has a valid point. When I read that NK said a prolonged low nominal interest rate must lead to prolonged deflation, my reaction was "huh?!" A low rate *as a result of* deflation, sure, no problem. But Narayana clearly said that pegging the fed funds rate below the equilibrium real rate leads to deflation.

    I've been reading both (all?) sides of this and I can't say that your explanation makes sense to me. Interest rates fell after Volcker's disinflation because he lowered them to a level consistent with eq'm r and lower expected inflation. Are you saying that if he'd kept policy tighter for longer (ie, after inflation had fallen) then inflation would've increased again?

    PS

    ReplyDelete
  5. Hi Pete,

    You said: "But Narayana clearly said that pegging the fed funds rate below the equilibrium real rate leads to deflation."

    But what he actually said was: "if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative."

    It's not the same thing. What he's saying is: a fed funds rate of 0-25 basis points forever implies deflation. To support a low nominal interest rate forever, the Fed has to be causing some monetary quantity to grow at a long-run rate so as to induce that. I would have thought that that is quite uncontroversial. But what do I know?

    "Are you saying that if he'd kept policy tighter for longer (ie, after inflation had fallen) then inflation would've increased again?" If, instead of reducing the nominal interest rate through the 80s, the Fed had maintained the fed funds rate target at, say 20% forever, then yes, we would have a long-run inflation rate of maybe 18% today. What you're calling "tighter" isn't actually tighter if you have to maintain the target by having the money stock grow at a very high rate. This is just long run vs. short run. Positive money growth shocks in the short run reduce the nominal interest rate through the liquidity effect (you pick the mechanism). In the long run, the Fisher effect dominates, and higher money growth implies a higher nominal interest rate. Here's the Euler equation that prices a nominal bond. It's hard to get away from this (talk to Tim Fuerst about this): q(t)u'(c(t))=BE[[P(t)/P(t+1)]u'(c(t+1)]. q(t) is the price of the nominal bond, c(t) is consumption, P(t) is the price level. E is the expectation operator, and B is the discount factor. Price the real bond this way, to determine the real interest rate: s(t)u'(c(t))=BE[u'(c(t+1)], where s(t) is the price (units of consumption) of the real bond. Now load this into whatever model you want, and you're going to get (if at all) liquidity effects in the short run, but Irving Fisher is going to determine the long run. I'm sure Chuck taught you all this stuff, Pete.

    ReplyDelete
  6. What Kocherlakota said a couple of paragraphs later:

    "If the FOMC hews too closely to conventional thinking, it might be inclined to keep its target rate low. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation."

    Here he seems to be saying that a policy of holding interest rates low (without ever raising them, even temporarily) will result in convergence to a deflationary equilibrium. Is that not what he's saying? If that is what he's saying, how is it a sensible thing to say? It will be true if inflation expectations move (at least) one-for-one with changes in the policy nominal interest rate, but that seems implausible to me. Assuming it is not the case, the Fed will have to tighten the money supply to produce deflation. Via the liquidity effect, that tightening will temporarily raise nominal interest rates. But Kocherlakota seems to be saying that the Fed could produce deflation without ever raising nominal interest rates.

    ReplyDelete
  7. Andy,

    Yes, I'm not sympathetic to that part of the argument. It's consistent with what Bullard was discussing in his "seven perils" paper. I'm not saying it's wrong. It makes sense in terms of the models we typically write down, but I don't think that this is relevant given the large stock of reserves in the system. See this post:

    http://newmonetarism.blogspot.com/2010/08/feds-balance-sheet-deflation-etc.html

    Let me know if that makes sense to you.

    ReplyDelete
  8. "It makes sense in terms of the models we typically write down, but I don't think that this is relevant given the large stock of reserves in the system."

    The whole problem in a nutshell.

    ReplyDelete
  9. Steve,

    "This means that no matter what the inflation rate is and no matter what the FOMC does, the real return on safe short-term investments averages about 1-2 percent over the long run.
    Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative."

    To me, this clearly says that if the equilibrium real rate is 1% and the fed keeps the funds rate 0-25%, we get deflation. Maybe that's not what he meant, and maybe that's not what you think he meant. In that case, I think the onus is on you the two of you to clarify.

    PS

    PS: I was grilling steak so haven't even had time to read the rest of your reply. Will do soon. (not tonight though...)

    ReplyDelete
  10. Pete,

    You shouldn't do that - could burn something. Yes, that's what he meant, and it's fine. But in the current cirumstances you could hold the fed funds rate at 0.25% for 20 years before you see the deflation, as it will take a very long time to run off the reserves.

    Steve

    ReplyDelete
  11. You said:

    "Yes, that's what he meant, and it's fine. But in the current cirumstances you could hold the fed funds rate at 0.25% for 20 years before you see the deflation, as it will take a very long time to run off the reserves."

    But it is not at all clear that is what NK meant. Especially when he says:

    "If the FOMC hews too closely to conventional thinking, it might be inclined to keep its target rate low. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation."

    In what respect is it "conventional" thinking to keep the funds rate at 0.25% for 20 years? If NK is really focused on the long run, he only has himself to blame for confusing the issue so badly.

    ReplyDelete
  12. "Sometimes theories are just wacky, and not deserving of attention."

    Yeah, but it is deserving of attention in the case that it's believed by many influential economists, and therefore has a significant chance of affecting policy. In that case, it's worth the effort to explain why it's wacky.

    So, please explain why it's wacky.

    ReplyDelete
  13. OK, I think I see where you are coming from. I'll accept that "it makes sense in terms of the models we typically write down" (since Rajiv Sethi is also now convinced of that). But what that suggests to me is that there is something wrong with the whole methodology, at least as applied to this type of issue.

    ReplyDelete
  14. Seems like emotions have gotten in the way of a rational discussion/argument.

    ReplyDelete
  15. I'm hoping the participants can provide some clarification on the nature of the current debate for me.

    Here is my attempt to characterize the argument of Thoma, DeLong, and others:

    The Kocherlakota quote of interest ("If the FOMC... many years of deflation.") was produced in the context of discussing immediate policy options. Accordingly, it is appropriately interpreted as a suggestion that, should the FOMC not depart from ZIRP within the foreseeable future (let's say 30 months, to be liberal), deflation would *result* from this choice. And this idea (Thoma/DeLong claim) is very clearly contrary to a body of economic theory and history, and so obviously and severely so that Kocherlakota's judgment is in question.

    The push-back, in support of Kocherlakota, does not appear to be directly in response to that claim. I have seen suggestions that certain models support the general idea that the inflation rate can correlate directly and positively to the cost of money as determined by the Fed. Thus, some claim, Kocherlakota has solid theoretical ground for his position.


    Right now it seems these ships are passing by in the night. Thoma/DeLong & co. suggest that these models are not relevant to the situation at hand - and I have not seen anyone contradict this claim.

    Here is my attempt to reduce this to a single question for Williamson: Is it reasonable to worry that another 6, 18, or 30 months of ZIRP will *increase* the likelihood or severity of deflation?

    And here is my question for Thoma/DeLong & co.: Are the models that have been discussed by Williamson (and perhaps a few others) truly so faulty as to justify the pejoratives? Or is the error primarily in the suggestion that these models are relevant to current discussion - something that Williamson does not advocate firmly.

    ReplyDelete
  16. I'm curious about that Euler equation you wrote in response to Pete Summers, addressing the question of it, in the 80s, the fed had left the nominal rate at 20% then we'd have 18% inflation today.

    If you join that equation to some other that determines the demand for real balances then as you said you get a liquidity effect and Fisher effect in the long-run.

    Fine, does it not follow that the manner in which the short rate is kept at 20% is to reduce the real money supply, relative to its demand, and the result is that the way in which we get our 18% expected inflation is that p(t) falls relative to p(t+1).

    Now, add some friction to generate a Phillips curve. Would that not make period t a nightmare?

    ReplyDelete
  17. I think the key to all of this is the liquidity effect. What Kocherlakota said makes perfect sense if you believe the way the Fed sets interest rates is by determining the rate of inflation, so that the way to deliver a low interest rate is to reduce inflation.

    But that's not the way monetary policy is conducted. Instead, the Fed sets the interest rate with the goal of influencing inflation. And it does so under the assumption of a liquidity effect: to increase the interest rate implies reducing the money supply.

    So, Kocherlakota's comments only make sense if he does not believe in the liquidity effect, and thinks the way the Fed sets the interest rate is by creating a certain amount of inflation. Unfortunately, this doesn't square with his statement that

    Monetary policy does affect the real return on safe investments over short periods of time.

    If he does believe that the Fed sets interest rates in the context of a liquidity effect, his main contention is wrong. His claim is by raising rates (i.e., reducing the money supply) there will be more inflation than if rates are held artificially low (which implies continual increases in the money supply). In other words, he is wrong because he is ignoring the mechanism by which the Fed sets interest rates.

    ReplyDelete
  18. Andy,

    No, it's not the methodology. This is just an issue about of how you account for the reserves, and their quantitative magnitude.

    ReplyDelete
  19. Kevin,

    There is nothing incorrect in what Kocherlakota said. It's all consistent with standard theory. Some of the arguments against are cases of either putting words in his mouth, or just bad economics. I can understand that it ends up looking very confusing. My interpretation of this is that a group of people, including DeLong, Thoma, and Krugman, have a particular policy agenda, they see Kocherlakota as opposed to that agenda (and by the way, it's not clear that is true) and they want to use whatever ammunition they can to make him look bad. The whole thing is a non-issue as far as I'm concerned.

    ReplyDelete
  20. There is nothing incorrect in what Kocherlakota said. It's all consistent with standard theory.

    No, it isn't. Standard theory says that if the Fed increases rates that takes money out of the economy, which reduces inflation. Keeping rates artificially low implies an increasing money supply, hence higher inflation.

    If he had said: "the only way for the fed funds rate to be consistent with a long-run equilibrium is for there to be deflation", that would have been correct.

    But instead he claimed that if the Fed maintained the fed funds rate at its current level, that would lead to deflation. This ignores the fact that the only way the fed funds rate could be kept at this level is by increasing the money supply (relative to what it would otherwise be) and that the implication would be real interest rates below their natural level. Hence the policy would be inflationary. For a long-run equilibrium, the fed funds rate would have to rise.

    I disagree with Krugman on most things, but on this he's right.

    ReplyDelete
  21. "Standard theory says that if the Fed increases rates that takes money out of the economy, which reduces inflation."

    No, standard theory says that if you take money out, rates go up. Now, are you talking about a level decrease in the money stock, or a change in the growth rate? If it's a level effect, then there is a level decrease in the price LEVEL. If it's a permanent reduction in the GROWTH RATE in the money stock, then there can be a short run liquidity effect (the nominal interest rate rises) but in the long run, the Fisher effect dominates. The inflation rate is lower and the nominal interest rate is lower.

    "This ignores the fact that the only way the fed funds rate could be kept at this level is by increasing the money supply"

    That's exactly the point. In the long run the Fisher effect dominates. If you maintain the nominal fed funds rate at a low rate forever, you ultimately are doing this with a LOWER MONEY GROWTH RATE. It's just Irving Fisher in the long run.

    Understand now?

    ReplyDelete
  22. But the point is you can't *maintain* the nominal fed rate at the low rate forever, because that would imply continual increases in the money stock, ie a higher rate of money growth, hence higher inflation. Thus the long run equilbrium would require an increase in the nominal rate.

    To acheive a permanently low nominal rate, you first must increase the nominal rate, because you need to reduce the rate of grow in the money supply.


    I

    ReplyDelete
  23. Stephen:

    I appreciate your response, but as I understand it, it does not directly address the core issue of Thoma/DeLong/Krugman. I'll re-ask what I think is the most important question:

    Is it reasonable to worry that (in the present economic situation) another 6, 18, or 30 months of ZIRP will *increase* either the likelihood or severity of deflation?

    -KM

    ReplyDelete
  24. Imagine trying to balance a broom handle vertically on your chin. In equilibrium, the broom handle is vertical and you are stationary.

    Now, try this. Balance the broom handle on your chin and then stop moving. Does the broom handle magically become vertical and remain balanced?

    Of course, it must do, as "Equilibrium is hard enough as it is, without having to deal with the lack of discipline associated with disequilibrium."

    ReplyDelete
  25. What is it with broom handles and such? Nick Rowe has a story like this too.

    ReplyDelete
  26. If I am thinking along the same lines as Nick Rowe, I must be doing something right.

    ReplyDelete
  27. Dave,

    You're probably long gone by now. I'll be serious now. You balance the broom handle on your chin and then stop moving. The vertical broom on your chin is the initial state. The broom falls on the floor and comes to rest. The dynamic path from your chin to the floor is an equilibrium path. When the broom is resting on the floor, that's the steady state. We can also think about systems (e.g. standard growth models) where the system is on a steady state equilibrium path, and it's moving forever.

    ReplyDelete
  28. Nice to be visiting your blog again, it has been months for me. Well this article that i've been waited for so long

    ReplyDelete
  29. These information helps me consider some useful things, keep up the good work.

    ReplyDelete
  30. I will be back soon on your site again so please continue sharing your great post manfaat daun sirsak

    ReplyDelete
  31. This is a smart blog. You have so much knowledge about this issue, and so much passion. visit here

    ReplyDelete
  32. Your post was really nice and the information that you giving your post that was really cool and amazing.

    ReplyDelete
  33. Thanks for sharing this great article, After reading the article, I feel that I need more information on the topic.

    ReplyDelete
  34. Thank you for taking the time to publish this information very useful! I've been looking for books of this nature for a way too long.

    ReplyDelete
  35. This website has very good content.
    so I am sure this website will form the well-known in the future.

    ReplyDelete
  36. I am very happy to read this. This is the kind of manual that needs to be given and not the random misinformation that's at the other blogs.

    ReplyDelete
  37. I needed to thank you for this excellent information!! Thanks dude

    ReplyDelete
  38. Amazing, this is a great article! I did enjoyed reading it, keep your post dompet kulit

    ReplyDelete
  39. Awesome post, I will be sure to bookmark your blog and definitely will come back from again.

    ReplyDelete
    Replies
    1. A wonderful and unique articles, I love reading and I am always searching for informative information like this! Thank you

      Delete
  40. I just realized that I would comment here and let you know , a very interesting post. jasa pembuatan website

    ReplyDelete
  41. A good example of content presentation. Thanks for sharing this information. Keep blogging.

    ReplyDelete
  42. I really fun with your Blog, I would like more information about this, because it is very nice., Thank You

    ReplyDelete
  43. I really love your site, it give me a lot of information and knowledge, really love your site. I'll be looking for another post and will share it to my friends. Thank you so much for sharing dude.

    ReplyDelete
  44. Oh! Amazing and really rich content and very useful information. Iam wait for the next post

    ReplyDelete
  45. The comprehensive and the talent to accomplishment an daily occupied the fruit age of the Internet is honestly to be full help of. The amity of awl is till to an end. Both works is attractive more and supplementary keen. Alike, more and added troubled is illness by disquiets. Properties gradations have not ever remained so available and value-less how to write essays at the passive time. It is normal yet that accessory and low value industrialized hand in backbone.

    ReplyDelete
  46. Awesome data, Any way I'll be subscribing to your feed and I wish you mail afresh shortly. Keep Blogging credit card processing

    ReplyDelete
  47. Our SQL consulting team optimizes your database and improve performance. Develop Microsoft SQL Server stored procedures. Database maintenance and SQL database Planning, Architecture, and database Design. We provide MS SQL Consulting services and develop a range of database solutions that are categorized as follows: Specialize in Search for People, using optimized stored procedures, MS SQL Database Trouble-shooting.

    ReplyDelete
  48. Nice information, valuable and excellent design, as share good stuff with good ideas and concepts, lots of great information and inspiration, both of which I need, keep your post pelangsing acai berry

    ReplyDelete
  49. Your informational post is great resource to lots of peoples, so i think it can easily to reach the correct market place.

    ReplyDelete
  50. Iam very happy to reading, Hope you continue to share your information more :) jual penghilang jerawat

    ReplyDelete
  51. This is a great site .And this article is so good.There are so many comment in this site.But I say Its a very helpful site.Because i like this article. Carpet Cleaners And I can solved my problem.

    ReplyDelete