Krugman quotes something Andolfatto wrote, and then writes:
OK, so “agents require” a fall in the inflation rate to induce them to hold more currency. How does this requirement translate into an incentive for producers of goods and services — remember, we’re talking about stuff going on in the real economy — to raise prices less or cut them? Don’t retreat behind a screen of math — tell me a story.
So, let's take that seriously. We'll tell a story, but telling a story about pricing in goods markets is not going to get at the essence of the problem. For Krugman, and for many macroeconomists, pricing is indeed the essence of the problem - their problem, not mine. Five years ago we went through a financial crisis, and we call it that for good reasons. Most of us are in agreement that the problem was financial. Thus, if we're looking to understand the crisis and its aftermath, we should start by thinking about financial markets. Financial market problems can indeed create problems for how goods markets and labor markets function, and that's part of what we want to understand.
Here's the story. No symbols. No equations. No numbers even.
Let's start with basic things we know about financial markets, neglecting risk for now. Savers who hold assets care about the rates of return on those assets. Indeed, what would seem to have to be true in a world without risk is that the rates of return on all assets would equalize - otherwise who would want to hold the low-return assets? But, we observe that, in the real world, different assets have different rates of return. Risk can explain some of that, but there are some assets - take currency and U.S. Treasury bills, for example - which appear to have exactly the same risk characteristics, but typically have different rates of return.
How to explain rate-of-return differentials? We might suppose that people just like some assets better than others. For example, maybe they enjoy holding General Motors stock more than they enjoy Microsoft stock. This might help us explain the rate of return on housing, relative to other assets, for example. If I own a house and live in it, I get an implicit flow utility return, and this will make me willing to hold a low-return house as an asset rather than high-return General Motors stock. Of course, I'll need to be concerned about the fact that it's possible to invest in housing as an asset and rent it out. In any case, trying to explain some rate-of-return differentials by positing a flow utility return from the asset won't be very satisfying in most contexts. For example, that won't produce any revelations if we're trying to explain why the rate of return on T-bills is typically higher than for currency.
But economists think about another factor - often expressed in vague terms - which helps to explain the rates of return on assets. That other factor is liquidity. So what is it? Liquidity is some extra value we get from an asset - a payoff not captured in it's measured rate of return - that comes from its acceptability in exchange for other assets or consumption goods, from its use as collateral in credit contracts, or for other reasons. We can all understand that currency is more liquid than T-bills, in the sense that no one accepts T-bills in retail transactions, but currency is widely accepted. However, there is a sense in which T-bills could be more liquid than currency in particular uses. For example T-bills are much more convenient for use as collateral in overnight repurchase agreements. Ultimately, it seems liquidity is a matter of degree. It seems hard to separate assets into the liquid and not-liquid. In one sense, a house is illiquid, in that it is hard to sell - not much use in making retail transactions, for example. In another sense, it has some liquidity value because homeowners can take out a home-equity loans using their houses as collateral.
We can conclude, though, that if the rate of return on asset A is higher than the rate of return on asset B, then part or all of the explanation for this is that asset A is less liquid than asset B. In other words, the two assets can carry liquidity premia - implicit flow liquidity returns - and the differences in rates of return in asset A and asset B could be all or partly due to differences in liquidity premia on the two assets, with the liquidity premium on asset B being higher.
So, those are some things we know about the determinants of rate-of-return differentials. What explains the average rate of return or, put another way, the aggregate rate of return on assets in an economy? That's just supply and demand logic. The demand for assets comes from the willingness of savers to hold those assets, and supply is determined by the actions of firms, financial intermediaries, and the government. Given demand, an increase in the supply of available assets will cause the rates of return on all assets to go up, so as to induce savers to hold those assets.
It's generally recognized that the effects of central bank actions in financial markets have something to do with liquidity. A conventional open market purchase is basically a swap of money for short-term government debt. Under conventional conditions, the rate of return on short-term government debt is higher than the rate of return on money (the nominal interest rate is positive), and that has to be solely due to the liquidity premium being higher on money than on short-term government debt, as money and short-term government debt have basically the same payoffs - they're equivalent in terms of risk. So under conventional conditions (a positive nominal interest rate) an open market purchase increases the average liquidity of assets in financial markets. How that matters is of course the subject of an enormous amount of theorizing and empirical work.
To get to the point, let's think about what happens in a liquidity trap. What's that? For some reason, possibly engineered by the central bank, the economy is in a state where the rates of return on money and short-term government debt are the same. The nominal interest rate is zero. Further, the rate of return on both of these assets is equal to minus the inflation rate. What is happening with liquidity premia in this liquidity trap? In the trap we are currently in, one can make the case that the aggregate stock of liquid assets is relatively small. Treasury debt and the liabilities of the Fed are liquid assets, but there are other liquid assets that are created by the private sector. Such private liquid assets include the liabilities of financial intermediaries and asset-backed securities. The financial crisis acted to reduce the supply of these private liquid assets, and we can also argue that there was an increase in the demand for U.S. liquid assets, coming from the demand abroad for our Treasury debt. Thus, in the liquidity trap we are in, the liquidity premia on money and short-term government debt are the same, and positive.
Next, conduct a thought experiment. What happens if there is an increase in the aggregate stock of liquid assets, say because the Treasury issues more debt? This will in general reduce liquidity premia on all assets, including money and short term debt. But we're in a liquidity trap, and the rates of return on money and short-term government debt are both minus the rate of inflation. Since the liquidity payoffs on money and short-term government debt have gone down, in order to induce asset-holders to hold the money and the short-term government debt, the rates of return on money and short-term government debt must go up. That is, the inflation rate must go down. Going in the other direction, a reduction in the aggregate stock of liquid assets makes the inflation rate go up.
But in a liquidity trap, since money and short-term government debt are equally liquid, if the central bank swaps one asset for another then this has no effect. That's why we call it a liquidity trap. Similarly, suppose that short-term government debt is more liquid than long-term debt. To be more precise, short-term debt may be a more preferable asset to use as collateral, perhaps because its market price is less volatile. Then, even though we are in a liquidity trap, quantitative easing (QE) - swaps by the central bank of money or short-term government debt for long-term government debt - will increase the effective stock of liquid assets in the aggregate. Just as I outlined in previous paragraph, that has to reduce the inflation rate.
What's the qualification? There are various short-run effects of monetary policy that could come into play. However, I think it's fair to argue that any of those short run effects have played themselves out in the financial crisis and its aftermath, and now we're looking at the effects I've described.