Monetary Policy in a Liquidity Trap

Robert Waldmann

Matthew Yglesias is puzzled by something Paul Krugman wrote.

I don’t totally understand this argument, however:

It’s also crucial to understand that a half-hearted version of this policy won’t work. If you say, well, 5 percent sounds like a lot, maybe let’s just shoot for 2.5, you wouldn’t reduce real rates enough to get to full employment even if people believed you — and because you wouldn’t hit full employment, you wouldn’t manage to deliver the inflation, so people won’t believe you.

Right now we’re very far from full employment. But we still have a little inflation. And so it seems to me that if real rates go down a bit, we’ll get a bit closer to full employment, and thus a bit more inflation. The result would be a much slower than necessary recovery, but still better than the current path.

I’m not sure my attempted explanation is of any use, but in case it is, it is after the jump.

This was two comments at Yglesias’s blog so it is addressed to him.

Krugman’s argument is that increasing the inflation target from 2 to 2.5% won’t cause any increase in inflation for the foreseeable future and, so, won’t cause any increase in expected inflation and so won’t affect expected real interest rates.

Your counter-argument is that inflation is now positive. it is important to remember is that standard macro models tell us something about the change in inflation not the level of inflation. In these models the level of inflation doesn’t tell us anything. The only points that matter are that the federal funds rate is almost exactly zero and inflation is declining.

Here we have Krugman academic economist (he made this exact proposal discussing Japan in the 90s). That means he is assuming rational expectations. Basically, if the Fed makes a promise it can’t keep, then people don’t believe them.

Your view of monetary policy is different, because you are sure that, even if the Fed couldn’t do anything to produce inflation for the foreseeable future, an increase in the declared inflation target will cause higher expected inflation. I’m not sure that Krugman would have come up with the 2.5% no good conclusion if he started fresh in his current avatar Paul Krugman columnist blogger.

In case anyone is still reading, I will explain the logic of the argument.
1) what the Fed does while we are in a liquidity trap has no effect on anything
(here really what’s true is that a huge intervention has a modest effect. Something involving as many dollars as QE1 (Fed interventions in 2008-9) was inconceivable in the 90s).
2) The Fed can cause higher inflation only when we are out of the trap. In this context “out of the trap” means that a zero federal funds rate implies rising inflation, that is unemployment below the NAIRU.
3) a modest increase in expected inflation will cause a modest decline in unemployment to a level such that the Fed will certainly want negative nominal interest rates even if it had a low inflation target. The assumption is that if unemployment is below the nairu inflation will decline (that’s what the acronym implies and Krugman assumes that there is a non inflation accelerating inflation rate of unemployment).

So actual Fed actions are the same whether the target is 2% or 2.5%. In either case the Fed sets the federal funds rate to zero.

So inflation expectations are the same whether the target is 2% or 2.5% (this argument very much relies on the assumption of rational expectations).

So changing the target from 2% to 2,5% has zero effect.

Krugman makes an implicit assumption that we will never ever get out of the liquidity trap with current policy. He discusses the resulting unemployment rate as if it were constant. In the real world, unemployment will decline, although it might take decades (basically firms will have to start investing again when a lot of their current capital will have depreciated). So Krugman is implicitly assuming that this FOMC can’t make promises which are binding decades from now. In fact, he doesn’t believe that promises made now will bind tomorrow (the assumption that outcomes are subgame perfect Nash equilibria).

In the academic economics literature “it is possible if the Fed can make a binding commitment to do something in the future which it won’t want to do when the time comes” is just like “it is possible if pigs can fly.” This isn’t because any of us believe in rational expectations (one guy once claimed to but I think he was joking). It is because … oh it’s just a rule of the game. Krugman has stopped playing the game, but he remains loyal to this specific conclusion.