tag:blogger.com,1999:blog-8702840202604739302.post4457399368890828374..comments2022-05-19T04:50:50.322-07:00Comments on MacroMania: Is it time for the Fed to raise its policy rate?David Andolfattohttp://www.blogger.com/profile/12138572028306561024noreply@blogger.comBlogger16125tag:blogger.com,1999:blog-8702840202604739302.post-44274830465674593842013-01-24T08:02:09.452-08:002013-01-24T08:02:09.452-08:00Matthew:
Good questions. If I remember correctly,...Matthew:<br /><br />Good questions. If I remember correctly, the authors do not even mention the price level. I'll have to go back and think this through.<br /><br /><i>That is, unless there is a way to raise the nominal rate by increasing future prices instead of decreasing current prices. </i><br /><br />I suspect that this is what must be happening. And it would be easy to accomplish without money because expectations are determined by the Euler equation!<br /><br />With respect to your last question, note that the Euler equation is not something that determines the *level* of consumption--it determines the rate of change of consumption. The real wage is the relative price of contemporaneous labor vis-a-vis contemporaneous output. So, to use language loosely, if the labor market is not clearing, the goods market is not either. This has nothing to do with the Euler equation, I don't think.David Andolfattohttps://www.blogger.com/profile/12138572028306561024noreply@blogger.comtag:blogger.com,1999:blog-8702840202604739302.post-13496721950063138852013-01-23T22:54:36.592-08:002013-01-23T22:54:36.592-08:00There is something that still doesn't make sen...There is something that still doesn't make sense to me. Maybe I'm reading the paper wrong. The equation (3) above actually isn't that controversial in the literature--it differs from what you would typically see only in the fact that there's nothing stochastic about the parameters of the production function. So the causal claim about next period inflation isn't a big deal per se. However, there is a problem with the causal claim about price levels--if I'm not mistaken in a typical model a change in the interest rate should affect the current price level (or consumption, in the case of sticky prices), not the future price level. Thus, increasing the interest rate would decrease current prices, which, because wages are downward rigid, increases the real wage rate, which in turn cause movement up the labor demand curve, leading to less consumption. Even with the assumptions here about wage rigidity and the taylor rule, interest rate hikes should still be contractionary in the short run. I don't see how a liquidity trap changes this.<br /><br />That is, unless there is a way to raise the nominal rate by increasing future prices instead of decreasing current prices. In a model with money, this would be accomplished by "credibly" committing to a larger money supply next period. But then, there is no money in this model. I suppose that government debt could serve as money in this economy (I'm having a haunting flashback to the recent blog debate between Paul Krugman and Steve Randy Waldman), so I suppose issuing government bonds would be both inflationary and increase the interest rate.<br /><br />Also, there's something else I'm having trouble understanding. This goes to Nick Rowe's comment below. The labor market, by the author's own statement, is not in equilibrium when we are in the "bad" steady state--we are always on the labor demand schedule, but not the labor supply. By Walras' Law, at least one other market should also not be in equilibrium. But if the consumption Euler equation holds in all periods, which market is it?Matthew Martinhttps://www.blogger.com/profile/10254244795963585737noreply@blogger.comtag:blogger.com,1999:blog-8702840202604739302.post-44073570834574626732013-01-23T08:05:41.334-08:002013-01-23T08:05:41.334-08:00Maybe you're not looking hard enough ;).Maybe you're not looking hard enough ;). <br /><br />AEnoreply@blogger.comtag:blogger.com,1999:blog-8702840202604739302.post-85918707459903600072013-01-22T19:32:02.213-08:002013-01-22T19:32:02.213-08:00Adam,
Take a look at their diagrams on p. 22. Evi...Adam,<br /><br />Take a look at their diagrams on p. 22. Evidently, the inflation rate does not jump to the target rate; instead, it marches upward toward target. Unemployment only falls to zero gradually. So, evidently, there is no level drop in the real wage rate on impact -- it declines slowly (relative to trend) to its market-clearing level. <br /><br />Ya, read the paper and then explain it to me! David Andolfattohttps://www.blogger.com/profile/12138572028306561024noreply@blogger.comtag:blogger.com,1999:blog-8702840202604739302.post-64281826232909793502013-01-22T19:28:01.980-08:002013-01-22T19:28:01.980-08:00Adam,
They do have a government budget constraint...Adam,<br /><br />They do have a government budget constraint (p. 8) which essentially says that a lump-sum tax is used to finance the carrying cost of the debt. The nominal debt does not appear to play any role in their analysis and, if I'm not mistaken, the price-level appears to be indeterminate. <br /><br /><i>The logic basically is that the lower value of the nominal debt (higher nominal rate) must satisfy the government's budget constraint with equality and this requires a lower price level today.</i><br /><br />No, a higher lump-sum tax can be used to finance the higher carrying cost of the debt. No?David Andolfattohttps://www.blogger.com/profile/12138572028306561024noreply@blogger.comtag:blogger.com,1999:blog-8702840202604739302.post-511600582089271342013-01-22T19:19:42.928-08:002013-01-22T19:19:42.928-08:00Nick,
Your Euler equation does not tells us what ...Nick,<br /><br /><i>Your Euler equation does not tells us what {P,R} will *in fact* be. It tells us what {P,R} *would need to be* to keep actual and expected output at the natural rate.</i><br /><br />I do not think you are correct here. Note that in their model, the Euler condition holds even in a liquidity trap, where output and expected output remain below potential forever. <br /><br /><i>If prices are sticky...</i><br /><br />...then we would have a different model. ;)<br /><br />I'm not so familiar with literature. Are you saying that by adding a standard Phillips curve (whilst maintaining rational expectations), the stability properties of A and B are reversed? Dang! Point me to a paper...<br /><br />David Andolfattohttps://www.blogger.com/profile/12138572028306561024noreply@blogger.comtag:blogger.com,1999:blog-8702840202604739302.post-77396531822309780932013-01-22T19:12:32.649-08:002013-01-22T19:12:32.649-08:00A lot of old research showed that timing matters--...<i>A lot of old research showed that timing matters--in the short run the liquidity effect exceeds the inflation effect, but in the long run the inflation effect dominates. This points to an interest rate hike being a very bad way to achieve short-run stimulus.</i><br /><br />The authors argue (p. 21) that the conventional wisdom you appeal to here is likely to be overturned in a liquidity trap situation. I'll have to think about it some more.David Andolfattohttps://www.blogger.com/profile/12138572028306561024noreply@blogger.comtag:blogger.com,1999:blog-8702840202604739302.post-72417133518066046212013-01-22T14:20:41.148-08:002013-01-22T14:20:41.148-08:00Interest on reserves changes the analysis a little...Interest on reserves changes the analysis a little bit in the sense that the Fed could potentially sterilize balance sheet expansion by paying higher interest on reserves. But, I don't see how it changes things that much. Interest rate policy still has two effects: raising interest on reserves causes banks to move funds from investments into reserves, which is the liquidity effect, but it also increases the total amount that banks have to invest by creating new money to pay the interest, which is the inflation effect.<br /><br />You mentioned that the authors' taylor rule makes an assumption about causality--this assumption basically says that the inflation effect is always larger than the liquidity effect. I see no reason to suppose that it is always this way. A lot of old research showed that timing matters--in the short run the liquidity effect exceeds the inflation effect, but in the long run the inflation effect dominates. This points to an interest rate hike being a very bad way to achieve short-run stimulus.Matthew Martinhttps://www.blogger.com/profile/10254244795963585737noreply@blogger.comtag:blogger.com,1999:blog-8702840202604739302.post-35268427817676918932013-01-22T07:26:24.421-08:002013-01-22T07:26:24.421-08:00I'm also struggling to see how we get a level ...I'm also struggling to see how we get a level drop in the real wage, that seems to require a discrete jump in the price level. You didn't even introduce a price level.<br /><br />Maybe I should just read the paper...Adam Pnoreply@blogger.comtag:blogger.com,1999:blog-8702840202604739302.post-84620580225092909782013-01-22T07:08:01.713-08:002013-01-22T07:08:01.713-08:00David,
I doesn't seem to me your interpration...David,<br /><br />I doesn't seem to me your interpration of the model is complete (I haven't read the paper).<br /><br />I believe your missing an important equation, the government's budget constraint. As I used to understand this class of models, the equations you've written down here determine the entire time path of inflation and the government's budget constraint, as well as nominal value of outstanding government bonds, then maps that path into a price level today.<br /><br />This implies that the way in which inflation expectations rise when the Fed raises the policy rate in the manner you describe (by setting a=0) is by the price level today falling.<br /><br />The logic basically is that the lower value of the nominal debt (higher nominal rate) must satisfy the government's budget constraint with equality and this requires a lower price level today.<br /><br />Nick: no, this economy is never at a point below the Euler equation. It always satisfies the equation. If you think it doesn't you need to explain to David why the poeple living in his model suddenly decided to stop acting according to their own preferences.Adam Pnoreply@blogger.comtag:blogger.com,1999:blog-8702840202604739302.post-87816681744805084572013-01-22T03:35:40.404-08:002013-01-22T03:35:40.404-08:00David: sorry for not getting to this earlier.
You...David: sorry for not getting to this earlier.<br /><br />Your Euler equation does not tells us what {P,R} will *in fact* be. It tells us what {P,R} *would need to be* to keep actual and expected output at the natural rate.<br /><br />If prices are sticky, and if the economy is at a point below your Euler equation, that means the actual real interest rate is below the natural real interest rate. The standard story then says that that means output will be above the natural rate, so that actual and expected inflation will be rising. Because there is a Phillips Curve in the standard story too. Which means that point A is locally stable, and point B is locally unstable.Nick Rowehttps://www.blogger.com/profile/04982579343160429422noreply@blogger.comtag:blogger.com,1999:blog-8702840202604739302.post-90153927225416517612013-01-21T18:14:53.531-08:002013-01-21T18:14:53.531-08:00Well, for one thing, I do not see a Phillips curve...Well, for one thing, I do not see a Phillips curve in the model above. David Andolfattohttps://www.blogger.com/profile/12138572028306561024noreply@blogger.comtag:blogger.com,1999:blog-8702840202604739302.post-38759053215606859392013-01-21T14:09:36.989-08:002013-01-21T14:09:36.989-08:00I'm not sure I understand how the authors'...I'm not sure I understand how the authors' argument is fundamentally different than simply an application of the expectations-augmented Phillips curve. It seems quite similar in many respects to an armchair economist like me. <br /><br />Somewhat of an aside: Is anyone aware of any research on the effect of wage subsidies in a liquidty trap environment? Armchair Economistnoreply@blogger.comtag:blogger.com,1999:blog-8702840202604739302.post-80832576490327147662013-01-21T08:28:11.946-08:002013-01-21T08:28:11.946-08:00I also think Matthew is misinterpreting it (though...I also think Matthew is misinterpreting it (though I haven't fully worked thought it either). I think the authors are saying that the Fed should wake up one day and say, "ZOMG! We've <i>already</i> done so much QE (or whatever magic it is that we do) that the inflation rate (and/or real output) will move above our target if we don't tighten now, so we had better tighten!" whereupon private agents will say, "ZOMG! The Fed's magic has raised expected output and inflation to the point where they will be above target if the Fed doesn't tighten now! This is much stronger than we thought! We had better start consuming more stuff now before it gets more expensive, especially since our income is likely to be higher than we thought." It's all about self-fulfilling prophecies. And in this model, I gather, the Fed makes a prophecy by setting the target interest rate, so as long as it keeps the rate low, it's telling people the economy will remain weak. It's remotely plausible, but only remotely: I expect it depends on people having some confident knowledge of the Fed's reaction function, whereas in practice, the Fed's actions give new information about its reaction function as well as about its expectations.Andy Harlesshttps://www.blogger.com/profile/17582263872850949568noreply@blogger.comtag:blogger.com,1999:blog-8702840202604739302.post-1268657429033304152013-01-20T12:21:54.519-08:002013-01-20T12:21:54.519-08:00Matthew,
I'm not sure if that is what the aut...Matthew,<br /><br />I'm not sure if that is what the authors are actually saying. I read them as saying "increase the policy rate." In the present context, this would mean raising the IOR rate. I do not think it is "sloppy" thinking to imagine that such a policy change would have an impact on market interest rates independently of what the Fed does with its balance sheet. (Well, maybe I have in mind an appropriate support from the fiscal authority...) David Andolfattohttps://www.blogger.com/profile/12138572028306561024noreply@blogger.comtag:blogger.com,1999:blog-8702840202604739302.post-15621320262767909982013-01-19T21:40:53.384-08:002013-01-19T21:40:53.384-08:00At the risk of commenting before I really work thr...At the risk of commenting before I really work through the model--I think that modern macro has been pretty sloppy about nominal interest rates. We used to talk about money supply and its impact on nominal interest rates. Now we talk about nominal interest rates and mostly assume that money supply does what ever it does to achieve the nominal interest rate target. That's fine from an abstract perspective--if the Fed controls the interest rate, it also determines the money supply by way of bank profit maximization and money demand. <br /><br />The problem, though, is that this is not very specific. There are two ways to raise the nominal interest rate--either through monetary expansion or through monetary contraction. The former works when the liquidity effect is greater than the inflation effect, and the latter works when the inflation effect is greater than the liquidity effect.<br /><br />So what Schmitt-Grohe and Uribe are actually saying is that the Fed should engage in so much quantitative easing that the interest rate actually rises. This is also what Milton Friedman argued when he said that low nominal interest rates were a sign that monetary policy was too tight rather than too loose.Matthew Martinhttps://www.blogger.com/profile/10254244795963585737noreply@blogger.com