...against fictions and other tall tales

Sunday 23 November 2014

It's baaack: Paul's Japan paper (monetary policy and expectations in an era of low inflation) (trying not to be wonkish)

One of the ongoing debates in economic policy these days is the question of whether a central bank on its own can be effective at getting an economy out of the doldrums.

The most famous exposition of the idea that a central bank, by itself, has the ability to boost economic activity is Paul Krugman's paper entitled "It's baaack: Japan's Slump and the Return of the Liquidity Trap" (1998).

In the paper, Prof. Krugman explains that, in a (hypothetical) world of Ricardian equivalence in which fiscal policy has no effect on the real economy, the central bank can get households and firms to borrow and spend by announcing it will bring about higher inflation in the future.

Prof. Krugman knows that the assumption of Ricardian equivalence is far fetched and unrealistic; he only includes this simplifying and unrealistic assumption in his paper to make the point that the central bank can on its own stimulate the economy when fiscal policy is unavailable as a policy option (due to policymakers ideological aversion to public spending, the presence of high public debt, etc.).

Now before I go any further I want to say that I'm a huge fan of Paul Krugman. I think he's one of the most sensible economic commentators out there and I agree with almost all his views on policy. On the effectiveness of central banks alone to boost economic activity during a deep recession or depression, however, I'm quite skeptical.

The logic in Prof. Krugman's paper can be summarized as follows:
  • households and firms will borrow and spend if they expect higher inflation in the future;
  • borrowing and spending is influenced by the real interest rate (i.e., the nominal rate of interest less the expected rate of inflation); and 
  • a rise in expected inflation is for all intents and purposes equivalent to (i.e., has the same effect as) a fall in the real interest rate.
In other words, Prof. Krugman is saying that an increase in expected inflation of, say, three percent will have the same expansionary effect as a three percent cut in interest rates.

All this makes for a plausible story. However, things aren't as simple in the real world.

The problem is that Prof. Krugman's 1998 paper makes inflation a function of expected future inflation, as in the New Keynesian Philips curve (which, in passing, since it assumes no trade-off between inflation and output gap stabilization, is "neither Keynesian or a Philips curve", as Robert Solow once quipped).

In the real world -- and the evidence and the current state of economic activity seem to support this -- inflation is a function of backward-looking expectations: inflation displays significant inertia. Peoples' beliefs about expected inflation are based on past and present inflation. The notion that past inflation is irrelevant, as embodied in the New Keynesian Philips curve, seems to me implausible.

Prof. Krugman is aware of this criticism. Economists Robert Gordon, Alan Blinder and Martin Neil Baily all raised this point during the discussion that took place following the presentation of his paper. Here are the minutes that were recorded from that discussion:
Robert Gordon...criticized the assumption in Krugman's models that the monetary authorities can easily change inflationary expectations for the future -- that the announcement of a policy will change expectations despite present slack in the economy. He believed that agents' expectations depend largely on actual experience, and that they will experience increased inflation only when there is pressure in the markets for goods, services, and labor. Alan Blinder agreed. He thought that Krugman's inflationary policy would work if it could be implemented; but that would require the Bank of Japan to create expected inflation, which, in turn, would require persuading people that the future was going to be fundamentally different from the past. Japan had zero inflation in the past six years, and the average in the previous decade was 1.8 percent per year. Thus to create expected inflation of 4 percent, with actual inflation lagging behind, would be difficult.[Martin] Baily concurred, observing that it would be easy for Russia to be credible in announcing inflationary policy but hard for Japan. (Krugman, 1998:201)
True believers in the power of central banks will respond to this line of criticism by reverting to this old saw: a credible central bank would not have let inflation get too low in the first place, thus people's expectations would never had been unhinged as a consequence. To this, I say: wishful thinking!

When it comes to the role of expectations in explaining macroeconomic outcomes, Robert Solow warned that it should be used with caution (though Solow said this in a different context):
...[T]o rest the whole argument on expectations -- that all-purpose unobservable -- just stops rational discussion in its tracks. I agree that the expectations, beliefs, theories, and prejudices of market participants are all important determinants of what happens. The trouble is that there is no outcome or behavior pattern that cannot be explained by one or another drama starring expectations. Since none of us can measure expectations (whose?) we have a lot of freedom to write the scenario we happen to like today. Should I respond...by writing a different play, starring somewhat different expectations? No thanks, I'd rather look at the data. (Solow and Taylor, 1998:93)
The problem with economics and economic policymaking these days is that too much of it relies on monetary policy and the role of the central bank. There are limits to what central banks can do because people do not believe central banks are omnipotent and have the ability to control inflation expectations on demand. For this reason, Old Keynesians had it rightfiscal policy must be resorted to bring about normal economic activity.

To summarize: Inflation displays inertia and peoples' expectations about the future cannot be dictated by the central bank alone. Basically, inflation is the result of the interplay of supply of demand for goods and services. When you have more demand than supply, prices and inflation accelerate; when you have more supply than demand, prices and inflation decelerate. It's that simple. That's the secret to understanding what creates inflation, barring the effect of any bottleneck issues.

The central bank can have an impact on future inflation, but mainly as a result of its influence in affecting aggregate demand and real economic activity in the present and future, not as a result of its ability to affect expected inflation and overall expectations in general.

The ongoing low inflation affecting economies at present despite considerable monetary stimulus and the use of unconventional monetary policies such as forward guidance in countries such as the U.S., the U.K, and Japan is evidence that expected inflation relies on past and actual inflation and that central banks' ability to stimulate economies at present via the so-called expectations channel or by attempting to increase expected inflation is currently severely limited.*

To follow me on Twitter, just look me up @circuit_FRB.


Solow, Robert, and John Tayor, Inflation, Unemployment and Monetary Policy, (MIT Press: Cambridge MA), 1998

Krugman, Paul. It's Baaack: "Japan's Slump and the Return of the Liquidity Trap", Brookings Papers on Economic Activity, 2:1998

* This post is dedicated to my heroes in macroeconomics: Robert Solow, Alan Blinder, Robert Gordon, Martin Neil Baily and Paul Krugman, to whom I owe so much for their insights


  1. Very good post Circuit! Here are some comments:

    Can central banks on their own get the economy out of the doldrums? It depends on what is causing the economic malaise. Remember, monetary policy is all about the nominal economy. If nominal wages or prices are too high for markets to clear, an excess supply of good and labor will result due to nominal rigidities. Here, monetary policy can be effective, as monetary policy can (on its own) increase nominal demand (NGDP) in the economy. In this case where there is an excess supply of goods and services, monetary policy can impact real variables like employment levels and RGDP. However, monetary policy has its limitations. It cannot alleviate economic structural problems. Case in example today is Japan. It unemployment rate is below 4% and therefore does not have an excess supply of labor. Japan is facing strong demographic headwinds with its labor force declining. Many European nations are experiencing similar circumstances. With a declining labor force, recessions may be frequent, with monetary policy largely ineffective.

    Can central banks change inflation expectations? This question is about the monetary policy transitions mechanism. That is, how exactly does a change in monetary policy result in a change in the economy. My answer to the question is: I don’t know. It may be that inflation expectations have more to do with past inflation than what the central banks may do or say. However, the answer may not matter. This is because inflation expectations are all about reducing real interest rates to affect the level of credit creation. Monetary policy is not just about impacting the level of credit creation in the economy. To understand, here is a thought experiment: There is an economy where credit or lending was illegal. Interest rates are therefore not relevant in the level of economic activity. A doubling of the monetary base would still impact prices as the real quantity of money people would want to hold will not necessarily change. The hot potato effect would eventually result in the doubling of prices as people would spend (that’s NGDP) their excess money holdings until prices levels adjusted upward.

    In the real world monetary policy aimed at reducing real interest rates will be largely ineffective as real interest rates are determined in world markets. Real interest rates are therefore exogenous to monetary policy in a particular country, especially a small open economy such as Canada. Whether central banks can or cannot impact inflation expectations cannot therefore be used as an arguments for the ineffectiveness of monetary policy as it does not matter.

    1. Thanks very much Bernhard for your comment. On your first point I agree monetary policy can't address the structural problems. That said, I'm not altogether sure why recessions would be more frequent when employment levels are declining. I would think that would depend on the level of aggregate demand, and whether monetary and fiscal policy is conducted properly to offset the weakening demand.

      On the issues of inflation expectations and real interest rates, I think we are on the same page; however, I find it hard to believe that in the real world price levels would adjust as a result of a huge expansion of the monetary base, as described in your thought experiment. I'm somewhat skeptical that such a big expansion and any ensuing hot potato effect (portfolio rebalancing effect) wouldn't impact other aspects of the economy or have detrimental effects elsewhere (It just seems to me that the hot potato effect can only go so far. I'm thinking mainly of the possibility of huge asset price inflation caused by massive speculation). Though I take it you are assuming that *eventually* price levels would adjust upward, once other aspects correct themselves.

      That said, your final point is well taken: it can't be concluded (yet!) that fiscal policy is the solution. I'll have to sharpen the argument ;)

  2. Great work Circuit. (!!!)
    The synopsis and your commentators were right on. I just want to add that the secret of public policy is finding the pragmatic space where economics and government can engage in a conversation that makes some reasonable sense although it may neither taste the way economists would like it or smell the way the politicians would like it. Sometimes both communities think they have an inroad to the good of the polity. Unfortunately in the last few years, fiscal initiatives, as a result of a poor demeanor by some parts of government, have been paralyzed. This has forced the Fed to assume the role of a fiscal motivator. Unfortunately it has not been effective because it cannot within its own jurisdictions. That was certainly a timely scapegoat for some members of the Right. But then some great stuff doesn't always taste and/or taste good...cod liver oil! The trope for that would be...

    Thank heaven for Chair Bernanke and Yellen.

    Looks like you have a great list of superheroes, but unless my recollection falters and that's very possible, you've accessed some departed mentors like Samuelson and Tobin more often than you have the living.

    Keep up the work, and stay clear of the sirens.

    Happy Holidays

    1. Thanks for your thoughtful comments, GC. As always, these are very much appreciated.

      I agree with you about Chair Bernanke and Yellen. To think that some commentators believe an increase in interest rates is warranted... In regard to quantitative easing (all iterations), I'm now of the view that it was indeed better than nothing, as some readers in the past were suggesting. Though, I think the beneficial effect was limited and several studies show the effect was positive (the Fed's own research seems to support this view). I'm still undecided about whether a cut in the rate of interest paid on reserves would do any good, as Alan Blinder proposes. Though I admit I would be interested to see the Fed adopt that proposal.

      As for the approach followed by Chair Yellen these days, I think it's the right way to go. As I read the news about how the Fed is cautiously seeking to improve the unemployment problem, I'm reminded of the idea of "exploratory monetary policy"(!), the notion that the Fed should as a general rule seek to reduce unemployment and that the Fed could always backtrack safely if inflation starts to pick up. We should know more in 2015 whether the Fed has indeed adopted this approach.

      I appreciate your insight about the challenge in making economic policy. I certainly used to think when I started this blog that there was "one best way" to do things. After reading yours and other readers' comments, I've become more humble about policy and the possibility of resolving policy problems. Your take on the importance of pragmatism reminded me of something Eli Ginzberg wrote in "The Skeptical Economist" (1987): "In a world beset by extremists in the realm of ideas and action, a skepticism that promises modest gains in understanding and policy is to be valued above rubies".

      Finally, as for the list above, I won't lie to you, my heroes include all the economists showcased on this blog! All the quotes here (I'm incapable of paraphrasing when the original is perfectly stated) are like music to my ears.

      Thanks again and Happy Holidays to you too!