Thursday, September 6, 2012

Wren-Lewis on Zero Lower Bound "Denial."

Wren-Lewis claims that some macroeconomists are in Zero Lower Bound "Denial."      This would be the view that monetary policy can overcome the problem of the zero nominal bound on interest rates so that fiscal policy is unnecessary.  

In my view, we Market Monetarists are a tiny minority struggling against a conventional wisdom that the Fed is "out of ammunition."    I do believe that an appropriate monetary regime can do all that is needed to provide for a stable macroeconomic environment.   And I certainly don't favor expanding government spending at this time.

Wren-Lewis argues that while a nominal GDP level target can help the economy recover, it cannot do it alone and needs help from fiscal policy.   His fundamental error here is to confuse what is really necessary today and what might be necessary under some hypothetical circumstance.

If the Fed had a nominal GDP level target all along, it is possible that it would have never found it necessary to lower its policy interest rate to near zero.   Further, if it shifts to a nominal GDP level target now, it is possible that a rapid recovery in spending on output will promptly occur and that keeping the policy rate at zero would be undesirable.

Wren-Lewis imagines a hypothetical where there is a negative shock to demand so large that it results in the target for the policy interest rate to go to zero whether there is an inflation target or a nominal GDP level target.   What he fails to make clear is that it takes a larger negative shock to create this problem with a nominal GDP level target than with an inflation target.    Presumably, given any particular negative demand shock, the period of time for which the policy rate would be at the zero bound would be longer with an inflation target than with a nominal GDP level target.

However, it is true that even with nominal GDP level targeting, it is possible that there could be a negative demand shock that is so severe than the zero nominal bound issue would be relevant.  

Wren Lewis also claims that a nominal GDP level target only helps a recovery now by imposing costs in the future.   Spending now is higher than it would have been because inflation and real output are higher than would be desirable in the future.  

There are two errors here.   The first is to assume that inflation targeting is the "true" goal.   In my view, the goal should be for spending on output to remain on a steady growth path.   In other words, at any future date, the goal is for total spending on output to be at a certain level.   The rate of change of nominal GDP and inflation are really irrelevant.

For example, suppose the target for spending on output for the first quarter of 2013 is $17 trillion.   There is no "goal" for spending growth really.   The proper growth rate depends on the difference between where nominal GDP happens to be and the target, along with the date of the current period.   Now, it is true, that if the target is a 5 percent growth path, and the economy is currently at target level, then the appropriate growth rate is 5 percent.   But if nominal GDP is below target, then that is the problem, and the greater than 5 percent of nominal GDP growth needed to get back to target is the solution.

As for inflation, that is just the wrong target.   The price level should be the target level of nominal GDP divided by the potential output.   The inflation rate then, should be based upon the difference between the current price level and that what the price level should be.   Now, if nominal GDP is remains on target, then the inflation rate will equal the difference between the growth rate of the target path and the growth rate of potential output.   But if nominal GDP is below target, and the current price level is below where it should be, then that the inflation rate is higher is not the problem, it is part of the solution.

Suppose the target were a constant price level of 100.    If the price level remained on target, the inflation rate would remain zero.   But if the price level falls to 98, then the "inflation" of prices from 98 back to 100 isn't a problem, it is the solution.   Of course, a price level target is a disaster when there is a shock to supply, and that is why nominal GDP is the proper goal.   If the target for nominal GDP is $10,000 billion and the target for next year is $10,300 billion, but actual nominal GDP is only $9,900 billion, that nominal GDP grows roughly 4 percent rather than 3 percent is the solution, not a problem.

While Wren-Lewis' argument that inflation will be too high is mistaken, he also argues that real output must be too high.   Nominal GDP targeting supposedly involves forcing real output to rise beyond potential to get nominal GDP back to the target growth path.    This follows (I think) from assuming that the policy interest rate this period causes an output gap in the next period which causes inflation to shift from its expected level in the period after that.    The assumption, then, is that to get nominal GDP back up to trend, the inflation rate will have to be higher, and to get that to happen, real output must rise above potential.

I am sure that there are some purposes for which models where the policy rate this period causes output gaps in the next period and then changes in inflation in the the next  period are useful, but I don't think they are realistic.   A more plausible neo-Wicksellian story would be that today's policy rate has little impact, but expected future policy rates influence spending on output in the current period and future periods.   And then spending on output during this and future periods determine both prices and real output in this and future periods.

If spending on output is too low this period, the likely result will be that both prices and production are too low.   When spending rises more quickly to return to target, both output and prices rise more quickly.    While it is certainly possible that output would rise too much and prices too little, (or vice versa,) it not necessary.

Wren-Lewis also is suffers from a fundamental confusion between something being "less" effective and something not being effective.  He writes:

Monetary policy that involves temporarily creating money to buy financial assets is of an order less effective and reliable than conventional monetary policy, or fiscal policy.

So, let's say that a temporary purchase of $20 billion of T-bills yielding 5 percent causes $200 billion of increased spending on output.   A temporary purchase of T-bonds is an order of magnitude less effective.  That is, it will only increase spending on output by a tenth as much.   A $20 billion temporary purchase of Treasury bonds yielding 2 percent will only raise spending on output by $20 billion.   

Now, let us suppose that nominal GDP is $ 2 trillion below target.   If T-bills were yielding 5 percent, then it would be necessary to purchase only $200 billion worth of them.   The yield on T-bills and other money market rates would presumably be slightly lower for a time and, in fact, the new Keynesian approach to describing this policy would be that the central bank should lower the yields on those money market instruments that amount.     Whether these T-bill purchases are permanent or temporary isn't really specified.   Anyway, if T-bill rates are zero, so that purchases of T-bills make no difference, and instead Treasury bonds yielding 2 percent purchased instead, then the fact that they are an order of magnitude less effective means that $2 trillion of Treasury bonds must be purchased.   

So what? 

As long as temporary open market operates in long term assets are effective at all, then the question of "effectiveness" just tells us how much must be purchased.   Under "normal" circumstances, only a small amount of T-bills must be purchased, but under unusual circumstances, a large amount of Treasury bonds must be purchased?   How does this make monetary policy ineffective?

I think that expanding the government's budget deficit and national debt reduces national savings and raises the natural interest rate.   Alternatively, have the government expand its national debt and sell lots of T-bills will tend to lower the equilibrium price and raise the equilibrium yield on T-bills.   However, I think the government is already spending too much, and it is also borrowing too much.   And so, expanding government spending is a bad idea, and funding more of the existing spending by borrowing rather than taxes is also a bad idea.   

Fortunately, it is possible that a nominal GDP level target might make it possible for the central bank to return to targeting short term interest rates using purchases and sales of short term assets.   And even if it is not enough,  the central bank can always purchase other sorts of assets and create spending even if the interest rates on T-bills and other short and safe assets remain near zero.

When the central bank has purchased all the assets that it can, then it is time to look to more radical remedies.   Perhaps deficit-financed tax cuts.  Or for an even more extreme example, government spending programs justified by there being no opportunity cost.   But I would instead go with privatization of hand-to-hand currency, ending the zero bound on nominal interest rates.


  1. You kept the formatting for Wren's quote on at the end, so it's not clear where his quote ends and your response begins.

  2. We need to keep our close eye to these stuff since it can be seriously risky if we’re not able to get use to the monetary policy happening. I always prefer to keep myself updated and thanks to OctaFX broker, my job is so much easy because they have highly qualified team of experts, they look after all these things and that’s why I get daily updates for free and they are seriously effective, so that’s why I make profits consistently.