Monday, June 1, 2009

in a liquidity trap there is simply no way for monetary policy to generate a real recovery without accommodating a sufficient amount of inflation.

TO BE NOTED: From Canucks Anonymous:

"The Phillips Curve in a Liquidity Trap

This note discusses the Phillips curve with special emphasis on understanding it not as a single equation standing alone but how it interacts with other equilibrium relationships. The modern Phillips curve has a specification that looks something like:

PC: Infl(t) = a*E(infl(t+1)) + b*OutputGap; a > 0, b < href="">consumption Euler equation, (see here as well), the other is the Fisher equation:

FE: 1+i = (1+r)*(1+E(infl)); i is the nominal interest rate, r is the real interest rate.

It is not correct to base an analysis on the Phillips curve alone, the time path of consumption, inflation and interest rates (both real and nominal) must satisfy all three equations simultaneously.

The Effect of an Increase in Expected Inflation

The first thing to notice is that the equation PC, on its own, implies that increasing expected inflation does not change output at all, it simply raises current inflation. The effect on output of an increase in expected inflation depends on the reaction of the nominal interest rate.

In particular, if the nominal interest rate does not change (perhaps because the central bank is targeting the nominal rate) then the Fisher equation implies that the real rate has fallen and this feeds into the consumption Euler equation to increase aggregate demand.

On the other hand, if the central bank increases the nominal rate one for one with expected inflation then the real rate and AD are unchanged. Finally, if the central bank increases nominal rates more than one for one then the real rate is actually raised and thus AD falls.

Two Important Conclusions for Policy in a Liquidity Trap

The Phillips curve and its relation to the other two equations makes clear two important points.

1) Higher inflation should be expected to precede a real recovery, it is unlikely to be the case that inflation only picks up after the output gap closes.

2) The real recovery will only happens if the central bank keeps nominal rates low for a time after inflation begins to rise. The central bank must accommodate some inflation for a period of time in order to increase output.

The three equations taken together imply that in a liquidity trap there is simply no way for monetary policy to generate a real recovery without accommodating a sufficient amount of inflation.

Don said...

From my point of view, this is how you want QE to work against Debt-Deflation, which is a panic phenomenon.
1) Low Short Term Interest Rates, as a disincentive to buy guaranteed assets, and an incentive to buy stocks and corporate bonds. This attacks the Fear and Aversion to Risk.
2) Rising Longer Term Interest Rates, which signal an end to Deflationary Fears, and are an incentive for Longer Term Investing.As well, as you say, the Spread often ( which is as exact as this gets ) signals a recovery.

Now, what's interesting, is that I take it that this is what Bernanke and Geithner have been arguing, although not necessarily saying it the way I do. And, in fact, it seems to be working, which , again, is about as good as it gets, since none of us know the future.

As near as I can tell, you agree with this.

Don the libertarian Democrat

Adam P said...

Don, yes I do basically agree.

In fact, I find it a bit curious that Bernanke and Geithner aren't saying it more explicitly. I'd imagine that they don't want to come out with anything too specific, like targets that might be missed, for fear of losing control and having a run on the dollar or what have you. I think they want the dollar to fall and inflation to rise but they want it to be in an orderly fashion that they have some sort of control over.

Of course, it could also just be politics.

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