Policy in the Great Recession

Pedro Serodio

July 25, 2016

The liquidity trap, disinflation and deflation

I In the 1930s, Keynes and Hicks argued that during adepression, monetary policy is completely ineffective atinfluencing the level of activity, since the nominal interest ratecannot be reduced below zero.

I When inflation is low, an economy might hit that zero lowerbound to nominal interest rates (ZLB). Fisher relation:r = i − π.

I In a liquidity trap, the equilibrium real interest rate thatpolicymakers would presumably like to achieve is negative.

I MP is approximately horizontal at approximately-zero nominalinterest rates (for a given inflation rate).

I For some time, it was thought that the liquidity trap and thezero lower bound were interesting theoretical special cases,but no longer practically relevant.

The liquidity trap, disinflation and deflation

I In the 1930s, Keynes and Hicks argued that during adepression, monetary policy is completely ineffective atinfluencing the level of activity, since the nominal interest ratecannot be reduced below zero.

I When inflation is low, an economy might hit that zero lowerbound to nominal interest rates (ZLB). Fisher relation:r = i − π.

I In a liquidity trap, the equilibrium real interest rate thatpolicymakers would presumably like to achieve is negative.

I MP is approximately horizontal at approximately-zero nominalinterest rates (for a given inflation rate).

I For some time, it was thought that the liquidity trap and thezero lower bound were interesting theoretical special cases,but no longer practically relevant.

The liquidity trap, disinflation and deflation

I In the 1930s, Keynes and Hicks argued that during adepression, monetary policy is completely ineffective atinfluencing the level of activity, since the nominal interest ratecannot be reduced below zero.

I When inflation is low, an economy might hit that zero lowerbound to nominal interest rates (ZLB). Fisher relation:r = i − π.

I In a liquidity trap, the equilibrium real interest rate thatpolicymakers would presumably like to achieve is negative.

I MP is approximately horizontal at approximately-zero nominalinterest rates (for a given inflation rate).

I For some time, it was thought that the liquidity trap and thezero lower bound were interesting theoretical special cases,but no longer practically relevant.

The liquidity trap, disinflation and deflation

I In the 1930s, Keynes and Hicks argued that during adepression, monetary policy is completely ineffective atinfluencing the level of activity, since the nominal interest ratecannot be reduced below zero.

I When inflation is low, an economy might hit that zero lowerbound to nominal interest rates (ZLB). Fisher relation:r = i − π.

I In a liquidity trap, the equilibrium real interest rate thatpolicymakers would presumably like to achieve is negative.

I MP is approximately horizontal at approximately-zero nominalinterest rates (for a given inflation rate).

I For some time, it was thought that the liquidity trap and thezero lower bound were interesting theoretical special cases,but no longer practically relevant.

The liquidity trap, disinflation and deflation

I In the 1930s, Keynes and Hicks argued that during adepression, monetary policy is completely ineffective atinfluencing the level of activity, since the nominal interest ratecannot be reduced below zero.

I When inflation is low, an economy might hit that zero lowerbound to nominal interest rates (ZLB). Fisher relation:r = i − π.

I In a liquidity trap, the equilibrium real interest rate thatpolicymakers would presumably like to achieve is negative.

I MP is approximately horizontal at approximately-zero nominalinterest rates (for a given inflation rate).

I For some time, it was thought that the liquidity trap and thezero lower bound were interesting theoretical special cases,but no longer practically relevant.

The liquidity trap, disinflation and deflation

The historical record suggests that this was indeed not a practicallyrelevant case for the UK. Interest rates in the aftermath of thegreat recession hovered marginally above 0%, a value which theyhadn’t reached in the preceding century.

The liquidity trap, disinflation and deflation

In fact, these rates are historically unprecedented in the history ofthe Bank of England.

Liquidity saturation

I In a liquidity trap, traditional monetary policy cannot get theeconomy out of the recession.

I In a liquidity trap, there is already liquidity saturation:

I(MP

)s> L(i ,Y )

I If the authorities raise MS in an effort to reduce i (and r),individuals will simply hold on to the extra money, sinceincome has not risen to induce people to spend more.

I There is no incentive to switch into bonds, so there will be nodownward pressure on interest rates (which could hardly fallanyway).

Liquidity saturation

I In a liquidity trap, traditional monetary policy cannot get theeconomy out of the recession.

I In a liquidity trap, there is already liquidity saturation:

I(MP

)s> L(i ,Y )

I If the authorities raise MS in an effort to reduce i (and r),individuals will simply hold on to the extra money, sinceincome has not risen to induce people to spend more.

I There is no incentive to switch into bonds, so there will be nodownward pressure on interest rates (which could hardly fallanyway).

Liquidity saturation

I In a liquidity trap, traditional monetary policy cannot get theeconomy out of the recession.

I In a liquidity trap, there is already liquidity saturation:

I(MP

)s> L(i ,Y )

I If the authorities raise MS in an effort to reduce i (and r),individuals will simply hold on to the extra money, sinceincome has not risen to induce people to spend more.

I There is no incentive to switch into bonds, so there will be nodownward pressure on interest rates (which could hardly fallanyway).

Liquidity saturation

I In a liquidity trap, traditional monetary policy cannot get theeconomy out of the recession.

I In a liquidity trap, there is already liquidity saturation:

I(MP

)s> L(i ,Y )

I If the authorities raise MS in an effort to reduce i (and r),individuals will simply hold on to the extra money, sinceincome has not risen to induce people to spend more.

I There is no incentive to switch into bonds, so there will be nodownward pressure on interest rates (which could hardly fallanyway).

Liquidity saturation

I In a liquidity trap, traditional monetary policy cannot get theeconomy out of the recession.

I In a liquidity trap, there is already liquidity saturation:

I(MP

)s> L(i ,Y )

I If the authorities raise MS in an effort to reduce i (and r),individuals will simply hold on to the extra money, sinceincome has not risen to induce people to spend more.

I There is no incentive to switch into bonds, so there will be nodownward pressure on interest rates (which could hardly fallanyway).

The liquidity trap, disinflation and deflation

r

yr0 = imin − πe

MP

DIS

The liquidity trap, disinflation and deflation

I Recall that the slope of the AD schedule in the IS-MP modelis given by:

∂π

∂y= −1− c + dφy

dφπ

I Looking at the expression for the slope, note that φy = 0 in aliquidity trap.

I In a liquidity trap, the MP curve is horizontal at the minimumnominal interest rate.

The liquidity trap, disinflation and deflation

I Recall that the slope of the AD schedule in the IS-MP modelis given by:

∂π

∂y= −1− c + dφy

dφπ

I Looking at the expression for the slope, note that φy = 0 in aliquidity trap.

I In a liquidity trap, the MP curve is horizontal at the minimumnominal interest rate.

The liquidity trap, disinflation and deflation

I Recall that the slope of the AD schedule in the IS-MP modelis given by:

∂π

∂y= −1− c + dφy

dφπ

I Looking at the expression for the slope, note that φy = 0 in aliquidity trap.

I In a liquidity trap, the MP curve is horizontal at the minimumnominal interest rate.

The liquidity trap, disinflation and deflation

r

yr0 = imin − πe

0

MP0

r1 = imin − πe

1

MP1

DIS

y1

The liquidity trap, disinflation and deflation

I For a given nominal interest rate, r increases ?autonomously?if inflation expectations fall (expected disinflation), so MPshifts up.

I This causes a reduction in AD.

I In normal circumstances, policymakers would choose φπ > 0,and nominal interest rates would be reduced so that targetreal rate < r0, thereby →↑ y , ↑ p.

I In a liquidity trap, nominal interest rates cannot fall.

I A delay in consumption, so IS shifts left. This causes a furtherreduction in AD.

The liquidity trap, disinflation and deflation

I For a given nominal interest rate, r increases ?autonomously?if inflation expectations fall (expected disinflation), so MPshifts up.

I This causes a reduction in AD.

I In normal circumstances, policymakers would choose φπ > 0,and nominal interest rates would be reduced so that targetreal rate < r0, thereby →↑ y , ↑ p.

I In a liquidity trap, nominal interest rates cannot fall.

I A delay in consumption, so IS shifts left. This causes a furtherreduction in AD.

The liquidity trap, disinflation and deflation

I For a given nominal interest rate, r increases ?autonomously?if inflation expectations fall (expected disinflation), so MPshifts up.

I This causes a reduction in AD.

I In normal circumstances, policymakers would choose φπ > 0,and nominal interest rates would be reduced so that targetreal rate < r0, thereby →↑ y , ↑ p.

I In a liquidity trap, nominal interest rates cannot fall.

I A delay in consumption, so IS shifts left. This causes a furtherreduction in AD.

The liquidity trap, disinflation and deflation

I For a given nominal interest rate, r increases ?autonomously?if inflation expectations fall (expected disinflation), so MPshifts up.

I This causes a reduction in AD.

I In normal circumstances, policymakers would choose φπ > 0,and nominal interest rates would be reduced so that targetreal rate < r0, thereby →↑ y , ↑ p.

I In a liquidity trap, nominal interest rates cannot fall.

I A delay in consumption, so IS shifts left. This causes a furtherreduction in AD.

The liquidity trap, disinflation and deflation

I For a given nominal interest rate, r increases ?autonomously?if inflation expectations fall (expected disinflation), so MPshifts up.

I This causes a reduction in AD.

I In normal circumstances, policymakers would choose φπ > 0,and nominal interest rates would be reduced so that targetreal rate < r0, thereby →↑ y , ↑ p.

I In a liquidity trap, nominal interest rates cannot fall.

I A delay in consumption, so IS shifts left. This causes a furtherreduction in AD.

Escaping the liquidity trap

I How to escape a liquidity trap: A. Fiscal expansion

I Fiscal policy can be effective: a massive deficit-financed fiscalexpansion could shift IS outwards

Escaping the liquidity trap

I How to escape a liquidity trap: A. Fiscal expansion

I Fiscal policy can be effective: a massive deficit-financed fiscalexpansion could shift IS outwards

Escaping the liquidity trap

r

yr0 = imin − πe

MP

DIS0

DIS1

y1

r1

Escaping the liquidity trap

I How to escape a liquidity trap: A. Generate expected inflation

I If the central bank can effectively communicate that inflationis going to be higher in the future, that lowers the realinterest rate faced by private agents.

I The full set of equilibrium conditions is given by:

DIS: yt = gt + (y et − g et )− 1

σ(r − r)

I MP curve shifts down in (r ,Y ) space if πet+1 rises, for given i .Generating expected inflation reduces the real interest rateand shifts MP downwards.

Escaping the liquidity trap

I How to escape a liquidity trap: A. Generate expected inflation

I If the central bank can effectively communicate that inflationis going to be higher in the future, that lowers the realinterest rate faced by private agents.

I The full set of equilibrium conditions is given by:

DIS: yt = gt + (y et − g et )− 1

σ(r − r)

I MP curve shifts down in (r ,Y ) space if πet+1 rises, for given i .Generating expected inflation reduces the real interest rateand shifts MP downwards.

Escaping the liquidity trap

I How to escape a liquidity trap: A. Generate expected inflation

I If the central bank can effectively communicate that inflationis going to be higher in the future, that lowers the realinterest rate faced by private agents.

I The full set of equilibrium conditions is given by:

DIS: yt = gt + (y et − g et )− 1

σ(r − r)

I MP curve shifts down in (r ,Y ) space if πet+1 rises, for given i .Generating expected inflation reduces the real interest rateand shifts MP downwards.

Escaping the liquidity trap

I How to escape a liquidity trap: A. Generate expected inflation

I If the central bank can effectively communicate that inflationis going to be higher in the future, that lowers the realinterest rate faced by private agents.

I The full set of equilibrium conditions is given by:

DIS: yt = gt + (y et − g et )− 1

σ(r − r)

I MP curve shifts down in (r ,Y ) space if πet+1 rises, for given i .Generating expected inflation reduces the real interest rateand shifts MP downwards.

The liquidity trap, disinflation and deflation

r

yr0 = imin − πe

0

MP0

r1 = imin − πe

1

MP1

DIS0 DIS1

y1

Escaping the liquidity trap

I How to make a promise of future inflation credible?

I Prof Paul Krugman suggested buying so much debt thatpeople would be convinced of future inflation.

I Or the CB could try to make a credible commitment to futuremonetary expansion by announcing a positive long-runinflation target, e.g. 4% for 15 years.

I Or,as suggested by Prof Lars Svensson, the CB couldannounce a price-level target.

Escaping the liquidity trap

I How to make a promise of future inflation credible?

I Prof Paul Krugman suggested buying so much debt thatpeople would be convinced of future inflation.

I Or the CB could try to make a credible commitment to futuremonetary expansion by announcing a positive long-runinflation target, e.g. 4% for 15 years.

I Or,as suggested by Prof Lars Svensson, the CB couldannounce a price-level target.

Escaping the liquidity trap

I How to make a promise of future inflation credible?

I Prof Paul Krugman suggested buying so much debt thatpeople would be convinced of future inflation.

I Or the CB could try to make a credible commitment to futuremonetary expansion by announcing a positive long-runinflation target, e.g. 4% for 15 years.

I Or,as suggested by Prof Lars Svensson, the CB couldannounce a price-level target.

Escaping the liquidity trap

I How to make a promise of future inflation credible?

I Prof Paul Krugman suggested buying so much debt thatpeople would be convinced of future inflation.

I Or the CB could try to make a credible commitment to futuremonetary expansion by announcing a positive long-runinflation target, e.g. 4% for 15 years.

I Or,as suggested by Prof Lars Svensson, the CB couldannounce a price-level target.