‘Downgrading’ Monetary Policy: the interest rate addiction

Arnold Kling comments on a post by John Cochrane who links to a paper purporting to show that the New Keynesian model did not ‘work’:

John Cochrane has been going after the New Keynesian model. The other day, he linked to a paper by Bill Dupor and Rong Li. They argue that the stimulus did not increase expected inflation, which is a channel by which fiscal policy is supposed to create an expansion in the New Keynesian model.

The fact is that students leave graduate school with no inkling about money. Monetary policy is all about interest rate policy. And they´re quite comfortable writing papers with titles such as: “Monetary Policy less powerful in recessions”:

Changes to key interest rates by central banks have a significant impact on economic activity during periods when the economy is expanding. Unfortunately, they seem to have virtually no effect during recessions – the time when the stimulus of monetary policy is most needed.

Our findings have important implications for the design of economic policy.
‘If changes in the policy rate have little impact in a recession, central banks need to resort to other measures to achieve the desired expansionary effect – ‘quantitative easing’ and ‘forward guidance’ are current examples.

‘Our results also suggest that policy-makers may need to rely more heavily on fiscal or financial policies to stabilise the economy in a deep or protracted slump.’

Unfortunately, more reliance on fiscal stimulus does not seem to work. In addition, high and rising rates in the 1970s didn´t stop inflation from booming and low and falling rates in 2001-03 did not stop real output growth (and inflation) from dropping. Instead, if you define the objective of monetary policy as ‘providing nominal stability’, there´s no problem with observing rising inflation in the 1970s and falling real output and inflation in 2001-03.

In the former period, nominal spending growth was on a rising trend and during the latter period it was on a declining trend. With nominal spending growth following a stable trend level path (constant growth) for most of 1987-06, nominal stability (low/stable inflation and stable RGDP growth) was obtained.

The charts illustrate:

MP Downgrade_1

MP Downgrade_2

MP Downgrade_3

 

HT David Levey

3 thoughts on “‘Downgrading’ Monetary Policy: the interest rate addiction

  1. John Cochrane:
    “New-Keynesian models act entirely through the real interest rate. Higher government spending means more inflation.”

    I think Cochrane expressed himself somewhat unclearly. What he meant to say is:

    New-Keynesian models generate fiscal multipliers *greater than one* at the zero lower bound in interest rates through the impact of higher government spending on inflation expectations. In such a context higher inflation expectations means lower expected real interest rates, which causes households and firms to bring consumption and investment forward due to intertemporal substitution. This is precisely how New-Keynesian models produce estimates of fiscal multipliers greater than one (i.e. why the change in aggregate expenditures is greater than just the increase in government spending).

    Is this true of all New-Keynesian models?

    Well it’s true of:

    The Zero-Bound, Zero-Inflation Targeting, and
    Output Collapse
    Lawrence J. Christiano
    March 2004

    When is the Government Spending Multiplier Large?
    Lawrence Christiano, Martin Eichenbaum, and Sergio Rebelo
    December 2010

    Optimal Monetary and Fiscal Policy in a Liquidity Trap
    Gauti B. Eggertsson and Michael Woodford
    September 2006

    Is There a Fiscal Free Lunch in a Liquidity Trap?
    Christopher J. Erceg and Jesper Lindé
    July 2010

    Simple Analytics of the Government Expenditure Multiplier
    Michael Woodford
    June 2010

    Just for starters.

    So it may not be true of all New-Keynesian models that produce such estimates, just all of the most important ones.

    I normally disagree with Cochrane when he argues that demand plays a limited role in business cycles.

    However in this particular instance Cochrane deserves to be applauded for pointing out the fact that New-Keynesian estimates of large fiscal multipliers are the result of the implausible assumption that the only channel of the Monetary Transmission Mechanism is the Traditional Interest Rate Channel.

    And based on the evidence presented by Dupory and Rong Liz (the subject of Cochrane’s post) if this assumption is true then the fiscal multiplier of ARRA is very unlikely to have been greater than one.

    P.S. Of course, since the assumption that the only channel of the Monetary Transmission Mechanism is the Traditional Interest Rate Channel is contrary to standard undergraduate textbook Monetary Economics (e.g. Mishkin), the fiscal multiplier is *zero* given an independent central bank will always and everywhere choose to offset fiscal policy.

    P.P.S. Cochrane’s post was especially welcome since one of the favorite taunts of pro-fiscal stimulus/anti-QE people is, “Where is the inflation?” Of course this is the wrong measure for policies meant to increase aggregate demand (AD), only NGDP is. But by New Keynesian standards at least, this taunt should be directed at fiscal stimulus as well.

    • OMG: Great attempt at explaining in plain English some seriously twisted logic. I can see, almost, how these sort of people could never really believe in the “expectations channel” as no one could really understand what they are trying to achieve.

  2. Mark: You said: “Cochrane’s post was especially welcome since one of the favorite taunts of pro-fiscal stimulus/anti-QE people is, “Where is the inflation?” Of course this is the wrong measure for policies meant to increase aggregate demand (AD), only NGDP is”.
    That´s exactly why Svensson should be favorable to NGDP Targeting as I argue in this post:
    .https://thefaintofheart.wordpress.com/2013/10/11/lars-svenssons-analysis-bolsters-the-case-for-ngdp-targeting/

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