The “timidity” is embedded in the model

Krugman´s take on Abenomics:

…Now, even in this case you can get traction if you can credibly promise higher inflation, which reduces real interest rates. But what does it take to credibly promise inflation? Well, it has to involve a strong element of self-fulfilling prophecy: people have to believe in higher inflation, which produces an economic boom, which yields the promised inflation.

But a necessary (not sufficient) condition for this to work is that the promised inflation be high enough that it will indeed produce an economic boom if people believe the promise will be kept. If it isn’t, then the actual rate of inflation will fall short of the promise even if people believe in the promise – which means that they will stop believing after a while, and the whole effort will fail.

Here’s the picture I put up this morning:

Timidity Trap_1

On one side we have a hypothetical but I think realistic Phillips curve, in which the rate of inflation depends on output and the relationship gets steep at high levels of utilization. On the other we have an aggregate demand curve that depends positively on expected inflation, because this reduces real interest rates at the zero lower bound. I’ve drawn the picture so that if the central bank announces a 2 percent inflation target, the actual rate of inflation will fall short of 2 percent, even if everyone believes the bank’s promise – which they won’t do for very long.

So you see my problem. Suppose that the economy really needs a 4 percent inflation target, but the central bank says, “That seems kind of radical, so let’s be more cautious and only do 2 percent.” This sounds prudent – but may actually guarantee failure.

Who knows, after so many years of mild deflation and little real growth if someone came along ‘promising’ 4% inflation we would likely witness “mass suicide!”

I believe Japan´s authorities certainly made life more difficult by focusing on inflation. In Krugman´s ‘model’ that comes out very clearly so you can go to the ‘bad equilibrium’ (inflation too low and so also too low output).

Now, keep the ‘2% inflation target’ but change the model. Instead of having a model where everything ‘flows through interest rates’ (whereby higher expected inflation lowers the real interest rate and increases spending), we have a dynamic AS/AD model. Instead of (real) output on the horizontal axis we have real output growth. The Phillips Curve becomes the short-run aggregate supply curve (SRAS) and the AD curve is a rectangular hyperbola whereby all points along it represent the same rate of AD growth.

The adapted chart shows that to get to 2% inflation the BoJ has to increase the rate of AD growth through permanent injections of money. In this model, the BoJ´s credibility derives from observable facts. If the BoJ increases the growth rate of AD purposefully, it will necessarily hit the inflation target. Note that at that point real output growth will also have risen.

Timidity Trap_2

By then, the Japanese economy will be ‘out of the swamp’ so a new set of monetary policy rules and targets (the monetary regime) can be chosen. Hopefully they´ll try NGDPLT!

5 thoughts on “The “timidity” is embedded in the model

  1. I sat through this on Friday at the LSE:
    http://www.boj.or.jp/en/announcements/press/koen_2014/ko140322a.htm/
    Gosh it was turgid. And so very sad. Two years ago it would have seemed exciting, now it is stale. Kuroda seemed so terribly, terribly timid. He’s getting towards his target of 2% and seemed to think his job was almost done. When challenged in the Q&A by none other than Sushil Wadwhani on the fact that market inflation expectations are very much stuck at 1% vs the BoJ forecast of 2% he waffled and worried something awful. He inspired zero confidence in getting to 2%.

    He so obviously needs a kick up the proverbial by his political masters. Wake up Mr Abe! Your country needs you, again. Politicians at risk of losing elections are far better at monetary policy than central bankers at risk of losing their credibility. Abe will lose the next election unless he acts soon. This time he needs to break the “2% taboo”. Or far better, demand 5% nominal wage growth.

  2. Richard Fisher, the Texas ranger, also gave a short talk. Apparently, he and Kuroda get on well. Not a good sign. The Japanese stock market is also a decent leading indicator. It is rolling over, too. The future is now, as SS said recently. Mr. Abe needs to apply some pressure as his second arrow is missing the target. In fact , if Krugman is right it can never hit the target. He needs to set a new target.

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