Economy / Finance

Talking Monetary Policy with Paul Krugman

From Macro and Other Market Musings
May 17, 2017 - 12:34am
Paul Krugman joined me for the latest Macro Musings podcast. It was a fun show and we covered a lot of ground from liquidity traps to secular stagnation to fighting the last war over inflation. Paul and I have had conversations in the blogosphere since the 2008 so it was real treat to finally chat with him in person.In our conversation there were two issues brought up that deserved, in my view, more time than we could give on the show. So I want to address them in this post.The first one is the important distinction between temporary and permanent monetary base injections. This distinction came up up in our discussion on what it takes to reflate an economy in a zero lower bound (ZLB) environment. Krugman's 1998 paper showed that to do so requires a permanent increase in the monetary base whereas a temporary one will not work. This 'irrelevance result' was further developed by Eggertson and Woodford (1998) who showed that QE programs that are temporary in nature will not spur rapid aggregate demand growth. Others have since built upon this point and there is also earlier monetarist literature that makes a similar argument (source). Here is an excerpt from a Michael Woodford FT piece in 2011 that nicely summarizes this view:The economic theory behind QE has always been flimsy. The original argument, essentially, was that the absolute level of prices in an economy is determined only by a central bank's supply of base money. Because of this, at least in the long run, any increase in supply must raise prices proportionally. It followed that, in the short run, QE must also have an effect on spending levels, that will eventually tend to raise prices, even if the channels by which this occurs are obscure.  The problem is that, for this theory to apply, there must be a permanent increase in the monetary base. Yet after the Bank of Japan's experiment with QE, the added reserves were all rapidly withdrawn in early 2006. More worryingly for Mr Bernanke, whatever the long-run effects would have been, there was no increase in nominal growth over the five years of the experiment.  The Fed has given no indication that the current huge increases in US bank reserves will be permanent. It has also promised not to allow inflation to rise above its normal target level. So for QE to be effective the Fed would have to promise both to make these reserves pe

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