Paul Krugman: Own Horn, Tooting Of


Own Horn, Tooting Of, by Paul Krugman, in NY Times: Matt Rognlie has been doing a series of posts on how the academic literature on liquidity traps relates to recent Fed actions, and why some kind of credible commitment to expansion after the liquidity trap ends is necessary to gain traction. He cites fine work by Eggertsson and Woodford, Svensson, and more.

However, I think it might worth pointing out that this whole line of thought began with this paper (pdf), which declares early on that

a liquidity trap fundamentally involves a credibility problem-but it is the inverse of the usual one, in which central bankers have difficulty convincing private agents of their commitment to price stability. In a liquidity trap, the problem is that the markets believe that the central bank will target price stability, given the chance, and hence that any current monetary expansion is merely transitory. The traditional view that monetary policy is ineffective in a liquidity trap, and that fiscal expansion is the only way out, must therefore be qualified: monetary policy will in fact be effective if the central bank can credibly promise to be irresponsible, to seek a higher future price level.

By the way, it’s worth reading Ken Rogoff’s discussion at the end, in part for his confident assertion that raising the rate of growth of the monetary base would be enough to increase inflation. Actually, Japan tried that a few years later, without success; nor has the surge in the US monetary base since 2008 been either inflationary or indeed effective. All of which is exactly as the model predicted.

Update: A key insight from this whole approach is that a liquidity trap corresponds to a situation in which the “natural” real rate of interest — the real rate consistent with more or less full employment — is negative. On that note, consider real yields on inflation-protected US bonds, which ended last week negative at all maturities 10 years and shorter, and were only 1.03 percent on 30-year bonds — this after what was widely viewed as a disappointing 30-year auction. And these are not, of course, real rates consistent with full employment — they’re real rates consistent with very high unemployment, so the natural rates must be even lower.

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