Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday 23 July 2012

The Zero Lower Bound and Price Flexibility

I’ve only written one of these Socratic/tutorial dialogue type posts before, mainly because I cannot make them as amusing as Tim Harford or Brad DeLong. This one was inspired by these questions.

Q: I get why interest rates cannot go below zero. But why is that such a big deal?

A: Because it means that monetary policy cannot do its job.

Q: But I thought monetary policy was about keeping inflation low.

A: In part. But we also rely on monetary policy to ensure that aggregate demand matches the output the economy as a whole wants to produce.

Q: Isn’t that what the price mechanism is for – matching supply and demand?

A: This is a good example of where thinking about a single market is not a good way of thinking about the macroeconomy. While in the long run you would expect aggregate supply and demand to match, in the short run they need not. People can decide to save more, and investment need not rise to compensate, so demand can fall below supply, leading to unemployment rising.

Q: Yes, I remember our discussion about savings and investment. But unemployment can always be cured by falling wages, surely.

A: Not if prices are falling at the same time. To say unemployment is too high because real wages are too high in this situation just misses the point.

Q: But if both wages and prices start falling, will that not lead to a recovery in demand? What stops that happening?

A: The conventional answer is that prices are sticky, so this process happens only slowly. That certainly seems to be true, but it’s an interesting question whether adjustment would occur even with flexible prices.

Q: Ah yes, sticky prices – that is all this Keynesian stuff that is so controversial. So if you believe prices are sticky, does that mean booms and recessions caused by fluctuations in demand are inevitable?

A: No, as I said earlier, that is monetary policy’s other job. We have very good reasons to think that aggregate demand depends negatively on the real interest rate. So there should always be some real interest rate that brings demand equal to aggregate supply.

Q: And the central bank tries to guess what that interest rate is each month?

A: Basically yes, although they can only determine nominal interest rates, so they also need to estimate what expected inflation will be. I hope you remember the definition of real interest rates.

Q: Of course. And now I see the problem. If the required level of real interest rates is significantly negative, and expected inflation is low, even nominal interest rates at zero may not be enough to get demand high enough.

A: Well done.

Q: But now I’m puzzled. If prices are flexible rather than sticky, surely that would make things worse, not better. In a recession it means negative inflation, and therefore higher real interest rates – it goes in the wrong direction!

A: Careful. I thought you said you remembered the definition of real interest rates. It’s expected inflation that matters, not actual inflation.

Q: Sure, but if inflation is falling, surely expected inflation will fall too.

A: Not if the central bank had a target for the price level, or something else related to it, and people believed the bank could and would achieve that target. Then for every fall in actual prices, expectations about inflation in the future would rise.

Q: Like what goes down, must come up again. That reminds me of the other day ..

A: I’ll stop you right there. You should not even attempt to make these dialogs as amusing as those other bloggers. Stick to the economics.

Q: If you insist. So you are saying flexible prices would work after all. If the price level fell enough, expectations about inflation would rise enough to get real interest rates low enough, even if nominal rates were at zero.

A: Yes, but remember what I said about people needing to believe that the central bank could and would do that. And if people are not fooled, it would require future actual inflation to rise in line with expectations.

Q: Which would conflict with the other goal of the central bank, to keep a lid on inflation.

A: Indeed. Most central banks now have inflation targets, rather than price level targets. So if they were doing their job, they would stop inflation rising enough to get real interest rates low enough.

Q: So with inflation targets, even price flexibility might not be enough to ensure aggregate demand was equal to supply if demand fell by a large amount. So why is this Keynesian stuff controversial – it seems to be important whether prices are sticky or not.

A: I would agree. In the past, before you were born, economists talked about the real balance or Pigou effect saving the day, but that is hardly mentioned nowadays. I’m not entirely sure why.

Q: But my textbook says Keynesian economics is all about the economics of sticky prices.

A: That is the same textbook that says the central bank fixes the money supply.

Q: Yes. You never did explain to me why the textbook says that even though it’s not true.

A: I’m not sure I can. But it helps explain the emphasis on price rigidity when discussing Keynesian economics. Money targets are a variation on a price level target, so in that case price flexibility could be enough as we have just seen. For this reason, and perhaps for other reasons as well, textbooks in my view place too much emphasis on price rigidity as a pre-condition for Keynesian analysis, and too little on good monetary policy as being essential in controlling short run aggregate demand.

Q: You do not seem to like my textbook much. But anyway, whether prices are sticky or not, being at the zero lower bound pretty well proves that there is not enough demand in the economy at the moment, and so we need to focus on ways to increase demand. That cannot be controversial.

A: Oh how I wish you were right. 


  1. This is a nice way of presenting a comprehensive and simple overview of the issue (well, more or less simple...).
    The public needs to better understand economic mechanisms, and it can only access that understanding if economists explain them in simple words and in a comprehensive fashion.
    That's how things may slowly become less controversial.

  2. Why can't the central bank simply set a negative nominal rate? It was done in sweden if I remember correctly.

    1. It can, insofar as going all-cash is inconvenient and expensive compared to debit cards.

      But there is still a lower bound on the interest rate, because eventually people will go all-cash. To have an arbitrarily negative interest rate, you need to go full Gesellian currency. Which is neither cheap nor convenient.

      - Jake

  3. Some questions for Professor Wren Lewis:
    - are you sure monetary policy sticks to strict inflation targetting even when this causes significant deviations of the real interest rate from the flexible price economy "natural" real interest rate? There's a nice paper by Curdia and coauthors at the New York fed arguing this is not a purely theoretical question: they showed specification of the interest rate rule in dsge models where the central bank kept track more directly of some measure of the natural interest rate fit the data better in the US.
    - how sure are we that the zero lower bound equilibria where price flexibility isn't stabilising are robust and realistic? There are other equilibria where price flexibility is stabilising, raising taxes on labour is contractionnary and government spending multipliers are below 1, so higher government without corresponding tax increases or some credibility re future tax increases can raise government and private sector external financing premia. Check out the papers by Anton Braun at the Atlanta fed and his co-authors for some doubts on these matters.
    - there are 2 theories of inflation determination in a cashless economy with interest rate targetting in modern macroeconomics which I find hard to reconcile. On one hand the commonly used loglinear Phillips curve suggests that inflation is purely driven by output gaps due to partial price rigidity. On the other hand, in a closed economy (or an economy where domestic credit markets are important in determining local interest rates) real business cycle model with a central bank interest rate target, expected inflation adjusts to deliver whatever real interest rates are determined by private debt markets (with possible effects from government debt markets in the presence of credit constraint- see a version of the Kiyotaki and Moore liquidity constraints model with government borrowing)- note I'm using a general definition of a real business cycle model as one where only relative prices matters,not necessarily the pareto optimal laissez faire is best world of Kydland and Prescott. The core of the new keynesian model is a real business cycle model. Yet in one version of the core model inflation is stable, in another version inflation can be quite volatile as inflation expectations (that are otherwise inderminate in a real business cycle environment) adjust to match the central banks nominal interest rate decisions to the market determined real interest rate. Isn't there a contradiction somewhere in the background? I'm a bit worried that analysis based on the loglinear phillips might underestimate the stabilising role of price flexibility.
    I'll guess I'll have to do more reading about the ZLB. In the meantime some more questions.


Unfortunately because of spam with embedded links (which then flag up warnings about the whole site on some browsers), I have to personally moderate all comments. As a result, your comment may not appear for some time. In addition, I cannot publish comments with links to websites because it takes too much time to check whether these sites are legitimate.