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.