Over the last eleven days something unusual has happened – I have not only failed to post a blog of my own, but I have not even read anyone else’s posts. Instead I have taken advantage of a sabbatical term to take a break  in Umbria, during a time of year when it is still cool enough to walk, but not too cold in the Piano Grande. Before I left I did write a couple of things that I thought I might quickly post while away, but with the help of the Italians’ penchant for starting dinner late and eating four (or more) courses that idea somehow got lost.
So I’m spending part of today catching up, and reminding myself why Paul Krugman and Martin Wolf are such great writers. (For example, from the former, a masterful analysis of the decent into worldwide austerity, and from the latter, a perfect short account of why when it comes to government debt the Eurozone really is different.) What I want to pick up on here is this Krugman post, where he questions the description in a Nick Crafts piece of higher inflation as a way out of the liquidity trap as being ‘textbook’. (See also Ryan Avent.)
So is raising inflation expectations to avoid the liquidity trap textbook or not? Let’s take the 2000 edition of the best selling undergraduate macro textbook. Here ‘liquidity trap’ does not appear in the index. There is a page on Japan in the 1990s, and in that there is one paragraph on how expanding the money supply, even if it was not able to lower interest rates, could by raising inflation expectations and therefore reducing real interest rates stimulate demand. One paragraph among 500+ pages is not enough to make something ‘textbook’, so it seems as if Paul Krugman has a point.
Yet how can this be? It is not one of those cases where textbooks struggle to catch up with recent events, because the Great Depression was a clear example of the liquidity trap at work. How can perhaps the major macroeconomic event of the 20th century, which arguably gave rise to the discipline itself, have so little influence on how monetary policy is discussed? Yet it is possible to argue that the discussion is there, in an oblique form. A standard way of analysing the Great Depression within the context of IS-LM, which this popular textbook takes, is to contrast the ‘spending hypothesis’ with the ‘money hypothesis’: was the depression an inevitable result of a negative shock to the IS curve, or as Freidman argued could better monetary policy have prevented this shock hitting output?
A standard objection to the money hypothesis is that nominal interest rates did (after a time) fall to their lower bound. The counterargument – which the textbook also suggests - is that, if the money supply had not contracted, long run neutrality would imply that eventually inflation would have to have been higher, and therefore real interest rates on average would be lower. So in one way the story about how higher inflation could avoid a slump is there.
What is missing is the link with inflation targeting. Because textbooks focus on the fiction of money supply targeting when giving their basic account of how monetary policy works, and then mention inflation targeting as a kind of add-on without relating it to the basic model, they fail to point out how a fixed inflation target cuts off this inflation expectations route to recovery. Quantitative Easing (QE) does not change this, because without higher inflation targets any increase in the money supply will not be allowed to be sustained enough to raise inflation. In this way inflation targeting institutionalises the failure of monetary policy that Friedman complained about in the 1930s. Where most of our textbooks fail is in making this clear.