Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday 1 August 2013

ZLB Models?

There was a little interchange between Noah Smith and Paul Krugman a couple of weeks ago on what kind of models could explain Japan’s stagnation, and perhaps by implication the Great Recession. (Original Noah post here, Paul’s response here, and second round here and here.) I thought it was interesting, but it has taken me a bit of time to put my finger on why I thought it was interesting.

Noah began by saying there were two dominant macro models: RBC and New Keynesian (NK). The problem with applying NK models to Japan is that in NK models recessions last for as long as it takes for prices to fully adjust.  So how can NK models explain a lost decade or more? (You see this now in economists asking ‘how can the US, UK or Eurozone still be in a demand induced recession, from a shock that occurred 5 years ago’? Often the implication is that this is implausible, so the explanation must be supply side.) The answer, as Paul pointed out, is the Zero Lower Bound (ZLB). Noah replied that “They [ZLB models] are not yet well-developed or well-explored”.

Now I think Noah makes a lot of valid points, but I was unhappy about how his discussion was framed. I should also say that this framing is common to a lot of macroeconomists, so if I think it is unhelpful it is important to understand why.

It is often said that NK models just add price stickiness to RBC models, and if prices are sticky in the short run, aggregate demand matters in the short run. [1] I like to express it differently. What is the mechanism by which we can or cannot ignore aggregate demand? That mechanism is monetary policy, and how that is influenced by price adjustment. The way NK models can work is that price adjustment induces a monetary policy response, and it is the monetary policy response that ensures demand shortfalls are not persistent. Break the monetary policy response, because you hit the ZLB, and you break the correction mechanism, particularly if the monetary policy regime also involves inflation targets.

The ZLB therefore allows NK models to generate much more persistent recessions, if the recessionary shock is itself large and persistent. But the implications of the ZLB for RBC models are just as profound.  Implicit in their construction is that demand shocks ‘do not matter’, because the correction mechanism to get demand back to supply works sufficiently quickly that we can just focus on supply decisions. If the correction mechanism is broken because of the ZLB, then the foundation on which the model is built becomes problematic. It is no good saying ‘we assume price flexibility’, when even if prices adjust rapidly monetary policy cannot get demand back up. Or to put it another way, you cannot assume that the real interest rate will always be at the natural level if there is no way that real interest rate can be achieved.

That is one of the benefits (there are also costs) of the NK model encompassing the RBC framework. We can see the conditions under which the ‘special case’ of RBC works. And at the ZLB with inflation targets, it does not.

Of course you can ignore this point, and try to use RBC models to explain the current recession or Japan’s lost decade. But there are two huge problems with this. First, it ignores a big piece of evidence - these economies are at the ZLB! Well, that could just be a coincidence, or an inconsequential by-product. But second, the ZLB under inflation targets undercuts a key principle on which RBC models are built. In that sense, the model is not microfounded. [2] Thinking about mechanisms rather than models helps you see that second point. [3]

We can use NK models to analyse the implications of the ZLB, by hitting them with a large and persistent negative demand shock of some sort and adding the ZLB constraint. But what is clearly missing here is any understanding of the large and persistent negative shock. There is much current work looking at ‘financial frictions’, and the balance sheet implications that these may have. This may help explain the persistence of ZLB recessions. But they may also explain much more, and help improve the ability of NK models to track trends before the Great Recession. So to describe this endeavour as ZLB modelling seems inappropriate (or at least premature).

This approach to modelling ZLB recessions still has a unique steady state, and sees prolonged recessions as involving a natural real interest rate below its steady state value. An interesting possibility is that the ZLB constraint can create an alternative steady state, where a positive real interest rate is associated with deflation (see this paper by Mertens and Ravn (pdf), for example). The central bank (unlike Milton Friedman) is not happy with this steady state, because inflation is below target, but cannot shift to its preferred steady state by lowering interest rates. Whether you would call this alternative steady state a recession, and whether it could be applied to Japan, are interesting questions.

I do not think it is very informative to describe both this approach, and the more standard persistent demand shock approach, as ‘ZLB models’? The mechanism behind a persistent recession in either case is very different. But more fundamentally, they both use similar NK models, but just take the ZLB constraint seriously in that model. So it seems very odd to talk about NK models on the one hand, and ZLB models on the other, when the ZLB is an undeniable fact.

Now at this point you may be thinking that I am just being a bit pedantic about labels. I am not sure I should apologise if I am, but I do have another motivation. Talk of different models that can be applied to the same problem harks back to ‘schools of thought’ days in macro. I think macro should be better than that now. For better or worse, the microfoundations project and the new neoclassical synthesis gave us a common language, where we could talk about different mechanisms within a shared approach. That should make the process of matching evidence to theory more straightforward.

[1] Of course NK models often ignore the capital accumulation process, which is much more central to RBC analysis. But the key point is that we can always add sticky prices to any RBC model.

[2] There could be some other mechanism which justifies ignoring aggregate demand, but the whole point of microfoundations is that this mechanism needs to be spelt out. In its absence, all that is left is to just assume that large negative demand shocks never happen. Which is a bit like assuming nominal interest rates can be negative. 

[3] Chris Dillow’s comment that I link to here was really helpful in allowing me to appreciate why seeing macro in terms of competing models can be so confusing. In a way I just had to remember what it felt like learning macro for the first time, but that is easy to forget when you spend the rest of your life building and analysing these things.


  1. Krugman September 26, 2011 'Lucas In Context (Wonkish)' and February 5, 2011, 'Exchange Rates and Price Stickiness (Wonkish)' set his views against RBC further.

    I can't help thinking that this has gone past being an economic argument, and as Skidelsky said (Jun. 30, 2013 Economic Rebalancing Acts), it's all political now, about what sort of post-recession country the UK will become.

    The RBC is a similar problem to that in the latest Shiller column ( Jul. 17, 2013 Bubbles Forever), in which Eugene Fama is still saying that there was no housing bubble as bubbles cannot exist.

    This run-up to the 2015 election will be ugly, as can be seen by the reaction of the Telegraph and Daily Mail to the BBC Trust criticising the John Humphrys programme of 2011 (see LRB blog, Ignoring the Facts, John Perry, 2 November 2011).

  2. "Or to put it another way, you cannot assume that the real interest rate will always be at the natural level if there is no way that real interest rate can be achieved."

    It is deeply ingrained in your NK intuition that higher nominal rates result in less, not more inflation. The result of this is that changes in the nominal short rate result in even greater changes in the real short rate, and monetary policy matters. I used to think that was patently obvious too, but debate with some rbc/new monetarist types has shown me that this intuition is not necessarily universally held. These RBC-types believe, as far as I can tell, that for all intents and purposes we can just assume that inflation adjusts pari passu with changes in the nominal rate, leaving the real rate unchanged. They talk as if the real rate is entirely endogenous, and to the extent that they talk about rates policy at all, the goal of it is nothing more than to minimize the (ad hoc imposed) costs of inflation uncertainty.

    The core of the problem, I believe, is that rbc people tend to he hard core ratex types. And the pi = i-r_natural solution *is* a ratex
    equilibrium. The critical paper (I think David Andolfatto pointed me to this a few years ago) is Peter Howitt (JPE, 1992), Interest Rate Control and Nonconvergence to Rational Expectations, in which Howitt shows that any divergence, no matter matter how small, from ratex leads to a
    Wicksellian cumulative process.

    So I think you are mistaken in believing that the rbc people fail by ignoring the failure of monetary policy at the ZLB. They don't. The failure is in assuming that rates policy can always be ignored (except for a bit of inflation volatility), by virtue of *perfect* ratex.

    [If you don't believe me, I will have to dig up old blog links to prove it. But you can look up Nick Rowe's post on Kocherlakota for starters if you are interested.]

    1. Good comment. I seem to be agreeing a lot with K these days.

      For example, Stephen Williamson has been known to discuss the ZLB on his blog. Perhaps he's not one of the RBC types that Simon is referring to?

  3. "For better or worse, the microfoundations project and the new neoclassical synthesis gave us a common language"

    Gave who a common language?

    Why do you insist on pretending that the neoclassical nonsense is the only form of economics that exists?

  4. A question to the author and to the readers of this educative blog.

    I wonder who are the "Cyrus", the "Alexander" or the "Julius Caesar" of Macro-economy?

    I quite curious to find the equivalent of "crying" of "Julius Caesar" in relations to "Alexander"

    "On his return to Rome, he was elected military tribune, a first step in a political career. He was elected quaestor for 69 BC,[28] and during that year he delivered the funeral oration for his aunt Julia, and included images of her husband Marius, unseen since the days of Sulla, in the funeral procession. His wife, Cornelia, also died that year.[29] After her funeral, in the spring or early summer of 69 BC, Caesar went to serve his quaestorship in Spain.[30] While there he is said to have encountered a statue of Alexander the Great, and realized with dissatisfaction he was now at an age when Alexander had the world at his feet, while he had achieved comparatively little. On his return in 67 BC,[31] he married Pompeia, a granddaughter of Sulla, whom he later divorced.[32]"

  5. The problem of course with RBC and New Keynesian (NK)macro models and their ilk is that they deal with only part of the overall economic response and are missing key interactive elements. To obtain a sensible prediction of how the economy behaves it is necessary to model all key elements of the economy simultaneously and in particular to model the time behaviour of each of these key elements using differential equations. A model that does just that, and which has been successfully predicting the behaviour of the uk economy for some time, is there for all to see (with interactive features) on website
    I would add that the model could, with a moderate amount of effort,be set up to model the Japanese economy for the purpose of analysing what actually caused Japan's stagnation.

  6. From that Wikipedia article: "Essentially, Friedman advocated setting the real interest rate at zero." This is wrong, surely?

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  8. Simon - I am fascinated with this "models are mechanisms are models" discussion and your piece here, calling everyone to intellectual account, is very valuable.

    I am slightly less fascinated - more chagrined actually - with the implication that RBC or NK models factor in all of the relevant variables (and in the case of the mysteries discussed above - macroeconomic outcomes at the ZLB - the most critical variables) necessary to answer the questions posed. Both the mircofoundational view and the neoclassical synthesis fall short in this regard.

    That the entire advanced world is at or near the ZLB cannot be ignored. That Japan has been at the ZLB for far longer than its advanced brethren provides us with an incredible laboratory for exploration that Noah is right to focus on. But that there may be an under-credited/appreciated exogenous input that is not factored in to NK - and especially RBC - models and mechanisms is for some reason never considered.

    What if it is not a demand shock that the globe is experiencing? What if instead, as I believe, the advanced nations (beginning with Japan only a few years after its more classic debt deflationary event - the collapse of its bubble economy) have seen a [reverse] supply shock? That is to say that the relatively sudden emergence of exogenous, and massively excess relative to global demand, supplies of labor prepared and able to generate production at a massive clip and at a price level with which the advanced nations cannot compete. Production and capital then flow to those developing nations in equally mass scale and enable investment in new productive capacity (including infrastructure) as those nations pursue a mercantilist model to boost their own employment and social/political harmony. Consumption in those nations does not rise together with supply and the demand deficit relative to supply in those countries is "exported" to the developed nations. So what looks like an endogenous demand deficit is in reality one that is being "imported."

    I believe that is the situation Japan faced on a smaller scale when it confronted competition from the Asian Tiger economies in the mid-nineties, just as it was confronting the after-effects of its credit bubble's collapse.

    Then, just as Japan was getting its head above water, another economic tsunami (excuse the bad pun) over-washed Japan - and all of the other advanced nations - as the BRIC's and others with vast pools of low wage labor were swiftly brought on line to the global free market. That expanded "The Age of Oversupply" to impact virtually every aspect the economies of the advanced nations and brought with it the reverse capital flows that fueled a global credit bubble and led to the present circumstances.

    That the advanced economies should be at the zero lower bound is no surprise under the foregoing circumstances. That we can't escape the ordeal without creating a substitute form of demand endogenously, seems to be understood by NK theorists, but - in my opinion - without a full appreciation of the real reasons therefor.

    I felt so strongly about this that I have written a book, coming from Penguin Portfolio in September. It is being released simultaneously in the U.S. and the U.K. and can be found at:

    Dan Alpert

  9. Krugman says “Monetary expansion is ineffective unless it can raise expectations of future inflation.”

    What on Earth is he on about? Assume an economy is well below capacity. Whether it’s at the ZLB or not doesn’t matter. There must be some quantity of money that the government / central bank machine can print and dish out to everyone that brings a rise in demand without seriously exacerbating inflation. Or have I missed something?

    What do people do when they win on a lottery? They don’t by any chance spend some of their winnings, do they?

  10. Ralph, I'm not sure exactly how Krugman defines monetary expansion but I'm certain it doesn't include printing money and dishing it out to everyone. That's seriously fiscal.

    1. Kevin,

      On the other hand in the paragraph just before my above quote, Krugman says “the only reason deflation “works” in the standard model is that it increases the real money supply..”. That sounds to me like he is referring to monetary base (which is a net asset as viewed by the private sector) as distinct from commercial bank created money (which is not an asset in that it nets to nothing – i.e. for every £ of such money, there is a £ of debt). I.e. he is referring to the Pigou effect, seems to me.

      So I’m sticking in a very uncertain manner to my “printing money and dishing it out” story.

      Yours, Confused.

  11. There are at least 2 other reasons why Japan had its lost decades.
    1. Demographics. It started to hit in around that time.
    2. There is still a lot of garbage of the crisis not properly cleaned up. Which messes up the bookkeeping but also how people behave.

    Some lessons can be learnt from that, but the situation is not totally comparable>
    1. The West tried to solve the issue with immigration. Which for roughly a half will do that job. However for the other half (under educated, difficult to integrate groups) it will not. These groups are undereducated even compared to EMs. Very likely like the elderly they will be an extra group of economic passengers. So also the quality of the immigrants is an issue (as said with roughly half better than the locals and the other half considerably worse).
    UK probably relatively not bad off the high potentials favour the UK and the US/Australia above most continental European countries.
    And the Eastern European inflow will play a large role. With roughly the Northern part being well educated but the Balkan part not.
    Japan had roughly immigration. And per capita didnot do that bad, but overall with a rapidly declining workforce it did (while populationdecreases went much slower and started much later).

    2. It is not in the Japanese culture to shame someone with a bankruptcy. What basically happened is with a lot of bookkeeping tricks the can was kicked forward.
    Looks very similar what is happening in the EZ especially the Southern part (only other bookkeeping tricks). But at the end of the day growth that has to compensate hidden bookkeeping losses isnot shown. And make the picture look much worse than it already is.

    UK and US look better they have cleaned up their banking sector much more than the EZ and Japan before.

    From there I doubt if simply using another model would have done the trick. It probably has to be combined with other policies. Like cleaning up the bankingsector. So banks start to act like normal banks not like ones with still some skeletons in the closet. And policies that attack the aging issue and the costs related to it.
    Basically the rest should be able to function normally before any model will work the way it is supposed to.

    That is why I am very pessimistic about the South of the EZ. They have all similar problems as Japan. While unlike Japan they are not able to compete in the top league (where the pricing power for a big part is located) while in the league they are in competition is immense with the China and Indias). Looking at the quality of their workforce simply hardly better than Chinese or good Indians only at least 5 times more expensive. Which imho likley will become an issue for countries like the UK in a not to distant future. And when you missed the the boat like the South it is nearly impossible to reverse.

  12. Ralph Musgrave, what you're missing out is that the expected real interest rate that clears the the loanable funds market is negative, requiring either large expected inflation or negative nominal interest rates to achieve: the ZLB is the observation that negative nominal interest rates are next to impossible, which leaves only expected inflation as a means to clear the market, but since you don't want that you have a non-clearing market and quantity rationing. Get it?


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