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.