Monetary Impotence in context

Mainly for macroeconomists

There are a significant group of people who think that monetary policy must be the right answer even in a liquidity trap because of the centrality of money in macroeconomics, and because of ‘basic’ ideas like money neutrality. Call them market monetarists if you like. They dislike fiscal stimulus because - in their view - it just has to be second best, or a fudge, compared to monetary policy. Their view is not ideological, but essentially based on macro theory. Now it may not be very relevant to the real world, but for many holding the theoretical high ground is important, because it colours their view of the real world.

That is the group that Paul Krugman has been arguing with recently, and why the point he made in his post yesterday is so critical. It is set in an idealised two period world where Ricardian Equivalence holds, but that is entirely appropriate for the task in hand. If people believe something because of (in their view) basic theory, and you think they are wrong in terms of basic theory, then that is the level on which to argue.

The argument is that in a liquidity trap, when prices are sticky, temporarily expanding the money supply - even if it involves helicopter money (i.e. money financed tax cuts) - will not do anything to get you out of the trap. Another, and more modern, way of saying the money supply increase is temporary is saying that the inflation target is unchanged, so the long run price level is unchanged. (Long run money neutrality does hold in this world.) I will not go through Paul’s argument in detail - I have gone through the same logic before. The basic point is that the temporary increase in money is saved, not spent, because agents know it is temporary. Short run money neutrality does not hold, and not because prices are sticky, but because of Ricardian Equivalence.

It is exactly the same reason why the Pigou effect is no longer discussed. Ricardian Equivalence killed the Pigou effect as a fundamental theoretical idea. If the inflation target is unchanged, when prices fall today the future price level must fall pari passu, reducing the future nominal stock of money. There is no wealth effect. As I noted here, even allowing money to be special in not being redeemable does not get the Pigou effect back, because with irredeemable money any wealth effect comes from the long run stock of money.

Money is not a hot potato in this world. The potato has gone cold because of the liquidity trap, and the money is happily saved to pay the future tax increases that will be required to keep the long run money stock (and price level) constant. 

While in this largely frictionless world money is impotent, additional government spending is a foolproof way of expanding demand. So is raising the long run price level, which means at some point raising the inflation target.

All I really wanted to do in this post was make an observation. The theoretical point that Paul makes depends crucially on thinking in an intertemporal manner, which gives you Ricardian Equivalence. Just as price rigidity kills short run monetary neutrality, so does Ricardian Equivalence in an inflation targeting liquidity trap world. So here is modern microfounded macroeconomic theory providing support to increasing government spending rather than monetary policy in a liquidity trap. Modern theory is not inherently anti-Keynesian. .  

Why the Pigou Effect does not get you out of a liquidity trap

For macroeconomists

This issue has surfaced again (see Krugman and Rowe). I wrote a post awhile back on this, but it was quite difficult (for me at least!), so here is an attempt to restate the key conclusions more directly. Ashok Rao has a post covering some of the same themes as my earlier post. The key point here is that I am going to follow Nick in saying that money is different from bonds because money is irredeemable, but even then the Pigou effect is not a magic bullet that gets us out of a liquidity trap.

How is the Pigou effect supposed to get you out of a liquidity trap? In a liquidity trap nominal interest rates are at zero (ZLB). However pretty well everyone agrees that if by some means the monetary authority could induce higher inflation expectations, then the ZLB could be overcome, because real interest rates would fall, stimulating demand. That is a real interest rate effect. It is what some people think Friedman had in mind when he was so critical of Fed policy in the Great Depression. (I have no idea if this is true.) It is what Michael Woodford argues the Fed should now promise to mitigate the impact of the ZLB. It is what Paul Krugman recommended Japan do to get out of the lost decade. But none of these things is the Pigou effect.

The Pigou effect is when the authorities keep the current stock of money constant, and falling prices mean that its real value increases. The idea is that at some point people feel sufficiently wealthier that they spend more, which adds to demand. For this to work, we have to assume that the nominal stock of money will remain unchanged, unaffected by falling prices. Now you might say fine, let’s assume that. But if you do, you might also agree that the fall in prices is temporary. Simple neutrality implies that if you hold the money stock constant, falling prices today will mean higher prices tomorrow. But we have already established that in that case you do not need a Pigou effect, because higher inflation tomorrow at the ZLB will mean lower real interest rates, and you get the demand stimulus the good old real interest rate route. Furthermore, if people understand that prices will rise, they are not really wealthier in an intertemporal sense, because their extra real money balances will be inflated away. If you like, they save their extra real money balances today to pay for future inflation taxes. [1]

The alternative case is where future inflation does not increase as current prices fall - as would happen if the monetary authority targeted future inflation for example, and did not raise that target as prices fell. That would imply that the current nominal money stock was not fixed, because to prevent future inflation rising, the monetary authority must at some stage reduce the nominal stock of money - long run neutrality again. How does it do that without raising interest rates? It could raise taxes. But if it did that, then Ricardian consumers would not think of their higher real balances today as wealth, because this would be offset by future tax increases.

The central bank could reduce the money stock by selling some of its government debt. But under the conditions that Ricardian Equivalence holds, that has the same effect. Now the government will have to raise taxes to pay the interest on that debt, whereas before any interest they did pay came straight back via the central bank.

We can sum this up rather neatly, as Willem Buiter did here with the aid of lots of maths, by saying that what matters is the terminal stock of money, not its current value. The government can only make people feel wealthier by printing money if people believe that the increase in its real value is permanent.

We can apply the same reasoning to a helicopter drop. The first issue is whether issuing money to pay for a tax cut is any different from issuing bonds, and in particular does Ricardian Equivalence apply? Now macroeconomists are confused on this (see my earlier post), but here I’m happy to follow Nick and agree that money financing is different, because money is not redeemable. So a permanent helicopter drop of money will tend to increase consumption. To put it another way, the Ricardian Equivalence mechanism does not apply to a helicopter drop.

However there is another, more economy wide mechanism. If long run neutrality holds, and if people understand this, they will realise that their extra wealth will eventually be inflated away, so they are no better off. (Equivalently, their tax gain today will be offset by a higher inflation tax at some point.) But those expectations of higher inflation, if we are stuck in a liquidity trap, will shift consumption to the present, so the helicopter drop increases demand through a real interest rate mechanism.

The bottom line is that we can forget about the Pigou effect as a way out of the liquidity trap, at least in what is now our baseline macro model. What is important for the liquidity trap is expectations about future monetary policy. If monetary policy allows future inflation to rise, and expectations are rational, we can get out of the trap. If they do not, then we stay in the trap until some other force gets us out. That force will not be the Pigou effect.

[1] What if neutrality does not hold? Neutrality is pretty basic, but for the sake of argument let’s briefly consider this. Consumers are now wealthier, because they have more real money with no future costs to come. However I have the following problem if we stick with intertemporal consumers of the Ricardian type, who only consume the annuity value of any increase in their wealth. When do these agents consume their new found wealth? Any answer except never appears to violate consumption smoothing.

Did Ricardian Equivalence kill the Pigou effect?

For macroeconomists

After the last time the world got into a liquidity trap, there was a debate about whether price flexibility would be sufficient to get us out of the trap. That debate tended to assume a fixed money supply. With that assumption, the answer today would be yes, if falling prices raised inflation expectations (given long run neutrality) and therefore reduced real interest rates. Back then that story was not so popular, perhaps because the debate pre-dated rational expectations. Instead the argument at the time focused on the Pigou or Real Balance effect. Falling prices raised the value of outside money, so everyone would feel wealthier and spend more.

We do not hear this argument so much nowadays. I have not seen this discussed in the advanced textbooks I know well (for example neither term is in the index of Romer or Obstfeld and Rogoff), so I was wondering why that was. Is the Pigou effect not what it was once thought to be? I could not find a clear answer to this question anywhere, but of course that may be my failing. So here are my thoughts, but they come with the possibility that I have just missed something. If I have, I will rewrite the post accordingly.

What I did find were a few papers that appeared to suggest that Ricardian Equivalence (REq) killed the Pigou effect. Here is a quote from a paper by Peter Ireland. After talking about REq, he writes

“Less widely appreciated, however, is a closely related finding, presented most explicitly by Weil (1991) but also implicit in earlier work by Sachs (1983) and Cohen (1985). These authors show that government-issued fiat money will not be perceived as a source of private-sector wealth if the households owning that money are the same households that, first, receive all of the transfers or pay all of the taxes associated with future changes in the money supply and that, second, incur all of the opportunity costs associated with carrying the money stock between all future periods. We are used to the idea of Ricardian Equivalence implying that government debt is not net wealth. Essentially consumers internalise the government’s budget constraint. But that argument applies to outside money as much as government debt. We can replace initial values of debt and money by the discounted future stream of primary surpluses they support.”

The easiest way to describe REq is that the infinitely lived representative consumer consolidates the government’s intertemporal budget constraint (IBC) into its own. Suppose this consumer owns some nominal (non-indexed) government debt, and the price level falls. Is that consumer better off? The real value of the future interest they receive on that debt will be higher, but this will be offset by the higher taxes in real terms that the government will raise to pay for this. The same argument applies to the higher real redemption value of the debt.

Ireland argues that exactly the same points can be made about outside money. Suppose money pays no interest, but consumers hold it because of the liquidity services it provides.

But if the consumer already has all the liquidity services they need (as they do in a liquidity trap), a fall in prices that creates more of this asset in real terms does not make the consumer better off on this account. So what about the redemption value of the additional real balances?

Here I’m inclined to think that money is different from government debt. In a paper[1] that I do not think has been published, Willem Buiter argues that money is irredeemable. The government only promises to redeem money with itself. So if I get a tax cut that is financed by printing money rather than issuing debt, there is no offsetting future tax liability. For this reason, money – unlike government debt – is net wealth for the consolidated public and private sectors.

Now a standard response is to say that a money financed tax cut does not make the consumer better off because the price level will rise, reducing the purchasing power of that money. It seems to me that is a different argument to REq – it requires going beyond just thinking about budget constraints. It is also an argument that does not apply to the Pigou effect, which is what happens if prices fall, raising the value of real balances.

Does the irredeemable nature of money rescue the Pigou effect from the REq argument? Yes and no. There is a crucial difference between Buiter’s analysis and the traditional view. In Buiter, it is the present discounted value of the terminal stock of base money that is net wealth for the consolidated private and public sectors, rather than its current value. To see why this matters, consider the liquidity trap case again.

As we have already noted, there is no liquidity trap in the flexible price case when the government holds the nominal stock of money constant, because falling prices today imply higher expected inflation. We do not need a Pigou effect. But the more interesting case, which I have talked about before, is where the government or central bank has an inflation target. In this case the authorities prevent inflation expectations rising, so real interest rates do not fall.

In that case nominal money will not be held constant when prices fall. Instead, the authorities will contract the nominal money stock in line with falling prices, to make sure inflation does not rise. As a result, there will be no increase in consumption, because the terminal value of nominal money falls, and its real value stays constant. Or, to put the same point another way, higher future taxes required to reduce the money stock will offset the wealth impact of higher current real money balances. There is no Pigou effect.

This is all terribly stylised and unrealistic, so there is no need to add comments that just point this out. However, I hope I’m not the only one who thinks this thought experiment is 
interesting. I also think that the proposition that inflation targets prevent macroeconomic ‘self-correction’ even when prices are flexible has a symbolic importance.

[1] Buiter, W.H. (2003) Helicopter Money: Irredeemable Fiat Money and the Liquidity Trap, NBER Working Paper No. 10163.