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. 

Ideology and Demand Denial

Thanks to Chris Dillow and then others, my post Mistakes and Ideology in Macroeconomics was widely read and commented on. As Chris pointed out, it is possible to think in terms of mechanisms or complete models. My post was about one mechanism, consumption smoothing, which the texts I was looking at appeared to ignore. Many responses were along the lines of ‘what the authors of these texts had in mind is a model of this type, and in this type of model fiscal policy will be ineffective’. I’m happy to pursue this, not because I would be presumptuous enough to imagine I know what the authors ‘really meant’, but because I think it strengthens the idea that antagonism towards fiscal policy in the current situation has ideological roots rather than a sound basis in macroeconomic theory.

The most widely suggested model is one where there is never any demand problem: we are always at ‘full employment’. Then, of course, increasing one component of demand will have no direct effect on output, and higher taxes will have some negative impact on supply. Expansionary fiscal policy would be quite inappropriate in these circumstances.

If that is the argument, then I would insist on asking just how it is that the economy is always at full employment. The standard response, which is that prices are flexible, is not enough when we hit a zero lower bound for interest rates. As a suggested in another post, the ‘self correction mechanism’ by which demand shocks never impact on output requires a combination of price flexibility and monetary policy. (Actually, price flexibility is not even necessary – if the monetary authorities effectively targeted the output gap, for example.) This mechanism fails when we hit a zero lower bound.

Now an argument that said that the current recession was the result of a large negative supply shock rather than a demand shock, and we hit the zero lower bound because central banks misunderstood this fact, makes perfect sense in theory – it is just a little difficult to square with the facts, as many have pointed out. But this is a contingent argument. What the debate over fiscal policy has revealed is an underlying generic antagonism towards Keynesian analysis.

There is an asymmetry here. Keynesian economists do not deny that productivity or other supply side shocks can often be important. On the other side there appears to be, among many at least, a belief that Keynesian economics is never relevant. What this amounts to is what Krugman and others call demand denial. Yet the basis in economic theory for demand denial appears very unclear. Say’s Law, or maybe some kind of quantity theory with fixed velocity, would do it – but these were really bad ideas that the profession dismissed many decades ago.

Demand denial seems both surprising (an individual firm facing a fall in demand will reduce output), and hardly something to feel passionate about. So demand denial genuinely puzzles me. Keynes had a number of thoughts on this, as the following from the General Theory shows (‘it’ in the first sentence is a theory that involves demand denial).

That it reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely on the whole to do more harm than good, commanded it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority.

Now beautiful though this passage is, a good deal has changed since 1936. New Keynesian theory is a ‘consistent logical superstructure’, so there is no intellectual prestige involved in denying its relevance (except, perhaps, to fellow believers). Yet two sentences still ring true. The first is the idea that austerity is virtuous. Some of the popular discourse around fiscal policy has moral overtones, perhaps stemming from the idea that governments, like individuals, have to practice self control. Now while I think seeing economics as a morality play is generally unhelpful, in the case of fiscal policy there is a problem of deficit bias: governments over the last few decades have tended, on average, to spend too much or tax too little. (Some particular evidence, and a fairly comprehensive discussion of reasons for deficit bias, can be found here. For lots of data, go here, click on ‘subject: Real GDP Growth’ and select the historical debt database.) However deficit bias is a long term problem and a recession is not the time to start dealing with it. 

The final sentence from Keynes also still rings true.  One explanation for demand denial is that it has ideological roots. In the real world we have the problem of ensuring aggregate demand matches supply, and this requires state intervention – normally monetary policy.  For those who want to argue that state intervention in the economy is generally a bad thing, it is embarrassing to acknowledge that there is one area where it is essential. But I get no joy in seeing ideology mess with economics, and so I would be more than happy to be convinced that there was another explanation for demand denial.  

Keynesian Economics, Price Rigidity and Demand Denial

Something prompted from revising my second year undergrad lecture notes, and so mainly for economists.

In mainstream macro today, Keynesian economics is synonymous with the macroeconomics of price rigidity. Most of the time I have no problem with that. All the evidence suggests there is significant inertia in aggregate prices, and it is very difficult to tell realistic stories about how inflation moves without taking this into account. Price inertia and imperfect competition are probably essential in understanding why output tends to follow aggregate demand in the short term.

My problem with identifying Keynesian economics with the macroeconomics of price rigidity is that it allows those who would like to ignore Keynesian theory with too easy an opt out. They can argue that, despite appearances to the contrary, prices are in fact pretty flexible. They then conclude that Keynesian economics is irrelevant. Unfortunately far too many academic macroeconomists appear to implicitly or explicitly take this view.

                Is it logically the case that if prices are flexible Keynesian economics can always be ignored? The answer is simply no. Price flexibility alone does not ensure demand always moves quickly towards supply: it is the combination of price flexibility and monetary policy that does this. And when something goes wrong with monetary policy, price flexibility alone may not work.

We are living through exactly such a situation. It is not just the zero lower bound for nominal interest rates that is important here. It is also the fact that monetary policy has an inflation target rather than a price level target. After a large negative demand shock, demand can only be restored in the short term (for a given fiscal stance) by a large reduction in real interest rates. Real interest rates are nominal rates minus expected inflation. The zero lower bound stops nominal rates falling enough, and inflation targeting stops inflation expectations rising enough. No amount of price flexibility can change this. (For a more detailed discussion see here.)

                Students often think that price flexibility must imply that output is supply determined, because if any workers were unemployed, nominal wages would continue falling until they were employed. But just imagine an economy made up of monopolistic competitors where production was linear in labour. In that economy firms would ‘determine’ a constant real wage through their mark-up, and no amount of nominal wage cutting would reduce real wages or increase employment. 

Demand denial is the belief that we can always ignore aggregate demand when analysing short term movements in output and employment. It sometimes seems to be based on a view that price flexibility alone always ensures demand is sufficient for supply. It does not.