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I can think of 4 variables which can help prevent the prevalence of black holes
1. growing population
2. growing productivity
3. growing trade
4. contant influx of new technology or products

An economy with high indebtedness,that cannot be paid for due to a lack of all 4, can probably experience it, much like a star that no longer burns but still has the weight of gravity pulling it in.

A Russian math book (from the Soviet era) says that there were riots in 19th century England against negative numbers. Hard to believe, but I wondered what about negative numbers might get people to riot? Maybe debt, eh? Without negative numbers, how can you have a negative net worth? ;)

Now, zero is just a number. Why does it have to be a lower bound for interest on a loan? OC, if you are a business, it does not make much sense for you (or you alone, anyway) to make negative interest loans. But if you are the government, or a philanthropist, or a parent, you might well do something that amounts to one. E. g., you could forgive the debt, or a portion of it, under certain conditions. For instance, you might give a loan to someone to start a business, with a forgiveness of 5% of the principal each year for two years if they actually start the business and employ at least three people for those years. Probably not a job for the Fed in the U. S. system, though.

What does macroeconomic theory say about that sort of thing?

Do you really want the Fed playing banker to the whole economy instead of simply at the top level? What you've described would involve massive amounts of centralized planning, which as we should know by now just doesn't work.

We may not have seen any black holes but we have seen several periods of deflation reaching ~10% a year extending for up to a few years. While we can say an increase in M/P accomplished this, I don't think we can say it happened by itself or was self righting. Increasing M/P still takes a cooperative government to keep M from falling as fast as P which it often did during these episodes, due to bank failures in the case of the 30s. So the question is one of how perverse government policy can be for how long, even when it asserts it is doing the right thing.

We could as well blame ourselves for undertaking actions government has to counter though, so perhaps it can be considered self righting if it is our own behavior we correct.

Nick, Very good post. Regarding Lord's comment, I think the reason we don't see black holes is that there are lots of ways of adopting expansionary monetary policies, apart from cutting nominal rates. Indeed in the US we adopted one of those alternative policies after the sort of deflationary episode mentioned by Lord. We began targeting commodity prices by altering the buying price of gold. It worked immediately, as prices began rising rapidly.

For scott sumner or anyone else, what happened to reserves when the USA went off the gold standard?

Hi Nick,

Happy Christmas!

The reason there is no black hole is that there are automatic stabilizers. Lower economic activity due to higher household saving (and hence lower consumption) and due to lower investment leads to a fall in taxes. The lower activity also leads to higher non-voluntary government spending and the hence the fiscal deficit widens to put a floor on the aggregate demand. This is because households accumulate more wealth while the government runs higher deficits than usual. There is a "stock-flow-consistency" spirit in the argument above. The reason I love the formal models of Marc Lavoie and his colleagues is that they are perfect laboratories to test these things. I havent read the work of Woodford except just browsing through some chapters on his website but I believe his work misses out the stock aspect of stock-flow consistent models.

Corporate bonds issuance just shifts the names of the deposits and monetary aggregates miss this. Banks have been "innovative" and have securitized loans and this information is not captured in M2/M3. Banks lend by creating deposits and the act of securitization removes those deposits from the banking system - increase in Ms by lending but decrease due to securitization. The total household debt is around $13T (?) in the US and M2 is just around $10T. So the monetary aggregates may miss any such activity. It is best to think of the aggregates as an output than anything else. Don't you think ?

Why not have the Fed charge a negative interest rate on bank reserves?

Greg,

You may find this useful http://neweconomicperspectives.blogspot.com/2009/07/why-negative-nominal-interest-rates.html and http://neweconomicperspectives.blogspot.com/2009/07/why-negative-nominal-interest-rates_14.html

Hear hear!

I'm sorry to be such a lazy and inattentive reader, but have you addressed why you think 1928-1933 didn't constitute a deflationary death spiral?

1. The deflation didn't start till 1929, well after the drop in RGDP started.
2. It wasn't more than 10% a year, wear-as, we have seen inflation rates as high as a trillion percent a year.


Also, the reasoning for deflationary death spirals is screwy. If people putting off stuff now because the future held better and cheaper goods was a problem, then the computer industry would have never done well in the 90's. We do see death spirals that have deflationary components, but its really obvious they aren't caused by deflation. Look at Detroit from '00 till now for an example. Its obvious that there is huge deflation, and its obvious that there is a death spiral, but it doesn't seem that deflation or postponement of buying is what caused the spiral. People left Detroit because of the high crime, high taxes, terrible schools and terrible job opportunities, before the deflation started, and the deflation was just a symptom of its demise.

The same happened in the great depression; the drop in RGDP started well before the deflation, the deflation was just a symptom of the drop. Also, a lot of the deflation during the great depression was regulatory, as the US adjusted the gold peg purposely adding delation to the system.

Rogue: "I can think of 4 variables which can help prevent the prevalence of black holes
1. growing population
2. growing productivity
3. growing trade
4. contant influx of new technology or products"

Dunno. Those 4 things should shift the AS curve to the right about the same amount that they shift the AD curve to the right (for a given interest rate). And even if they did shift the AD right by more, there must be times when those 4 forces are weaker than average, and so would make deflation more likely.

Min: it's the existence of currency that puts a lower bound on nominal interest rates. If interest rates fell too far below zero, people would just hold currency instead.

Lord: But M isn't a policy variable in the models I'm criticising, so, if those models are correct, governments can't prevent deflation by increasing M. All they can do is lower nominal interest rates, and when interest rates get down to 0%, they can't even do that.

Scott: Thanks! Agreed.

Ramanan: Merry Christmas!

My understanding and memory of Marc's models may be a little hazy. With that proviso:
1. There is a distinction between automatic stabilisers preventing (real) AD falling without limit, and automatic stabilisers restoring AD back to full employment to stop the deflation.
2. The main destabilising channel in the models I'm talking about is the effect of expected deflation on real interest rates for a given nominal interest rate. I don't think Marc's models have that channel??

Greg: a negative interest rate on bank reserves could gain a little bit of extra space for policy. But too far below 0%, and banks would just hold currency instead.

Thanks Doc!

Bruce: The early 1930's saw deflation, but then it stopped. It didn't accelerate into a total destruction of the monetary system. And the deflation was small compared to episodes of hyperinflation, some of which did spiral out of control and destroy the existing money, which had to be replaced by a new money.

Doc: yes, the significant deflation in computers is a good example. But don't you think that some people postponed buying because they figured there'd be a better cheaper model next year?

Nick,

From the GT chapter 19:

"But if the quantity of money is virtually fixed, it is evident that its quantity in terms of wage-units can be indefinitely increased by a sufficient reduction in money-wages; and that its quantity in proportion to incomes generally can be largely increased, the limit to this increase depending on the proportion of wage-cost to marginal prime cost and on the response of other elements of marginal prime cost to the falling wage-unit."

What does he mean by "marginal prime cost"?

"A "horizontalist" macroeconomic theory creates a vertical AD and predicts the existence of black holes."

I thought fiscal expansion was the complement to "horizontalist" theory, shifting even a vertical AD curve to the right when implemented. Assuming that works, there's no reason to expect realized black holes, is there? Isn't it horizontalist theory without the fiscal complement that predicts them? But that's never been tested, so the lack of observation is no proof of your thesis.

Where am I wrong?

JKH: To paraphrase (I think) Lady Joan Robinson: "The trouble with Maynard is that he never bothered to spend the 30 minutes it would have taken him to learn value theory".

I think he means what we nowadays call just "marginal cost": the increase in total cost to produce one more unit of output.

Here is a simple explication of what Keynes should have meant (as opposed to what he might actually have meant):

A profit-maximising firm operating in competitive labour and output markets will set output where Marginal Cost = Price. Alternatively, it will set employment where Price x Marginal Product of Labour = Wage. These two equations are just different ways of looking at the same thing, since MC = W/MPL. (MPL is defined as the extra output from one extra worker holding other inputs like land and capital constant).

So, P = MC = W/MPL

If P is perfectly flexible, and W adjusts slowly (which seems to reflect Keynes' preferred way of thinking), then a 10% fall in W should cause a 10% fall in P, holding MPL constant. And MPL should stay constant, unless employment rises, and there are diminishing marginal returns (diminishing MPL).

But Keynes probably had some sort of Ricardian fixed coefficients technology at the bank of his mind, where one worker plus one shovel produce output, so you have to talk about the marginal product of a worker plus shovel combo. So we replace my P = W/MPL with:

P = (Wage + shovel rental)/Marginal product of worker+shovel combo

Which means you get a slightly more complicated relation between falling W and falling P.

So what's happening to M/P isn't quite the same as what's happening to M/W. Which is why I said, in my post's interpretation of Keynes:

"...increasing the real money supply M/P (or M/W, same difference)."

Keynes was waving his hands around here. But it doesn't really affect his argument. "same difference".

Wow! I'm impressed you asked!

Thanks for the explanation @ 11:16, Nick. I attempted to read chapter 19 only as a result of your post. My impression is that he tries among other things to identify potential sources of leakage from a 1:1 relationship between declining money wages and declining output prices – e.g. ways in which m/p changes could deviate from m/w changes, in such a way as to upset the potential desired effects of an employment increase. E.g. profit variation seems like one of them. My guess was that “marginal prime cost” was a general category of such leakage having something to do with what would be classified as “cost of goods sold” in a modern income accounting statement – something like your example of shovel rental cost – but maybe that’s not it at all.

I look at the GT only once in a while; it’s too exhausting otherwise, especially for a non-economist. But every time I do I see the same theme in all cases - the fallacy of composition. Isn’t that what a lot of macro is about?

Nick,

Quoting you:


My understanding and memory of Marc's models may be a little hazy. With that proviso:
1. There is a distinction between automatic stabilisers preventing (real) AD falling without limit, and automatic stabilisers restoring AD back to full employment to stop the deflation.
2. The main destabilising channel in the models I'm talking about is the effect of expected deflation on real interest rates for a given nominal interest rate. I don't think Marc's models have that channel??

I think Marc's models are too behavorial to be simplified like that. Automatic stablizers put a floor to the process - both AD and deflation but as the fiscal deficit widens and the public debt increases, governments go into a fiscal austerity mode and by itself the process does not lead to full employment. The new "steady state" has lower employment. Lot of it also depends on the severity of the fall. I wouldn't call it a defect of the model(s) but in fact the correct depiction of reality. The government has to take (ultra)active fiscal measures to get to full employment. His collabrator Wynne Godley wrote this article "Prospects for the United States and the World: A Crisis That Conventional Remedies Cannot Resolve" http://levy.org/vdoc.aspx?docid=1109 in Dec 2008. I like the title.

JKH: When Keynes was writing, the fallacy of composition was a big part of his argument. It's a part of the micro/macro distinction, but I think the importance of monetary exchange, and the idea of effective vs notional demand are important parts of the GT (and macro).

It's hard to read the GT, even with a strong macro background.

I think the case for a (roughly) 1:1 relation between W and P in this context is pretty strong. Because all the forces operating on W should also be operating on other costs of production too, either directly (if those other inputs suffer from unemployment too), or indirectly (from the effect of falls in W and P). If you think about (real) interest rates as a cost of production, and a component of Marginal Cost, that would complicate the analysis, but has the same overall effect on demand for the ultimate resources, like labour, as the effect of expected deflation on real interest rates on the demand for output.

Keynes discusses marginal prime cost in GT, Appendix to User Cost, Section 1, and elaborates in Footnote 7.

I think the flaw in the standard models is in the formation of deflationary expectations and that these could reach totality. It is hard to believe in the end of civilization indefinitely. More interesting is a critique of M/P. If you were becoming wealthier at an increasing rate, you would be more inclined to delay, but while sellers may be willing or forced to sell inventory below cost, they are not likely to produce below cost, so eventually price declines reach a limit of wage declines and at best M/P increases at this rate. The duration of the production cycle would throttle the rate of decline. At this point, there is little more incentive to delay. If prices fall, wages also fall, and attempts to save more fail as they do so. In this case, it is not rising M/P that turns deflation around but that the increase in M/P maxes out, or equivalently, that real wages cease to increase, not their rise.

"Nick Rowe argues that the neo-Wicksellian approach of much modern macroeconomics — by which he means the tendency to define monetary policy in terms of the choice of a short-term interest rate — leaves economists ill-equipped to think about monetary policy once interest rates have hit the zero bound."

http://krugman.blogs.nytimes.com/2009/03/03/hey-who-you-callin-neo-wicksellian-wonkish/

"You can always add money to the model, if you like, by adding a money demand function. But it doesn't do anything. The quantity of money would be demand-determined, by whatever amount people want to hold at the rates of interest, prices, and incomes determined by the rest of the model. Money is a fifth wheel: an epiphenomenon. You could delete it from the model without anything else changing."

http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/03/the-return-of-monetarism.html


Nick "In that approach, the central bank sets a nominal interest rate, and that interest rate is what is meant by "monetary policy". And in this regard there is no difference between the Neo-Wicksellian orthodoxy and, for example, Post-Keynesians and other "horizontalists". The stock of money is an endogenous variable, and plays no causal role in determining aggregate demand."

How do you define a "horizontalist" and the 'stock of money'? Someone that believes in a horizontal LM curve and therefore only believes in 'horizontal' money expansion - bank money assets/liabilities which net to zero?

This is how a PK would define a 'horizontalist'.

Yet a PK also believes 'vertical' money, government issued money, is endogenous and plays a causal role in determining aggregate demand, especially during times of a deflating price/wage level. A PK sees government, bank, and nonbank money as separate yet linked entities.

It would be more accurate to call PK's 'verticalists' that understand the limits of horizontal bank, nonbank money expansion.

"If this stylized analysis bears any resemblance to the real problem facing Japan, the policy implications are radical. Structural reforms that raise the long-run growth rate (or relax non-price credit constraints) might alleviate the problem; so might deficit-financed government spending. But the simplest way out of the slump is to give the economy the inflationary expectations it needs. This means that the central bank must make a credible commitment to engage in what would in other contexts be regarded as irresponsible monetary policy - that is, convince the private sector that it will not reverse its current monetary expansion when prices begin to rise!"

http://web.mit.edu/krugman/www/japtrap.html


The 'simplest' method boils down to scaring people into dissaving thereby increasing the monetary velocity without distinguishing between bank and government issued money.

Krugman does think government issuing money might help solve the AD problem though doesn't say how. Post-Keynesians don't see any other long-term viable way.


Winslow: By "horizontalist" I mean someone who sees the LM curve as horizontal, who believes the money supply (both commercial bank money and central bank money) is demand-determined, and therefore plays no independent causal role (once interest rates are specified).

In Krugmans' model, if we believe that the economy will be out of the liquidity trap in future, due to some exogenous shock or deus ex machina, then a commitment today to have looser monetary policy in the future will mean a higher price level in the future, which increases expected inflation today, which lowers the real interest rate today, which increases AD today.

Nick "By "horizontalist" I mean someone who sees the LM curve as horizontal, who believes the money supply (both commercial bank money and central bank money) is demand-determined, "

PK's see the transformation between long-term CB/gov money and short-term CB/gov money as demand-determined.

PK's see the 'supply' of central bank money as politically determined as its creation is limited by government deficit spending. This is where you misrepresent PK's viewpoint.

Nick"In Krugmans' model, if we believe that the economy will be out of the liquidity trap in future, due to some exogenous shock or deus ex machina, then a commitment today to have looser monetary policy in the future will mean a higher price level in the future, which increases expected inflation today, which lowers the real interest rate today, which increases AD today."

Isn't an 'exogenous shock or deus ex machina' too arbitrary/ill defined for a useful theory?
PK's would replace these things with something understandable if not politically feasible, increased government deficit spending. Yes some exogenous shock might temporarily allow the economy to recover (export boom) allowing for a horizontal expansion, but eventually, without sufficient deficit spending to match net savings (sufficient vertical expansion), it would fall into a deeper slump.

If we see inflation we will need a sufficient vertical contraction.

Nick Rowe:

"Min: it's the existence of currency that puts a lower bound on nominal interest rates. If interest rates fell too far below zero, people would just hold currency instead."

Yes, which is why I said that philanthropists, parents, or the government might do it. ;)

By "do it" I mean lending at negative rates. :)

Phew! I was worried that we might be getting entirely the wrong sort of traffic...

To respond to your response of my response:
Price deflation by itself is a very bad way of looking at it, Nick, price deflation by itself covers up a lot of important micro variables that in aggregate behave very differently from each other.

In the case of computers, no one buys the latest model except the early adopters. They pay a higher price than everyone else and have to deal with more bugs. Yes, some people put off their purchases, but no one does so indefinitely, because at some point the marginal benefit gained by waiting, is lost by missing out on the technology along the way.
So you have people that buy a new computer every year, some that wait a couple years, some 3, and so on.

The Keynesian view assumes that humans have constant time rate discounting, which is not only unphysical, but constant time discounting is very irrational when multiple time-changing variables are being considered.

Nick Rowe: "yes, the significant deflation in computers is a good example. But don't you think that some people postponed buying because they figured there'd be a better cheaper model next year?"

Well, I was one. I am only retiring my 10 year old laptop because it is finally falling apart.

A few questions and comments:

1) With persistently falling computer prices, how come the $1,000 line held for so long?

2) Software provided, and provides, planned obsolescence. For a while there was backward compatibility, but now new software usually requires new machines, and vice versa. This is a well known tactic, and was probably made easier by the monopoly power of Microsoft and Intel.

3) In terms of expectations, if you expect prices to go down next year, then it makes sense to postpone the purchase. But if you expect persistently dropping prices, next year will be like this one. You might as well buy now. (Your choice is no longer now vs. next year, but now vs. never. There is a similarity to an all pay English auction. If you bid at all, you only bid once.)

Thanks for your response to my comment on the previous post, Nick – about the shape of the AD schedule. Actually, on reflection, even if inflation expectations are held fixed, I think that an ISLM type model is not suitable to answer the question you pose in the title of that post, because the LM curve is designed to describe a stock relationship, whereas your question – about accelerating deflation or inflation, is essentially about dynamics. Adapting the LM curve to interest rate targeting – ie a horizontal line – misses something, because in practice, a central bank supplies money by buying debt, and, even if the capacity of the central bank to buy debt is infinite, the pace of the supply of debt is limited (unless the central bank is trying to set an interest rate less than the interest rate on money, in which case, in the absence of increasing inflation expectations, there is a liquidity trap). This debt supply restriction can be overcome if the central bank effectively "prints money" by financing the infinite expenditure of a desperate government, which is why hyperinflation can occur. In a deflationary situation, on the other hand, the capacity of the central bank to hold its target interest by selling debt is not unlimited. This explains the asymmetry, I think.

In the past, academic economists have been able to ignore the practicalities of monetary policy implementation because of the relatively small scale of the operations involved, but the financial crisis and the authorities’ response to it is revealing the weaknesses of this abstraction. In the wake of the crisis, as Borio and Disyatat remark in their excellent paper, "monetary policy will probably never be the same again".

Nick, the black holes you're talking about are absolutely NOT predictions of the class of models you refer to. Therefore the lack of them in reality says absolutely nothing about the validity of the models.

The inescapable black holes are predictions of the linearized versions of the models but not predictions of the fully specified non-linear models. The linearizations are explicitly intended to be LOCAL approximations and although this is often not stressed in papers written for insiders, it is always implicitly understood.

In fact, in his book Woodford is quite careful to explicitly point this out.

Also Nick, just to flesh out my comment above this statement, "If it does escape, it can only escape via the effects of an increase in M/P", is flat out wrong.

The whole problem with the liquidity trap is that raising M/P does absolutely nothing to stimulate activity, and this is true whether it happens via M going up or P going down. Otherwise the trap wouldn't be a trap. (I'm talking about the standard model there, as were you, Bernanke-Gertler type effects are important but different).

Their is an automatic escape from the trap eventually, it happens when depreciation has depleted the capital stock to the point where the marginal product of capital has risen enough that firms invest even with the real rate stuck too high.

Adam: I have been thinking about your first comment, trying to wrap my intuition around it, but failing.

Forget the distinction between real and nominal interest rates, for a minute. The IS may be non-linear, but that doesn't seem to matter, since the only point on the IS curve that matters is were r=0. That point then defines a vertical AD curve in {P,Y} space. If that vertical AD is to the left of the equally vertical LRAS, the price level falls to zero, eventually. Re-introduce the distinction between real and nominal interest rates, with any sort of adaptive expectations mechanism for inflation (adaptive expectations seems much more realistic than RE in this sort of circumstance, where the event is novel, so people haven't had time to learn RE) and it only seems to make things worse.

I see your point about capital depreciation. That makes sense. Over time, the IS would shift right, and the LRAS shift left too. Whether they could shift fast enough to meet before people resort to barter is an open question.

"The whole problem with the liquidity trap is that raising M/P does absolutely nothing to stimulate activity, and this is true whether it happens via M going up or P going down. Otherwise the trap wouldn't be a trap. (I'm talking about the standard model there, as were you, Bernanke-Gertler type effects are important but different)."

We are on the same page here. I was making the same point about the equivalence between raising M/P via increasing M or reducing P. But then if falling P eventually helps us escape the "whatever" trap, why can't increasing M do so too? If we *define* a "liquidity trap" as one where M/P has no effect, then of course M/P has no effect. But then we can just change the question to: "Do liquidity traps exist?", or, "Is i=0% a sufficient condition for a liquidity trap?"

Or, just revert to Doc Merlin's question: even if the standard model can indeed eventually escape a deflationary spiral, the lower bound on nominal interest rates must make it harder to do so. So why are inflationary spirals much more common empirically than deflationary spirals?"

Nick, let me take things in reverse order. The answer to Doc Merlin's question is, I think, quite obvious and is well handled by the fiscal theory of the price level (so we are now not talking about the models you had in mind but a non-Ricardian regime, I'm free to switch context because the question is about the data and not the model).

If governments behaved in a globally Ricardian way then what they would have to do in a deflation was raise their future surpluses to justify the higher real value of their outstanding debt (which includes the money stock), if they did this you would see deflationary spirals as the more valuable money got the higher it's expected real return would be, thus feeding the loop. But governments don't do this, if there is a deflation they don't raise future surpluses and so you have a situation where the higher is the current value of the debt the LOWER is it's expected real return, thus the spiral is damped out. All a direct implication of the fiscal theory (see Cochrane's "Money as Stock" paper).

Inflationary spirals on the other hand are when future surpluses are too low, a situation more common and which the government in question usually can't do anything about. (Sargent's four big inflations paper makes this point starkly).

Have to step away for a minute, will get to the linearizaton queston in a bit.

The non-linearity point is related directly to the point about the marginal product of capital rising to meet the real rate and arresting the spiral. In the full model this will always happen because as the capital labour ratio goes to zero the marginal product of capital goes to infinity. Thus, in the full model there will always be a point where the marginal product of capital will meet the real rate and stabilize the model.

In a similar mannner marginal utility of consumption usually goes to infinity as consumption goes to zero, again arresting the spiral.

Of course, in the log-linearized model the marginal utility of consumption is constant at its steady state value as is the marginal product of capital and thus the spiral would never stop.

PS: the fact that the marginal utility of consumption goes to infinity as consumption goes to zero is important because it ensures that some labour will always be supplied, avoiding the labour supply going to zero at the same rate as the capital stock.

The last point is a subtle one and comes from Krugman's work (he was making a slightly different point). The rate of deflation is bounded, there is a maximum rate of deflation that the economy will deliver (even with flexible prices) and this prevents the real rate from going to infinity and guarantees that at some point the feedback loop stops.

Nick, just thinking a bit more about this I think we need to be careful to distinguish the price level determinacy problem from the escape from liquidity trap problem.

In the self-fulfilling inflations/deflations that make the price level indeterminate in the globally Ricardian models the real rate need never change. The deflation (say) happens because as inflation falls, interest rates are lower according to the taylor rule but expected inflation falls also by an amount that leaves the real rate unchanged. Nothing real changes, there is no recession, it is just that the CB can't control the inflation rate.

But the thing is, it's the assumption of a GLOBALLY Ricardian regime that is causing all the problems (this is Cochrane's point), the deflation only continues because the government is assumed to raise future surpluses as the real value of it's debt rises. The thing to notice (and Woodford points this out in his book) is that because of this property of the globally Ricardian regime the same thing could happen in a quantity theory model (operating through V of course).

On the other hand, the issue of whether or not an economy ever escapes the liquidity trap on its own is different, here there is a recession because the natural rate is negative but the real rate is stuck above zero, thus consumption falls to reconcile marginal utility growth with the higher real rate and investment falls to match the marginal product of capital to the higher real rate.

The problems come from the investment side, reduced investment doesn't reduce the capital stock, only its growth rate. Thus lower investment doesn't immediately reconcile the marginal product of capital with the too high real rate, only once the capital stock has depreciated to a low enough level does investment begin again.

The magic comes from the shrinking capital stock, one of the many equivalent characterizations of the natural real rate is as the marginal return to capital investment and so as the capital stock shrinks (through depreciation) the natural rate rises. Eventually the natural rate will turn positive again and the trap will be broken.

At that point full employment is restored but not though an increase in consumption but because the marginal return to investment is high enough that investment demand soaks up all of the savings.

The point though is that, since this all happens in a predictable fashion, agents with rational expectations know it eventually will and so that prevents expected future consumption (for times far enough in the future) from falling in lockstep with current consumption and preventing the spiral from finding a bottom.

Again though, this is distinct from the self-fulfilling deflation that is entirely a product of the global Ricardian assumption and can happen with no real effects whatsoever.

That said, my opinion of the real world is that it just can't be globally Ricardian and so the answer I gave to Doc's question is the one I think is most empirically relevant.

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