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The post makes some good and clarifying points.
I think it could be restated a different way: if you have an existing monetary target, monetary policy is not free to serve a different target related to the government budget.
When I think of the phrase "money financed deficits" I think of one of two things:
1) Inflation hawks who fear that central banks will abandon their targets to help out a government unwilling to shrink its deficits
2) Proponents of simultaneous fiscal stimulus, who argue that the central bank will have more efficacy in getting NGDP back to target if the fiscal authority agrees to an increase in deficits while the monetary authority buys government bonds. So "money financed deficits" are a flavor of helicopter money.
Not sure this post addresses either. Maybe you were referencing someone else's writing - if so would appreciate a link.

louis: this post (indirectly) addresses both your points. I am asking how much of deficit spending will in fact be helicopter money?

Simon Wren-Lewis had a good post answering my "silly question for anti-austerians". Simon mentioned money-finance. In comments I started to do some back of the envelope calculations, and this post is a continuation of my comments. But it's a more general question, and this post isn't directly a response to Simon. Nor, more generally, a response inflation hawks or to MMT guys. We need to think about this anyway, and try to get our heads straight.

If I were a troll, I would have made the title "Can MMTers do arithmetic?" But since I'm bad at arithmetic myself, and have probably gotten something wrong, that would not be a very prudent title.

Got it. I feel a little dense for missing that.
Thanks for pointing me to Simon's post. He seems to be thinking more in terms of the CB as a backstop to the government (to take out the possibility of default), in the vein of Draghi's "whatever it takes" rather than his QE program.

You conclusively show that if a government wants to finance deficits by issuing currency, it loses control of NGDP under all but the most special of conditions. So we lead with monetary policy. Fiscal deficits are independent of monetary policy, unless the market is unwilling to finance new gov't debt issuance. And the only question is how long it takes monetary policy to close the output gap by itself, vs how long it takes with some level of temporarily elevated deficits.

But the economy will not get rid of reserves by itself. To "unwind" from QE requires paying interest on reserves up until the normal currency demand causes those reserves to shrink to zero (we can assume we are Canada, with effectively zero reserves).

But the central bank has to pay interest on reserves with more reserves. Currency demand grows, in real terms, at a rate of g. The interest on reserves that the central bank pays grows, in real terms, at r. Are you assuming that r > g? Why would NGDP outgrow the reserves?

In other words, the CB has to "pay back" the reserves in exactly the same way the government has to "pay back" debt. You have to raise taxes (or don't raise taxes, depending on r and g).

So the total costs will be the same, whether deficits are money financed, or bond financed, at least to first order, regardless of whether or how long we keep the excess reserves/excess debt after rates become positive.

I have a clarifying question.

Your point 1 discusses a CB targeting NGDP. Your point 2 and 3 then discuss NGDP being temporarily or permanently affected by a govt deficit. Is the CB still there in 2 and 3 trying (but failing) to hit the NGDPT ?

If no: then how does the stock of money increase in the bond financed cases of 2 and 3 if there is neither govt money printing or CB asset swaps to change the supply of money? You say 'Assume that the demand for currency is 5% of Nominal GDP' but if there is no mechanism for adjusting the supply of currency then this implies that NGDP is just fixed at 20 times M.

If yes: Then why is monetary policy not offsetting the affects of the deficit spending ?

^^In the above, the last sentence should be "the total costs, in terms of future taxes, will be the same whether deficits are money or bond financed". Namely, 0 if r < g, and positive if r > g.

..and if we were to add some realism to the model, then it will always be cheaper to sell the most bonds that you can, because currency demand does not grow as fast as GDP due to increasing use of electronic payments. E.g. the medium of exchange aspect of money can largely (but not entirely) be done more efficiently by the private sector, whereas the issuance of risk free debt can only be done by the Government. The government's fundamental monopoly is the ability to issue risk free debt in the unit of account, and the government's potential earnings in terms of exploiting this bond monopoly (say by selling risk free debt and purchasing private sector bonds) are much greater than its potential earnings from exploiting its currency issuance monopoly even though one derives from the other.

..finally, it means we have to worry about the future tax burdens of printing money (if r > g), because the government will need to tax that money away in the future. :P

I'm trying to think through the differences between simply telling the central bank to target a higher level of NGDP, and hitting the higher level by either running money , or bond financed deficits.

Assume there is a stock of interest-bearing bonds and interest-free cash issued by the govt and they can give away (and tax back) money whenever they want. At any given interest rates they will allow people to swap money for bonds with no restrictions. Assume that the more money in the economy the higher NGDP.

There are 3 choices to increase NGDP

1) Just give away money
2) Sell bonds for money, then give the money raised away
3) Buy bonds for new money and get more money and less bonds in the economy.

It appears to me that 2) is a combination of 1) and 3) in reverse , since to get people to hold the new bonds you will need to increase interest rates to a higher level than if you just gave the money away. In effect you are reducing NGDP by selling bonds, then reversing that tightening by giving away the money raised to boost NGDP.

So I think this means there are only 2 ways of increasing NGDP A) by giving money away or B) by getting people to swap bonds for new money.

This leads me to the disturbingly MMT conclusion that the only reason to sell bonds when you are aiming to increase NGDP is to increase interest rates above what they would be if you did any combination of A) and B).

What is wrong with my logic ?

Sorry I can't stop myself! You also have the same crowding out effect. E.g. to the degree that bond financed deficit spending crowds out private savings, money financed deficit spending does too -- i.e. households reflux unwanted deposits onto the banking sector but at the expense of a decrease in net interest income earned by the banks (which now have to hold excess reserves rather than interest bearing bonds on the asset side). This increases the wedge between the premiums paid by private borrowers and the interest income received by private savers, effectively requiring a higher equilibrium rate to compensate savers for holding the same quantity of (non-govt) savings as they did before the money was printed. WooHoo!

^^^ That's not right. Sorry! In a zero rate environment, assuming only bills are sold, there is no difference in yields between the deposit and the bill. In a higher rate environment the CB has to pay interest on reserves and still there is no difference between the bill and the deposit. Really the bank interest income issues become more relevant when you are talking about longer maturity debt, and to whether flattening the yield curve a bit by purchasing longer maturity debt really results in lower rates paid by borrowers (no) or lower rates received by lenders (yes). My apologies.

Still, I don't see much difference between bond or money finance. If you think high NGDP will save you, then you might as well argue that debt can be inflated away. It's basically the same argument, with the same counterarguments, and not much relevance for whether money financed spending incurs lower future taxes during the recovery than bond finance spending.

FWIW, I think that the main difference between debt financing and currency financing is psychological and, hence, political.


This post has got me totally and completely baffled.

You say “If the central bank targets NGDP, then 0% of a deficit will in fact be money-financed.” Why? As you yourself say, a deficit can be funded by bonds or money. If government aims to expand NGDP by say 4% a year (the sort of target normally advocated by NGDP enthusiasts), a deficit will be needed to do that: either a bond funded one or a cash funded one. You seem to assume it’s a cash funded one. But then you say “0% of a deficit will in fact be money-financed”. I’m lost.

Next: “a deficit has no effect on NGDP, by assumption..” First, where was that assumption made? Nowhere that I can see. Second, deficits do in fact have an effect on NGDP: that’s the WHOLE POINT of deficits, isn't it?

Next: “a deficit has no effect on NGDP, by assumption, and so has no effect on the stock of currency, by assumption.” But a money financed deficit “by definition” DOES INCREASE the “stock of currency”, unless I’ve completely lost contact with reality.

And that’s just two sentences near the start of the post. To deal with the rest would take me all night.

MF: I have left it implicit or ambiguous in my examples (except 1) what it is the central bank is targeting. I have just assumed that fiscal policy has the sort of effect that its supporters say it does. It is really up to the supporters of fiscal policy to answer those questions. But, trying to put myself in their shoes, we can perhaps imagine them thinking that monetary policy cannot work for a short period, so we need fiscal policy to get the economy rolling, after which the central bank takes over again. (But if the economy were at the ZLB originally, my case 2 would not be right, because interest rates on bonds would be even lower, so my estimate would be too high.)

rsj: "But the economy will not get rid of reserves by itself."

You are starting to sound like a hot potato monetarist! I like it!

Think about Canada, where reserves are very close to zero. Base money is currency. If people don't want to hold it, because the currency/NGDP ratio is higher than desired, then either: they spend it, driving up NGDP; or else the Bank of Canada buys it back, in an OMO, to prevent NGDP increasing.

Ralph: in my case 1, I am assuming the central bank can and does 100% offset any effect of fiscal policy on NGDP. In cases 2, 3, and 4, I am assuming it either cannot or chooses not to do 100% offset, so that fiscal policy works like the fiscalists say it works.

Currency is demand determined and does not pay interest, quantities of reserves are set by policy but must pay interest (if there is a positive interest to be paid).
There is no difference between issuing bonds paying r or issuing reserves paying r. You still pay r on the total of bonds + reserves. the total tax obligation is the same, ricardian equivalence considerations are the same, "future generations" considerations are the same, etc. Reserve-financed deficit spending is equivalent to bond financed deficit spending.

So perhaps the real question is, given a central bank that already has liabilities 100x the size of its capital, can you imagine any situation in which it's better to just go ahead and reduce the size of its balance sheet or do you blindly push on with more QE in a functional finance approach that ignores the burdens placed on future generations as a result of such massive central bank debt?

...and it sure, it might be easy for the central bank to have such a big balance sheet now, when rates are so low. But what will happen when rates go up? Then the central bank will be faced with a real crisis. It will need to turn to the Government to fiscalize some of that debt. But how much will the Government need to fiscalize in order to bail out the bloated central bank?

OK, that's enough fun for the moment. I wrote a blog about it! https://windyanabasis.wordpress.com/2015/03/10/money-financed-deficits-have-the-same-future-tax-obligations-as-bond-financed-deficits/

rsj: I'm not 100% sure, but I think the MMT guys will be really after you now!

Nick, I think this is consistent with their understanding of how things work.

Govt costs are financed by 1.borrowing or 2.the printing of 'money' - clearly as a means of avoiding taxation at that time.

1. Borrowing prints up a legally-enforceable obligation of the govt to another party and transfers a wealth/asset to a holder of the asset and the cash given up by them to obtain the bond is used to cover the costs incurred by the govt. (Ignoring timing matters and transaction costs too). The economy sees a net zero in terms of money being in the economy as the bond holder would have taken their money and given it to the govt who turnstiles it out to cover its costs.

2. Printed-money is transferred directly to cover the costs incurred by the govt, paying payroll, contracts, rents, suppliers, contractors, grantees, other lawful recipients. Here the money adds to the money supply at that time, though the 'money' only runs through the hands of these payees.

In 1, an asset is established on accounting books outside the govt. and the cash withdrawn from the economy and obtained by the govt re-enters the economy on a permanent basis via the payees. The govt needs to pay interest and the principle on the held asset, and when it does this, it must again find the cash somehow that it transfers back to the owner of the asset at that later time (assuming these are lumps). At this later point the principle and interest amounts are added to the money supply, permanent then. This logic indicates that deficit spending that is financed by borrowing has its greatest influence on money supply effects in a subsequent period, not in the period in which the initial borrowing takes place.

In 2, printed-money enters the economy on a permanent basis and the money supply and aggregate demand effects occur at the time the govt's costs are paid (there is no net zeroing of the money as none is provided by an outside entity).

I have not mentioned a thing called a central bank; thinking about their set of books with the banks just complicates this. How a central banks bookkeeping is affected ought to be a separate thread, it seems to me.

In point 1, borrowing-based financing, the public's debt increases (principle and interest due). In point 1, new/added money MAY enter the economy when the debt instrument is retired/paid-off, which is a future time, and via the bond owner's subsequent use of the money repaid. Point 1 avoids taxation then, serving one purpose, but it may not help aggregate demand at that time except via the wealth effect for the group who purchased the debt or if the govt's payees have a higher propensity to spend then the un-taxed buyers of the bond.

In point 2 the public debt does not increase, and there is no wealth transfer result either, and new money enters the economy then; none is taken out at the time like in 1. so it increases money in the economy at that time, not in the future.

The purpose of non-tax financing schemes is, of course, to avoid taxation. But it may also be intended that the govt add money into the economy to assist in supporting a gap in aggregate demand (AG). AG support is most seen, obviously, if the govt spending is above expected trends, not 'austerely' below expectations (in the Keynes sense this ADDED spending is replacing the spending that has been curtailed elsewhere in the economy).

From a simple money supply standpoint future taxation pressures are the same, the govt can remove money from the economy if this is needed - by selling an asset (like oil reserves) or by taxation in the future. It isn't the same pressure on future taxation though, if you recognize that public debt obligations will need to be paid eventually They are legally enforceable obligations to pay. On contrast, helicopter money (of reasonable amount), point 2, since it is NOT debt places less pressure on taxation policy in the future (while it support AG in the time period of the govt activity and it avoids taxation then). If the economy grows well, it may be that future taxation is not needed to remove printed-money because the economy in the future actually needs money of this magnitude to flow. You can't exactly say the same thing about public debt held privately.

If the purpose is to avoid taxation of the wealthy you can see that this group likes the borrowing scheme better than helicopter money. You may still want to do that if you feel you need the cash in order to fuel AG. If the more important purpose is to pump aggregate demand, and you still want to assuage the wealthy, then it is clear that helicopter money is quite the better approach (even for the wealthy it avoids taxation at that time while the economy's stable growth may mean taxation isn't needed in the future either).


Well, banks are kinda important since the CB is the one financing the deficit no?

In any case, you can't assume irrational behavior here. If you get an unexpected windfall you don't rush out and spend it, you spread the spending over your lifetime to smooth consumption, and you deposit the rest in the bank. Now banks have excess vault cash which is turned into excess reserves. That means that the surplus cash lending rate falls to zero. Yes, you get inflation (assuming the natural rate was above zero before the cash drop), but you get the inflation because interest rates are too low -- e.g. you would get the same inflation if the government, not dropping any cash or bonds at all -- just lowered interest rates to zero and walked away.

But that type of cash drop is not being proposed here. What's being proposed here is deficit spending followed by QE, with the government still in control of interest rates and desiring to raise them to the natural rate when the natural rate goes up. Sure, debts can be inflated away and, what is equivalent, excess cash can stop being excess when NGDP shoots up. That type of inflation can be thought of as a tax, an inflation tax, which can be applied to whether the government does or does not money-finance a deficit. It's properly a third term that we should call "inflation-financing" the deficit.

But if the government's goal is to stimulate the economy but continue to limit inflation to its target, then it will need positive interest rates which means it pays interest on reserves. Once you are paying interest on reserves, there is no difference between reserve-financing and bond-financing a deficit. Both have the same future tax obligations.


This reader's observation is that when government borrows from either the Central Bank or the private sector, the product that government gets is MONEY. Both sources give government the same thing!

With money from either source, government can pay it's bills. NGDP will be enhanced equally when government borrows from either source, at least so far as government spending enhances NGDP.

Now there is a huge difference in how a Central Bank obtains money to loan and the way the private sector obtains money to loan. The Central Bank can 'print' money but the private sector must 'earn money'.

All monetary effects on the economy flow from the differences in these two ways of funding deficits.

Money finance can be viewed as a commitment not to default, since as long as money is legal tender, default isn't possible.

rsj refers to the CB as the one financing the deficit. I think some of these discussions are more focused on rationalizing the role of a thing called a central bank that is not a govt agency, and understanding the dance of its mechanisms related to the non-central bank financial institutions. It would be simpler to discuss these things without considering the existence of a central bank as people spending time on accounting identities reflected in the bookkeeping instead of the reality. Roger Sparks hits it, the govt prints (it's the Mint) while the non-govt sector "earns" the money used to purchase govt bonds and this withdraws the money from the economy at the time of purchase (unless it is permitted to use endogenous money creation, so the money is electronically added to the bookkeeping of reserves - and this is a Ponzi-like matter, isn't it, and I hope it is unlawful?).

Also, in the US finance laws, the public debt issuances are NOT bought directly by the FRB, as I understand it, the FRB buys from a private entity who is the first buyer (using earned money, hopefully).

But there is a central bank in the US. Clearly, if the US Treasury when confronted with a bill to pay could simply direct the Mint to pay the bill, the central bank would not necessarily know this cash-management practice would have happened (except they would probably be told so they can manage statistics on money supplied, compared to money in required and in excess reserves, for instance). That would be helicopter money, this does not involve a central bank in the payment processes or its accounting books.

In comparison, when the FRB directs the printing of new money, so to speak, it is doing this under the laws of US Finance along with private entities with whom they share a system of bookkeeping of the amounts, recording liabilities and assets among the parties. That is not the same type of helicopter money that Keynes or Freidman envisioned I believe (this is described in the paragraph before). A central bank permitted by law to buy bonds direct from Treasury would be employing helicopter money to "finance" the purchase; but they are not permitted by law, so a discussion about helicopter money versus borrowing-finance ought not really involve the FRB in the discussion. But if the thread is more about the bookkeeping mechanisms of the central bank, that is what the thread should be about, not helicopter money.

Clearly, borrowing-finance, instead of taxation as the source of cash, deserves a whole lot more attention, as it is not clear to me that people understand that it draws earned cash out of the economy (thanks Roger Sparks for the terminology) when the private interest buys the bond first, but then the private interest nets close to zero in terms of money supply for those parts of the debt that is then purchased by the FRB, almost simultaneously. In the meantime the earned cash transferred to buy the debt originally is used by the recipient govt to finance costs in the current period. The lender of this earned cash, and these are already-wealthy persons predominantly, avoids a tax bill and then holds an asset (this is a doubling of their change-in-wealth position, which is why they like this scheme of govt financing). The FRB apparently must offer IOER to the banks to get them subsequently to sell some of the debt positions issued by Treasury to the FRB, reducing the earnings the FRB can transfer to the govt (raising additional costs to the financing using this method).

I am not assuming irrational behavior, but I think that a focus on reserve-system bookkeeping has made it hard for economists to see that borrowing-finance is absolutely a wealth transfer, increasing the economic capacity of the already wealthy, but helps AG in the period of interest ONLY because the govt's payees spend at higher rates than the already wealthy buyer of the bonds, who would simply have banked the excess portfolio-money. This scheme shifts taxation to the future (which may be ok in some downturns of significance, though tax cuts for those of lesser means would be a much better thing to do then instead). If the cash were raised via taxation of the wealthy, AG would have been seeing the same effect, as payees get the cash and spend the money differently than the already wealthy (in essence, tax-financing un-idles wealth converting it to income of greater economic value, hopefully). But tax-financing does NOT transfer wealth to the already wealthy. Borrowing-finance, instead of tax-financing via higher taxes on the already wealthy, is nothing but a wealth transfer scheme and a tax avoidance scheme. (I am ignoring foreign purchasing of US bonds in this, and the story is different for their purchasing, and probably a reason to structure some kind of sales to foreigners. And also consider the UK Exchequer's new 4% bonds for retirees to buy, and apparently only for them to buy - clearly an instrument for pushing AG, and for other reasons, including the no-taxation goal.)

I've been involved in public finance for 40 years, even testified in Congress several times - what am I missing in my aged condition?

In the US Congress of 2017, new Finance law enactments can come with more rationality to them, it seems to me (and one of the new provisions might be to allow the Treasury to perform helicoptering within narrow statutorily-defined channels, another might be to permit the FRB to buy direct from Treasury with the authority to erase the book-entry whenever economically sensible to do so, as determined according to statutory direction). Interesting to consider these as counter-factual mechanisms, isn't it!


Suppose the government borrows $100 at 5% interest, to finance a deficit of $100. It sells a $100 bond to the public and pays $5 per year interest to the public. Now suppose the central bank buys that $100 bond from the public, by printing a $100 note that pays 0% interest. The government now pays $5 per year interest to the central bank, which means the central bank has $5 per year profits (minus costs of printing the $100 note, which I will ignore). But since the government owns the central bank, and gets all the central bank's profits, the central pays that $5 per year right back to the government.

It is exactly as if the government just printed the $100 note to finance the deficit. (Except most central banks are independent, to some degree, and can decide themselves whether or not to print that $100 note.)

Yes, but I would say:

1. Government borrows $100 at the rate set by the CB, in this case 5%.
2. CB buys $100 bond.
3. There is no $100 more in excess reserves
4. Therefore rates drop to 0%, not 5%.
5. CB pays interest on reserves of 5%
6. Rates go back up to 5%, but now there is no difference, in terms of cost to the government, between reserve and bond financing.

So the cost is always determined by the time path of interest rates. E.g. the government could have sold a bond for $100, and then the CB could have lowered rates to 0 without buying the bond. Now the government pays no interest on the bond (it is as if the deficit was monetized).

So it doesn't matter how the deficit is financed. What matters is the time path of interest rates.

As for seignorage income -- the flow of bonds that the CB can buy without creating excess reserves -- this income can be applied to pay for either bond or reserve financing expenses, or can be used to fund other spending. It doesn't matter, as the govt. gets seignorage income in all cases. So ignore seignorage income. The amount of seignorage income will be determined by inflation which will be determined by the time path of interest rates. The amount of future tax obligations will also be determined by the time path of interest rates.

Nick Rowe, Thanks. You are justifying borrowing as a form of public finance.

From the books of the CB to the Treasury, yes, I understand either one can print the currency needed to pay the $5 (so to speak), and this nets to zero in the current period, from an income/flow standpoint. The thread was about comparing the need for the CB to buy the bond (it is from the public first) instead of the Treasury just paying the payee directly.

So the thread is really about borrowing-finance and rationalizing it (I'd say it is for some other reasons other than to get cash for warfighting demands and/or because revenues are now abysmal from a huge recession's effects, when govts scramble to get cash to pay bills).

In borrowing, the original buyer of the debt uses earned money to make the buy, taking the money out of their portfolio (where it would have sat somewhat idle, almost by definition of a portfolio of wealth/assets). This buyer get their cash back when they sell, plus any additional fees and interest associated with this sale transaction, selling to any one.

But you do understand that there is an asset on someone's books at that time, and this is trade-able, convertible to cash, usable as collateral, available to improve the economic capacity of the owner? This is the difference in borrowing-finance compared to direct-paying-helicoptering or tax-financing. Do you agree that wealth has economic significance (for the holder and in the aggregate), or do we only need to concern ourselves only with the flow related to the interest rate?

If FRB is the buyer, the flow with Treasury nets to zero until the debt reaches its term. The FRB can offer to sell a bond at any time, for "reserves" or for real cash when selling outside the reserve-system. Or they can lend it to earn profits (repos) or sell it at an apparent, market-loss as a front-runner to markets in order to exert influence on these markets. When the bond comes due, if not sold, the Treasury and FRB offset their electronic books so the principle of the bond is re-paid - we assume at that time that the govt is either using tax-finance to get the money for this, or new borrowing, or helicopters the payment, or maybe the FRB erases the book-position with concurrence of the govt.

Do you agree that borrowing takes money out of the economy, just like taxation? Do you agree that borrowing is represented on the books of a legal person as an asset? Do you agree that to the extent a person avoids taxation because money is borrowed instead of taxed that they are made wealthier at that time? Do you agree that a person uses their fungible wealth/cash freed up from avoided-taxation to buy another asset, such as the public's bond, that their wealth position has essentially doubled (the change is from minus $10 to plus $10 wealth)?

I guess I am just bothered that a focus on the interest rate amount and the books of the FRB with the Treasury is getting economists to talk a lot about rationalizing borrowing as a public financing scheme and missing something of great significance.

I'd understand if the only buyers of Treasury issues were non-residents and we were getting money returned to the domestic economy that had been held idly in foreigner's portfolios - that makes good sense. I'd understand that we want a public debt trading marketplace to stabilize for efficiency reasons and if we currently have a little tiny marketplace now doing no good for the govt or society in terms of helping to inform markets on classical interest rates terms , so we need more debt instruments for trading purposes - seeing this marketplace as a public good makes some sense to me (is this what Singapore is doing?). Of course, State and locals and provinces have long borrowed long in fairness to spread the costs of a long term asset across taxpaying generations who benefit it (roads, schools, bridges, etc.), traditional public finance.

Right now we already have a huge, global public debt marketplace that is highly liquid, lots of products to trade, and we also have incredible wealth in the US, Japan, UK, Europe.

Don't you think economists should be helping to rationalize people's understanding of tax finance - more than providing rationalizations for borrowing-finance postures in these wealthy, currency-issuing societies of such scale? Even Brad Delong said yesterday that he has to do some rethinking about wealth, value and fiscal matters - good to hear.

Oh, well. I very much enjoy the blog, it really makes me think, and maybe I'll get it clear in my head. Thanks again.

Totally Offtopic and feel free to delete this comment:

Can I put in a request to look at the Cochrane's "Doctrines Overturned" blog and the paper referenced therein? It was very confusing for me to read. It seems like he is telling the private sector: deposit your money at the CB and we will pay you X%, where X% is a high nominal amount, and then he assumes that in the long run, the real natural rate will converge to the real rate paid by the CB on reserves. I don't understand the convergence mechanism here, and I can't see where he models a natural real rate that could be different from the real rate as set by the CB.


rsj: I don't understand it either. It's that sign wars stuff again.

I'm trying to think about what would happen if we let rates stay too high. IIRC, Wicksell argued that banks would get reserve constrained and this would stop price increases, but what would stop price decreases? What is the current state of thought about the cumulative process for when rates are too high? Any references?

rsj: it's basically symmetric, except maybe for prices (and wages) being a bit stickier down than up. Nothing stops the cumulative process, in either direction (though stickiness slows the process).

Now, I'm confused. I thought Don Patinkin and Wicksell both argued that something would stop the process, but after all this Googling I can't find it, so perhaps I'm wrong.

Everyone is agreed that prices will spiral permanently and in an accelerating way? Wouldn't, for example, declining MPK or declining propensity to consume put a stop to things? Could there be some kind of overshooting that might bring you to an actual reversal?

What I'm trying to get at is that for nations that spend a long time at the zero bound, why is there no cumulative process observed? Price stickiness is one thing, but Japan has been at the zero bound for some time now.

rsj: the standard line is that if you hold something like base money (Patinkin) or the price of gold (Wicksell) fixed, that stops the cumulative process. But if the central bank allows base money/the price of gold to spiral up/down too, then nothing stops the cumulative process.

"What I'm trying to get at is that for nations that spend a long time at the zero bound, why is there no cumulative process observed? Price stickiness is one thing, but Japan has been at the zero bound for some time now."

That bothers me too, and we're not alone. And it's not just Japan. Part of the answer is that the BoJ (and other central banks at the ZLB) did not let base money spiral down to zero. Many made it increase instead. But it's still a puzzle why there wasn't more deflation than there actually was, given what looks like deficient aggregate demand. One answer (Paul Krugman's answer) is that prices and/or wages are stickier down than we thought they were. That might be true, but it still raises the question why they are stickier down than it looked like they used to be, because in the 1930's we did see some significant deflation.

My guess is that inflation targeting itself (though Japan and the US weren't explicit inflation targeters) made prices stickier. If you spend many decades where inflation stays roughly constant, it creates some sort of momentum where it won't fall much even if there is a shock. But that isn't a very good answer. But it's the best I can do.

And John Cochrane is (quite correctly) putting his finger on our weak spot.

That whole question is by far the biggest thing I have got wrong about the recent recession. Given the magnitude and duration of the rise in unemployment and apparent deficiency of aggregate demand, I would have predicted inflation would have fallen much more than it actually did. In Canada it didn't really fall much at all. In the UK it actually rose. It means I don't understand the Phillips Curve as well as I thought I did. I never thought I really understood it theoretically, but I used to think I understood it empirically, at least good enough for government/policy work.

And that's the main reason I have switched from supporting IT to supporting NGDPLT. Inflation has turned out to be a much poorer signal of excess/deficient AD than I thought it was.

How about coming over to the dark side of the fiscal theory of the price level? Interest rates are very low, so government debt has to be extremely money like. Because rates are low the economy is more non-Ricardian than in other times, so an increase in government debt should increase the natural interest rate more. We had very high deficits initially and these are falling as the economy grows. So while the nominal rate may have been fixed, the natural rate was moving in response to both the deficit spending and the improving economy. That is equivalent to the natural rate being fixed and the nominal rate heading toward it. During the great depression, we had tight fiscal policy and were at the zero bound and so there was great deflation.

Here is a very nice paper: http://www.newyorkfed.org/research/staff_reports/sr515.html

Say you are at the zero bound, and you run up a HUGE debt to GDP of long dated bonds. If inflation ticks up a bit, that corresponds to enormous capital losses, which has the effect of a rate hike. On the other hand, if inflation ticks down a bit, that corresponds to a huge capital gain, which has the effect of a rate cut. They show that under learning, there is a stable equilibrium due to the duration effects with almost no active management other than being sure to keep rolling the debt over with more long dated bonds. It's even better than having FOMC meetings, since they can save on the sandwiches. They also show other (more active) fiscal rules can stabilize inflation under learning, but the duration effect is the nicest one.

rsj: FTPL doesn't help resolve this problem. Assume FTPL is 100% true. AD is determined by expected future fiscal policy only. There's still a puzzle why we didn't see more deflation when AD appeared to be too low. This is a Phillips Curve/SRAS problem, not a "what determines AD?" problem.


I was asking how Japan can keep a fixed nominal rate for so long without some form of cumulative process. I think you're asking a different question -- what happened to the structure of the economy between 1929 and 2008. In the Great Depression NGDP fell by about 50% but real GDP by only 25%, with about 25% layoffs. Maybe the question to ask is why did unemployment go so high for such a small decline in NGDP (-2.7%) and a pathetic reduction in prices. Also, the time path of corporate profits and labor's share of income is very different now than in the Great Depression.

"A bond-financed deficit is where the government prints bonds to finance a deficit. A money-financed deficit is where the government (or the central bank it owns) prints money to finance the deficit."

How should the situation be described if the gov't issues a new bond for the deficit and the central bank issues new "money" to buy it?

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