Worthwhile Canadian Initiative

If you don't like low interest rates, you want the Bank of Canada to loosen monetary policy now

Two weeks ago I wrote a post "Monetary stimulus vs financial stability is a false trade-off".

My opening lines in that post were: "There's an idea floating around out there that I fear may be influential. And that idea is horribly wrong. Which makes it dangerous. And I want to try to kill it."

Today, the C.D. Howe Institute publishes a Commentary by Paul Masson "The dangers of an extended period of low interest rates: why the Bank of Canada should start raising them now".

That's the idea I was talking about.

If you are worried about the dangers of an extended period of low interest rates, the worst possible thing the Bank of Canada could do would be to start raising them now. Because if the Bank of Canada tightens monetary policy now, and this causes the economy to slip back into recession and disinflation, that would require an extended period of even lower interest rates in the future.

Now go read my old post. Update: and posts by Mike Konczal and Brad DeLong. Update2: and see how the Bank of Japan's looser monetary policy is raising interest rates on 10 year bonds (finally, now the bond market has woken up to the fact that monetary policy really has loosened).

Update 3: To see pictures of recent Canadian data, which illustrate my point here, see Marcus Nunes' post.

Update4: if you want a mechanical metaphor to help you understand the paradox here: the Bank of Canada is like a man balancing a pole upright in the palm of his hand. If he wants the pole to move north, he must first move his hand south, so the pole begins to lean north, so he can then move his hand north to prevent the pole falling over. Except the pole has expectations.

Do New Keynesians need to assume (much) labour hoarding?

We know that measured productivity falls in a recession (relative to trend).

Real Business Cycle theorists say that this is because a negative productivity shock is what caused the recession.

Keynesians say that a negative aggregate demand shock is what caused the recession, and labour hoarding (firms don't like to lay off workers even if they don't need all of them to produce the goods they can sell) is what causes measured productivity to fall.

But New Keynesians assume firms are monopolistically competitive. As every first year economics student knows, monopolistically competitive firms in zero-profit long run equilibrium produce where their Average Total Cost curve slopes down. If the ATC curve slopes down, total factor productivity will fall if output falls (and rise if output rises).

So New Keynesians don't need to assume labour hoarding to explain why productivity is procyclical.

But do the numbers add up right? Is this effect big enough to explain all the cyclical variation in productivity? Maybe not. Maybe they need to assume some labour hoarding too.

I don't know if any of this is new.

Macroeconomics when all goods are non-rival

Sometimes it's good to build really weird models. Because bits of the real world are a bit weird, even if the whole world isn't as totally weird as the model, and taking an extreme case can help us understand the effect of those weird bits. Plus it's fun.

I'm going to assume that all produced goods are strictly "non-rival".

Testing productivity shocks vs labour hoarding in a traditional industry?

This is just an idea that's been floating uselessly in my mind for some time. I have never been able to apply it. But maybe someone out there could.

This isn't an earth-shattering post. Maybe someone else has already thought of the same idea. Or even applied it, and I just haven't heard about it. But I might as well throw it out there, just in case they haven't, and someone reading this might figure out how to pick up the ball and run with it.

There are two main theories of business cycle fluctuations:

1. Productivity shocks cause fluctuations in output and employment. (Real Business Cycle theory.)

2. Aggregate Demand shocks cause fluctuations in output and employment. (Keynesians and Monetarists etc.)

We've know for a long time that in a recession, output generally falls by a greater percentage than does employment (both relative to trend). We call this empirical regularity "Okun's Law".

Real Business Cycle theorists say that this is because there has been a negative productivity shock, because productivity is output per unit of input, and that same negative productivity shock is what caused the recession.

Aggregate Demand theorists say that a fall in Aggregate Demand is what caused the recession, but firms don't like to lay off workers, so they hoard some workers even if they don't really need them to produce goods right now, which is why measured productivity falls.

How can we test between the two theories? Was there really a productivity shock? Or did measured productivity appear to fall because of labour hoarding?

Monetary stimulus vs financial stability is a false trade-off

There's an idea floating around out there that I fear may be influential. And that idea is horribly wrong. Which makes it dangerous. And I want to try to kill it. But macro is hard. And it's not easy to explain clearly and simply.

I can only try. And I can only hope that others who are more influential than me, or can explain things better than me, will do the same.

"Sure, there's a risk that inflation is falling below target, and a risk that recovery will be delayed, and it would be nice if the Bank of Canada (or Sweden or wherever) could loosen monetary policy to prevent this happening. But monetary policy works by lowering interest rates and encouraging people to borrow more and spend more. And that creates a problem for financial stability, because some people are already borrowing too much. So there's a trade-off between monetary stimulus and financial stability, and monetary policy needs to take both objectives into account."

I made up that quote. But I don't think I made up the influential idea it expresses. And it's horribly wrong. It's almost the reverse of the truth.

What happened in 2008?

1. Did a financial crisis cause a fall in expected and actual aggregate demand? (With central banks being unable or unwilling to do enough to stop it).

2. Or did a fall in expected and actual aggregate demand cause (or worsen) a financial crisis? (With central banks being unable or unwilling to do enough to stop it).

Obviously, there is a positive feedback multiplier between financial crises and expected and actual aggregate demand growth. (If central banks are unable or unwilling to prevent there being positive feedback.)

I started to write a post on this, but scrapped it, because I couldn't think of any way to provide good evidence one way or the other.

Now David Beckworth has a very important post which provides evidence for the second hypothesis. Go read it. Or simply look at the picture. US households' expected dollar income growth started to fall well before the US financial crisis.

[Update: see also Marcus Nunes' post and graph.]

The purpose of this post is simply to draw attention to David's post, and to raise a few minor points:

Begging the long run question: inflation variability vs NGDP growth variability

Forget about the short run benefits of NGDP targeting. This post is about the long run benefits.

Just suppose, in some alternative universe, the Bank of Canada for the last 20 years had been targeting 5% NGDP growth rather than 2% inflation. And that everyone had gotten used to NGDP growing at 5%. And suppose that, like in the real world, real GDP growth had been around 3%, and inflation had been around 2%. (3% real growth + 2% inflation = 5% NGDP growth).

Now suppose that some heretic then came along and said that Canada should switch to targeting 2% inflation instead. I can guess what the reaction would be:

"But suppose there's a productivity growth slowdown and real GDP growth slows to (say) 2% in future. Your 2% inflation target would then mean that NGDP would only grow at 4%. That's the problem with inflation targeting. If long run real growth rates vary, inflation targeting would mean variable NGDP growth. Unless you adjust the inflation target to take account of changes in the long run real growth rate, but then it isn't really inflation targeting, is it?"

Did inflation targeting make the Phillips Curve really flatter or just look flatter?

We know that inflation targeting failed. But we don't know why it failed.

One theory is that inflation targeting failed because inflation targeting made the Phillips Curve flatter. It made the Phillips Curve so very flat that keeping inflation close to target wasn't enough to keep output and employment close to potential. Inflation targeting contained the seeds of its own destruction. It destroyed the usefulness of inflation as a signal of whether money should be tightened or loosened.

We want to test that theory.

The trouble is, it is hard to distinguish econometrically between: inflation targeting made the Phillips Curve really flatter, and; inflation targeting made the Phillips Curve look flatter.

Modern LM curves are vertical

Modern teaching of modern macroeconomics and modern monetary theory should reflect modern monetary policy -- what modern central banks actually do nowadays. That means the modern LM curve is vertical.

Teaching Mundell Fleming

The Mundell Fleming model is usually taught in second year macroeconomics. It's the open economy version of the ISLM model.

This post is me disagreeing with Simon Wren-Lewis about teaching open economy macro (in textbooks and in the classroom). It is not a disagreement about open economy macroeconomics.

Simon says that the textbook Mundell Fleming model, in some circumstances (like a temporary increase in government spending), violates Uncovered Interest Parity.

I say that the textbook Mundell Fleming model always preserves Uncovered Interest Parity, but in some circumstances (like a temporary increase in government spending), violates model-consistent ("rational") expectations.

Big disagreement? Not really. But I think my way of looking at it is more intuitive.

Exchange controls, barter, and Cunning Plans

It was sometime in the 1960's. My uncle was teaching in Bulgaria. He wanted to buy stuff in Britain, but wasn't allowed to take much money out of Bulgaria. My father was farming in Britain. He wanted to buy stuff in Bulgaria, but wasn't allowed to take much money out of Britain.

My uncle and father thought up a Cunning Plan. My father went to Bulgaria, where my uncle gave him money, and my father bought stuff. My uncle went to Britain, where my father gave him money, and my uncle bought stuff.

Fiscal policy with Old and New Keynesian IS curves

With the Old Keyensian IS curve, the natural rate of interest is a positive function of the level of government expenditure. High G means high r*.

With the New Keynesian IS curve, the natural rate of interest is a negative function of the rate of change of government expenditure over time. High Gdot means low r*.

That's because:

In the Old Keynesian IS curve, the levels of desired C and I are negative functions of the level of r.

In the New Keynesian IS curve, the rates of change of desired C and I are positive functions of the level of r.

Please don't make me do the math. I'm not very good at math.

I have a very strong hunch that this is at the root of the disagreement between Paul Krugman and John Taylor.

I did a post on this, about a year or so back. Somewhere.

If you are a dyed-in-the-wool New Keynesian, and you want an expansionary Aggregate Demand policy, to get the economy up off the ZLB, and if you don't agree with Scott Sumner and other "monetary policy optimists", and so you want to use fiscal policy, you will want to increase the natural rate of interest, and you do that by ensuring that G will be expected to be falling over time from now on. And there are two ways to do that: either raise current G holding expected future G constant; or else cut expected future G holding current G constant. Probably: Paul Krugman wants to do the first; John Taylor wants to do the second.

John Taylor: "In contrast, in our Wall Street Journal article and our research on fiscal consolidation we consider the effect of permanent changes [presumably reductions NR] in government spending which are phased in over time to bring the budget deficit down."

Whether the New Keynesian or Old Keynesian IS curve is right, is another question.

Deposit insurance, bank runs, international currencies, and the inflation tax

Just a short post on one point about the recent Cyprus business. (It looks like Cyprus will impose a "one-time tax" on bank deposits rather than honour its deposit insurance.)

Boys, retention, and multiple regression

A followup to my previous post on university retention and males.

Assume boys and girls are identical, except: there's something in the water at high schools that causes boys to do worse than girls; and there's something in the water at universities that causes boys to do worse than girls.

Suppose you had a data set for all university students, that told you for each student i: that student's performance at university Ui; that student's performance at high school Hi; and that student's sex Si (Si=1 for male, Si=0 for female).

Suppose you ran a multiple regression of Ui on Hi and Si:

Ui = a + bHi + cSi + ei

What would you expect to find?

Why don't we have disinflation (until now)?

Just a quickie, between meetings.

Paul Krugman asks "Why don't we have deflation?" His answer is: downward nominal wage rigidity. And he shows that graph of frequency distribution of nominal wage changes with a big spike at zero.

I don't think that's quite the right question. So I don't think that's quite the right answer. (Even though, sure, that graph is almost certainly telling us something important.)

"Deflation" means falling prices (a negative inflation rate). "Disinflation" means a falling rate of inflation, so prices rise less quickly than they did before. My question is: why don't we have disinflation (until now)?

What is an "excess demand for money"?

I know what it means to say there is an excess demand for apples. And I know where to look to see whether there's an excess demand for apples. I go to the apple market, where people buy and sell apples for money. If I see that it is hard for people who want to buy apples to find someone who wants to sell, and easy for people who want to sell apples to find someone who wants to buy, I would say there is an excess demand for apples.

Draft notes for teaching Intro Money

I always suffer self-doubt when I teach the Money part of Intro Economics. Perhaps I'm over-thinking it, and it would be better for my students if I told myself to shut up, and just give them some simple clear story. But how to get it simple and clear, yet not horribly wrong or incomplete?

I'm writing these notes mostly for myself. (To try to organise my thoughts, because I don't actually use notes when I teach.) But I might as well do it in public. Read at your own risk. Because I haven't got it right yet.

Hot potatoes and hot yams

Money (the medium of exchange) is an asset. But the demand for money is different from the demand for any other asset. Here is an (inadequate) parable that tries to explain why it is different.

A monetary policy target can only be defeated by a better monetary policy target

"Monetary policy can cause bad things to happen in financial markets, which can cause bad things to happen in the rest of the economy. Therefore NGDP targeting is wrong."

I made up that quote. But if I had to summarise M.C.K.'s long article in two short sentences, that is how I would do it.

University retention and males

Carleton University admits more male students than females. But it graduates more female students than males. Why? What, if anything, can and should we do about it? (I don't know.)

The public access data is here. (Datacubes is a lovely tool, but it takes a little time learning how to use it.)

You can see there's a difference from the public access data. I can also get access to Carleton internal data. Except I can't seem to access it from home, so what follows comes from memory: