Short vs long-run natural rates of interest

Just a quickie, because I'm (supposed to be) grading exams.

I want to suggest a small change in Paul Krugman's two recent posts (here and here). One that would narrow the gap between his way of thinking and (say) Scott Sumner's.

Desired saving and desired investment depend on a lot of things. One of the things they depend on is expectations of future aggregate demand and hence future (real) income. So, no matter how you define the "natural rate of interest", the natural rate of interest will depend on expected future (real) income.

The natural rate of interest plays a central role in New Keynesian/Neo-Wicksellian ways of thinking about monetary policy. If you want to loosen monetary policy, the central bank should lower the actual rate of interest relative to the natural rate of interest.

The natural rate of interest, by definition, is a real rate of interest. If the nominal interest rate is already at the Zero Lower Bound, the only way for the central bank to lower the real rate of interest is to do something (or promise to do something in future) that would increase expected inflation. That's what Paul wants the Fed to do.

OK. But there's a second thing the Fed could do that would reduce the actual rate relative to the natural rate despite the ZLB. That is to raise the natural rate itself. And raise it by doing something (or promising to do something in future) that would increase expected future real income, which would increase current desired investment and reduce current desired saving.

So, to escape the ZLB, the Fed could do something (promise to do something) that would either: increase the expected future price level (and thus raise current expected inflation and reduce the actual real rate of interest); or, increase expected future real income (and thus raise the natural rate of interest).

And Scott Sumner would say "Hell Heck, why not just add (multiply?) those two things together and get the Fed to do something (promise to do something) that would increase expected future nominal income (NGDP), especially since we don't really know much about short run Phillips Curves and so can't say much about how a loosening of expected future monetary policy will be divided into an increased price level vs an increased real income".

Another way of saying the same thing is that it might be useful to distinguish between a short-run and a long-run concept of the natural rate of interest. The short run concept takes the state of expectations as given. The long run concept assumes expectations consistent with the future economy being at the future natural rate.

This is all connected to my old post on the upward-sloping IS curve. Another way of thinking about that post is to say that the short-run natural rate may be negative (if expectations are currently depressed because the economy is in recession), but the long-run natural rate could be positive.

The natural rate of interest is not a number; it's a time-path. And the central bank doesn't observe that time-path, so when it sets the actual rate it will almost always miss the natural rate time-path. And when the economy is off that time-path, that will cause the time-path to shift. Because expectations will change. And because reality will change too, as investment changes and capital stocks (understood in the broadest sense to include human capital and the stock of employment relations) change too. So, while useful as a theoretical concept, the natural rate of interest is perhaps not so useful as a practical guide to monetary policy as the Neo-Wicksellian approach requires.

Which is perhaps why all of us, central banks especially, should stop framing monetary policy in terms of interest rates. Setting interest rates is not what central banks really really do. It's a social construction of what they do. When central banks talk about setting interest rates that is only a communications strategy, and not a very good communications strategy, especially at times like this.

[Update: Tom Hickey asks: "So monetary policy boils down to central bank communications leading to expectations?"

My response: That's 99.9% of it, yes!

Ultimately, as central bankers themselves have told me, all the central bank really controls is its own balance sheet. But a snapshot of that balance sheet at one second in time tells you almost nothing about what the central bank is doing. It's the central bank's commitment about how it will change that balance sheet over time, and conditional on what events, that really tells you what monetary policy is. A snapshot doesn't work. You need a movie camera, that can also show lots of hypothetical future paths contingent on different circumstances, if you want to see monetary policy.

For example: if you took a snapshot of the Bank of Canada's balance sheet right this instant you would see gold reserves and forex reserves on the asset side. How could you tell whether the Bank of Canada was on the gold standard, had a fixed exchange rate, or was targeting 2% CPI inflation? You couldn't.

Monetary policy is dynamic, not static.

(That last bit was slightly tongue in cheek, along the lines of "my model is dynamic, yours is static". But there's a serious point there. If you want to find out whether the Bank of Canada is targeting 2% CPI inflation, or doing something quite different, you need to read what it says it is doing (and, if you don't trust it, you might have to check to see if in the past it actually did what it said it was doing.)]

Comments

[Kevin Donoghue]

The Fed can promise to increase expected future real income? Getting into Belle "and a pony" Waring territory here aren't we?

Not (just) being snarky; I'm not clear as to what you're trying to say.

[Nick Rowe]

Roosevelt did it by promising to raise the price of gold, and keep on raising the price of gold until the price level got to be where he wanted it. It doesn't have to be gold. Stock prices would work fine. Almost anything would work fine, except, the one damn thing they've chosen: TBill prices! TBill prices: are invariant wrt the equilibrium price level; can't go above 100.

[Kevin Donoghue]

Okay, I tend to interpret NK economics as being based on an assumption that the output gap will disappear in due course even with bad policy. Hence expected future real income is outside the Fed's control. But maybe that's not an article of NK faith or maybe you're a heretic. Either way I'll let you get back to work.

[Dan Kervick]

It's the central bank's commitment about how it will change that balance sheet over time, and conditional on what events, that really tells you what monetary policy is. A snapshot doesn't work. You need a movie camera, that can also show lots of hypothetical future paths contingent on different circumstances, if you want to see monetary policy.

I don't think the issue is just snapshots vs. cinema, Nick. Consider any arbitrary business with a reasonable degree of control over its balance sheet. People might have all kinds of faith in the ability of that business to control its balance sheet, both in the immediate term and the long term. But they aren't going to base many of their macroeconomic expectations on what that one business is communicating to the public about its own balance sheet operations.

Isn't that the real issue with monetary policy. For expectations management to be an effective, durable and rational policy approach, doesn't the Fed's expectation-dependent influence on the economy have to be grounded somewhat in transmission mechanisms that are not expectations-dependent? Mystique and vibes can't do all the work.

[dwb]

yep, spot on.

I am deeply skeptical that the long run natural rate of interest is negative (nobody was saying this in 2007, doesn't china and asia have a lot of capital to build, doesnt the US and Canada export a lot of capital and materials to them?). there is a tendency to extrapolate the present indefinitely into the future. I am not sure what effect the baby boomer retirement has on the natural rate, honestly: thinking of it as time preferences, the rate could be just as well be positive to keep the boomers from spending their assets too fast. Plus, the population is still growing after all and we'll need more houses and diaper factories.

[Nick Rowe]

Kevin: "Okay, I tend to interpret NK economics as being based on an assumption that the output gap will disappear in due course even with bad policy."

They are indeed based on that assumption. And it's a very bad (internally inconsistent) assumption. In other words, NK models assume (without any euilibrating mechanism) *future* full employment. I did a post on this 2 years ago, but can't find it.

Dan: we live in a monetary exchange economy, where people demand money to buy and sell everything else, and everything else is priced in that money. All bank money is asymmetrically convertible on demand into central bank money, so central banks control commercial bank money as well. Central banks control the medium of exchange and medium of account. If you don't think money is important, and that the world would unfold in much the same way even with barter, then monetary policy won't matter either. But that's why central banks balance sheets matter in a way that the balance sheets of other corporations don't matter as much.

dwb: Yep. Demographics will affect it. But as the boomers retire, it should rise.

[philippe]

If you looked at the Fed's balance sheet and assumed they were on a gold standard because of their gold holdings, wouldn't you also have to assume that they were completely mental and about to experience hyperinflation due to their vast mountain of government bonds?

[Dan Kervick]

@ Nick

No, I think money is very important. And I also think that since the government is the monopoly supplier of the monetary base and final means of payment - into which as you note, other forms of money are convertible on demand - then central bank accommodation of credit expansion is essential if additional money is to make its way into the economy through the bank credit channel.

But while I think the central bank can be very influential in slowing down or constricting the pace of credit money expansion by pulling back and declining to accommodate the private sector market for credit, I don't think it can do much in circumstances like the present ones to push money into the economy by exercising its influence over bank reserves, policy interest rates and the payments system. The central bank can't force bank reserves to give birth to consumer loan deposit balances and consequent consumer spending, not when diminished private sector income and wealth, and high private sector debt, are holding back the demand for additional credit. The central bank can also, at best, only spur additional credit. But what is most needed in the private sector is additional private sector income, not more credit.

If we lived under a system with a single, centralized monetary/fiscal authority, then certainly that authority would have the power to do what is needed, because in addition to supplying money to bank reserve accounts by purchasing financial assets, it could also manufacture money unilaterally to buy ships, roads, tunnels, space shuttles, schools, office buildings, office equipment and supplies; as well as hire teachers, construction workers, accountants, astronauts, engineers, computer programmers, landscapers, child care specialists, park rangers and more.

But we don't live in such a system. We live under democratic governments in which most public spending power is assigned to elected legislatures. In fact, monetary power also lies, ultimately, in the hands of those legislatures since the monetary authority of the central bank was created by delegated legislative authority. The national legislature can, at any time it chooses, vote to direct the central bank to credit funds to the public public treasury, in any quantity it chooses, and then spend those funds into the private sector economy in the ways described in the last paragraph. The central bank cannot do these things under any politically realistic scenario. Nor do I suspect most citizens would want the central bank to usurp those authorities.

We live in a time in which many people seem to be under the impression that if the public does not shoulder the responsibility to carry out the enormously important and expensive public works described above, the private sector will accomplish them on its own. I have to say that that attitude strikes me as completely unhistorical, and there is not a shred of evidence in the historical record that a fully private economy can come anywhere close to accomplishing the large and fundamental tasks that an organized public can accomplish when it employs governmental tools and commands large stocks of the nation's resources to pursue public purposes. But the school of X-treme privatization has succeeded in strangling public vitality, and keeping the atrophied, latent power of the public sector tied up and tied down.

I sometimes criticize monetarism as an economic philosophy. But it's really not monetarism that is the culprit. The culprit is "central-bankism". This is a strange, fussy and clenched doctrine that preaches a constipated public policy of attempting to squeeze all additional monetary resources into the economy through the narrow bank lending channel, and holds that those needed resources should always come encumbered with credit obligations, rather than flow freely as unencumbered income. What is even worse is that central-bankists seem fanatically bent on undermining the capacities of our own democracies. Central-bankism is an awful influence in the US; and it has become a virtual reign of terror in Europe.

If One is really a consistent monetarist, they shouldn't be a central-bankist. That's because an informed understanding of the structure of our institutions should tell monetarists that in a democracy the central bank does not possess the kind of monetary power and authority that is assigned to the black box labelled "monetary authority" in the monetarist-inflected textbooks. Most of that power and authority lies with the political branches of the government, not with the central bank.

I rail against these attitudes all the time, but I think we are actually seeing the gasping death throes of central-bankism. What central-bankism has come down to in these final months is a daily series of despondent calls for the central bank to exercise power over broad private sector spending simply by pretending it has those powers, gargling in public, and hoping against hope that enough people will benightedly believe the gargling means something to be moved to go out and buy a car or an iPad or a school building in response, or to hire someone.

[philippe]

It took a global financial meltdown scenario to push western central banks to adopt 'unconventional policies'. As they did they might have been holding their breath and hoping that mass panic didn't break out, with everyone stupidly withdrawing all their money and spending it on guns and tins of tuna whilst screaming "they're prining money! The end is nigh!" Thankfully most people aren't that dumb so they didn't. Austrians did though, of course, but also added gold bullion to the shopping list. The rest of the world mainly carried on.

If we had been under a gold standard, there probably would have been panic, but we don't live in such superstitious times thankfully. However, a major reason why people don't do crazy things now when central banks do their thing is because they've sort of earned our trust over the last twenty plus years. People assume that CB's know what they're doing. Unless they're Austrian, of course.

[W. Peden]

Dan Kervick,

How many people do you think advocate that the private sector can do every last one of those jobs you listed? I am sure that the list is shorter than the total number of people who want a smaller public sector than exists in most Western countries today.

As for the power of the mobilisation of the public sector: sure, but the power to do good is also the power to do harm.

[Philo]

Scott Sumner doesn't say "hell."

[Lorenzo from Oz]

Well, at least the Reserve Bank of Australia knows its job is to anchor expectations, it says so.

Dan Kervick: The state was better at infrastructure when it was not trying to do quite so much. The problem is, at least in part, that infrastructure is also competing with welfare, etc much more than it used to.

Another wrinkle is that permit raj's in land use undermine a fundamental incentive to publicly provide infrastructure. Much of the point of the state providing infrastructure is that (unlike the private sector) it can gain revenue from increased land value and production: it can tax the positive externalities infrastructure provides. Unfortunately, a much cheaper and easier way to generate increased land tax, etc revenue is simply to engage in land rationing (Krugman's Zoned Zone) and reap higher land/property/capital taxes. (And, not coincidentally, makes developers a great source of political donations.) This both raises the cost of infrastructure (by driving up land prices) and lowers the incentive to provide it.

Add in "infrastructure is evil" environmentalism, which turns NIMBY (not in my backyard) into BANANA (build absolutely nothing anywhere near anyone) and I suspect you have factors undermining infrastructure provision which are at least as important as "it should be private!"

On which point, there is a long history of infrastructure provision wavering back and forth between public and private provision, depending on which set of policy pathologies have been most saliently problematic in the preceding period. Countries have gone through a period when public provision/production pathologies were most salient, hence the swing to private provision, including of infrastructure.

[Scott Sumner]

I was raised in a very polite state (Wisconsin.) I would have said "heck." Otherwise you have my response down exactly right.

Just thinking out loud, isn't the "indeterminacy problem" with fiat money one reason why people have so much trouble agreeing on how to think about monetary policy? There are nearly an infinite number of expected money supply (or interest rate) paths over the next 50 years that are all consistent with 2% inflation over the next 12 months.

NKs say monetary policy is the market interest rate relative to the natural rate. But the only way we can observe that differential is by observing NGDP expectations. And once we've done that, observing the interest rate adds no useful information. So why not just observe NGDP expectations and forget about interest rates? The same with policy tools. If easier money is lowering the actual rate relative to the market rate, why not just raise NGDP expectations directly? After all, the only thing the central bank really controls is its balance sheet---both interest rates and NGDP expectations are "out there." Admittedly, NGDP expectations may be hard to observe, but no harder than actual interest rates minus the natural rate.

[george]

It puzzles me why Canada's politicians and the mainstream news media are not talking about the huge (total) debt levels we have in this country, huge debt levels that are skyrocketing even higher as we speak.

The following link will take you to a data table on the Statistics Canada web site which gives a summary of the total credit market debt in Canada over the last 5 years. Take note of the 6th line from the bottom - Total funds raised equals total funds supplied ,and how much it has increased over the last 4 years. Clearly this is not going to end well.

http://www5.statcan.gc.ca/cansim/pick-choisir?lang=eng&p2=33&id=3780050

[DaRkJaWs]

W. peden and Lorenzo from Oz: do you realize that you didn't really rebut any of Dan's commentary?

Nick: if you believe money is non-neutral then why do you put all your baskets into an institution that can only (possibly) control expectations and nothing else?

Indeed, I think it's just the fact that people like W. Peden don't want to admit the obvious, else they enter their mid-life crisis.

[Dan Kervick]

As for the power of the mobilisation of the public sector: sure, but the power to do good is also the power to do harm.

I accept that. But do you think maybe we've gone a little bit overboard with the "First, do no harm" philosophy? Where's the social imagination?

[David Beckworth]

I loved this post. An implication of all this is that the Fed can affect the short-run natural interest rate, but not the long-run natural interest rate. For example, if the economy is in a slump because monetary policy is too tight, then desired saving and desired investment will be depressed pushing down the natural interest rate. Or, alternatively, if there is a negative output gap because of tight monetary policy, the natural interest required to close the gap would be low.

Over the long-run with monetary neutrality,however, monetary policy should not matter to the natural interest rate as desired saving and desired investment respond to trend growth in productivity, labor, and time preferences. Or, alternatively, the output gap closes and pushes up the natural interest rate.

Graphically, then, we would need to see three lines: the short-run natural interest rate, the long-run natural interest rate, and the actual policy interest rate. It would nice if there were real-time measures of these natural interest rate measures. It would go a long way in ending the low interest rate is easy money fallacy and the financial repression critique (at least for the US).

[Nathan Tankus]

@Nick: there was a topic in the demand side thread that i let drop but want to bring back: sticky prices. to turn your answer about sticky prices existing but you don't know why around I'd like you to answer my question. Why wouldn't prices be sticky?

[Lorenzo from Oz]

DaRkJaWs: I was simply suggesting there is more going on than policy fads. That Dan's But the school of X-treme privatization has succeeded in strangling public vitality, and keeping the atrophied, latent power of the public sector tied up and tied down. was too simple.

On the sticky prices issue raised by Nathan Tankus, is there any manifestation of sticky prices which is not a form of risk management? Sticky wages, for example, surely fall into that category. Yes, it makes unemployment larger than it would otherwise be, but most workers keep their jobs and have their income less subject to shocks.

[philippe]

"why not just raise NGDP expectations directly?"

How does one do this exactly?

"the only thing the central bank really controls is its balance sheet"

i.e. it buys and sells mainly government bonds thereby setting the interest rate, no?

[W. Peden]

DaRkJaWs,

"Indeed, I think it's just the fact that people like W. Peden don't want to admit the obvious, else they enter their mid-life crisis."

I hope I'm not at mid-life just yet.

As for Dan's points: I addressed the points other than the assertions about central banks, because I'm a bit tired of that particular debate with Post-Keynesians. However, I suppose it's worth noting that "Market Monetarists believe that central banks only control expectations" is a strawman.

[W. Peden]

Dan Kervick,

"I accept that. But do you think maybe we've gone a little bit overboard with the "First, do no harm" philosophy? Where's the social imagination?"

There's certainly a balance to be struck, somewhere between Murray Rothbard and Karl Marx. It's setting up a false debate to say (as some do) that Keynesians just believe that "Government is always good and the private sector is always bad", but it's ALSO a false debate to say that the fiscal austerity vs. Keynesianism debate is just a matter of the former saying "The private sector can do everything the government does and better".

Hypothetically, if I did think that monetary policy is powerless under present circumstances, I'd simply want a strategy of underfunding of CURRENT public sector spending under NGDP growth was back on its pre-crisis path. That would avoid the public choice problems involved in classic Keynesian stimulus, while still increasing the money supply.

[Phil Koop]

"An implication of all this is that the Fed can affect the short-run natural interest rate, but not the long-run natural interest rate."

I think what you mean by this, David, is that there is a ceiling on real growth that "is what it is", and optimum CB policy merely allows this ceiling to be realized. But I think this is a poor expression of the idea and in fact I would have put it the other way around. The CB has little control over the short-run natural rate, which may deviate unpredictably because of shocks or CB policy errors, but so long as the CB communicates the correct expectations, the long-run rate will be preserved. The point, though, is that this long-run rate is endogenous to CB policy. If the Fed could not the long-run rate, monetarism would not exist.

[David Beckworth]

Nick,

Here is a paper that roughly follows your short-run vs. long-run view. It makes the following distinction:

(1) Long-run equilibrium rate: "Determined by economic fundamentals such as long-term saving behaviour, productivity and population growth."

(2) Neutral real interest rate: "Determined by all the disturbances to the economy that influence the prospect of closing the output gap in the medium term. These include the fundamentals that determine the long-term equilibrium real interest rate, but also disturbances of a more temporary nature."

(3) Actual real interest rate

Again, a great research project would be able to find a way to estimate these in real time. Most estimates I have seen of the natural interest rate use structural DSGE models, but they at best create quarterly values. A few other papers have used the real yields off of TIPS to get more real time estimates, but I am not sure exactly what they are measuring.

The paper can be found here: http://www.norges-bank.no/Upload/62923/ec_bull2_07_neutral_real_interest_rate.pdf

[Diego Espinosa]

"Roosevelt did it by promising to raise the price of gold"

FDR's 1933 action spurred a rally in a host of risk asset prices, one that indicated that markets dramatically shifted their future NGDP expectations higher.

Bernanke's 2009 actions spurred a similar -- if not superior -- rally in a host of risk asset prices, indicating that markets dramatically shifted their future NGDP expectations higher. The link between the asset price and real economy recoveries, however, has been surprisingly weak. To a large part, this is a function of the incredible outperformance of domestic corporate profits over employment. That outperformance has produced historically favorable credit spreads and P/E's. The corporate WACC improvement has helped spur a robust recovery in business investment ex-structures. All of this is inconsistent with the thesis that deeply negative real rates are needed to boost investment in broad swaths of the economy

For stock, corporate bond and commodities markets, 1933 already came and went. What does this market outcome imply about the nature of our output gap?

[Pedro Bento]

@David Beckworth: Wouldn't it be better to say in the long run, the stock of money doesn't matter, but monetary policy surely does (since in the long run, monetary policy will still be active).

[Nick Rowe]

Sorry about my depay in responding to comments.

Philippe: I don't think so. I think I can imagine an economy just like Canada's in which the Bank of Canada was targeting the price of gold (maybe a crawling peg), in which the BoC's balance sheet would look exactly the same at this point in time.

Dan: I'm not 100% sure I follow your comment.

I think you agree that monetary policy can work fine in "normal" times, and work in both directions -- either expanding or contracting demand? (Because inflation targeting central banks were able to keep the inflation rate from both rising above target and falling below target.) It's your "in circumstances like the present one" I see as key. And that's what the big debate is all about, of course. Some New Keynesians like Paul Krugman would tend to agree with you. But only because PK is sceptical about the Fed's ability to make credible commitments about the future, and influence expectations about future monetary policy.

Here's where I would differ. I see central banks' commitments about what they will do in future as being part and parcel of what central banks do. Money is an asset, and like all assets, the demand for that asset depends 99.9% on expectations. Suppose you were planning to buy a $100,000 house. Then you learned that it would fall down one day after you bought it. How much would you pay for it? Almost nothing. One day's rent. Suppose a central bank were on the gold standard, and it then announced it would double the target price of gold next week. Everyone would rush to exchange almost all their money for gold this week. Suppose a central bank targeted a rate of interest, and then announced it would cut the target rate of interest this week from 5% to 4% and raise it next week from 4% to 6% and keep it there. That would be a tightening of monetary policy, not a loosening.

Central bankers are not existentialists. They do not live in the present, and decide each day what to do de novo. Their actions *are* (also, and most importantly for all practical purposes) communications about their future actions.

But it also matters *how* they frame what they are doing. The exact same physical behaviour could be part of many different actions, and can create very different expectations about future physical behaviour depending on how it is interpreted. "What action is he performing?".

A central bank targeting the price of gold, or targeting a rate of interest, or targeting a rate of inflation, will be performing very different *actions* and creating very different expectations about its future physical behaviour, even though its current physical behaviour (its current balance sheet) could be identical in all 3 cases.

(You're a philosopher, right, and could probably explain what I'm trying to say more clearly than I can. I can't even remember which philosopher I am channeling, but it's probably some Cambridge Brit from the 1960's.)

I see part of the problem as not "central bankism" but "bankism". We have a screwed up monetary system in which commercial banks create a large part of the money supply as a counterpart to commercial loans.

But the main part of the problem is that (at least for the Fed) its *actions* (as opposed to behaviour) are setting a target rate of interest. Those actions cannot create the expectations it needs to create.

[Nick Rowe]

philo and Scott: Yep, sorry, "Hell" changed to "Heck"!

Scott: "Just thinking out loud, isn't the "indeterminacy problem" with fiat money one reason why people have so much trouble agreeing on how to think about monetary policy? There are nearly an infinite number of expected money supply (or interest rate) paths over the next 50 years that are all consistent with 2% inflation over the next 12 months."

I think that's exactly what's at the root of it, but your second sentence is not really the "indeterminacy problem". Take the simple case of a perfectly flexible price level. For any present P and M there exists an expected P that makes current M/P an equilibrium. But even if we rule out "bubble" paths, for any current P and M there exists a future M that makes that M/P an equilibrium. The same is true of all assets, of course, like IBM shares, but unlike IBM the central bank is free to do what it wants, and doesn't have to maximise shareholder returns from owning money. (What's the betting someone will misunderstand that last remark?)

The people from the concrete steppes are looking for a billiard ball type causal explanation, in which A causes B causes C etc. This is fine for engineering, but doesn't work for asset prices. Asset prices are determined by expectations. Money is an asset (OK, it's very different from other assets, but it's still an asset.)

[Nick Rowe]

David: thanks! Yep, that's I think a good way of looking at it.

You have to be a little careful though. In e.g. a Solow growth model there exists a long run natural rate that is independent of history. But in e.g. an AK type growth model, the natural rate at any time may depend on history.

Nathan: "Why wouldn't prices be sticky?"

If supply and demand are varying continuously over time, and prices don't vary continuously over time, it suggests someone is not maximising profits or utility. In other words, it suggests that there is some other cost or benefit missing from our theory, and we want to know what it is. Something like "menu costs" (costs of printing new price lists) is the simplest answer, but whether it's even close to the right answer is open to debate.

philippe: "i.e. it buys and sells mainly government bonds thereby setting the interest rate, no?"

The Bank of Canada (e.g.) *says* that it adjusts its balance sheet (or, allows its balance sheet to adjust) to set an interest rate, but only for 6 weeks. More importantly it says it adjusts that rate of interest (or, allows that rate of interest to adjust) to set the rate of inflation equal to a fixed 2%. What it really *sets* is the inflation rate. What it really controls is its balance sheet and what it promises to do to that balance sheet in future to keep inflation at 2%. Interest rates are only an intermediate step between the balance sheet and the inflation target. It doesn't have to use that particular intermediate step. It doesn't have to *talk about* what it is doing in that way.

Any way you look at it, the Bank of Canada does not *set* a rate of interest, except for a brief 6 week period, and it does not have to even do that.

Whenever a Bank of Canada official gives a speech, he always talks about the 2% inflation target. That's what matters to them. That's what they want to communicate. That's the strategic communication.

If the Bank of Canada wanted, (and except for the fact that it might upset Americans if it talked this way), it could talk about setting a temporary exchange rate target path, and varying that exchange rate target path to keep inflation at 2%, and stop talking about setting interest rates all together. Or chose some other tactical intermediate target.

[K]

Nick: "But only because PK is sceptical about the Fed's ability to make credible commitments about the future, and influence expectations about future monetary policy."

That's not true, Nick. Monetary policy *with* commitment is better than without given a ZLB. But neither is optimal. Fiscal stimulus *is* required for optimal policy, and for an arbitrarily large shock, the fiscal portion is an arbitrarily large fraction of the required stimulus. So, no, it's *not* about expectations. It's about *instruments*.

[Nick Rowe]

K: that depends on how you define "fiscal stimulus", and on whether monetary policy would require a higher than optimal inflation rate to escape the liquidity trap.

If real interest rates are temporarily low, for whatever reason, even a microeconomist doing standard cost benefit analysis would recommend temporarily higher G and lower tax rates. Would we call that 'fiscal stimulus"? Maybe yes, or maybe no.

In the Canadian context I really wasn't very worried about temporary deficits over the last few years. I reckon fiscal policy was roughly optimal before the recession, and I'm reasonably confident the deficits will be temporary. I'm not so willing to say that for the US.

In any case, my point there was about whether PK thinks that monetary policy can work. Yes, he also wants fiscal policy too.

[Dan Kervick]

Nick,

Here in a nutshell is what I think about the extent of the central bank's powers:

The primary thing central banks control directly is the price commercial banks pay for reserves. Since the price banks pay for reserves has some bearing on the interest rates they are willing to offer to their customers, the central bank can influence the latter by adjusting the former.

Since the willingness of people to borrow depends not just on current rates, but on what they expect rates to be at various times in the future, it can be important for the Fed to make credible commitments about future interest rates.

When rates are near the zero bound, the Fed's chief tool for positively stimulating economic activity is lost. It does, of course, still have a tool for negatively influencing economic activity: it could raise rates.

Demand and spending depend, in part, on the availability of credit at various prices. When not at the zero bound, the central bank can influence demand and spending through its influence on interest rates. But that is really the only effective channel it possesses for influencing demand and spending.

I don't think the overall quantity of reserves matters much, other than to the extent that changes in quantity of reserves can influence the rates banks pay for reserves.

I don't think the Fed controls the rate of inflation, so I don't think that any commitments they do or do not make in that area are especially important.

I believe the reason we have had several decades now of low inflation is because conservative governments in the 80's attacked labor unions and destroyed labor bargaining power. As a result, there is now little upward wage pressure on prices. The central banks were just a bystanders in this process. The efforts the central banks had made on their own to beat inflation - monetary aggregate targeting - failed completely, and also produced economic harm in the process of failing.

I don't think the Fed would be able to control the rate of aggregate nominal spending, so I don't think that any commitments they do or do not make about the level of aggregate nominal spending will be very important.

I don't believe that the relationship between inflation expectations and the propensity to spend is as simple as it is often believed to be. Some people do spend more quickly in an inflationary environment to maximize the exchange value of their depreciating currency. Others, however, are worried that their nominal incomes will not keep pace with price level changes, and so they actually save more to hedge against the possibility that they will have to spend a greater proportion of their income in the future just to maintain their current standard of living. So even if the central bank could control the rate of inflation and control inflation expectations, I don't think that means they would have a straightforward tool to use to adjust nominal spending.

Central banks do have a certain degree of erratic and unpredictable psychological impact on the economy, since people's expectations about the impact of monetary policy are sometimes based not on an informed understanding of the central bank's actual operational connections with the economy, but on a variety of loose - and sometimes crackpot - theories they have about the nature of those connections. For example, some people were convinced QE was going to cause hyperinflation. Those fears might have had an impact on their economic behavior. Attempting to direct or stabilize the economy by managing these residual psychological effects is no way to run a government, since the psychological effects are all over the map, and sometimes pull in opposite directions.

_______

I tend to see the private sector economy as driven by households and small businesses exerting aggregate influence upward, not by banks and asset markets exerting influence downward. The problem in the current environment is not that households are hoarding too high a percentage of their incomes. They are debt strapped and have seen their real incomes falling, and are saving appropriately to deal with their debt. The problem is that households in the aggregate do not have enough income to buy all of the output that the private sector could be producing at full employment. The fiscal authorities have important powers the central bank lacks. The fiscal authority can directly increase the rate of nominal income. It can also do this in a way that would be very credible, in the sense that people would believe the income support is permanent.

[Nick Rowe]

Dan: "The problem is that households in the aggregate do not have enough income to buy all of the output that the private sector could be producing at full employment."

Just a quickie, because I have to go do admin stuff. Some/many economists would agree with the other things you say, but that particular sentence is problematic for nearly all economists. Taken at face value, it violates National Income Accounting, and the valid version of Say's Law.

[Nathan Tankus]

@ Nick 12:59 pm: how does it violate the national accounts? goods supplied equals goods demanded only applies ex-post. It's very possible for households not to have enough income to demand enough goods to drive all firms to normal capacity utilization.

@Nick 8:26 am: What does maximizing profits mean? why would a firm care about maximizing profits at this very moment? Most agents of a firm (wall street and enronesque employees will be ignored for now) are incentivised to generate stable or reasonably growing cash flows to either stabilize (or improve) their position in the firm and possibly increase their personal cash flow. a firm that tried to squeeze as much as it could from consumers right this moment alienates customers and the longer time frame existence of the firm.

There's also the problem that firms (contrary to economic theory) don't really have a very good idea of what the market demand curve is or how it changes over time. Further, even if they could figure it out, that might be too costly in itself and not worth it. In the 1980's and 1990's "Activity-based costing" became all the rage in management accounting circles. it was basically rather then assigning overhead costs equally to all products, the firm would try to figure out how much each activity absorbed in capacity and time terms. The problem with it was, those accounting systems were costly and difficult on their own terms. The move to Activity Based Costing fizzled out by and large.

trying to find the market clearing price might be NOT maximizing profits so most firms don't try.

[Nick Rowe]

Nathan: when we say "choose" to buy we are talking ex ante. When we say "afford" to buy we are talking ex post Income=Output=Expenditure identity. Say was correct when he said that supply creates the *wherewithall* to purchase itself. He was wrong when he said supply creates its own demand (in a monetary exchange economy).

Understanding Say's Law, both where it's right and where it's wrong, is central to understanding deficient-demand recessions.

But I'm too tired to explain it (and I've done too many posts on Say's Law in the past in any case). I just spent a long afternoon pretending I was associate dean again. And the Senators are on tonight.

[Dan Kervick]

but that particular sentence is problematic for nearly all economists. Taken at face value, it violates National Income Accounting, and the valid version of Say's Law

Nick, the statement wasn't that they don't have enough income to purchase all of the actual output. It was that they don't have enough income to purchase the output that could be produced at full employment.

[Nick Rowe]

Dan: "It was that they don't have enough income to purchase the output that could be produced at full employment."

I understood what you meant. It is deeply problematic, though could probably be made true under some interpretation. Taken at face value, it is wrong. This is not a classical/keynesian/monetarist/whatever argument. This is very central to all macro.

Let me try to give you the intuition.

Suppose I alone build a $1 million supercar. I can afford to write myself a cheque for $1 million and deposit that cheque in my own bank account, to buy that car from myself.

Suppose you and me build that supercar together. We can afford to write ourselves cheques for part shares (adding up to 100%) to buy the car from ourselves.

Suppose I build the car but owe $100 debt that I must repay. Then my creditor can afford to buy the $100 share in the car that I cannot afford.

Suppose the government taxes me $100 of my income from selling the car to myself. Then the government can afford to buy that $100 share in the car that I cannot afford.

And so on. If we can produce it, we can afford to buy it from ourselves. Whether we would *choose* to buy it is another question.

And (though this is more of a BTW), once you start thinking along these lines, you inevitably end up seeing monetary exchange and an excess demand for the medium of exchange as the root of all deficient demand failures. It is only if we choose to try to hoard part of our income in the form of medium of exchange that we get a generalised excess supply of goods.

[Nick Rowe]

Dan and Nathan: I don't want to do a cheap "gotcha!" on this point, because you are both far to thoughtful and intelligent for tactics like that. But this really is a very fundamental point.

Let me put it like this: if I too thought that people wouldn't have the income and so simply couldn't afford to buy the output they could produce at full employment, I too would (probably) be advocating policies like you advocate: the government should print a flow of money and give them the extra income they would need to buy the output they could produce at full employment. Because, I can't (offhand) think of any other policy that would work. And I could certainly see why you would think that standard monetary policy couldn't work. I think this point is at the root of (almost) everything.

The (ex post) National Income Accounting *identity* Income=Output=Expenditure is not just true at the *actual* level of output. It is true at *all conceivable* levels of output. It's like saying: # of my kids=# of my sons + # of my daughters. It is true for all possible numbers of kids. It's like saying X+2=X+4-2.

[K]

Nick, Dan:

I really don't get how Nick's original statement that Dan's statement violates NIA is consistent with Nick's statement that NIA applies at any level of output. The latter statement is correct. Income/Output can be at a depressed level or at an optimal level. Dan said it was at a depressed level. The question of whether it can stay at a suboptimal level has nothing to do with NIA.

Imagine that 1% of the population lends to 99% percent of the population which fuels a prolonged period of consumption/investment boom. Then we have a negative shock, and despite zero risk free rates the drop in asset values and rise in risk spreads forces deleveraging causing reduced consumption by the 99%. (Don't forget Nick, the welfare theorems assume equal access to borrowing which is massively violated here.) In order to keep income at the previous level the 1% needs to make up the difference. But the 1% doesn't want to buy massive extra quantities of cheesy hair cuts, Ford Fiestas or copies of Call of Duty. So to maintain GDP the economy needs to shift to produce luxury yachts, golf courses and monster SUVs. And if real wages are going to have to drop, working hours will have to rise as will the retirement age. So the problems are structural and getting to the new equilibrium will take time.

Of course, there *is* a way to get back to an efficient level of output, but given credit constraints on the 99% there is no *pareto improving* way to get there from here. That way, of course, is to take a sufficiently large bunch of money from the 1% and give it to the 99% so that they can unload their excess debt burdens. Then they can (essentially) immediately resume the previously optimal consumption pattern for which the economy is currently structured.

Personally, I think a very negative policy rate would be sufficiently deleveraging to do the trick for the debtors, so there could be a pareto path to the optimum. But not unless we eliminate paper money (Dan! :-) ).

[Nick Rowe]

K: "But the 1% doesn't want to buy massive extra quantities of cheesy hair cuts, Ford Fiestas or copies of Call of Duty. So to maintain GDP the economy needs to shift to produce luxury yachts, golf courses and monster SUVs."

1. There can be structural unemployment, due to a mismatch between the particular goods supplied and demanded. Excess demand of some; excess supply of others. Even Say allowed this could happen. That's what you are talking about, I think.

2. There can be deficient demand unemployment, because *if* the economy *were* at full employment people would not *choose* to demand as much output as was being produced. The earlier Say denied this; the later Say changed his mind and said it was possible after all, if there were an excess demand for money.

3. I interpret Dan as saying, and I think Dan confirms, that there can be deficient demand unemployment because, *if* the economy *were* at full employment, income would be less than full employment output, so people could not *afford* to buy as much output as was being produced. I think (not 100% sure) that something like this position was put forward by Major Douglas and Social Credit in the A+B theorem. I don't know of any macroeconomist who holds it nowadays. This is not the Keynesian position.

[Dan Kervick]

Nick, I think there are few important points to make here:

First, businesses can't base their production decisions on what level of income their customers will have if all other businesses make the same decisions they do. If a business is considering whether to expand production by 10%, in making that decision they do not assign a high probability to the prospect that all other businesses will increase their production (and thus employment) by 10%. Instead, the default assumption is that they have almost no control over the behavior of other firms, and that everyone else will continue doing more or less what they are currently doing.

The economy as a whole sells its output to the economy as a whole. But a business typically does not sell its output to its own workers. The business can't say, "I'm going to increase my workforce by 10% and produce 10% more Mustard, because after I do, my own workers will then buy all the additional mustard." They make their production decisions based on what they expect others to do, which is something over which they have no control, and so their default assumption is that their consumers (a population much larger than their own workers) will have only marginally more or less income to spend in the quarters to come than they have right now.

You can have an unemployment equilibrium because you can have a situation in which, even if all producers increased employment by X% and created full national employment that would be good for everyone, no individual firm has a compelling rational basis for increasing employment and production by any amount.

And you seem to have made the same mistake again in paraphrasing my comment when you say, "if I too thought that people wouldn't have the income and so simply couldn't afford to buy the output they could produce at full employment ..."

I didn't say that the problem is that people wouldn't have enough income to purchase the output that would be produced at full employment. I said that they don't now have enough income to produce the output that would be produced at full employment. That's important because businesses respond to what they perceive to be current unmet demand. Demand is not just a wish or a like. It is the manifestation of some kind of pressure for purchases in the market. In order to manifest demand, people need a surplus. Dreaming of a Tahitian vacation, or even saying to people "going to Tahiti would be nice if I had more money", is not demand for Tahitian vacations. People calling up a travel agent and looking for Tahitian vacations, or doing the same online and pricing them out, bidding for them etc. is demand - something that a business takes as evidence of the fact that people might buy more of these vacations if there was a greater supply or lower price or both.

The national income identities only say total national product is equal to total national expenditure. But they don't say that total household income is equal to total household consumption; nor do they say that total household consumption is equal to total firm output for consumption. If output for consumption exceeds actual consumption expenditures, then the portion of expenditure that went into producing that surplus is part of inventory building.

I would say that consumers manifest unmet demand for products in a given period with part of the surplus saved from the previous period. They have to have something they are willing to part with that they can, figuratively, take into a market and wave around. If their savings are getting poured into debt repayment, then they cannot manifest demand.

To my mind, what is backward about our current supply-side approaches is that they call for business to take a mass, collective leap of faith by financing expanded production and employment with the promise to repay based on hoped-for increases in sales. The idea is that the increased employment will then produce the increased household income which will then generate the demand for the additional products produced. To me this seems commercially unrealistic. A better approach is to transfer a certain proportion of existing surplus national income to consumers, which they will then use to manifest real, concrete demand for more products, and which will result in the rational, non-faith-based response of firms to increase production and employment. That would re-start the virtuous engine of employment, production and consumption.

There are two ways to do this redistribution. You can basically tax saved surplus away from people and transfer to others who are more disposed to exchange it for consumption; or you can create more money and distribute the money. Ultimately that is also redistributive because it redistributes the balance of purchasing power.

[Nick Rowe]

Though, I would be the last person to take National income Accounting as authoritative. The NIA definitions of income, output, and expenditure aren't the only possible ones, and maybe aren't the most useful. That's why I hedged and talked about Dan's statement being "problematic" and wrong *if taken at face value*.

[Dan Kervick]

I really don't get how Nick's original statement that Dan's statement violates NIA is consistent with Nick's statement that NIA applies at any level of output. The latter statement is correct. Income/Output can be at a depressed level or at an optimal level. Dan said it was at a depressed level. The question of whether it can stay at a suboptimal level has nothing to do with NIA.

Right K. The original statement was "the problem is that households in the aggregate do not have enough income to buy all of the output that the private sector could be producing at full employment."

So "do not" for the first verb phrase and "could be producing" for the last one.

[Nick Rowe]

Dan @02.22. Not sure if you had read my previous comment when you posted that.

There are two types of "Keynesian" (understood loosely) models:

1. Standard keynesian models. (Keynesian Cross, ISLM, most Post Keynesian models, AFAIK). There is a unique equilibrium, but it may be less than full employment. What prevents the economy being at full employment is that if it were at full employment people would *choose* to demand less goods than were being produced. (Desired investment less than desired saving at full employment).

2. Non-standard "coordination failure" models, and "Keynesian" only in a slightly loose sense. (Roger Farmer builds these, I built one once.) There is a multiplicity of equilibria, or even a range or continuum of equilibria, maybe up to and including full employment. There is nothing preventing the economy getting to full employment, but nothing making it go there either. It's like a ball on a perfectly flat table. If everybody expects everybody else to go to full employment, the economy goes there. If not, it doesn't.

In your comment above I think you are talking about that second type.

In neither of these types of models is an inability to *afford* to buy full employment output what stops us getting there.

[K]

Nick,

"There can be structural unemployment, due to a mismatch between the particular goods supplied and demanded."

Yup. What I'm saying is that *if* you suddenly throw a constraint (borrowing) into the optimization, then the economy has to make its way to a new (suboptimal) equilibrium. That has costs that may appear similar to involuntary unemployment. Those workers are currently actually ZMP, but *only* because of that constraint. If you don't lift the constraint, the adjustment will be long, structural and suboptimal compared to the unconstrained optimization. Lift it, and the economy can go right back to previous unconstrained (optimal) equilibrium.

Think of it as a stag hunt. Lets say you are a big stag hunter and I just hunt rabbit. For awhile you convinced me to hunt stag with you, but since I didn't have the capital you lent me a few rabbits during each hunt so I'd be able eat on the trip. It worked out pretty good and I got to eat a little bit of stag along the way. Then we went on an epic stag hunt, I had to borrow lots of rabbit from you, but disastrously (for me) we never got any stag. And now you are wondering why we aren't hunting stag any more.

Here's why: Lets say that I knew you'd keep lending me rabbit at a reasonable rate for at least another 5-10 stag hunts. Over that period of time I think I have a high chance of coming out ahead so I'd do it. But I can't risk one more failed stag hunt: what with your extortionate rate on rabbits you'll be sending the dogs after *me* if we fail. So if you want to hunt stag, give me a few rabbits. Otherwise I'm done with your stag hunts. I'll be hunting rabbits so I can pay the man.

Is this basic Keynesian logic where the real rate is too high?

[K]

I'm with Dan. Lets say it takes a year for business to ramp up production of the consumption basket. There's unused capacity so why not? So they hire, workers get more income and then, what do you know, given current rates, they'd all rather pay off consumer debt than buy the extra consumption basket output. Unless the lenders want to buy the stuff (they don't), there will be deflation. If prices are sticky the goods market *will not clear*. Much of the inventory may eventually clear (though some haircuts will be forever unsold), but there will be deflation and losses and, especially if producers borrowed heavily to expand, there will be significant downward wage pressure and layoffs (if wages are sticky). There's no money in this story. Just uncertainty, stickiness and wrong real interest rates.

Any time you constrain a price, markets will not clear. The real rate is just a price in an intertemporal consumption/investment/labour market. I don't see how setting it badly could permit the system *not* to fail.

[Nathan Tankus]

@Nick: ah now i think i notice were we're talking past each other. you're talking about ex-post spending multipliers which lets income rise with purchases/sales. Here is my restatement of Dan's sentence.

"Given firms, households etc expected income, they will not budget enough purchases in the coming year to purchase all output at full employment levels."

There's also the important point that, especially in the u.s, a private sector led expansion hits huge fiscal drag because the payroll taxes (and other taxes) of the newly employed.

[Dan Kervick]

I think I have probably run together two different problems. One is the problem K describes which is a macroeconomic possibility.

But what I’m also interested in are plain old prisoner’s dilemma effects. Policies can only produce global macro effects by creating micro incentives that lead individual units to take actions in their limited local spheres that add up to the big collectively optimal macro action. Most businesspeople don’t think like macroeconomists. They are not basing their decisions on applied macroeconomics.

I fight this battle every day. I am often trying to convince my bosses to invest in various kinds of new production related to the particular product my unit sells. If I could convince my bosses to invest in this production, and if a million other people like me could also convince their bosses to do similar kinds of production, then the money that is invested in the production would make it into the pockets of the consumers of all of our products, and people would perhaps be able to purchase the additional output if they don’t have to save too much.

But bosses don’t think that way. If we expand production, the people who have to be paid to do the production are not the people who need to buy the stuff we produce. Very few business decision-makers are attending to grand, large macroeconomic conditions or basing their decisions on the expectations of the global or national future. They base those decisions on phenomena that are right in front of them. If I can show my bosses concrete evidence that 10 people said that if we can deliver X they will pay $Y, then that will move the bosses to produce the X. If all I can show them is that the customers said that if we deliver X and they are all richer next year, then they will pay $Y, that won’t move the decision-makers.

For a policy to be effective, it has to be more than the case that the policy creates conditions such that it would be collectively rational for the business sector F as a whole to do some collective action A. There is no such collective action, really, because the “business sector” is not a decision-making agent. You need to create conditions such that it is rational for business F1 to do A1, and for business F2 to do A2, etc., where A1, A2, etc. add up to A.

[Nathan Tankus]

@ my last comment: *where we're

[rsj]

In neither of these types of models is an inability to *afford* to buy full employment output what stops us getting there.

For the equality of expenditures and income, unwanted inventory accumulation must be counted as income to the producer, but unwanted inventory accumulation is by definition output that that cannot be sold at the given price vector, and therefore cannot be exchanged for other output.

All you know is that the income paid out to the factors of production was *insufficient* to get them to voluntarily purchase the excess inventory, and so in order for NIA to hold, you imputed that the firms received income from the products that they failed to sell equal to the income that the production of the product cost the firm.

With such a definition, it is impossible for a firm to go bankrupt, as whatever they spend on producing output will be imputed to the firm as income in case the output doesn't sell. Suppose all firms price all goods to be too expensive, in terms of labor. So no goods are sold. Yes, in equilibrium, whatever the firms paid out in labor costs is their imputed (NIA) income due to unwanted inventory accumulation. And in theory, there is enough of this income to buy all output. But in reality we know that workers cannot afford to buy output, that no output is sold, and that firms themselves are going bankrupt.

NIA only makes sense if the economy is at a market clearing price vector. If prices are away from the market clearing price, then it can certainly be the case that there isn't enough income for all the output to be sold, and the belief that this has something to do with our current predicament is a legitimate belief. IMO, much more legitimate than things like "CB communication policy failures".

[J.V. Dubois]

Interesting debate, especially about the question: "The problem is that households in the aggregate do not have enough income to buy all of the output that the private sector could be producing at full employment."

And I am with Nick in this one. Imagine that the Say's law holds perfectly. In such an environment this sentence basically means, that the households in aggregate cannot produce anything of worth in exchange for what they need/want. They are forced to sit idly (or consume their own product) forsaking any trade and we observe unemployment and recession.

If we use K's example of 1% population fueling investment consumption boom for the rest of the 99%, this basically means that this 1% of population produces something essential (financial services?) to the rest of the population and people within that 99% cannot do anything useful within this community. There is no trade among those 99%. So if those 1% decide that they do not want that much of what 99% offer (IOU's) people among 99% are forced to sit idly. Please realize, that there does not need to be "something" else that 1% want (yachts, monsterer SUVs). They may for example require more leisure and thus collectively restricting the amount of financial services they produce for 99%.

Hmm, now I realized if I did not find another weak spot in Say's law. What if insufficient demand for some goods and services can be "balanced" not only by insufficient demand in another area, but also by excess demand for leisure? And the decision about the amount of leisure you decide to consume is similar to the the decision about the amount of money you want to save. This decision cannot be forced on you this potentially standing behind recessions. Maybe we may adjust the sentence "Recessions is always and everywhere a monetary phenomena, unless they are leisure phenomena" :D

[Nick Rowe]

Dan: "But what I’m also interested in are plain old prisoner’s dilemma effects. Policies can only produce global macro effects by creating micro incentives that lead individual units to take actions in their limited local spheres that add up to the big collectively optimal macro action. Most businesspeople don’t think like macroeconomists. They are not basing their decisions on applied macroeconomics."

Totally agreed. (I would just delete your "Most" businesspeople, to make it even stronger; because almost none of them think like macroeconomists.) If what you said there wasn't true, we would have to scrap the whole of macroeconomics.

Nathan: "Here is my restatement of Dan's sentence.

"Given firms, households etc expected income, they will not budget enough purchases in the coming year to purchase all output at full employment levels.""

Totally agreed. Though I would add that expected income is just one of the things (albeit a very important thing) that determines their planned expenditure. New Keynesians/Neo Wicksellians would add the real rate of interest as an important extra thing. Monetarists would add the stock of money as an important extra thing.

Now, start with underemployment, where planned expenditure equals expected income equals actual income.

New Keynesians would say the central bank should cut the rate of interest, (and monetarists would say the central bank should increase the money supply) so that people revise their plans, and planned expenditure now exceeds expected income. As time passes, and those revised expenditure plans are implemented, people now are surprised to find their actual sales and actual income exceeds what they had expected. So they revise upwards their expected income, and revise upwards their planned expenditure, and the recovery continues.

(Actually, New Keynesians nowadays almost never, AFAIK, spell those steps out, because they skip the whole disequilibrium process story. When monetarists talk about hot potatoes, they are spelling out that process story.)

[Nick Rowe]

K: "There's no money in this story."

So people are trying to barter yachts for haircuts, (or yacht builders services for barbers services). There would be an excess demand for yachts matched by an excess supply of haircuts.

Totally possible, but most recessions don't look like that. There are almost no goods in excess demand.

rsj: start at the beginning. If I build a $1 million supercar, I can afford to write myself a cheque for $1 million, deposit that cheque in my bank account (the same one on which the cheque was drawn), so the cheque won't bounce, so I can always afford to buy that supercar from myself. (Whether I would *choose* to buy that car from myself is another question, of course).

Now add in a second person who helps me build the car, and wants to be paid. But we can afford to buy the car together.

Now add in debt. If I have to repay my debt with the proceeds from selling the car, I can't afford to buy it myself. But me and my creditor can afford to buy it between us.

And so on.

JV: "Hmm, now I realized if I did not find another weak spot in Say's law. What if insufficient demand for some goods and services can be "balanced" not only by insufficient demand in another area, but also by excess demand for leisure?"

You have just rediscovered Real Business Cycle Theory!

[Nick Rowe]

Nathan: In case you hadn't seen it, here is my version of the New Keynesian/monetarist (mixed together) process story.

[Nick Rowe]

rsj: think about it this way: for any level of output, people could afford to buy that level of output if they chose to do so. But if they chose to buy less than that level of output, then they would be unable to afford that (original) level of output.

Or, think of it this way. Suppose that, in aggregate, people always chose to spend their expected income plus a single $1 bill (per year). Then output and income would rise without limit until it hit capacity and they were unable to spend that extra $1. If I changed it to "minus a single $1 bill", output and income would fall to zero.

[J.V. Dubois]

Nick: Neat! I have never thought about RBC in this way and you are of course right. It seems that for me thinking about the Say's law is the approach with most added value for me. I was able to order my thoughts about New Keynesians thanks to one online presentation by Brad DeLong on Say's Law. And now it seems that RBC can be grasped very intuitively just by expanding on it. What is interesting for me, is that even DeLong "accuses" RBC economists (Fama, Lucas) from believing in the strong version of the Say's law without them thinking about money, or financial instruments in a broader sense. But all the while he just discarded another equally plausible explanation of Say's law via insufficient demand for goods and services being countered by "excess demand for leisure".

And in the way, it is interesting to see that very similar story being played out over again. 80 years ago Keynes promoted using fiscal policy to bring us back into the realm of classical economy - back into a Say's world. And we can see the similar story unfolding here - let's use market monetarism to get the money out of the picture so that we can go back into the comforting RBC world where Say's law stands firm and that makes intuitive sense for most of us.

[Nick Rowe]

JV: Understanding Say's Law (different versions, when right and when wrong) is very important for understanding macro. Brad DeLong is very good on Say's Law.

[rsj]

think about it this way: for any level of output, people could afford to buy that level of output if they chose to do so.

Only if it is correctly priced. 2 people -- a firm spends 1 million to build a supercar, which it then tries to sell for 1.1 million. We have only 1 million in income and so cannot buy the supercar. We are wondering why the supercar has gone unsold, since by definition supply creates its own demand, etc. It hasn't sold because it was incorrectly priced.

Now if it *does* sell for 1.1 million -- say we take out a loan for the 100,000 and the bank creates enough money for us to buy the car. Then the owners of capital take delivery of an extra 100,000, which they turn around and invest (by purchasing our note). Now the car has sold and because it sold there is enough income to buy it. An extra 100,000 million was needed, and the banks created the additional income which then accrued as additional savings to capital.

That is ex-post. Ex-ante, there is only enough income to build it, not to buy it.

In order for there to be enough income to buy it, it has to be correctly priced.

And one can imagine, when debts are going up, that businesses succeed in selling overpriced cars for a long period of time, during a period of constantly increasing debt, and simultaneous to that, owners of capital succeed in taking delivery of excessively large amounts of capital income for a period of time.

When it stops, suddenly we don't have enough income to buy the car.

[Nick Rowe]

rsj: "Only if it is correctly priced. 2 people -- a firm spends 1 million to build a supercar, which it then tries to sell for 1.1 million."

No. Even if the price is outrageous. Suppose it cost the firm nothing to build the car. It's all their own labour, scrap materials, and a massive markup. If it prices the car at $1 trillion, the two people just write themselves cheques for half a trillion each, and buy half shares in the car each.

[rsj]

Nick,

"Suppose it cost the firm nothing to build the car. It's all their own labour, scrap materials, and a massive markup. If it prices the car at $1 trillion, the two people just write themselves cheques for half a trillion each, and buy half shares in the car each."

You are assuming some sort of coordination that happens outside of the price mechanism. For example, a legally binding commitment by the car maker to increase the income of everyone who buys cars from them. In a many-goods economy, there are no such assurances -- all we have are the market prices.

In your example, the workers receive an income of 0. The firm wants to sell a car for 1 Trillion. In such an environment, it is perfectly reasonable to say that the workers do not have enough income to buy the car.

You are pointing out that there is an equilibrium in which the workers, *after* buying the car, receive $1 Trillion of dividend income from the sale of the car, and with this income they can, ex-post, afford to buy the car.

First, you cannot switch cause and effect like that. The car needs to be bought *first* if it is to be sold for more than production costs. On the other hand, if it is to be sold for less than or equal to production costs, then the workers are paid first. There is a coordination problem here. It matters who is paid first, as there is always a choice that the other side can defect.

If workers could receive guarantees that for every additional dollar of consumption spending paid, their own wages would increase by one dollar as well, then of course they would buy -- it would be foolish not to. But we do not have these guarantees. Then we would be focusing on things like central bank communications strategies, since all that messy market clearing stuff would be solved by some coordinator (who, I guess, must exist but cannot be the government :P).

[rsj]

Or better yet, assume it takes one day to build the car, and the workers need to be paid first. So today, they are building stuff to sell tomorrow, and buying stuff built yesterday. Forget cars, just call it food.

For the workers to defect means that they work today but don't buy all the stuff they built yesterday at the current prices. They demand lower prices today to buy the goods that they were paid to produce yesterday.

For the firms to defect, after selling all their inventory today, they decide to supply less tomorrow, meaning their labor demand curve falls today, but they still expect to sell all the inventory they produced yesterday.

[Nick Rowe]

rsj: "In your example, the workers receive an income of 0. The firm wants to sell a car for 1 Trillion. In such an environment, it is perfectly reasonable to say that the workers do not have enough income to buy the car........If workers could receive guarantees that for every additional dollar of consumption spending paid, their own wages would increase by one dollar as well, then of course they would buy -- it would be foolish not to."

Capitalists (the owners of the firm) are people too. They earn income and spend it. There is always and everywhere exactly enough income to buy the goods we produce, at any price.

"There is a coordination problem here....."

Yes! That coordination problem is *exactly* what I'm yammering on about when I talk about "communications strategies"!

Whether we would choose to spend enough to buy all the goods we can produce is the question. Yes, there certainly is a coordination problem; when we make those choices individually we may or may not choose to buy what we would agree to buy in some hypothetical Big Meeting. And the job of the central bank is to help us coordinate on a good equilibrium, both by printing the right amount of money so we choose to spend the right amount, and, even more importantly, by telling us it is committed to some target (like NGDP) that would act as a focal point to help us get to that good equilibrium.

It's a cross between: the central bank acting as conductor of an orchestra coordinating the different instruments; the central bank getting the money supply right. (And the people of the concrete steppes go all funny and start talking like engineers in Yorkshire accents when I talk about the central bank as conductor of an orchestra, or coxswain on a racing eight.)

[Nick Rowe]

rsj @3.30. Let me translate that into my language: it takes time to build a car. Starting to build a car is an investment. Investment depends on expected future demand. Yes! That's what this post is all about.

[dilletaunted]

rsj is back! o frabjous day

[K]

Nick: "In neither of these types of models is an inability to *afford* to buy full employment output what stops us getting there."

A bit late, but got back to thinking about this. There is another kind of equilibrium, technically more akin to yours and Farmer's, but in effect, more like Keynes'. Imagine that the world has thousands or millions of stochastic factors, most of which are inactive. At any given time only a small fraction are dominant, and while they are active the agents in the world have to do their best to determine the structural parameters before new ones arise and become dominant. Though only a small fraction of the factors are dominant, the risk space is still of enormous dimensionality, especially compared to the relatively small number of periods that the agents (econometrists) have to take measurements and estimate a model. I don't know if you are familiar with this (pdf) paper by Weitzman. Basically, even with high a high information prior (like a normal) the posterior can be hypersensitive to the exact parameters of the prior, even in the limit of an infinite number of observations. And in the real world with the comparatively tiny number of observations, our subjective posteriors may *rationally* be radically different from each other. The paradigm of a universe with agents who *know* the structural parameters of the dynamic couldn't be more irrelevant. 

If we return to our stag hunt, the reality is that I have only gone on a few hunts, and my initial vague prior was strongly conditioned by your assurance that there I would score big by hunting stag. After our epic failure, I have massively revised lower my estimate or the returns from hunting stag. And despite your vast experience, I don't trust your estimates because our interests are not aligned. So now we suddenly have radically different posteriors, and though the structural parameters of the model are unchanged, we can easily find ourselves in a totally new equilibrium, as prices and quantities are determined by our *subjective* preferences and probabilities, and not by the absolute (model designer?) probabilities. In a world of such vast uncertainty, the rapidly changing and divergent nature of subjective agent probability measures (even perfectly rationally formed ones) is essentially indistinguishable from Keynes' animal spirits.  In a world of such vast and overwhelming complexity, to insist on real world conformity to a paradigm of perfect, consistent and fully processed information requires an extreme degree of pedantry. 

Returning to the ability to "afford"... it's all just a matter of expectations. "Afford" means *I* think I can make it. Your opinion may rationally differ. But my expectation is all it takes to move the equilibrium.

[K]

Nick,

Rereading my comment... It wasn't my intent to accuse you, in particular, of pedantry. It was more intended as a comment on what we all do, as a profession, when we build models, and confuse the proverbial map with the territory. Anyways, sorry.

[Nick Rowe]

K: I didn't take it as an accusation. No worries.

I think I see what you (might be) saying, and I think you are right. It would take me a lot of words, or math, to say it precisely. Here's a rough rendering:

Robinson Crusoe does not know what he can afford, and does not know what he can produce, but he does know for certain that he can afford what he can produce. But this does not aggregate up. The sum (across agents) of expected abilities to afford does not necessarily equal the sum of the expected abilities to produce.

[K]

Yes! I like you succinct summary. So now we can have a pure demand (or supply) shock without any medium of exchange and without even a unit of account. Because agents in the real world know literally nothing about the expectations and plans of almost all the other agents in the economy (nor do they even know the "real" probabilities) there are essentially no constraints on their own rational expectations. And in a world of massive leverage it doesn't take a big change in expectations to cause an asset price fall which pushes people into negative equity which in turn causes forced selling causing further large drops in asset prices at which point our aggregate income expectations and our ability and desire to take risk is so low that we are suddenly all hunting rabbit. Crusoe by himself would *never*. But add Friday, and all hell can break loose.

[Nick Rowe]

K: 2 agent model: you and me. Suppose you can only produce left shoes, and I can only produce right shoes, and we can't communicate before we get to market and barter left for right shoes (assume we both have 2 feet). Yes, we could have a coordination failure, in which the number of pairs of shoes produced is too small.

But real world recessions don't seem to look like that. We don't see an excess supply of right shoes and an excess demand for left shoes. Yours would look more like a PSST problem.

[rsj]

And the job of the central bank is to help us coordinate on a good equilibrium, both by printing the right amount of money so we choose to spend the right amount, and, even more importantly, by telling us it is committed to some target (like NGDP) that would act as a focal point to help us get to that good equilibrium.

Here, I would argue that the central bank is just one tool, which may or may not be effective. Fiscal policy is another tool that may or may not be effective. But the track record of fiscal policy is at least as good as the track record of monetary policy, irrespective of its theoretical position. In both cases, the tools are limited, because just as households can offset changes in government debt issuance with more savings, so the financial sector can offset changes in bond purchases by the central bank with bond sales, so that the total number of bonds available to the non-financial private sector remains unchanged, and the balance sheet of the non-financial private sector is unchanged, and the income of non-financial private sector remains unchanged. In that case, the central bank is not able to supply households with more money.

When it is an income problem, then changes in the OIR may not be effective, or the effect of those changes may be too small to make a difference.

The point of my example was to argue that it *can* be an income problem. If firms believe that demand will be lower in period 2, then they hire less labor in period 1, and if prices are sticky, then there isn't enough income in period 1 to purchase the goods produced in period 0 because the prices of those goods are stuck. As soon as you acknowledge that it can be an income problem, then you stop only looking solely to the central bank to orchestrate the economy, but you look to the whole toolbox: fiscal policy, financial regulations, trade policy, government investment, etc.

rsj is back! o frabjous day
Thanks! Really busy with a new career, so not much room in my head for learning econ now. But still a great forum!

[rsj]

On order is important/coordination failures -- television dialogue between detective Adrian Monk and his assistant, Natalie Teeger:

ADRIAN MONK
What's this?

NATALIE TEEGER
A check for $300. I'm hiring you, Mr. Monk. I need your help. I can't do it myself.

ADRIAN MONK
Oh, this check's no good.

NATALIE TEEGER
That's sweet of you to say, but...

ADRIAN MONK
No, I mean it's literally no good. You can't cover this.

NATALIE TEEGER
Sure I can. I just deposited my paycheck on Wednesday.

ADRIAN MONK
Right. But I happen to know that that check is going to bounce. So this check is pretty much worthless.

NATALIE TEEGER
You wrote me a bad check? How could you do that?

ADRIAN MONK
I might ask you the same question.

[K]

Nick,

Your shoe swap economy is a bit too simple to make my point. What's missing is probabilities and risk, which is why I like the stag hunt. All that's happened in that story is that we are all hunting rabbit instead of stag despite *no* change in the supply of rabbit and stag. What's changed is my tolerance for failure has declined because of my rabbit debt to you.

So now, in my subjective assessment, the balance has tipped in favour of hunting rabbit rather than investing in the stag hunt. That is very suboptimal in terms of output, but it does (barely) feed my family. If you want to get back to a more optimal equilibrium you'll have to lower your lending rate on rabbits to shift my risk adjusted returns back in favour of the stag hunt. Where is the excess demand in this story?

The most important thing about this story is that the "objective" or "absolute" or "model designer" probabilities don't matter. We might as well agree that there is no such thing. All that matters in determining the equilibrium is the agents' subjective probabilities and risk preferences and also what *actually* happens. But given that, there is no material difference between the two following scenarios:

1) The real rate is constant at a previously optimal level, but the risk tolerance or subjective expected returns of the agents are reduced; and

2) Everything is unchanged *except* the real rate is increased from the previously optimal level.

The second scenario is easy to analyse and clearly results in a transition from an optimal equilibrium to a suboptimal one, with lots of deficient demand and unemployment during the disequilibrium phase while the economy transitions from stag to rabbit hunting. Or do we not agree that suddenly raising the real rate by e.g. 10% would result in a state of the economy that we would all recognize as a recession? If not, we should definitely discuss that first.