Worthwhile Canadian Initiative

Micro Profs teaching Intro Macro

My crappy little Twitter poll isn't conclusive of course, but it mostly agrees with my priors based on anecdotal evidence, so I think it's probably mostly right.

I think this points to a problem, in two senses:

1. Finding profs willing and able to teach Intro well is not easy. It's low status (and economists dumping on "Econ101" doesn't help); it doesn't help with your research (which is what gives most status and career advancement); and some profs are not good at teaching large classes and explaining things simply and clearly to students who might not be natural economists and who don't know much math. And if more than half the profs in a department (Macro profs are a minority) aren't comfortable teaching the Macro half of Intro, this makes it harder. (This can be ameliorated only partly by having Micro profs teach only Intro Micro and not Intro Macro).
2. As K D said in reply to my Twitter poll: "How in the heck can a person have an econ phd and not understand the basics of both? We all passed qualifying exams. An Econ PhD should be capable of teaching intermediate in both, IMO." He's got a point. Something's not right. It is a puzzle that needs to be explained. But the puzzle is the asymmetry.

I think this problem has always been there (at least in the 40 years I have been teaching Intro), but suspect it's been getting worse over time as the content of graduate Macro has become more different from the content of Intro Macro.

This is what I think is going on:

All teaching benefits from having an intuitive feel for the subject you're teaching. But this is more true for Intro than for more advanced courses in economics. Because the students themselves, being (mostly) new to economics (some have taken it in high school), don't yet have an intuitive feel for the economic perspective, and it's your job to teach it to them. When you are teaching Intro you are going to get all sorts of questions coming out of left field, and you have to do your best to answer them; you can't just crank through the model and point to the equations. Teaching Intro is not like passing a PhD comprehensive exam (though that might say something about PhD comp exams).

Macro profs "get" Micro; Micro profs don't "get" Macro. Macro just feels weird to them.

Yes of course this is a gross generalisation, to which there are many exceptions. But I think there is a real asymmetry here.

If I'm right about that (and Microeconomists can tell me whether they think I'm right), we need to ask why that is. (And it's obviously not because Micro profs are less smart than Macro profs.) Here is my hypothesis:

Macro feels weird to Micro profs because Macro is weird. And Macro is weird because Macro (often implicitly) assumes monetary exchange and Micro doesn't. (Yes I'm back on my hobbyhorse again.)

It's got nothing to do with Macro being about "the economy as a whole" and Micro being about parts of the whole (which we sometimes misleadingly tell our Intro students when trying to explain the difference between Micro and Macro). Yes Macro is (mostly) about "the economy as a whole", but a lot of Micro is too. And Micro profs are comfortable thinking about General Equilibrium as well as Partial Equilibrium.

It's got nothing to do with Money as Unit of Account. Microeconomists are perfectly comfortable treating any good as numeraire, so if you tell them the numeraire is money, because that's what real people use as numeraire, they're fine with that.

I think it's about the role of Money as Medium of Exchange. Which makes general equilibrium, and general disequilibrium when some prices are "sticky", very different from a barter economy or one with a central Walrasian market where any combination of goods can be swapped with any other combination of goods by all agents meeting simultaneously in one big market.

If my hunch is right, then Micro profs should feel more comfortable teaching the Long Run Growth theory part of Intro Macro, because Long Run Growth theory ignores monetary exchange. It's the other part of Intro Macro -- Short Run Macro -- that they won't feel comfortable with. Microeconomists: do you think I'm right about that?

Suppose we introduced Short Run Macro like this:

"Micro starts out with Scarcity and Choice. Then it talks about how people Gain From Trade (exchange), and Markets and Supply and Demand. And you can get Gains From Trade even in a pure endowment economy with no production. But if you add Comparative Advantage (Ricardo) and Economies of Scale (Adam Smith) you motivate Division of Labour in production and the Gains From Trade get even bigger. And what Micro says about all that is important. But Macro adds that trade is very difficult if you don't use money to buy and sell goods. And if something goes wrong with the supply or demand for money, this can make trade more difficult in all markets in which money is used. So some of the potential Gains From Trade are lost, which makes people worse off, and reduces the amount of goods produced. A shortage (excess demand) of money, for example, can reduce demand in all markets where money is used to buy whatever is being sold in that market. And that's a big economic problem."

So I'm asking Microeconomists in particular: if we introduced Short Run Macro that way, would it make more sense to you than Y=C+I+G+NX and Saving and Investment and Income and Expenditure and Aggregate Demand and Aggregate Supply?

[Today (tomorrow if you count Saturdays) is my last day at "work". I'm vaguely thinking about retirement projects.]

Hydraulic Monetarism

There are two ways to increase your stock of money: 1. increase the flow in; 2. reduce the flow out.

There is only one way to increase your stock of any other asset: 1. increase the flow in.

(Unless you are a producer of that other asset. Or unless you are a dealer in that other asset, who both buys and sells and holds a buffer stock of inventory. But we are all dealers in money.)

Money is different because it circulates. That difference matters. If I want to increase my flow in, I must find some other individual who is willing to increase his flow out. Because trade is by mutual consent. And if everybody else is trying to do the same thing as me, I won't be able to find some other individual who wants to increase his flow out. But if I want to decrease my flow out, I can do it unilaterally. Quantity traded is whichever is less: the quantity buyers want to buy; the quantity sellers want to sell.

There is no circular flow of income; there is a circular flow of money. People in a barter economy still have income, when they trade the apples they produce for the bananas they consume, but nothing flows in a circle. And when money flows one way, something else flows the other way. That something else could be anything: newly-produced final goods; inputs like labour land and machine services; intermediate goods; or non-money real and financial assets. And if barter is too difficult, nothing else can flow unless money flows in the opposite direction.

If we observe a buyers' market for one good, it makes sense to ask what has happened to increase the supply or reduce the demand for that particular good. If we observe a buyers' market for lots of goods, it makes sense to ask what has happened to reduce the supply or increase the demand for money. Because every market is a money market: the demand for apples is a supply of money; the supply of apples is a demand for money.

If everyone wants to increase their stock of land, and the aggregate stock of land does not increase to satisfy their desire, there is nothing they can do in aggregate, and there is nothing they can do as individuals. They cannot buy more land (increase the flow in) because nobody is willing to take the other side of the trade.

If everyone wants to increase their stock of money, and the aggregate stock of money does not increase to satisfy their desire, there is nothing they can do in aggregate, but there is something they can do as individuals. They cannot buy more money (increase the flow in); but they can sell less money (decrease the flow out). And as individuals they will do what is individually rational, even though the outcome, like Prisoners' Dilemma, is collectively irrational. So the circular flow of money falls, and the flow of everything else in the opposite direction falls too. And since exchange makes people better off, that reduction in the volume of exchange makes people worse off. We call that a recession.

I've said all this before (and it's all in Yeager and Clower and others). But maybe I've said it clearer this time.

The Parable of the Fruit Trees

The apple producer produces apples. The banana producer produces bananas. The cherry producer produces cherries. Every year they always work exactly the same number of hours and produce exactly the same quantity of fruit.

If you define "recessions" as a decline in output and employment, there cannot be a recession in this economy. By assumption.

But suppose the apple producer prefers eating bananas; the banana producer prefers eating cherries; and the cherry producer prefers eating apples. And the Wicksellian triangle (lack of coincidence of wants) means they use money to buy and sell fruit, because it is difficult for all three agents to meet at the same time at a central Walrasian market and trade all three fruits simultaneously. Then a shortage of money (an excess demand for the medium of exchange) would cause a decline in the volume of trade. Unable to sell as many apples as he wants to sell, the apple producer buys fewer bananas than he normally would. So the banana producer is unable to sell as many bananas as he wants to sell, and buys fewer cherries than he normally would. So the cherry producer is unable to sell as many cherries as he wants to sell, and buys fewer apples than he normally would. Each is stuck consuming too much of his own fruit, and too little of the fruit he prefers to eat.

I would call that a "recession", even though (by assumption) output, employment, and (aggregate) consumption are unchanged. People are worse off, because of a reduction in the volume of exchange, due to a reduction in the circular flow of money around the Wicksellian triangle. (A triangle is just a very small pointy circle.) It wouldn't make much difference to this story if they all decided to work fewer hours and produce less fruit because they couldn't sell it to earn the money to buy the fruit they wanted to eat.

Now let's change the parable slightly.  Each individual's tastes change over time, in a regular circular way. After a year of eating apples, they want to switch to eating bananas. And after a year of eating bananas, they want to switch to eating cherries. After a year of eating cherries, they want to switch to eating apples. But people only eat the fruit they themselves have picked from the trees they own (it tastes better that way). So there is a triangular trade in fruit trees, instead of the original triangular trade in fruit. The owners of apple trees sell their trees and buy banana trees. The owners of banana trees sell their trees and buy cherry trees. The owners of cherry trees sell their trees and buy apple trees. (Like a 3-crop rotation.)

In the new version of the parable, just like in the original version, a shortage of money (an excess demand for the medium of exchange) would cause a decline in the volume of trade. Unable to sell as many apple trees as they want, the owners of apple trees buy fewer banana trees than they normally would. And so on around the triangle.

I would call that a "recession". It looks exactly like the recession in the original version of the parable. The only difference is that in the new version there is no trade in newly-produced goods and services (by assumption); the only trade is in assets -- people exchange fruit trees for money.

And in the new version of the parable it cannot be said that recessions are caused by an excess of (desired/planned/ex ante) saving. Nobody ever saves or wants to save part of their income in this parable (by assumption). They don't even have any "income", in the sense of "monetary income". It is not an excessive desire to accumulate assets that causes recessions; it is an excessive demand for one particular asset (the medium of exchange) relative to other assets. It's about the composition of their portfolios of assets, not about the total size of that portfolio.

Recessions are not about saving and investment. Recessions are about the supply and demand for the medium of exchange. A shortage of money causes a decline in the volume of monetary exchange. The volume of monetary exchange of flows of newly-produced final goods and services is just one part of the story, because those are not the only things that are traded. It's not all about GDP and its components. It's about gains from trade, where trade requires the use of money.

Public Debt: A Global Perspective

There is much international preoccupation with debt at the public sector, household and corporate levels and the upward creep in interest rates does apparently keep central bankers - including our own Mr. Poloz - awake at night.  Given the problem is an international one, sometimes it is useful to try and get a global perspective on the numbers.  One report from a relatively new  outfit known as the Institute of International Finance (IIF) recently pegged the total amount of global debt at $237 trillion (USD) or well over 300 percent of the world's annual economic output. According to one of their slides, in 2017 financial sector debt was $59 trillion, household debt $45 trillion, government debt $64 trillion and non-financial corporate debt $70 trillion.  This would make global public debt about 27 percent of the global debt total in 2017 and household debt about 19 percent with the remaining 54 percent from the corporate and financial sectors.

"Trickle Down", "Magic Dirt", memes and deep parameters

"Trickle Down Theory" is a meme used (mostly by non-economists) to ridicule certain economic policies and the theories on which those policies are supposedly based. My first year students sometimes ask me to explain it to them, not understanding that it's a meme and not a theory.

"Magic Dirt Theory" is a similar meme, of more recent (and "deplorable") origin (a quick search tells me it's from Vox Day/Supreme Dark Lord). But ideas, including memes, should be evaluated on their merits. Here is a critique of that meme, from a nationalist/conservative perspective.

You have probably heard of "Trickle Down Theory". But only 16% of the (probably unrepresentative) 127 people who answered my Twitter poll (thanks!) had heard of "Magic Dirt Theory". And the percentage was smaller for economists than for non-economists. This is a smaller percentage than I thought it would be, but not trivially small. I don't know whether in the long run it is memes that are powerful for good or evil.

Monetary and Fiscal Federalism, Debt, Canada, and the Eurozone.

A government that undertakes a commitment to target 2% CPI inflation does not, strictly speaking, "borrow in its own currency". Its bonds are an indirect promise to pay, via transversality transitivity (damn!), a specified quantity of CPI baskets of goods and services. In much the same way that bonds under the gold standard were an indirect promise to pay a specified quantity of gold. See my old post.

It is true nevertheless that a government whose bonds are promises to pay money that it itself prints, even if it targets 2% CPI inflation, cannot suffer a liquidity crisis. If there were a run on those bonds, where bondholders wanted to sell and hold money instead, the central bank could and would (to keep inflation on target) simply print as much extra money as people wanted to hold and use it to buy back the bonds they did not want to hold.

It cannot suffer a liquidity crisis, but it can nevertheless suffer a solvency crisis. The Magic Money Tree is real, but not very big. If we assume a currency/NGDP ratio of 5%, and Nominal GDP growing on average at 4% (2% Real GDP growth plus 2% inflation), the Magic Money Tree gives the government that owns the printing press profits worth 0.2% (=5%x4%) of GDP per year. Which isn't very big, and is already built into the government's budget anyway, as the profits from the central bank. In a solvency crisis the government would face a choice between defaulting on its bonds and defaulting on its commitment to not let inflation rise above 2%. Much like a government under the gold standard would face a choice between defaulting on its bonds and defaulting on its commitment to making its money worth a specified quantity of gold. But a solvency crisis like that could not coincide with a deficiency of Aggregate Demand where inflation threatens to fall below the 2% target. Instead it could coincide with an excess of Aggregate Demand, where inflation threatens to rise above the 2% target.

The above describes the Canadian Federal government.

Canadian Provincial governments are different. They do not "borrow in their own currency"; they can't pay their debts by printing money. They can suffer a liquidity crisis and/or a solvency crisis.

Canada is not like other countries. Canadian provinces play a big role fiscally, in taxing, spending, and borrowing. [Can anybody find that lovely graph I saw a few months ago showing Canada at the extreme end of the fiscal federalism measure?] Update: Thanks to Jim Sentance for pointing me to Kevin Milligan's post.

If you drew a line, with a unitary state at one end, and the Eurozone at the other end, Canada is halfway along that line. If you abolish the Federal government, leaving only the Bank of Canada, you get the Eurozone. Eurozone national governments are like Canadian provincial governments.

So what happened in the Eurozone could happen here, at the provincial level, even though it wouldn't be exactly the same. The biggest difference is that someone is in charge who can ultimately control both monetary and fiscal policy at the Federal level and decide who gets bailed out under what conditions.

I am not aware of any problems in the near and foreseeable future. But then I don't trust my foresight. And it may be a good idea to think through how we should respond to problems before they happen, and how we might reduce the probability that they do happen. Under what conditions should the Bank of Canada do a Draghi whatever it takes buying provincial government bonds?

Price Level Targeting targets the Stickiest Prices; Inflation Targeting targets the more Flexible Prices

And it's good to target the stickiest prices; and bad to target the more flexible prices.

It means that recessions under inflation targeting can last as long as it takes for the stickiest prices to change. Which is bad. And it's especially bad for us old macroeconomists, who remember that the whole point of New Keynesian macroeconomics, when it began in the 1970's, was to show that a good feedback rule for monetary policy, unlike a k% money growth rule, meant that recessions did not have to last as long as it took firms to change prices.

Some prices are stickier than others. Here's a simple extreme example to illustrate my point:

Half the firms change their prices every n periods; so a fraction 1/n of them change their price each period. Think of n as a big number, so 1/n is a small number. And they have to announce any price changes one period in advance, to warn their customers (this assumption doesn't matter much). The other half the firms change their prices every period, (without advance warning).

The economy is humming along normally, with all prices constant. Then a negative shock hits aggregate demand. The central bank does not have a crystal ball, so does not see the shock coming. It only learns of the shock when it sees all the flexible price firms cut their prices 10%. How does the central bank respond in the following period?

Constant Price Level Target. The central bank wants the price level to go back to where it was before the shock. So it loosens monetary policy just enough to offset the shock fully, so the flexible price firms raise their prices back to where they were before. The sticky price firms, since they know the central bank will do this, don't change their prices at all. The recession is over after one period (as long as it takes for the central bank to recognise the shock and respond to it).

0% Inflation Target. Since half the firms have cut their prices by 10%, the average price level has fallen by 5%. The central bank lets bygones be bygones, and wants the price level to remain at its new lower level, so inflation stays at 0% thereafter. The central bank knows that every period a fraction 1/n of the sticky price firms will cut their prices by 5%, and to offset this it loosens monetary policy just a little so that the flexible price firms raise their prices by (5/n)%. After n periods all firms have prices that are 5% lower than originally. The economy slowly recovers from the recession, but does not fully recover until all firms have adjusted their price to the new level of aggregate demand. Which means the recession lasts for n periods. After n/2 periods, for example, 3/4 of firms's prices are where they want them to be, but 1/4 of firms still have prices that are too high, so their sales and output is too low.

Intuition. Inflation targeting ignores the levels of prices. It only looks at changes in prices. It wants all price changes to average out to 0% (for a 0% inflation target). So firms that change their prices twice as frequently get twice the weight in the average that the central bank targets. But firms who change their prices twice as frequently should only get half the weight; because they can adjust to aggregate demand shocks twice as easily, and have only half the need for the central bank to adjust aggregate demand so they don't have to change prices.

Other off-topic stuff: A Price Level Target also acts as an automatic stabiliser (for a central bank that sets a nominal interest rate). Because the expected inflation in the second period means the real interest rate falls in the first period. So the shock to aggregate demand is partly offset even if the central bank doesn't see it. And an NGDP level path target would be better still, if there are supply shocks, especially if the Short-Run Phillips Curve is flattish. But all that other stuff is beyond this post.

"Profits = Investment - Saving"

Or, "Profits = Expenditure - Income". Those are just alternative ways of saying the same thing, for a closed economy, if investment and saving include government investment and saving.

Most economists will say that's wrong. And it is wrong by standard definitions, where aggregate expenditure and income are the same thing, and investment and saving are also the same thing (for a closed economy, including government investment and saving).

But let me tell you a story:

There are firms and households (ignore government and foreigners). Firms rent land and labour from households, and use it to produce food which they sell to households (ignore capital). There is a fixed stock of currency that is used to buy and sell everything. Food cannot be stored. No other assets.

In any given year, if households spend $100 more buying food than the income they earn from rent and wages, then at the end of the year households own $100 less currency and firms own $100 more currency than at the beginning of the year. Firms have made a profit exactly equal to the $100 difference between households' expenditure and income. Or, firms' $100 profits are equal to households' negative saving (there is no capital and no investment in this story).

But who owns the firms?

If households own the firms, we can say that firms' assets are owned by households, and firms' profits are included in households' income. And if we do that, then we are back at the standard definitions where Expenditure = Income, and Investment = Saving, must always be true.

Or we could adopt an intermediate position: we could say that firms' profits are part of household income only if firms actually distribute those profits to the households that own them. In which case we get: Undistributed Profits = Expenditure - Income = investment - Saving.

There's a number of different ways we could add things up. Which is the best way? It depends.

Suppose firms were like a strange religious cult; they save all their profits for six years, then on the seventh year they blow the lot by spending it all on food which they burn as a sacrifice to the gods. None of the households want firms to do that; it's just what firms do, following some weird internal logic of their organisational structure. If so, you had better build that fact about firms' behaviour into your macroeconomic model. And it would not make sense to include firms' profits as part of households' income, because households know they will never be able to consume firms' profits. (And a corporate profit tax might really be a tax on corporations, and not on the households who own them, work for them, or buy from them.) So Profits = Expenditure - Income = Investment - Saving.

There is no one right way to do the accounting (though there are conventional ways, and it's easier to understand what others are saying if we all follow the same conventions). The accounting can't tell you what the world looks like (though it can help you keep your head straight when you are looking at the world). First decide what the world looks like; then do your accounting accordingly.

[An economist will probably make a comment on this post, and that comment will go automatically into the spam folder. Because Typepad, and history, across this and other macro blogs. But if it's a reasonable comment I will fish it out, after a short delay.]

"Monetary Policy Accommodation" and Upward-sloping IS curves

If you believe that the IS curve slopes up, then what the Bank of Canada says about "monetary policy accommodation" makes sense. If you believe the IS curve slopes down, like in the textbooks, then it doesn't make sense.

This is supposed to be a simple teaching post. My own mind is pretty simple anyway.

The IS equation is D(Y,r)=Y, where D is output demanded (desired expenditure), which depends positively on actual output (=income) Y, and negatively on the real interest rate r.

If we take the total derivative of the IS equation D_ydY+D_rdr=dY, and rearrange, we get the slope of the IS curve as dr/dY= (1-D_y)/D_r. The textbook assumes that 0 < D_y < 1, so the IS curve has a negative slope, because D_r < 0. If instead we assume D_y > 1, we get a positive slope. And if firms don't want to invest when output is low and there is lots of spare capacity, this assumption that D_y > 1, and so the IS curve has a positive slope, may be plausible.

Define the natural rate of interest r* as the solution to D(Y*,r)=Y*, where Y* is "potential output" -- the level of output consistent with inflation staying at the 2% target.

If there is a recession, so Y < Y*, then the Bank of Canada will need to set r below r* just to prevent Y falling even further below Y*, and set r even lower still to get Y to grow back to Y*. The Bank of Canada calls this "monetary policy accommodation".

Here's a picture:

It's more complicated than this of course. It always is. Expectations of future interest rates, output, inflation, and exchange rates, matter too. And it may take time for output and expectations to adjust. The natural rate of interest moves around over time, and a loss of "business confidence" (firms fear demand won't be there to justify investment) may take time to recover. And the IS curve might not slope up everywhere -- it might slope down at very low levels of Y, when gross investment is already zero and can't fall any further. But I think that's the gist of it.

And yes, if the Bank of Canada just sets an interest rate and holds it constant regardless of what happens to output and inflation (so the LM curve is horizontal forever) this is an unstable system (so resist the temptation to say that an upward-sloping IS curve means that if the Bank of Canada cuts the rate of interest this will cause a recession). But the Bank of Canada doesn't do that.

The (In)efficiency of Perfect Price Discrimination

I have always thought, and taught, that Perfect Price Discrimination leads to an efficient allocation of resources. I now think that is wrong. It only seems to work if we use partial equilibrium reasoning, for a single monopolist that practices PPD, holding constant consumers' income and the monopolist's Marginal Cost curve. It doesn't work in general equilibrium. And the easiest way to see this is to construct a counterexample where all consumption goods are produced by monopolists who practice PPD, while the labour market is perfectly competitive.

A PPD monopolist captures 99.99% of Consumers' Surplus by setting a different price for each apple for each consumer, that is 99.99% of that consumer's Willingness To Pay for that apple, down to where the marginal price equals the Marginal Cost of producing an extra apple. So the consumer buys all the apples up to the point where his marginal Willingness to Pay (Marginal Benefit) equals Marginal Cost, but is almost at the point of walking away from the deal and not buying any apples at all. It looks like it works to get an efficient allocation of resources (where Marginal Benefit equals Marginal Cost) if we think partial equilibrium.

But it doesn't work in general equilibrium. If all producers of consumption goods practice PPD, this is like the government imposing a 99.99% marginal tax rate on labour income. It reduces the marginal incentive to work extra hours to earn extra income to buy extra consumer goods to enjoy extra Consumer Surplus by 99.99%, because the monopolists will raise your individual price schedules in response to your increased income to capture 99.99% of your increased Consumer Surplus.

TLDR: if you make the rich pay more, because they are willing to pay more, nobody will do any work to produce anything.

A Balassa Samuelson theory of negative real interest rates despite productive investment and impatient representative agent

I think this is right (but I can't do the math to work out an example to be sure, though any competent grad student could). The idea is that you can get negative interest rates, despite productive investment and impatient consumers, because the prices of the goods you can invest to produce more of will be falling over time relative to goods you can't invest to produce more of. It might be a theoretical curiosum, but it might also be empirically relevant, with falling prices of manufactured goods and falling share of expenditure on manufactured goods, relative to services. And all that.

[And of course, I figure out this model of negative real rates just as it looks like the Bank of Canada will be raising rates soon. Oh well. They are still not very high.]

Here's a toy model, just to illustrate the basic idea:

Don't even try to "Normalise" interest rates

If you think that the rest of the economy is normalised, so it is time to normalise interest rates too, you are wrong. If the rest of the economy is normalised, then interest rates must already be normalised.

Wicksell said there was some underlying "natural" rate of interest. If the central bank sets a rate of interest below the natural rate this would cause inflation; and if the central bank set an interest rate above the natural rate this would cause deflation. So any central bank that wanted to stabilise the price level should aim to set the actual rate of interest equal to that underlying natural rate of interest. And the actual rate of interest would need to be (roughly) equal to the natural rate on average over any extended period of time if we wanted price stability.

We haven't advanced much since Wicksell. The only important thing a Neo-Wicksellian would add is that it's important to distinguish between nominal and real rates of interest (real = nominal minus inflation), so if we have a 2% inflation target we add 2% to the natural rate to get the "neutral" nominal rate. And the actual nominal rate would need to be (roughly) equal to that neutral nominal rate on average over any extended period of time if we wanted to keep inflation stable at 2%.

You can see how this matches the idea of "normalising" interest rates. We've got "normal" both in the sense of an average over time, and in the sense of a desirable norm that central banks should aim for.

But when I hear the words "The Bank of Canada (or some other central bank) needs to normalise interest rates soon" I reach for my shovel. Let me try to tell you why.

The Sustainable Bond-Finance Laffer Curve

Imagine an economy growing at rate g, with an interest rate on government bonds r, and a constant debt/GDP ratio D/Y. The government gains revenue from issuing new bonds gD each year, and loses revenue from paying interest rD each year. If r<g then the government earns positive net revenue from having and maintaining a positive Debt/GDP ratio, and can run a primary budget deficit forever with the debt/GDP ratio staying constant. But r is an increasing function of the debt/GDP ratio (the interest rate must rise to persuade people to hold a higher stock of government bonds, relative to their annual income), so past a certain point r will exceed g. So there is a Laffer Curve, like the one I've drawn above.

Seeing through Sovereign Wealth Funds?

In the first country, the government imposes a 50% flat tax on each individual's income, and uses the proceeds from that tax to finance an annual $10,000 transfer payment to each individual. The government has zero debt.

In an otherwise identical second country, the government has a sovereign wealth fund that owns a 50% non-voting equity share of each individual's personal business, and each individual owns a government bond that pays an annual $10,000 dividend. The government has zero net debt.

In an otherwise identical third country, the government imposes a 50% flat tax on each individual's income, and each individual owns a government bond that pays an annual $10,000 dividend. The government has positive net debt.

In an otherwise identical fourth country, the government has a sovereign wealth fund that owns a 50% non-voting equity share of each individual's personal business, and uses the proceeds to finance an annual $10,000 transfer payment to each individual. The government has negative net debt.

What is the difference between the four countries?

Remember that each individual can borrow or lend to other individuals. An individual in the second or third country can sell his government bonds, but an individual in the first or fourth country can borrow against his future transfer payments.

And each individual can buy or sell shares to other individuals. But there might be a non-negativity constraint here, that I can't quite get my head around. An individual can always issue more than 50% shares in his own business. But I can't figure out how an individual can issue negative shares to bring the total down to 40% if the government insists on owning a 50% share in his business.

Liquidity and risk of default might make a difference. And I haven't said what happens when individuals die or emigrate and new individuals are born or immigrate (things that might make Ricardian Equivalence false). But distorting "taxes" are already in the "model".

Negative Average Cost but Positive Marginal Cost of Debt-Finance

If the rate of interest on government bonds is less than the growth rate of the economy (r<g), then the average cost of bond-finance is negative. A government that has issued bonds, and issues more bonds each year to keep the debt/GDP ratio (B/Y) constant (which is sustainable), can have permanently higher spending, or permanently lower taxes, than an otherwise identical  government which has issued no bonds. Issuing bonds is a (permanent) source of government revenue. Bonds are not a "liability" in the normal sense of the word.

But it is important to distinguish between average cost and marginal cost. Unless the demand for government bonds is perfectly elastic, an increase in the debt/GDP ratio will increase the equilibrium rate of interest required for people to be willing to hold those government bonds. So the government is like a monopsonist facing an upward-sloping supply curve of finance, and the marginal cost of extra bond-finance will exceed the average cost of all bond-finance. The marginal cost of increasing the debt/GDP ratio might be positive even if the average cost is negative. It all depends on the interest-elasticity of demand for government bonds.

I will now try to do the math.

Monetary tightening can lower real interest rates

It's the investment accelerator. Monetary tightening means lower expected NGDP; real interest rates can go either way. Think of this as a teaching post, to explain the intuition. Or look at Miles Kimball's great post.

Here's a thought-experiment. Do not take this thought-experiment literally. It's just my weird way of doing the math, where I start with the answer and work back to the question it answers. Sometimes it's easier this way. Like trying to figure out the relationship between policy X and outcome Y when you know that Y/2=X but you are really bad at algebra so you can't solve for Y=2X.

Imagine that expectations are totally non-rational. Expectations are just exogenous, and do not adjust to match what is actually happening. And one day everyone wakes up expecting a permanent recession. When they went to bed they expected that output would remain at 100 forever, and nothing would ever change. Now they expect that output will be 90 forever. A permanent 10% drop in output.

But the central banker is an New Keynesian macroeconomist who years ago made a bet with his grad skool classmates that expectations are rational. He has since learned that expectations are totally non-rational and exogenous, but he doesn't want to lose his bet. So he has to figure out a way to make the world adjust to match the expectations people hold, since the expectations people hold do not adjust to match the world.

So what does the central banker need to do to the real interest rate to make those non-rational expectations of a permanent recession look like a rational expectations equilibrium? (Remember, I'm just solving for the New Keynesian equilibrium in a weird way, to make the math easier.)

The Bank of Canada's "Hot Hand" experiment and Price-level Targeting

This (pdf) might be the most important controlled experiment economists have ever run. The results of this experiment have been influential in the Bank of Canada's decision (so far) to stick with targeting inflation rather than a price-level path. And making the right decision on that question could save many billions of dollars (trillions worldwide) in reducing the risk and magnitude of recessions. I had read about the results of that experiment (by Robert Amano, Jim Engle-Warnick, and Malik Shukayev) soon after it came out, but only now decided to take a closer look.

Shocks hit the economy, and the Bank of Canada responds to those shocks to try to keep Aggregate Demand growing steadily despite those shocks. But there are lags, and the Bank of Canada does not have a crystal ball, so it will always fail. But the amount by which it fails depends on the strength of the automatic stabiliser properties of the monetary policy regime -- what the Bank of Canada targets, and what instrument it uses. And there are reasons to believe that a price-level path target would make for a stronger automatic stabiliser than an inflation target. If a shock causes aggregate demand to fall, and the Bank is (unavoidably) slow to respond, so inflation falls temporarily, a price-level path target means that people will expect temporarily higher than normal inflation thereafter, which reduces the expected real interest rate for any given nominal interest rate, which partially offsets the negative shock to aggregate demand.

The strength of automatic stabilisers will matter even more if you believe that the Zero Lower Bound on nominal interest rates may be a binding constraint on the Bank of Canada.

But it only works if people understand the difference between an inflation target and price-level path target, and expect temporarily higher inflation with a price-level path target following a negative shock. And this experiment was designed to see whether people could figure it out.

So What Happens in the Next Recession?

I’m not a macro economist by any stretch of the imagination and yet I cannot help wondering what is going to happen in terms of policy response the next time Canada goes into a downturn.  It is not a question of whether there will be another recession, only when. By policy response, I am of course wondering about the traditional tools used to affect aggregate demand such as fiscal and monetary policy.

Rip van Winkle on Price Level vs Inflation Targets

Rip van Winkle is put in charge of a New Keynesian central bank. He sets a nominal interest rate that he believes will keep inflation at 0% and the price level constant. (It doesn't matter if I change this to rising at 2% per year.) Then he falls asleep for 70 years, and that nominal interest rate cannot be changed until he awakes. This is clearly not good, because the nominal interest rate cannot be adjusted in response to any shocks that hit the economy over the next 70 years.

But before falling asleep, he has a choice of posting one of two announcements of what he will do when he wakes up:

1 Price level target. He will do what is needed to bring the price level back to what it was when he fell asleep, and keep it there.

2 Inflation target. He will do what is needed to keep the price level constant at whatever new level it is at when he wakes up.

Which is best?

What is the worst that could happen with a price level target? Suppose the natural rate of interest rises by 1% just after he falls asleep, and stays there. If prices are perfectly flexible the equilibrium price level will double, then fall slowly at 1% per year, returning to its original level just as he wakes up. (The 1% deflation means the real interest rate is the same 1% higher as the natural rate of interest.) With sticky prices it won't rise quite as much as that, and will fall a little more slowly.

What is the worst that could happen with an inflation target, if we hit the economy with the same shock? God only knows. If prices are perfectly flexible then anything can happen. The price level doubling then falling at 1% per year is one equilibrium. The price level quadrupling then falling at the same 1% per year is another equilibrium. The price level halving then falling at 1% per year is another equilibrium. And so on. And it could switch from one equilibrium to another just on a whim. What happens depends on what people expect to happen. And there are lots of things they could rationally expect to happen. And if prices are sticky? Well, it's going to depend on the exact nature of that stickiness. As well as on what people expect to happen. I can't answer that question with any confidence at all. I don't think any macroeconomist can.

In both cases we know the inflation rate will be 0% after Rip wakes up. But with a price level target we also know what the price level will be after Rip wakes up. That helps me figure it out. That also helps the people in my story figure it out.

Now you might think that's a daft thought-experiment. Because central banks don't fall asleep for 70 years. But central banks do not and cannot respond immediately to shocks that hit the economy. They don't observe changes in the natural rate of interest (or anything else) in real time. There are always lags between something happening, the bank figuring out what has happened (is it a temporary or permanent shock?), and responding to what has happened, and the economy responding to the bank's response. Sure, it's less than 70 years. But it is exactly as if the central bank fell asleep.

Would your answer change if Rip van Winkle fell asleep for only 10 years, or 1 year, or less? Why?

Price-level targeting as an automatic stabiliser for inflation

Targeting the price level could mean lower variation of inflation than targeting inflation. The best way to target inflation might be to target the price level instead. It's one of those paradoxes of pre-commitment. A promise to do something you don't want to do can affect others' expectations, and others' actions, and help you get what you want. Price-level targeting acts like an automatic stabiliser, which works even if there's a lag between the shock and the central bank's response to that shock. If expectations of the future price level matter, lags get offset by leads. And it could be better than letting bygones be bygones, depending on the parameters.

This is supposed to be a simple "teaching" post, to try to explain a point.