Monday, August 5, 2013

On Krugman's Models and Mechanisms

This is a thinking out loud post -- I am still a novice when it comes to how to translate results in the information transfer model (ITM) into the language of economics. If any economists are out there reading this, I'd appreciate some guidance.

Paul Krugman wrote up a blog post where he talks about the AD-AS model picture. I was initially drawn in by his comment
"... deflation could be expansionary if it is perceived as temporary, so that deflation now gives rise to expectations of future inflation."
I found this interesting -- it gives a way to achieve a weird effect in the information transfer model: expansionary contraction of the money supply. However, the ITM version doesn't depend on microfoundations or expectations. It simply happens when the the base is large compared to NGDP.

After musing on that for awhile, I decided to look at supply and demand curves in the information transfer model (since that's what Krugman was talking about). The keen thing about this model is the way it represents these curves. The supply and demand diagrams you frequently see in economics are a projection from a three dimensional space to a two dimensional space. I show what these look like for 1985 and 2010:

Both the red and blue curves show what the supply and demand curves look like at the given value (solid curve) and for shifts of +3% (dashed curves).

The red curves show what I call the supply curve, which is defined to be the equilibrium point at constant values of the monetary base for various values of AD and has more in common with the LM curve in the IS-LM model than the AS curves (SRAS or LRAS) in Krugman's pictures. I am also showing these curves vs NGDP which is different (I will show RGDP like Krugman does below). One interesting thing that is apparent is the MB-NGDP orthogonality line makes the AD curves bend over on themselves when viewed in the 2D space for 2010.

I took 1985 to constitute a "normal" time relative to the orthogonality line. The supply and demand curves for 1985 (graphed vs RGDP) look like this:

Here is the logic of the diagram. A boost of real AD at a constant monetary base should be deflationary as the monetary base is now too small relative to the new economy -- the real value of a dollar has gone up because each dollar now buys the same fraction of a larger economy. Increasing the monetary base without an increase in AD should raise the price level. Each dollar now buys a smaller fraction of the same real economy and real output falls.

Now we look at our current predicament. The supply and demand curves for 2010 (graphed vs RGDP) look like this:

Note that the "SRAS" curve has the same slope identified as showing a liquidity trap by Krugman in his post. However, the AD curves slope downward as opposed to upward. 

Here is the logic of the diagram in this case. A boost of AD at a constant monetary base will generate inflation because the monetary base is now too large relative to the size of the economy -- we are in a Japanese-style lost decade. Increasing the monetary base without an increase in AD will be slightly deflationary and lead to only a small increase in the new equilibrium RGDP (basically, the new money you printed doesn't budge inflation, so becomes real money). Since we are near the orthogonality line, monetary policy doesn't accomplish terribly much.

Where this boost in AD could come from is not specified in the information transfer model. It could be increased government spending. It could even potentially come from a market rally based on what the conventional wisdom says about monetary policy targets. In this second scenario, talk from the Fed about expanding the monetary base could cause people using one traditional model (i.e. not listening to me or people who say monetary policy is ineffective) to expect a boost in AD causing markets to go up producing an actual boost in AD. According to the ITM any concrete steps (concrete steppes?) to enact said policy would lead to some actual deflationary forces. If the AD boost had a larger effect on the price level than the deflationary MB effect, then the Fed could potentially eke out a victory. If the reverse occurred (MB effect overpowering the AD boost), then the deflation would catch up ... looking eerily like Japan's experience since the 1990s.

On a side note, Scott Sumner had a post up August 2nd or 3rd (2013) apparently critical Krugman's post (it simply quoted some of Krugman's post and said something along the lines of economics professors should take econ 101 again), but it has since disappeared. Maybe it was a mistake.

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