Wednesday, November 20, 2013

QE and inflation

After reading this Scott Sumner post, I thought I'd try to be more explicit about the differences between the information transfer model, Sumner's monetarist view and, say, Krugman's Keynesian view. Let's do it with through four questions:

Was the great recession peculiar to 2008?

Sumner: No. It could have happened in the 1970s, the 80s or the 90s for example. It was caused by bad monetary policy.

Krugman: Yes and no. Interest rates were too low in 2008 and a shock hit that conventional monetary policy couldn't handle. (However, there is no reason interest rates had to be too low in 2008 and they also were low in the early 2000s and the 1960s ... the shocks experienced at the time just weren't big enough.)

Smith (i.e. me): Yes. The circumstances had been building since after WWII, making the probability of a "great recession" more and more likely. A "great recession" could not have happened in the 1960s.

Why didn't QE cause inflation?

Sumner: QE is expected to be temporary and thus inflation will stay at the long run target. If QE had been done with literal currency, then it would either not be expected to be temporary or would change expectations about future inflation. (n.b. The expectation that it is temporary is really hard to justify given Japan is apparently expected to cut its monetary base by 80% sometime in the near future.)

Krugman: Liquidity trap conditions exist and conventional monetary policy has no traction at zero or near zero interest rates. Unconventional monetary policy like QE only works through expectations (promising to be irresponsible) limiting the impact.

Smith: Monetary policy has become steadily more ineffective since WWII (which is mistaken as falling inflation expectations or secular stagnation). Many states are past, at or near the point where monetary policy is totally ineffective (∂P/∂MB = 0) including Japan since the 1990s, the UK and EU. Canada and Australia are not yet at that point. This loss of effectiveness has nothing to do with interest rates, except that it happens when interest rates are "low" compared to rates in the past. The interest rate at which ∂P/∂MB = 0 depends on the size of the economy and other factor: it ranges from 2% in the EU to 0.1% in the US. This rate also steadily increases as the economy gets bigger.

How did we get inflation in the 1970s?

Sumner: Post-war Keynesian economics didn't believe inflation and the money supply were tightly linked. Excessively loose monetary policy caused inflation, basically the quantity theory of money.

Krugman: Essentially the same reasoning as Sumner.

Smith: The inflation of the 1970s was normal except for the two big oil shocks. It's low inflation in the 1960s that's mysterious. Since then, inflation has steadily decreased as the low hanging fruit of capturing under-utilized NGDP by simply expanding the monetary base to allow information to flow was eaten up.

How do we get inflation today?

Sumner: NGDP targeting. Or at least something that makes people expect inflation (e.g. higher inflation target). The situation will likely persist for an extended period (indefinitely?) if some other monetary policy is not adopted.

Krugman: Keynesian stimulus. There is potential for the economy to return to normal eventually through internal deleveraging but secular stagnation may make that take a really long time.

Smith: Start conducting monetary policy without regard to economic indicators. New monetary targets (NGDP, higher inflation) will not work. Generate hyperinflation through monetizing the debt. Print money and give it to people. Set interest rates by fiat as done by the US and UK during WWII.  Keynesian stimulus will work because ∂P/∂NGDP ≠ 0.

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