Tuesday, February 18, 2014

Tight monetary policy is an artifact of being in a liquidity trap

Nick Rowe discusses Chris House and comes to the conclusion (surprise!) that monetary policy is too tight: "What this means is that the so-called ZLB 'liquidity trap' is merely an artefact of tight monetary policy."

There is some theory at the link behind this statement, but essentially it says that monetary policy isn't ineffective, it's just too tight. It seems to me that monetary policy is, at least according to monetarists, universally too tight: the EU, Japan, the US, etc all have monetary policy that is too tight. This is a strange coincidence.

Imagine an off-road car race. A bunch of cars at one location on the track don't seem to be going anywhere. Is the explanation that they aren't pushing on their gas pedals hard enough? Or should we look and see if they are stuck in mud?

There is an alternative explanation: monetary policy is ineffective because of a liquidity trap. Interestingly, a monetary policy that is ineffective will look too tight from the perspective of someone who thinks it is effective. This explains that strange coincidence: all these economies are stuck in mud. A monetary policy that seems too tight is an artifact of being in a liquidity trap.
The information transfer model shows that monetary policy is ineffective when the monetary base is large compared to NGDP (the picture is on the left below; note the bending of the curve as the monetary base MB increases). There's our mud. Specifically, changes in the monetary base (δMB) do not lead to as large of changes in price level (δP) as they do when the monetary base is small compared to NGDP. This situation, δP/δMB ~ 0, I called an information trap that has a lot of similarity to Krugman's (and Keynes') liquidity trap. Additionally, ineffective monetary policy (liquidity trap) is associated with low interest rates. This picture is on the right below:

The line where δP/δMB ~ 0 is given by the black line -- this is the liquidity trap. Interest rates are the red lines and the path of long term interest rates (and the economy) in NGDP, MB space is the dark blue line. Short term interest rates are light blue. The gray lines are the contours of the price level. (The 3D version of this picture is actually on the right side of this page with the red surface describing the interest rates and the white surface, the price level.)

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