Werning On Liquidity Trap Policy

For macroeconomists

I finally got circular to reading this paper past times Iván Werning - Managing a Liquidity Trap: Monetary in addition to Fiscal Policy. It takes the canonical New Keynesian model, puts it into continuous time, in addition to looks at optimal monetary in addition to financial policy when in that place is a liquidity trap. (To live precise: a menses where existent involvement rates are higher upwards their natural degree because nominal involvement rates cannot live negative). I would country it clarifies rather than overturns what nosotros already know, but I establish unopen to of the clarifications rather interesting. Here are but two.

1) Monetary policy alone. The optimum commitment (Krugman/Eggertsson in addition to Woodford) [1] policy of creating a blast after the liquidity trap menses mightiness (or mightiness not) generate a path for inflation where inflation is e'er higher upwards target (taken every bit zero). Here is a film from the paper, where the output gap is on the vertical axis in addition to inflation the horizontal, in addition to nosotros plot the economic scheme through time. The dark dots are the economic scheme nether optimal discretionary policy, in addition to the bluish nether commitment, in addition to inward both cases the economic scheme ends upwards at the bliss betoken of a cypher gap in addition to cypher inflation. 

In this experiment existent involvement rates are higher upwards their natural degree (i.e. the liquidity trap lasts) for T periods, in addition to everything after this daze is known. Under discretionary policy, both output in addition to inflation are besides depression for every bit long every bit the liquidity trap lasts. In this illustration output starts off 11% below its natural level, in addition to inflation most 5% below. The optimal commitment policy creates a positive output gap after the liquidity trap menses (after T). Inflation inward the NK Phillips flexure is but the integral of futurity output gaps, thus inflation could live positive right away after the shock: hither it happens to live zero. As nosotros motion forrard inward fourth dimension unopen to of the negative output gaps disappear from the integral, in addition to thus inflation rises.

It makes sense, every bit Werning suggests, to focus on the output gap. Think of the causality involved, which goes: existent rates - output gap (with forrard integration) - inflation (with forrard integration), which in addition to thus feedback on to existent rates. Optimum policy must involve an initial negative output gap for sure, followed past times a positive output gap, but inflation involve non necessarily live negative at whatever point.

There are other consequences. Although the optimal commitment policy involves creating a positive output gap inward the future, which implies keeping existent involvement rates below their natural degree for a menses after T, every bit inflation is higher thus could nominal rates live higher. As a result, at whatever betoken inward fourth dimension the nominal charge per unit of measurement on a sufficiently long term bond could also live higher (page 16).

2) Adding financial policy. The newspaper considers adding authorities spending every bit a financial instrument. It makes an interesting distinction betwixt ‘opportunistic’ in addition to ‘stimulus’ changes inward authorities spending, but I practise non retrieve I involve that for what follows, thus hopefully it volition live for a later on post. What I had non taken on board is that the optimal path for authorities spending mightiness involve a prolonged menses where authorities spending is lower (below its natural level). Here is unopen to other film from the paper.

The bluish draw of piece of job is the optimal commitment policy without whatever financial action: the same designing every bit inward the previous figure. The ruby draw of piece of job is the path for output in addition to inflation amongst optimal authorities spending, in addition to the light-green draw of piece of job is the path for the consumption gap rather than the output gap inward that instant case. The vertical departure betwixt ruby in addition to light-green is what is happening to authorities spending.

The showtime betoken is that using financial policy leads to a distinct improvement. We involve much less excess inflation, in addition to the output gap is e'er smaller. The instant is that although initially authorities spending is positive, it becomes negative when the output gap is itself positive i.e. beyond T. Why is this?

Our initial intuition mightiness live that authorities spending should but ‘plug the gap’ generated past times the liquidity trap, giving us a cypher output gap throughout. Then in that place would live no involve for an expansionary monetary policy after the gap - financial policy could completely stabilise the economic scheme during the liquidity gap period. This volition laissez passer us declining authorities spending, because the gap itself declines. (Even if the existent involvement charge per unit of measurement is besides high past times a constant amount inward the liquidity trap, consumption cumulates this forward.)

This intuition is non right partly because using the authorities spending musical instrument has costs: nosotros motion away from the optimal allotment of populace goods. So financial policy does non dominate (eliminate the involve for) the Krugman/ Eggertsson in addition to Woodford monetary policy, in addition to optimal policy volition involve a mixture of the two. That inward plough agency nosotros volition yet get, nether an optimal commitment policy, a menses after the liquidity trap when in that place volition live a positive consumption gap.

The practise goodness of the positive consumption gap after the liquidity trap, in addition to the associated lower existent rate, is that it raises consumption inward the liquidity gap menses compared to what it mightiness otherwise receive got been. The damage is higher inflation inward the postal service liquidity trap period. But inflation depends on the output gap, non but the consumption gap. So nosotros tin ameliorate the trade-off past times lowering authorities spending inward the postal service liquidity trap period.

Two finally points on what the newspaper reaffirms. First, fifty-fifty amongst the most optimistic (commitment) monetary policy, financial policy has an of import purpose inward a liquidity trap. Those who yet believe that monetary activism is all y'all involve inward a liquidity trap must live using a dissimilar framework. Second, the gains to trying to implement something similar the commitment policy are large. Yet everywhere monetary policy seems to live trying to follow the discretionary rather than commitment policy: in that place is no intelligence of allowing the output gap to travel positive 1 time the liquidity trap is over, in addition to rules that mightiness mimic the commitment policy are off the table. [2] I wonder if macroeconomists inward twenty years fourth dimension volition human face dorsum on this menses amongst the same bewilderment that nosotros at nowadays human face dorsum on monetary policy inward the early on 1930s or 1970s? 

[1] Krugman, Paul. 1998. “It’s Baaack! Japan’s Slump in addition to the Return of the Liquidity Trap.” BPEA, 2:1998, 137–87. Gauti B. Eggertsson & Michael Woodford, 2003. "The Zero Bound on Interest Rates in addition to Optimal Monetary Policy,"Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(1), pages 139-235.

[2] Allowing inflation to rising a picayune chip higher upwards target spell the output gap is yet negative is quite consistent amongst next a discretionary policy. I retrieve unopen to people believe that monetary policy inward the US of America mightiness live secretly intending to follow the Krugman/Eggertsson in addition to Woodford strategy, but every bit the whole betoken most this strategy is to influence expectations, keeping it hush-hush would live worse than pointless.