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Usually the limiting factor in stimulating an economy is how much inflation can a currency handle before the money being spent has a negative effect overall. But now we seem to have the opposite problem of having a lot of leeway, but somehow we are not able to use it to stimulate growth.

It seems like in theory, we could print a bunch of money and do a helicopter drop at the expense of higher inflation, which would help since the US is almost in a deflationary state. Obviously central banks (mostly US but also the rest of the developed world) have better ideas as to what should be done to help the economy, and so I would like to understand what those ideas might be and why they cannot take advantage of the low inflation.

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It's not theoretically hard to stimulate the economy. It's just the means to do so are terribly unfashionable. And that means it's politically hard.

We've had two similar depressions in the last couple of centuries: the Long Depression in the second half of the nineteenth century, and the Great Depression in the first half of the twentieth. Each saw significant monetary contraction as a policy response. Which was astonishingly daft.

But after the Great Depression, we also learnt that monetary expansion was insufficient when there's a large debt hangover and demand is suppressed: hence we got the famous analogy of monetary expansion being like pushing on a piece of string.

For many centuries, a once-in-a-human-lifetime jubilee - a cancellation of all personal debts - was seen a way to cure these huge debt hangovers. And they do, broadly speaking, provide a means of cutting the closed circle of monetary expansion which takes place through savings and loans. These jubilees used to happen once every fifty years - and that was, roughly speaking, a human lifetime. A jubilee removes all of the demand-suppression effect that personal debt has: it removes wealth from those with the lowest propensity to spend (thus has a small negative effect on demand), and increases the wealth of those with the highest propensity to spend (which has a much larger positive effect on demand). The net result is a return to increasing demand. In some ways, the bailing out of the banks in 2008 was the very opposite of a jubilee: commercial borrowers (bank bond-holders) were bailed out, and private borrowers were left hanging. Expensive and ineffective. A jubilee cancelled all private debt, but did not touch commercial debt.

The other very unfashionable intervention is fiscal expansion. Keynesian expansions were a successful response to a demand-led depresssion, when the multiplier was higher (as it is now: even Lagarde of the IMF admitted this); but they also got used in subsequent decades in other circumstances too, when the multiplier was lower, and showed less success. And that's when they dropped out of favour, and remain so in many countries now, despite them being part of the right thing to do in the current particular circumstances.

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To answer this question, you have to understand why the central bank targets a positive inflation rate in the first place. There are tradeoffs between high and low inflation. High inflation can reduce the real value of labor and is often more vloatile, but low values of inflation make cutting wages more difficult, particularly in recessions, reducing the demand for workers.

A lower inflation rate generally leads to lower interest rates because creditors demand inflation premiums when lending over longer periods of times. As those interest rates fall, the Federal Reserve has to lower their reserve rate (overnight lending to other banks). The idea is that the Federal Reserve has to try and give good rates so banks feel comfortable lending and being protected from liquidity crises. The nominal interest rate cannot fall below zero percent though, for obvious reasons (can't give away free money!)

So if the interest rate can't fall any further, we have a zero interest floor (ZIF) problem. The central bank will find it hard to encourage banks to lend out and increase the flow of money (which will usually then pump up inflation). So we get perpetually low inflation.

So why can't we just drop money from a helicopter to help alleviate the recession? After all, we learned from the Phillips curve that usually inflation and output are tradeoffs, right? And we want some inflation to encourage growth then, right? Well, outside of basic economics, it's a little different. One, it's illegal to just print money and create wanton seignorage (at least in America and most Western countries), and two, you run into the Lucas Critique of monetary policy. In a nutshell, if people expect inflation, inflation won't actually increase output in the short run. So dropping money is a very obvious way of increasing inflation that people will surely notice, and all you will have done is inflated the prices of goods and not done anything to help move out of recession, risking stagflation.

So what should the central bank do? The major tool the central bank uses in case of hitting a zero-interest rate floor and having low inflation is quantitative easing. Basically the central bank buys huge amounts of financial assets from commercial banks and other financial institutions,as opposed to government short term bonds. So the price of those assets rise, their yield falls, and the money supply increases. If that doesn't work, there is always price level targeting, although it hasn't been used a whole lot (yet). The idea is that the central bank, instead of committing to targeting inflation for every period, it promises to target a price level as if there was that "optimal" amount of inflation every period.

Targetting inflation is usually important because of Ramsey's time-inconsistency problem. If Lucas's Critique is right, then the Fed should have an incentive to lie about what inflation they will target, in order to increase output, but then they will lose credibility and lose all power to conduct monetary policy. So the central bank commits themselves to targeting one level of inflation--or in times like these, perhaps price level.

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  • $\begingroup$ how is targetting price level done, if not trough similar mechanism such as QE? Cant price level targeted be translated into inflation targets just as easily without really needing to make a distinction between the two? $\endgroup$ – Revoltic Oct 18 '15 at 16:42
  • $\begingroup$ Yes, but the inflation you target will become greater and greater and greater to reach an equivalent price level as if inflation was at its optimal target. So that would probably look much scarier to people, and it's part of why central banks are indeed wary of doing price-level targeting. $\endgroup$ – Kitsune Cavalry Oct 18 '15 at 17:03
  • $\begingroup$ I can't remember seeing much empirical evidence in favour of the Lucas Critique? $\endgroup$ – Thorst Oct 19 '15 at 8:45

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