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October 18, 2012

Latest Posts from Economist's View

Latest Posts from Economist's View

Helicopter Money

Posted: 13 Oct 2012 12:15 AM PDT

Simon Wren-Lewis:

... In this sense, helicopter money is just another name for a fiscal stimulus combined with QE. We have the QE, so why not call for fiscal stimulus rather than helicopter money?

Much more here.

Links for 10-13-2012

Posted: 13 Oct 2012 12:06 AM PDT

'Some Unpleasant Properties of Log-Linearized Solutions when the Nominal Interest Rate is Zero'

Posted: 12 Oct 2012 06:13 PM PDT

[This one is wonkish. It's (I think) one of the more important papers from the St. Louis Fed conference.]

One thing that doesn't get enough attention in DSGE models, at least in my opinion, is the constraints, implicit assumptions, etc. imposed when the theoretical model is log-linearized. This paper by Tony Braun and Yuichiro Waki helps to fill that void by comparing a theoretical true economy to its log-linearized counterpart, and showing that the results of the two models can be quite different when the economy is at the zero bound. For example, multipliers that are greater than two in the log-linearized version are smaller -- usually near one -- in the true model (thus, fiscal policy remains effective, but may need to be more aggressive than the log-linear model would imply). Other results change as well, and there are sign changes in some cases, leading the authors to conclude that "we believe that the safest way to proceed is to entirely avoid the common practice of log-linearizing the model around a stable price level when analyzing liquidity traps."

Here's part of the introduction and the conclusion to the paper:

Some Unpleasant Properties of Log-Linearized Solutions when the Nominal Interest Rate is Zero, by Tony Braun and Yuichiro Waki: Abstract Does fiscal policy have qualitatively different effects on the economy in a liquidity trap? We analyze a nonlinear stochastic New Keynesian model and compare the true and log-linearized equilibria. Using the log-linearized equilibrium conditions the answer to the above question is yes. However, for the true nonlinear model the answer is no. For a broad range of empirically relevant parameterizations labor falls in response to a tax cut in the log-linearized economy but rises in the true economy. While the government purchase multiplier is above two in the log-linearized economy it is about one in the true economy.
1 Introduction The recent experiences of Japan, the United States, and Europe with zero/near-zero nominal interest rates have raised new questions about the conduct of monetary and fiscal policy in a liquidity trap. A large and growing body of new research has emerged that provides answers using New Keynesian (NK) frameworks that explicitly model the zero bound on the nominal interest rate. One conclusion that has emerged is that fiscal policy has different effects on the economy when the nominal interest rate is zero. Eggertsson (2011) finds that hours worked fall in response to a labor tax cut when the nominal interest rate is zero, a property that is referred to as the "paradox of toil," and Christiano, Eichenbaum, and Rebelo (2011), Woodford (2011) and Erceg and Lindé (2010) find that the size of the government purchase multiplier is substantially larger than one when the nominal interest rate is zero.
These and other results ( see e.g. Del Negro, Eggertsson, Ferrero, and Kiyotaki (2010), Bodenstein, Erceg, and Guerrieri (2009), Eggertsson and Krugman (2010)) have been derived in setups that respect the nonlinearity in the Taylor rule but loglinearize the remaining equilibrium conditions about a steady state with a stable price level. Log-linearized NK models require large shocks to generate a binding zero lower bound for the nominal interest rate and the shocks must be even larger if these models are to reproduce the measured declines in output and inflation that occurred during the Great Depression or the Great Recession of 2007-2009.[1] Log-linearizations are local solutions that only work within a given radius of the point where the approximation is taken. Outside of this radius these solutions break down (See e.g. Den Haan and Rendahl (2009)). The objective of this paper is to document that such a breakdown can occur when analyzing the zero bound.
We study the properties of a nonlinear stochastic NK model when the nominal interest rate is constrained at its zero lower bound. Our tractable framework allows us to provide a partial analytic characterization of equilibrium and to numerically compute all equilibria when the zero interest state is persistent. There are no approximations needed when computing equilibria and our numerical solutions are accurate up to the precision of the computer. A comparison with the log-linearized equilibrium identifies a severe breakdown of the log-linearized approximate solution. This breakdown occurs when using parameterizations of the model that reproduce the U.S. Great Depression and the U.S. Great Recession.
Conditions for existence and uniqueness of equilibrium based on the log-linearized equilibrium conditions are incorrect and offer little or no guidance for existence and uniqueness of equilibrium in the true economy. The characterization of equilibrium is also incorrect.
These three unpleasant properties of the log-linearized solution have the implication that relying on it to make inferences about the properties of fiscal policy in a liquidity trap can be highly misleading. Empirically relevant parameterization/shock combinations that yield the paradox of toil in the log-linearized economy produce orthodox responses of hours worked in the true economy. The same parameterization/shock combinations that yield large government purchases multipliers in excess of two in the log-linearized economy, produce government purchase multipliers as low as 1.09 in the nonlinear economy. Indeed, we find that the most plausible parameterizations of the nonlinear model have the property that there is no paradox of toil and that the government purchase multiplier is close to one.
We make these points using a stochastic NK model that is similar to specifications considered in Eggertsson (2011) and Woodford (2011). The Taylor rule respects the zero lower bound of the nominal interest rate, and a preference discount factor shock that follows a two state Markov chain produces a state where the interest rate is zero. We assume Rotemberg (1996) price adjustment costs, instead of Calvo price setting. When log-linearized, this assumption is innocuous - the equilibrium conditions for our model are identical to those in Eggertsson (2011) and Woodford (2011), with a suitable choice of the price adjustment cost parameter. Moreover, the nonlinear economy doesn't have any endogenous state variables, and the equilibrium conditions for hours and inflation can be reduced to two nonlinear equations in these two variables when the zero bound is binding.[2]
These two nonlinear equations are easy to solve and are the nonlinear analogues of what Eggertsson (2011) and Eggertsson and Krugman (2010) refer to as "aggregate demand" (AD) and "aggregate supply" (AS) schedules. This makes it possible for us to identify and relate the sources of the approximation errors associated with using log-linearizations to the shapes and slopes of these curves, and to also provide graphical intuition for the qualitative differences between the log-linear and nonlinear economies.
Our analysis proceeds in the following way. We first provide a complete characterization of the set of time invariant Markov zero bound equilibria in the log-linearized economy. Then we go on to characterize equilibrium of the nonlinear economy. Finally, we compare the two economies and document the nature and source of the breakdowns associated with using log-linearized equilibrium conditions. An important distinction between the nonlinear and log-linearized economy relates to the resource cost of price adjustment. This cost changes endogenously as inflation changes in the nonlinear model and modeling this cost has significant consequences for the model's properties in the zero bound state. In the nonlinear model a labor tax cut can increase hours worked and decrease inflation when the interest rate is zero. No equilibrium of the log-linearized model has this property. We show that this and other differences in the properties of the two models is precisely due to the fact that the resource cost of price adjustment is absent from the resource constraint of the log-linearized model.[3] ...
5 Concluding remarks In this paper we have documented that it can be very misleading to rely on the log-linearized economy to make inferences about existence of an equilibrium, uniqueness of equilibrium or to characterize the local dynamics of equilibrium. We have illustrated that these problems arise in empirically relevant parameterizations of the model that have been chosen to match observations from the Great Depression and Great Recession.
We have also documented the response of the economy to fiscal shocks in calibrated versions of our nonlinear model. We found that the paradox of toil is not a robust property of the nonlinear model and that it is quantitatively small even when it occurs. Similarly, the evidence presented here suggests that the government purchase GDP multiplier is not much above one in our nonlinear economy.
Although we encountered situations where the log-linearized solution worked reasonably well and the model exhibited the paradox of toil and a government purchase multiplier above one, the magnitude of these effects was quantitatively small. This result was also very tenuous. There is no simple characterization of when the log-linearization works well. Breakdowns can occur in regions of the parameter space that are very close to ones where the log-linear solution works. In fact, it is hard to draw any conclusions about when one can safely rely on log-linearized solutions in this setting without also solving the nonlinear model. For these reasons we believe that the safest way to proceed is to entirely avoid the common practice of log-linearizing the model around a stable price level when analyzing liquidity traps.
This raises a question. How should one proceed with solution and estimation of medium or large scale NK models with multiple shocks and endogenous state variables when considering episodes with zero nominal interest rates? One way forward is proposed in work by Adjemian and Juillard (2010) and Braun and Körber (2011). These papers solve NK models using extended path algorithms.
We conclude by briefly discussing some extensions of our analysis. In this paper we assumed that the discount factor shock followed a time-homogeneous two state Markov chain with no shock being the absorbing state. In our current work we relax this final assumption and consider general Markov switching stochastic equilibria in which there are repeated swings between episodes with a positive interest rate and zero interest rates. We are also interested in understanding the properties of optimal monetary policy in the nonlinear model. Eggertsson and Woodford (2003), Jung, Teranishi, and Watanabe (2005), Adam and Billi (2006), Nakov (2008), and Werning (2011) consider optimal monetary policy problems subject to a non-negativity constraint on the nominal interest rate, using implementability conditions derived from log-linearized equilibrium conditions. The results documented here suggest that the properties of an optimal monetary policy could be different if one uses the nonlinear implementability conditions instead.
[1] Eggertsson (2011) requires a 5.47% annualized shock to the preference discount factor in order to account for the large output and inflation declines that occurred in the Great Depression. Coenen, Orphanides, and Wieland (2004) estimate a NK model to U.S. data from 1980-1999 and find that only very large shocks produce a binding zero nominal interest rate.
[2] Under Calvo price setting, in the nonlinear economy a particular moment of the price distribution is an endogenous state variable and it is no longer possible to compute an exact solution to the equilibrium.
[3] This distinction between the log-linearized and nonlinear resource constraint is not specific to our model of adjustment costs but also arises under Calvo price adjustment (see e.g. Braun and Waki (2010)).

'Romney Sticks to Ridiculous Emergency-Room Argument'

Posted: 12 Oct 2012 01:26 PM PDT

In case you missed Romney's 'they can always go to emergency rooms argument,' here's Steve Benen:

Romney sticks to ridiculous emergency-room argument, by Steve Benen: Just three weeks ago, CBS's Scott Pelley asked Mitt Romney, "Does the government have a responsibility to provide health care to the 50 million Americans who don't have it today?" The Republican didn't answer the question directly, but instead suggested there's no cause for alarm -- the uninsured can rely on emergency rooms.

The exchange was widely panned for being both callous and ignorant, and yet, as Rebecca Leber noted, Romney apparently can't help himself. ...

Sigh. It's disconcerting to see Romney stick to such a ridiculous position, but my greater fear is that the Republican candidate actually believes what he's saying. ...[W]e know exactly why he keeps talking like this: under his approach, the number of Americans without health insurance will soar. ...

Romney's argument isn't a responsible approach to American health care in the 21st century; Romney's argument is ridiculous.

Qualitative Easing: How it Works and Why it Matters

Posted: 12 Oct 2012 11:46 AM PDT

From the Fed conference in St. Louis, Roger Farmer makes what I think is a useful distinction between quantitative easing and qualitative easing (the distinction, first made by Buiter in 2008, is useful inependent of his paper; in the paper he argues that it's the composition of the balance sheet, not the size, that matters -- in the model people cannot participate in financial markets that open before they are born leading to incomplete participation -- qualitative easing works by completing markets and having the Fed engage in Pareto improving trades):

Qualitative Easing: How it Works and Why it Matters, by Roger E.A. Farmer: Abstract This paper is about the effectiveness of qualitative easing; a government policy that is designed to mitigate risk through central bank purchases of privately held risky assets and their replacement by government debt, with a return that is guaranteed by the taxpayer. Policies of this kind have recently been carried out by national central banks, backed by implicit guarantees from national treasuries. I construct a general equilibrium model where agents have rational expectations and there is a complete set of financial securities, but where agents are unable to participate in financial markets that open before they are born. I show that a change in the asset composition of the central bank's balance sheet will change equilibrium asset prices. Further, I prove that a policy in which the central bank stabilizes fluctuations in the stock market is Pareto improving and is costless to implement.
1 Introduction Central banks throughout the world have recently engaged in two kinds of unconventional monetary policies: quantitative easing (QE), which is "an increase in the size of the balance sheet of the central bank through an increase it is monetary liabilities", and qualitative easing (QuaE) which is "a shift in the composition of the assets of the central bank towards less liquid and riskier assets, holding constant the size of the balance sheet."[1]
I have made the case, in a recent series of books and articles, (Farmer, 2006, 2010a,b,c,d, 2012, 2013), that qualitative easing can stabilize economic activity and that a policy of this kind will increase economic welfare. In this paper I provide an economic model that shows how qualitative easing works and why it matters.
Because qualitative easing is conducted by the central bank, it is often classified as a monetary policy. But because it adds risk to the public balance sheet that is ultimately borne by the taxpayer, QuaE is better thought of as a fiscal or quasi-fiscal policy (Buiter, 2010). This distinction is important because, in order to be effective, QuaE necessarily redistributes resources from one group of agents to another.
The misclassification of QuaE as monetary policy has led to considerable confusion over its effectiveness and a misunderstanding of the channel by which it operates. For example, in an influential piece that was presented at the 2012 Jackson Hole Conference, Woodford (2012) made the claim that QuaE is unlikely to be effective and, to the extent that it does stimulate economic activity, that stimulus must come through the impact of QuaE on the expectations of financial market participants of future Fed policy actions.
The claim that QuaE is ineffective, is based on the assumption that it has no effect on the distribution of resources, either between borrowers and lenders in the current financial markets, or between current market participants and those yet to be born. I will argue here, that that assumption is not a good characterization of the way that QuaE operates, and that QuaE is effective precisely because it alters the distribution of resources by effecting Pareto improving trades that agents are unable to carry out for themselves.
I make the case for qualitative easing by constructing a simple general equilibrium model where agents are rational, expectations are rational and the financial markets are complete. My work differs from most conventional models of financial markets because I make the not unreasonable assumption, that agents cannot participate in financial markets that open before they are born. In this environment, I show that qualitative easing changes asset prices and that a policy where the central bank uses QuaE to stabilize the value of the stock market is Pareto improving and is costless to implement.
My argument builds upon an important theoretical insight due to Cass and Shell (1983), who distinguish between intrinsic uncertainty and extrinsic uncertainty. Intrinsic uncertainty is a random variable that influences the fundamentals of the economy; preferences, technologies and endowments. Extrinsic uncertainty is anything that does not. Cass and Shell refer to extrinsic uncertainty as sunspots.[2]
In this paper, I prove four propositions. First, I show that employment, consumption and the real wage are a function of the amount of outstanding private debt. Second, I prove that the existence of complete insurance markets is insufficient to prevent the existence of equilibria where employment, consumption and the real wage differ in different states, even when all uncertainty is extrinsic. Third, I introduce a central bank and I show that a central bank swap of safe for risky assets will change the relative price of debt and equity. Finally, I prove that a policy of stabilizing the value of the stock market is welfare improving and that it does not involve a cost to the taxpayer in any state of the world.

10 Conclusion An asset price stabilization policy is now under discussion as a result of the failure of traditional monetary policy to move the economy out of the current recession. Most of the academic literature sees the purchase of risky assets by the central bank as an alternative form of monetary policy. In this view, if a central bank asset policy works at all, it works by signaling the intent of future policy makers to keep interest rates low for a longer period than would normally be warranted, once the economy begins to recover. In my view, that argument is incorrect.

Central bank asset purchases have little if anything to do with traditional monetary policy. In some models, asset swaps by the central banks are effective because the central bank has the monopoly power to print money. Although that channel may play a secondary role when the interest rate is at the zero lower bound (Farmer, 2013), it is not the primary channel through which qualitative easing affects asset prices. Central bank open market operations in risky assets are effective because government has the ability to complete the financial markets by standing in for agents who are unable to transact before they are born and it is a policy that would be effective, even in a world where money was not needed as a medium of exchange.

I have made the case, in a recent series of books and articles (Farmer, 2006, 2010a,b,c,d, 2012, 2013), that qualitative easing matters. In this paper I have provided an economic model that shows why it matters.

[1] The quote is from Willem Buiter (2008) who proposed this very useful taxonomy in a piece on his 'Maverecon' Financial Times blog.
[2] This is quite different from the original usage of the term by Jevons (1878) who developed a theory of the business cycle, driven by fluctuations in agricultural conditions that were ultimately caused by physical sunspot activity.

Bogus Arguments about the Burden of the Debt

Posted: 12 Oct 2012 07:31 AM PDT

The first time I ran across the point that Dean Baker makes here about the burden of the debt was in the late 1980s teaching principles of economics from Baumol and Blinder's textbook. Here's a summary of the point from this old post (and a later, but dated, edition of the text -- the point Dean makes is Argument 1 -- there is quite a bit more, including an example to illustrate the point and additional comments from Dean Baker, in the post):

... Let's start with a textbook treatment from Baumol and Blinder's Macroeconomics text (9th ed.):

Bogus Arguments about the Burden of the Debt

Having gained some perspective on the facts, let us now turn to some of the arguments advanced by those who claim that budget deficits place an intolerable burden on future generations.

Argument I Our children and grandchildren will be burdened by heavy interest payments, which will necessitate higher taxes.

Answer It is certainly true that a higher debt means higher interest payments and, therefore, higher taxes on our children and grandchildren. But think who will own the bonds and therefore receive the higher interest payments as income: our children and grandchildren! Thus, one group of future Americans will be making interest payments to another group of future Americans. So we conclude that:

As long as the national debt is owned by domestic citizens, as the majority of the U.S. debt is, future interest payments transfer money from one group of Americans to another. These transfers mayor may not be desirable, but they hardly constitute a burden on the nation as a whole.

However, this argument is valid-and worrisome-for the portion of our debt that is held by foreigners, a share that has been growing rapidly... Paying interest on this portion of the debt will burden future Americans in a concrete way: For years to come, a portion of America's GDP will have to be sent abroad to pay interest on the debts we incurred in the 1980s, 1990s, and 2000s. For this reason, many thoughtful observers are becoming concerned that the United States is borrowing too much from abroad.

Another valid element of this argument is that the taxes that will have to be raised to pay interest even to U.S. citizens may reduce the efficiency of the economy.

Argument 2 Repaying the enormous debt will ruin the nation.

Answer A first answer to this argument merely rephrases the answer to the previous one: Most of America's debt is owed to Americans. But this argument raises an even more fundamental point. Unlike a private family, the nation need never payoff its debt. Instead, each time the principal is due, the U.S. Treasury can simply "roll it over" by floating more debt. Indeed, that was done routinely for decades.

Was this a bit of chicanery? How could the U.S. government get away with making loans that it never intended to pay back? The answer lies in the fallacy of comparing the U.S. government to a family or an individual. People cannot borrow in perpetuity, because they will not live that long. Sensible lenders will not extend long-term credit to very old people because their heirs cannot be forced to pay up. But the U.S. government will never "die" - at least, we hope not! So this problem does not arise. In this respect, the government is in much the same position as a large corporation. GE never pays off its debt. It, too, rolls it over by floating new debt all the time.

Argument 3 Like any family or any business firm, a nation has a limited capacity to borrow. If it exceeds this limit, it is in danger of being unable to pay its creditors. It may go bankrupt with calamitous consequences for everyone.

Answer This is another false analogy. While private debtors and many foreign governments have to worry about defaulting on their debt, the U.S. government does not. Why not? First, because it has enormous power to raise revenues by taxation. If you had such power, you would never have to fear bankruptcy either.

But once again, the statement raises a more fundamental point - one that distinguishes the U.S. debt from that of most other nations. The American national debt is an obligation to pay U.S. dollars: Each debt certificate obligates the Treasury to pay the holder so many U.S. dollars on a prescribed date. But the U.S. government is the source of these dollars. It prints them! No nation need default on debts that call for repayment in its own currency. If worse comes to worse, it can always print whatever money it needs to pay off its creditors. This option is not open to countries whose debts call for payment in U.S. dollars, as a number of Southeast Asian countries learned in 1997 and Argentina learned in 2001.

It does not, of course, follow that acquiring more debt through budget deficits is necessarily a good idea. Sometimes it is a very bad idea. As we know, printing money to pay the debt will expand aggregate demand and cause inflation. In addition, as we will learn in Chapter 18, printing more dollars should make the international value of the dollar fall. We may not relish either of these outcomes. The point is not that budget deficits are either good or bad; they can be either under the appropriate circumstances. Rather, the point is that worrying about a possible default on the national debt is unnecessary and even foolish. ...

Nick Rowe take issue with the claim in Argument 1 here:

The burden of the (bad monetary policy) on future generations

Brad Delong responds:

The Intergenerational Burden of the Debt: Nick Rowe Tempts Fate Weblogging...

Dean Baker also responds:

Brad DeLong Beats Me to Responding to Nick Rowe

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