Thursday, September 6, 2012

Now let me be a liquidity trap (ZLB) denier

I am put in an awkward situation. I recently read an article by Simon Wren-Lewis (who is getting to be one of my favorite economists) called "Zero Lower Bound Denial". In the article, Professor Wren-Lewis cites two reasons that the "belief that somehow monetary policy alone can overcome the problem of the ZLB" is wrong. The first is summed up by a quote of Michael Woodford in his recent paper presented at the Jackson Hole conference, "Methods of Policy Accommodation at the Interest-Rate Lower Bound".

Central bankers confronting the problem of the interest-rate lower bound have tended to be especially attracted to proposals that offer the prospect of additional monetary stimulus while (i) not requiring the central bank to commit itself with regard to future policy decisions, and (ii) purporting to alter general financial conditions in a way that should affect all parts of the economy relatively uniformly, so that the central bank can avoid involving itself in decisions about the allocation of credit. Unfortunately, the belief that methods exist that can be effective while satisfying these two desiderata seems to depend to a great extent on wishful thinking.

Simon Wren-Lewis points out that this implies the temporary creation of additional money, which is less effective and less reliable than "conventional" monetary policy. The second reason he cites is that even NGDP-targeting relies on the promise of future above-average inflation to partially mitigate a demand-shock to economic output. In short, the output gap will remain for a while, but will gradually be eliminated and its main mechanism is basically in expectations.

Presumably this argument is that in a liquidity trap (at the zero lower bound), monetary policy is effective if it is perceived as guidance on future monetary policy. Let me try to explain why I think this is not necessarily correct.

Let us imagine that we have an economy where monetary policy is conducted by open-market sales and purchases of foreign assets (generally government bonds) using fiat domestic currency. The central bank buys foreign-currency denominated bonds, which results in a depreciation in the value of the domestic currency. Foreign goods cost relatively more, which means domestic firms which compete with foreign firms in the foreign and domestic markets have a short-run advantage in lower prices. Obviously it's a bit different if the depreciation also makes "inputs" (like oil or other raw materials) more expensive, but if many of the countries which supply raw materials peg their currencies to the domestic currency, then this should not be a big problem. In any case, I think it's pretty clear that such a monetary policy can be effective even if interest rates are stuck at the "zero lower bound" and not entirely through expectations regarding future policy.

That being said, I am not one for putting all of the U.S. and Europe's eggs in the monetary policy basket. Clearly there has not been enough monetary or fiscal stimulus to close the output gap and return them to full employment.

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