## Sunday, January 6, 2013

### Managing a liquidity trap

I've been catching up on my new-Keynesian economics and found a little gem by Ivan Werning, "Managing a liquidity trap"

The policy issue is this: we're in a recession. Interest rates are zero, and can't go lower. The Fed is desperately trying to goose the economy. Lots of people (most of the recent Jackson Hole Fed conclave) are advising  "open-mouth operations," and  "managing expectations," that the key to current prosperity is for the Fed to make statements  about what it will do in the future; and these statements on their own, with no concrete action, will "increase demand" and lower today's unemployment. The Fed has been convinced, with more and more "forward guidance" as part of its strategy.  For example, the latest FOMC statement made history by promising zero interest rates as long as unemployment stays above 6 and a half percent and inflation below two and a half.

Does any of this make any sense?

There are piles of complicated new-Keynesian models on this topic. Ivan's paper gets right to the core, giving a very simple model that explains their logic.  The version on p. 20 is the simplest and clearest of all. We only really need one equation

log consumption growth = (substitution elasticity) x real interest rate

$$\frac{dc(t)}{dt} = \sigma^{-1} r(t)$$

(Hang in there, non-economists, you don't really even need the equations; everything is in words too. Also, this is an experiment with Latex macros in blogger. You should see a nice equation above. Let me know if it doesn't work in your browser.) When real interest rates are high, people choose to save more, so consumption is lower today and higher in the future. Thus, high consumption growth goes with high interest rates, and vice versa.

Now, forget about capital, so consumption equals output. Assume the Fed can set the real interest rate to whatever it wants.  Also, think of everything as deviations from "potential output" or "trend." The level of consumption becomes the "output gap." Thus, by controlling interest rates, the Fed controls the growth rate of consumption, output, and the output gap.

Now, here's the key. If the Fed raises the interest rate, and hence the growth rate of consumption, the  level of consumption (now the output gap) falls. New-Keynesian models (correctly) anchor the level in the future; consumption (output) sooner or later must be equal to "potential."   This is the key new-Keynesian mechanism by which higher interest rates lower output, and quite different from the static stories you may remember from old-Keynesian models. (I call this "IS" curve the "interntemporal substitution" curve.)

You might have thought that raising the growth rate of consumption would just be a good thing; implicitly anchoring the level of consumption at last year's value. That would be a mistake. The only way to raise the growth rate of consumption next year is for the level this year to drop. (In this economy without capital.) Then we grow faster by catching up.

Furthermore, if people expect high interest rates for many years, there will be many years of strong consumption growth, and today's level will be very depressed. In equations, we find the level of consumption (output gap) by  integrating all its future growth rates (bottom of p. 19)

$$x(t) = \sigma^{-1} \int_t^\infty r(t) dt$$

In sum, the level of today's consumption, output, and output gap all depend on today's interest rate and people's expectations of the path of future interest rates.

You can start to see how managing expectations of future interest rates might be an attractive idea. If we can't do anything about today's interest rates, lowering expected future rates will have the same effect on today's consumption.

In this paper's model, as most new-Keynesian thinking, our current problem is that the "natural rate" of interest, required to keep us at potential output, is sharply negative. (This is all exogenous.) With "only" 2% inflation and nominal interest rates stuck at zero, the Fed cannot deliver anything less than a negative 2% real rate of interest. If the "natural rate" is something like negative 5%, then we are stuck at a 3% "too high" real interest rate.  Taking differences to "trend" or "potential,"  our situation is equivalent to a too-high real interest rate that the Fed can't do anything about.

The solid line in Figure 3 of the paper, reproduced above, shows this situation. The lines plot differences relative to potential output, or "output gaps," so being on the horizontal axis is the best outcome. We have a "negative natural rate" until time T, when the world returns to normal, the Fed regains control, and consumption and output revert to the trend line. You see that the too-high growth of consumption between now and T, and the too-low level of consumption (output gap) now.

Well, says Ivan, why not pull the whole line up? Suppose the Fed could promise now that, at time T, it will set interest rates too low, from the point of view of that time? This will encourage people to consume at time T rather than in periods after that, i.e. it will engineer the negatively sloped dashed line from T onwards. If people knew there was going to be this boom at T, consumption today would be less depressed. (Again, the way the graph works is that you work from right to left, and the Fed controls the output and consumption growth rates from right to left in order to produce today's level.)

More formally, Ivan assumes that the Fed wants to minimize the squared deviations from potential. A policy like the dashed one produces smaller sum-of-squared output deviations than the solid line we're facing now.

This pretty little graph illustrates lots of policy advice you're hearing from inside and outside the Fed. According to this view, the key thing the Fed can do to raise "demand" today is to promise that it will keep interest rates low longer than it normally would do -- in the period after T -- engineering a bout of output that is a little too high (in a bigger model, inflationary).

But the graph, and the paper, illustrate the central problem: At time T, the Fed will not want to keep rates low. "Too much" consumption means inflation, and in this model too much output (beyond "potential") is just as bad as too little. When time T hits, and the "natural rate" returns to normal, the optimal thing for the Fed to do looking  forward is to set the interest rate equal to the natural rate, and follow the solid green line. In turn, people today know this, which is why their expectation for consumption at time T is at the solid line level, which is why consumption today is depressed.

Chicago Fed Chair Charlie Evans describes the needed policy as "Odyssean." As Odysseus realized in having himself tied to the mast, the ability to commit yourself today that you will do things tomorrow, things that you will not choose tomorrow if you will have the choice, can improve overall performance. This is a deep principle of good policy, and its violation describes many of our current problems. If the government refuses to commit today that it will not bail people out in the future, then people will take risky actions, and  the bailout will recur.

And this is the central problem for this little parable in describing the Fed's actions. Let's read the Fed's Odyssean revelation (the FOMC statement) a little more carefully, with the model in mind:
"..the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time...;"  "currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent..." "the Committee will also consider other information."
There is no commitment at all in this. It's a description of how the Fed thinks it will feel in the future, but nowhere in here is what the new-Keynesian model demands: a commitment to do things in the future that the Fed will not want to do when the time comes.

The problem is deep. How can the Fed have the power to take the "discretionary" action today, in response to the current situation, but that action is somehow to commit itself to doing something in the future that it very much will not want to do when the time comes -- that it has so far explicitly and loudly promised that it will not do, and has built up 30 years of reputation against doing -- undershoot and cause inflation? Why can't the Fed 2015 convene another Jackson Hole conference, bring out Charlie Plosser and Jeff Lacker's friends to say "we're heading to a repetition of the 1970s, it's time to become new-Monetarists and promise that we'll be looking at monetary aggregates not unemployment rates?" It's so much hot air, and people know it.

True commitment requires legal, institutional, or constitutional restraints. It at least needs language like "the Committee commits to keep a highly accomodative stance of monetary policy long after it is appropriate" or better an institutional commitment "and to that end no further FOMC meetings will be scheduled until inflation hits 3%." But no institution gives up its discretion easily.  (To be clear, I think this would all be a terrible idea; more below. I'm explaining the central commitment/discretion problem highlighted by Ivan's model.)

The paper, of course achieves the same thing in much greater generality, while also presenting this gorgeously transparent example. This example makes it crystal clear that the reason for "forward guidance" in new-Keynesian models is not to raise inflation and thus lower real interest rates -- it works here with constant inflation. "The reason for holding the interest rate at zero is not to promote inflation [and hence negative real rates] as is commonly assumed."..."The real reason for committing to zero interest rates is to create the expectations of a future consumption boom" (p. 4)

Cautioning implicitly against the Fed's "twist" policies aimed at lowering long-term interest rates "I show that optimal policy... actually raises long run interest rates.... This cautions against simple assessments of monetary policy centered around the lowering of yields at long maturities." In the full model, promising the inflationary boom raises long term rates. I.e. exactly the opposite of the Fed's "quantitative easing" operations.

To be clear, I don't buy any of this: that our current problems would all be solved if interest rates could be negative 5%; i.e. that the "natural rate of interest" is sharply negative; that the economy is being strangled by tight credit; and that committing to a repetition of the late 1970s would be a great way to escape our current troubles. I don't think you can analyze the situation in a model without capital, as saving translates to investment demand when there is capital. (Christiano, Eichenbaum and Rebelo's When is the Government Spending Multiplier Large? makes this point, next on my review list.) I don't think a model that says we are experiencing a low level and high growth rates makes much sense. I think the Fed is even more powerless than these models posit.

But this is the great point of clean, theoretical models. They are not black boxes that make predictions. They are collections of clear "if, then" statements. I see the core of the new-Keynesian forward-guidance argument clearly in Ivan's model. If I disagree with the "then," I have to find what I don't like about the "if." And he very clearly shows the difference between "commitment" in the new-Keynesian model vs. how it is translated to policy practice, for better or worse.

1. OK, let me know if I've got this straight:

Unlike Odysseus (or Ulysses for the latin buffs), the FOMC have really not had themselves tied to the mast (As a technical aside, Odysseus did not "tie himself to the mast". Even Houdini would have had trouble with that. He had the others do it.) And even if the FOMC are tied, it's with a slip-knot.

Of course, the Sirens episode of the Odyssey is just one of many chapters. I'm not sure that Evans had that specific episode in mind when he called the policy "Odyssean". Maybe he meant that the journey is long with a lot of mis-judgements, (unnecessary) detours and casualties along the way. If so, I'd agree with that description. Perhaps everyone would have been better off had Odysseus just stayed at home with Penelope rather than running off to save Helen in the first place.

2. The point about inflation is only partly true. The conventional view is that we want to generate inflation this period by promising to increase inflation next period. That the little model on page 20 does this without inflation is unremarkable--it is simply a result of the fact that interest rates and price levels are redundant in economies with only one good.

And the point about how optimal policy actually raising long run interest rates needs to be taken with a grain of salt--he's saying that the nominal rate should rise, because we want so much stimulus that the inflation effect exceeds the liquidity effect, while the real interest rate still falls. Thus, it is basically the same point Milton Friedman made when he said that low interest rates were a sign that monetary policy was not too loose, but rather too tight. This is all rather dubious because of the way New Keynesian models assume that the Fed controls the nominal interest rate, making them rather clumsy for looking at inflation effects versus liquidity effects on interest rates.

3. John,

"Assume the Fed can set the real interest rate to whatever it wants."

The Fed cannot set the real interest rate, it can only set the nominal interest rate. The Federal Reserve is not in the credit allocation business, meaning they don't get to decide whether an individual borrows money to fund consumption or a company borrows money to fund production.

"In this paper's model, as most new-Keynesian thinking, our current problem is that the "natural rate" of interest, required to keep us at potential output, is sharply negative. (This is all exogenous.) With only 2% inflation and nominal interest rates stuck at zero, the Fed cannot deliver anything less than a negative 2% real rate of interest."

The pretax nominal interest can't go below 0%. The after tax nominal interest rate most certainly can be below 0%. Funny how the New Keynesians, the Monetarists, or the Supply Siders never bother to look at how tax policy affects the cost of money (interest rate).

1. The Federal Reserve is not in the credit allocation business,....

Ahhhh. There was such a time. Meet the New Fed.

2. Yeah. The Fed is now buying up the majority of new mortgages, and the majority of new Treasury issues. The too-big-to-fail banks under its protection are making a lot of money (filling up the hole) on borrowing short and lending long. When we talk about "exit strategy," I fear the main issue will not be conventional monetary policy but instead the backlash from mortgage markets, treasury and banks all used to receiving vast sums from the Fed.

3. John,

http://www.federalreserve.gov/releases/z1/Current/z1.pdf

Page 76 - L.108 Monetary Authority
Mortgage Backed Securities:
2010 - $1.139 Trillion 2012 (3rd Quarter) -$918.4 Billion

4. Prof Cochrane writes, "I fear the main issue will not be conventional monetary policy but instead the backlash from mortgage markets, treasury and banks all used to receiving vast sums from the Fed," raising a very interesting question and that is, What word picture is he trying to create by using the word "backlash."

At present, lenders are making home loans and reselling them to the Fed. A back lash would be they would stop selling them to the Fed, but that would happen only if the Fed cut their fees and other upfront charges.

The prospect of hell here on Earth being raised by the preacher seems to be: The Fed has stopped buying loans and no one else has a appetite for buying loans like those previously sold to the Fed. IOW, the passage of time doesn't cure our problem---the World has less appetite for risk.

I would suggest that what we have here is a failure of finance (and implicitly of our blogger). Capitalism has failed to produce new products to deal with increasing risk (or at least the perceptions of increased risk).

In sum, the right question is, Why hasn't Booth produced a LLoyd's for our New Century? IOW, doesn't the fault law with finance for not having found ways to deal with increased risk?

4. "To be clear, I don't buy any of this:"

Yep, was looking for solid thought.

5. Why don't you buy the logic that negative interest rates should help our economy? Do you believe that the natural rate of unemployment is now 7.5%?

Also, I think you're being unfair when you describe advocates of monetary stimulus as wanting "a repetition of the late 1970s." Nobody wants a half-decade of NGDP growth between 9 and 15%. You need to describe others' views accurately if you want to persuade people that others are wrong.

FWIW, I think an NGDP level target would solve the pre-commitment issues, because it would mean that the FED would never have to over-shoot its own target.

1. I think that our main problem right now is not the rate of interest on short term-treasuries, but rather a long list of "supply-side" sand in the gears. See many previous blog posts. If you're having a heart attack, discussing whether a cappuccino would perk you up a bit is sort of beside the point.

The literature I'm citing does call for deliberate, expected inflation, induced by deliberately holding interest rates "too low" for an extended period. I think I'm allowed to cite the last historical episode. Yes, advocates want to stop before it gets out of hand.

Lots of previous posts on NGDP. If they can change course today to commit to NGDP target, what stops them from changing course in the future to commit to something else? That's not a commitment!

2. "That's not a commitment!"

Not only that, prior commitments seem to go out the window even when they are codified into law:

http://en.wikipedia.org/wiki/Humphrey%E2%80%93Hawkins_Full_Employment_Act

1. Explicitly states that the federal government will rely primarily on private enterprise to achieve the four goals.

2. Instructs the government to take reasonable means to balance the budget.

3. Instructs the government to establish a balance of trade, i.e., to avoid trade surpluses or deficits.

4. Mandates the Board of Governors of the Federal Reserve to establish a monetary policy that maintains long-run growth, minimizes inflation, and promotes price stability.

And so now that the federal government and the federal reserve have failed stupendously to achieve any of these goals - what do the Keynesians want to do - change the goal.

3. Prof Cochrane:

Even the hardest-core inflationistas today (Christy Romer?) would advocate a period of catch-up NGDP growth to get us to pre-crisis trend output, after which the Fed would basically go back to targeting 2% inflation. More level heads (Scott Sumner) only advocate closing a third of the "output" gap. We could get there with inflation in the 3-4% range. That is just completely different from the monetary policy of the 70's, in which we had double-digit NGDP growth every year for over a decade. Saying "they want to go back to monetary policies of the 70's!" is no different from liberals saying that Paul Ryan wanted to END MEDICARE when he proposed premium support. It's a scare tactic.

Also, I don't understand your doubts about Central Bank "commitment". The question is not whether the Fed can change its mind. Of course it can. That's true today, and it was true back in the 1980's when Fed policy changed long-run inflation expectations. The main issues the Fed has to come to grips with are CLARITY and ACCOUNTABILITY. As you've pointed out, the Fed's stated goals of QE (lowering long-term interest rates) contradict the actual effects of the policy, which are to RAISE inflation expectations and, correspondingly, interest rates. Furthermore, despite its recent forward guidance, the Fed really hasn't made much of a commitment to do anything specific and quantifiable. Unsurprisingly, this approach hasn't produced big results.

The reason I think NGDPLT is a good idea is not because it keeps the central bank from changing its mind in the future (it doesn't), but because it provides a clear target for which the fed can be held accountable. To my mind this increases the liklihood that the Fed will stick to hitting its target.

4. John,

Is your belief that the problems in the US economy are supply-related based on more than just your intuition? Do you believe demand-side problems simply cannot exist?

If the "natural" real interest rate were above -2%, then presumably we would have accelerating inflation in the US and Europe. But we don't. So, it seems like one of two situations are possible.

1) The "natural" real interest rate just happens to be at -2%, the lowest rate achievable by the central bank (i.e. we are at full-employment output given supply problems and there is nothing monetary policy can do). Emphasis on 'just happens'.

2) The "natural" real interest rate is below -2% and as a result we have a demand related (granted, part of the output gap can be supply related) recession. Yes, there is no deflation, but that can be explained by expectation anchoring. To be consistent: It doesn't seem plausible that expectation anchoring can explain the lack of accelerating inflation in the case that monetary policy is too loose because the Fed continues to set longer time frames for low rates without increasing inflation.

6. "True commitment requires legal, institutional, or constitutional restraints."

-- Well, we don't have any to that, so we're kind of in the pigs flying land here. From a personality/psychology standpoint, the only way you are likely to get confidence that the Fed is likely to behave much differently is appoint a new chairman and some new governors who come in with the stated purpose of implementing this plan.

"Suppose the Fed could promise now that, at time T, it will set interest rates too low, from the point of view of that time? This will encourage people to consume at time T rather than in periods after that, i.e. it will engineer the negatively sloped dashed line from T onwards. If people knew there was going to be this boom at T, consumption today would be less depressed."

I don't think that assumption is very well grounded and can be made in an uncertain world. Some of the people will care about pre-time T and others will care more about post-T. And since the situation is completely novel, you may end up with panicked or herd-like behavior that does way to little or way too much. Plus there is an implicit assumption that no other variables matter.

All of this simply suggests that the Fed is probably incapable of solving the current problems with the tools it has in its bag, as you concluded in the end.

7. Dear Professor Cochrane

It seems to me that your arguments above make the overwhelming case that Soros is the economist most worthy of attention, today.

In his Introduction to Open Society he writes, that a modern economy is a "reflexive process in which the participants' biased decisions interact with a reality that is beyond their comprehension." The statements by the Fed about re-evaluating show that the reality is beyond their comprehension.

Your writing shows your bias interacting with reality in the same way.

Adam Smith, if he were alive today, would realize that there is an entirely different way to look at these problems and that is through the lens of risk and insurance. For many years, there has been world wide demand for safe assets, telling us that the risk is the global economy is too great for the participants to handle.

If economists were required to work in a bank and actually apprentice in economics they would learn first hand that people know when they don't know and cannot measure risk accurately enough to properly price such (see Noah's recent blog on pricing risk).

Consider just for a moment the economics of the 1700s, before the industrial revolution. It was a world exporting/importing commodities. Risk had on dominant form: fragile sailing ships that could sink at any time. GB became dominant because Lloyds provided a way to handle that risk, paying over 1000 claims on ship sinkings.

You can argue about the Fed, interest rates, inflation, until you either turn blue in the face or the cows come home. It matters not.

It is meaningless for such wholly avoids the fundamental problem of the global economy--we have come to understand that the risk is greater than our present tools for dealing with such.

Keynes understood such, which is why is said the government had to be the spender of last resort.

But Keynes would also be the first to say that the gov't cannot be the spender of last resort forever, that it can only buy time until new mechanisms are found that restore confidence. John Boyd teaches these new mechanisms, themselves, will only be temporary. Destruction and Creation. http://www.goalsys.com/books/documents/DESTRUCTION_AND_CREATION.pdf

You need to go see a Civil War movie, not Lincoln, but Gone With the Wind. Our problems are not sand grains in the gears. Our problem is a global economy that is too uncertain and risky and becoming more so everyday (example: look at the risk to everyone of a lack of job permanency due to the Internet, automation, and robotics. How do you price a 30 year mortgage when common sense argues that in 30 years there will be no jobs?)

There is a interesting lesson in just that question. In the 1930s we learned that we couldn't price the risk of real estate loans, so we created deposit insurance. As technology has made the economy ever more risky, the cost of deposit insurance keeps rising. Now, we are cutting back on insurance and over time that will reduce bank deposits as people move cash to safer locations, reducing the capacity of the system to lend.

What does reducing the capacity to lend do: Increase risk.

1. anonymous above agrees with Cochrane but seems not to understand it. There is a lot of unpriceable risk, arising from uncertainty about government actions. Which was Cochrane's point or part of it, about sand in the gears. Anonymous also agrees with Cochrane that monetary policy is a sideshow.

8. I just saw R. Bachmann present this paper at the AEA conference called "Inflation Expectations and Readiness to Spend." The summary is: "Altogether our results tell a cautionary tale for monetary (or ﬁscal) policy designed to engineer inﬂation expectations in order to generate greater current spending."

9. FYI, the equation does not show up in Google Reader within Chrome. It renders just fine in Chrome if I come to your page.

10. I think you're being a bit unfair in regards to the level of commitment to the policy. Sure, they technically have not given up discretion, same as they did not give up discretion to reverse policy in the midst of QEI and QEII.

However, the Fed chooses the wording of statements very carefully. They know how they are read, how they are interpreted, and the power of their statements. Several members have made comments in the past to the effect of "I initially voted against policy X (i.e. QEII), but once it was announced I felt we needed to complete the action to preserve the credibility of the Fed."

Certainly, this announcement does not 100% guarantee that rates will be kept low until unemployment falls below 6.5% or core CPI rises above 2.5%. But they made the statement for a reason. They meant to say that, at this time, if in a few months expected medium term core inflation rises to, say, 2.35%, they will not immediately reverse policy and increase rates. Taking into account the probabilities of future policies, the expectation of future interest rates across the wide range of possible economic states (i.e. 7.2% unemployment 2.4% expected inflation, etc.) is now lower, and inflation expectations are higher (breakevens have moved higher following the announcement).

11. I'd just like to point out that despite their obvious ideological differences, Cochrane and Krugman have essentially identical views on monetary policy at the zero lower bound.

Krugman, from the AEA conference last weekend:

"If a central bank can credibly promise that it will allow a higher inflation rate over the medium term then it ought to be able to reduce real interest rates and have a significant expansionary effect on the economy. The problem is how do you in fact make that promise credible. There are multiple hurdles that you have to cross. First, you have to cross the threshold of the political acceptability of the policy of changing the inflation target, which has proved virtually impossible to tackle ...

Then, how do you make it credible? Why will the people running the central bank five or ten years from now—who are not the people running it now—go through with it?"

Here's the problem, Professor Cochrane: assuming we have a demand problem (an assumption you accept for the purpose of analyzing the model), your logic leads you down the road to fiscal stimulus. If you believe that we have a demand problem, and if you DON'T believe in monetary policy, your only option is good old-fashioned fiscal stimulus boondogles.

You've critiqued NGDP targeting, you've critiqued flexible inflation targeting, and you've critiqued fiscal stimulus. Assuming we have a demand problem, what is YOUR preferred policy?

1. I don't assume we have a "demand" problem.

2. But if we did, do you have a preferred policy response?

3. Professor, you state, I don't assume we have a "demand" problem.

1) What do you assume?

2) What evidence do you have that we do not have a demand problem?

4. Huh? Anonymous, what sloppy thinking led you to believe that the problem is always demand until proven otherwise?

I opened a restaurant recently serving only cat feces on aged bread. It failed not because my product was cat shit on mouldy bread but because of low aggregate demand (maybe if I'd served it on fresh bread? Nah. It was the recession that took me out).

5. Sure, we can put "demand" in scare quotes and pooh-pooh the concept, but it doesn't change the fact that there is such a thing as a recession induced by reduced aggregate demand. The Fed caused one in the early 80's by tightening the money supply.

Besides, as Prof. Cochrane has demonstrated, you don't necessarily need to agree with the assumptions underlying a model in order to critique it.

My question is, if we engage new Keynsians on their own terms, and assume, for the sake of argument, that our economy suffers from a shortfall of aggregate demand, then what should we do about it? Cutting interest rates doesn't work because of the ZLB. QE doesn't work because money = zero yield treasuries. The "expectations" channel doesn't work because the Fed, for whatever reason, can't commit to a future course of action. What works? Fiscal stimulus? Or should we just do nothing?

6. This is what I find confusing, as a non-economist. Since demand and supply are both important and have to equal each other for the economy to be in equilibrium, I do not understand why John does not at least entertain the possibility that we have mostly a demand problem. We definitely have a supply problem to some extent ( e.g. "structural issues" ), but we also had them in 2007 when unemployment was low. So why not humor us and at least admit that it is possible for the current problem to be 80% demand and 20% supply ? I haven't seen any logical explanation so far on this blog regarding this

7. I too am very curious to hear a response to this. It is important to understand what the contentious points are. It is clear that there is disagreement about what is ailing the current economy. But, suppose policy-makers are convinced we have a demand-side recession. Or, suppose future economists want to look back and see what John Cochrane would have done when, lo and behold, we do have a demand-side recession and short-term nominal interest rates are at 0. Could fiscal policy conceivably be effective? Or is it best just to avoid making things worse and let price adjustment do the trick?

12. You want x(t)=c(t) after you integrate to find the consumption correct?

13. Dear Professor Cochrane:

I adopting a New Years Resolution of commenting in a different way on your blog, based on posts by Miles Kimball and others, for the tried and true way of commenting leads to unintelligent responses by trolls.

In that regard, it seems to me that Crooked Timber has two posts on the same topic as your comments, above, to which you should have a response.

The first, by Roger Farmer, where he asks and answers the first question and he thinks should be asked and answered, being, "What causes large sustained shocks to aggregate demand?" His NBER answer: The Inefficient Markets Hypothesis: Why Financial Markets Do Not Work Well in the Real World.

It seems to me that, to accurately evaluate your position, we would need to know where your stand in relation thoughts of Mr. Farmer. Specifically, is his POV on the first question and Financial Markets correct?

I look forward to your comments, for I don't recall you writing at length on the causes of the current lesser depression.

Second, John Quinn on the same blog has a post,

The state of macroeconomics: it all went wrong in 1958.

In that piece he has several interesting thoughts, of which I will mention two

First he writes,

"The real decline [in macro economics] was in the 1970s and 1980s, as Friedman’s already overstated critique of Keynesianism was pushed to the limits of credibility and beyond. The big ideas of the period: Ricardian equivalence, Rational Expectations, Policy Ineffectiveness, Microfoundations, Real Business Cycle theory and the (strong-form) Efficient Markets Hypothesis were based on plausible (to economists, anyway) arguments. They didn’t have much empirical support"

It seems to me fair to ask, is he correct. Do these critiques have any real empirical support?

Quinn then questions New Keynesian thinking by asking whether the "great moderation" was a success, writing:

"[There is] the idea that the Great Moderation was a policy success and that the subsequent Great Recession was the result of unrelated failures in financial market regulation. My view is that the two can’t be separated. In the absence of tight financial repression, asset price bubbles are regularly and predictably[3] associated with low and stable inflation. Central banks considered and rejected the idea of using interest-rate policies to burst bubbles, and the policy framework of the Great Moderation was inconsistent with financial repression, so the same policies that gave us the moderation caused the recession."

What are your thoughts or responses?

1. Thanks for feedback all.

I have a new year's resolution too: try to keep blog posts a bit shorter and focused on one topic. So, while reviewing a paper and trying to understand the logic of new-Keynesian models, it's not the moment for me to veer off into John Pontificating On His Opinions Of What Is Wrong With the US Economy. Glad to know it's an interesting subject, I'll get there in future blog posts.

I also am not that much into blog wars; I'll comment on other blogs occasionally, when there is a really interesting issue, but not as a matter of habit. Life is short. But thanks for the feedback you find it interesting, maybe I'll do a bit more.

Now back to trying to figure out those New-Keynesian models.....

2. In your POV, what distinctive factors make a model a New Keynesian Model, as opposed to any other dead economist model?

IOW what has to be in a model to make it New Keynesian?

14. Scott Sumner says there's no switching back from an NGDP target, because it's just always better than an inflation target (or the goofy dual-mandate non-target we have in the U.S):
http://www.themoneyillusion.com/?p=18594

15. All of this talk ignores the fact that fiscal policy is truly horrible for economic growth. Massive deficits, higher taxes, threats of a trade war, and a regime which has increased business regulations at a record pace.

No monetary policy, even if they knew what they were doing, would overcome that toxic stew.

But, on the other hand, talking about what you are going to do in the future is probably better than anything the Fed might actually do.

16. But, in a Western democracy can any federal agency have credibility? Especially a central bank? Oh sure, bankers, that is who I trust.

The public has become so distrusting, so cynical, so jaded.

Then you have the related problem of loose cannons. You have Richard Fisher running around in wild-eyed, sweat-drenched hysterics about inflation. So, he sits on the FOMC (alternate years, or something like that).

Okay what is the public to think? The Fed is serious about growth, but Fisher might turn the tide someday.

I just talked to four institutional real estate investors, and I queried them on central bank stances. They all said they cannot make investment decisions based upon central bank stances, because such stances can change.

That was four for four.

It may be the time of the FOMC is past. We need one voice at the Fed. The public can barely believe Bernanke as it is, but with FOMC members frothing about inflation....

Happily, I am not sure it matters, forward guidance that is.

Milton Friedman just told the Bank of Japan to keep printing money until they got growth and inflation. He didn't jibber-jabber about forward guidance.

There is another question: If the Fed has to stick with QE for 10 years, what does the Fed do with the \$4-5 trillion in assets it owns. If it sells, it has to forward receipts to the Treasury.

Look for huge tax cuts...oh, now you like the idea?

17. John,

"Assume the Fed can set the real interest rate to whatever it wants."

This is the critical "if" that leads to all the "then"s.

*If* the Fed controls the real rate, *then* when the natural rate drops below zero we *will* have a negative output gap, i.e. a Keynesian recession. So the theoretical issue is not whether we are in a demand deficient environment. The issue is whether demand deficient environments are likely occurrences and what do we do when they happen. To answer that, *all* we need to know is whether the Fed controls the real rate.

Obviously the Fed controls the nominal short rate. So if the Fed surprise-hikes the short rate by 1% what happens to the real rate? If the spot inflation rate increases by more than 1%, the short real rate goes down, and otherwise it goes up. In the current environment it seems pretty clear that whenever the Fed surprise-hikes the short rate, inflation goes down or remains the same ("is well anchored"). Therefore when the Fed hikes the nominal rate by 1%, the real rate goes up by *at least* 1%. Therefore the Fed controls the real rate. Therefore liquidity traps are real, and therefore we need a plan for what to do about them (current conditions aside).

18. The fact that the Fed can, and does, control the real rate is, of course, a terrible indictment of RBC theory as an encompassing framework for the model of everything. If the fed *can* set the real rate then 1) they definitely won't always do it right (who *knows* where the natural rate is) and 2) liquidity traps are real. RBC assumes that inflation always moves one-for-one with changes in the nominal rate, which is frankly ridiculous.

Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.