Monetary Policy with Interest On Reserves

Or, Heretics Part II

I just finished a big update of a working paper, "Monetary Policy with Interest on Reserves." It also sheds light on the question, what is the sign of monetary policy? (Previous posts here, here and here).

Again, the big issue is whether the "Fisherian" (Shall we call it "Neo-Fisherian?") possibility works. The Fisher equation says nominal interest rate = real interest rate plus expected inflation. So by raising nominal interest rates, maybe expected inflation rises?

The usual answer is "no, because prices are sticky." So, I worked out a very simple new-Keynesian sticky price model in which prices are set 4 periods in advance.

The top left panel of the graph shows the heretical result. I suppose the Fed raises interest rates by 1 percentage point for two periods, then brings interest rates back down (blue line). Prices are stuck for 4 periods (red line) so don't move. After 4 periods prices fully absorb the repressed inflation -- the Fisher equation works great, only waiting for prices to be able to move.

In the meantime the higher real interest rates (green) induce a little boom in consumption. So, raising rates not only raises inflation, it gives you a little output boost along the way! Raising rates forever does the same thing, but sets off a permanent inflation once price stickiness ends.  

Why do conventional models give a different result?

Heretics

Low inflation is back in the news.  The Wall Street Journal covers the latest decline in European inflation. Peter Schiff has a nice article explaining that inflation is not such a great thing, unless of course you're a government that wants to pay back debt with cheap money. I dipped into this heresy in an earlier post, explaining that maybe zero rates and slight deflation just represent the arrival of Milton Friedman's optimal quantity of money.

But this news also brings to mind some thoughts on the second heresy -- maybe we have the sign wrong, and we're getting low inflation or deflation because interest rates are pegged at zero, and maybe the way to raise inflation (if you want to) is for the Fed to raise interest rates, and leave them there. (Earlier posts on this question  here and here)

Back in 2010, Narayana Kocherlakota explained the basic idea

Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent.

To sum up, over the long run, a low fed funds rate must lead to consistent, but low, levels of deflation.”

It's really simple. One of the most fundamental relations in economics is the Fisher equation, nominal interest rate = real interest rate plus expected inflation. Real interest rates can be affected by monetary policy in the short run. But not forever. So if the Fed raises the nominal interest rate and leaves it there, expected inflation should eventually rise to meed that nominal rate.

Chicken and Egg Inequality

The FT's Martin Wolf weighs in on "Why inequality is such a drag on economies"

This is the question that was bugging me last week. Why is inequality a problem in and of itself, rather representing a symptom of problems that should be fixed for their own sake?

Since last week's review of these ideas was rather scathing, I hoped Wolf would offer some new, and better tested ideas.

Alas, and interestingly, no.

Envy and excess

In the inequality post, I puzzled over the following conundrum:

Why does it matter at all to a vegetable picker in Fresno, or an unemployed teenager on the south side of Chicago, whether 10 or 100 hedge fund managers in Greenwich have private jets? How do they even know how many hedge fund managers fly private? They have hard lives, and a lot of problems. But just what problem does top 1% inequality really represent to them? 

I emphasized the quantity issue here. His grandfather in the 1930s watched movies and saw glamorous lifestyles way beyond what he could achieve. Increasing inequality is about larger numbers who live a lavish lifestyle. And the claim is that increasing inequality is changing behavior.

There is a view motivating the left that inequality is just unjust so we - the federal government is always "we" -- have to stop it. If they'd say that, fine, we could have  productive discussion.

But they say, and I was going after in the post, all sorts of other things. That inequality will cause poor people to spend too much, that it will cause them to rise in political rebellion, for example. For that to happen, for the presence of the rich to affect their behavior in any way, they have to know about how the exploding 1/10 of 1% live, and how many of them there are. Which just doesn't make any sense.

Paul Krugman had a few revealing columns over the weekend. (No, not the endlessly repeated Say's Law calumny. I trust you all understand how empty that is.)

Returns to unwanted education

In my inequality post, I wrote, somewhat speculatively,

The returns to education chosen and worked hard for are not necessarily replicated in education subsidized or forced.

Marginal Revolution points to a nice new paper by Pierre Mouganie making this point. From the abstract:

In 1997, the French government put into effect a law that permanently exempted young French male citizens born after Jan 1, 1979 from mandatory military service while still requiring those born before that cutoff date to serve. ... conscription eligibility induces a significant increase in years of education, which is consistent with conscription avoidance behavior. However, this increased education does not result in either an increase in graduation rates, or in employment and wages. Additional evidence shows conscription has no direct effect on earnings, suggesting that the returns to education induced by this policy was zero.