Tuesday, February 21, 2017

Long Run Fed Targets

What should the Fed's long-run interest rate target be? The traditional view is that the glide path should aim at 4% -- 2% real plus 2% inflation.


One big question being debated right now is whether the "natural'' real rate of interest -- r* or "r-star" in econspeak -- has declined below 2%.

Over the long run, the Fed cannot control the real rate of interest -- that comes from how much people want to save and what opportunities there are for investment, i.e. the marginal product of capital. So, if the real rate of interest is now permanently lower, say 1%, then one might argue that the glide path should aim for 3% long-run interest rate -- 1% real plus 2% inflation target -- not 4%.

Janet Yellen recently came to Stanford and gave a very interesting speech that talked in part about a lower r-star, and seemed to be heading to something like this view. See the picture:

Source: Federal Reserve. 

(She also talked a lot about Taylor Rules, seeming to move much closer to John Taylor's view of how to implement monetary policy. See interesting coverage on John Taylor's blog. On r*, see Measuring the Natural Rate of Interest Redux by Thomas Laubach and John C. Williams for a central paper on r*. Henrike Michaelis and Volker Wieland have an interesting post on r* and Taylor rules, also commenting on Ms. Yellen's speech.)

Of course, cynics will say that it's just the latest excuse not to raise rates. But these are serious arguments which should be considered on their merits.


Should the glidepath head to 3% interest rates? Maybe not. How about zero?

Long ago, Milton Friedman explained the "optimal quantity of money,'' which is really the optimal interest rate. It is zero. Peramazero in St. Louis Fed President Jim Bullard's colorful terminology. At interest rates above zero, people hold less cash, and spend time and effort collecting bills early, paying them late, and so on. This is all a waste of time. Also, taxes on rate of return are a bad idea. With all rates of return that much lower, the tax distortion is that much lower. With 0% interest rates, and correspondingly lower inflation, infaltion-induced capital gains taxes vanish.

So maybe the glidepath should be to 0% interest rate, not 3%.  If the natural real rate is 1%, then inflation should be -1%.

In this line of thinking, the long-run interest rate is what counts directly. It is not a sum of a natural rate and an inflation target. Variation in the natural rate takes care of itself in variation in inflation.

4% ?

Why not? The primary reason often given is that interest rates at zero cannot go substantially below zero, at least without banning cash and many other gyrations of our monetary and financial system. So, if the interest rate is near zero, the Fed does not have "headroom" to stimulate the economy in a recession. I don't necessarily agree that this is so important, but let's go with it for a moment.

Additionally, conventional Keynesian policy analysts worry about a "deflation spiral," if the Fed can't lower rates. I'm not convinced this is a problem either, as recent experience and new Keynesian models don't spiral, (recent paper here), but again we're here today to flesh out the arguments not to adjudicate them.

(A correspondent points out Sticky Leverage by João Gomes, Urban Jermann and Lukas Schmid, and Optimal long-run inflation with occasionally binding financial constraints by Salem Abo-Zaid as two papers pointing to desirable positive long-term inflation and thus long-term nominal rates to keep away from the zero bound. Both have financing constraints as well.)

Both arguments for "headroom" above zero however seem to imply a direct nominal interest rate target, not inflation plus real rate. If the Fed needs four percentage points of headroom (2% real + 2% inflation) then it needs four percentage points of headroom (1% real + 3% inflation), no?

So, from the optimal quantity vs. zero bound-headroom argument it does not follow obviously that the interest rate target should move up and down with the ``natural rate.''


The question is, why is there a direct role for the inflation target? Why is that 2%, and then we add r* the long run real rate, to deduce the nominal rate glide point?

I think the answer is this: prices and wages are felt to be sticky, especially downward. That's the second argument against the Friedman rule: its steady deflation is said to require people to change prices and wages downward. That is said to cause disruption.

OK (maybe), no Friedman-optimal deflation. But why then 2% rather than 0% inflation?

Quality and pi star

One argument there is that inflation is overstated due to quality improvements. 2% is really 0%.

The issue: Suppose the iphone 6 turns in to the iphone 7, and costs $100 more. How much of that is inflation, and how much of that is that the iphone 7 is $100 better? Or maybe $200 better, so we are actually seeing iphone deflation? The Bureau of Labor Statistics makes heroic efforts to adjust for this sort of thing, but the consensus seems to be that inflation is still overstated by something like 1-2%.

Some reading on this: The Boskin Commission Report suggested the CPI is overstated by about 1%, as of 1996. Mark Bils, Do Higher Prices for New Goods Reflect Quality Growth or Inflation? argued that it's a good deal more. Mark measured that sales move quickly to new models, which they would not do if it were a price increase after controlling for quality. But Mark's analysis was limited to consumer durables, where quality has been increasing quickly. Many other CPI categories, especially services, are likely less affected.  Philippe Aghion, Antonin Bergeaud, Timo Boppart,  Pete  Klenow and Huiyu Li's Missing Growth from Creative Destruction suggest there is another 0.5%-1% overall because of goods that just disappear from the CPI. (This post all started with discussion following Pete's presentation of the paper recently.)

This is good news. Nominal GDP growth = real GDP growth + inflation. Nominal GDP growth is relatively well measured. If inflation is 1% overstated, then real growth is 1% understated.

It also means our real interest rates are mismeasured. If 2% inflation is really 0% inflation, then 1% interest rates are really +1% real rates, not -1% real rates.

But back to monetary policy. Suppose that 2% inflation is really 0% inflation due to quality effects. Does that mean we should have a 2% long run inflation rate target?

I don't think so. Again, the motivation for a positive inflation target is that there is some economic damage to having to lower prices. But during quality improvements of new goods, nobody has to lower any prices. They are new goods! No existing good has to have lower prices. In fact, actual sticker prices rise.

There is a deeper point here. Not all inflations are equal. One purpose of the CPI is to compare living standards over time. For that purpose, quality adjustments are really important. Another purpose of the CPI is to determine if people have to undergo whatever the pain is associated with lowering prices. For that purpose, quality adjustments are irrelevant.

(On both prices and wages, we also should remember the huge churn. Lots of prices and wages go up, lots go down. The individual is not the average. Changing the average one or two percentage points doesn't change that many individual prices.)

In sum,  the argument that quality improvements mean 2% inflation is really 0% inflation does not argue that therefore the inflation target should be 2% because otherwise people have to lower prices. They don't. Standard-of-living inflation is not the right measure for costs-of-price-stickiness inflation. In price stickiness logic, the Fed should be looking at a CPI measure with no quality adjustments at all!  (At least in this simplistic analysis. This is an invitation to academic papers. If new and old goods are Dixit-Stiglitz substitutes, what are the costs of price stickiness with quality improvements?)
(Update: my correspondent points to "On Quality Bias and Inflation Targets" by Stephanie Schmitt Grohé and Martín Uribe.)

So the argument for a separate inflation target much above zero seems to be weak to me. We're back to Friedman rule vs. headroom, which argues for a direct nominal interest rate target. Since I'm not much of a fan of headroom, I lean to lower values.

Leaving aside price-stickiness, I'm still sympathetic to a price level target on expectations grounds. If the quality adjusted CPI is the same forever, then we have a CPI standard, the value of a dollar is always constant, and long-run uncertainty decreases. We don't shortern the meter 2% every year. For this purpose, we do want the quality-adjusted CPI, and for this purpose the inflation target is primary. An interest rate target would have to rise and fall with r*.

Real rate variation

r* is the real rate. There really is no reason that the "natural" real rate only varies slowly over time. Interest rates crashed in a month 2008 because real rates crashed -- everyone wanted save, and nobody wanted to invest. The Fed couldn't have kept rates at 6% if it wanted to.

So, the procedures used to measure r*, like those used to measure potential output, are a bit suspect. They amount to taking long moving averages, and assuming that "supply" shocks only act slowly over time. More deeply, typical optimal monetary policy discussions use a Taylor rule

         funds rate = r* + 1.5 ( inflation - target) + 0.5 (output gap)

and recommend active short run deviations from the Taylor rule if there are "supply shocks" i.e. r* shocks. Just how the Fed is supposed to distinguish "supply" from "demand" shocks is less clear in reality than the models, which presume shocks are directly visible. A "secular stagnation" fan might say that the moving averages used to measure r* are instead picking up eternally deficient "demand," like a driver with his foot on the brake complaining of headwinds.

Bottom line

As often in policy, we argue too much about the external causes and not enough about the logic tying causes to policy. r* may or may not have declined. But it does not follow that the glidepath nominal rate should be r* plus 2% inflation target. Maybe the glidepath should be 0% nominal rate or 4% nominal rate independent of r*.  You see lots of mechanisms and tradeoffs worthy of modeling.


  1. You speak of interest....which is quality of money, but you don't speak of quantity of money. When you have the world's central bankers printing trillion after trillion it may appear that interest can be at zero....but as with through much of history...interest for money is necessary. Or do you believe in infinite debt?....zero interest...why not!!! We are building a debt bomb to end all debt bomb. The FED has horribly "missed" very dangerous imbalances in the past...and they(and others) are constructing a Zero Interest(or even more moronic negative interest) debt bomb where government can appear to avoid their fiscal responsibilities. It won't be pretty that is for sure...economics has a way of disciplining you eventually...no matter how much control you think you have!

  2. Having come of age in the 1970s, a two percent inflation target is acceptable to me only because I believe it over states the real rate of inflation.

    If the calculated rate of inflation is overstated then median wages have not stagnated - a politically significant result consistent with what I observe to be rising standards of living around me.

    It does seem to me that we are having arguments over monetary policy over plus or minus 1% when we cannot define or measure inflation within that error range.

    1. It is indeed difficult to measure inflation, with some of the big problems mentioned in the blog post. There is some elegance to the approach of NGDP-targeting to focus on a good match between incomes and obligations for the typical worker.

    2. Absalon makes a good point. And small errors in counting, especially if errors continue to be wrong on the same side, eventually because big statistical errors which may drive policy decisions.

      The Fed very clearly can't measure rates as accurately as they lead the public to believe.

      I often wonder if small consistent errors take place in our productivity measures, which seem distorted since the tech boom.

  3. The advocates of NGDP-targeting have an excellent critique of this approach to monetary policy. It is much better to use a policy that calibrates the units used for long-term contracts (like debt, employment contracts) to the productivity of labor, to maintain equilibrium. The costs of changing store prices are definitely a second-order concern.

    1. Anwer,

      From what I have read, the advocates of NGDP targeting have argued that the central bank should buy risky assets to hit an NGDP target.

      So if NGDP is below target and pencils are part of NGDP, the central bank should run out and buy a bunch of pencils? But suppose the reason that people are not buying as many pencils is that they are using more pens, typewriters, computers, PDA's?

    2. Frank I think that they only started advocating QE as a way to hit NGDP targets because we were at the ZLB when this school was forming. In fact, they have been criticized for specifying a goal but not saying enough about the instruments used to reach it. But we now have a new generation of theory, with people like Prof. Cochrane saying above that he is "not much of a fan of headroom". Perhaps a clear announcement of regime change will allow the central bank to start hitting its nominal targets.

  4. If the Fed holds the Fed Funds Rate a X% for long enough, then the r* will become X%. Empirically and theoretically this makes sense. John - who do economists not realise this?

    Consider the hypothetical scenario where the Fed sets the Fed Funds Rate at 1% for a long period. All business opportunities that yield more than 1% will have been taken. For example consider a business opportunity that once risk adjusted had a yield of 3%. If you can borrow at 1% and invest at 3%, you would do it right? Yes. Now, what about those yielding 2.9%. Ok, we'd have taken those off the table too. Then we work are way down to 1%. No entrepreneur would borrow at 1% to invest in a new enterprise with a risk adjusted yield of less than or equal to 1%. In this case the potential return on new unit of investment (ie at the margin) is 1%.

    The Fed is in part responsible (along with ageing demographics) for the yield on investments being so low. They allowed funding of enterprises too cheaply for way too long. The Fed trying to set their Fed Fund Rates below r* is like chasing the water down the plug hole.

    Please forgive me on my terminology. Economics is not my first language. Business and finance are.

    1. Most economics says that if the Fed holds the Fed funds rate at X% for long enough, then pi* will become x-r*. The fed cannot, in the long run, affect real growth.

    2. John,

      Unless people are willing to borrow at r* without changing pi*.

      "The fed cannot, in the long run, affect real growth."

      The fed cannot (by themselves) do anything. They can set an interest rate they will lend at and wait and see how many borrowers will come to the table.

  5. I am with 0% inflation.Anything else is a hidden tax.But the reality is the grasping at perceived netted Markov chains in moving sets of normalized numbers still adds up to 100% inflation in real estate markets in most western economies over a 10 year period and another round propaganda as to importance and usefulness of theory rather than the fact that in the long run they are wrong and can be counted on to be so which is what the inside money wants and will get even if they do not because 100% inflation in real estate property markets is the standard rate of failure of the Fed and most western reserve banks( RBA and RBNZ being the ones I follow) achieve on a reliable basis over the long term.The irony is if you write as I have to teh Federal Reserve they cannot even tell you what their own accounting rules are for the issue of Quantative easing currency and since most economic aggregates proceed on the leverage created by currency issuance it is clear there is no intellectual benefit in following any of teh logic which proceeds from a arbitrary an stalinist like unwillingness of the Federal Reserve to allow any real and open debate on economic policy as they refuse to state( and appear to not k=now what the seminal rules of currency creation are namely:

    Is the unit of currency whilst in circulation recognizes as a asset due for repayment from a retail bank and with an off setting liability as to its return from circulation being the neutral position or an asset without a provision for iaabilty for its return being the net gain position. The reality is as the issuance of currency increaes there is zero probability of all currency being returned and therefor the function for the amount of non returnable currency ought to be recognized as an asset under the accounting rules.The fact that the seminal legal position under all reserve bank legislation is ignored confirms the sad state in which economic discussion occurs.

  6. John,

    Perhaps the question you should be asking is "How do you get someone to knowingly borrow at a positive real interest rate?".

    1. Option #1 - Floating interest rates on existing loans. Bank offers a teaser rate (below the inflation rate) then bumps it back up above the inflation rate.

    2. Option #2 - Desparation / starvation - I need money to buy necessities so bad that I will borrow at nearly any rate (even high positive real rates).

    3. Option #3 - Technological innovation. I have invented the better mouse trap. I have a competitive edge that allows me to produce more goods for the same amount of capital.

    4. Option #4 - I have a monopoly (see government and taxes). My income stream is not subject to fads, outmoded technologies, or competition.

    5. Option #5 - Tax deductibility of interest. This works for positive inflation and positive real rates. Inflation is 2%, I borrow at 7% nominal (5% real) then deduct the 7% nominal interest that I am paying from my tax liability. This does not work during bouts of deflation, for instance -4% inflation (deflation) while borrowing at 1%. I can only deduct the nominal cost (1%) not the real cost (5%).

    6. Option #6 - Government equity. Using government equity, I can offset my real cost of borrowing. Bank is lending me money at 5% real interest, government is selling me equity that offers a 5% potential real return.

  7. John,

    "Interest rates crashed in a month 2008 because real rates crashed -- everyone wanted save, and nobody wanted to invest."


    Personal savings rate - 1950 to 1980 averaged 10% of disposable income
    Personal savings rate - 1980 to 1990 averaged 8% of disposable income
    Personal savings rate - 1990 to 2000 averaged 6% of disposable income
    Personal savings rate - 2000 to 2010 averaged about 3% of disposable income

    Where is this excess savings of 2008 that you are referring to?

    1. "Where is this excess savings of 2008 that you are referring to?"

      Frank - I don't see where Professor Cochrane was talking about excess savings. However, some places where the excess total savings exist are: China, Germany, Japan, American multinationals building up stranded profits in tax havens, African dictators hiding embezzled money in international havens, Russian oligarchs hiding money in international havens.

    2. Absalon,

      "Everyone wanted to save..."

      Really? Then why was the personal savings rate dropping like a stone leading up to the crash?

      What John may be referring to is credit spreads. They did widen significantly in 2008, and so it would have been more correct to say that there was a significant "flight to quality" in 2008. That doesn't mean that people were saving more (they weren't). It only means that people shifted their savings from higher risk to lower risk securities.

    3. Frank, you posted the averages for 10 year periods. Show the savings rate by year for the 2000's! People absolutely delevered after the crash.

    4. The Donk,

      John's statement - "Interest rates crashed in a month 2008 because real rates crashed - everyone wanted save, and nobody wanted to invest." is off base.

      Real rates were positive all through the 1980's and 1990's despite higher personal savings rates.

  8. The fed cannot, in the long run, affect real growth.--John Cochrane.

    As the French economist said, "Central banks may be effective in practice. But more importantly, can central banks be effective in theory?"

    Japan, even then an exporting nation, entered the Great Depression when their export markets dried up. No fault of their own, you might say. Lowering interest rates to zero did not help.

    The Japanese finance minister (central banker), Takahashi Korekiyo, went to money-financed fiscal programs, aka helicopter money.

    Japan largely sidestepped the Great Depression, while the U.S. moldered until WWII.

    Many economists, including Milton Friedman, say the Fed either caused or prolonged the Great Depression through tight money.

    So...what is the long run? The Great Depression is long enough for me!

    And if a Great Depression lasts long enough, are cultural norms altered, and defeatism replaces optimism? Why invest and build a business if a nation is in decline?

    In practice, central banks can be enormous institutions for good or bad. They have responsibilities whether they want them or not.

    To say, "Well, central banks can do nothing for long-run growth," does not seem to hold water given history and even recent history.

    1. Perhaps you should tell the whole story of Japan during the Great Depression:


      The good:

      "The Great Depression did not strongly affect Japan. The Japanese economy shrank by 8% during 1929–31. Japan's Finance Minister Takahashi Korekiyo was the first to implement what have come to be identified as Keynesian economic policies: first, by large fiscal stimulus involving deficit spending; and second, by devaluing the currency. Takahashi used the Bank of Japan to sterilize the deficit spending and minimize resulting inflationary pressures. Econometric studies have identified the fiscal stimulus as especially effective."

      "The devaluation of the currency had an immediate effect. Japanese textiles began to displace British textiles in export markets. The deficit spending proved to be most profound and went into the purchase of munitions for the armed forces. By 1933, Japan was already out of the depression."

      The bad

      "By 1934, Takahashi realized that the economy was in danger of overheating, and to avoid inflation, moved to reduce the deficit spending that went towards armaments and munitions."

      The ugly

      "This resulted in a strong and swift negative reaction from nationalists, especially those in the army, culminating in his assassination in the course of the February 26 Incident. This had a chilling effect on all civilian bureaucrats in the Japanese government. From 1934, the military's dominance of the government continued to grow. Instead of reducing deficit spending, the government introduced price controls and rationing schemes that reduced, but did not eliminate inflation, which remained a problem until the end of World War II."

  9. I like the 0% inflation as well. In fact, artificially stimulating the economy with monetary policy, which only works due to short-run money illusion depresses me and seems ethically challenged. Problem is, as you mentioned, it's hard to know what is really 0%. On the other hand, "Five-dollar foot longs" are now $6...and I don't think there has been a huge quality difference.

    Pete Bias

  10. “What should the Fed's long-run interest rate target be?” Since the rate which maximises GDP is presumably the free market rate, the state should not attempt to manipulate interest rates.

    “Over the long run, the Fed cannot control the real rate of interest..” Well the government machine as a whole can control interest rates: e.g. if government borrows excessive amounts, that presumbly increases rates.

    1. Right. And if you look at the ex-post real rate of return on one-year U.S. Treasuries, so you take the Treasury yield and you subtract off the Dallas Fed trimmed mean inflation rate over the last three years, you’re going to get minus—about a minus 140 basis points. So we took that to heart as part of the regime. It hasn’t changed much in the last three years. Don’t see any reason for that to really change over the forecast horizon of two to two-and-a-half years going forward.

    2. Ralph,

      "Since the rate which maximises GDP is presumably the free market rate, the state should not attempt to manipulate interest rates."

      These kinds of statements make me laugh. First, nobody at the central bank is forcing the market to borrow from them. Credit is a two way street - it takes a willing borrower and a willing lender. Second, who is this "free market guy" that also acts as a lender of last resort?

      You say the interest rate for lending of last resort should be set by the market or some subset of the market - care to be more specific on who this person / group of people are? Any private bank can refuse to lend money to you irregardless of the interest rate you are willing to pay - it's owners don't like that you are Catholic or Jewish, they don't like the color of your skin, they don't like your sexual orientation, etc.

      Truly free markets embrace the bad with the good - hence the "need" for a central bank that offers equal opportunity for all.

    3. Frank,

      Not that I disagree in principle, but prior to the Fed, there were banking clearinghouses that performed this role. They were later internalized upon creation of the Fed

    4. James,

      There are 12 fed districts today spanning the U. S.:


      Part of the reason for the creation of the Fed (central bank) was to de-centralize banking away from New York. Also, you may not realize it, but those clearinghouses still exist:


  11. I think we’re in a slow-growth, slow-inflation world, and I think that the fed funds rate is going to top off at 2 percent—well, maybe a little bit more if you’re squeezing the economy. That’s where that r-star should be, which is in the Taylor rule.

  12. Up until recently, I always felt the interest rate target was entirely about headroom. As long as it was sufficiently above 0, then in times of distress, they could cut interest rates. This would allegedly send signals to the credit market to keep lending constant who would interpret fed's posturing so as to not become overly risk averse.

    One could argue this is pretty much what happened, given your priors for how bad the great recession could have been if the fed did nothing.

    As for promoting inflation because of wage and price stickyness - this argument strikes me as a bit strange. Even ignoring all of the measurement issues, how is 2 percent annual inflation supposed to combat deep wage rigidities - where people are unwilling to take wage cuts even when facing unemployment.

    Or maybe there's another side of this argument that I'm missing. Is this not what the conventional view of Monetary Policy was up till recently?

  13. If r* approximately represents the real 3-month T-Bill rate, then what do we think short term, low risk investors should earn? I'd say very little--0.3% to 0.5%, especially in a world of lower growth.

    If we are projecting 2.0% to 2.5% real growth going forward, r* of 2.0% indicates that investors could earn near the growth rate of the economy with little risk. I find that hard to accept.

    When Paul McCulley was at Pimco in the early 2000s, he argued for a low r* of 0.5%. He viewed the money markets as protecting investors from inflation (2.5% back then) and taxes (about 25% average rate), so he backed into a 3.2% or so 3-month T-Bill yield.

    My view of the world is that cash investors earn a small premium over inflation; 10-year government bonds earn just a little bit below the growth rate of the economy; and equity investors earn about 3.0% over the growth rate of the economy.

    1. Anonymous,

      My own view is that we only need one asset that offers an inflation risk free rate of return - currency. That leaves the question - what should the return on government bonds (even of the short duration) be?

      It is my own contention that government should sell equity in lieu of bonds.

      In that instance the potential rate of return on government equity should be greater than the real cost of private borrowing.

    2. Anonymous,

      Also, this statement:

      "10-year government bonds earn just a little bit below the growth rate of the economy"

      Even if 10-year bonds earn the growth rate of the economy, you still need to contend with the growth rate of the debt itself.

      If the growth rate is 3%, the 10 year yield is 3%, but debt is growing 10% per year, the interest expense on the debt grows (10% + 3%) = 13% per year. Pretty soon you don't have enough tax revenue to pay the interest even with 3% economic growth and the additional tax revenue.

  14. It's worth remembering the specification in the Federal Reserve Act, sction 2A: "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."

    This reads to me like a simple nonlinear optimization problem. Why is this a matter of opinion, and why are interest rates being considered in isolation? Where are the models, what do they recommend, and what are the error bars on the model parameters?

  15. I just read a Scott Sumner post where he discussed the problem of targeting hedonically adjusted indices to confront the problem of wage/price stickiness: http://www.themoneyillusion.com/?p=32339.
    Do you have any thoughts, or previous posts, on the claim that cyclically swinging price indices represent counter-cyclical monetary policy when NGDP expectations are stable? The Sumner post and this post seem similar, but don't quite cross over into shared language.

  16. For some time, economists have been taking the view of "keep inflation at 2% unless there's proof that it should be below that point".

    But, the first order effect of inflation is negative: making it harder to store wealth.

    So, really we should be saying: "keep inflation low, unless there's proof that it needs to be higher"

    Given a definite first-order cost, and questionable gain, we should move the inflation target to 0% until someone can demonstrate why it should be any higher.

    1. There are (unsurprisingly) arguments set out in the literature as to why 2% or thereabouts is the optimum rate. One argument is that it's beneficial for the price paid for different types of labor to change relative to each other in line with supply and demand. However, actually CUTTING wages (particularly in unionised sectors) is difficult - Keynes's "wages are sticky downwards" point. Erge it is easier to change relative wages if there is a small amount of inflation.

  17. When trying to solve a problem, take the simplest possible case of the problem, solve that, then add real-world complexities. So take an economy where there is no government borrowing (as actually advocated by Milton Friedman and Warren Mosler – so that’s not such a ludicrous over-simplification as it might seem).

    Also assume private banks are not allowed to create / print money (again, actually advocated by Friedman and several Nobel laureate economists). Also the latter “no private printing” is actually inherent to the “dispose of banks’ run prone liabilities” system advocated by John Cochrane.

    In that economy, the optimum amount of money (base money) for government to issue is whatever keeps the economy at full employment. There is no obvious merit in issuing so much that inflation gets excessive and government has to borrow money back so as to control demand (though I wouldn’t rule out raising interest rates in an emergency).

    Conclusion: Friedman and Mosler were right to advocate a permanent zero rate of interest: i.e. there should be no attempt (normally) for the state to artificially raise rates. I.e. adjusting aggregate demand should ideally be done simply by varying the amount of new money that government creates and spends into the economy.

    1. Ralph,

      "In that economy, the optimum amount of money (base money) for government to issue is whatever keeps the economy at full employment."

      "...adjusting aggregate demand should ideally be done simply by varying the amount of new money that government creates and spends into the economy."

      The "government" I presume that you are referring to is the Legislative Branch of government comprised of 435 House members and 100 Senators. Care to explain how you get 500+ members to agree on the right amount of money to issue, and what they should buy with that issued money?

      "When trying to solve a problem, take the simplest possible case of the problem, solve that, then add real-world complexities."

      Real world complexity #1 - We live in a Representative Democracy.

      Or does your plan include replacing our Representative Democracy with an Imperialist State?

      King Donald tells you that you must accept $20,000 from him for your current residence because he has determined that your house is now for sale and that his purchase would be beneficial to adjusting aggregate demand - you should of course:

      1. Believe he is correct
      2. Acquiesce to his purchase

      Is that what Friedman had in mind in "Free to Choose"?

    2. Frank,

      The answer to your questions was set out in a paper a few years ago (first link below), which was recently endorsed by Bernanke (2nd link). See B’s para starting “A possible arrangement…”.


      Basically the answer is to have some committee of economists decide the SIZE of any stimulus package, while obviously political decisions like what % of GDP goes to the pubic sector and how that is split between education, health, etc stays with politicians.

      The committee could perfectly well be the EXISTING committees at central banks which decide on interest rate adjustments. That system is not actually much different to the existing system in that under the existing system, the latter central bank committees can overrule (via interest rate adjustments, QE, etc) what they see as excessive or deficient fiscal stimulus.

      Note that the above paper ALSO advocates full reserve banking. However full reserve is not an essential ingredient of a system that involves creating and spending base money as a means of implementing stimulus.

    3. Ralph, this is already happening with large-scale asset purchases. The Fed decides the size of the stimulus on a regular basis.

    4. Anwer,

      I quite agree. As I said above, "That system is not actually much different to the existing system...".

    5. Ralph,

      Ben Bernanke's arrangement as described in the article you reference:

      "A possible arrangement, set up in advance, might work as follows: Ask Congress to create, by statute, a special Treasury account at the Fed, and to give the Fed . . . the sole authority to fill the account, perhaps up to some prespecified limit."

      This solution runs into the problem that I described above - getting 500+ members of Congress to create, maintain, and utilities this proposed statute. Any statute enacted by one Congress can be repealed by the next - see Glass Steagle Act. And it is no guarantee that money injected by the central bank will be spent by the federal government - Bernanke admits as much later in the article.

      "At almost all times, the account would be empty; the Fed would use its authority to add funds to the account only when they assessed that a of specified size was needed to achieve the Fed’s employment and inflation goals. Should the Fed act, under this proposal, the next step would be for the Congress and the Administration—through the usual, but possibly expedited, legislative process—to determine how to spend the funds (for example, on a tax rebate or on public works)."

      ...how to spend the funds (for example)... or on a war, or paying farmers to burn their crops, or bailing out banks...

      Bernanke is under the central banker dillusion that money spent by the federal government is always well spent.

      "Importantly, the Congress and Administration would have the option to leave the funds unspent. If the funds were not used within a specified time, the Fed would be empowered to withdraw them."

      So Bernanke wants the central bank to have the authority to drop money into some special Treasury account to meet the central bank's prescribed inflation and employment goals but ultimately it is up to Congress to decide how to spend or not spend that money.

      Presumably, Bernanke also understands that a central bank is not needed to perform the actions of helicopter money. The U. S. Treasury under the direction of Congress already has the authority to print money.

      If Ben Bernanke wants helicopter money so bad, the logical first step would be to eliminate the central bank (board of governors and open market committee) altogether. Why have a central bank at all when everything that Bernanke proposes can be achieved without one?

    6. Some more recent pronouncements from Ben Bernanke:


      "There is still a case for fiscal policy action today, but to increase output without unduly increasing inflation the focus should be on improving productivity and aggregate supply—for example, through improved public infrastructure that makes our economy more efficient or tax reforms that promote private capital investment."

      I am all for government expenditures that improve the productive capacity of the economy. The problem is that Congress (and a number of economists) don't parse between expenditure opportunities in that manner. Instead, Congressional expenditures are approved in a "I scratch your back and you scratch mine." mine.

      Meaning, I get my new bridge and in exchange you get your military excursion into BFE. Or as a specific example - I get my dual wars in Iraq and Afghanistan and you get your Medicare part D benefit.

      I am a bigger fan of tax reform that promotes private capital investment as long as:

      - That tax reform doesn't add to the federal debt putting it on a collision course with both monetary policy adjustments and Congressional debt ceiling concerns -

      That kind of tax reform could be done through the Executive Branch of government and bypass Congress entirely.

  18. There is no fixed R-star rate of interest. As MMTers often point out, a country which issues its own currency can choose any rate of interest it likes to pay on its debt which in turn will influence interest rates in general. See:


  19. The government already can borrow at 0%, by issuing Outside Money, aka Cash. I'm surprised seignorage didn't come up at all in the post. I don't advocate that the debasement of money is good prima facie (the Treasury gains, but the public holding cash loses). However, as Rogoff notes, dollars are largely held by drug dealers, tax dodgers, and foreigners, so the US gains from this on net. After this, it's all term premium, inflation and credit risk -- why anyone thinks rates should be zero and not positive (or negative, sometimes, depending on FX and monetary regimes) is beyond me. But I've only been an international fixed income professional for 22 years.

    Shrinkflation is a fun topic, with which Pippa Malmgren is obsessed.


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