John Cochrane, Michael Woodford, and the Efficacy of Monetary Policy
Cochrane has already received pushback on his post from Scott Sumner, Bill Woolsey, and David Glasner. Here, I wanted to provide my own response to two of Cochrane’s statements that highlight the divergence between his and Woodford’s actual views on the efficacy of monetary policy at the lower bond and its ability to keep long-run inflation expectations anchored. Here is the first of Cochrane’s statements:
Mike recognizes, as I do, that the Fed can do nothing more to raise nominal GDP today. Rates are at zero. The Fed has did what it could.
It is important to recognize first that according to standard macroeconomic theory, people’s expectations about future policy are a critical aspect of the way in which monetary policy decisions affect the economy. The overnight interest rates (such as the federal funds rate in the US)… are not in themselves of such import for the economic decisions (about spending, hiring, and price-setting) that central bank ultimately wishes to influence. It is instead the anticipated path of short-term rates, years into the future…that is a more important determinant of these decisions… It follows from this view that, even when the current policy rate is constrained by the lower bound, a variety of different short-run outcomes for the economy should remain possible, depending on what is expected about future policy.
a practical way for the Fed to conditionally commit to a future path of
monetary policy that would raise aggregate nominal expenditures today. To underscore this point, Woodford notes this approach would be equivalent to the Fed convincing the public that some part of the increase in the monetary base were going to be permanent, something that has not happened with the Fed’s QE programs:2
If, instead, one were to assume a permanent increase in the size of the monetary
base, and assume that it is immediately understood by everyone in the economy that
such a permanent change in policy has occurred, then such a policy would be predicted
to have an immediate positive effect on economic activity during the period in which
the lower bound binds, in either the model of Krugman (1998) or Eggertsson and
Woodford (2003).
More deeply, how does the Fed commit to allowing “just a bit” of inflation in the future, and not starting down the path of the 1970s again?
[S]uch a commitment would accordingly require pursuit of nominal GDP growth well
above the intended long-run trend rate for a few years in order to close this gap. At
the same time, such a commitment would clearly bound the amount of excess nominal income growth that would be allowed, at a level consistent with the Fed’s announced long-runt target for inflation.
A commitment not to let the target path shift down means that, to the extent that the target path is undershot during the period of a binding lower bound for the policy rate, this automatically justifies anticipation of a (temporarily) more expansionary policy later, which anticipation should reduce the incentives for price cuts and spending cutbacks earlier, and so should tend to limit the degree of the undershooting. Such a commitment also avoids some of the common objections to the simple Krugman (1998) proposal that the central bank target a higher rate of inflation when the zero lower bound constrains policy.
base money could alternatively be used to show that welfare could be increased by
committing to keep the nominal interest rate at zero until it is possible to hit a certain
deterministic target path for nominal GDP, and then use monetary policy to keep
nominal GDP growing at a steady rate thereafter. The inferior initial equilibrium is
instead one in which nominal GDP is allowed to follow a permanently lower path,
albeit with the same long-run growth rate.”
3Another benefit of returning nominal GDP to its pre-crisis trend is that it would restore nominal incomes to where they were expected to be when creditors and debtors agreed to fixed nominal contracts prior to the crisis. This would help repair household balance sheets and further strengthen a recovery.
2012-09-09 23:41:08
Source: http://macromarketmusings.blogspot.com/2012/09/john-cochrane-michael-woodford-and.html
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