"If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008

Monday, October 18, 2010

Really good links - Price level targeting - Optimal inflation rate - Interest on bank reserves - Unemployment puzzles - Government sector - QE 2

Charles Evans, President, Chicago FED - Developing a State-Contingent Price-Level Target - " I would like to use this opportunity to expand the discussion about additional communications tools available to central banks in a low-inflation environment. In a nutshell, I think there are special circumstances when price-level targeting would be a helpful complement to our current and prospective strategies in the U.S. Clearly communicating an expected path for prices would help guide the public’s understanding of the Fed’s intentions while we carry a large balance sheet and promise continued low interest rates for an extended period.
        There are quite a number of academic studies of liquidity trap crises that find either price-level targeting or temporary above-average inflation to be nearly optimal policies; and yet, central bankers and the public generally loathe the idea that even a temporarily higher inflation rate could be beneficial or be consistent with price stability over the longer term.
        Nevertheless, with potentially beneficial policies so well grounded in rigorous economic analysis, I cannot stare at our current projections for high unemployment and low inflation and think that these projections are consistent with the best monetary policies to address the Fed’s dual mandate responsibilities." - The implied inflation rates for a 2 percent P* path where the current price gap is closed by the end of 2012 (pdf). - A more aggressive P* policy that is assumed to close by the end of 2013 (pdf)

Joe Gagnon - Friedman rule and optimal inflation rate - "Another argument for a positive inflation rate has to do with a fundamental asymmetry built into the Friedman rule that, to my knowledge, has not been explored in the academic literature. Friedman was concerned about the “shoe-leather” cost of minimizing cash holdings when inflation is positive. What gets almost no attention, however, are the much larger costs to society in lower capital and output arising from deflation. Why would anyone hold risky capital with an expected real return of 5 percent during a steady deflation of 6 percent? In that case, the riskless returns to holding cash exceed the risky returns on productive capital. As the rate of deflation increases, the entire economy shrinks as the capital-output ratio contracts. This cost is many orders of magnitude greater than the “shoe-leather” cost associated with positive inflation of 6 percent. The Friedman-optimal rate of inflation may be -1 or -2 percent, but the costs of deviating below that are sky-high whereas the costs of deviating above it are small."

Stephen Williamson - Liquidity, Financial Intermediation, and Monetary Policy in a New Monetarist Model (pdf) - "One source of much confusion concerning current monetary policy in the United States concerns how policy works when the central bank pays interest on bank reserves, in circumstances where the quantity of excess reserves held overnight is greater than zero. The Fed has now been paying interest, at 0.25%, on overnight reserves since October 2008. In our model, it is a straightforward exercise to include interest bearing reserves. What the model shows is that, if excess reserves are held in equilibrium, then open market operations are irrelevant at the margin, much like in the liquidity trap equilibrium, but with a positive nominal interest rate. Monetary policy works in this regime through changes in the interest rate on reserves, which essentially determines all short-term market interest rates. <..>
        An increase in risk can make liquidity more scarce in general, and this acts to reduce the real interest rate, and to increase the marginal social cost of inflation. An optimal policy response is for the central bank to sell interest-bearing assets and reduce the inflation rate. The real interest rate rises due to the policy action. This is quite different from typical Keynesian financial crisis analysis, where a problem arises because of the zero lower bound on the nominal interest rate, and the real interest rate is viewed as being too high. Here, the real rate is too low in the absence of intervention, due to the shortage of liquid assets. The optimal policy
response in our model is consistent, in a sense, with what the Fed actually did during the financial crisis. After the Lehman Brothers collapse in fall 2008, the Fed sold a large portion of its portfolio of Treasury securities."

Alex Tabarrok - Unemployment puzzles - "The first puzzle about unemployment when thought about from within the search-matching framework is that unemployment rates are highest among the least skilled and most homogeneous skills, i.e. among those worker/jobs with the easiest matches. It's hard to believe that it takes a year to match a construction worker to a job. <..>
        The second puzzle is that uncertainty should matter most when hiring and firing costs are high and once again these costs are lowest for those workers with the greatest unemployment rates."

Menzie Chinn - Government sector (USA) - "The following four figures highlight: (1) normalized Federal outlays are not much higher than in 1986; (2) government consumption to GDP is back up to 1991 levels (and not yet back to 1987 levels; (3) the cyclically adjusted budget deficit is only 2 ppts larger than that recorded in 1987; and (4) Federal consumption remains far below the previous peak in 2007."

Scott Sumner - QE II is arriving right on schedule

CNBC Video - Discussing whether QE2 will work, with James Hamilton, professor of economics at University of California at San Diego.

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