Would negative nominal interest rates have stopped the Great Recession?

This was Miles Kimball’ contention, questioned by David Andolfatto recently.   An anecdote from the sticky price DSGE literature.  Suppose we take the view that the Great Recession was primarily a credit crunch.  As such, looser policy would have been a very weak instrument to offset it. In the New Keynesian framework modified to include credit frictions, a credit crunch causes actual output to fall, but also the natural rate of output consistent with flexible prices.  A monetary expansion afforded by negative nominal rates would boost aggregate demand, net worth, and lower spreads, counteracting the credit crunch, but at the expense of prohibitively high inflation.

In that same framework, where the microfoundations enable us to figure out what the best policy would be, it would be actually extremely costly to try to entirely offset the effect of the credit crunch on output.  By the same token, the same logic would suggest that conventional aggregate demand-boosting fiscal policy would not do the job either, since in this framework such policy works through the same output-gap inflation-boosting channel.

Even if you buy the basic set up of the model, (ie, sidestepping all the conversations about macro wars and microfoundations), how much weight you place on this prescription depends on weighing up a few things.

For starters, the result depends on the model encoding very high costs of inflation.  These come about because it’s assumed that demand for a firms’ goods, which has to be satisfied no matter what, is very sensitive to a relative price misalignment caused by not being able to adjust prices for higher inflation.  This causes firm production and hours worked to be volatile, and this volatility hurts the consumer-worker-firm-owners.

That said, the model excludes a couple of things that may understate the cost of deviations of inflation from target.  i) it doesn’t model money seriously, and doing so seems often to make inflation more costly.  ii) it assumes rational expectations and full commitment to the inflation target.  In reality, it would be fair to assume that there would be doubt about the authorities’ commitment to that target.  That would dispose a policy maker to be reluctant to let inflation wander a long way from target in pursuit of reversing a credit crunch, for fear of incurring large costs of disinflation down the road.

This isn’t to say that these models suggest that what the Fed did was wrong.  On the contrary, you could use them to explain why the Fed cut rates as aggressively as they did.  Note that inflation hasn’t wandered all that much from target throughout, in the US.

Much more effective at increasing output, and therefore much more desirable, in these models, would be policies that attack the credit crunch at source and substitute the reduced capacity for the private sector to intermediate and bear risk for the deeper pockets of the public sector:  capital injections into banks;  subsidies for private lending; asset purchases.  The Fed and HMT/BoE did just this.  Still we had a credit crunch and a Great Recession.  One inference is that the authorities did too little counter-credit-crunching of this sort.  Or it could indicate that in reality the credit policies have costs not encoded in the model.  Or of course the models may be off for any number of other reasons.

I would agree with Miles that it would be useful to have negative nominal rates to eliminate the risk of losing control of inflation on the downside, and being stuck in a liquidity trap.  In fact, we might even be on our way there now.  But that didn’t happen during the Great Recession period in question.  (Perhaps fortuitously).  And through the lens of these models it would not have been effective or desirable as a tool to counter it.

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9 Responses to Would negative nominal interest rates have stopped the Great Recession?

  1. Luis Enrique says:

    “In the New Keynesian framework modified to include credit frictions, a credit crunch causes actual output to fall, but also the natural rate of output consistent with flexible prices.”

    that gets at something that really bugs me about NK models – thinking about optimal policy in terms of welfare optimization, where welfare optimization says the economy “ought” to have a recession and employment ought to fall because we’ve been hit by a shock that makes working less rewarding, so that policies to raise employment (too far) would actually harm welfare. To my mind, this is completely barmy.

    This bugs me in the sense of a nagging questions I want to resolve, rather than being something I am convinced is wrong, because I do not know the literature well enough to know whether what I’ve described is going on.

    By analogy, suppose the credit crunch is a spanner thrown into the workings of a machine. If a spanner has been thrown into the works, one optimal policy is to go home and put your feet up, because you’re not going to be able to produce anything with a busted machine. Another optimal policy is to remove the spanner and fix the machine.

    I worry that the modelling strategy of conceiving of the origins of business cycle fluctuations as exogenous spanners thrown somewhere into the production side of the economy leads economists to advise the former kind of policy response when we want the latter: remove the spanner.

  2. Luis Enrique says:

    I should add: spanners thrown into household preferences are equally problematic, imho

  3. Luis Enrique says:

    gah! and another addition – my original comment did not acknowledge what you wrote about attacking the credit crunch at source. That is removing the spanner and the better policy – I just don’t know how well mainstream NK models, with recessions caused by other things than credit crunches, cater for that type of response, and had that in mind.

    • Tony Yates says:

      Thanks for your comments… I can’t think of many other spanner examples. One is monopoly power. Cured by costly inflation, which erodes firms’ relative prices and forces them to produce more than they would want to, closer to the socially optimal level that mimics competition. But better dealt with by a subsidy to production financed by taxes in these models.

      • Luis Enrique says:

        how do you interpret a simple technology shock in an NK model?

        We sophisticates do not suppose firms have forgotten how to make things, but rather that a technology shock is a proxy for something else, some spanner thrown into the works of the supply side of the economy.

        But should we take the spanner as given, so welfare is optimized by reducing labour supply whilst it is still in the works, or is a technology shock a proxy for something that policy makers could hope to attack at source, like a credit crunch, if economists were able to identify the problem?

        I cannot think immediately think of any interpretations of “a negative technology shock” that suggest some way of attacking them at source, as opposed to taking them as given and responding accordingly. Oil price shocks? But maybe that’s just because my economics education has skimped on thinking too hard about what technology shocks really represent.

        Am I making any sense here? That thinking in terms of exogenous negative shocks to be taken as given rather than “fixed” could be a conceptual error, that has constrained how economists think about optimal policy responses? With Y=F(A,K,L), when A is hit with a negative shock, we ought to have directed our thinking towards how to repair A, whatever that means, whereas we’ve thought about how to respond to A?

        Maybe I am merely saying that I don’t like the policy implications of supposing recessions are symptoms of supply side shocks, in the fashion that I currently understand mainstream models to do so. But for all I know, when the current generation of NK models are estimated, they attribute little to technology shocks in any case.

      • Tony Yates says:

        A lot of ink has been spilled on this subject.
        You’re right that if we estimate the model and find such shocks, it might simply be that those estimated shocks are proxies for deeper unmodelled changes.
        Many of the greats talk informally about those shocks standing in for something we haven’t yet fathomed.
        Others prefer a more literal interpretation.
        There are some examples that fit the literal interpretation well. Like the weather. Try cutting the lawn when its wet. It’s the same lawn mower, but the blades slip and clog.

      • Luis Enrique says:

        sure, I realise economists have long thought about what tech shocks represent, and I did not mean to dismiss the idea that a rather literal interpretation can be plausible, even if I would place more weight on other factors. And of course it’s also well understood that the modelling strategy of regarding shocks as exogenous precludes research into their origins, from a prevention point of view (I think I recent read a big gun – maybe Sims or Sargent – talking about that). But I think it might also preclude research into their cure, once they’ve hit – an idea I have not seen much discussed. This is in addition to my original worry about the approach which conceives of recessions as being something which “ought” to happen, in a sense, from a welfare optimising point of view.

        Thanks for your replies!

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