Liquidity and Fisher effects of a helicopter drop. Reply to Paul Krugman’s comment on my comment on Adair Turner

Adair Turner wrote arguing for helicopter money, as an alternative to lower, or negative interest rates, to stimulate the economy.  Paul Krugman comes down on the side of Adair, concluding that I have got confused about what effect a helicopter loosening would have on nominal interest rates by staying in the confines of a static IS/LM-type model.

I repeatedly get confused about lots of things, but not on this occasion.  Although, who knows, I might just be plain wrong.

I think what Paul is drawing attention to is the difference between what’s often termed ‘the liquidity effect’, of a monetary expansion, [which is captured in IS/LM] and the ‘Fisher effect’ [which is not].

To explain.  Suppose the hawks on the FOMC fall terribly ill before the next meeting, and the doves get to decide what to do next.  They conclude that they need a massive monetary stimulus.  They could either do it by a helicopter drop, or by setting out a declared plan for lower – potentially negative – interest rates, following the prescription of Eggertson and Woodford.

The first, instantaneous effect of either policy is the liquidity effect.  More liquidity lowers its price.  The second effect, if either policy is ultimately successful in raising expected and actual inflation, is the ‘Fisher effect’.  This will, when the economy returns back to the inflation target which otherwise would have been missed, lead to higher nominal interest rates than if the Fed had settled for lower inflation.

One case where the Fisher effect dominates right away anyway is in a land of flexible prices.  Suppose the Fed thought that, if it followed its current reaction function, inflation would settle below target.  And they simply announced an increase in the rate of money expansion.  This would raise inflation and expected inflation immediately.  However, in the more realistic case of sticky prices, it takes time for the Fisher effect to override the liquidity effect.  [This statement is a bit more contentious than it used to be, as the debate over ‘neo-Fisherian’ effects between Cochrane, Woodford and Williamson testifies.  These authors isolate sticky-price cases where Fisherian effects kick in right away, and debate whether they are realistic or not.]

My comment on Adair is about his contention that if the Fed chose helicopter drops it could somehow avoid the initial, instantaneous liquidity effect that pushes down on interest rates [and which Adair thinks has damaging effects on leverage].

Contrary to what Paul says, I don’t think Adair is making a case that the Fisher effect kicks in earlier than with a conventional interest rate policy loosening.

We could have a discussion about whether it would or not.  It’s arguable.  Perhaps the ‘shock and awe’ element of the helicopters would be so powerful that the Fisher effect dominates right away.  In Adair’s paper he doesn’t stress this.  In fact, he’s at pains to discuss ways of reducing unpleasant expectational dynamics of helicopter money;  and he queries whether expectational effects of forward guidance would work [see, eg page 15] since perhaps agents are not so forward-looking as supposed.  And part of his case for HM is that – so he argues – it works more effectively in the case that expectations are not as forward-looking.  But it is these same expectational effects that determine the speed with which the Fisher magic works on the nominal interest rate.  If we downplay them, then we slow down the point at which the Fisher effect outweighs the liquidity effect.

Also, note that Adair tweets ‘central bank can pay different rate on different reserve tiers‘.  He is countering my argument about the force of the liquidity effect not by invoking the Fisher effect, but by talking of some central bank intervention.

So, to restate, helicopter money involves taking your hands off interest rates for a while.  It might be more stimulative than lowering rates from their current level, or it might not, but it works partly through exactly the same interest rate channel as lowering interest rates directly.

We could overlay either policy with peculiar taxes or subsidies on banking, but this would not obscure the fundamental effects of money/liquidity demand in the short run, and the Fisher effect in the longer run.

Ultimately, if either policy – lowering rates, even below zero, or helicopters – work, then they will raise nominal rates and inflation.

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11 Responses to Liquidity and Fisher effects of a helicopter drop. Reply to Paul Krugman’s comment on my comment on Adair Turner

  1. James Alexander says:

    “One case where the Fisher effect dominates right away anyway is in a land of flexible prices. Suppose the Fed thought that, if it followed its current reaction function, inflation would settle below target. And they simply announced an increase in the rate of money expansion. This would raise inflation and expected inflation immediately. However, in the more realistic case of flexible prices, it takes time for the Fisher effect to override the liquidity effect. ” A typo? Second “flexible” is “inflexible”, surely?

    I still think you are wrong. Eg raise rates too early and you end up lowering them. Look at the rate curve in the US pre and post the Dec 15 raise. Even the next Fed tgt rate move might be down. Best to work to manage market expectations rather than against them. Expectations are all we have to know where we think we are headed. In life and macro.

  2. Steve Williamson says:

    “Ultimately, if either policy – lowering rates, even below zero, or helicopters – work, then they will raise nominal rates and inflation.”

    You don’t have to go through all the intermediate contortions. Just recognize that nominal interest rates have to go up, and do that – maybe slowly. Otherwise you’re just losing time. The next recession will come along and you won’t be able to do anything to intervene – other than weird contortions.

    • Tony Yates says:

      Are you invoking Neo-Fisherianism there when you urge that? Or flexible prices? Or are you saying ‘even if you don’t buy that NF is an REE we should take seriously, and you think prices are sticky, you should start raising rates gradually…’

  3. Which brings me to an off-topic point – Krugman who has half-seriously suggested helicopter drops, trillion dollar coins, and faux alien invasions is picking on Sanders for his lack of realism in proposals, when part of what has been so charming about Krugman is his willingness to look outside the VSP box of realism.

    I have no problem that he likes Clinton more, just I suspect that his thesis on Sanders could be better put by just saying, “I like Clinton more,” instead of, “I have a problem with the realism of Sanders proposals.” The later smacks of carrying water in the guise of objective analysis. That is, I suspect it doesn’t matter what Sanders proposes, he’s going to find fault with it because he’s already decided he Clinton is his choice.

  4. Mike Duda says:

    “Contrary to what Paul says, I don’t think Adair is making a case that the Fisher effect kicks in earlier than with a conventional interest rate policy loosening.”

    A shame that it’s impossible for you to contact Adair and then come to a consensus (or not) with Paul based on a correct, shared understanding of what each of the parties involved actually intends to say. Oh, wait…

    • Tony Yates says:

      This exchange of blogs and tweets is about as close as one can get to that. I doubt they would answer my emails. And once Adair makes his claim in public, I think it’s the right thing to do to unpick it in public.

  5. Biagio Bossone says:

    I think Turner’s basic argument is much more simple: helicopter drops simply give new spending power for the government or the people to spend: they raise aggregate demand. The newly created money is either used by the government to finance new public spending programs or is distributed to people (possibly those with a higher propensity to consume) through tax cuts or transfers. Whether and when this translates into higher inflation depends on how much slack there is in the economy and on the economy’s supply response. Eventually output, employment, wages and prices all increase. The “permanence” assumption (i.e., the central bank purchases the newly issued debt and commits to holding it perpetually or to rolling it over for ever) avoids possible Ricardian equivalence effects, which might weaken the impact of helicopter drops on aggregate demand.
    Why do you have to go through all the intermediate steps, especially considering that the logic underlying helicopter drops is simply that of giving people free-money to spend (under no expectation that it will be taxed away)?

    • Tony Yates says:

      You give a reasonable account of Adair’s description of the transmission in his paper, but I am taking issue only with his contention that you can avoid temporarily lower rates with HM, in contrast to simply lowering rates. For the moment, I am not taking issue with the efficacy of HM. That is for another debate.

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