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.