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Monday, November 01, 2010

The Stagnation Regime of the New Keynesian Model and Current US Policy

My colleague George Evans has an interesting new paper. He shows that when there is downward wage rigidity, the "asymmetric adjustment costs" referenced below, the economy can get stuck in a zone of stagnation. Escaping from the stagnation trap requires a change in government spending or some other shock of sufficient size. If the change in government spending is large enough, the economy will return to full employment. But if the shock to government spending is below the required threshold (as the stimulus package may very well have been), the economy will remain trapped in the stagnation regime.

(I also highly recommend section 4 on policy implications, which I have included on the continuation page. It discusses fiscal policy options, quantitiative easing, how to help to state and local governments, and other policies that could help to get us out of the stagnation regime):

The Stagnation Regime of the New Keynesian Model and Current US Policy, by George Evans: 1 Introduction The economic experiences of 2008-10 have highlighted the issue of appropriate macroeconomic policy in deep recessions. A particular concern is what macroeconomic policies should be used when slow growth and high unemployment persist even after the monetary policy interest rate instrument has been at or close to the zero net interest rate lower bound for a sustained period of time. In Evans, Guse, and Honkapohja (2008) and Evans and Honkapohja (2010), using a New Keynesian model with learning, we argued that if the economy is subject to a large negative expectational shock, such as plausibly arose in response to the financial crisis of 2008-9, then it may be necessary, in order to return the economy to the targeted steady state, to supplement monetary policy with fiscal policy, in particular with temporary increases in government spending.
The importance of expectations in generating a “liquidity trap” at the zero-lower bound is now widely understood. For example, Benhabib, Schmitt-Grohe, and Uribe (2001b), Benhabib, Schmitt-Grohe, and Uribe (2001a) show the possibility of multiple equilibria under perfect foresight, with a continuum of paths to an unintended low or negative inflation steady state.[1] Recently, Bullard (2010) has argued that data from Japan and the US over 2002-2010 suggest that we should take seriously the possibility that “the US economy may become enmeshed in a Japanese-style deflationary outcome within the next several years.”
The learning approach provides a perspective on this issue that is quite different from the rational expectations results.[2] As shown in Evans, Guse, and Honkapohja (2008) and Evans and Honkapohja (2010), when expectations are formed using adaptive learning, the targeted steady state is locally stable under standard policy, but it is not globally stable. However, the potential problem is not convergence to the deflation steady state, but instead unstable trajectories. The danger is that sufficiently pessimistic expectations of future inflation, output and consumption can become self-reinforcing, leading to a deflationary process accompanied by declining inflation and output. These unstable paths arise when expectations are pessimistic enough to fall into what we call the “deflation trap.” Thus, while in Bullard (2010) the local stability results of the learning approach to expectations is characterized as one of the forms of denial of “the peril,” the learning perspective is actually more alarmist in that it takes seriously these divergent paths.
As we showed in Evans, Guse, and Honkapohja (2008), in this deflation trap region aggressive monetary policy, i.e. immediate reductions on interest rates to close to zero, will in some cases avoid the deflationary spiral and return the economy to the intended steady state. However, if the pessimistic expectation shock is too large then temporary increases in government spending may be needed. The policy response in the US, UK and Europe has to some extent followed the policies advocated in Evans, Guse, and Honkapohja (2008). Monetary policy has been quick, decisive and aggressive, with, for example, the US federal funds rate reduced to near zero levels by the end of 2008. In the US, in addition to a variety of less conventional interventions in the financial markets by the Treasury and the Federal Reserve, including the TARP measures in late 2008 and a large scale expansion of the Fed balance sheet designed to stabilize the banking system, there was the $727 billion ARRA stimulus package passed in February 2009.
While the US economy has stabilized, the recovery has to date been weak and the unemployment rate has been both very high and roughly constant for about one year. At the same time, although inflation is low, and hovering on the brink of deflation, we have not seen the economy recording large and increasing deflation rates.[3] From the viewpoint of Evans, Guse, and Honkapohja (2008), various interpretations of the data are possible, depending on one’s view of the severity of the initial negative expectations shock and the strength of the monetary and fiscal policy impacts. However, since recent US (and Japanese) data may also consistent with convergence to a deflation steady state, it is worth revisiting the issue of whether this outcome can in some circumstances arise under learning.
In this paper I develop a modification of the model of Evans, Guse, and Honkapohja (2008) that generates a new outcome under adaptive learning. Introducing asymmetric adjustment costs into the Rotemberg model of price setting leads to the possibility of convergence to a stagnation regime following a large pessimistic shock. In the stagnation regime, inflation is trapped at a low steady deflation level, consistent with zero net interest rates, and there is a continuum of consumption and output levels that may emerge. Thus, once again, the learning approach raises the alarm concerning the evolution of the economy when faced with a large shock, since the outcome may be persistently inefficiently low levels of output. This is in contrast to the rational expectations approach of Benhabib, Schmitt-Grohe, and Uribe (2001b), in which the deflation steady state has output levels that are not greatly different from the targeted steady state.
In the stagnation regime, fiscal policy, taking the form of temporary increases in government spending, is important as a policy tool. Increased government spending raises output, but leaves the economy within the stagnation regime until raised to the point at which a critical level of output is reached. Once output exceeds the critical level, the usual stabilizing mechanisms of the economy resume, pushing consumption, output and inflation back to the targeted steady state, and permitting a scaling back of government expenditure.

Here is the section on policy options recommended above (it is relatively non-technical):

4 Policy
We now discuss at greater length the policy implications when the economy is at risk of becoming trapped in the stagnation regime. Although the discussion is rooted in the model presented, it also will bring in some factors that go beyond our simple model. We have used a closed-economy model without capital, a separate labor market, or an explicit role for financial intermediation and risk. These dimensions provide scope for additional policy levers.[15]
4.1 Fiscal policy
The basic policy implications of the model are quite clear, and consistent with Evans, Guse, and Honkapohja (2008) and Evans and Honkapohja (2010). If the economy is hit by factors that deliver a shock to expectations that is not too large, then the standard monetary policy response will be satisfactory in the sense that it will ensure the return of the economy to the intended steady state. However, if there is a large negative shock then standard policy will be subject to the zero-interest rate lower bound, and for sufficiently large shocks even zero interest rates may be insufficient to return the economy to the targeted steady state. In the modified model of the present paper, the economy may converge instead to the stagnation regime, in which there is deflation at a rate equal to the net discount rate and output is depressed. In this regime consumption is at a low level in line with expectations, which in turn will have adapted to the households’ recent experience.
If the economy is trapped in this regime, sufficiently aggressive fiscal policy, taking the form of temporary increases in government spending, will dislodge the economy from the stagnation regime. A relatively small increase will raise output and employment but will not be sufficient to push the economy out of the stagnation regime. However, a large enough temporary increase in government spending will push the economy into the stable region and back to the targeted steady state. This policy would also be indicated if the economy is en route to the stagnation regime, and may be merited even if the economy is within the stable region, but close enough to the unstable region that it would result in a protracted period of depressed economic activity.
Because of Ricardian equivalence, tax cuts are ineffective unless they are directed towards liquidity constrained households. However, in models with capital a potentially effective policy is investment tax credits. If the investment tax credits are time limited then they work not only by reducing the cost of capital to firms, but also by rescheduling investment from the future to now or the near future, when it is most needed. Investment tax credits could also be made state contingent, in the sense that the tax credit would disappear after explicit macroeconomic goals, e.g. in terms of GDP growth, are reached.
In the US an effective fiscal stimulus that operates swiftly is federal aid to state and local governments. This was provided on a substantial scale through the ARRA in 2009 and 2010, but this money will largely disappear in 2011. Why are states in such difficulties? The central reason is that they fail to smooth their revenues (and expenditures) over the business cycle. States require themselves to balance the budget, and tend to do this year by year (or in some States biennium by biennium). Thus, when there is a recession, state tax revenues decline and they are compelled to reduce expenditures. This is the opposite of what we want: instead of acting as an automatic stabilizer, which is what happens at the federal level, budget balancing by states in recessions acts to intensify the recession. Indeed, in the US the ARRA fiscal stimulus has largely been offset by reductions in government spending at the sate and local level.
4.2 Fiscal policy and rainy day funds
This does not have to be. States should follow the recommendation that macroeconomists have traditionally given to national economies, which is to balance the budget over the business cycle. This can be done by the states setting up rainy day funds, building up reserves in booms to use in recessions.[16] A common objection to this proposal is that if a state builds up a rainy day fund, then politicians will spend it before the next recession hits. This objection can be dealt with. Setting up the rainy day fund should include a provision that drawing on the fund is prohibited unless specified economic indicators are triggered. The triggers could either be based on either national or state data (or a combination). For example, a suitable national indicator would be two successive quarterly declines of real GDP. State level triggers could be based on the BLS measures of the unemployment rate, e.g. an increase of at least two percentage points in the unemployment rate over the lowest rate most recently achieved. Once triggered the fund would be available for drawing down over a specified period, e.g. three years or until the indicators improve by specified amounts. After that point, the rainy day fund would have to be built up again, until am appropriate level is reached. Obviously there are many provisions that would need to be thought through carefully and specified in detail. However, the basic point seems unassailable that this approach provides a rational basis for managing state and local financing, and that the political objections can be overcome by specifying the rules in advance.
It is also worth emphasizing that the establishment of rainy day funds would act to discipline state spending during expansions. Instead of treating the extra tax revenue generated during booms as free resources, to be used for additional government spending or for distribution to taxpayers, the revenue would go into a fund set aside for use during recessions. This is simply prudent management of state financial resources, which leads to a more efficient response to aggregate fluctuations.[17]
Currently (in late 2010), there is clearly a need for fiscal stimulus taking the form of additional federal aid to states. Politically this looks difficult because people are distrustful of politicians and concerned about deficits and debt. Here, therefore, is a proposal: additional federal money to states should be provided now, contingent on a state agreeing to set up an adequate rainy day fund, to which contributions would begin as soon as there is a robust recovery. This proposal has the attraction that it provides states with funds that are much needed now, to avoid impending layoffs of state and local government employees, but in return for changing their institutions in such a way that federal help will be much less likely to be needed in future recessions.
4.3 Quantitative easing and the composition of the Fed balance sheet
Since aggressive fiscal policy in the near term may be politically unpromising, especially in the US, one must also consider whether more can be done with monetary policy.
In the version of the model used here, agents use short-horizon decision rules, based on Euler equations, and once the monetary authorities have reduced (short) interest rates to zero, there is no scope for further policy easing. In Evans and Honkapohja (2010) we showed that the central qualitative features of the model carry over to infinite-horizon decision rules, and the same would be true of the modified framework here. In this setting there is an additional monetary policy tool, namely policy announcements directed toward influencing expectations of future interest rates. By committing to keep short-term interest rates low for an extended period of time, the Fed can aim to stimulate consumption. An equivalent policy, which in practice is complementary, would be to move out in the maturity structure and purchase longer dated bonds. As Evans and Honkapohja (2010) demonstrates, however, such a policy may still be inadequate: even promising to keep interest rates low forever may be insufficient in the presence of a very large negative expectational shock.
Since financial intermediation and risk have been central to the recent financial crisis, and continue to play a key role in the current economy, there are additional central bank policy interventions that would be natural. One set of policies is being considered by the Federal Reserve Bank under the name of “quantitative easing” or QE2. Open market purchases of assets at longer maturities can reduce interest rates across the term-structure, providing further channels for stimulating demand. More generally the Fed could alter its balance sheet to include bonds with some degree of risk. If expansionary fiscal policy is considered infeasible politically, then quantitative easing or changing the composition of the Federal Reserve balance sheet becomes an attractive option.
In an open economy model, there are additional channels for quantitative easing. If the US greatly expands its money stock, and other countries do not do so, or do so to a lesser extent, then foreign exchange markets are likely to conclude that there is likely, in the medium or long run, to be a greater increase in prices in the US than the rest or the world, and therefore a relative depreciation of the dollar. Unlike wages and goods prices, which respond sluggishly to changes in the money supply, foreign exchange markets often react very quickly to policy changes, and thus quantitative easing could lead to a substantial depreciation of the dollar now.18 In a more aggressive version of this policy the Fed would directly purchase foreign bonds. This would tend to boost net exports and output and help to stimulate growth in the US. This policy could, of course, be offset by monetary expansions in other countries, but some countries may be reluctant to do so.[19]
Another set of policies being discussed involve new or more explicit commitments by policymakers to achieve specified inflation and price level targets. For example, one proposal would commit to returning to a price level path obtained by extrapolating using a target inflation rate of, say, 2% p.a., from an earlier base, followed by a return to inflation targeting after that level is achieved. From the viewpoint of adaptive learning, a basic problem with all of these approaches is that to the extent that expectations are grounded in data, raising πe may require actual observations of higher inflation rates. As briefly noted above, policy commitments and announcements may indeed have some impact on expectations, but the evolution of data will be decisive.
An additional problem, however, is that there are some distributional consequences that are not benign. Households that are savers, with a portfolio consisting primarily in safe assets like short maturity government bonds, have already been adversely affected by a monetary policy in which the nominal returns on these assets has been pushed down to near zero. A policy commitment at this juncture, which pairs an extended period of continued near zero interest rates with a commitment to use quantitative easing aggressively in order to increase inflation, has a downside of adversely affecting the wealth position of households who are savers aiming for a low risk portfolio.
4.4 A proposal for a mixed fiscal-monetary stimulus
If political constraints are an impediment to temporary increases in government spending at the Federal level, as they currently appear to be in the United States, it may still be possible to use a fiscal-monetary policy mix that is effective. State and local government’s are constrained in the United States to balance their budgets, but there is an exception in most states for capital projects. At the same time there is a clear-cut need throughout the United States to increase investment in infrastructure projects, as the US Society of Civil Engineers has been stressing for some time. In January 2009 the Society gave a grade of D to the nation’s infrastructure. Large investments will be required in the nation’s bridges, wastewater and sewage treatment, roads, rail, dams, levees, air traffic control and school buildings. The need for this spending is not particularly controversial. The Society estimates $2.2 trillion over five years as the total amount needed (at all levels of government) to put this infrastructure into a satisfactory state.[20] Thus there is no shortage of useful investment that can be initiated.
The scale of the infrastructure projects needed is appropriate, since a plausible estimate of the cumulative short-fall of GDP relative to potential GDP is around $2 trillion[21] and the current unemployment rate of 9.6%.[22] The timing and inherent lags in such projects appear acceptable. If we are in the stagnation regime, or heading toward or near the stagnation regime, then it is likely to be some time before we return to the targeted steady state. Projects that take several years may then be quite attractive. The historical evidence of Reinhart and Rogoff (2009) indicate that in the aftermath of recessions associated with banking crises, the recovery is particularly slow.
Furthermore, this area of expenditure appears to be an ideal category for leading a robust recovery. In the stagnation regime, the central problem is deficient aggregate demand. In past US past recessions, household consumption and housing construction have often been the sectors that lead the economic recovery. But given the excesses of the housing boom and the high indebtedness of households, do we want to rely on, or encourage, a rapid growth of consumption and residential construction in the near future? It would appear much more sensible to stimulate spending in the near term on infrastructure projects that are clearly beneficial, and that do not require us to encourage households to reduce their saving rate. Furthermore, once a robust recovery is underway, these capital investments will raise potential output and growth because of their positive supply-side impact on the nation’s capital stock.
How would this be financed? State and local governments can be expected to be well-informed about a wide range of needed infrastructure projects, but financing the projects requires issuing state or municipal bonds. Many states and localities are currently hard pressed to balance their budget, and this may make it difficult for them to issue bonds to finance the projects at interest rates that are attractive. Here both the Federal Reserve and the Treasury can play key roles. The Treasury could announce that, up to some stated amount, they would be willing to purchase state and local bonds for qualifying infrastructure projects. The Treasury would provide financing, at relatively low interest rates, for productive investment projects that are widely agreed to be urgently needed. Ideally there would be a Federal subsidy to partially match the state or local government expenditure on infrastructure investment, as has often been true in the past. This would both make the investment more attractive and help to orchestrate a coordinated program over the near term.
The ARRA did include a substantial provision for funding infrastructure through “Build America Bonds,” which has provided a subsidy by the Treasury to state and local governments issuing bonds for infrastructure projects. (Interest on these bonds is not tax-exempt, so the subsidy is partially offset by greater federal taxes received on interest). The Build America Bonds have been very popular, but there is clearly room for a much larger infrastructure spending at the state and local level.
The Treasury could be involved in vetting and rationing the proposed projects, ensuring geographic diversity as well as quality and feasibility. One possibility would be for the President to announce a plan that encourages states and localities to submit proposals for infrastructure projects, which are then assessed. To finance their purchases of state and municipal bonds, the Treasury would issue bonds with a maturity in line with those acquired. For the Treasury there would be no obvious on-budget implications, since the extra Treasury debt issued by the Treasury to finance purchases of the state and municipal bonds would be offset by holdings of those bonds.
What would be the role of the Federal Reserve? The increase in infrastructure projects would go hand-in-glove with a policy of quantitative easing in which the Fed buys longer-dated US Treasuries, extending low interest rates further out the yield curve. In effect, the Fed would provide financing to the Treasury, and the Treasury would provide financing to states and local government, at rates that make investment in infrastructure projects particularly attractive now and in the near future. In principle, the Federal Reserve could also directly purchase the state and municipal bonds. Alternatively they could provide financing indirectly by making purchases in the secondary market for municipal bonds.
Thus this proposal meshes well with the current discussion within the Federal Reserve Bank for quantitative easing, with the additional feature that the injections of money in exchange for longer-dated Treasuries would
be in part aimed at providing financing for new spending on infrastructure investment projects.
The three proposals discussed above are complementary. Federal aid to states and localities is needed in the near term to reduce current state budget problems and avoid layoffs. A commitment by states to set up rainy day funds during the next expansion will help ensure that state budgeting is put on a secure footing going forward. A large infrastructure program can provide a major source of demand that will also expand the nation’s capital stock and enhance future productivity. Finally, quantitative easing by the Federal Reserve can help provide an environment in which the terms for financing infrastructure projects is attractive.
5 Conclusions
In the model of this paper, if an adverse shock to the economy leads to a large downward shift in consumption and inflation expectations, the resulting path can converge to a stagnation regime, in which output and consumption remain at low levels, accompanied by steady deflation. Small increases in government spending will increase output, but may leave the economy within the stagnation regime. However, a sufficiently large temporary increase in government spending can dislodge the economy from the stagnation regime and restore the natural stabilizing forces of the economy, eventually returning the economy to the targeted steady state.
The aggressive monetary policy response of the Federal Reserve Bank over 2007-9, together with the TARP intervention and the limited ARRA fiscal stimulus, may well have been helped to avert a second Depression in the US. However, recent US data show continued high levels of unemployment, modest rates of GDP growth, and very low and possibly declining inflation. Although the economy has stabilized, there remains the possibility of either convergence to the stagnation regime or of an unusually protracted period before a robust recovery begins.
Although forecasting GDP growth is notoriously difficult, it seems almost certain that in the near-term the economy will continue to have substantial excess capacity and elevated unemployment. In this setting there is a case for further expansionary policies. My recommendations include a combination of additional federal aid to state and local governments, in return for a commitment by states to set up rainy day funds during the next expansion, quantitative easing by the Federal Reserve, and a large-scale infrastructure program, funded indirectly by the US Treasury and by the Federal Reserve as part of the program of quantitative easing. 
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*I am indebted to the University of Oregon Macro workshop for comments on the first draft of this paper, and to Mark Thoma for several further discussions. Financial support from National Science Foundation Grant no. SES-1025011 is gratefully acknowledged.
[1] See Krugman (1998) for a seminal discussion and Eggertsson and Woodford (2003) for a recent analyses and references.
[2] For a closely related argument see Reifschneider and Williams (2000).
[3]However the CPI 12-month inflation measure, excluding food and energy, does show a downward trend over the last several years, and in September 2010 was at 0.8%.
[15]The discussion here is not meant to be exhaustive. The three most glaring omissions, from the list of policies considered here, are: dealing with the foreclosure problem in the US, ensuring that adequate lending is available for small businesses, and moving ahead with the implementation of regulatory reform in the financial sector.
[16] Of course the size of the fund needs to be adequate. The state of Oregon recently started up a rainy day fund, which has turned out to be very useful following the recent recession, but the scale was clearly too small.
[17] Similar issues arise in the European context. Eurozone countries are committed to the Stability and Growth Pact, which in principle limits deficit and debt levels of member countries. However, these limits have been stressed by recent events and enforcement appears difficult or undesirable in some cases. Reform may therefore be needed. An appropriate way forward would be to require every member country to set up a rainy day fund to which contributions are made during the next expansion until a suitable level is reached.
[18] This is the mechanism of the Dornbusch (1976) model.
[19] And if all countries engaged in monetary expansion, this might increase inflation expectations.
[20] For example, see the January 28, 2009, New York Times story “US Infrastructure Is In Dire Straits, Report Says.”
[21] Assuming a 6% natural rate of unemployment and an Okun’s law parameter of between 2 and 2.5 gives a range of $1.7 trillion to $2.1 trillion for the GDP shortfall if the unemployment rate, over the next three years, averages 9% , 8% and 7%, respectively.
[22] For comparison the ARRA stimulus program is currently estimated by the Congressional Budget Office to have reduced the unemployment rate, relative to what it would otherwise have been, by between 0.7 and 1.8 percentage points. A number of commentators argued in early 2009 that the scale of the ARRA might be inadequate.

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If you are familiar with this type of work, here is the graph showing the dymanics under asymmetric wage and price rigidity:

Stagnation-regime

    Posted by on Monday, November 1, 2010 at 10:17 AM in Academic Papers, Economics, Fiscal Policy, Macroeconomics, Monetary Policy | Permalink  Comments (8)


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