While this is the framework that some papers use, this issue brief will examine shifts in the supply of and demand for savings. Increased demand for assets means that money that would have increased demand for current goods is now being saved to purchase goods and services at a later date. This is similar to how recessions, or temporary declines in aggregate demand, happen in Keynesian models. Something causes households or businesses to pull back on consumption and increase their savings, which leads to a decline in output.
But in the long-run case, the market for supply moves to a new equilibrium with a lower interest rate. Other models looking at the decline in the natural rate of interest use the market for savings or assets as the key to understanding movements in the interest rate. Economists Adrien Auclert at Stanford University and Matthew Rognlie at Northwestern University look at how the increase in income inequality in the United States may have increased savings as high-income households increase their precautionary savings to protect themselves from income volatility.
These modeling changes might be interesting in and of themselves, but what do they imply for policymakers? The implications for fiscal policy are greatest. In short, fiscal policy appears to be a much stronger stabilization tool than previously thought. The dominant view of fiscal policy before the Great Recession of — was that it was an inefficient form of stimulus and that the stabilization of the macroeconomy should be left to central banks and monetary policy.
This understanding is a product of the Great Moderation, the period of relative macroeconomic stability starting in the late s and ending with the Great Recession. Many economists believed that more effective macroeconomic management, mainly via monetary policy, was responsible for a good part of the moderation. But the events of the Great Recession and research work since then highlights the important role of fiscal policy in stimulating the economy in the current environment.
Jason Furman , during his time as the chair of the Council of Economic Advisers in the Obama administration, presented this new view of fiscal policy and the attendant policy implications. Yet the models of secular stagnation find fiscal policy to be an effective tool against secular stagnation in a different way. Remember that secular stagnation and declining interest rates are due to changes in the supply and demand for savings.
In these papers, stimuative fiscal policy rising budget deficits leads to increases in interest rates that counteract secular stagnation by increasing the demand for savings and loans. Government debt, in these models, soaks up the excess savings in the economy. What should the government do with the funds it borrows?
But the while the distribution of the funds might not be important, the source of the funding is key for understanding the impact of fiscal policy. The highest multipliers are found when the increase in spending or reduction in taxes are funded entirely by debt. Remember, the problem of secular stagnation is an excess of savings.
Fiscal policy is most effective if it can increase the demand for loans and push up interest rates the price of loans. Financing an increase in spending with taxes or reducing spending to pay for a tax cut would reduce the amount of excess savings the government is using.
Unemployment, Inflation and New Macroeconomic Policy
In fact, Eggertsson, Mehrotra, and Robbins find that certain tax increases in their model would make the fiscal multiplier negative and actually reduce growth by increasing the amount of savings in the economy. How should these results inform the thinking of fiscal policymakers?
Fiscal policy is an important and powerful tool in a state of secular stagnation. Policymakers should be well aware of the context of fiscal policy and how increased government debt can be a solution. If policymakers are concerned about an economy where low interest rates imperil macroeconomic stabilization or that excessive savings might inflate a financial bubble, then increased government debt would help solve those problems. Monetary policy in a state of secular stagnation faces a significant problem. Monetary policymakers try to bring the economy into equilibrium by changing the price of loans and credits via interest rates.
Secular stagnation throws a wrench into the monetary policy machine as interest rates have dropped so much that policymakers have less control over them. Models of secular stagnation find that monetary policymakers could make some changes to their toolkit, but their ability to stabilize the economy on their own is still more constrained.
The problem for monetary policy during secular stagnation is the nominal zero lower bound. Interest rates can be thought of as the return on holding onto money. Central banks can make money less valuable to hold onto and make consumers and businesses more likely to spend that money if they lower interest rates. A negative nominal interest rate would mean that money in a bank account would decline in nominal unadjusted for inflation terms. The dollar figure in your bank account would go down.
The thinking has long been that depositors would just with draw their money from bank accounts and hold them in cash, which has a fixed zero percent nominal interest rate. It always has the same value in nominal terms. The current approach is to sidestep the issue of control over current interest and use promises around future interest rates as a policy tool itself.
A central bank may promise to keep nominal interest rates at zero until unemployment or inflation hits certain levels. Forward guidance, as this is called, is premised on the assumption that households and businesses will be aware of this commitment and that they believe the central bank will hold firm to the commitment. Furthermore, since the state of secular stagnation is permanent and interest rates will be near or at the zero lower bound for quite some time, then households might not believe that monetary policy will have traction anytime soon.
In the model, then, forward guidance is far less powerful than many models and policymakers believe. One popular suggestion for counteracting the zero lower bound is to bypass the nominal bound by increasing the amount of inflation in the economy.
Central banks may be bound by a nominal lower bound, but they can make the inflation-adjusted value of money lower by decreasing inflation-adjusted interest rates. But a higher inflation target—say, 4 percent—would reduce this bound to negative 4 percent a 0 percent nominal interest rate minus 4 percent inflation. The models from Auclert and Rognlie and from Eggertsson, Mehrotra, and Robbins both find that a higher inflation rate could be effective, but that central banks must not be timid and have to set the inflation target high enough.
A shift to a 4 percent inflation target might not be large enough if the natural rate of interest has fallen below negative 4 percent.
What about getting rid of the nominal lower bound or at least significantly lowering it? While economists and central bankers had long regarded the zero lower bound on nominal interest rates as a solid border, it appears to be a bit porous. The European Central Bank and the Bank of Japan have both managed to set short-term nominal interest rates below zero. How is this possible?
People were supposed to take their money out of bank accounts and convert it to cash if the possibility of negative nominal rates was raised. But it appears that money in a bank account and cash in a wallet or under a mattress are not perfect substitutes. The benefit of the convenience of having money in a bank account may outweigh the cost of seeing a nominal decline in the value of the account. Just how negative nominal interest rates can get is likely a function of demand for cash in an economy.
In the Auclert and Rognlie model, moving the effective lower bound below zero has a sizeable effect. According to one exercise using their model, pushing the nominal lower bound a bit below negative 0. Other research by Eggertsson, however, takes a dim view of the expansionary effects of negative nominal rates. If secular stagnation is an enduring feature of the U. Ignoring it could mean the recovery from the next recession will be weak and result in a material declining in living standards for millions of Americans through higher unemployment and lower wages.
The long-term decline in interest rates and excess savings means fiscal policy can no longer be thought of as a secondary concern. Increased federal budget deficits and higher federal debt in a state of secular stagnation are positives, as they will increase short-term growth and push interest rates up. How much U. Forward guidance may not have the power that the current consensus believes it does, but changes to inflation targets and pushing nominal interest rates below zero may hold some promise. Whether monetary policy could be further strengthened by changing the current regime of inflation targeting to a price-level target or a nominal GDP level target is an interesting possibility.
Unemployment and Inflation: Implications for Policymaking - comppyrridaro.gq
The current debate among members of the Federal Open Market Committee will hopefully consider these questions moving forward. Of course, more research and thinking about these questions are needed. The papers reviewed in this brief are part of the beginning of what will hopefully become a large literature.
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