In the previous post I provided evidence that extended UI benefits tend to reduce aggregate supply and increase unemployment. (BTW, the most recent three posts are best read in reverse order, this one last.) Now I will argue that extended benefits probably trigger a more contractionary monetary policy.
Let’s assume a sort of “Bernanke put” on the price level. More specifically, assume that if inflation threatens to fall below the 0% to 1/2% range, the Fed will pull out all the stops with some sort of unconventional easing, say QE or lower interest rates on excess reserves. I’ll call this a “zero lower inflation bound” assumption.
The standard Keynesian argument against cutting extended UI benefits is that it would reduce inflation expectations, and hence AD would fall. Any job-creating effects from lower wages would be swamped by the deflationary impact of falling prices. But if the economy is at the zero lower inflation bound, then cutting UI benefits does not reduce inflation. To better understand this counter-intuitive result, imagine an AS/AD diagram (some day I need to learn how to make graphs on a computer.) Lower UI benefits will tend to shift the SRAS curve to the right. Normally this would lower inflation. But if we are already at the zero inflation bound, then the Fed will react to this policy shift by moving the AD curve to the right, in order to prevent prices from falling. In that case we are in a classical world, where less UI and lower minimum wage rates will lower both nominal and real wage rates, and also boost employment.
You may have noticed an amusing irony in this argument. Keynesians like Paul Krugman argue that all the laws of classical economics go out the window when nominal interest rates are at the zero lower bound. Cutting UI doesn’t create jobs. There is a paradox of thrift. But if we assume that inflation is at the zero lower bound (due to the Fed’s reaction function) then much of (old) Keynesian economics goes out the window. In one sense there is nothing new here. The new Keynesians have long recognized that the old Keynesian model is invalid when the central bank has a symmetrical policy of inflation targeting. Fiscal policy can’t affect inflation, and, ipso facto, it can’t affect AD.
Here I am proposing something more modest–an asymmetrical lower bound on inflation, but a central bank that is still willing to tolerate slightly higher inflation rates. In that case fiscal stimulus can still boost NGDP, but fiscal austerity no longer contracts NGDP. This is roughly analogous to the zero interest rate bound, where conventional monetary policy can lower NGDP, but is powerless to increase NGDP.
I still believe the symmetrical inflation target is the better policy assumption, but I think this one is also fairly plausible for small changes. It also loosely relates to a point that Andy Harless recently made in the comment section to one of my posts. Harless argued that the Fed may be reluctant to engage in unconventional easing out of fear that they might overshoot into high inflation. If I’m not mistaken, implicit in that view is the idea that there is some inflation rate (perhaps 0%?) where the Fed hits the panic button and engages in more QE or lower interest on reserves. Maybe even an explicit inflation target. If I have interpreted Harless correctly, this would allow for a bit of the sort of asymmetry that I have assumed in this post.
PS. I am frequently amused by how often Paul Krugman suggests that any discussion of fiscal stimulus is completely out of bounds if it doesn’t implicitly acknowledge that monetary policy is ineffective at zero nominal rates:
If you believe stimulus is a bad idea, fine; but surely the least one could have expected is that opponents would listen, even a bit, to what proponents were saying. In particular, the case for stimulus has always been highly conditional. Fiscal stimulus is what you do only if two conditions are satisfied: high unemployment, so that the proximate risk is deflation, not inflation; and monetary policy constrained by the zero lower bound.
Notice how Krugman sort of rolls his eyes in disgust at us fools who refuse to “listen” when Keynesians claim that central banks are unable to debase fiat currencies. OK, I will try to listen more in the future. But I don’t think Krugman is being fair when he implies that people who believe the following are ignorant of the basic tenets of macroeconomics:
But even given the Fed’s own projections, it’s not doing its job, it’s missing its targets. Yet it apparently sees no need to act.
The preceding quotation was made just a few days ago by a distinguished economist. I don’t think it is very polite to suggest that this economist doesn’t “listen” and somehow never learned that the Fed is “constrained” once rates hit zero. And then consider this quotation from a few days earlier:
But how, exactly, does it serve the Fed’s credibility when it fails to confront high unemployment, while consistently missing its own inflation targets? How credible is the Bank of Japan after presiding over 15 years of deflation?
Whatever is going on, the Fed needs to rethink its priorities, fast. Mr. Bernanke’s “it” isn’t a hypothetical possibility, it’s on the verge of happening. And the Fed should be doing all it can to stop it.
There is nothing objectionable about these two quotations. At worst, you could accuse the economist who made them of being a tad inconsistent.
Seriously, I do understand how Krugman reconciles all this in his own mind. The Fed could do a lot more, but it’s risky and they probably won’t. Ergo, we need fiscal stimulus. (Of course Congress won’t either, as some of us warned last year.) But not all of us buy into his assumptions about how the Fed operates, and hence not all of us believe the rules of classical economics fly out the window once rates hit zero. That was the point of this post—to show that you could make an equally plausible claim that the laws of Keynesian economics fly out the window when inflation falls to its lower bound.