Wednesday, December 4, 2013

Intuition Part II

Here's some more intuition to add to this post. It's interesting to consider what is going on with respect to consumption and labor supply behavior as well. Take my cash-in-advance notes as a starting point.

Here's what happens in a conventional sticky-price New Keynesian model at the zero lower bound. Anticipated inflation is essentially fixed (anchored), and the central bank would like to lower the real rate of interest but cannot do so. Thus, the real interest rate is too high, which makes consumption too low. Firms hire fewer workers "because demand is low," and for the workers to be happy with working less, the real wage must be low.

In my model, consumers need liquid assets to purchase goods. Here, liquid assets include all assets - not just money - that have some use in exchange or as collateral. In the model, the economy can be in a state where there is a shortage of liquidity. The low supply of liquid assets makes consumption low. Indeed we could say that "demand" is low, though I'm not a big fan of that language (as it's misleading in general equilibrium). The people living in this world work today, acquire assets, and consume tomorrow by selling the assets. When there is a shortage of liquidity, firms hire fewer workers, and the workers are reconciled to working less because the return they are getting on their assets is low - that's another way of looking at the high liquidity premium. The real rate of return on assets is essentially determining the effective wage the worker faces, so what's going on in the labor market looks exactly the same as in the New Keynesian model - the real wage is low. What's different is that the real interest rate is not too high, it's too low.

Then, suppose the central bank comes along and does quantitative easing (QE). This increases the stock of liquid assets (say, because long-maturity government debt is worse collateral than short-maturity government debt). This relaxes constraints for consumers, and consumption goes up - it's "demand stimulus," if you like. Firms want to hire more workers, but the workers have to be reconciled to working harder, so their real wages need to go up. This means that the real return they receive on their assets must be higher. At the zero lower bound, the only way that can happen is if inflation goes down.

So, if I were inclined to do it, I could sell that as Keynesian story. The inefficiency in this economy arises from a shortage of liquidity. Relieving that liquidity shortage through QE has the effect of increasing spending and wages. But inflation goes down and the real interest rate goes up. And less inflation is associated with more output. No Phillips curve for sure.

65 comments:

  1. David Beckworth empirical results reject your hypothesis.

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    1. Macroeconomics which runs counter to the facts is not serious theoretical work.

      Given this model, your failed inflation around the corner predictions and this: "Market efficiency is simply an assumption of rationality. As such it has no implications. If it has no implications, it can't be wrong." (http://newmonetarism.blogspot.de/2011/08/john-quiggin.html) one has to wonder how more ludicrous it can become.

      By the way, I am all for microfoundations, internal consistency and so on. As evidence is often anything but clear in economics (or other social sciences) theoretical work is important. But sometimes the evidence is clear.

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  2. Steve, what if you had titled an earlier post something like "Why QE works in a liquidity trap"? You could have told the story that QE increases output through a liquidity premium channel. And oh-by-the-way, the new equilibrium has lower inflation. The price level may rise or fall depending on total government debt (money plus bonds), but equilibrium inflation is lower. I think the reception would have been entirely different.

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    1. "I think the reception would have been entirely different."

      No, I don't think so. When presented with a new idea, some people have conniptions. Especially in the blogosphere.

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    2. "Some people have conniptions..."

      It's like you have no idea that you should include yourself in "some people."

      Bias seems to affect the intelligent more strongly because they train their increased brainpower on protecting their own delusions and finding creative ways to dismiss real objections.

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  3. One more question. Based on your model, it seems your policy recommendation is to expand government debt. What should be the monetary policy rule?

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    1. In part, that's ongoing research. In the basic framework, making the outstanding consolidated government debt more liquid is always a good idea - that's a general principle. And if QE is a good idea now, it's always a good idea. Expanding this to think about policy rules in a stochastic environment is another task.

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    2. To follow up on that, is there an optimal level of V (debt) in this model, or is it just whatever can be sustained?

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    3. Yes, as is, we want V to be large enough to relax the liquidity constraints. That's just a Friedman rule equilibrium. So you need to tweak it if you want something to push the optimum away from negative inflation forever.

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  4. Stephen, What's the mechanism? Surely asset prices are a more convincing candidate?

    For portfolio balance the real rates of returns on money and capital must be equal. The return on money is its marginal non-pecuniary return on money (liquidity services MNPSm) minus expected inflation. The return on capital is the rental rate on capital services (rk) plus its marginal non-pecuniary return (value as collateral for access to credit - as the price of capital pk increases MNPSk increases which in turn reduces MNPSm). So no arbitrage implies:

    MNPSm - inf(e) = rk + MNPSk (1)

    So assume we are hit by a 'shortage' of liquidity (or a deflationary shock) MNPSm - inf(e) increases:

    MNPSm - inf(e) > rk + MNPSk (2)

    To equilibrate either the LHS must decrease through higher inflation expectations of the RHS must increase. At given prices, the rate of return on money is higher than on capital so people sell capital for money reducing asset prices until the return on capital is high enough for portfolio balance (note this is a deflationary spiral - this process is as falling pk reduces MNPSk which increases MNPSm in a positive feedback loop).

    So assume we are now back at (1) and MNPSm>>MNPSk. CB does QE reducing MNPSm:

    MNPSm - inf(e) < rk + MNPSk (3)

    Either LHS increases through deflation or more convincingly, arbitrageurs swap the lower return asset (money) for the higher return asset (capital), increasing pk and reducing rk until portfolio balance is restored.

    What is the mechanism that causes the deflation beyond workers' real wages 'needing' to go up?

    Doesn't it make more sense that the increase in currency's rate of return that is required to induce agents to hold it is an increase relative to other assets, which is achieved by buying those assets and increasing their price/reducing their yield?

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  5. “Firms want to hire more workers, but the workers have to be reconciled to working harder, so their real wages need to go up. This means that the real return they receive on their assets must be higher.”


    That is even sillier than before. In the real world, unemployed workers are not indifferent between working or not. There is no need to increase return on assets to generate more hours of work because those workers who kept their employment are earning a rent.

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    1. Unemployment is a detail. We could put something else in there to have people searching for work. Won't change the results.

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    2. It would. If you model unemployment properly (not the complete markets fairy tale where workers insure the idiosyncratic component of their income as in the RBC tradition), there is no need to raise real wages to get more hours of work. You still do not have a mechanism whereby term premia affect inflation (which is to be expected, because that is non-sense).

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    3. " If you model unemployment properly (not the complete markets fairy tale where workers insure the idiosyncratic component of their income as in the RBC tradition), there is no need to raise real wages to get more hours of work."

      Wrong.

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    4. I am not sure I understand. If this is the case, why are workers not taking jobs at lower wages? Are we back to the sticky wages assumption?

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    5. Stephen:

      That is because most (almost all) the action is in the extensive margin, not the intensive one.

      During recessions, workers who keep their jobs work MORE for lower effort-adjusted real wages. While those who lose their jobs would like to work at even lower wages but cannot.

      When firms start to hire, they do not need to raise wages to get the unemployed to line up for vacancies. Those who kept their jobs during the recession see an increase in their effort-adjusted real wage because their outside option improved.

      Anyway, that is probably a waste of time, you teach macro, there is no way you do not know this stuff.

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    6. "I am not sure I understand. If this is the case, why are workers not taking jobs at lower wages? Are we back to the sticky wages assumption?"

      CA: Not necessarily. There are many other mechanisms that generate inefficient unemployment, from minimum wages to efficiency wages. The facts on the ground are that becoming unemployed is associated to a huge loss in welfare - which suggests that there are economic rents flowing to employed workers. Any macroeconomic theory of business cycle fluctuations that does not take that into account deserves to be laughed out of the seminar room.

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    7. a) Why is the Fed doing QE at all in this model, since an increase in real wages is needed to attract more labour supply, which is the definition of full employment? (Involuntary) unemployment is what you have when there are workers who would be prepared to supply labour at the current wage rate but cannot.

      b) Even if I've missed something and there can be unemployment equilibria in which an increase in real wage rates is needed to attract more labour, why can't this be achieved by an increase in nominal wage rates? The employers have, also ex hypothesi seen an increase in sales, so they can afford to raise wages. Nobody thinks wages are upward-sticky, do they?

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    8. "...which is the definition of full employment."

      Actually, no. Efficient employment is whatever employment is when policy is optimal. For example, in Woodford's sticky price model (in his book, for example), the labor market always clears. But there can be an "output gap," which in his model comes from the sticky price friction. Here, the output gap comes from low liquidity.

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    9. @ CA. Sticky wages (and prices) are not a theoretical assumption, they are an empirical fact.
      Any model that doesn't take these facts into account (or explains them via the Blanchard-Mankiw imperfect competition story like DSGE models) is simply worthless.

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    10. Well this now makes it clear that your result is based on a particular formalisation (and a highly controversial one which few New Keynesians would really defend other than as a modelling simplification). DeLong, Krugman et al are certainly basing their arguments on the premis that "unemployment" means "involuntary unemployment". To be frank, the fact that you keep making references to the Federal Reserve's actions in 2009 as if they were relevant to your paper would seem therefore to commit you to the somewhat indefensible claim that labour markets were clearing in 2009.

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    11. Anonimo, efficiency wages, the minimum wage, etc. are just examples of sticky wages. Its fine to believe that this is the problem. But then you should be alarmed and opposing the wave of minimum wage hikes that have taken place and/or are in the works in various states. However, I personally have a hard time accepting that this is the main problem here.

      Anonymous 6:41, how long are prices and wages sticky? Its been more than five years since the beginning of the recession. Are you telling me that during that time firms and workers have not had the chance to adjust prices and wages?

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    12. Brushettaboy, can you define involuntary unemployment?

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    13. Stickiness/rigidity doesn't mean "do not change", it means that prices/wages change slowly over time. If you are not aware of this fact I can point you towards ample of sources although, to be blunt, it would feel like showing somebody that the earth is indeed round. It is after all not a new invention, economists have been well aware of it for decades.

      About involuntary unemployment, do you seriously now know that you are involuntary unemployed when you seek a job, are willing to accept a low wage and find none? Do you seriously not know that this what millions of people are going through right now?
      Gee, this is not even a "get out of the ivory tower argument" as you are ignorant of what is going on in the inside of the ivory tower (a term like involuntary unemployment is as unambiguous as demand and supply curve) as well as the outside.

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    14. Involuntary unemployment is when someone would be willing to take a job at the prevailing real wage but cannot find one. It's contrasted with the kind of market-clearing unemployment Steve is talking about, where output can't increase without an increase in the real wage (I still don't understand, by the way, why an increase in the real wage can't be achieved by increasing the nominal wage, rather than this deflation story).

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    15. And are you certain that at least some of the unemployed are not so because they are looking for jobs that pay close to the ones they lost even though the equilibrium wage is now quite lower? I have several personal examples in which this is the case.

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    16. Anonymous, yes, that's right, I have no people looking for jobs in my ivory tower, except my wife, my sister-in-law, my father-in-law and others. Enough with this notion that we somehow live in a separate world, which conservatives like to use just as much as liberal-types like you. The idea that everybody who is unemployed cannot find work at any wage shows ignorance on your part.

      For my wife the problem is that the jobs she can find no longer pay her enough to cover the cost of daycare for our kids. For my sister-in-law they do not pay enough to cover the cost of hiring for additional hours someone to take care of her mother, who is quadriplegic. And my father-in-law is refusing to consider even lower-paying-jobs that the one he lost, especially given the medical bills, in hope that something better will come along, while in the meantime making some extra money by helping people here and there with his expertise. We are real people, and experiences like these motivate our research (for example, Rogerson has done wonderful work on the trade-off between market and home production).

      The fact that there are job options out there but at much lower wages does not make the suffering of the aforementioned family members any less real. And if there is some inefficiency somewhere that is responsible for the scarcity of higher-paying jobs it is important that it is addressed. Wage stickiness is not the only inefficiency out there, and assuming that the labor market clears does not automatically imply that the outcome is efficient.

      So again, how long does it take for wages and prices to adjust completely? How slow is this adjustment? Especially given that prices have been going up, albeit slowly, it should not take six years for the real wage to adjust completely. Rather than attacking people you know little about, try to learn a few things.

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    17. "So again, how long does it take for wages and prices to adjust completely? How slow is this adjustment? Especially given that prices have been going up, albeit slowly, it SHOULD not take six years for the real wage to adjust completely."

      About your question, I can once again only repeat that wage stickiness has been observed for decades. The data is available so look at it instead of asking me such "is the Earth really round?" questions and at the same time telling me to "learn a few things".

      Your SHOULD reflects a problem, namely that you choose to ignore facts when your theory says that it cannot be (that the labour market has to clear).

      About your personal examples, well, I could counter them with ample of examples about people who are involuntarily unemployed but I have very little interest in descending into a "all these unemployed folks in the thirties and all those unemployed 20 somethings in Europe actually chose to be unemployed, they could find have found a job if they had just accepted a lower wage" nonsense argument.

      I find it interesting that you associate accepting the fact of wage rigidity and taking involuntary unemployment during recessions seriously with "liberal- type" (I guess if you translate this into proper English it is suppose to to mean centrist / left-liberal because just liberal without adding left or right liberal is kinda pointless, especially on an econ blog where you can be virtually certain that there are only people in favour of liberalism and no Marxists or nazis or whatever hanging out).

      As Stephen emphasizes so often, proper technical economics has little to do with politics. You can e.g. be for demand management (more precisely conducted via monetary policy in normal times and via fiscal policy during liquidity traps) and a small government at the same time if you think that unemployment implies grave costs (happiness studies suggest it does far beyond the mere consumption reduction) and if you think that the disincentive effects of taxation are large.

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    18. About whether wage and price rigidity are the actual source of underemployment equilibria, I agree with you that they are not. NK DSGE are problematic as they "create" the underemployment equilibrium precisely via (usually only) price stickiness. You know that it is not so, Keynes argues against wage and price flexibility alleviating the problem it in the General Theory and Stiglitz and Greenwald wrote a series of underappreciated papers in the nineties that create underemployment equilibria via asymmetric information issues in financial markets (I hope that Keynesians and Monetarists agree that money is the source of the problem, i.e. that a barter economy would not suffer from recessions) and also do not imply that wage and price rigidity are the cause of the problem.

      So yeah, I would totally agree that with you and Stephen there are plenty of market imperfections which could be the theoretical causes of our problems.
      I wouldn't want wait though until they are all explored while we have simple Econ 101 models that do not explain WHY underemployment equilibria arise but WHAT we can do to get employment/GDP up again. In Mankiw speak, macroeconomist cannnot only be scientists but also gotta be engineers.

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    19. Anonymous, I think you need to re-examine your priors. Wage and price stickiness does not last for decades, at least not according to the data. This is particularly true for real wages, which can decline eventually even if nominal wages do not, as prices increase.

      Second, my question on involuntary unemployment was motivated by a point made by Robert Lucas. It is important to define exactly what we mean by "involuntary". This is because many of the people who claim that they cannot find a job usually mean within certain parameters (type of job, earning at least so much, etc.) This is not necessarily because they are lazy (value leisure), other circumstances like the ones I highlighted are also important. I seriously doubt that the people you have in mind have a reservation wage below the minimum wage, and yet cannot find any type of job. Maybe that was the case in the beginning of the recession, but not so now. If you have people in such a situation, let me know as several small businesses in my area are hiring sales people, waiters, etc. Maybe I can help.

      To conclude, if you are so concerned with the proper conduct of economics it would be wise to keep your responses a little bit more measured, especially on issues that are not at all evident.

      P.S. In US politics the term liberal has for a very long time described the left. I am not sure what "proper English" has to do with this.

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    20. OK, so we did descent into "all those European 20 somethings and all those guys during the Great Depression could have found a job if they had just accepted a lower wage" territory.
      Calling this utter nonsense is a euphemism.

      Not that I am surprised about right-wing demand denial.

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    21. Dude, a drop in the availability of higher-paying jobs IS a demand story. You don't need sticky wages for that. In the data the real wage is procyclical, not counter-cyclical. You just don't get it (and neither do many right-wingers)!

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  6. Steve, in the second to last paragraph, inside the parenthesis, I think you need to switch the terms "long-maturity" and "short-maturity" around.

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  7. "Firms want to hire more workers, but the workers have to be reconciled to working harder, so their real wages need to go up. This means that the real return they receive on their assets must be higher. At the zero lower bound, the only way that can happen is if inflation goes down."

    Is there any way you could explain that in a way that makes sense to normal people?

    Demand increases so firms hire more, but the unemployed people don't want to work unless there is deflation (??) so somehow deflation happens??

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    1. You are confusing disinflation (drop in inflation) with inflation (drop in prices). With the nominal interest rate at zero, higher inflation reduces the incentive to work, because any income you earn loses purchasing power faster. So a crude way to explain this is that firms agree to raise prices slower relative to wages in order to convince workers to supply more labor.

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    2. Oops, I meant you are confusing disinflation with deflation.

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    3. "Is there any way you could explain that in a way that makes sense to normal people?"

      Define normal.

      Seriously though. I make my wages today in dollars, but I'm going to spend my wages in the future on consumption goods. In the meantime, I put my wages in my bank account, and it earns some rate of interest. But in a liquidity trap I'm earning zero interest in my bank account. So, I earn my wages today, and spend them in the future.
      I care about my effective real wage. What's that? It's my real wage today, in current consumption goods multiplied by the current price of goods in dollars, divided by the future price of goods in dollars. So, given my current real wage (in current consumption goods) if the inflation rate goes down, then my effective real wage goes up.

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  8. Hi Dr. Williamson, I am naturally sympathetic to anyone whom Krugman attacks, but in the verbal discussions of your position, something doesn't sound right.

    You (and Andolfatto) are saying: "In order to get the public to hold more money, its return has to increase so the rate of inflation has to fall."

    Yet if we took that argument and applied it to, say, Zimbabwe, obviously it's not the whole story.

    So, my question is, are you handling "the whole story" and are just focusing on this particular effect? Because clearly that effect doesn't dominate in general, when governments increase the stock of money, even though the specific reasoning is still valid.

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    1. Something else going on there entirely. In my model, there's a more-or-less well-behaved fiscal authority, though it's doing something suboptimal. Hyperinflations typically arise in the context of a very poorly-behaved fiscal authority (e.g. see Sargent's Four Big Inflations paper). I think that's well understood. I can do the hyperinflation in the model for you if you want. You can do it with the fiscal authority taking over the central bank, and then generating seignorage through the inflation tax to finance government spending.

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    2. "You can do it with the fiscal authority taking over the central bank, and then generating seignorage through the inflation tax to finance government spending"

      Doesn't the inflationary impact of this depend on how much the fiscal authority spends in this way, what it spends on, and what else is going on in the economy?

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    3. i.e. you don't automatically get hyperinflation just because the fiscal authority creates some new money and spends it. It depends on how much they create and spend, etc.

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    4. Sure, I'm just saying that you could take the same basic model, and produce a hyperinflation.

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  9. This post by the author is along the lines of the provocative but unproven hypothesis of 'dark imports' 'dark exports' see this 2006 article: http://www.economist.com/node/5408129 It exploits accounting and/or mathematics to come up with an explanation. But absent further evidence, Occam's Razor says that QE should be more inflationary, but people are still irrationally hoarding money, akin in reverse to the bubble of 1999 in the stock market.

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  10. Why must wages rise to induce people to work? Can't there be an excess supply of workers over demand?

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    1. Here', the labor market clears, just like in Woodford's model.

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  11. Steve's argument seems to boil down to "the central bank cannot print money if the public refuses to sell it assets, which it will only do if it expects a positive rate of return. Thus, printing money must reduce the rate of inflation, or else no one would 'buy' CB reserves".

    It seems to me that two things happen when the CB increases the money supply. The public either spends the money, or it saves it, and chooses which option to pursue based on expectations of inflation. In other words, QE doesn't lead to lower inflation; lower inflation leads the public to save the extra liquidity created by QE (which, by the way, is the classic "excess demand for money" story).

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  12. Sounds like a Giffen good - with inelastic supply and upward sloping demand, an increase in supply raises the price. Demand only slopes up in an unusual region, however, so when you get beyond that region the usual rules apply. In a liquidity trap, add a little money and inflation goes down. Add a lot and inflation goes up.

    Does it make sense to think about the model like that?

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    1. Actually, there's nothing unusual like that going on. There are income and substitution effects working in there alright, but whenever that's the case, the assumption is that the substitution effect dominates.

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  13. Stephen,
    A question from someone who's a bit skeptical that base money demand is the binding constraint in the modern world (either because it's literally a cashless economy, or the modern payments system successfully saturates the cash in advance constraint). So let's keep only the long term bonds and private credit related liquidity/financial frictions. In a cashless limit economy successful quantitative easing would reduce liquidity premia and raise the natural (flexible prices and wages) interest rate. Now if the central bank still thinks it's appropriate to have very low nominal interest rates and prices and wages are flexible, the rise in real interest rates together with no change in nominal rates means investors must expect lower inflation in order to hold bonds. Doesn't this capture most of what you've been saying regarding the QE/inflation link? Of course, Keynesians would never agree with this mechanism, because it assumes flexible prices and wages (or price and wage stickiness that isn't allocational). I think you'd get this sort of result in the models by Gertler, Karadi and Kiyotaki, e.g
    http://www.econ.nyu.edu/user/gertlerm/gertlerkaradifrbconference2012.pdf

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  14. Steve, you repeatedly suggest that people check out your cash in advance notes, and I after taking a look I had a few questions:

    - In equation (2), where is c_t defined? Is it supposed to be c1_t? If so, that would be more consistent with your budget constraint.

    - This might be a stylistic thing, but why does b'_{t+1} not mean the quantity of bonds used to purchase good 2 in period {t+1}? Wouldn't that make the notation more consistent? Otherwise, why not just call it b_{t+1}? m_t seems to be the amount on money brought by the agent from one period prior, and then b_{t+1} would just be the amount of bonds that the agent would bring to the next period. That would also seem consistent with your line about what the consumer chooses, as if b'_{t+1} really represented the quantity of bonds held from period t to period t+1, then that should also be a control variable.

    All that aside, I think you have a small math error in equations 13 and 14 -- in no way do I see how combining (11) and (12) makes (13). I presume you are adding the equations, yet that doesn't get the right answer. Are there other equations that you're evoking? I'm still quite confused.

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    1. Yichuan, 13 follows from 11 and 12 assuming you're in steady state. Note the second term in 13 on rhs has the marginal rate of substitution for good 1 *between time t and time t+1*, NOT the marginal rate of substitution between good 1 and good 2 (this confused me at first as well).

      In equation 10 we have the lambda t+1 multiplier. mu is always the constant marginal disutility of labor, beta is a constant and in steady state inflation is constant. That means lambda t+1 is constant. So marginal utility of good 1 in all periods is 1.

      So that u'(c1t)/u'(c1t+1) term in 13 is really just a 1. Stephen is just rewriting the equation this way to put the "wedge" interpretation on it.

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    2. I don't have time to go back and check right now. There's certainly no guarantee that those notes are typo-free or that the notation is perfect - I wrote it pretty quickly. Give me a couple of days.

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    3. Actually there is a straightforward mistake here. From equation 9, q=l2(t)/l1(t). From 6, 7 and 8 l1(t)=MU(c1(t))-g and l2(t)=MU((c2(t))-g. So 12 should be

      q={MU(c2(t))-g}/{MU(c1(t))-g}

      Also, I think (not sure) that FOC (9) should actually have q(t-1)*l1(t-1) in it. There's a budget constraint for (t-1) which also has b'(t) in it.

      (My own confusion here - how can you get inflation in a model where consumption, output, money balances, gov debt, and interest rates are constant. I.e. with no monetary growth)

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  15. ...errr I mean "so marginal utility of good 1 in all periods is constant"

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  16. until and unless you overturn Beckworth and Sadowski empirical evidence, this is a failed project, Steve.
    No sense flogging a dead horse.

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    1. So, far, this is just a piece of theory, and I haven't thought about how to incorporate this in a more complete theory that one could actually take to the data. So, there's no hypothesis which I would feel comfortable taking to the data. What I did with the model just gives you a long run result. My main arguments in my original post had to do with a policy trap, and I made some comments that this appears at least not to be inconsistent with the data. How Beckworth and Sadowski think they can refute anything with a couple of time series plots and one two-variable VAR is beyond me, let alone a statement as weak as the one I made. I'm not sure what you're all excited about.

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    2. I looked at that post again. Beckworth is looking at the wrong data. He's just looking at the size of the Fed's balance sheet. The key issue relates to the maturity composition of the debt held by the public. You have to take into account how the maturity composition is altered, both by what the Fed is doing, and what the Treasury is doing. The Treasury has been lengthening the average duration of the debt, while the Fed is reducing it.

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  17. Stephen,
    regarding the last paragraph, if we are telling a story in Keynesian terms, would it be correct to summarize it this way:
    QE shifts AS curve to the right more than it shifts AD curve to the right. Keynesians get the different result on inflation as they usually ignore the effects of QE on the supply-side of the economy.

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    1. I was wondering about this too, because I see people arguing this elsewhere. But I don't think it has to shift the AS curve more than the AD curve; I think it has to shift them by exactly the same amount (in terms of the price axis). As I understand it, there is no price rigidity in this model, so if there's a shift in AS, it should affect the current price level, not the rate of inflation. I can imagine offsetting shifts where (1) the reduced liquidity premium shifts AD, causing the price level to rise immediately relative to its long run level, so that it will subsequently be on a downward trajectory, and (2) the increased liquidity shifts AS, causing a permanent reduction in the path of the price level, enough to just offset the immediate effect of the AD shift, thus leaving us with a price level that doesn't jump but subsequently falls. I have no intuition for why the shifts should be precisely offsetting, but perhaps there is an explanation.

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    2. You're asking me how I would teach it to an undergraduate. See Chapter 11 in my intermediate macro book. Think of it shifting the output demand curve.

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  18. If the fed made return on cash minus 2% for ten years (QEeen Janet is on board for 9 at least), then the excess reserves would loose 22% of their value in real terms (ignoring the IOER). if the stock market fell 22% in real terms, no one would argue that it is NOT deflationary.

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  19. Stephen,

    "Firms want to hire more workers, but the workers have to be reconciled to working harder, so their real wages need to go up. This means that the real return they receive on their assets must be higher. At the zero lower bound, the only way that can happen is if inflation goes down."

    Could you please explain why the firms couldn't just pay higher wages?

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