Thursday, August 15, 2013

more shock and awe from meally macro ....simon lewis plays it mighty again ?

"Why the Pigou Effect does not get you out of a liquidity trap"

" money is different from bonds because money is irredeemable, but even then the Pigou effect is not a magic bullet that gets us out of a liquidity trap."

"How is the Pigou effect supposed to get you out of a liquidity trap?"

" In a liquidity trap nominal interest rates are at zero (ZLB)."

".. if by some means the monetary authority could induce higher inflation expectations,
 then the ZLB could be overcome"

" real interest rates would fall, stimulating demand. "

"That is a real interest rate effect."

" But none of this  is the Pigou effect."

"The Pigou effect is when the authorities keep the current stock of money constant, and falling prices mean that its real value increases. "

"The idea is that at some point people feel sufficiently wealthier that they spend more, which adds to demand. "

"For this to work, we have to assume that the nominal stock of money will remain unchanged, unaffected by falling prices."

" Now you might say fine, let’s assume that. But if you do, you might also agree that the fall in prices is temporary."

" Simple neutrality implies that if you hold the money stock constant, falling prices today will mean higher prices tomorrow."

" But we have already established that in that case you do not need a Pigou effect"

" higher inflation tomorrow at the ZLB will mean lower real interest rates,
 and you get the demand stimulus the good old real interest rate route."

"if people understand that prices will rise,
 they are not really wealthier in an intertemporal sense"

" their extra real money balances will be inflated away."

" they save their extra real money balances today to pay for future inflation taxes."

"The alternative case is where future inflation does not increase as current prices fall - as would happen if the monetary authority targeted future inflation for example, and did not raise that target as prices fell. "

"That would imply that the current nominal money stock was not fixed"

" to prevent future inflation rising, the monetary authority must at some stage reduce the nominal stock of money - long run neutrality again. "

"How does it do that without raising interest rates?"

" It could raise taxes."

" if it did that, then Ricardian consumers would not think of their higher real balances today as wealth, because this would be offset by future tax increases."

"The central bank could reduce the money stock by selling some of its government debt."

" under the conditions that Ricardian Equivalence holds, that has the same effect. "

""Now the government will have to raise taxes to pay the interest on that debt"

" before the bond sale any interest they did pay came straight back via the central bank."

see Willem Buiter here 

"what matters is the terminal stock of money, not its current value. "

"The government can only make people feel wealthier
 by printing money"

" if people believe that the increase in its real value is permanent"

helicopter drop.

" The first issue is whether issuing money to pay for a tax cut is any different from issuing bonds, and in particular does Ricardian Equivalence apply?"

" money is not redeemable. So a permanent helicopter drop of money
will tend to increase consumption. "

" the Ricardian Equivalence mechanism does not apply to a helicopter drop."

"However there is another, more economy wide mechanism.
 If long run neutrality holds, and if people understand this,
 they will realise that their extra wealth will eventually be inflated away
, so they are no better off."

"Equivalently, their tax gain today will be offset by a higher inflation tax at some point."


"those expectations of higher inflation, if we are stuck in a liquidity trap,
will shift consumption to the present"


" the helicopter drop increases demand  through a real interest rate mechanism."

"The bottom line is that we can forget about the Pigou effect
as a way out of the liquidity trap,"

" at least in what is now our baseline macro model."

" What is important for the liquidity trap is expectations about future monetary policy."

" If monetary policy allows future inflation to rise,
and expectations are rational, we can get out of the trap."

" If they do not, then we stay in the trap until some other force gets us out
. That force will not be the Pigou effect."