For me, the issue is, if you’re in a liquidity trap, then you can be commited but not creible, as the Fed is ineffective. This is not inconsistent with your views, but it’s definitely a problem for someone like Krugman, who believes Japan was in a liquidity trap but could commit to a higher price level.

Buying longer term assets has also been proposed by Gagnon, though you’ve probably seen this on Sumner’s blog.

http://www.piie.com/publications/interstitial.cfm?ResearchID=1451

I’ll check out the references today, thanks for that

The Fed could start by announcing an explicit target for the price level. Your issue seems to be credibility. I don’t think credibility is much of an issue when there is an explicit target.

“Do you like Svenson’s foolproof way? If so, how would it be implemented? I.e. if you want more QE, then what’s the mechanism for increasing aggregate demand?”

Bernanke floated the idea of buying long term assets. Ed Nelson has a paper on whether this would work with theory and evidence (I am mentioning it, so he obviously agrees with me). I will find the cite.

Unless you believe that sole transmission channel is the federal funds rate, then conducting open market purchases of longer term assets should have an effect on aggregate demand.

To understand my position, I think we need to delve into the literature. Ed Nelson has two papers that I think can help you to understand my position:

“The Future of Monetary Aggregates in Monetary Policy Analysis” JME 2003

“Direct Effects of Base Money on Aggregate Demand: Theory and Evidence” JME 2002

How would monetary policy be effective? Will the next trillion be more effective than the last? I just don’t understand the mechanism.

I support Svennson’s foolproof way, but how do you commit to future inflation? By increasing reserves? If massive monetary expansion can’t get inflation above 2%, then how can the Fed credibly commit to future inflation?

I think the temporary currency peg is the best way, as this means that arbitrage will raise the domestic price level of import competing goods, which is a mechanism to increase expectations of inflation. Like I said, the 1934 repeg of the dollar to gold I would cite as a classic example. How do we do this though? Thinking of this, my first guess would be a repeg to gold temporarily, but it is already at a high price, so would this work? (I don’t know). We have substantial oil reserves, so maybe an oil peg would work, but considering that oil price increases tend to lower GDP, it doesn’t seem like it would.

Do you like Svenson’s foolproof way? If so, how would it be implemented? I.e. if you want more QE, then what’s the mechanism for increasing aggregate demand?

EE, yes this is true that the Fed funds rate is lower than the interest rate on reserves. This is why it is a mistake. But if the interest rate on reserves is 0%, then how much excess reserves would be held? To put it another way, given that interbank rates are only 0.12%, then banks obviously don’t much like the prospect of loans for anything other than interbank overnight or 3-month T-bills. Why would more reserves change that? Would a Fed funds rate of 0.06% spell recovery? At a certain point 0.0025 and 0.0012 are just an epsilon.

BTW, one thing that I forgot to mention on an earlier comment. You wrote, “I finally found how much interest is paid on excess reserves, and it’s a quarter of a percent or 0.25%. It seems for Sumner and EE that this is enough to have excess reserves, while an interest rate on reserves of 0.0000 would cause little to no excess reserves, right? 0.25 This is hardly a leg to stand on.”

What is the current federal funds rate? The effective federal funds rate as of December 9 is 0.12%. So let’s see, I can loan out my excess reserves to another bank at an overnight rate of 0.12% (and bear some degree of risk) or I can hold the excess reserves (without any risk) and receive 0.25% (TWICE THE RETURN) from the Fed.

Here is excess reserves (from the FRED, in billions of dollars):

2008-07-01 1.916
2008-08-01 1.971
2008-09-01 60.053
2008-10-01 267.902
2008-11-01 559.036
2008-12-01 767.397
2009-01-01 798.233
2009-02-01 643.482
2009-03-01 724.623
2009-04-01 824.367
2009-05-01 844.076
2009-06-01 751.364
2009-07-01 732.996
2009-08-01 765.857
2009-09-01 860.074
2009-10-01 994.734
2009-11-01 1077.268

Here is the monetary base (for beginning and end of period for brevity):

2008-07-02 863.332
2009-11-04 2024.393

So the base increases by roughly $1.2 trillion and excess reserves increase by roughly $1 trillion. Gabe interprets this as a result of the fact that banks are simply willing to hold excess reserves as a near perfect substitute for the bonds that the Fed is taking off their books.

Whether I am correct or Gabe is correct, I still don’t understand why monetary policy cannot be effective. Lars Svensson has his foolproof way:

(1) an explicit central-bank commitment to a higher future price level

(2) a concrete action that demonstrates the central bank’s commitment, induces expectations of a higher future price level and jump-starts the economy

(3) an exit strategy that specifies when and how to get back to normal

I think the issue is the EE believes that Fed is simply offsetting increased money demand, with increased demand for base offset by increases in reserves, leading to no real change, which is “tight” policy. Perhaps I am misunderstanding, but I think this is too coincidental, especially considering the excess reserves, to be anything but a liquidity trap.

I made a spreadsheet to illustrate. It’s money base-excess reserves, which shows how much of the increase in reserves is not becoming excess reserves. This has gone from ~840 billion before the Sept 2008 to 940 b now, while base has gone from 900 billion to 2000 billions, an increase as 1.1 trillion dollars. This is not that money and bonds are complete substitutes, but pushing on this string isn’t moving it much.

http://tinyurl.com/ya2rrfx

1) I will look around re: interest rate channels. I am not knowledgable on the channels- how else does monetary policy get transmitted? I just don’t get how credit increases without lower interest rates. Why else would the quantity demanded for loanable funds increase?

2) I am not opposed to the “foolproof way”, indeed I think this explains a lot about the recovery from the GD. Many people think the US left the gold standard in 1933, which is true, but the new peg of $35 a troy ounce was set in 1934, to continue until the collapse of Bretton Woods. This seems akin to the “foolproof way” and indeed inflation increased and the economy recovered rapidly.

3) Fair enough. I think we agree that paying interest on reserves is a mistake. I think we disagree on how much this explains of excess reserves.

4) I’ll explain more on this with my next post responding to push

5) This is a completely fair question. I think that this would be helpful, as it would increase inflation expectations, but not too helpful, as most of the increase would show up in excess reserves without affecting the broader economy. To be clear, I think that the prescence of excess reserves is good in that once the economy recovers, then there will be reserves available for new loans and plenty of money supply to raise inflation temporarily. Also, monetizing debt is good for the long term budget concerns. However, if the monetary stimulus will be withdrawn eventually, then these bonds will need to be resold at lower prices when rates are higher, so that means a significant capital loss. So it’s a tradeoff between leaving plenty of reserves available with future capital losses. But obviously enough reserves should be available for the recovery. I am surprised that the Fed has been selling treasuries while buying other assets. If the goal is to increase reserves, then selling bonds shouldn’t be an option.

6) Agreed that temporary tax cuts don’t work. We will see whether these will be permanent expansions of government- I don’t see that happening for many of the projects- broadband, aid to states, etc. Much of US infrastructure is woefully underfunded, so permanent increases in infrastructure would be beneficial imo. Similarly, funding of basic research is also sub-optimal. Is the stimuls imperfect? Yes, but the stimulus package is still a net positive. However, I think debating the stimulus details is much more fruitful discussion than the long discussion of whether government spending works.

You’re suggesting the measures of the multiplier are a statistical artifact, but could you spell it out? I’m wondering if there might be an alternative measure or other evidence that could resolve the issue.

Six things:

1. Empirical evidence for the interest rate channel is weak. Show me an empirical paper that identifies a statistically significant relationship (with a sizable magnitude) between the real interest rate and fixed capital investment or inventory investment. Allan Meltzer has a paper in a book on the transmission mechanism printed by the Bundesbank (I will find the reference) in which he shows that the real interest rate does not provide a useful guide for explaining monetary policy or the downturn and recovery. (There is a great deal more evidence on why one should doubt the interest rate channel. Perhaps I will write up a post on it soon.)

2. Given that you believe in the interest rate channel, what is wrong with Svensson’s “Foolproof Way”?

3. I did not say that banks never hold excess reserves. I also did not say that banks would hold zero excess reserves without the interest payments. What I said is that if we are going to pay interest on excess reserves, we can expect excess reserves to be higher than without interest payments. Do banks not respond to incentives? This is bad policy whether or not a liquidity trap exists.

4. You seem to think that the money multiplier is falling because the monetary base is increasing. The timing suggests otherwise.

5. If we are really in a liquidity trap, why not just have Bernanke come out and announce that he is going to start to monetize the debt. After all, money and bonds must be perfect substitutes for a liquidity trap to exist. Thus, one of two things occur: (1) people view this as credible, inflation expectations rise, or (2) people substitute money for bonds and the national debt is eliminated. (I am being facetious — but not entirely.)

6. Finally, we are ignoring the elephant in the room regarding fiscal policy. It is not sufficient to just “do something” with fiscal policy. The current stimulus package is a giveaway to political interests. What’s more, it does everything wrong according to economic theory. Temporary tax cuts don’t work. Much of the spending is a permanent expansion of government. Whether monetary policy works or not, I wouldn’t mind of some type of fiscal policy so long as it is consistent with what we know from theory and evidence — of course, I also have little faith in politicians to create such policies. If they are going to waste money on policies that don’t work, I prefer we not use fiscal policy at all.