Gauti Eggertsson and Neil Mehrotra have a new paper that seeks to provide a formal model of secular stagnation. The paper is a welcome addition to a debate that, prior to their paper, was mostly muddled thoughts sprinkled throughout speeches and blog posts. The purpose of this post is to express doubts about some of the features of their model and also talk about the role of money (which is absent from the choices made in the model, but somehow prevents policy from going below the zero lower bound).

The basic idea in the Eggertsson and Mehrotra (henceforth EM) paper is that some sort of shock, like a de-leveraging shock, can cause the real interest rate to fall below zero. Since monetary policy is limited by the zero lower bound, the central bank (potentially) cannot equate the real interest rate with the real natural rate of interest. The only solution is for the central bank to increase its inflation target until the real interest rate is equal to the natural rate. In fact, EM argue that there is no equilibrium possible if the inflation rate isn’t raised to minus the real natural rate of interest.

Essentially, my problem with the model is as follows. As I will discuss below, the zero lower bound is only a constraint if individuals can hold currency. However, if individuals are capable of holding currency, when the real interest rate on savings is less than the real rate of return on currency (minus the rate of inflation), then everyone will hold currency. Thus, it is not true that no equilibrium exists when the inflation rate is less than minus the real rate of interest. The inclusion of money has important implications for their model in terms of the welfare effects of the shocks generating the so-called secular stagnation.

The EM model can be summarized as follows. The model is an overlapping generations model in which agents live for 3 periods. Thus, at any one point in time, there are three generations living — young, middle-aged, and old. Agents are assumed to only receive an endowment (or produce) in middle-age. Thus, in order to consume when old, agents have to save some of their endowment for old age. To consume when young, agents have to borrow from middle-aged agents. Middle-aged agents save by lending their endowment to young agents. When young agents become middle-aged, they repay their debt to the now old agents who use the repayment to consume. The model is a pure credit economy in the sense that money serves as a medium of account, but not a medium of exchange. The key feature of the model is that young agents are debt constrained. EM assume that young agents can only borrow an amount less than or equal to . They assume that this constraint is binding such that young agents always borrow an amount, . The key equation in their framework is the equilibrium condition in the savings market, given by

where is the real interest rate, is the discount rate, is the rate of population growth, and is the size of the endowment. Secular stagnation results when the real interest rate falls below zero and the central bank cannot reduce the nominal interest rate sufficiently to clear the market. One potential cause of this phenomenon is de-leveraging. For example, suppose that permanently declines (i.e. young agents find it harder to borrow). In this case, the real interest falls in period and falls again in period . If the decline is large enough, this can cause the real interest rate to be negative.

Now in a pure credit economy, this shouldn’t be a problem. The market rate of interest should just become negative. However, EM assume two things. First, they assume that the central bank determines the nominal interest rate. Second, they assume that “the existence of money precludes the possibility of a negative nominal rate.” The assumption they seem to be making is that nobody holds currency, but the threat that people could hold currency prevents the nominal rate from going below zero. The reason that this is important is because they make the following statement: “…it should be clear that if the real rate of interest is permanently negative, there is no equilibrium consistent with stable prices.” This argument follows directly from the Fisher equation. If prices are constant, the Fisher equation implies that

which is a contradiction since we've assumed that .

However, if we are to take currency seriously, we should consider the conditions under which people would hold currency. To do so, consider a simple modification to their model. Assume that we endow the initial old agents with currency and assume that the supply of currency is constant such that the price level is constant. Now, middle-aged agents face a portfolio allocation decision. They can lend to young agents at the real rate of interest or they can sell their endowment to old agents for money.

In this modified environment there are three possible equilibria. For both debt and currency to be used in equilibrium, it must be true that the rate of return on debt and the rate of return on currency is equal (it is straightforward to show this by adding money to the EM choice problem and solving out the Kuhn-Tucker conditions). If the rate of return on debt is higher than currency, then nobody holds currency and everybody issues debt. If the rate of return on currency (technically, in an OLG model with a constant supply of currency, this is equal to the rate of population growth) is greater than the rate of return on debt, then everybody holds currency.

This point is not a mere formality. The reason is because EM argue that the world blow up with price stability (actually when they say there is no equilibrium, I think they actually mean that autarky is the equilibrium result). However, the simple addition of currency to the model implies that if the real interest rate ever became negative, all middle-aged agents would simply sell their endowment to old agents in exchange for currency rather than lend to young agents. Thus, if young agents become sufficiently debt constrained, nobody lends to young agents and young agents do not consume. Nonetheless, there is an equilibrium consistent with stable prices.

The importance of the explicit inclusion of currency is as follows. The central bank therefore faces a trade-off. If the central bank increased the growth rate of currency and thereby the inflation rate, they could increase the inflation rate sufficiently such that the inflation rate was equal to minus the real rate of interest. In this case, individuals would be indifferent between debt and currency and the debt market would clear at the desired negative real interest rate. This allows young agents to borrow, which given the assumption of diminishing marginal utility of consumption, means that welfare increases. However, this increase in welfare comes at the expense of a reduction in welfare via inflation. It is well-known that in OLG models, the optimal policy is a constant money supply.

This point might seem subtle, but I think it is important. The reason that I think it is important is because by arguing that the zero lower bound causes autarky when the real rate of interest is sufficiently negative, this overstates the welfare losses from the so-called secular stagnation. Introducing a constant supply of currency in this environment, significantly improves welfare relative to autarky. In fact, in standard OLG models, a constant supply of currency produces an optimal allocation.

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In this case, would equilibrium not be restored as the real interest rate rises due to falling asset prices? If the rate of expected deflation is higher than the real interest rate, investors simply substitute currency for capital, capital prices fall until r = expected def. The question is whether falling asset prices would increase expected deflation, which would mean the asset prices would have to overshoot the comparative static equilibrium level and adjustment to a new equilibrium would be more painful than an increase in inflation expectations.