Has Woodford Gone Soft on the Interest Rate Channel?

Probably not, but here is the abstract from Michael Woodford and Vasco Curdía’s new paper entitled, “The Central Bank Balance Sheet as an Instrument of Monetary Policy”:

While many analyses of monetary policy consider only a target for a short-term nominal interest rate, other dimensions of policy have recently been of greater importance: changes in the supply of bank reserves, changes in the assets acquired by central banks, and changes in the interest rate paid on reserves. We extend a standard New Keynesian model to allow a role for the central bank’s balance sheet in equilibrium determination, and consider the connections between these alternative dimensions of policy and traditional interest-rate policy. We distinguish between “quantitative easing” in the strict sense and targeted asset purchases by a central bank, and argue that while the former is likely be ineffective at all times, the latter dimension of policy can be effective when financial markets are sufficiently disrupted. Neither is a perfect substitute for conventional interest-rate policy, but purchases of illiquid assets are particularly likely to improve welfare when the zero lower bound on the policy rate is reached. We also consider optimal policy with regard to the payment of interest on reserves; in our model, this requires that the interest rate on reserves be kept near the target for the policy rate at all times.

There is a lot to digest here — the paper is over 80 pages. Nonetheless, I would argue that the central bank balance sheet is not an instrument of monetary policy, but the instrument. More on this later.

Are Unemployment Benefits Stimulus?

There has been much debate recently about the extension of unemployment benefits. In particular, this debate has focused on Speaker of the House Nancy Pelosi’s claim that unemployment benefits are a source of stimulus for the economy. Much of the discourse has centered on the magnitude of the disincentives to work caused by the increased benefits. However, this recent discourse is a distraction from a much more fruitful discussion about the effects of unemployment compensation on output. Rather than arguing about the magnitude of the disincentives to work, the central proposition in question concerns the determinants of consumption.

The idea that unemployment benefits might stimulate the economy is based on the Keynesian consumption function under which consumption is determined by current income. Following a negative economic shock, output and employment fall. As a result of the decline in employment and therefore current income, consumption falls as well, which further reduces output. Under such a scenario, unemployment compensation serves to increase current income and thus current consumption.

An alternative to the Keynesian consumption function is Milton Friedman’s Permanent Income Hypothesis (PIH). Under the permanent income hypothesis, individuals make consumption decisions based on their expectations of permanent income rather than current income. In other words, the future path of consumption is determined by the expectations of future income. Transitory fluctuations in income do not affect the consumption path.

Consider an unemployed worker under the PIH. The worker loses his job and his current income declines. His consumption path, however, will only be affected to the extent that he believes that the reduction in current income represents a permanent change. If the change is expected to be permanent, he revises his future consumption path downward and lowers his reservation wage. If the change is expected to be transitory, he does not change his consumption path. As time goes by, the worker continues to update his expectations.

Now consider unemployment compensation under this scenario. When the unemployed worker receives these benefits, his current income receipts increase. However, the unemployment compensation is only transitory and does not affect the worker’s permanent income and therefore does not influence the future consumption path of the worker.

The distinction between alternative theories of consumption has important implications for whether or not unemployment benefits stimulate the economy. The Keynesian consumption function, for example, supports Nancy Pelosi’s claim that increasing unemployment benefits lead to increases in consumption and output. However, the PIH casts doubt on this proposition. The question is therefore largely empirical.

A careful reading of the empirical literature suggests that the PIH performs better than the Keynesian consumption function. For example, a series of research over the last decade or so by John Seater at North Carolina State University and his various co-authors has produced a great deal of support for the PIH using microeconomic data (see here, here, and here). In fact, nearly all of the evidence against the PIH is based on macroeconomic data, which Seater finds to be the result of misspecification or problems with using aggregate data. It is also important to note that DeJuan and Seater’s Journal of Monetary Economics article finds little evidence of liquidity-contrained consumers or the so-called “rule of thumb” consumers, which are often suggested as reasons why the PIH might not hold.

Taken together with the theoretical propositions stated above, the empirical evidence would seem to cast doubt on the efficacy of unemployment benefits in providing stimulus to the economy. Advocates of further extensions to unemployment benefits can continue to argue that such extensions are beneficial by smoothing income receipts for the jobless in this lengthy recession or other similar arguments. However, it would be incorrect to say that we should expect unemployment benefits to provide stimulus to the economy.

Quick Announcement

Blogging will be light of the next couple of days as Mrs. Economist and I welcomed our second little boy into the world yesterday. Baby and mom are doing great.

Nominal GDP Targeting Merchandise

Thanks to Will Luther, you can now buy nominal GDP targeting t-shirts — just choose your color and size. Somebody buy 12 of them and send them to the FOMC voters.

Federal Debt

John Taylor posts a very scary chart of the forecast of federal debt as a percentage of GDP from the CBO.

This Time is Different

There is a great piece in the New York Times profiling Ken Rogoff and Carmen Reinhart and their book, This Time is Different. The background on each of them makes for an interesting read in and of itself.

Quote of the Day

“Those of us in the blogosphere know about the possibility of unconventional measures like QE and/or higher inflation targets. And I think it is fair to say that this knowledge is pretty widespread; Krugman, DeLong, Yglesias, Tim Duy, Andy Harless, Ambrosini, James Hamilton, Ryan Avent, Nick Rowe, Bill Woolsey, David Beckworth, Josh Hendrickson, and many other bloggers have discussed these options. They certainly aren’t some sort of secret, or some oddball strategy that is only discussed at this blog. But almost no mainstream journalist or mainstream politician, of any ideology, seems to even know that additional monetary stimulus is an option.”

— Scott Sumner

Monetary Policy in Emerging Economies

A new NBER working paper by Jeff Frankel discusses monetary policy in developing economies. Here is the abstract:

The characteristics that distinguish most developing countries, compared to large industrialized countries, include: greater exposure to supply shocks in general and trade volatility in particular, procyclicality of both domestic fiscal policy and international finance, lower credibility with respect to both price stability and default risk, and other imperfect institutions. These characteristics warrant appropriate models.

Models of dynamic inconsistency in monetary policy and the need for central bank independence and commitment to nominal targets apply even more strongly to developing countries. But because most developing countries are price-takers on world markets, the small open economy model, with nontraded goods, is often more useful than the two-country two-good model. Contractionary effects of devaluation are also far more important for developing countries, particularly the balance sheet effects that arise from currency mismatch. The exchange rate was the favored nominal anchor for monetary policy in inflation stabilizations of the late 1980s and early 1990s. After the currency crises of 1994-2001, the conventional wisdom anointed Inflation Targeting as the preferred monetary regime in place of exchange rate targets. But events associated with the global crisis of 2007-09 have revealed limitations to the choice of CPI for the role of price index.

The participation of emerging markets in global finance is a major reason why they have by now earned their own large body of research, but it also means that they remain highly prone to problems of asymmetric information, illiquidity, default risk, moral hazard and imperfect institutions. Many of the models designed to fit emerging market countries were built around such financial market imperfections; few economists thought this inappropriate. With the global crisis of 2007-09, the tables have turned: economists should now consider drawing on the models of emerging market crises to try to understand the unexpected imperfections and failures of advanced-country financial markets.

The paper contains a wealth of information and I found it to be a very useful survey. (Sorry, gated.)