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The stagnation regime of the new keynesian model and current US policy George Evans Discussion Frank Smets Asset prices, credit and macroeconomic policies Marseilles 25-26 March 2011 The opinions expressed are our own and not necessarily those of the ECB, the Eurosystem or the NBB. Introduction • Builds on previous work with Honkapohja and Guse, which investigates which policies can avoid an unstable deflationary spiral, which arises in a standard New Keynesian model with active monetary policy and passive fiscal policy, a zero lower bound on interest rates and adaptive learning by the private agents. • Proposed policy: A combination of aggressive lowering of interest rates to zero when a minimum inflation rate is reached and expansionary government spending. Introduction Evans, Guse and Honkapohja (2008) Introduction Evans, Guse and Honkapohja (2008) Introduction • What’s new? • The inclusion of downward nominal wage/price rigidity. This explains why the economy may get stuck at a low inflation equilibrium, rather than trapped in a deflationary spiral (e.g. Japan) • A discussion of current US policies to avoid the deflationary trap • Proposal: • Aid to local municipalities and states to avoid countercyclical fiscal policy in return for setting up rainy-day funds. • Large-scale public infrastructure works financed by low interest rate bonds and central bank QE. Introduction Evans (2010) Comments on proposals • The world has moved on in the meantime: • QE2: assessment of effectiveness of QE2 has been quite positive (e.g. Krishnamurthy and VissingJorgensen (2011)) • Unemployment is falling; inflation started rising; government debt is accumulating. • But many elements of the proposal make a lot of sense: • Importance of automatic stabilisers (US vs EU); • Rainy-day funds and the SGP; • Focus on productive government investment (but lags are long and efficiency may be affected). Comments/questions • How large has been the risk of a deflationary spiral? • What is the evidence of downward nominal wage rigidity? • Can the policy recommendation be described as a switch from a combination of active monetary and passive fiscal policy to the reverse? • Fiscal space and government default risk? • What about a price-level targeting policy? Inflation expectations: US vs euro area 5-year spot 5-year forwards 5 years ahead 3.0 4.0 2.0 3.0 1.0 2.0 0.0 US, 5-year forward 5-year ahead BEIR 1.0 US, 5-year BEIR -1.0 Euro area, 5-year forward 5-year ahead BEIR Euro area, 5-year BEIR -2.0 0.0 95 97 99 01 03 05 07 09 95 97 99 01 03 05 07 09 Sharp rise in unemployment, but … Wage inflation has not responded much Survey evidence of downward nominal wage rigidity in the euro area Incidence of wage cuts and freezes during the crisis: follow-up survey Total Euro area Non-euro area % of firms cutting wages Original Follow-up survey survey % of firms freezing wages Original Follow-up survey survey did cut will cut 3.2 2.1 6.5 3.1 3.3 2.7 did freeze 34.5 37.1 27.4 2.6 1.3 6.4 9.5 7.6 14.8 will freeze 34.5 43.1 10.3 Notes: Source: Messina and Rõõm (2009). Figures for the original survey have been calculated including only the firms that are in the 2009 sample. Figures are employment-weighted and rescaled excluding “do not know” answers. The sample includes AT, BE, CZ, EE, ES, FR, IT, NL and PL. The construction sector is not covered by the follow-up survey in ES, FR and IT. The financial intermediation sector is not covered by the follow-up survey in CZ, EE, ES, and FR. Country details in Table 5.2 of the WDN Report. Note: The surveys were conducted in the context of the ESCB Wage Dynamics Network (WDN). See http://www.ecb.europa.eu/home/html/researcher_wdn.en.html for the main findiings of the WDN and details of the surveys conducted. The original survey was conducted mostly druing 2007. The follow-up survey was conducted mostly in the beginning of 2009. 12 Fiscal theory of the price level • Can the policy recommendation be described as a switch from a combination of active monetary and passive fiscal policy to the reverse? • How large would the necessary fiscal expansion be in that case? There is a need for realistic quantitative versions of these models. Sovereign CDS spreads (5-year in bp) 1200 1000 800 at be de es Jan 08 to Sep 08: global increase in risk aversion, first moderate increases in sov. CDS fi fr ie it nl pt Apr 10 to Feb 11: focus on country risks 1000 800 Oct 08 to Mar 10: risk transfer from fin. sector to public sector 600 gr 1200 600 400 400 200 200 0 0 Jan-08 Source: Datastream Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 7 Euro area countries: rapid budget deterioration General government budget balance (as a percentage of GDP) 8 2007 2011 6 4 2 0 -2 -4 -6 SK -8 PT CY FR ES -10 GR -12 -14 IE Source: European Commission Forecast (Spring 2010). SI NL AT BE IT DE LU MT FI Euro area countries: rapid rise in gross government debt General government gross debt (as a percentage of GDP) 160 2007 2011 140 120 100 80 60 40 20 0 LU SK SI FI CY NL ES Source: European Commission Forecast (Spring 2010). MT AT DE IE FR PT BE IT GR Price level targeting • Is in my view too easily dismissed in the paper. • How does it change the stability analysis of the New Keynesian model? • If a credible price level targeting regime is established beforehand, then the learning rules will adapt, which in turn will stabilise the economy; much larger expectational shocks will then be needed to get trapped in the deflationary equilibrium. • Probably need long-horizon learning to analyse this properly. • Needs to be symmetric. End