The mistake of 1937: a general equilibrium anlaysis

This paper studies a dynamic general equilibrium model with sticky prices and rational expectations in an environment of low interest rates and deflationary pressures. We show that small changes in the public’s beliefs about the future inflation target of the government can lead to large swings in both inflation and output. This effect is much larger at low interest rates than under regular circumstances. This highlights the importance of effective communication policy at zero interest rates. We argue that confusing communications by the US Federal Reserve, the President of the United States, and key administration officials about future price objectives were responsible for the sharp recession in the US in 1937-38, one of the sharpest recessions in US economic history. Poor communication policy is the mistake of 1937. Before committing the mistake of 1937 the US policy makers faced economic conditions that are similar in some respect to those confronted by Japanese policy makers in the first half of 2006. JEL Classification: E32, E52, E6

Optimal Monetary Policy in a Liquidity Trap

We consider the consequences for monetary policy of the zero floor for nominal interest rates. The zero bound can be a significant constraint on the ability of a central bank to combat deflation. We show, in the context of an intertemporal equilibrium model, that open-market operations, even of unconventional' types, are ineffective if they do not change expectations about the future conduct of policy; in this sense, a liquidity trap' is possible. Nonetheless, a credible commitment to the right sort of history-dependent policy can largely mitigate the distortions created by the zero bound. In our model, optimal policy involves a commitment to adjust interest rates so as to achieve a time-varying price-level target, when this is consistent with the zero bound. We also discuss ways in which other central-bank actions, while irrelevant apart from their effects on expectations, may help to make credible a central bank's commitment to its target, and consider implications for the policy options currently available for overcoming deflation in Japan.

Fiscal Multipliers and Policy Coordination

This paper analyzes the effectiveness of fiscal policy at zero nominal interest rates. I solve a stochastic general equilibrium model with sticky prices assuming that the government cannot commit to future policy. Real government spending increases demand by boosting public consumption. Deficit spending increases demand by generating inflation expectations. I compute multipliers of government spending that calculate by how much each dollar of spending increases output. Both the deficit and the real spending multipliers can be large, but the multiplier of deficit spending depends critically on monetary and fiscal cooperation: it can be large with cooperation and zero without it. The theory suggests one interesting interpretation of why recovery measures–such as fiscal spending, exchange interventions, and large increases in the money supply–had a smaller effect on nominal demand in Japan during the Great Recession (1992-2006) than during the US's Great Depression (1929-1941). In both episodes, the short-term nominal interest rate was close to zero. The theory suggests that part of the difference can be explained by the fact that, while monetary and fiscal policy were coordinated in the US during the Great Depression, they were not in Japan during the Great Recession. The overall conclusion of the paper is that the effect of given policy actions depends crucially on the institutional setup in the economy.

The Zero Bound on Interest Rates and Optimal Monetary Policy

This paper considers the consequences for monetary policy of the zero floor for nominal interest rates. The zero bound can be a significant constraint on the ability of a central bank to combat deflation. The paper shows, in the context of an intertemporal equilibrium model, that open-market operations, even of "unconventional" types, are ineffective if future policy is expected to be purely forward looking. However, a credible commitment to the right sort of history-dependent policy can largely mitigate the distortions created by the zero bound. In the model, optimal policy involves a commitment to adjust interest rates so as to achieve a time-varying price-level target, when this is consistent with the zero bound. The paper also discusses ways in which other central bank actions, although irrelevant apart from their effects on expectations, may help to make a central bank's commitment to its target more credible.macroeconomics, Zero Bound, Interest Rates, Optimal Monetary Policy

The Mistake of 1937: A General Equilibrium Analysis

This paper studies a dynamic stochastic general equilibrium model with sticky prices and rational expectations in an environment of low interest rates and deflationary pressures. We show that small changes in the publicfs beliefs about the future inflation target of the government can lead to large swings in both inflation and output. This effect is much larger at low interest rates than under regular circumstances. This highlights the importance of effective communication policy at zero interest rates. We argue that confusing communications by the U.S. Federal Reserve, the President of the United States, and key administration officials about future price objectives were responsible for the sharp recession in the United States in 1937?38, one of the sharpest recessions in U.S. economic history. Poor communication policy is the mistake of 1937. Before committing the mistake of 1937, the U.S. policymakers faced economic conditions that are similar in some respects to those confronted by Japanese policymakers in the first half of 2006.Deflation; Zero bound on interest rates; Regime changes; Great Depression

Policy Options in a Liquidity Trap

Taken from page 76 -- "The specter of a “liquidity trap,” originally proposed as a theoretical possibility by John Maynard Keynes (1936) but long considered to be of doubtful practical relevance, has recently created alarm among the world’s central banks. In Japan, the overnight rate has been essentially at zero for most of the time since February 1999, making further interest-rate cuts impossible. Yet until well into 2003, growth remained anemic while prices continued to fall, suggesting a need for further monetary stimulus. Since March 2001, the Bank of Japan has supplemented its “zero-interest-rate policy” with a policy of “quantitative easing,” under which additional bank reserves are supplied beyond those needed to keep overnight interest rates at zero. Yet an increase in base money of more than 50 percent failed to halt the deflation, suggesting a liquidity trap. More recently, other central banks, including the Fed, have come close enough to the zero bound to worry about how they would deal with a similar predicament. Here we first discuss whether monetary policy should actually become ineffective when the zero bound on interest rates is reached. We argue that open-market operations, even of “unconventional” types, will be ineffective if they do not change expectations about the future conduct of policy; in this sense, a liquidity trap is possible. Nonetheless, a credible commitment regarding future policy can largely mitigate the distortions created by the zero bound. We fully characterize the optimal commitment in a simple example.

A Model of Secular Stagnation.

Japan's two-decade-long malaise and the Grea