Skip to main content

The difference between Sumner and Krugman on liquidity traps


Daniel Kuehn and Robert Murphy wonder why Scott Sumner takes Paul Krugman to task on liquidity traps when they each seem to be saying the same thing - monetary expansion will get you out of a trap.

The phrase "monetary expansion" can mean many things. I think Krugman and Sumner have categorically different opinions concerning one specific sense of the phrase  –quantitative easing's ability to have independent effects in a liquidity trap, .

When it comes to thinking about monetary policy, Krugman, Delong, Eggertson, Woodford, and other New Keynesians begin with a frictionless model populated by rational agents. No individual has the power to set prices and everyone can attain any quantity of assets at a given price. There is no limit on borrowing. With these assumptions and interest rates at zero, quantitative easing is powerless. That's because all asset prices are uniquely determined by the present value of their future cash flows. A central bank that threatens to buy bonds/stocks/gold so as to push their prices above their fundamental value will be unable to do so. All central bank purchases will be met with a wave of hedge funds sales (and short sales), thereby ensuring that the prices of these assets stay at their fundamental value. QE can't get any traction, so it's irrelevant.

On the other hand, Sumner, Nick Rowe, Miles Kimball, and others attribute an independent effect to quantitative easing. This is because they either explicitly or implicitly do not accept the assumptions of the frictionless model used by Krugman et al.

The market monetarist's departure from the assumptions of a frictionless model begins with the colourful idea of Chuck Norris walking into a room and telling everyone to get out. If they don't, he'll beat them up. Because his threat is credible, people file out of the room without Chuck Norris having to lay a finger on them. Now take a central bank that threatens to move up prices through large scale asset purchases. Hedge funds refusing to accept the threat will be pummeled by the central bank. Rather than resist, hedge funds cry uncle. Asset prices rise above their fundamental value because Chuck Norris says so. That's how QE gets traction.

So the difference between New Keynesians and market monetarists seems to rest on a few assumptions. In a frictionless model, hedge funds will undo the effects of central bank purchases. In a market monetarist model, hedge funds can't beat Chuck Norris and QE has bite. It'll be a long time before Krugman and Sumner agree on the specifics.

Sources:
Nick Rowe, Miles Kimball (here, here and here) , Michael Woodford (pdf), Paul Krugman (and here). See my old posts Don't fight the Fed and QE Zero.
Labels:

Comments

Post a Comment

Popular posts from this blog

Shadow banks want in from the cold

Remember when shadow banks regularly outcompeted stodgy banks because they could evade onerous regulatory requirements? Not any more. In negative rate land, regulatory requirements are a blessing for banks. Shadow banks want in, not out. In the old days, central banks imposed a tax on banks by requiring them to maintain reserves that paid zero percent interest. This tax was particularly burdensome during the inflationary 1970s when short term rates rose into the teens. The result was that banks had troubles passing on higher rates to savers, helping to drive the growth of the nascent U.S. money market mutual fund industry. Unlike banks, MMMFs didn't face reserve requirements and could therefore offer higher deposit rates to their customers. To help level the playing field between regulated banks and so-called shadow banks, a number of central banks (including the Bank of Canada) removed the tax by no longer setting a reserve requirement. While the Federal Reserve didn't go as f...
Post a Comment
Read more

The bond-stock conundrum

Here's a conundrum. Many commentators have been trying to puzzle out why stocks have been continually hitting new highs at the same time that bond yields have been hitting new lows. See here , here , here , and here . On the surface, equity markets and bond markets seem to be saying two different things about the future. Stronger equities indicate a bright future while rising bond prices (and falling yields) portend a bleak one. Since these two predictions can't both be right, either the bond market or the stock market is terribly wrong. It's the I'm with stupid theory of the bond and equity bull markets. I hope to show in this post that investor stupidity isn't the only way to explain today's concurrent bull market pattern. Improvements in financial market liquidity and declining expectations surrounding the pace of consumer price inflation can both account for why stocks and equities are moving higher together. More on these two factors later. 1. I'm with...
Post a Comment
Read more

A way to make anonymous online donations

Paying for things online usually means giving up plenty of privacy. But this needn't always be the case. Last night I donated to a local charity via their website and didn't have to give up any of my personal information. The trick for achieving a degree of online payments anonymity? Not bitcoin, Zcash, or Monero. I used a product created by old fashioned bankers: a non-reloadable prepaid debit card. (I wrote about these cards here and here ). Had I used a credit card or PayPal, all sorts of parties would have gotten access to my personal information including the site owner, the payments processor, my bank, the site owner's bank, the credit card networks, my partner, and many more. To get a good feel for how many different parties touch an online payment, check out this graphic by Rebecka Ricks, which shows how PayPal shares your information. A powerful visualization by @baricks showing how PayPal shares your data: https://t.co/vd8w8d8xn6 ht @akadiyala Due to Europe...
Post a Comment
Read more