The resurrection of the Lucas supply function at the hands of Keynesians

Wolfgang Munchau has perhaps the clearest statement of the view that an extra dose of current inflation will boost output:

A helicopter drop means that the ECB would print and distribute money to citizens directly. If it were to distribute, say, €3,000bn or about €10,000 per citizen over five years, that would take care of the inflation problem nicely. It would provide an immediate demand boost, and drive up investment as suppliers expanded their capacity to meet this extra demand.

I don’t mean to pick on Munchnau, who is one of the two or three best columnists in the world (thus the clarity), but I view this as incorrect as stated.  And it is symptomatic of a mistake which I see more and more frequently, including from reputable economists.  Given the genesis of the Great Recession, commentators have become obsessed with stimulating demand, but “mere inflation” does not on its own put people back to work, at least not by much.

To be clear, if aggregate demand is on the verge of falling, and expansionary monetary policy maintains aggregate demand, that will indeed prevent a big increase in unemployment.  And typically that is very much worth doing, and most of all what is useful is an ex ante AD maintenance rule from the get-go.  But that does not mean inflation in any particular state of affairs will boost employment significantly.

Let’s go back in time to the 1970s and 1980s.  Bob Lucas developed a monetary misperceptions version of business cycle theory, in which boosts of inflation encouraged people to work more, at least temporarily, and set off a cyclical pattern of boom and bust.  Fortunately the Keynesians stepped in and criticized Lucas in a rather devastating manner.  The measured responsiveness of labor supply, or for that matter investment, to inflation, or for that matter relative price changes, simply wasn’t that large.  That also was a big problem with the core labor market mechanisms of real business cycle theory; for instance read the prescient critique by Larry Summers (pdf).  Those same arguments imply that today more inflation will boost employment by only small amounts.

And consistent with that claim, the Phillips Curve is not exactly stable as of late.

There are also plenty of papers on inflation and investment.  They are hard to summarize, but overall it is easier to argue that more inflation harms investment rather than helping it (pdf).  And at the most general level, it is real cash flow that predicts investment well, not nominal cash flow.  So I am not so optimistic about more inflation today boosting investment by very much, even though I agree that a higher price inflation or ngdp target in the steady state would be very useful for preventing aggregate demand collapses.

Now you might think we are in special circumstances with rates of price inflation at especially low levels.  What harm is there in risking more inflation and having prices rise at 2 percent, 2.5 percent, or even three percent a year?  I agree with this argument.  (I’d be happy to see higher rates of price inflation if only to erode the value of academic tenure.)  Still, if we ask ourselves what is the best point estimate for how much more an extra dose of inflation today will boost investment (and not just the stock market), any strongly positive answer is based more on faith than on clear evidence.  The mere fact that you know “demand hasn’t been high enough” — which is true — doesn’t have to mean current doses of price inflation are going to get us very far.  Yet that is the mistake I see people making again and again.

People, economists have known this for a long time, it’s just that they now are starting to forget it.

One more point: demand could go up through yet another mechanism.  Imagine the economy becomes more productive, wages rise, and stronger consumer demands percolate throughout the broader economy.  That too is an increase in demand, and for that matter supply, and a decline in the risk premium.  It is quite possible the effect of that kind of demand increase on output is stronger than the effects of higher price inflation.  We should not conflate these two scenarios, and I get nervous when I see the word “demand” without further qualifiers or description.

Here are related remarks from Matthew C. Klein.


'I’d be happy to see higher rates of price inflation if only to erode the value of academic tenure'

Lucky that you have another job, then, isn't it?

Excellent blogging.

Right now I would prefer Ben Bernanke's or Lord Adair Turner's money financed fiscal programs as a type of stimulus (money-financed tax cuts, not chopper drops) until demand gets to the level that it begins to pull inflation up. Then we know we are probably getting close to full capacity.

But it is not inflation that is desired, it is increased demand.

I am beginning to think that the clarity of money financed fiscal programs as monetary policy provides the much better platform then the current convoluted Rube Goldberg Federal Reserve Board with its interest on excess reserves, reverse repos, QE, and interest-rate drama.

This is a particularly ugly comment by Klein the the linked article when referring to countries that keep their currency "undervalued";

"Countries following this approach are leeches, siphoning scarce spending power from the rest of the world because they think any reduction in their already-large surpluses would reflect poorly on their national character, or “competitiveness”, or something."

This is a good example of bad economic thinking which you see commonly in financial journalists. Its just another form of protectionism. Sweden is providing goods and services at lower prices than they would otherwise to other countries - but that is seen as "leeching" their "spending power". I guess that nice restaurant serving cheap food needs to be condemned for "leeching" my "spending power". The purpose of work is not to work, it is to generate funds to spend to be able to consume. Far from leeching spending power, Sweden is increasing the spending power of countries that it exports to. The people being damaged here are not the countries that receive the cheaper exports, but the Swedish people whose pay is worth less in foreign currency and who therefore will consume less than otherwise.

Please shout this from the rooftops. Surplus that accumulates to the consumer is too often treated as worthless in discussions about trade.

Reading your quote, I wonder if he's trolling. That said, mercantilism seems to work to make a country richer, empirically. Since so much dollar savings is overseas, I wonder if targeting a higher inflation rate, like say 5%, would be a net benefit for the United States. The FED could deal with the ZLB by systematically pushing longer term treasuries to 0%, sort of like quantitative easing, but first targeting 2 months, than 3 months, than successively longer terms and pushing them to zero. This would help the federal government control it's debt risk because it could borrow at longer terms for very little. It would also disincentivise overseas central banks from currency manipulation (which I think is entirely legitimate), weaken the mercantilism strategy, and help bring the trade deficit into balance.

Yup. Economists get themselves all tangled up here, but printing money/devaluing the currency reduces consumers' purchasing power in the devaluing country for any import and increases purchasing power of consumers in every other country for products exported from the devaluing country. Pretty simple, really, and not some kind of skulduggery on the part of the devaluing country.

If other countries don't like it, they can print more of their own currency. The upside of "worldwide QE" is bolstering of AD. The potential downside is inflation (not any of your fantasy bubbles, bubbleheads). Is anyone anywhere in the developed world worried about inflation right now? Didn't think so. Keep printing money then, until you see inflation becoming a problem.

I you want to distribute money to increase demand give it to people that don't invest, but spend, like 16 year old teens. ;-)

For the economically ignorant like me, could you explain this thing called "Debt", and what it does to demand? And what writing off bad debts by the billions of dollars does to inflation?

I offer you a counter example. Since the beginning of last year ECB has been doing monetary stimulus via quantitative easing (buying mostly government bonds and hence printing new money).

The effect has been:
- practically no change in inflation (though downward trend has stopped)
- NGDP growth is up one percentage point year over year

The value of increasing aggregate demand in eurozone is extremely high.

Sounds like they need to do more then.

I saw a report recently about how Japan is basically retiring its debt much faster than expected thanks to the QE.

If all QE did was lower government debt without creating inflation, why not do it? And if it had some other spin offs, like increasing demand, that's even better.

Having had the pleasure of reading Münchau's columns in German, I cannot find anything sympathetic or competent in his writings.

" demand could go up through yet another mechanism. Imagine the economy becomes more productive, wages rise, and stronger consumer demands percolate throughout the broader economy. That too is an increase in demand, and for that matter supply, and a decline in the risk premium. It is quite possible the effect of that kind of demand increase on output is stronger than the effects of higher price inflation."

An increase in productivity is what really counts, not fiddling with interest rates, money printing and tax policy, as Hayek kept trying to explain.

Of course, inflation is a product of greater demand not the cause of it. I've asked this question before: can there exist "inflation" (i.e., a general increase in prices) absent an increase in wages (relative to increases in productivity)? I suppose the helicopter drop is meant to increase "wages" (relative to increases in productivity) so that "inflation" will result, and "inflation" will increase demand today because consumers will come to expect higher prices tomorrow and buy goods today. Psychology (or is it voodoo) masquerading as economics. Cowen: "Given the genesis of the Great Recession, commentators have become obsessed with stimulating demand, . . . ." And I thought the genesis of the Great Recession was the financial collapse, not a collapse in demand. By "commentators [who] are obsessed with stimulating demand", Cowen likely means Paul Krugman. Indeed, it's Krugman who berates anyone whose remedy is something other than stimulating demand (via fiscal stimulus). On the other hand, fiscal stimulus is a euphemism for redistribution; or to put it succinctly, fiscal stimulus redistributes downward while monetary stimulus redistributes upward. If love means never having to say you are sorry, then inflation means never having to stimulate demand. Some have an irrational fear of love, while others have an irrational fear of inflation. A rational fear is another financial collapse, rational because history tells us so.

Trump horrified everyone by suggesting that the US debt be renegotiated. The ECB, Japan, the US Fed have been buying their own sovereign debt using names that suggest some grand scheme where the masters of illusion try desperately to not call it what it is.

That is the only tool left in the chest. All governments almost without exception are spending more than they collect. The economies are not responding as everyone expects, so obviously the answer is to do more.

Purposely increasing inflation is another in a long line of schemes where if we make everyone poorer we will all get rich. I suggest that the continued expressed desire and policy initiatives that are designed to tell everyone that a currency is not worth very much will eventually come to fruition with disastrous results. If there is anything that anyone has learned it is that in the economy, you know the thing made up of a very large numbers of transactions by individuals who each make decisions based on a whole series of factors, is that there is a serious amount of hysteresis or resistance to change. But that when the change occurs it is sudden and seemingly unpredictable. So if the central banks manage to induce inflation, it will come as a result of their efforts to convince all those independent actors that the currency they use is not worth as much as it was yesterday.

In Canada due to currency devaluation I am seeing items that cost me $25 a year ago cost $40 now. These are not consumer items although the prices in of many consumption goods have increased by the same amounts. The money coming from Chinese socking away their assets somewhere out of reach of the Chinese Communist Party is providing the only bright spot in the economy. Otherwise it sucks.

"Purposely increasing inflation is another in a long line of schemes where if we make everyone poorer we will all get rich."

I disagree. A lot of dollar savings is overseas, much of that in foreign central banks that bought it to boost exports. They are not pursuing mercantilism because they want Americans to have more purchasing power, but because a mercantilist strategy for development correlates with growth stronger than that of contemporary peers: the United States in the late 19th and early 20th centuries, Germany and Japan in the mid-late 20th century and Germany now, Korea from the 60s to now, China from 1980 to now. It really seems to work.
If the United States allowed higher inflation, we could make it work for us. The value of federal debt would be eroded at the same rate as savings, and since so much of those savings are overseas, there would be a net gain to Americans. As it would erode the value of the mercantilism strategy, it would also cause foreign central banks to reduce purchases of US assets, and make US manufacturing more competitive.

At some point lots of people simply stopped drawing distinctions between demand collapse recession stimulus and stimulus from any arbitrary economic equilibrium. The erosion of this distinction entirely suits people who want nothing more in life than perpetual increases in public spending.

I have to wonder if the problem we're facing is one that can be addressed by stimulating demand (though efforts to do so should be done by allowing the consumers to act rather than feeding it through a lot of intermediaries where additional distortions and injection effects will be present). Then again I generally don't think money can really drive a real economy, only facilitate the underlying behavior in a more or less efficient manner.

Consider models of leverage boom-and-bust models as a description of recent troubles. A large group of debtors are denied any further borrowing but are told to reduce their (nominal) debts. They restrain their spending. The creditors get payments from the debtors doing deleveraging. But here is the Keynesian rub, the credits have a lower marginal propensity to save than the debtors, so deleveraging suppresses demand. The same works for households and businesses.

A surprise burst of inflation reduces the real value of debts, helping debtors but hurting creditors. It may seem like a wash, but on net, it would boost demand through redistribution. Inflation speeds up the deleveraging cycle.

None of that depends on any price stickiness, it only depends on debts being nominal rather than real.

It should work, although Lucas would observe that creditors will eventually wise up and demand higher nominal interest rates to compensate for no-longer-surprising inflation.

" Imagine the economy becomes more productive, wages rise, and stronger consumer demands percolate throughout the broader economy." << The modern problem is that, thru tech & capital investments, productivity per worker has increased -- but most of the benefit has gone to the owners of the capital and the bankers who financed the increased productivity.

This is why the big increase in income and wealth to the top 1%. With plenty of college educated folks feeling underemployed, there's no reason for companies to offer higher wages, even if they are getting higher profits.

A helicopter drop to wage earners will result in a big increase in their consumption, plus more savings/reduced borrowing. All pretty good, especially at the cost of 0% interest gov't bonds. The easiest way is a tax cut, however it's implemented -- one month of no withholding, for instance, with a 10% cut of prior years taxes paid as a this year tax reduction.

Why do the central banks keep doing monetary stimulus to help the rich get richer (buying bonds)? The rich like getting richer and the economists fail to support direct monetary stimulus to workers.

All taxes and gov't programs have distribution issues. I'm annoyed that so many economists have been supporting central bank action helping the rich much more than avg or median workers.

Imagine the economy becomes more productive, wages rise

Isn't that what's been happening over the last 40 years in the US? Compensation has been rising, but the vast majority of the gains are going to the upper quintile, and for the bottom 80% the rise in "compensation" is disproportionately in the form of health insurance.

It's a sad state of affairs for this blog that this post doesn't have 200 comments, but only 20 at the moment. Instead, something about Obamacare or Trump or gun control will get more comments. And a post on better IP? Forget it. You might have to start off by explaining to the uninterested reader than IP means Intellectual Property. Yet, the public flocks to the latest Broadway musical Hamilton, without understanding what he stood for.

Bonus trivia: NY rival to Hamilton, A. Burr, was vice president to T. Jefferson, and narrowly avoided being elected to president in 1800.

Perhaps I'm wrong, but the mechanism inflation --> higher demand is at the heart of New Keynesian policy prescriptions, about the efficacy of fiscal policy. Perhaps this fact is why earlier evidence is not being considered: "This mechanism simply has to be correct, since it is built into the model we all agree must be approximately correct."

Mikko Särelä (above) is correct. The gov't is printing money. And that's not helping.

Giving €10,000 per citizen over five years is a tax cut. And much of that tax cut would get spent.
But a tax cut isn't by definition, inflation. Those words have different meanings.

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