Wednesday, March 17, 2010

Zero Bound Smackdown II

Paul Krugman, Janet Yellen, and other observers who still think that zero bound on the policy interest rate is a binding constraint for monetary policy should take a look at Josh Hendrickson's latest post. There, he provides a thoughtful discussion of why the zero bound constraint is nothing more than an artifact of simplifying assumptions made in the baseline New Keynesian model.

Update I: Paul Krugman in a recent post concedes that the zero bound is not binding in theory, but is in practice since unconventional monetary policy is never pursued with enough vigor to make it fully effective. Fine, but why not then use his bully pulpit to encourage central bankers to fully utilize unconventional monetary policy?

Update II: I like Ryan Avent's response to the Krugman post mentioned above:
Now, the Fed might easily have done more, and as Mr Krugman notes... But the fact that central bankers haven't done more isn't necessarily an indication that they're unable to do more, or lacking the courage to do more. They might just think that more isn't necessary. Ben Bernanke has said pretty explicitly that additional easing would have created an inflation threat. And while both Mr Krugman and I believe that additional expansion is necessary, fed funds markets appear to expect at least one rate increase by the end of the year. Given Mr Bernanke's Depression scholarship and his comments through the recession, I believe you can't ignore the possibility that the Fed eased precisely as much as it wanted to. I honestly don't think that the Fed would be cutting rates now if it had room to cut rates. If the Fed has policy where it wants it, it's not in a liquidity trap. And it may well react to additional sources of stimulus by offsetting them.

1 comment:

  1. It seems to me that a McCallum type monetary rule could handle zero bound interest rate with flying colors, particularly if the rule used got a good handle on changes in the velocity of money.
    http://en.wikipedia.org/wiki/McCallum_rule

    What's needed is for someone to run some simulations on how well such a rule would have handled The Great Recession.

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