image Andy Harless corrects Kocherlakota’s thinking on deflation. Andy has the story right though I’d like to walk through the results of the “pure model” perspective that Kocherlakota seems to be speaking from. There is nothing wrong with the basic reasoning, as I see it, its just how Kocherlakota employs it.

Kocherlakota suggests that the superneutrality of money implies that a low Fed Funds rate will lead to permanent deflation. This is true in a frictionless world with perfect information.

A permanently low funds rate combined with a constant real rate of return would imply deflation. It is also the case that the Fed choosing a permanently low funds rate would cause the deflation to come about. The question is: how do we get to deflation from here.

You actually wind up with what’s known as a bang-bang solution. That’s where the economy instantly jumps to a new equilibrium path. That is, everything we think we know suddenly changes and then works itself out from there. There is evidence of quasi-bang-bangs in real life. When the stock market suddenly crashes on a piece of bad news but the slowly creeps up from there, that’s essentially bang-bang.

With money and deflation what you’d have to be suggesting is that as soon as people realized that the Fed was committed to this path, prices on everything, not just stocks and bonds but everything, instantly jumped sky high.  So, high in fact that from there on out we would be set up for permanent deflation.

In the real world such an instant transition is not possible because there are frictions and uncertainty. What is possible is hyperinflation. Hyperinflation that would then leave the price level so high that deflation from then on out was the norm.

UPDATE: The stock market analogy seems to interest people so let me give you a specific example of a bang-bang that works how Kocherlakota is thinking.

Suppose, that you found out that the future of Ford Motor Company was way more uncertain than you thought. They are facing risks that no one saw until Erin Burnett pointed them out at 2pm on Wed. What happens?

Well one thing we know is that investors need to be compensated for risk. So that means the average return from holding Ford stock should rise. Ford is paying no dividend, however, so that return must come in the form of greater capital gains.

Huh? You are telling me that finding out that the fact Ford is facing a bunch of risks will raise the expected capital gain?

It sure will.

Or at least it will from 2:10 pm onward. From 2pm (the moment we find out) until 2:10pm what we will see is a disastrous crash in Ford stock price. So disastrous that from there on out the expected gains will be higher than they were before.

That’s bang-bang and it can work out so smoothly because there is an actual formal market in Ford stock which clears out most of the frictions. In the world of normal goods and prices such smooth transitions are not possible.

The thought experiment in more detail.

About these ads