Tumblr Icon RSS Icon

€conomia, The Game Of Terrible Monetary Policy

Posted on

"€conomia, The Game Of Terrible Monetary Policy"


google plus icon

The good people at the European Central Bank have a game on their website called €conomia that I would really encourage anyone who reports on economic policy to play around with for a while. The game embeds a number of assumptions I would disagree with, but that seem telling. Short-term interest rates are your only policy tool. And their view of the transmission mechanism seems to be that inflation in QN is jointly determined by the change in inflation rate between QN-1 and QN-2 and the level of real output growth in QN-1. But a change in interest rates affects output immediately. So if the inflation rate is rising, whether because of demand-side or supply-side factors, the only way to prevent it from spiraling out of control is to raise rates enough to reduce real output. If inflation is plugging along at your target level, then bad weather causes crop failures and food prices go up and output goes down, you need to raise interest rates. If you don’t raise rates, then what happens is that inflation momentum pushes inflation up further in the next quarter and then the hit to output fades away which further increases inflation. Then since there’s even more inflation built into the system, you need to undertake a bigger rate hike down the road to drive output growth down enough to get inflation under control.

Long story short, the only responsible thing to do is to prophylactically raise rates in the face of adverse supply shocks. It shouldn’t stun us that this is what the game says, since it’s how the ECB behaves in practice. But the consequences have been disastrous in practice and I’m not sure what theoretical support they think they have for this view of how the world works.

The other thing, of course, is that they grade you on the basis of a pure inflation targeting regime asymmetrically centered at 2 percent. I played a round in which inflation averaged -0.25% and we had a continent-wide depression in which output fell for twelve straight quarters. They gave me 2 stars out of four. I also ran a game in which inflation average 4.16% and we had zero quarters of recession. They gave me zero stars even though in the higher inflation scenario I was closer to the 2% target!

That’s the ECB’s view of the world. Output doesn’t matter. Unemployment doesn’t matter. Having inflation close to 2 percent matters a little. But it matters more to be below 2% than to be close to the target. If forced to choose between full employment and 4.16% inflation and a years-long deflationary recession, choose the recession.

« »

By clicking and submitting a comment I acknowledge the ThinkProgress Privacy Policy and agree to the ThinkProgress Terms of Use. I understand that my comments are also being governed by Facebook, Yahoo, AOL, or Hotmail’s Terms of Use and Privacy Policies as applicable, which can be found here.