Monetary Policy for the Long Haul

Tim Fernholz brought to my attention Robert Reich’s argument that more aggressive monetary expansion won’t boost employment. I have a variety of objections to the details of what he says, which I think misdescribe the mechanisms, but the most important issue is that I think what he has in mind when he describes “easy money” and what proponents of monetary stimulus want to see are actually quite different.

Consider Paul Krugman’s 1998 paper on “Japan’s Trap” in which he constructs a rigorous model of a situation in which “the economy finds itself in a slump against which short-run monetary expansion, no matter how large, is ineffective.” Reich sees the United States as being in such a situation, and views proposals for monetary stimulus in terms of this kind of short-run expansion. But in the same paper, Krugman argued that there was a monetary solution to the problem:

If this stylized analysis bears any resemblance to the real problem facing Japan, the policy implications are radical. Structural reforms that raise the long-run growth rate (or relax non-price credit constraints) might alleviate the problem; so might deficit-financed government spending. But the simplest way out of the slump is to give the economy the inflationary expectations it needs. This means that the central bank must make a credible commitment to engage in what would in other contexts be regarded as irresponsible monetary policy — that is, convince the private sector that it will not reverse its current monetary expansion when prices begin to rise!

To try to rephrase this in a less-provocative (but hopefully more appealing to opinion leaders) way, here’s what needs to happen. Instead of saying “inflation is below two percent, so we need some expansion to bump it back up” we need the FOMC to say “inflation’s been running below two percent for a while now, so we’re going to try to bump it back up to four percent or so until we make up for all that lost ground.” That’s not the same as a one-shot injection of some cheap loans into the economy, it’s an effort to shift expectations about the trajectory of demand and therefore change present-day economic behavior.