GAUTI B. EGGERTSSON - The Deflation Bias and Committing to Being Irresponsible

"I model deflation, at zero nominal interest rate, in a microfounded general equilibrium model. I show that one can analyze deflation as a credibility problem if three conditions are satisfied. First: The government’s only policy instrument is increasing the money supply by open market operations in short-term bonds. Second: The economy is subject to large negative demand shocks. Third: The government cannot commit to future policy. I call the credibility problem that arises under these conditions the deflation bias. I propose several policies to solve it. They all involve printing money or issuing nominal debt. In addition they require cutting taxes, buying real assets such as stocks, or purchasing foreign exchange. The government “credibly commits to being irresponsible” by pursuing these policies. It commits to higher money supply in the future so that the private sector expects inflation instead of deflation. This is optimal since it curbs deflation and increases output by lowering the real rate of return."

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"Can the government lose control over the general price level so that no matter how much money it prints, it’s actions have no effect on inflation or output? Economists have debated this question ever since Keynes’ General Theory. Keynes answered yes, Friedman and the monetarists said no. Keynes argued that increasing the money supply has no effect at low nominal interest rates. This has been coined as the liquidity trap. The zero short-term nominal interest rate in Japan today, together with the lowest short-term interest rate in the U.S. in 45 years in 2003, makes this old question interesting again, since the Bank of Japan (BOJ) cannot lower interest rates below zero. The BOJ has nearly doubled the monetary base over the past 5 years, yet the economy still suffers deflation, and growth is stagnant.1 Was Keynes right? Is increasing money supply ineffective when the interest rate is zero? This paper revisits this classic question using a microfounded intertemporal general equilibrium model and assuming rational expectations. The results suggest that both the Keynesian and the monetarist view can be supported under different assumptions about policy expectations. The paper has three key results..."

Source: http://www.newyorkfed.org/research/economists/eggertsson/JMCBpaper.pdf