Over at Worthwhile Canadian Initiative, Nick Rowe suggests that central banks should find something else to discuss instead of interest rates. The analogy provided is that of oligopoly competition: namely how the Cournot-Nash and Bertrand games have exceedingly different outcomes, even though the only superficial difference is that one game involves choosing output and the other game involves choosing price.
However, in the same way I don’t believe the difference in these games is just the product of “framing”, I am not sure if the call to arms against using interest rates as a focal point is necessarily that compelling.
On quantity and price competition
Back in the 19th century some economists called Cournot and Bertrand came up with separate models of firm oligopoly behaviour. In the Cournot model firms picked quantities, and they kept some market power – albeit less than in the monopoly case. In the Bertrand model firms picked prices – and we got this crazy result that merely having two firms in a market provided perfect competition.
As a result, economists became concerned. We had two models, one which seemed to fit data better (Cournot) and one which had assumptions we felt were more realistic (Bertrand). A multitude of ex-post imperfections could be introduced to a Bertrand game to create “supernormal profits”, such as heterogeneous goods, transaction costs, and imperfect information – but there was still the problem that, if we had only two firms competing and they decided to “play” in prices instead of quantities we had a different outcome. Given that the demand curve is the thing along which both price and quantity were picked, and given that the firms in both cases were seen as equivalent, this didn’t seem consistent.
Eventually economists realised that there was something else at play here. The Cournot and Bertrand firms were not equivalent at all.
In the Cournot game the question is: if I LIMIT myself to producing a quantity how will other firms react – and given that reaction what level of quantity would I want to limit myself to.
In the Bertrand game the question is: I have an unlimited ability to produce. As a result, if I set a price how will other firms react – and given that reaction what price would I charge for the produce I will be able to make.
So in the Cournot game you build things first, set the price later. In the Bertrand game you set your price and immediately satisfy this demand. As a result, economists realised that the Cournot game was simply a Bertrand game with capacity constraints.
What in the hell does this have to do with the point on monetary policy!
I was getting there. Fundamentally, in the same way that Cournot and Bertrand games were discovered to only give different results because they were fundamentally different, I believe that any difference between an interest rate target and other targets only differs if “effective policy” is different – I don’t believe in a framing issue persee (although framing explanations can be funky).
Now I don’t disagree with the idea that just talking about the nominal interest rate would be silly. But central banks don’t just talk about a nominal interest rate – they also discuss an inflation target, which anchors inflation expectations. In essence the current “focal point” for policy is the real interest rate.
Furthermore, since they control a real interest rate, and have anchored inflation expectations, they can print money which in turn increases demand for goods and services. As Nick states:
And most of the power of a central bank comes from its ability to influence people’s expectations of the future. Like governments, police, armies, and referees, most of central banks’ power comes from belief in their power
The fact that inflation expectations are anchored implies that people believe they know the future price level, given that a significant portion of any nominal increase in income will be confused for real income – leading to extra spending activity. That is the very power of an inflation target – an inflation target that is easy to communicate and explain to the public by discussing interest rates.
Targeting arbitrary variables that are positively related to an economic recovery, but not appropriately related to “monetary policy” seems both sort of aimless and potentially dangerous. A central bank can keep discussing interest rates and its inflation target, and even at a “zero bound” it could stimulate activity by printing, printing, and printing.
Finally, I think it is important to note that this subject only really matters in the rare occasion that it really matters . Outside of zero interest rates and a steep, depression like, drop in demand the interest rate (or some indicator of “monetary/financial” conditions) is an amazingly effective tool for communication.
However, my belief is that this effectiveness continues even in the extreme conditions.