Matt Nolan

On “currency wars”

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We keep hearing concerns about “currency wars” around the wold, with the blame being put on Quantitative Easing.  In fact our Reserve Bank even came out to complain about QE.

But to be honest, this argument is nonsensical unless you are explicitly forecasting “monetary policy failure” overseas.

Lets go back to Essays on the Great Depression by Ben Bernanke – when talking about countries depreciating by rolling off the gold standard:

Depreciation, in this context, should not necessarily be thought of as a “beggar thy neighbor” policy; because depreciations reduced constraints on the growth of world money supplies, they may have conferred benefits abroad as well as at home.

With interest rates stuck at the zero lower bound, and a sharp contraction in lending across the world, the fact that QE lead to devaluation in the US currency should not be seen as a bad thing.

QE is, in essence, aiming to lower interest rates within the US economy in order to bring forward spending and investment – to stimulate “aggregate demand”.  Why did we not get similar arguments from people whenever the US cut interest rates prior to the crisis … as it is essentially the same thing.

Instead of getting annoyed at the high currency, lets ask what it is telling us about monetary and economic conditions here – instead of assuming that the value of the dollar is “wrong”, and asking for arbitrary organisations to “do something” lets use it like any other price, and try to understand what it is telling us.

Matt Nolan

Interpretation and the model

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Following the Jackson Hole speeches there was this post over at Uneasy Money.  The money section for me is:

The reductions in long-term interest rates reflect not the success of QE, but its failure. Why was QE a failure? Because the only way in which QE could have provided an economic stimulus was by increasing total spending (nominal GDP) which would have meant rising prices that would have called forth an increase in output. The combination of rising prices and rising output would have caused expected real yields and expected inflation to rise, thereby driving nominal interest rates up, not down. The success of QE would have been measured by the extent to which it would have produced rising, not falling, interest rates.

Now this is an interesting quotation for me.  There is one thing I think I know – and that is that market interest rates are very hard to interpret, given the number of different things they are representing!

This quote argues with the simplified standard economic model that is put out there.  In that model, when there is an output gap central banks aim to get the realise real interest rate below its “natural level”, taking from this paper we have:

Thus, the mechanism through which monetary policy influences aggregate demand can be thought of as working as follows: Given the sluggish adjustment of prices, by varying the short-term nominal interest rate, the central bank is able to influence the short-term real interest rate and, hence, the corresponding real interest rate gap. Through its current and expected future policy settings, the central bank is able to affect the corresponding path of [the short term real interest rate gap] and, in turn, influence the long-term real rate gap … and the gap in Tobin’s q.

In this setting, monetary policy works by pushing down real interest rates (which happens by boosting inflation expectations and lowering the nominal interest rate) and by boosting aggregate asset prices.

But it is also true that if monetary policy “succeeds”, long term interest rates should be representative of the “natural” rate of real growth and inflation (as well as including factors for risk and time preference) … essentially the long term real interest rate is a constant.

From what I can tell, the afformentioned quote by Uneasy money relies on two things outside the basic model:

  1. A central bank sets expectations of nominal income growth, not inflation
  2. There are multiple equilibrium in the macroeconomy, making unemployment of the current sort the result of a failure in a co-ordination game.

However, if anyone has any more insight that can tie these view together, I would appreciate hearing it in the comments.

Matt Nolan

Interpreting information, markups, and the economic cycle

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Over at Worthwhile Canadian Initiative, Nick Rowe bemoans the fact that economists keep ignoring the “very short run”, and the transition from that to the short-run.  In the very short-run, we may view a shock (an increase in demand) and interpret as noise – it is only when the shock persists that we may respond.

This reminded me of tacit collusion.  Why … well why not!  In a paper by Green and Porter, discusses collusion and competition between firms with market power in a way that I’ve always found compelling.  Essentially a firm sits around doing what it does, and then it observes a drop in demand for its product.  The question it then has to answer is, “is this due to the other firm undercutting me, or has consumer demand for my product fallen?”.  Given that the firm does not know, under some conditions it will respond as if the drop in demand was due to a cut in prices by the competing firm – leading to a break down in any “tacit collusion” that existed before.  Weak demand therefore leads to price wars!

Now this isn’t the only explanation of price wars – in fact Rotemberg and Saloner showed the opposite.  In their model, there was a greater “prize from deviating”  when demand is high, and so times of high demand see collusion break down!

What does this mean for markups over the business cycle?  Well in the Green and Porter case, where this issue of interpreting information is a key driver of behaviour, markups are procyclical – in the Rotemberg Saloner model, markups are countercyclical.  Furthermore, there are many other models that aim to explain changes in the markup over the business cycle – it isn’t all about models of tacit collusion.

At an industry level, things differ – and so in different cases, the different models are supported empirically when looking at this as an industrial economics issue.  But what about over the economy as a whole, which one holds?  Generally it seems markups have been shown to be procyclical and to be countercyclical… while a fair amount of economic modeling often assumes countercyclical markups (in response to demand shocks).  This is an interesting area, very interesting.

Matt Nolan

The Dismal Science … on Sciblogs

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Eric Crampton over at Offsetting has managed to wrangle the NZ econblogger community some space over at Sciblogs.

I’m very impressed that Sciblogs has allowed this, and it shows that they recognise that their desire to add to the policy debate in NZ can be helped by having an economist feed loitering around.

Although I read all these NZ economics blogs already, it will be nice to have a summary of the more indepth stuff sitting around – go and have a look 😉