tag:blogger.com,1999:blog-4039434.post7863079206822721679..comments2022-11-25T10:30:29.975-05:00Comments on Rajiv Sethi: Lessons from the Kocherlakota ControversyRajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.comBlogger34125tag:blogger.com,1999:blog-4039434.post-73590552923105934712014-05-28T10:43:08.103-04:002014-05-28T10:43:08.103-04:00People who don't agree can shout all they like...People who don't agree can shout all they like... the data universally supports this conclusion and neo-classical economists have to jump through contorted intellectual loops and spins to try and weave a tangled explanation as to why they are not wrong... Akum's Razor would suggest they are wrong both by the complexity of their arguments, and by the fervor of their objections.Macroboyhttps://www.blogger.com/profile/00942522663109806195noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-90098078046523364552010-10-01T18:58:18.458-04:002010-10-01T18:58:18.458-04:00Robert, I agree, and my comment was intended as an...Robert, I agree, and my comment was intended as an addendum and not a correction. I'm sorry if this was not sufficiently clear.Rajivhttps://www.blogger.com/profile/13667685126282705505noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-21958514175213170022010-10-01T15:33:31.208-04:002010-10-01T15:33:31.208-04:00Please note that I did not use the word "stab...Please note that I did not use the word "stable" in the quoted passage. Therefore your comment which notes that the monetary equilibrium is not stable is not a correction.Roberthttps://www.blogger.com/profile/14455788499385673507noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-81930312736483848922010-09-12T04:35:07.739-04:002010-09-12T04:35:07.739-04:00The fact is that both assumptions discussed in thi...The fact is that both assumptions discussed in this post do not match observations. The fed's rate has always been lagging behind inflation and thus has been a passenger not the driver. To argue about the capabilities of a driver not controlling the wheel is a profound topic, without real outcome, however. <br />The rate of price inflation has been driven by a different force and the approaching deflationary period had been predicted long before the FOMC downed the rate to the level between 0% and 0.25%. Hence, this action of the feds was also well foreseen five years ago (http://mechonomic.blogspot.com/2010/09/of-deflation-once-again.html).Ivan Kitovhttps://www.blogger.com/profile/16756147426052505832noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-37701893799059766112010-09-02T14:39:53.495-04:002010-09-02T14:39:53.495-04:00ok, thanks for your patience:)ok, thanks for your patience:)Adam Phttps://www.blogger.com/profile/16316584837610367439noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-20150654401725638312010-09-02T14:27:58.254-04:002010-09-02T14:27:58.254-04:00Adam of course you can have weaker and stronger no...Adam of course you can have weaker and stronger notions of equilibrium than Nash but they all involve restrictions on beliefs and need to be checked for stability under disequilrium dynamics, starting from states in which beliefs are not self-confirming. Sargent Evans Howitt all do this, most people don't.Rajivhttps://www.blogger.com/profile/13667685126282705505noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-5495073327625415752010-09-02T14:18:45.322-04:002010-09-02T14:18:45.322-04:00I'm asking, if Sargent's self-confirming e...I'm asking, if Sargent's self-confirming equilibria aren't equilibria then what are they?<br /><br />As I recall the whole point of these examples was that both the private sector and monetary authorities had mis-specified forcasting functions in such a way that they found an equilibrium where each other's behaviour confirmed the other's forecasting function and so neither ever learned the true model. (Or perhaps the misspecification was such that they couldn't learn the truth, like they used linear forcasting functions when the truth is non-linear).<br /><br />These agents would never find a Nash equilibrium but they did find states that Sargent called an equilibrium.Adam Phttps://www.blogger.com/profile/16316584837610367439noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-28480478272649554642010-09-02T14:00:23.907-04:002010-09-02T14:00:23.907-04:00yes, and aren't their other notions of equilib...yes, and aren't their other notions of equilibrium besides Nash's?Adam Phttps://www.blogger.com/profile/16316584837610367439noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-9454828884865796532010-09-02T13:49:08.265-04:002010-09-02T13:49:08.265-04:00Adam I'm on the road so this will be brief but...Adam I'm on the road so this will be brief but the REH is nothing more or less than Nash equilibrium.Rajivhttps://www.blogger.com/profile/13667685126282705505noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-44651641679663247992010-09-02T12:36:01.082-04:002010-09-02T12:36:01.082-04:00Rational expectations is part of the definition of...Rational expectations is part of the definition of equilibrium? Aren't we now ruling out any notion of equilibrium in many classes of models? Say those with bounded rationality or other behavioural models with less than rational agents?<br /><br />It's been a few year but I seem to recall in Sargent's conquest of inflation book that agents were boundedly rational, there were self-confirming equlibria where private agent beliefs were consistent with the monetary authority's beliefs but neither had beliefs consistent with the true data generating process. Hence the study of escape dynamics where eventually a large enough shock got you out of the self-confirming equilibrium. Was that not really an equilibrium? Would this model have any equilbra by your definition?<br /><br />And what about what gets taught to undergrads, they certainly use the term "equilibrium" to mean the intersection of the IS and LM curves or the intersection of AS and AD curves. In this context, with a static model, the word equilibrium means nothing other than clearing of all markets.<br /><br />Perhaps I've never properly understood but I always thought of rational expectations as a property of agents, not as part of the very definition of equilibrium.Adam Phttps://www.blogger.com/profile/16316584837610367439noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-89143071563163586952010-09-02T09:40:42.348-04:002010-09-02T09:40:42.348-04:00Adam, a fundamental feature of equilibrium (aside ...Adam, a fundamental feature of equilibrium (aside from those you mention) is consistent beliefs. Equilibrium paths need not be steady states, they can be transition paths to steady states, limit cycles, or even chaotic attractors (as in Grandmont, Econometrica 1985). But they satisfy consistent beliefs (or rational expectations) by definition. <br /><br />In this sense the Howitt model (and the Evans video posted by Mark) explored <i>disequilibrium</i> dynamics, while the model that Jesus sent me looks at <i>equilibrium</i> dynamics in response to a changed target inflation rate.<br /><br />Now here's the point: the convergence of an equilibrium path to a steady state tells us nothing about the stability of the path with respect to disequilibrium dynamics (what Evans calls adaptive learning). The path might converge to a steady state but will agents converge to the path if they start with inconsistent beliefs? Understanding this question, I believe, is key to the future development of macro. I don't know why there is so much confusion about it since Marcet/Sargent introduced least-squares learning to deal precisely with this issue and Evans and collaborators have been working on it for years.<br /><br />Please read my posts (linked above, before I mention Howitt) on disequilibrium dynamics and rational expectations. I would never confuse an equilibrium path with a steady state.Rajivhttps://www.blogger.com/profile/13667685126282705505noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-9231422764130247982010-09-02T04:47:32.328-04:002010-09-02T04:47:32.328-04:00Rajiv,
I don't mean to beat a dead horse her...Rajiv, <br /><br />I don't mean to beat a dead horse here but I think there's another sort of deeper question going on here.<br /><br />Does "equilibrium" really mean "steady-state equilibrium"? You use it that way when you talk about the transition to steady state as "disequilibrium dynamics". Clearly so does Kocherlakota, Williamson and friends.<br /><br />Seriously though, someone on one of the blogs made the analogy with the Solow Growth model, if you're on the saddle path but not at the steady state aren't you in equilibrium?<br /><br />This is mystifying me a bit, my understanding of equilibrium is just that markets clear, everyone optimizes and nobody violates a constraint. Thus, "dis-equilibrium" is something you'd never really see. If a price is too high to sell all the stock of some good then we'd say the seller of the good still holds hit, the market has "cleared" in the sense that everything is held by someone and no constraint is violated. <br /><br />As to why the price didn't fall to sell all stock you'd say that either a constraint prevented or the vendor made a decision that holding it in inventory was preferred to selling at a lower price.<br /><br />The point here is that the Howitt thought expirement of the fed shifting to a lower steady-state nominal rate doesn't seem to lead to any instabilty if you allow for equilibrium paths that aren't in steady-state.<br /><br />The manner in which the Fed tries to shift to a lower steady-state nominal rate would not be to simply lower today's nominal rate and hope expectations coordinate on lower inflation, that is not how the Taylor rule models work (and if you're thinking John Cochrane here I think he has it wrong).<br /><br />If the fed shifts to a lower steady-state nominal rate it does so by setting a lower inflation target then, if inflation doesn't move immediately to the new steady state rate the fed *increases* the current nominal rate by enough to raise the real rate, output and inflation fall and we move towards the steady state.Adam Phttps://www.blogger.com/profile/16316584837610367439noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-83427022970195924702010-08-31T12:55:17.801-04:002010-08-31T12:55:17.801-04:00"Would you agree that under the assumptions o..."Would you agree that under the assumptions of the model, starting from a steady state, a lower target inflation rate requires a lowering of the nominal interest rate? "<br /><br />I'm tempted to say no, that a lower inflation target implies that the nominal rate must increase until inflation falls. However, I don't think that's what this model says. <br /><br />I think you're correct that in the model a lower inflation target implies that inflation falls instantly to the new value (because otherwise the Fed threatens to tighten and the threat is believed) and if the Fed fails to lower the nominal rate immediately then actually the real rate ends up too high and inflation falls further. So a lower inflation target should require a lowering of the nominal rate. (The Woodford/Curdia papers had some impulse responses under differing policy rules that, in a different context, I think made this point more starkly then the standard NK off-equilibrium threats to pin down equilibrium paths.)<br /><br />Is this a disconnect with reality? It depends on whether it's prices or inflation that is sticky and people are usually pretty loose on this. The model, to my understanding, says prices are sticky and inflation is not. The data tends to say inflation is very persistent (on average) but then it sometimes has been observed changing abruptly to policy changes (thinking Sargent's 4 big inflations here).<br /><br />So I guess the conclusion is that I'm not ready to give an opinion on the second point. But you're right, it is the more interesting question.Adam Phttps://www.blogger.com/profile/16316584837610367439noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-14921119467788547872010-08-31T11:28:03.031-04:002010-08-31T11:28:03.031-04:00Adam, there are two separate (but related) issues ...Adam, there are two separate (but related) issues here: (i) does the model have any bearing on the validity of Narayana's claim, and (ii) are the predictions of the model robust? <br /><br />Regarding the first point, I'm inclined to agree with you since we are obviously not in a steady state. It's possible that Narayana had something like this in mind when he made the claim but as you say, the model is actually silent on this. However, I should note that Jesus thinks it is relevant because he has in mind a "virtual" nominal rate, currently negative, so "raising" this virtual rate to make it less negative involves no change in the actual rate. <br /><br />But it's the second point that I find more interesting because it shows just how different RE predictions are relative to the old monetarism, and raises important questions about robustness. Would you agree that under the assumptions of the model, starting from a steady state, a lower target inflation rate requires a lowering of the nominal interest rate? If so, this would come as a big surprise to the likes of Friedman or Volcker. So who is right in this case and why? I think this is a more important question right now than whether or not Narayana's claim is coherent. (But you're right, I should not have said that the model establishes the coherence of his claim, it does not really do this.)Rajivhttps://www.blogger.com/profile/13667685126282705505noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-81223201259206178762010-08-31T09:14:46.317-04:002010-08-31T09:14:46.317-04:00Rajiv, thanks for the response. I've only jus...Rajiv, thanks for the response. I've only just now scanned it but still, I think Jesus's counter-example somewhat misses the point.<br /><br />As you say, R_target pins down pi_target (inflation target), lowering R_target is equivalent to lowering pi_target.<br /><br />This brings up 2 things:<br /><br />1) (I know you've already said you agree with this but it is relevant to whether Kocherlakota is saying something even a bit sensible.) Is lowering of R_target really what's happening right now? Clearly not. FFR is low because pi is persistently below target and the output gap is huge. Yet Kocherlakota seems to be inerpreting it that way.<br /><br />2) What Kocherlakota advocates, as a change to the policy rule, is for FFR to be raised before pi has risen up close to pi_target. That is, he wants the Fed to raise earlier than the current policy rule would stipulate. This is equivalent lowering pi_target, just as Jesus interprets it, but that constitutes an increase in the prevailing real interest rate *today* and as such the policy rule change that Kocherlakota is advocating for is a tightening. That's just crazy and, most importantly, that would make the deflation worse. This sort of change to the policy rule would not mitigate the deflation.<br /><br />Again, I understand that neither you nor Jesus is defending Kocherlakota here but nonetheless, what he said does not have a sound theoretical basis (or at least Jesus is not providing one). Kocherlakota directly implied that this sort of change to the policy rule would help *avoid* a prolonged defltation. This is manifestly not what NK models would say.Adam Phttps://www.blogger.com/profile/16316584837610367439noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-73400187696198801512010-08-31T08:41:46.771-04:002010-08-31T08:41:46.771-04:00Adam, continuing on from my last message, Jesus se...Adam, continuing on from my last message, Jesus sent me simulation results for a particular specification of the model. I don't want to post his figures without permission, but here is what they show:<br /><br />Begin Quote<br /><br />To illustrate this point, I have a dynare code, changing_target.mod, where I do the following:<br /><br />1) As I was mentioning before, I take a basic NK model with Calvo pricing and capital. It is a relatively simple model because I do not have habit persistence and investment adjustment costs. On the other hand, I introduce quite a bit of nominal rigidities (the calvo parameter is 0.75, implying an average duration of prices of around 1 year, quite more than the micro evidence).<br /><br />2) I make R_target_t, instead of being a fixed value, a changing variable (and with it, the inflation target). The idea is that, by doing so, I can explore what are the effects of a change in the target FFR. Ideally, it would be great to specify a change once and for all of the target FFR. However, it will take me quite a bit of time because it implies a non-stationarity of the problem and I wanted to get a quick answer.<br /><br />Instead, I assume that it follows an AR(1) in logs:<br /><br />log(Rtarget) = (1-rrhotarget)*0.01+rrhotarget*log(Rtarget(-1))-0.01*etarget;<br /><br />where rrhotarget= 0.9999999<br /><br />that is, as close as 1 as I can before the code breaks down. The idea is that we have today a shock that lowers the target FFR and that shock stays with us (nearly) for ever. While I recognize that, sometimes, there are subtle converge problems when we go from 0.9999999 to 1, I do not think this is the case here.<br /><br />Note that also, the shock to the Rtarget is multiplied by -0.01 (the minus is just to generate a shock that lowers the target FFR and 0.01 is scaling it so it is not too big, we want to avoid being thrown into Rtargets less than 1, which are not feasible).<br /><br />The fact that, in my specification, agents believe that other shocks can come in the future to the target FFR is not terribly important because we are linearizing and hence, the variances of future shocks do not enter into the current decision rules of agents at time t. Also, I checked that in a non-linear second order approximation these effects are nearly zero...<br /><br />In summary, by tracing down the Impulse-Response functions (IRFs) of the economy to a shock etarget of standard deviation 1 (scales by -0.01) which lowers the target FFR (nearly) for ever, we can answer the question of causality in a well-defined (and rather standard) way.<br /><br />What happens after this change in the target FFR by the central bank?<br /><br />The IFRs are included in the file irf_target.pdf. Look at the bottom panel on the right: it shows the drop in the FFR target. Then, you can see, right on top, ppi (inflation) going down. The interesting thing is that in panel (3,2), the FFR goes down less than R_target_t at impact. This is the equilibrium stability showing herself up.<br /><br />Again, let me emphasize that this is a well defined experiment: we wake up, the FED decides to lower the FFR target, this lowers inflation in a causal way and we do not lose stability.<br /><br />How can this happen? I think that part of the confusion on the discussion is that all these New Keynesian models assume Rational Expectations. When the FED changes its target FFR, everyone knows it (and everyone knows that everyone knows it and so on) and we just jump directly into the new equilibrium path (in my model it is a bit more subtle because agents know there is a distribution of probabilities on this happening, but let's forget about that) because everyone immediately readjust their behavior to the new policy regime (except firms that cannot adjust their prices, they would wait until it is their turn to update them). <br /><br />End QuoteRajivhttps://www.blogger.com/profile/13667685126282705505noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-72485211317735094942010-08-31T08:39:16.784-04:002010-08-31T08:39:16.784-04:00Adam, thanks for the comments, it's important ...Adam, thanks for the comments, it's important to get all this straightened out. I don't have a link to the model the Jesus sent me but will quote from his email below. Before I do that, let me say a couple of things. First, as you suspected, the analysis starts with a steady state and asks what should be done to move to a steady state with lower inflation. In particular, should nominal rates be raised or lowered in the short run. I agree with you that this is not relevant to current policy, but it has a bearing on the theoretical debates that Kocherlakota's sppech triggered. Second, Jesus want is made clear that he is not endorsing an increase in rates sooner rather than later, he just wanted to clarify some theoretical issues. <br /><br />Now for the model. I quote directly from Jesus' email.<br /><br />Begin Quote:<br /><br />1) Take a basic NK model with Calvo pricing and capital, something like Mike Woodford would write.<br /><br />2) Specify a Taylor rule of the form:<br /><br />FFR/R_target_t = (inflation/inflation_target_t)^gamma*exp(m)<br /><br />where FFR is the federal funds rate, R_target_t is the target FFR (with an index t because we let it change) and m is a monetary shock. Gamma>1 ensures stability of the model.<br /><br />Remember that, in a Taylor rule world in general equilibrium, the central bank can pick either R_target or inflation_target, but not both. Once one of them is picked, the other needs to satisfy:<br /><br />beta*R_target_t = inflation_target_t<br /><br />(subject of course to the Zero Lower Bound that prevents us to set a R_target below 1).<br /><br />3) Then, you can rewrite the Taylor rule as:<br /><br />FFR = R_target_t * (inflation/inflation_target_t)^gamma*exp(m)<br /><br />4) Substitute beta*R_target_t = inflation_target_t<br /><br />Then, we get:<br /><br />FFR = R_target_t * (inflation/beta*R_target_t )^gamma*exp(m)<br /><br />and rearrange terms:<br /><br />FFR = ((1/beta)^gamma) *(R_target_t^(1-gamma)) * (inflation^gamma)*exp(m)<br /><br />What happens if there is a shock to R_target_t? for example, if R_target_t falls?<br /><br />Well, given a level of inflation, since (R_target_t^(1-gamma)) is bigger than before (R_target_t is smaller and gamma>1). That is, the monetary authority responds by raising the FFR in this period. As inflation goes down because the FFR is higher, we get closer to the R_target_t. This increase in the FFR ensures that the equilibrium is stable.<br /><br />End Quote<br /><br />Continued in next message...Rajivhttps://www.blogger.com/profile/13667685126282705505noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-87564935484051234282010-08-31T05:57:20.743-04:002010-08-31T05:57:20.743-04:00Rajiv, just to follow up. If the Fed changes the ...Rajiv, just to follow up. If the Fed changes the Taylor Rule to lower the current fed funds rate then in a situation where current inflation is below target (like now) then expected inflation, in no case, will fall.<br /><br />Either the fed has *raised* the inflation target and thus lowered the nominal rate because we're no further from target, in which case expected inflation rises.<br /><br />Or, the fed has made the coefficient on (inflation - target) higher in which case expected inflation shouldn't change. (If it does change it increases as we get back to target sooner).Adam Phttps://www.blogger.com/profile/16316584837610367439noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-79502318150561106932010-08-31T01:57:38.941-04:002010-08-31T01:57:38.941-04:00Rajiv, do you have a reference to a paper that sho...Rajiv, do you have a reference to a paper that shows RE to justify what Kocherlakota said? The argument as you've stated it doesn't seem right in the statndard NK type models.<br /><br />When you say "Suppose the Fed decides to change the Taylor Rule in such a manner as to result in a lower target nominal rate" I take it you mean the "target nominal rate" to be the one that will prevail in the steady state? So then basically you just refer to lowering the inflation target?<br /><br />If that's the case then the response of inflation depends on whether or not we start in the steady state. If we are in the steady state when the policy rule is changed then yes inflation falls immediately. If target inflation is being reduced from 2% to 1% and current inflation is 1% then inflation doesn't change but yes the nominal rate is increased by the Fed.<br /><br />If target inflation is reduced from 2% to 1% and current inflation is 0% then neither inflation nor the nominal rate changes today, the Fed simply stands ready to raise the short earlier than under the old policy rule. <br /><br />This last case seems to best describe what Kocherlakota has in mind but he is still wrong. He is advocating for the policy shift that stands ready to raise the nominal rate earlier but seems to think it constitutes an increase in the target inflation rate, it helps avoid a deflationary steady state.<br /><br />RE doesn't save him here, in no RE model does the Fed raising nominal rates from 0% to 10% cause todays expected inflation to go to 8% or higher (if the natural real rate is negative).Adam Phttps://www.blogger.com/profile/16316584837610367439noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-17503666004385844042010-08-30T12:51:12.851-04:002010-08-30T12:51:12.851-04:00Hi Nick,
I'm sorry to have scattered my comm...Hi Nick, <br /><br />I'm sorry to have scattered my comments all over the place, I've actually been following you and Andy around.<br /><br />I think that you're right to highlight the importance of considering out-of-equilibrium beliefs. An upward nominal interest rate surprise, if interpreted in an optimistic manner by enough people, could indeed be expansionary. <br /><br />In the simple RE model that I've been describing, the policy instrument (by your definition) is the Taylor Rule itself. This is assumed to be chosen freely by the bank and common knowledge. There is no explicit consideration of out-of-equilibrium beliefs but the implicit assumption is that beliefs about the rule are insensitive to observation. That is, the beliefs would be maintained even if the data were found to be inconsistent with these beliefs. But, of course, on the equilibrium path this never occurs.Rajivhttps://www.blogger.com/profile/13667685126282705505noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-6427633289481785032010-08-30T12:21:54.147-04:002010-08-30T12:21:54.147-04:00Rajiv: but in that thought experiment, what is the...Rajiv: but in that thought experiment, what is the (exogenous) policy instrument? And what does "policy instrument" mean?<br /><br />I interpret "policy instrument" to mean that variable which is assumed fixed, and is assumed to be expected by the agents in the model to be held fixed, even at points off the equilibrium path, that are not observed in equilibrium. An outside observer, who observed only the equilibrium path, could not tell which variable is the exogenous policy instrument.<br /><br />Right now, given the way people think of monetary policy as a path for the nominal interest rate, and how the Fed communicates its policy as a time-path for the policy instrument, we can't expect raising the interest rate to be associated with raising actual and expected inflation. Because people would interpret it as a tightening of monetary policy.<br /><br />Now, change the way the Fed communicates policy, and how people interpret policy, and I think it is perfectly possible for a loosening of monetary policy to be consistent with rising nominal interest rates, even immediately.<br /><br />(And, I think that this is what's really going on in Jesus' models. He has (implicitly) switched the instrument and communications strategy.)<br /><br />It's all to do with the Game-theoretic idea that expectations of players' actions off the equilibrium path matter, even though they are not observed.<br /><br />I think this stuff is very important. If we understood it, we could easily escape the zero lower bound. It's what I've been trying to say for some time.<br /><br />I've been chasing you across Mark Thoma's and Brad DeLong's blogs, making essentially this point.Nick Rowehttps://www.blogger.com/profile/04982579343160429422noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-70156814419017704772010-08-30T12:18:01.349-04:002010-08-30T12:18:01.349-04:00Andy, here's how the RE thought experiment wor...Andy, here's how the RE thought experiment works, as I understand it. Suppose the Fed decides to change the Taylor Rule in such a manner as to result in a lower target nominal rate. Suppose that it is common knowledge that this change has been made and that it is permanent. Then nominal rates fall right away, inflation falls by an even greater amount, real rates rise temporarily and then fall back as convergence to a new steady state with lower nominal interest rates is attained.<br /><br />There is no need in this scenario for a period of high nominal rates to lower inflation - in sharp contrast with the old monetarism.<br /><br />I don't believe that this is how the world works. I also have no way of knowing whether Naryana believes this model or whether he just misspoke. But I thought it important to communicate that there is a coherent (if empirically dubious) argument to support a literal reading of his words.<br /><br />Regarding your broader point, you're right that implicit in Narayana's argument is the view that there is genuine policy discretion at any point in time, and this kind of policy uncertainty is difficult (if not impossible) to absorb into the RE framework.Rajivhttps://www.blogger.com/profile/13667685126282705505noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-69142065331165428372010-08-30T11:13:27.453-04:002010-08-30T11:13:27.453-04:00Even if we are willing to suspend disbelief and ma...Even if we are willing to suspend disbelief and maintain the rational expectations assumption absolutely (and also exclude the non-monetary equilibrium), I don’t think the RE analysis makes any sense.<br /><br />As I understand it, the setup is something like this: The Fed follows a Taylor rule, for which it must choose parameters. Consider two alternative sets of parameters, one of which results in a maintained zero nominal rate and the other of which doesn't, and both of which result in a monetary equilibrium. The first rule, the one in which the zero nominal rate is maintained, will result in deflation. Since the Fed chooses the parameters of the Taylor rule, we can say that the Fed has, in the first case, chosen to keep the nominal rate at zero.<br /><br />But here's the problem: Rational expectations assumes that agents know beforehand (at least to an unbiased estimate) which rule the Fed is following. But it is implicit in Kocherlakota's argument that agents don't know beforehand which rule the Fed is following. He is talking about a choice that the Fed will have to make, say in 2011 or 2012, about whether to raise the nominal interest rate. He is considering what would happen if the Fed makes the wrong choice at that point in time. But if agents already know – before the Fed makes the choice – which rule the Fed is following, then it's meaningless to talk about the Fed's choice at that point in time. The Fed has already made the choice by committing to whatever Taylor rule agents believe it is following. If the Fed makes a choice different than what agents previously believed, that is a violation of rational expectations.<br /><br />So no matter how confidently one believes in RE, once can't use it to analyze an interest rate decision that takes place at a specific point in time. One can only use it to analyze policy rules. Kocherlakota worries about what will happen "if the FOMC hews too closely to conventional thinking." But surely conventional thinking does not require the FOMC to follow a rule that would result in a zero interest rate even when the equilibrium real rate rises above zero. If Kocherlakota thinks it does, I'd like to hear him specify the parameters of that rule. I very much doubt he can come up with a set of parameters that is plausibly consistent with "conventional thinking."Andy Harlesshttps://www.blogger.com/profile/17582263872850949568noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-45195822096081772602010-08-29T21:06:14.315-04:002010-08-29T21:06:14.315-04:00what is your opinion about Hysteresis (effects of ...what is your opinion about Hysteresis (effects of monetary in the long term o ver the product)?Obicekhttps://www.blogger.com/profile/14737743825805647400noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-66582066425166096862010-08-29T18:48:56.568-04:002010-08-29T18:48:56.568-04:00Robert, thanks, and yes, I agree completely. In fa...Robert, thanks, and yes, I agree completely. In fact, the <i>only</i> stable equilibrium in the Howitt model is the non-monetary one. And although he doesn't mention this, the dynamics in his model fit the case of the German hyperinflation quite well.Rajivhttps://www.blogger.com/profile/13667685126282705505noreply@blogger.com