The stagnation regime of the new keynesian model and current US policy George Evans

1. The stagnation regime of the new keynesian model and current US policy George Evans Discussion Frank Smets Asset prices, credit and macroeconomic policies Marseilles 25-26 March 2011 The opinions expressed are our own and not necessarily those of the ECB, the Eurosystem or the NBB.

2. Introduction • Builds on previous work with Honkapohja and Guse, which investigates which policies can avoid an unstable deflationary spiral, which arises in a standard New Keynesian model with active monetary policy and passive fiscal policy, a zero lower bound on interest rates and adaptive learning by the private agents. • Proposed policy: • A combination of aggressive lowering of interest rates to zero when a minimum inflation rate is reached and expansionary government spending.

3. Introduction Evans, Guse and Honkapohja (2008)

4. Introduction Evans, Guse and Honkapohja (2008)

5. Introduction • What’s new? • The inclusion of downward nominal wage/price rigidity. This explains why the economy may get stuck at a low inflation equilibrium, rather than trapped in a deflationary spiral (e.g. Japan) • A discussion of current US policies to avoid the deflationary trap • Proposal: • Aid to local municipalities and states to avoid countercyclical fiscal policy in return for setting up rainy-day funds. • Large-scale public infrastructure works financed by low interest rate bonds and central bank QE.

6. Introduction Evans (2010)

7. Comments on proposals • The world has moved on in the meantime: • QE2: assessment of effectiveness of QE2 has been quite positive (e.g. Krishnamurthy and Vissing-Jorgensen (2011)) • Unemployment is falling; inflation started rising; government debt is accumulating. • But many elements of the proposal make a lot of sense: • Importance of automatic stabilisers (US vs EU); • Rainy-day funds and the SGP; • Focus on productive government investment (but lags are long and efficiency may be affected).

8. Comments/questions • How large has been the risk of a deflationary spiral? • What is the evidence of downward nominal wage rigidity? • Can the policy recommendation be described as a switch from a combination of active monetary and passive fiscal policy to the reverse? • Fiscal space and government default risk? • What about a price-level targeting policy?

9. Inflation expectations: US vs euro area 5-year spot 5-year forwards 5 years ahead

10. Sharp rise in unemployment, but …

11. Wage inflation has not responded much

12. Survey evidence of downward nominal wage rigidity in the euro area Note: The surveys were conducted in the context of the ESCB Wage Dynamics Network (WDN). See http://www.ecb.europa.eu/home/html/researcher_wdn.en.html for the main findiings of the WDN and details of the surveys conducted. The original survey was conducted mostly druing 2007. The follow-up survey was conducted mostly in the beginning of 2009. 12

13. Fiscal theory of the price level • Can the policy recommendation be described as a switch from a combination of active monetary and passive fiscal policy to the reverse? • How large would the necessary fiscal expansion be in that case? There is a need for realistic quantitative versions of these models.

14. Sovereign CDS spreads (5-year in bp) 7 Source: Datastream

15. Euro area countries: rapid budget deterioration Source: European Commission Forecast (Spring 2010).

16. Euro area countries: rapid rise in gross government debt Source: European Commission Forecast (Spring 2010).

17. Price level targeting • Is in my view too easily dismissed in the paper. • How does it change the stability analysis of the New Keynesian model? • If a credible price level targeting regime is established beforehand, then the learning rules will adapt, which in turn will stabilise the economy; much larger expectational shocks will then be needed to get trapped in the deflationary equilibrium. • Probably need long-horizon learning to analyse this properly. • Needs to be symmetric.

18. End