Thursday, 16 July 2015

Expectations and the Infinite Future

Neo-Fisherism is on the blogs again (e.g. Noah SmithJohn Cochrane and Nick Rowe).  This is the idea that if the monetary authority raises the nominal interest rate and holds it there permanently, that it will eventually lead to higher inflation.

I think this discussion says something important about the way expectations and the infinite future are used in models.

It is not hard to construct models which behave in a neo-Fisherite way.  However many of these models involve GDP initially responding negatively to the interest rate rise.  For example, the charts below show the response to a permanent increase in the nominal interest rate in the SFC / DSGE hybrid model described in my recent post.

Some models may not show this negative effect, but only really those that abstract away from all the real world features that would be typically be expected to give rise to it.

So can we draw something useful from models that show a permanent increase in the nominal interest rate eventually leading to inflation?

Monetary policy impacts on the economy in two different ways.  It matters what the current policy is.  But it also matters what policy is expected to be in the future.  The monetary authority can control what policy is now, but as regards what policy is expected to be in the future, it can only hope to have an influence.

In models, specifically those with rational expectations, the monetary authority has much greater power.  In order to determine the expectation of future policy, it merely needs to actually carry out that policy in the future.  In a model, it's very easy to say that the monetary authority raises the nominal interest rate and holds it there to eternity.  In reality, this is not a policy choice that the authorities can make today.  They may intend today to hold the rate at that higher level forever.  But that is no way the same as ensuring it will happen.

So, realistically what would happen if the monetary authorities hiked the nominal rate and the economy plunged into a prolonged downturn as many models suggest it would?  Would the authorities stick to their neo-Fisherite plan, maintaining the high rate for ever in order to validate their original policy?  Or is it more realistic to assume that events might overtake them, some time before eternity?

Preferred policies come and go.  We live in a world of inflation targeting, but have not always done so and will not be doing so at some point in the future.  The longer a monetary authority or the government persists in pursuing a policy with sustained adverse effects, the more risk there is that they are forced by political expediency (or maybe revolution) to change.

And it is therefore entirely rational for economic agents to expect this.  Economic models can often display explosive results, where continuation of a particular policy makes the outcomes tend to zero or infinity.  But all these results should tell us is that the assumption of a particular policy being maintained to eternity is absurd.

We have to think of fiscal and monetary policy as endogenous in the long run.  It is useful in models to examine what happens if a policy is continued forever - indeed we are often forced to assume something like this.  But these are just useful fictions. 

What these models say will happen today is often critically dependant on what the agents in the models expect to happen in the future.  But we then attribute to them the belief that policy will pan out exactly as the authorities today decide.  This may be a rational belief in the world of the model, but it's hardly a rational belief in the real world.


  1. Excellent post! But isn't this the problem with policy derived from most DSGE models, where seemingly small changes have large effects because most of the action is happening at distant horizons.For example, increasing inflation from 2 to 3 or even 5% (assuming it is even possible) is not going to make anyone change their decisions unless it is permanent.

    1. Thank you. Yes, there is often a big difference in these models between the impact of a permanent and a temporary measure. And, in most cases, I think it's just not realistic to talk about taking permanent measures. What the interest rate is in 100 years time is unlikely to depend to any material extent on what is decided on monetary policy now. And rational people will understand that.

  2. This touches an interesting point what should be treated as endogenous. I find it elusive. On the long run all (like CB policy) economic variables can be thought to be endogenous, so there economics seems to approach/depend on other social sciences (e.g. democracy implications in the post). And the short run is always messed up because of the vague division of short / long and the long run expectations effects. But yes, maybe we have some useful fictions - yet many times there are many of them giving totally different results.

    Thank you, very good post as always.

    1. Thank you.

      Endogenous and exogenous are just properties of models, not the real world. We can make what we like exogenous in a model - we just need to be careful in how we then interpret the results.

  3. "Expectations" --> untestable, unscientific, metaphysics. "Infinite Future" --> never reached. "Monetarism" --> no empirical evidence that the quantity theory of money has any predictive capacity, at best it's only a historical, backwards looking accounting identity.

    Prove me wrong. Cite me an econometrics study that shows a central bank has influence over an economy. At best, with a mere 60% confidence, monetarism works says this econometrics study: Martin Eichenbaum, Charles Evan, "The Effects of Monetary Policy Shocks: Evidence from the Flow of Funds", Review of Economics and Statistics, February 1996, 78-1, cited in Olivier Blanchard "Macroeconomics", 2nd edition., p. 96, 5-6, 'Does the IS-LM Model Actually Capture What Happens in the Economy?' Shows for data 1960 to 1990, that a 1% increase in Fed funds rate shows over 4-8 quarters a decrease in sales, decrease in output, decrease in employment, increase in unemployment rate up to 6 quarters (then a decrease after 8 to original level). However, the "confidence band” is only 60% probability! (not the usual 95% confidence interval).

    Again, prove me wrong. I work a lot with lawyers who claim without lawyers society would fall apart, that you need a special class of people skilled in law to argue cases and make society work. I doubt it, but that's their deeply held belief. What are your priors Sir?

    1. I'm not sure if you are challenging what I'm saying. On the whole, I think are views are aligned.

    2. QP=MV is deeply misunderstood. The causality flows from MV (V being measure of ex-ante money demand). The two residuals are Prices (including wages and asset prices) and Employment (as the supply curve is fixed ex-ante by the available real capital, the only variable businesses' control in determining output is Employment).

      What this means is that expectations have no bearing on the Future, but rather, are just another dimension describing the present. In other words, price expectations reduce income growth expectations in the current period thus determining the ex-ante desired supply and demand for money. Due to banking and the exogenous nature of the monetary base, there is no requirement that ex-ante desired money supply and demand should equal. Such ex-ante imbalance causes fluctuations in current output and prices as to enforce the ex-post identify QP=MV.

    3. QP=MV is an accounting statement and says absolutely nothing about causality.

  4. "There are other significant ‘anomalies’ that have challenged the old as well as the new mainstream approaches. While theories place great store by the role of interest rates as the pivotal variable that has significant causal force, empirically they seem far less powerful in explaining business cycles or developments in the economy than theory would have it. In empirical work, interest rate variables often lack explanatory power, significance or the ‘right’ sign. When a correlation between interest rates and economic growth is found, it is not more likely to be negative than positive. 6 Interest rates have also not been able to explain major asset price movements (on Japanese land prices, see Asako, 1991; on Japanese stock prices, see French and Poterba, 1991; on the US real estate market see Dokko et al., 1990), nor capital flows (Ueda, 1990; Werner, 1994) – phenomena that in theory should be explicable largely through the price of money (interest rates). Furthermore, in terms of timing, interest rates appear as likely to follow economic activity as to lead it."