Expectations and the Infinite Future

Neo-Fisherism is on the blogs again (e.g. Noah Smith, John 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.