The Deflation Threat in the New Neoclassical Synthesis

The Deflation Threat in the New Neoclassical Synthesis Marvin Goodfriend Federal Reserve Bank of Richmond November 2003

Introduction • Benchmark NNS model • Classical features: intertemporal optimization, rational expectations, real business cycle core • Keynesian features: monopolistic competition, markups, sticky prices 2

Components of the Core Real Business Cycle Model: Households • Household lifetime consumption: C 2/C 1 = (1 + r)/(1 + rho) • Household labor supply: Ns = 1 - (C/w) • C 1, C 2 = current and future consumption; r = real interest rate; rho = time preference Ns = labor supply; w = real wage 3

Components of RBC Model: Firms and Production • Monopolistically competitive firms adjust prices flexibly to maintain constant profit maximizing markup of price over marginal cost of production: M* = P/MC • The production technology is C = AN, where C = output; A = productivity per hour; N = hours worked 4

The Determination of Employment and Output • Since MC = W/A, then M* = P/W/A • M* = A/w • So the real wage is determined by w* = A/M* • And labor supply Ns = 1 - (AN/AM*) • Equating labor supply Ns and hours worked N, yields employment: N* = 1/(1+M*) • And output: C* = A/(1+M*) 5

Comment on Employment and Output in the RBC Model • Flexible price setting firms stabilize employment by maintaining the constant profit maximizing markup • Employment depends only on the markup and does not fluctuate with productivity • Output and the real wage grow and fluctuate with productivity, A • Satisfies the basic facts of long run growth 6

Real Interest Rate: Coordinating Demand Supply • Households have enough income to buy all the output--wage and profit income equals: w. N* + (AN* - w*N*) = AN* • The real interest rate adjusts to make desired household lifetime consumption match the intertemporal supply of consumption goods 7

The Real Interest Rate • Current and future consumption supplied: C 1* = A 1(1/(1 + M*)) C 2* = A 2(1/(1 + M*)) • Substituting these into desired household lifetime consumption yields: A 2/A 1 = (1 + r)/(1 + rho) • The real interest rate r adjusts to the expected growth of labor productivity A 2/A 1 to coordinate demand with supply 8

The Real Interest Rate (2) • The real interest rate induces the representative household to consume its current income exactly • The real interest rate does so by clearing the economy-wide credit market, making the representative household neither a borrower nor a lender 9

The New Neoclassical Synthesis • The NNS takes account of costly price adjustment within the core RBC model • Firms do not adjust prices to maintain the constant profit maximizing markup • Instead, firms let the markup fluctuate temporarily in response to demand productivity shocks 10

New Neoclassical Synthesis (2) • Markup variability plays a dual role in the new neoclassical synthesis • As a guide to profit maximizing pricing decisions, the markup is central to inflation • As a ‘tax’ on production and sales, the markup is central to fluctuations in employment and output 11

Firm Pricing Practices, Inflation, and the Markup • A firm will change its product price to restore the profit maximizing markup the larger and more persistent it expects a deviation of its actual markup from the profit maximizing markup M* to be • Firms move their prices with expected inflation or deflation of the general price level, independently of the average markup 12

Firm Pricing Practices (2) • Absolute price stability: expected inflation (deflation) is zero, the current and expected future markup equal the profit maximizing markup: M 1= M 2 = M* • Deflation potential: expected deflation is zero, but current markup elevated relative to the profit maximizing markup, although the future markup is not: M 1 > M 2 = M* 13

Firm Pricing Practices (3) • Price stability is said to be “credible” in these situations • Firms are disinclined to change prices in response to a deviation of the current markup from the profit maximizing markup expected to be temporary • The current price level is nearly invariant to current shocks and monetary policy actions 14

Employment Fluctuations and the Markup • Output is demand determined in the short run when price level stability is credible because prices are sticky and (1) each firm can only sell as much as households wish to buy at the going price, and (2) firms are happy to sell as much as they can, since labor productivity exceeds the real wage w* = A/M* < A, since M* > 1 15

Employment Fluctuations (2) • Keynesian perspective: if aggregate demand decreases, firms require less labor to meet demand, and weak labor market causes the nominal (real) wage to fall • Classical perspective: lower wage reduces marginal cost and elevates the markup; the higher markup acts like a tax increase to shrink employment and production 16

Employment Fluctuations (3) • In the flexible price RBC model: (1) firms insulate employment from fluctuations by adjusting prices to maintain markup constancy and (2) the real interest rate automatically adjusts to equilibrate the credit market, making aggregate demand conform to fluctuations of productivity 17

Employment Fluctuations (4) • In the NNS model: (1) fluctuations in aggregate demand can induce fluctuations in employment and output. In that sense, the model is Keynesian (2) but since the NNS model has the classical RBC model at its core, we call it the new neoclassical synthesis 18

Employment Fluctuations (5) • Firms maintain the profit maximizing markup on average over time in the NNS • Hence, the NNS model behaves like the classical, flexible price RBC model on average • But with leeway for monetary policy to influence aggregate demand stabilize employment and inflation 19

Interest Rate Policy • Suppose that price stability is credible so that expected inflation (deflation) is zero • And the public expects the future markup to be at its profit maximizing level: M 2 = M* • Then the central bank’s nominal interest rate target translates into a real interest rate target 20

Interest Rate Policy (2) • It follows that expected future consumption is anchored by future income prospects at C 2* = A 2(1/(1 + M*)) • Substitute for C 2 in the household lifetime consumption plan to get: • C 1 = [(1 + rho)/(1 + r)]A 2(1/(1 + M*)) • Here we see the leverage that interest rate policy exerts on aggregate demand C 1 --21

Interest Rate Policy (3) • Current aggregate demand is inversely related to the real interest rate target when expected future consumption is anchored by credible price stability, which means that expected M 2= M* • Interest rate policy actions influence employment, in turn, because temporary departures of output from potential are demand determined 22

Monetary Policy Objectives • The benchmark NNS model recommends that interest rate policy should stabilize the markup at its profit maximizing value M* in order to stabilize the price level and make employment and output behave as in the core RBC model with flexible prices • We call this ‘neutral’ monetary policy because neutralizes fluctuations in employment and output that would otherwise occur due to sticky prices 23

Monetary Policy Objectives (2) • Neutral monetary policy maximizes household welfare because (1) firm price adjustments preclude markup stabilization anywhere but M*, (2) interest rate policy can stabilize the markup at M*, (3) desired household labor supply is invariant to productivity at M*, and (4) welfare would be reduced if monetary policy allowed the markup to fluctuate 24

Monetary Policy Objectives (3) • Neutral policy stabilizes employment at the ‘natural rate’ • Neutral policy eliminates any ‘output gap’ between actual and potential output • The pursuit of neutral policy perpetuates price stability if the central bank has already acquired credibility for stabilizing the price level 25

Monetary Policy Objectives (4) • Price stability confers additional benefits: minimal costly price adjustment; minimal relative price distortions; lower incidence of inflation or deflation scares; and low nominal interest rate tax on currency and bank reserves 26

Monetary Policy Objectives (5) • Neutral policy can be implemented by maintaining price stability--there is no need to target the profit maximizing markup directly in practice • An economy in which firms show little inclination to raise or lower prices is one in which the profit maximizing markup is realized on average 27

Monetary Policy Objectives (6) • Activist interest rate policy that consistently achieves price stability implicitly shadows the real interest rate that moves with expected productivity growth as in a real business cycle • Real interest rate must fluctuate over the business cycle to maintain markup constancy and price stability 28

The Deflation Threat • Arises if markup (M) is elevated above profit maximizing markup (M*) and firms doubt that monetary policy will stimulate demand to restore M = M* promptly • Firms respond by lowering prices to restore profit maximizing markup themselves • Deflation can be associated with protracted period in which markup tax is elevated and output remains below potential 29

Sources of Deflation Threat • Ongoing, surprisingly high productivity growth so that demand is insufficient to absorb added output at M = M* and at initial central bank interest rate target, weak labor demand means MC = W/A falls and the markup rises over time • Pessimism about future taxes, productivity, or war, negative effect on current demand • Aftermath of excessive investment boom 30

Sources of Deflation Threat (2) • In principle, the central bank can reduce its real interest rate target to maintain markup constancy and price stability in the presence of such deflationary shocks • The zero bound on nominal interest rates could prevent the central bank from achieving the required real interest target if (1) the required rate is negative or (2) the public already expects some deflation 31

Sources of Deflation Threat (3) • Proximity to zero bound creates doubt that interest rate policy can restore the profit maximizing markup promptly and deter deflation • That credibility problem has the potential to create a “deflation scare, ” i. e. , deflation expectations that make the zero bound constraint more severe 32

Overcoming the Zero Bound • In principle, monetary policy can defeat deflation at the zero bound--otherwise the government could eliminate explicit taxes and finance expenditure forever with money creation • Credibly sustained money financed government spending could defeat deflation in two ways 33

Overcoming the Zero Bound (2) • Money growth could defeat deflation without creating inflation by increasing aggregate demand, closing the output gap, and restoring the profit maximizing markup • Or money growth could create inflation and inflation expectations, make interest rates negative at the zero bound, and enable the central bank to eliminate the output gap through interest rate policy 34

Overcoming the Zero Bound (3) • Establishing central bank credibility for dealing with deflation at the zero bound will be difficult for the following reasons: • Inexperience and nervousness about creating excessive inflation makes a central bank reluctant to use quantitative monetary policy aggressively to fight deflation at the zero bound 35

Overcoming the Zero Bound (4) • Independent open market ops in short term securities have no effect--central bank must buy long bonds, or other assets--OMO alternatives have credibility problems, too • A central bank may need cooperation from the Treasury to credibly inject enough money into the economy to defeat deflation and then drain the money to control inflation 36

Overcoming the Zero Bound (5) • Inclination to do nothing unusual at the zero bound creates a policy vacuum which could encourage ill-advised fiscal actions such as occurred in the US in the 1930 s and in 1990 s Japan • Wasteful government spending, inefficient credit subsidies, anti-competitive measures could lower potential output and growth, and exacerbate the deflation problem 37

A Reasonable Inflation Target • Until central banks learn how to overcome the zero bound on monetary policy, and acquire credibility for doing so, it is reasonable for central banks to defend a 1 percent lower bound on inflation • For log utility, 2 to 3 percent trend productivity growth and a 1 to 2 percent inflation target would yield nominal interest rates around 4 percent on average, sufficient leeway to deal with deflation 38