Paul Krugman finds another example of an economist who does not seem to have thought about the disequilibrium foundations of his equilibrium economics, and writes about Immaculate Stability:

David Andolfatto [writes:]

One of the effects of QE… is to increase the real stock of currency held by the private sector, and agents require an increase in currency’s rate of return (a fall in the inflation rate) to induce them to hold more currency….

OK, so “agents require” a fall in the inflation rate to induce them to hold more currency. How does this requirement translate into an incentive for producers of goods and services–remember, we’re talking about stuff going on in the real economy–to raise prices less or cut them? Don’t retreat behind a screen of math–tell me a story. I don’t think either Andolfatto or Williamson have any such story in mind; they are, in some form, invoking the doctrine of immaculate inflation. And I don’t even think they realize that they have a problem….

Equilibrium is often a very convenient way to think…. I might say something like “the currency has to overshoot its long-run value, so that investors expect appreciation that offsets the interest differential.” But behind that verbal shorthand is a story… investors selling… because yields are down, the currency falling until it’s so low that people figure it has nowhere to go but up. The trouble is that we have a lot of economists who apparently don’t understand why they’re doing what they’re doing; they solve their equations without even trying to picture what those equations are supposed to be saying about the actual behavior of consumers and firms. It’s a very sad state of affairs.

There are actually two disequilibrium stories that might underlie the claim that “agents require an increase in currency’s rate of return…”

The first is: (i) the Federal Reserve injects more currency into the economy; (ii) people notice that they have more currency than they want given projected rates of return; (iii) people try to sell their currency for currently-produced goods and services and so drive the price level up; (iv) as the price level rises people note that prices are elevated, and begin to expect a return to normal–deflation–(v) when prices have risen high enough that expectations of deflation are large enough (and the real value of the currency low enough), people are now happy to hold the stock of currency and stop trying to turn it into currently-produced goods and services.

This is a fine story of the Federal Reserve undertaking a policy of Quantitative Easing. This story, however, makes nonsense of the claim being advanced–that QE is deflationary. In this story, QE is inflationary–and only after it has done its inflationary work do you reach a new steady-state in which deflation is expected.

The second is: (i) people think “there is going to be a deflation; I need to hold more currency”; (ii) people sell their assets to the Federal Reserve, and so the Federal Reserve injects more currency into the economy; (iii) people notice that they have more currency, and think “it would not be rational for me to hold this much currency unless there were a deflation going on”; (iv) people think “if there is a deflation going on, I need to cut my prices in order not to lose my customers”; (v) people start cutting their prices, and the deflation begins.

This is also a fine story. But it is not a story of the Federal Reserve undertaking Quantitative Easing. It is a story of a self-fulfilling deflationary-expectations panic.

And let me agree with Paul Krugman’s conclusion: It is not a healthy state of affairs when people build models and do not recognize when they are modeling a policy of monetary expansion via QE and when they are modeling a self-fulfilling deflationary-expectations panic.

And: Karl Smith: Immaculate Inflation