Must-Read: Gauti Eggertson and Michael Woodford: The Zero Bound on Interest Rates and Optimal Monetary Policy
Must-Read: The reality-based piece of the macroeconomic world is right now divided between those who think (1) that Bernanke shot himself in the foot and robbed himself of all traction by refusing to embrace monetary régime change and a higher inflation target, and thus neutered his own quantitative-easing policy; and (2) that at least under current conditions markets need to be shown the money in the form of higher spending right now before they will give any credit to factors that make suggest they should raise their expectation of future inflation. What pieces of information could we seek out that would help us decide whether (1) or (2) is correct?
(2003): The Zero Bound on Interest Rates and Optimal Monetary Policy: “Our dynamic analysis also allows us to further clarify the several ways…
…in which the central bank’s management of private sector expectations can be expected to mitigate the effects of the zero bound. Krugman emphasizes the fact that increased expectations of inflation can lower the real interest rate implied by a zero nominal interest rate. This might suggest, however, that the central bank can affect the economy only insofar as it affects expectations regarding a variable that it cannot influence except quite indirectly; it might also suggest that the only expectations that should matter are those regarding inflation over the relatively short horizon corresponding to the term of the nominal interest rate that has fallen to zero. Such interpretations easily lead to skepticism about the practical effectiveness of the expectations channel, especially if inflation is regarded as being relatively “sticky” in the short run.
Our model is instead one in which expectations affect aggregate demand through several channels…. Inflation expectations, even… [more than] a year into the future… [are] highly relevant… the expected future path of nominal interest rates matters, and not just their current level… any failure of… credib[ility] will not be due to skepticism about whether the central bank is able to follow through on its commitment…