The Shock of the Normal

 JANUARY 7, 2017 11:13 AM January 7, 2017 11:13 am

Some further thoughts on the macro situation: some of us spent years trying to convince others that the post-crisis environment changed the rules, especially for fiscal policy. Now we have a new problem: how to explain that the rules have (somewhat) changed back without leading to a lot of stupid gotchas, “You said that and now you say this”

The thing is, people like me or Simon Wren-Lewis have been consistent all along; and saying that the rules have changed back is just an application of the same basic framework that worked so well after 2008 — basically an updated version of IS-LM.

Again, think of aggregate demand as reflecting the interest rate, other things equal, while monetary policy normally leans against changes in GDP, so that there’s an upward-sloping LM curve — but because it’s really hard to cut rates below zero, that curve is flat at low levels of output. Short-run equilibrium of output and interest rates is where the IS and LM curves cross:



Now, suppose you’re considering the effects of policies that will, other things equal, raise or lower aggregate demand — that is, shift the IS curve. In normal circumstances, where the IS curve intersects an upward-sloping LM, such shifts have limited effects on output and employment, because they’re offset by changes in interest rates: fiscal expansion leads to crowding out, austerity to crowding in, and multipliers are low.

In the aftermath of the financial crisis, however, we spent an extended period at the ZLB, as shown by the “2010” IS curve. In those conditions, shifts in the IS curve don’t move interest rates, there is no crowding out (actually crowding in because increased sales lead to higher investment), and multipliers are large.

In that kind of world, prudence is folly and virtue is vice. Almost anything that leads to higher spending is a good thing; we were in coalmines and aliens territory.

Even at the time, however, I tried to explain that this wouldn’t always be the case. From the linked post:

Oh, and let’s always remember that Keynesians like me don’t believe that thing like the paradox of thrift and the paradox of flexibility are the way the economy normally works. They’re very much exceptional, applying only when interest rates are up against the zero lower bound. Unfortunately, that happens to be the world we’re currently living in.

So are we still there? No. Wages are finally rising, quit rates are back to pre-crisis levels, so we seem to be fairly close to full employment, and the Fed is raising rates. So it now looks like the “2017” IS curve in the figure. We’re just barely over the border into normality, which is why I think the Fed should hold and we could still use some fiscal stimulus for insurance, and very low rates still make the case for lots of infrastructure spending. But it’s not the same as it was.

Or actually it’s not the same in the U.S.. Europe is still fairly deep in the liquidity trap.

The point here is that argument by gotcha is even worse now than usual. If you see progressive economists saying different things about Trump deficits than they said about Obama deficits, it’s because the situation has changed, and the very same models that called for fiscal stimulus when Republicans pretended to be fiscally responsible say that deficits are no longer good now that they’re showing what they always were.



About Uy Do

Banking System Analyst, former NTT data Global Marketing Dept Senior Analyst, Banking System Risk Specialist, HR Specialist
This entry was posted in economists, Uncategorized, US economic, US economy. Bookmark the permalink.

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