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My Reply to Paul Krugman

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Paul Krugman appreciates my efforts against the hard money advocates.  He questions, however, my and other quasi-monetarists' belief that monetary policy can still pack a punch when short-term interest rates hit the zero bound:
[T[hey want to keep that policy action narrowly technocratic, limited to open-market operations by the central bank.  As I’ve argued before, this doctrine has failed the reality test: liquidity traps are real, and blithe assertions that central banks can easily pump up demand even in the face of zero short-term rates have not proved correct.
It is true that us quasi-monetarists believe that the efficacy of monetary policy is not limited by the zero bound, but we have never said the that all it takes is further open-market operations.  Rather, we have said that monetary policy can be highly effective regardless of circumstance if the following steps were taken by the Fed:

(1) Set an explicit nominal GDP level target so that expectations are appropriately shaped.  If such a rule were adopted expectations of current and future nominal spending would be anchored around the level target and make it less likely there would be aggregate demand crashes like the one in late 2008, early 2009. Even if a spending crash did occur the catch-up growth needed to return nominal spending to its level target would most likely imply an expected path of short-term real interest rates consistent with restoring full employment. (See here, here, and here for more on a nominal GDP rule.)

(2) Purchase assets other than t-bills as needed to make sure the nominal GDP level target is maintained.  Thus, if the monetary base and t-bills became perfect substitutes because the 0% bound is reached the Fed should buy longer-term treasuries or foreign exchange.  Nowhere have we said simple open market operations in t-bills would always suffice. A big difference, though, is that where Krugman and others see the move from t-bills to other assets as a discrete jump from conventional to unconventional monetary policy, quasi-monetarists see it as simply moving down the list of assets that can affect money demand.  The 0% bond for us really is not a big deal, but simply an artifact of monetary policy using a short-term interest rate as the targeted instrument.

In practice, this understanding is not that different operationally than a New Keynesian invoking a higher inflation target to lower the expected path of real interest rates or the portfolio channel to drive down the term premium on long-term bonds.  We just do it with a lot less angst.  Maybe Andy Harless with his modified Taylor Rule can bridge the gap between us.

Finally, because of these views we believe the Fed could have done much more in late 2008, early 2009.  Its failure to do so amounted to a passive tightening of monetary policy then.  Even now monetary policy is not all that loose given that money demand continues to be elevated.  Don't believe me? Then just look at domestic spending per capita, it is still below its pre-crisis peak. 

Update:  Fellow quasi-monetarist Bill Woolsey also responds to Krugman.

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