Subject: Re: DEFLATION Date: Fri, 05 Mar 1999 21:44:27 GMT From: oldnasty@mindspring.com (Grinch) Newsgroups: sci.econ References: 1 , 2 , 3 , 4 Grinch wrote: > Kind of interestingly, theory indicates that the optimum monetary > policy goal is not price stability, but deflation sufficient to reduce > the basic interest rate to zero. > > A couple of papers from the Fed on this, and whether it has any > practical importance in the real world: > > "Zero Nominal Interest Rates: Why They're Good and How to Get Them" > http://research.mpls.frb.fed.us/research/qr/qr2221.html > > "Zero Inflation and the Friedman Rule: A Welfare Comparison" > http://www.Rich.FRB.org/eq/fall97/fall97ab.html wfhummel@mediaone.net (William F. Hummel) wrote: >When the Fed presents papers by its economists along these lines, >it gets pretty scary. Nah, this is just basic monetary theory going back decades regarding the "logic of money", pretty mainline stuff. Whether it has any practical application in the real world is another story. All kinds of reality impinge on theory -- the "precipice" of deflation, the Fed's inability to really fine tune any price level, etc. Also whether even the theoretical benefits would be meaningful or trivial, which is what the other two papers I mentioned dispute (academics have to argue about something). Nobody I know is seriously arguing anywhere that the Fed should have a targeted deflation rate. I just mentioned this because I thought it was interesting that, while so many people are talking fear of deflation, theory says mild deflation has a good side. For the record, here's an explanation of the idea lifted from a Fed newsletter at http://www.frbsf.org/econrsrch/wklyltr/el97-27.html ~quote~ .... While money is useful for carrying out transactions, it is also costly to hold. Monetary instruments generally earn less interest than securities such as Treasury bills. In fact, some forms of money, such as currency, earn no interest at all. The decision to hold more money means investing less in securities that pay more interest, and the cost of holding money depends on how much interest income is forgone. In order to decide how much money to hold, consumers must trade off the benefits of ease and convenience in carrying out transactions against the cost in terms of forgone interest earnings. In the end, people strike a balance between the two factors, holding more money when the cost is low and less when it is high. But as long as monetary instruments pay less interest than other securities, money will be costly to hold and consumers will have an incentive to economize on its use. But economizing on money is somewhat wasteful from society's point of view. For while money is costly to hold, it is essentially costless for central banks to produce. Thus, by increasing the quantity of real balances (i.e., the nominal quantity of money divided by the price level), the central bank could make everyone better off at no cost to itself. That is, consumers would benefit from additional real balances because they would make it more convenient to carry out transactions, and it would cost the central bank nothing to provide this service. Robert Lucas (1987) writes that this is "one of the few legitimate 'free lunches' economics has discovered in 200 years of trying." Pursuing this idea to its logical conclusion, Friedman argued that the optimal policy involves eliminating incentives to economize on the use of money. To do so, the central bank should seek to eliminate the difference between interest rates on monetary instruments and on other securities, because then money would be costless to hold. At the time Friedman wrote, money paid no interest, and the optimal policy called for setting nominal interest rates on bonds equal to zero. To a first approximation, the nominal interest rate equals the real interest rate plus expected inflation. To set the nominal interest rate to zero, it follows that the inflation rate must equal minus the real interest rate. If the latter were around 2 to 3%, Friedman's arguments suggest that the central bank should seek to deflate at a rate of 2 to 3%. This would involve reducing the nominal quantity of money, but this would fall at a slower rate than the price level, and the quantity of real balances would increase. An alternative way to eliminate the interest differential between money and bonds would be to pay interest on money. While monetary instruments such as checkable deposits now earn interest, narrow measures such as currency do not, and it is difficult to imagine a low-cost way to begin paying interest on cash. But since currency is still essential for some purchases, it would still be optimal for the central bank to make it costless to hold. And since no interest is paid on currency, the Friedman rule carries through.... ~end quote~ REPLY: Hi, I read over the Economic Quarterly Volume 83/4 Fall 1997 article and have these comments. It was very theoretical, and I wonder if the author considered all of the aspects of a negative inflation (deflation) rate and of zero interest rates. For example, the typical pattern is for people to borrow when they are young (for a house, education, or car) and to save during their working life, first to pay off those loans and then to save/invest. By retirement, they plan to live from the interest/returns from their saving (plus Social Security). So while a goal of zero interest rates may sound good to the young and those who want to borrow, it sounds like a very bad idea to people nearing retirement who plan to live from the interest on their savings. And if the interest rate were zero , why would anyone save in the first place? And which interest rate? Safer loans charge lower interest rates. I suppose he was considering the "safest loans" like treasure bonds. I wonder what the interest rate on New York City bonds, or on AAA corporate bonds would then be? Another aspect: As we learned in science early in this century, there is theory and then there is observation. And theory must consider the effect of observation, since science is not concerned with what IS, but rather with what is OBSERVED or MEASURED. Thus things like the Heisenberg Principle must be considered. As applied to this case, the question is one that I raised in "Deflation & Negative CPI?": just how is the inflation rate MEASURED? Wolman ASSUMED that the Consumer Price Index (CPI) is the proper measure, or at least that is what I think the APPENDIX on page 18 says. Thus, to achieve a negative inflation rate, the CPI would have to register negative. But if the Boskin report is correct, the US may well be in (or near) a state of "negative inflation" now with a 1% per year CPI increase. Also, I noticed that the (only) attempt to apply these ideas to "real" data resulted in Figure 1: a somewhat scattered graph that is unable to resolve between two models (unstricted and nonsatiation imposed). My question to Wolman: if you were to reprocess your data in figure 1 using a Boskinized CPI, would the data have less scatter? Perhaps enough to resolve which model is the better fit? ,,,,,,, _______________ooo___(_O O_)___ooo_______________ (_) jim blair (jeblair@facstaff.wisc.edu) Madison Wisconsin USA. This message was brought to you using biodegradable binary bits, and 100% recycled bandwidth.