30 January 2016

Extended Response to Nick Rowe

Nick Rowe on Twitter earlier today:
If [a] central bank targeted the price of peanuts, would we blame recessions on bad peanut harvests? Or blame [the] central bank for not raising [the] target price?
It depends. It depends on how quickly the central bank finds out about the bad peanut harvest, how quickly the new policy can be enacted, and how effectively the central bank can control the price of peanuts.

Suppose no one know about the size of the peanut harvest until the following period. In this case, the central bank, which we will assume can completely control the price of peanuts for the time being, is not culpable for the recession that occurs because the price of peanuts is too low. The central bank could not have known that the price level (of peanuts) at which output remained at potential was higher than they otherwise thought, so they cannot be blamed for the recession that ensues.

If, on a slightly different note, the central bank faces a delay in policy implementation, it may not be able to act quickly enough to prevent a recession; they can raise the target price with a delay, but there will still be a recession in the meantime and the central bank is not culpable.

Alternatively, assume that the central bank knows about the bad harvest in real time and doesn't face a policy lag, but, for some reason, is unable to set the price of peanuts any higher. In this case, the central bank can't be blamed either -- there is nothing it can do to prevent it from happening, so the correct culprit for the recession is the bad peanut harvest.

Generally, assuming there are no significant lags in information or implementation, the central bank would be to blame for not preventing the recession. The only time that the blame really shouldn't fall on a central bank is when it can't control the price (of peanuts) -- in this case, central bank impotence is to blame for the recession, not actions taken by the central bank.

With that aside, now we can go about determining when central banks are impotent.


  1. John: why would the central bank be unable to set the price of peanuts any higher? There is no upper bound on the dollar price of peanuts.

    How would we know whether a central bank was or was not targeting the price of peanuts?

    1. Nick, "why would the central bank be unable to set the price of peanuts any higher?"

      This also depends. What theory of money demand do you want to use? If agents face some kind of inequality constraint on their money holdings, then, any time the opportunity cost of holding money is zero, the price level is indeterminate; the central bank has no power over it anymore because money demand is not determined by anything in the model.

      If agents just happen to like holding money (or it makes shopping go more quickly or makes shopping cheaper), then, whenever the opportunity cost of holding money is zero, money demand is infinite, the central bank has a limit on how far it can raise the price level without also committing to raise all future price levels.

      Equivalently, if the nominal interest rate consistent with an on-target price level falls below zero, the central bank will not be able to raise the price (of peanuts).

      "How would we know whether a central bank was or was not targeting the price of peanuts?"

      We would know what the central bank was targeting if they told us what they were targeting. Otherwise, we would just have to guess.

  2. O/T: John, are you familiar with the numerous posts that were done in response to David Levine's piece last March? This Stephen Williamson post has all the requisite links:

    Avon Barksdale's quoting of Levine (from the original piece that set that all off), on Rowe's most recent post is what led me through that mess.

  3. The exchange between Avon and Jason on Nick's "hoarding" post is quite good. Avon brings up Ricardian Equivalence, which I've read you thoughts on before.

    1. I vaguely remember reading the various responses to Levine, but I'll have to spend some time reacquainting myself with the arguments before I can really weigh in.

    2. No worries. You don't need to know any of that to appreciate the Avon-Jason match up.