Notice that as Keynes, Tobin and subsequently Brad Delong and I have emphasized, wage and price flexibility may well exacerbate the problem. The more flexible wages and prices are, the more they will be expected to fall during an output slowdown leading to an increase in real interest rates. Indeed there is the possibility of destabilizing deflation with falling prices leading to higher real interest rates leading to greater output shortfalls leading to more rapidly falling prices and onwards in a vicious cycle.
Read the whole thing. There were many sentences I wanted to excerpt. Pointer from Mark Thoma.
In AS-AD, if your Y-axis is inflation rather than the price level, then AD slopes upward. That is, the more inflation you have, the lower the real interest rate, and the higher is AD. If AD gets steeper than AS, then have a nice day. Because if that happens, then a “favorable” supply shift leads to lower employment and output. One way to interpret secstag is as a claim that we have been experiencing an AD curve that is upward-sloping and steeper than AS.
Keep in mind that Summers and other mainstream macro economists talk about potential GDP as if it were some tangible quantity, rather than a made-up number. In mainstream macro, we all work in a GDP factory, and the factory has a capacity that we call potential GDP.
The PSST story rejects that. It says that we produce many different types of output, and we only have the potential to produce the output for which we have discovered patterns of sustainable specialization and trade. If we could discover other patterns of sustainable specialization and trade, we could produce a different mix of output, and perhaps this would raise the level of GDP. But raising GDP by discovering patterns of specialization and trade is akin to raising GDP by discovering a practical cold fusion technology. Complaining about the economy operating below potential is like complaining that we do not have cold fusion.
Related: Tyler Cowen on the difficulty of disentangling AD from AS. Plus Scott Sumner commenting on Tyler Cowen.
PSST seems to be secular stagnation writ large, whether due to psychology or technology raising the questions why aren’t we doing more to discover and exploit new ideas and where the bottlenecks are and why these are so synced though technology is recognized as lumpy.
Perhaps I am just too thick to study economics, but I really don’t get it. How does increasing inflation decrease the real interest rate? I mean, obviously absent state intervention higher inflation implies a higher nominal interest rate, since lenders will demand (real return + inflation) in nominal currency units. And I could believe that inflation might push up real interest rates too, by increasing uncertainty– the increased likelihood of default by borrowers whose income, fixed in nominal terms of currency units, decreases in real terms, might drive lenders to demand higher real rates as risk compensation. But I can’t think of a plausible mechanism running from more inflation to lower real interest rates.
Can anyone help me? Dr. Kling?
Central-bank intervention has kept market interest rates low for several years, but only by monetizing government and TBTF debt. Private lenders would like to demand higher interest rates but are competed down by central-bank money-printing. Private borrowing seems low despite the low interest rates mainly, I think, because of credit rationing and the difficulty of identifying any investment likely to earn more than even the low nominal interest rate on borrowed capital.
It is a truism that on average over some time all investment classes offer the same return (net of taxes and some allowance for risk– and subject to Eric-Falkenberg-type envy effects), because any class offering outsized returns attracts more investment until competed-down to average. So in theory when the central bank says it will supply funds to any investment at a very low rate, no entrepreneur will pay more than that rate for funds, so no investor can expect to earn a return over that rate; possibly not even equal to it, net of transaction costs unsubsidized by the central bank.