Is a currency crisis bad for you at the ZLB?

The second direction is to focus on the short run costs of the nominal depreciation. Some of those who commented on my original post talked about a ‘downward spiral’ in sterling. Now of course the depreciation itself may raise inflation to some extent, but this is not an unstable process. At some point sterling falls to a point where the market now thinks it is OK to hold. There is no bottomless pit.

As domestic prices are sticky, the depreciation increases UK competitiveness, which increases the demand for UK goods. If the Zero Lower Bound (ZLB) is a constraint, then this increase in demand reduces or eliminates the constraint. It may also raise inflation because demand is higher, but higher demand is what monetary policy wanted but was unable to achieve. If the depreciation is so large that demand has to be reduced through increasing interest rates, that is fine: this is what monetary policy is for. In essence the ZLB is a welfare reducing constraint that the crisis relieves, and we are all better off.

If that sounds too good to be true, I think it could be. It treats the depreciation as simply a positive demand shock, that first eliminates the cost of the ZLB, and then can be offset by monetary policy. However a sterling crisis may also involve a deterioration in the output/inflation trade-off: equivalent to what macroeconomists call a cost-push shock. Take a basic Phillips curve. If agents start to believe inflation will be higher - even if these beliefs are incorrect (the crisis, and QE, is temporary) - while these mistaken expectations last this is a cost to the economy, because the central bank will have to raise interest rates to prevent these expectations fully feeding through into actual inflation. Either output will be lower, or inflation higher, or both.

Now as long as interest rates stay at zero, this is not a problem: the ZLB constraint still dominates. [1] However if the crisis was big enough, we could overshoot Brad DeLong’s sweet spot, and end up living with a cost-push shock that was more costly than the ZLB constraint. Personally I think this is stretching non-linearities rather too much. First you have to believe that austerity, which reduces debt a bit more quickly than otherwise, is just enough to prevent a crisis, and then that the crisis is so big that it more than offsets the ZLB constraint. Unlikely, but it seems to be a coherent possibility.

via mainlymacro.blogspot.com.es