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
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