Friday, January 13, 2012

Liquidity Trap: Mankiw v Krugman

Said Mankiw: "I've made a regression
Of the Fed funds rate setting progression,
Which suggests we may snap
Our liquidity trap,
Or at least, that's the graphic impression."

Said Krugman, with Nobel derision:
"Your regression requires revision;
This tract on the Trap
I have shown to be crap,
When corrected with Keynsian precision."

Economic heavyweights Paul Krugman and Greg Mankiw recently debated whether the United States is exiting the "liquidity trap," an impossible state of affairs in which the Fed would have to drop rates below zero to set the right balance in its fight against inflation and unemployment. Some years ago, Mankiw had analyzed the Fed's interest rate actions and determined that they approximated a simple formula: FF = 8.5% + 1.4 (I - U), where FF is the Fed funds target rate, I is inflation (core CPI) and U is the unemployment rate. In other words, if the rates of inflation and unemployment are equal, then the Fed would set rates at 8.5%. For every percentage point by which unemployment exceeded inflation, the Fed funds rate would decline by 1.4%. If unemployment is high and inflation is low, as is currently the case, the Fed funds rate would logically be negative, but this is not possible; hence, the liquidity trap.

Professor Mankiw notes hopefully that an application of his formula to the recent CPI and jobless rates suggests that the theoretical Fed funds rate is heading upward and will soon break through zero (see graph), thus signalling an end to the liquidity trap. Enter Professor Paul Krugman, pouring cold water on the hopeful graph. First, he notes that the formula is based on actions that the Fed took in the '90s, which are not necessarily those that they should take today, in a different economy. Second, he notes that a recalibrated formula, based on Fed actions of the '00s, suggests that the US is still deeply within the liqudity trap (although headed upward). More stimulus, anyone?

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