Monday, October 20, 2014

Updated "A Model of Secular Stagnation"

Eggertsson and Mehrotra have released their secular stagnation paper at NBER, and since the last draft they have made a lot of progress. I will look at it more when I get some time, but given my whining I figured I should at least flag it. Excerpt:

The paper closes by extending the main model to consider investment and capital accumulation. While introducing capital does not change any of the results already derived in the baseline model, it allows us to illustrate a new mechanism for secular stagnation emphasized by both Keynes (1936) and Summers (2013). According to these authors, a decline in the relative price of investment may also put downward pressure on the natural rate of interest and thus serve as an additional trigger for secular stagnation - an insight that we verify in our model.

The price of capital is exogenous in the model, based on an argument by Summers that capital goods have gotten cheaper such that investment does not pull the interest rate up as much as it used to.

I would say that this is an important paper and is definitely worth a thorough read, which I will give it soon. If it answers my investment questions I will have to rethink things. The investment complaint is this: investment is positive in the data. The Mian & Sufi story is that investment is not linked to savings because of the ZLB. The odd thing about that is that, in the real world, the return on investment is not the Federal Funds rate. In the real world there is some sort of equity premium, etc. So even in partial equilibrium where we take the risk-free rate as exogenous (and very low/negative), it's hard to understand why returns on investment are necessarily negative as well. Then the next step of getting the low rates endogenously has its own problems, though I'll see what E&M have to say about it. Quantitatively it may be tricky.

Another thing to watch for is this from Pedro DM SerĂ´dio, whom you should follow on Twitter; in response to my post from last week he tweeted:

I'd add that the EM paper didn't have money either, so of course you'd pay a fee to consume part of your harvest tomorrow.
That's the most important channel for their 'negative real interest rate' result: you have to eat but can't produce tomorrow.
And also

The middle generation pays for storage in this model. If they held cash, negative rates would no longer be optimal.
[Updated: Was just reminded that Josh Hendrickson explained this here]. It is definitely tricky to motivate ZLB models without money. In the real world we say that the ZLB arises endogenously because cash guarantees a return of zero. You simply can't force people to pay for wealth storage, more or less. Imposing the ZLB exogenously is a nice modeling simplification, but it comes at a cost. So there is much to think about here.

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