The Making Of A Great Contraction With A Liquidity Trap And A - PowerPoint PPT Presentation

The Making Of A Great Contraction With A Liquidity Trap And A Jobless Recovery Stephanie Schmitt-Groh´ e Mart ´ ın Uribe Columbia University August 23, 2015

A jobless growth recovery is a situation in which (Bernanke 2009): • Output growth recovers, • but employment does not. A liquidity trap is a situation in which: • the nominal interest rate is zero and • inflation is below target. 2

Recent Historical Examples of the Joint Occurrence of a Jobless Growth Recovery and a Liquidity Trap. 1. United States: 2008- 2. Japan: 1991-2000 3. Euro Area: 2008- 3

United States, 2005-2015 Real Per Capita GDP Growth, yoy Employment−Population Ratio 64 2 63 percent per year 0 62 percent 61 −2 60 −4 59 −6 58 2005 2010 2015 2005 2010 2015 Federal Funds Rate Inflation, GDP deflator, yoy 6 3.5 3 5 percent per year 2.5 4 percent 2 3 1.5 2 1 1 0.5 0 0 2005 2010 2015 2005 2010 2015 Vertical lines: NBER recession dates, 2007Q4 and 2009Q2 4

Japan, 1989-2001 Real Per Capita GDP Growth, yoy Employment−to−Population Ratio 6 63 4 Percent Per Year 62 Percent 2 61 0 60 −2 59 1990 1992 1994 1996 1998 2000 1990 1992 1994 1996 1998 2000 Interest Rate, call rate Inflation, GDP deflator, yoy 10 3 8 2 Percent Per Year Percent Per Year 6 1 4 0 2 −1 0 −2 1990 1992 1994 1996 1998 2000 1990 1992 1994 1996 1998 2000 Vertical lines: Cabinet Office Recession dates, 1991Q1, 1993Q4, 1997Q2, 1999Q1. 5

Euro Area, 2005-2015 Real Per Capita GDP Growth Employment−Population Ratio, male 4 73 2 Percent Per Year 72 0 Percent 71 −2 70 −4 69 −6 2005 2010 2015 2005 2010 2015 Interest Rate, Eonia Inflation Rate, HICP 4 4 3 Percent Per Year Percent Per Year 3 2 2 1 1 0 0 2005 2010 2015 2005 2010 2015 Vertical lines: CEPR business cycle dates, 2008Q1, 2009Q2, 2011Q3 6

This paper: 1. Develops a model that predicts that a confidence shock can cause a liquidity trap with a jobless growth recovery. 2. Offers a policy strategy to exit the liquidity trap and restore full employment based on raising nominal rates. 7

The Three Main Elements of the Model 1. Downward Nominal Wage Rigidity. 2. The Taylor Rule. 3. A Downward Revision in Inflation Expectations. 8

Downward Nominal Wage Rigidity. W t ≥ γ ( u t ) W t − 1 , where • W t denotes the nominal wage rate. • u t denotes the unemployment rate . γ ′ ( u ) < 0. Assumption: Wages become more downwardly flexible as unemployment increases. 9

Evidence On Downward Nominal Wage Rigidity 10

Distribution of Nominal Wage Changes, U.S. 2011 Source: Daly, Hobijn, and Lucking (2012). 11

Unemployment and Nominal Wages Growth Evidence from the Eurozone Unemployment Rate Wage Growth W 2011 Q 2 2008Q1 2011Q2 W 2008 Q 1 Country (in percent) (in percent) (in percent) Bulgaria 6.1 11.3 43.3 Cyprus 3.8 6.9 10.7 Estonia 4.1 12.8 2.5 Greece 7.8 16.7 -2.3 Ireland 4.9 14.3 0.5 Italy 6.4 8.2 10.0 Lithuania 4.1 15.6 -5.1 Latvia 6.1 16.2 -0.6 Portugal 8.3 12.5 1.91 Spain 9.2 20.8 8.0 Slovenia 4.7 7.9 12.5 Slovakia 10.2 13.3 13.4 Source: Schmitt-Groh´ e and Uribe (2015). 12

Firms Production function: Y t = X t F ( h t ); with X t /X t − 1 = µ > 1 Labor demand: W t = X t F ′ ( h t ) P t 13

The Labor Market W t P t = X t F ′ ( h t ) Labor Demand: h t ≤ ¯ Inelastic Labor Supply: h P t ≥ γ (¯ W t − 1 h − h t ) Downward Wage Rigidity: W t ≥ γ ( u t ) W t − 1 ⇒ W t π t P t − 1 X t F ′ ( h t ) W t P t γ ( ¯ h − h t ) W t − 1 P t − 1 π L If π t = π ∗ , then the equilibrium is at B point A . A If π t = π L < π ∗ , then the equilibrium is γ ( ¯ h − h t ) W t − 1 P t − 1 π ∗ at point B . h L ¯ h t h 14

The Euler Equation and the Taylor Rule U ′ ( C t +1 ) U ′ ( C t ) = βR t E t π t +1 � π t − π ∗ � + α y ˆ R t = max { 1 , R ∗ + α π y t } In the steady state they become, respectively, � π − π ∗ � + constant } R = π β and R = max { 1 , R ∗ + α π R R ∗ Solid Line: R = max { 1 , R ∗ + α π ( π − π ∗ ) } Broken Line: R = β − 1 π 1 π L π π ∗ 15

A Downward Revision in Expectations. In period 0, expectations change from t →∞ E 0 π t = π ∗ lim To t →∞ E 0 π t = π L < π ∗ lim 16

A Lack of Confidence Shock: π 0 < π ∗ Interest Rate Inflation 6 2 5 1 4 0 % annual % annual 3 −1 2 −2 1 −3 0 −4 0 10 20 30 40 50 0 10 20 30 40 50 t t Output Growth Rate Employment Rate 1.8 100 1.6 99 1.4 98 % annual 1.2 % 97 1 96 0.8 95 0.6 0.4 94 0 10 20 30 40 50 0 10 20 30 40 50 t t 17

An Exit Rule Based On A Rate Increase Consider the interest rate policy: � � ��  1 , π ∗ F ( h t ) β + α π ( π t − π ∗ ) + α y ln max if s t = 0  F (¯ ˜ R t = h ) . R ∗ if s t = 1  � 1 if R j = 1 for any 0 ≤ j < t s t = . 0 otherwise 18

Exiting the Slump: Tightening is Easing Interest Rate Inflation 7 3 6 2 5 1 % annual % annual 4 0 3 −1 2 −2 1 −3 0 −4 0 10 20 30 40 50 0 10 20 30 40 50 t t Output Growth Rate Employment Rate 3 100 2.5 99 2 98 % annual 1.5 % 97 1 96 0.5 95 0 94 0 10 20 30 40 50 0 10 20 30 40 50 t t 19

Capital Accumulation 20

Findings are robust to allowing for capital accumulation Production Function Y t = K 1 − α ( X t h t ) α t Evolution of capital K t +1 = (1 − δ ) K t + I t Again 2 steady states exist. New now that the scaled real wage is the same in both steady states, that is, the real wage converges in the long-run to the same balanced growth path regardless of whether the economy is in the liquidity trap or the target steady state. 21

A Great Contraction With Capital Accumulation Nom. Int. Rate % pa Inflation, % pa Real Int Rate, % pa Emp Ratio, % 8 4 4 100 6 2 3.8 98 4 0 3.6 96 2 −2 3.4 0 −4 3.2 94 0 20 40 0 20 40 0 20 40 0 20 40 Output Investment Real Wage Consumption 0.3 0.3 0.3 0.3 0.2 0.2 0.2 0.2 0.1 0.1 0.1 0.1 0 0 0 0 −0.1 −0.1 −0.1 −0.1 0 20 40 0 20 40 0 20 40 0 20 40 22

Exit Strategy in Model with Capital Nom. Int. Rate % pa Inflation, % pa Real Int Rate, % pa Emp Ratio, % 8 4 4.5 100 6 2 4 98 4 0 3.5 96 2 −2 0 −4 3 94 0 20 40 0 20 40 0 20 40 0 20 40 Output Investment Real Wage Consumption 0.3 0.2 0.3 0.3 0.2 0.1 0.2 0.2 0.1 0 0.1 0.1 0 −0.1 0 0 −0.1 −0.2 −0.1 −0.1 0 20 40 0 20 40 0 20 40 0 20 40 23

Conclusion • The present model characterizes liquidity traps that are accompanied by jobless growth recoveries. • In an environment with falling inflation expectations, an increase in nominal rates can contribute to re-anchoring expectations around the intended target and lifting the economy out of a slump. • The results of this paper extend to economies with capital accumulation. 24

Extras 25

Recovery Vs. Growth Recovery 26

What is the difference between a recovery and a growth recovery ? Recovery — output level returns to trend path. Growth recovery — output growth rates return to long-run mean but level does not return to trend path We can use data from the Great Recession in the United States to illustrate this difference. 27

United States: 1948Q1-2014Q4 −2.5 log of real GDP per capita −3 −3.5 −4 1960 1980 2000 Vertical lines: NBER recession dates, 1980Q1-1980Q3, 1981Q3-1982Q4, 2007Q4-2009Q2. 28

Observations on the figure. Recovery from great recession was a growth recovery. Recession ends in 2009Q2. But output level does not return to trend path. It grows at a rate of 1.2% percent per year, not very different from the average growth rate since the 1990s. (And close to the average growth rate in real per capita GDP since 1870, which is 1.5 percent). Graphically, a growth recovery is a parallel downward shift in the path of the log level of output. Compare this to the recovery from the double dip recession of early 1980s. Those were recoveries because the level of output returned to the trend path. After the recession ends, 1982Q4, output grows at a faster rate than normal taking the level of output back to its trend path. 29

Expected Inflation 30

Expected inflation evidence from the United States 31

U.S. 10-Year Expected Inflation: 2005Q1-2015 3 2.5 percent 2 1.5 1 2005 2010 2015 Source: Federal Reserve Bank of Cleveland. 32

Additional Evidence On Downward Nominal Wage Rigidity 34

• Downward nominal wage rigidity is the central friction in the present model ⇒ natural to ask if it is empirically relevant. • Downward nominal wage rigidity is a widespread phenomenon: — Evident in micro and macro data. — Rich, emerging, and poor countries. — Developed and underdeveloped regions of the world.