Last week I blogged about my perplexity regarding the Keynesian notion of a liquidity trap.
In thinking about this harder, I’ve come to realize that a good part of my confusion has nothing to do with liquidity traps. It comes down to a very specific question about sticky-price models in general.
I expect this discussion will be interesting only to the most wonkish of my readers. The non-wonkish are invited to ask for clarifications, but please don’t jump in claiming to have “definitive” answers unless you’ve got a good grasp of the basics. I’d like to keep this discussion on track, and I’d like to learn something from it. Uninformed noise will be counterproductive.
For what it’s worth, I’ve discussed this offline, at considerable length, with several very good macroeconomists who eventually pronounced themselves as confused as I am. I really am hoping somebody with the right insight will pop up here and set us all straight.
By way of analogy, let me start with something I do understand — a world with flexible prices and (for simplicity) no inflation. (What follows is standard textbook material, which we all learned from Milton Friedman, who in turn probably learned it from Iriving Fisher. It is not controversial. If you think it’s wrong, the probability is 99.9999% that you’re mistaken.)
Let’s consider the supply and demand for money in this economy. Money is supplied at (essentially) zero social cost (the cost of paper and ink being essentially zero). However, the private cost of holding money — measured in forgone consumption — is positive. Whenever the private cost of an activity is greater than the social cost, people engage in too little of that activity. In this case, they hold too little money. Or in other words, they spend too much money. That means that each additional dollar you spend must hurt your neighbors more than it helps them. It remains to ask who, exactly, is hurt by your spending.
Answer: When you spend a dollar, you bid up prices. That’s good for sellers, bad for buyers, and bad for other people holding money (because it depletes the value of their dollars). The first two effects wash out, because every transaction involves both a seller and a buyer, leaving the moneyholders as the bearers of the net harm.
Note the logic: First we identify a discrepancy between private and social cost. This tells us that spending a dollar must (at the margin) do more external harm than good (“external” means “not felt by the decisionmaker”, the decisionmaker in this case being the spender). This in turn tells us that we ought to ask who bears that harm. The answer isn’t immediately obvious, but it’s clear once it’s pointed out.
Now I want to apply the same logic to a “Keynesian” world of fixed prices. In order to focus on one very specific question at a time, I’m going to assume this world is at full employment. (I eventually want to understand worlds without full employment, but one thing at a time!). Better yet, let’s follow Paul Krugman’s example and simplify things as much as possible by assuming that consumption goods just fall from heaven, so there’s no such thing as labor. They do, however, have to be purchased with money.
Okay, back to the money market. Once again, money is provided at zero social cost. Once again, it seems to me that the private cost of holding money is positive (that old forgone consumption again). Therefore, once again, people must hold too little money. Therefore, once again, they spend too much. Therefore, once again, an additional dollar spent must do more external harm than external good.
The problem, then, is to identify the bearer of that external harm. Well, what happens when I spend a dollar? Back in the old flexible-price world, I bid up prices. But in the fixed-price world, I can’t bid up prices, so I must bid up the real interest rate instead. That’s good for lenders and bad for borrowers, but that washes out because every lender is matched with a borrower. So where is the missing extra external harm?
To break this down further:
- Am I right that in the fixed-price world, the social cost of providing money is still zero and the private cost is still positive? These things are certainly true in the flexible-price world, and I can’t see any reason why fixed prices would change this part of the story. Maybe I’m missing something, but I’ll be very surprised if I am.
- Assuming the answer to 1) is yes, we know from the general theory of externalities that spending a dollar must cause net external harm at the margin. Who feels that external harm?
I understand that there are all sorts of Keynesian reasons why spending a dollar might cause net external benefits, but those reasons are all centered on unemployment. I want to know what happens in the simple no-unemployment world I described above. Once I get that down, then I can start thinking about the harder cases.
Edit: One could take a stab at an answer along the lines of “people expect deflation, which reduces the private cost of holding money, so they don’t hold too little after all”. But we can assume an economy with both zero inflation/deflation and zero expected inflation/deflation, and the same questions remain.