Wednesday, February 9, 2011

Inflation, inflation expectations and the usefulness of structuralism

Paul Segal (a lecturer at Sussex but also a graduate from Oxford) has an excellent entry today in the FT about inflation and inflation expectations. As you can see, there are still interesting people that think about inflation in terms of bargaining and conflicts over income distribution... with expectations playing a more central role that we have discussed.

It is important to understand that any increases in interest rates will have a direct effect on the economy through two channels: The cost of investment and the potential appreciate of the exchange rate. Giving sluggish conditions, it is unclear why one would want to do it and may only be explained by political economy considerations.

The multiple potential impacts of CCTs

This paper by Francesca Bastagli highlights the different impacts that CCTs may have on Latin America´s welfare regimes depending on their initial characteristics. This is the abstract:

"During the 1990s, conditional cash transfers (CCTs) were adopted by countries across Latin
America as central elements of their poverty reduction strategies. Alongside other
developments in the area of social assistance, CCTs represent an opportunity for countries to
develop an integrated and inclusive set of social policies. At the same time, particular CCT
features risk promoting the further residualisation and fragmentation of safety nets. Drawing
on the experience of six countries in Latin America, this paper identifies the variations and
recent trends in CCT design and implementation. Based on this review, it considers the
contribution of CCTs to the potential transition from a largely absent or minimal safety net to a
coordinated system of social policies."

This is a key arena for future research on CCTs: we must place them within a better understanding of the welfare regime in each country. Also, it is directly connected to the research Juliana Martínez and I are undertaken on Costa Rica where the question has always been: how can you build universalism from the bottom up?

Thinking about exchange rates through the Venezuela case

Via Rosanna an interesting article on Venezuela´s January devaluation. Why was the country forced to devalue? And what are the potential consequences of a devaluation on prices? Things to think about as we see the application of macro-discussions to real life.

The NYT and inflation in Argentina

The New York Times echoed a worry in various places about Argentina´s growing inflation. There is little doubt that inflation is higher than the government recognizes and that a combination of a weak nominal exchange rate and growing public deficits may have contributed to it. However, it is just surprising that the NYT implicitly mentions a risk of hyper-inflation and, moreover, places Brazil in a similar vote:

"Inflation has reared its head elsewhere in Latin America as well. Brazil, which was ravaged by hyperinflation of more than 2,000 percent as recently as 1994, has become increasingly concerned that inflation will exceed 5.5 percent this year."

Is a 5.5 percent really such a problem, particularly in times of soaring commodity prices and growing capital inflows?

Thursday, February 3, 2011

New policy brief

Juliana Martínez and I have just published a brief on the Comparative Research Program on Poverty ( You can find it here. Based on our research on Costa Rica, we argue that building complementarities between the welfare regime and the economic regime in developing countries is very complicated. Structural heterogeneity (sharp differences between low productivity and high productivity sectors) means that it is hard to generate enough revenues to support social policy and, at the same time, a high demand for education spending. It is a first attempt to understand these complementarities, which are probably at the heart of our future research and policy agenda in Latin America.

Comments most welcome!

The liquidity trap

The concept of the liquidity trap goes back to Keynes and to Hicks' interpretation of the argument. For a long time, it was more part of a theoretical debate than a real possibility, but Japan's crisis in the 1990s changed this slightly.

To understand the "liquidity trap" is important to remember that it takes place in moments of highly recessionary environments. In these instances, nobody is really interested in investing much and the price level may be going down. The key insight is that monetary policy may end up being irrelevant in this situation. Why? Because there is a downward limit in the reduction of interest rates: when nominal interest rates are zero or almost zero, how can you reduced them more?

With interest rate equal to almost zero (with bonds at very high levels), the is no real reason to hold bonds. This mean that any expansion of money will result in an expansion of liquidity in the hands of people... and at the same time there are a lot of idle resources in the economy. You can find useful explanations of this process here and here.

Since the late 1990s, the concept entered into the debate on the Japanese crisis: in Japan, low interest rates were very low and monetary policy ineffective. Paul Krugman elaborated a dynamic model in which he showed that the liquidity trap can be a real possibility if people think that the price level will not increase steadily. You can find his explanation here (just read the introduction as the rest is somewhat complicated).

We represent the idea that monetary policy by a horizontal LM curve. Again, expansions of money supply do not affect the interest rate and will only result in more liquidity in the hands of people.

What about fiscal policy? In this environment, fiscal policy will be very effective both in the simple IS-LM model but also in the more complicated, Krugman version.

How can we see the intuition in our graph? Here is a possibility: there is a lot of liquidity (and a lot of idle resources) in the hands of households and firms. In this case, government spending will simply put some of this money "to work" but there will not be further increases in the demand for money (people are already holding a lot of money).

Is this an ideal world because you have fiscal policy with crowding out? Not really because we are in a deep recession and you may need to expand fiscal policy more than you are capable of (in terms of your borrowing constraint). Moreover, it could be that fiscal policy does not help to re-start the economy.

To follow all this discussion and the IS-LM model a little better, you can also check these slides from a professor at the University of Hawai.

Finally, how likely is the liquidity trap in practice? There is a lot of debate about it, but many people believe that we were very close to one in the recent global crisis, particularly in the US. Interest rates were very low, but this did not promote investment. People (and banks) simply kept more money in their pockets. At the same time, however, there has not been a process of deflation and the economy is slowly recuperated (although nobody knows for how long).

How likely are liquidity traps in developing countries (our main interest)? The answer is probably that not very likely because inflation is higher than in developed countries and interest rates can go down significantly. Moreover, as our Stiglitz et al book argues, the expansion of liquidity can have a positive effect on firms that are constraint by a lack of credit.

Wednesday, February 2, 2011

Macroeconomic webpage and lectures

Nouriel Roubini has a very useful webpage of his two courses on Macroeconomics and Macroeconomic policy. The notes and book on the bailouts are particularly interesting.