Precursors of NeoFisherism, by Scott Sumner

August 26, 2017

In a series of posts I’ve argued that NeoFisherism is wrong as usually presented, but in a quite interesting way. More specifically, higher interest rates don’t generally reflect easier money (as NeoFisherism claims), but they can do so on certain occasions. For instance, the Swiss National Bank simultaneously cut interest rates sharply and tightened monetary policy in January 2015–which tended to reduce inflation in Switzerland. They did this by sharply appreciating the Swiss franc against the euro. That’s a NeoFisherian policy.

It recently occurred to me that a relatively well-known paper by Lars Svensson represented a sort of precursor to NeoFisherism. Svensson discussed a “foolproof” way that a country could get out of a liquidity trap, which was almost a mirror image of what the Swiss did in January 2015. In 2001, Svensson suggested that the Japanese could sharply devalue the yen and simultaneously raise nominal interest rates:

It is technically feasible for the central bank to devalue the currency and peg the exchange rate at a level corresponding to an initial real depreciation of the domestic currency relative to the steady state. (2) If the central bank demonstrates that it both can and wants to hold the peg, the peg will be credible. That is, the private sector will expect the peg to hold in the future. (3) When the peg is credible, the central bank has to raise the short nominal interest rate above the zero bound to a level corresponding to uncovered interest rate parity. Thus, the economy is formally out of the liquidity trap. In spite of the rise of the nominal interest rate, the long real rate falls, as we shall see. (4) Since the initial real exchange rate corresponds to a real depreciation of the domestic currency relative to the steady state, the private sector must expect a real appreciation eventually. (5) Expected real appreciation of the currency implies, by real interest parity equations (15) and (16), that the long real interest rate is lower. (6) Furthermore, given the particular crawling peg equation (38), a real appreciation of the domestic currency will arise only if domestic inflation exceeds the inflation target. Therefore, the private sector must expect inflation to eventually rise and even exceed the inflation target.

Why is this important? Two reasons:

1. Keynesians tend to be rather dismissive of NeoFisherism.

2. Lars Svensson is a highly respected New Keynesian.

I’m not sure whether Svensson sees his proposal as being NeoFisherian in spirit, but it is. And I think we can learn something from this exercise. Easy money policies don’t always lead to higher interest rates, but the more effective the policy, the more likely that it will produce NeoFisherian results.

For those who don’t have time to read the paper, here’s a brief summary:

1. Imagine Japan starts in a liquidity trap with 0% inflation and 0% interest rates. The US has 2% inflation and 2% interest rates.

2. Because of interest parity, the yen is expected to appreciate at 2% per year.

3. Now the BOJ suddenly devalues the yen sharply and then pegs it to the dollar.

4. Because of interest parity, the nominal interest rate in Japan rises to 2%. Because of purchasing power parity, the expected inflation rate in Japan rises. Thus the policy is expansionary, despite the higher nominal interest rates.

“Never reason from a price change” is one of the most important tenets of monetarism (both the older and the market variety). Keynesians and NeoFisherians make the mistake of reasoning from a price (interest rate) change, but in opposite ways. My hope is that as these two schools of thought try to reconcile their conflicting views, they will arrive at monetarism.

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