Inflation

- We're very happy to have John Cochrane telling us about inflation.

- So this is a, it's been my on the run talk since I published the fiscal theory, the price level, and then I was invited to come give it as a Bruno lecture at the Swiss Central Bank. I thought this was a keynote speech for a conference. So I filled it with equations and, and give, you know, my last 20 years of thinking about inflation. And they, they told me a week ahead of time, no, no, no, no, this is for business people. You can't have equation. But I think actually that, that made it a better communication device for everyone. So I, I thought you might enjoy it. In any case, I've got on about an hour of talk. If I talk really fast, the best stuff is the end. So just to keep that in mind when you decide how much you wanna ask questions. Other than that, usual. So the theme, which primarily we'll get to the end, big question, what is the source of inflation in, in today's economy with today's institutional framework? By which I mean an interest rate target, no money, supply control, ample reserves, liquid assets. How do central banks by changing interest rates, control inflation? That seems like old settled questions. And if you go to monetary policy conferences, you go, you, it seems like we all understand this, we have for 40 years and we just have the details of the transmission mechanism. In fact, it is not, there's a chasm between the, what I'll call the policy doctrine, the way people talk about monetary policy, the Fed and the actual equations in today's models. I think that chasm is, is we're, we're getting, we're making progress. There is an answer emerging about how theory and doctrine can relate to each other. So in fact, this is not monetary policy. Is that an exciting physics 1903 paradigm shift moment? If you follow me all the way to the end, not a old and settled and just little epicycles to discuss moment. So let's just get right into inflation. And I think I'll start by example rather than by theory. And some of you have heard this, this part before, but it'll get more novel as we go on. So what recently happened in the us we had a surge of inflation starting in January, 2021 without anything particularly strange from the Fed. They did what they always did in recession. So it's not a monetary policy. Shock inflation surged the Fed, sat on his hands for a whole year ignoring John Taylor's advice to follow. Now inflation then plateaued and eased long before the interest rate got above the inflation rate. Traditional doctrine says you have to raise the interest rate above inflation to push inflation down. No, it started going away on its own. There was no spiral and there was no deep recession like 1982. And then here we are, we're trundling along, which is either a soft landing or stalling 50 feet off the runway, depending what it looks or who knows what comes next. So what happened here? Well, you, you can tell what elephant I'm gonna look at in this room. The black line presents the US debt as a way of showing you what happened in COVID. The US government borrowed 2 trillion, printed 3 trillion and handed it out as checks to people in businesses. I I, I guess I should back off the tone of that. They needed to do something. I think it was overdone, but that's not our point today. That's what they did. And if you think that was the right thing to do, fine, but that's what they did. Importantly, they moved to huge deficits in spending even after COVID ended. And, and that's an enormous fiscal shock. So, and I, I, I do note that in the graph with the A-R-A-I-R-A, the CHIPS act in starting January, 2021, there was additional spending. So that obviously is, is an elephant in the room as far as where inflation came from. Here's another graph showing the primary surplus to GDP and showing you just how enormous this set of deficits was, both the COVID deficits and the deficits in the first year after COVID. Notice that we are now back to regular levels of dysfunction. So as far as we, we, we bemoaned debt and deficits around here, but a lot of that is interest costs on the debt. We are not particularly unusual by the standards of the two 2000 tens. This is a graph looking across countries by Barrow and Bianchi on the right and on the bottom, how much government spending during COVID on the y axis, how much total inflation they got. And you can see that this, the size of this fiscal shock correlates nicely with the amount of total inflation that they got. So that's certainly seems like the elephant in the room for where did the inflation come from. Now I, this is how, how do I think of at fiscal shock causing inflation? And here's my ad for the fiscal theory of the price level, which I've been working on for about 30 years. And my job was to summarize it in three minutes. The basic idea is imperialistic asset pricing, nom the ratio of nominal government debt to the price level. That's the real value of government debt is the expected present value of government surpluses. A couple of stories may make that salient. One is like stocks. If you see there's no dividends, you try to sell the stocks, price goes down. If we wake up and see these guys aren't gonna pay off the debt, it will be eventually inflated away or defaulted. We run to get rid of debt. The only way to get rid of debt is to drive up the price of goods and services. So just like stocks it and, and it, it feels like aggregate demand, if everyone's trying to get rid of government debt, what you feel like is, you know, too much money chasing too few goods. Another story to tell is that if inflation's always too much money chasing too few goods, the, a government can soak up that money by charging taxes and excess of spending or by issuing bonds. But the only reason people buy bonds is 'cause there's gonna be future taxes in excess of spending to pay off the bonds. So money current or future deficits is surpluses is what soaks up the too much money. Now once you write that down, that enforces enforces some d discipline. It is not that debt and deficits cause inflation, debt and deficits relative to what people think will be repaid, not today's debt and deficits. And the top graph here illustrates a, a great and good kind of debt, suppose that the government borrows to say to finance a war or a crisis or whatever and promises to repay that debt. And everyone believes that promise, the present value, the sum of the ups and downs on the right hand side, discounted by the interest rate is zero. That has no inflationary effect whatsoever. Even in, in fiscal theory. Debt and deficits can have no inflation whatsoever. And that is great and good fiscal policy, government debt is a great and good thing. You heard that right here at Hoover because properly managed it allows a government to fight and win a war and spread the tax payments over a generation rather than to do it right. Right. Now that also that now, well where does the problem come? The problem comes in debt and deficits that people don't be believe will be repaid. Now there's, you know, it's not gonna get soaked up. That's what causes inflation. And technically this is very important. Technically 90% of the, of people who write complicated fiscal theory, the price level papers assume that the government may only do that. It may never issue debt that it promises to repay. 'cause that's kind of an a R one. They say, well let's suppose it's an A one. Well that's not an A one. You write down an A one you are in, you are assuming the government cannot ever commit to repay its debts and you're ti and that's a terrible assumption. Yes, Valerie.

- So I'm thinking about that graph from Al Bianchi that shows for COVID this amazing positive correlation to the the amount that they spent and the inflation. My understanding is if you try to do that same graph during the global financial crisis, when there are quite a few stimulus packages adopted, you just see a cloud. And so then the question is, is there any statistical evidence? Has Steve Davis or somebody like that had a survey where, where you ask people if you think the debt will be repaid because I'm thinking why, why didn't we get inflation? And plenty of people were predicting it from all of that spending during

- I, so I got a slide with a little more of that in so moment.

- Feel free to say,

- But this is the, the problem of the theory of finance is that it would be lovely, you know, how how have we dealt with that for 50 years Now, it would be lovely if there were surveys of expected dividends that we could discount back and, and produce stock prices that looked anything like actual stock prices that don't work. So let's not repeat that mistake. But there is, I think I'll, I'll tell you some stories and and hopefully we can inspire some survey evidence here. But just to, so the, the other possibility of course is people lose faith and inflation seemingly comes outta nowhere where it sometimes does. And the last thing that looking at the formula, John, why don't you just directly look at bond yields? Yeah, bond yields should be informative. Bond yields never forecast inflation and they never forecast, they never forecast the end of inflation and there's always no they're risk premiums in there.

- Yeah,

- Yeah, yeah, I understand that. I'm I and they're off and wrong, right? I mean, when the Fed lowered the but absolute funds rate to zero in December of 2009, the market said it was gonna stay there for nine months. It stayed there for seven years. So it can be off, way off, but it is kind of in a sense the best guess of the people that have funds to

- Stay. Absolutely. No, there's nothing wrong. I I think that's a great idea and one should do it and hopefully I'm inspiring somebody to go do more work on this. The other important thing is, is know the RS discount rates or interest costs on the debt matter equivalently with surpluses and actually to account for what's happened in the post-war data as a whole paper I wanna show you, it's almost all the discount rate variation up until 2020. So what happens is in a recession, interest rates go down and the reason you get less inflation and a recession is because you get to pay it off at low real interest rates. Not because there's a whole lot of fiscal surpluses coming up. Okay? So with that sort, why now, why not 2008?

- Your, your simple version of the fiscal theory of the price layer has no role for alter, how do I say it? There's other values to government debt, especially the US dollar, beyond just their ability to smooth the relationship between, I'm not saying this very well, there's all these convenience, yield, whatever you want to call it, special privileges of the dollar that that provided a source of demand for government debt. And one view is those are just too small. And so do a first order approximation. You don't need to think about them and they can't shocks to the, to that can't really matter that much. Is that your view? Or, or no, no, it's not your view. This is 630 page book. I understand. So I'm

- Every, I will, I will say now every possible, well we'll try, but I think every generalization you can come up with in the next hour and a half. I I, well I'm just trying to understand if you think this particular one is material in

- Magnitude.

- So what does it do? It you get a little bit of senior age, which you can put in the s or you can think of it as a distortion of the rate of return R and to the extent those matter, go for it to the story I'm gonna tell right now, I don't think it particularly, it's not first order. Okay. Senior age is kind of second order to the US Maybe we get exorbitant privilege a percent or so of of treasury return being lower than it would otherwise be. Certainly true at the level of this talk. Okay, I'm not, I'm gonna ignore it, but this is not the end of fiscal theory. This is just the very simplified textbook version. Okay, so with that in mind, why not 2000

- Comment here. A lot of research on internationally and econometric risks are showing that inflation pressures depend on the level of debt. And of course by the time of the COVID crisis, it had been built up a lot, especially after the great recession, it kind of doubled the share of GDP. So maybe we got to a level at which it became more salient. Is that relevant?

- That's, well the, the question here is why not, not this time, not 2008. Okay, I'll, I'll I'll accept that one. Of course, Japan got to a higher level. Yeah, Argentina has a debt crisis at 40%. So I think there's something to this, there's something around a hundred percent debt to GDP is where we run into our limits of we can promise to repay it. So yeah, let's the, the story level. There's about five stories one can tell. It was certainly interesting that in 2008 there was deficit. Now repayments later we all laughed at it, but at least they had the decency to say it. No one had the decency to say that this time it was all modern monetary theory. Go big interest costs are low. A a decade of, of secular stagnation. Don't worry about government debt was certainly there and the last 10 years had negative interest rates. So that interest costs on the debt really bailed us out of 2008, not this time. So I think there's a plaus, you read the history, which I'm not gonna go into in depth. You, I'll show you the papers. There's a plausible story but not proof. 'cause proof is hard to come by. So, but that's conceptually you need to think about debt relative to expect repayment. That's the big point. Now of course we need models, not just stories. So let's build a model, which is really the point today. What kind of model do we have of interest rates and inflation? So let me start with flexible prices and a constant wheel interest rate. So first equation is just constant wheel interest rate. Nominal interest rates are reflected in expected inflation. Our second equation of our model, flexible prices is gonna be simple fiscal theory equation. Multiply and divide the left hand side by pt. Take unexpected values. Notice that BT over PT is known at time t So unexpected inflation comes from revisions to the present value of future surpluses. So there you have it, a complete theory of in inflation under interest rate targets and there's a separation. If, if you think of central banks as setting interest rates without having anything to do with fiscal policy, the central bank matters. It sets the interest rate by, it sets expected inflation, fiscal policy sets, unexpected inflation fiscal policy matters too. And a, you know, lower surpluses present value is gonna be give you a higher price level. Now this is a complete beautiful theory, but it's utterly nutty. Raising interest rates raises inflation. Well, when you think about it, this is the flexible price model. So of course, you know, a hundred percent inflation in Argentina comes with a hundred percent interest rates. But that's the long run in flexible price models. The long run happens overnight. So if you ask a flexible price question, you're gonna get a flexible price answer. But watch for that 'cause that is gonna be the, that's gonna be the gaping wound. Trying to turn that around in the short run is the gaping wound of current monetary policy. Avoiding this, this force that higher interest rates want to raise inflation is very hard. The other difficulty of this, it says if there's a fiscal shock, you get a one time instant overnight price level jump. Well, obviously not. What do you do? Let's add a complication, namely sticky prices. So here is a model I I don't expect you to read the equations, I just expect you to know there are inflate equations here. Those of you who are familiar with this will recognize the textbook new Keynesian sticky price model. Don't innovate in two dimensions at once. So I just added fiscal theory to the Woodford golly equation. One, there's some sticky prices in here, is all you really need to know. The graph shows you the effects of what happens if you throw 5 trillion bucks of money or debt on people and, and with no plans to repay it and the fed does nothing. So the, this is just fiscal policy with a constant interest rate what happens? But we had a price level jump. Now we have a slow price level rise. God, that's what sticky prices do. Now this even with one period debt, how, how do these people lose money? Well, what happens is the interest rate is below the inflation rate. So you lose money over a period of years by low real real rates. So the the spending has to come from somewhere. And if it's not coming from taxpayers, it's an inflation induced default on bond holders, which they get from this period of, of low interest rates. So, and what you see is this one-time surge in inflation that seems to come from nowhere. It eventually goes away. Why? It was a one-time shock. And when a one-time shock goes away, the price level's gone up. We've inflated away the debt, it goes away even with no action by the fed, no high real interest rates, no recession inflation eventually goes away. That's what the, that's just the model version of, of the story that I told. And at least you know, you know, just 'cause there are equations doesn't mean it's right. But if there aren't equations, it's almost certainly wrong. So at least you know, there are equations behind the story. Now what about the fed and interest rates? We have this problem of higher interest rates raise inflation and I'll show you the best I can do in a rational expectations model. Here I have sticky prices. That alone doesn't do the trick. Well the trick here is sticky prices and long-term debt that together gives you higher interest rates. Notice it's raising inflation the very long run, but that lowers inflation today so that the fed by raising interest rates can lower inflation today at the cost of slightly higher inflation, lower run. Why? Well, there's gonna be inflation. There's nothing the fed can do about it, but it can change when the inflation happens. So here's the story and here's why I'll never be fed chair 'cause I would have to honestly explain this in front of Congress. How do higher interest rates lower inflation? Well, higher interest rates raise future inflation that kills long-term bond prices. That makes the value of the debt smaller, but the surpluses haven't changed. So the value of short-term debt has to be bigger. How does that happen with lower inflation? Your eyes are glazing, but that's how it works. Yes, Steve,

- In a in a world where there's multiple sectors and the degree of price, price flexibility is differs across sectors, you can actually get a real benefit from reallocating this inflation over time. Right? So contrary to the idea that monetary is neutral, even understood not monetary policy because the, the differential price responsiveness across sectors leads to distortions and resource allocation. Absolutely. And the Fed can mute that distortion by altering. So there is, it doesn't come through in this model, but there is a coherent argument within the broader context of what you're talking about for why the Fed should smooth it. It

- Actually even comes, it comes through in this model, does it notice, look at the second equation. Phillips curve, the output gap is essentially inflation relative to future inflation. So in this model, a, a random walk inflation is the best thing you can have as inflated away slowly and steadily. So if the Fed sees this okay and responds with that, what it creates is a, a slow permanent inflation with very little output gap.

- Okay?

- It's even optimal in this setup and somewhat different reason than the one I suggested. Yes. Now of course this too is just the textbook version. We need many more equations in the Phillips curve. We need wage stickiness, all that other stuff. But I, and I think that will just emphasize that and I just don't wanna finish. Another way to do this is for the interest rate to follow the inflation. If you write a rule, interest rate equals five times inflation, you do this automatically. And so the Taylor rule is always the answer. It's just the questions that keep changing. And in this case that is praise not not in answer. Right? Right. I got it. So sorry

- Bill, I, I'm thinking about Turkey where they tried this, but in the short run got the usual kind of result was they were doing it for quite a while. Was there any evidence that things started turning around for them when they were lowering interest rates in order to fight inflation?

- Well this is a case where it goes the wrong way in the short run, which is part of the difficulty for the Turkey strategy is you have to be able to willing wait it out while it goes the wrong way in the short run. But didn't they? Well that's the second thing is this is a change in interest rates with no change in fiscal policy. If you're lowering interest rates in order to try to print money to solve an outta control fiscal situation, that's an s shock along with an I shock. And I think that's the problem for Turkey. So does Neo Fisher in policy work and when, that's a great question, which we're not gonna talk about right now, but there's a whole chapter

- If you want, if you want interesting historical antecedents of the idea that lowering interest rates will lower inflation as Jimmy Carter went on national television, 78 or 79 said the inflation's horrible, the Fed should lower interest rates.

- It's called the right,

- How's the disaster in the foreign exchanges, by the way? But that's

- All it's

- Called the right effect.

- It was, it does sometimes work. And there are cases where higher interest rates have raised inflation 'cause they raise interest costs on the debt. So it's, it's a subtle issue when it does and when it doesn't work, certainly when there's a big fiscal reform in interest rates go down and inflation goes down. So I'm not, as you'll see, getting theory to not say this is true is very, very difficult. But we'll get there, hopefully. Okay, so summary so far there's what happened? Here's the fact, here's the theory. Inflation surges when there's a big fiscal blowout, even if the Fed does nothing go, go away on its own, when the fed wakes up and does something that brings down inflation faster at the cost of slightly persistent, longer term inflation, not perfect, but at least we have theory and a model that sort of talked to each other and not necessarily bad. What what we did in COVID was classic war finance, spend like crazy, don't worry about whether it's efficient, monetize the debt, hold interest rates down, state contingent default, make the bond holders pay for it. And, and it, it only ended before we went on to financial repression and price controls, which is what you do in a war. It just says, you know, this was a choice. It wasn't some shock. I think it's important to say that there's a lesson from this episode, the 2000 tens, all the, everybody outside of Hoover was saying, chronic insufficient demand, modern monetary theory, secular stagnation, endless appetite for us death. All you gotta do is print it or borrow it and hand it out and, and, and happy days will be with us. We did exactly what you asked. We got a big inflation that's over. Growth comes from supply, not demand, but that's orthogonal today. Let's onto the next topic. Well, there's one theory of inflation, how about all the others? So what about the other theories? Inflation? I will try, I will cover them all at rapid pace. I will try to convince you the theory, the new Sey model plus fiscal theory that I've just shown you is the only known complete economic of those adjectives matter theory of inflation under interest rate targets consistent with current institutions. There is no other that holds that, that holds together. But more importantly, facts, recent history gives us a clean set of experiments to distinguish all the known theories of inflation. And guess which one is gonna come out on top. I wouldn't selection bias. I wouldn't be here otherwise. So this slide is to make fun of, of, you know, what do our politicians and too many central bankers say? Oh, it was all supply shocks, greed, monopoly, price, gouging, hoarders, and speculators, all the usual suspects that have been rounded up since diocletian inflation and 3 0 1 ad. The problem is all of these are stories about relative prices. It's like saying the ocean is high because I see a big wave. Well, the level of the ocean is not the sum of the level of the waves, it's the level of the ocean.

- John, what bothered me about this story is the Fed people in the, in the early 2021 did not think they were choosing 9% inflation. No, they, they don't believe, I don't think they believed this now they certainly didn't believe it then.

- Believe what I just said, that, that we did an

- That we that we, yes. So how, how do you explain

- That as if Yeah, I understand. I I don't the fiscal, there's so what you're explaining, the fiscal shock came whether the and and there's nothing the Fed could have done. We're gonna run fiscal policy with debt that is not gonna get repaid. You're gonna get inflation. The fed's job is only when is it gonna happen. So there was really not much, it was a transitory shock that came to them out of the blue as they perceived it to be.

- Okay. They, they did not see it that way in real time by any means. No, they said this is a and and Mickey has, and others have shown this, and I'm, I'm not sure many, I'm not sure many of me agree with that assessment. Now we had a fiscal shock, so we're gonna get an increase in the price level one way or another. And your only job was to figure out the timing. But it doesn't matter what they thought, the fiscal shock is gonna cause inflation. It doesn't

- Matter what the Fed does. So, you know, with, if

- They had acted earlier, they would've pushed it off into the future. That's what you're saying

- A little bit. Yeah, yeah. Okay, let's stop making fun of supply shocks. Oh, what I was gonna say is, in every model with supply shocks, just like the story we tell the seventies, the only way it causes inflation is because it induces the fed and fiscal policy to provide the demand. We need the money to pay the higher prices. So like these seventies oil shocks, it induces fiscal monetary policy. So the causal chain is the supply shock is is the carrot that causes fiscal monetary policy to, to cause the inflation. And that's important. Shocks are a reason, but they're not an excuse. Inflation is a choice by fiscal or monetary policy. Let's get to real theories of, of inflation not making fun of people. Of course, in this room we have to talk about money Friedman. Now this is a wonderful theory, but in, but in in today's economy, we are at a perpetual liquidity trap. Either 0% interest rates or interest on reserves. And central banks don't control the money supply. If you don't control the money supply. MV equals PY is a theory of m it's not a theory of py, but let's not worry about or or it also is 99% the same as fiscal theory. If I give you 5 trillion bucks, well if you print up 5 trillion bucks, Milton Friedman would say, yeah, you're gonna get big inflation. Here's the big question. Suppose I give you 5 trillion bucks and take back 5 trillion treasury bills. Milton Friedman says, well, money supply went up. That's exactly the same inflation his fiscal theory says, well, money's just a form of government debt. You haven't changed the total amount of government debt. So an OA huge open market operation has no effect the first order, whereas financing a deficit has a huge effect.

- So you consolidate the balance sheet of the Fed and central bank and the treasury

- The first order, yes. And today will be, you don't have to, many frictions can be added, but let's just start by consolidating, well, wouldn't it be nice if they did an experiment for us first, let's print up 5 trillion and give it to people. See what happens then let's print up 5 trillion, give it to people and take back 5 trillion in treasury bills and see what happens then. And they just did this that was QE and it had no effect at all on inflation. They, in COVID, we gave 'em 5 trillion bucks and you got a big inflation. You pretty much can't ask for a cleaner experiment. Yeah.

- Couldn't you say that it's liquidity that matters, not money. Like I, I think you would agree that right now, short term debt is highly liquid, arguably as liquid as money. Couldn't one argue that the story is the treasury is kind of doing the money printing via more and more short debt issue. That's, that's actually John's job market paper has the, the treasury is issuing a lot more short debt in 2020s response than they were in the 2008 response. You can't, you square the inflation now and not then with like the liquidity and debt being issued. Like if you're issuing liquid debt, it's pretty much the same as issuing liquid reserves. No, everything you said applies still. If you have a monetary theory of money, supply money demand, just

- Then you're saying, which you're saying is the maturity structure of the government debt should be driving inflation and the maturity structure has changed dramatically over time. I think you're gonna have a hard, hard time with, it's not the level, it's the maturity structure alone that causes inflation.

- The demand matters as well. Just like money, the demand matters for a monetary state.

- But you also have, yeah, you also have to control. Okay, maybe,

- Maybe not. I wanna go on. So you, you may want to defer this, but monetarism, you know, was thought to work because there was a stable money demand function and you know, and that was sort of religion, you know, in 19, in the 1970s. And then that fell apart with, you know, innovations in technology and, and you know, and, and so, you know, people kept on expanding, you know, what, you know, to the, you know, issues of liquidity, you know, in the fiscal theory of the price level, you know, you're relying on some kind of, you know, finance specification in which there is a pricing kernel and are are shocks to the pricing kernel, you know, stable are, you know, are they, you know, or is there, you know, like the same kind of instability that, you know, that could lead to, you know, just random inflation because people wake up one day and they, you know, they don't wanna hold the debt. You know, they're not, there's, you know, there's no, there's no demand for debt in the, in the model, you know, and you know, and, and is there stability in the, you know,

- No. And that's what makes it hard because the discount rate changes, the, the interest costs on the debt change. And in fact, empirically when I looked at it for postwar inflation, it's all the discount rate change. So that demand for debt as a function of future surpluses changes all the time because the discount rates change. So there's nothing as, there's nothing as beautiful as, as plots of MV and py. And then we don't talk about correlation causation too much, but there's nothing that is that beautiful. Okay, let's move on to, we need a theory of inflation under interest rate targets. Why? Because our central banks do not control money supply. That's the central challenge. So we've got them, there's three coming. This is the, what I call the policy view, ISLM, old Keynesian or slow moving expectations. And, and the doctrine says you raise interest rates that lowers demand, that lowers employment via the Phillips curve. That's what causes inflation in equations. Top right, I just wrote down an I curve and a Phillips curve. The key here is that the expected, the inflation expectations are lagged inflation adaptive expectations is, is, or at least the green one, sort of the current Fed thinks of inflation as a expectations as a third variable, a minimal to speeches. The important thing is it doesn't react to what the Fed does. It's short, short of expectations are out there that that'll work the same way. Now take the top two equations, eliminate X from from the two equations, put the X from the first equation and the second equation solve for PI T. And you get the relationship between inflation and interest rates, which is what we're after. How do interest rates affect inflation? Notice two features of this. The coefficient in front of lagged inflation is greater than one inflation is unstable under an interest rate peg, that's sort of a central doctrine. Milton Friedman 1968, you can't peg interest rates 'cause inflation will spiral up or spiral down second notice the minus sigma KI, higher interest rates, lower inflation going forward, central doctrine of, of how they think inflation works. And, and then that carries a lot of experience. I'm gonna work hard to make theory come back to that doctrine. Maybe the doctrine's wrong, but let's try to make theory come back to that. You can't run into straight peg and higher interest rates, lower inflation. So inflation, the job of the Fed is like being the, the seal, the ball is inflation, it's unstable on its own. How can you fix it? Taylor rule, if you put I equals five pi in the inflation equation and now solve for, for the inflation dynamics that changes the quotation that was greater than one to less than one. So the Taylor rule stabilizes an inherently unstable economy. The the Taylor rule fed is like the seal who moves his nose more than one for one with the ball and thereby stabilizes the ball, right? That's the standard view of inflation. What's wrong with that? Well, theory, adaptive or non-reactive expectations. The expectations in the model are not the expectations of the model. And that's fine. I don't mind that as icing on the cake. And, and certainly to understand episodes we don't wanna be religious about that. But if you take this view, there is no nominal anchor. There is no economic model of the basic sign and operation of monetary policy. It's not icing on the cake. This is the cake. Now I'm uncomfortable with that, that everything we do in this room has no supply and demand foundation. You must believe people are irrational for, to get anywhere talking about monetary policy. So let's keep looking and see if we can find something rational that understand that gives you explain the basic sign of monetary policy. But let's also not argue about theory. Let's argue about facts. This makes a clear prediction which nobody really knew the answer to In 2007, if you peg the interest rate for a long time or hit the zero bound for a long time, inflation or deflation will spiral out of control. And everybody in the policy world was loudly predicting that as of 2007, you can tell where we're going. They just ran this experiment for us.

- Don, I I thought go back to your equation. I thought there's a lot of latitude when you plug in pi e in there Yes. Into what that is and whether the fed can move it around or not. Isn't that relevant here to whether you're gonna get things spiraling out of control?

- That is, but as long as the, as long as the PI e in their view I think reacts very slowly to lags of inflation that amenable the, and the negative sign is certainly there so long as the PI E is not ETF plus one. But yes, I put that in because I think a or honest reading of the fed's policy model has to have the PI E and how that's formed. Yeah, and there's some lags in this in futures, but I think it, there's a

- Lot of flexibility is like umpteen different expost rationalizations of what happened based on. But

- I think the key on PAE key, the key to the doctrine is the answer is not the question that inflation is inherently unstable. Higher interest rates, lower inflation going forward. And the job of the Fed is to stabilize an economy that on its own will be unstable as opposed to what's gonna happen next. Okay? So lots of different ingredients will get to that answer. And I think the answer is more important than the ingredients because if you ask them, do you believe adaptive expectations say no, no, I'm not. Yeah, but then they believe that's how it works. So that's the important part. That's how they think it works. Okay, new Keynesian model brought in rational expectations. This is an economic model and how it works. The two equations on i I gave you the flexible price version, which is even clearer, but the sticky price version we have et pie t plus one where they used to be pie T minus ones. What happens now? Well eliminate the X from those two equations. Solve for the ET pi t plus one. Now on the left hand side and there is the relationship between inflation and interest rates. So what do we notice about that? First of all, the sign is now less than one inflation is stable under an interest rate. Pay inflation will go away all on its own. Higher interest rates raise expected inflation going forward, even the sticky prices didn't get around that sign prediction. This sign prediction is in every current new kaine model, higher interest rates left alone will raise inflation. So that the whole, I don't know about the Turkey facts question, but that is every theory we've got since 1990 and, and getting around, that's the hard nut which we'll get to eventually. The problem is that we've only determined et pi t plus one. We don't have unexpected inflation. So the, the doctrine here is that the interest rate peg is stable, but it is indeterminate. It leaves multiple equilibrium. That's the problem. So what, what does the Taylor rule do? It's always the answer. The questions keep changing in this model, it takes an economy that is stable on its own, inflation would go away, but it deliberately induces instability to fight the scourge of multiple equilibrium. That's Powell calling. The main job of the Fed is equilibrium selection equ. Now, now the problem with this is in theory it's a beautiful, like, it's a beautiful theory, but central banks don't do that. We don't need fancy estimates. Just ask central bankers here. I am gonna appeal to what they say about what they do. Tell them, ask them, is your central job not to stabilize inflation? Do you deliberately destabilize inflation because your main problem is multiple equilibrium and you want to induce us all to jump to the equilibrium you like? Indeed. The only way, how do you produce higher interest rates, lower inflation. In a model where the, I has a positive sign on the pie T plus one, you induce an equilibrium selection shock to make them jump to a different, one of the multiple equilibrium coincident with raising interest rates, which on their own raise inflation. And that's how we lower interest rates compared to what I just said about my testimony to congress. An honest testimony of Mike Woodford to Congress, which would be this, we know that would be even more laughable, but let's not complain about theory. Let's look at facts. And here there's a prediction loudly made by the nus. If you had a peg or a zero bound or repeat the 1970s where PHI is less than one, you'll get multiple equilibrium volatility in sunspots. Why don't we try it and see what happens? You know where this is going. So in this context, what does fiscal theory do? It is what I've done is the new Keynesian model. You, you can match fiscal theory to old keying models if you want. I just took what was popular on the bookshelf. It's the same model as before. But the unexpected inflation, instead of this destabilizing the economy business, there's only one of those equilibria that's consistent with our friend, the fiscal theory. Only one of those equilibria, the unexpected inflation matches the revision in the, in, in the fiscal surplus. So we solve the indeterminacy problem right away. So now just imagine, admire the beauty of the adjectives. We have a theory, it's a complete theory of inflation under industry targets. Inflation is stable, it goes away on its own. That's kind of a nice property like m vehicles. PY raise money, growth sooner or later, inflation goes up, it's stable, it's determinant, there's only one answer. It's long run neutral, raise the interest rates. Eventually inflation will go up just as raising money, growth, eventually it'll go up. Those are kind of completely normal things. And this is my claim that it's the only complete economic model, rational expectations under an interest rate target, not money consistent with current institutions. The Fed doesn't threaten to blow up the economy in order to fight multiple equilibrium. But enough theory, how about the prediction? Now, if you have a peg or a zero bound with no fiscal news, inflation can be stable and determinate and quiet. I'm I'm using quiet as the opposite of volatile. So wouldn't it be nice if they ran, you know, it's 2007. Well, we've never seen that. The fed has never left interest rates alone for long enough for us to see what happens. But they just ran this experiment. This is the zero bound era. And, and you know the answer, interest rates got stuck at zero. The Fed stopped doing anything and inflation was quieter than it had ever been before. There was no deflation spiral, there was no multiple equilibrium volatility. It just went along. Now, fiscal policy wasn't great, especially as viewed from this room, but there wasn't a lot of news about fiscal policy. It was just, oh, someday the bond vigilantes will come and the bond markets are saying, yeah, someday they'll they'll they'll fix it before that day happens. So it was, it was also quiet, not just here. Europe, 14 years, Japan 27 years. This is a good and experiment as you get in economics. The fundamental, the doctrine dividing these theories is what happens at a long lasting interest rate pay Is inflation unstable? Is it indeterminate or is it determined and potentially quiet. Bingo.

- But didn't Japan spend enough during that period to get their debt to GGP ratio up to 250%?

- Yeah. And, and arguably with similar commitments to repay the debt, every time something goes in trouble, they raise the consumption tax there. There's the perpetual, what about Japan question, you know, how is it possibly fiscally sustainable? I, I'll only give the short answer. Well, at a negative interest rate it is, and at a positive interest rate, it ain't so just wait. But

- As an advertisement, one of the titles of future EP wg talk is what about Japan?

- Good. So I don't have to like alistic, so I won't answer that question today. Now just outside of my, my theory, this is big news unknown in 2007. In 2007, you could have a re we could have a whole monetary policy conference about what happens at a long lasting peg. What happens if we flood the economy with reserves, pay interest on reserves and live in a perpetual liquidity trap. And the fact that we can do this with inflation going absolutely nowhere is really important news. This is a, a deep experiment just on its own. And, and one that I I think also tells you which theory is right. What about the 1980s? The one what about, I'm prepared to ask, you know, that's the, that's the classic of oh monetary policy solved the inflation problem. And there's, so the 1970s, three waves of inflation, sort of a wonder about, are we right here, 1980, very high interest rates and inflation came down. So isn't that proof that monetary policy worked? Well, not ev that's not all that happened in the 1980s. Notice that the interest rates, the, the interest rate is way above the inflation rate. The real interest rate rose, interest costs on the debt rose who paid for those? Similarly, those of us of a certain age wish that we had bought bonds when the yields were 15% and paid off when in, when inflation down to 5% a windfall to taxpayers who paid for that answer? Taxpayers paid for that. Sorry. It was a windfall to bond holders. And for reasons the, the eighties were a classic disinflation combining monetary policy and a big tax reform, a social security reform, growth oriented microeconomic reform. And there's the surpluses. This present value of surpluses did in fact repay the disinflation. That's just an accounting identity. Now do people know that Steve is gonna worry me about that, but certainly in terms of ex post accounting identities that those surpluses in fact repaid, re repaid the disinflation.

- I'm also thinking about shocks to the expected value of future transfer payments and extent to which they're backed or unbacked. There's a lot of that happening over this period. Absolutely. So you could try to feed that in and see whether we get inflation movements the right sort, right time. It's hard. Like after, back to the point about the real, there really is a need for solid survey data on expectations.

- Yeah, but you know, survey data on dividend expectations is pretty useless for stock prices. Does that mean prices are irrational and prices? Well, I, I haven't looked those surveys I'll, I'll just

- Say there's 99 bad ways to do survey questions. I've seen many of them. It doesn't mean there aren't good ways.

- I wanna encourage all of this just to discourage that you're gonna get an easy proof.

- No, I that I, there are such surveys, the fed run surveys, et cetera. They got one, three and five years John's, right? They're not very helpful.

- And I, I must say, so when I think about the expect expectations, the ones we have now are, I don't think that Joe and Jane sit down and say, honey, the CBO forecast for 2045 is, you know, down two percentage points. No, there's, there's a generic faith in institutions. That's why we have fiscal policy institutions. These guys, after they do everything else, they will get around to paying off the debt before we have a, i I think

- That's right. That's why it's tricky. You gotta look at certain historical episodes in which it does look like there was either a restoration of trust or declining. I mean this is partly sergeants end of four big inflations. Oh that's coming up. Sergeant's end of budget. Okay. I paid him to do this.

- The recent thing, maybe Olivier Blanchard's, a EA presidential address on R minus G was the shock that eventually led to,

- And Janet Yellen going in front of congress and saying, you know, spend all you want, don't worry about the debt and Stephanie Kelton and all the rest Larry Summers is secular stagnation. Okay, we'll stop making fun of people. This of course is the sergeant's ends up for inflations. Notice the vertical axis. This is not a physics lecture. So what happened? Inflation Germany ended with the fiscal reform renegotiating the Treaty of Versailles. And so they had, they could stop printing money during that. When the inflation ended interest rates went down, not up, money growth went up, not down. 'cause people were willing to hold money again. They actually were able to borrow more and the economy boomed, no, no recession. So that's the classic. And, and many similar ends of inflation seem to involve fiscal and monetary and usually microeconomic reform altogether. Not just one of, okay, now to the big puzzle where I really should have started to talk 'cause this is a new part. How can central banks by raising rates lower inflation, can we have, what is the undergraduate simple model of this phenomenon that everybody believes in? 'cause so far we got higher interest rates raising inflation in the rational expectations model. Now what, what a lot of the literature is running back to adaptive expectations after a hundred pages of fancy math. But let's try to a avoid them. And here I wanna try to fix, fix the theory, not fix the facts. One, one answer is, well, you know, those morons have it wrong. But no, I think there's a lot of experience. So let's see if theory can somehow agree with the facts, it's gonna end up agreeing with the outcome, but not at all with the mechanism is the best I can do. Now why is this hard? If inflation is stable and in the long run neutral, then higher interest rates must eventually raise inflation. There's just no getting around that unless you wanna make it unstable or not neutral. But maybe it can go the other way in the short run. So what more can we throw into the soup to make it go the other way in the short run? And there are two challenges. First, how do you get higher interest rates to lower inflation at all? And second, how do you get them to lower future inflation, not just one downward jump. So the left hand graph is what the policymakers believe. The bottom left is the new Keynesian rational expectations model where higher interest rates, sticky prices raise inflation unless you add an equilibrium selection jump that is also tightening a fiscal policy. Footnote four says, oh, fiscal policy raised lump sum taxes to pay the interest costs on the debt. So I would say that's a fiscal shock combined with a monetary shock, whatever you want to call it. It is a combined equilibrium selection. Fiscal shock is the only way to get inflation going down. And then the second is, how do we get it to go down going forward? How do we get something like the graph in the middle on the bottom where it goes down before eventually going up? And you know, policymakers don't ever see the long run. So it's quite understandable they wouldn't, their doctrine wouldn't have have gotten that part. Now it's really hard because unlike money growth and inflation, we just add some sticky prices and output makes up the difference to get it here. We gotta get the, when you raise the nominal rate, the real rate has to go, has to go up more than one for one. I can't just have a nominal rate be a little bit of inflation and a little bit of real rate to get the inflation to go down. I gotta get the real rate to go up more than one for one. That is quite a challenge. So let's go see, can we do it? And the philosophy, it is possible. So let Marty achenbaum at this in a hundred equations. He will produce something that looks like the top left, but that's not something you could present to Congress or, or explain to an undergraduate. I want what is the basic model that explains the basic sign and operation of monetary policy. And you'll see how hard it's now you may say, come on John, there's no textbook economic model. How about the new Keynesian model? Here is the textbook new Keynesian model. There's the equations, an AR one shock to the Taylor rule. So u is the, is the Taylor rule disturbance? I is the interest rate. I goes up, pie goes down, X goes down. What are talking about it is just fine, right? Well, let's look a little bit harder. Is that our textbook model? So on the left, I hope you've been trained by now to look at the I minus the pie and notice, oh wait a minute, there's interest costs on the debt there. Who paid those interest costs on the debt? Footnote four of chapter two in Woodford says, oh, lump sum taxes came along to pay this interest costs on the debt. So I call that a joint fiscal and monetary policy shock. But that's, you know, one problem with this. What if, if you redefine the question is what can the Fed do acting alone then that's not the answer to that question. What can the Fed do Acting alone? The, the problem is there's multiple equilibrium. The right hand graph asks, what if the shock is not an a R one? There's within the, there's a family of u disturbances that all produce the same interest rate, same observed interest rate, but by being different stochastic processes produced different inflations, there are still multiple equilibria conditioned on, we see the same interest rate path. I'm, I'm phrasing this all in new Keynesian language. And some of them have more or less fiscal implications. The, the, the one marked S equals zero is the choice of U disturbance that produces the same interest rate path and no fiscal requirement. And notice inflation goes up even in the stock NCAs model. Another way of seeing it, the equation gives you the analytical solution. So the analytical solution of the standard three occasion new canine model inflation is an ex a, a weighted moving average of interest rates with positive weights. Higher interest rates raise inflation, but there's in transient shock. Aha, let's make the equilibrium selection shock with the fiscal footnote that does all the work of lowering inflation. Even if this is the answer, it does not embody the standard story. Remember we were after lowering demand, lowering Philips curve, pushing things down. No, this is equilibrium selection machinery along with a fiscal shock. The hope of the new keynesians was that we would sprinkle Lucas holy water on ISLM. But the problem is when you take the pi T minus ones and you make 'em pi t plus ones, the iGen valleys all change sign. You. You went in looking for horses, you found a zebra. And no wonder you come home saying this is a horse, but honey, it's a zebra, it's not a horse. It's equilibrium selection is what the Fed is doing. So that's not the answer. In fact, not even adaptive expectations works if what you want is the Fed acting alone. So here I I have the adaptive expectation model, it has a Taylor rule in it, and there's a permanent rise in the ta in the, in the Taylor rule disturbance interest rate goes up, that sends inflation down. This looks just like the 1980s, right? This is the standard story for the 1980s. And then, and then following the Taylor rule, the interest rate comes down with inflation, but the interest rate line is above the inflation line. Who paid the interest costs on the debt answer fiscal policy. This is a joint fiscal and monetary policy de disinflation and I, I'm, I'm not gonna show you the proof you can prove in this model that interest rates with no change in fiscal policy cannot lower inflation even in the adaptive model. Why? Because you need high real interest rates to push inflation down and then you gotta bring the in interest rates back down again in order to repay the interest costs on the debt. And then the inflation goes right back up again. Again, this one's for Bob. Same puzzle International. How do higher interest rates raise the exchange rate? We all think that's right. Raise interest rates that raises the exchange rate, right? Well here's the flexible price model. I is the interest differential in a flexible price model that's equal to the inflation differential and that has to be matched with the, the change in the nominal exchange rate. I hope I didn't get the signs wrong. That's, that's so what, what should happen? Well if I raise domestic interest rates, flexible prices, I raise domestic inflation, the exchange rate should just start going down the dollar depreciates. 'cause our stuff is our inflation's higher, the eline, how do you get otherwise? Well, people say the nominal exchange, we pick among the multiple equilibrium. You always get a multiple equilibrium jump by the nominal exchange rate coming back to where it was. But why should the nominal exchange rate come back to where it was? The yen never came back to parity. The lira never came back to parity. The Argentine peso never came back to parity. So the standard, you know, the pol that the policy view wants the right hand side. Our standard models say that higher interest rates should lower the exchange rate going forward with that best multiple equilibrium selection jump. So the same puzzle exchange. This is of course the, I've shown you this graph before. This is the only one that I know of sort of works that higher interest rates interacted with long-term debt. The Fed can lower inflation now at the cost of raising it going forward. It's, it's a, I wish I want a better mechanism. This is my quest. The long run we know it's gotta go up. How does it go down in the short run? I've got one model that works. I want other models. That's what I'm working on these days. Now here's the second challenge, not just this one too. Notice it jumped down and then went back up again. Our challenge is to get it to go down, but to get it go down in the future. How in the world do we get higher interest rates to make inflation go down in the future the way the policy world thinks? So here's the challenge. The policy belief is higher interest rates make inflation go down in the future. What our models do is at is higher interest rates make inflation go up in the future. And in the short run, unless you have a fiscal equilibrium selection shock or my long-term debt mechanism, my long-term debt mechanism gives you the same answer without the fiscal part of the of the shock. Could we possibly get to something that looks like the right hand side? What else do we need in the simple show? Now, what are you not allowed to do? What I think we tend to do is we write models with the central graph and then we go long and variable lags. But you're not allowed to do that in modern macro. Modern macro. You have to write down the dynamics. You don't get to say long and variable lags. So that doesn't work. And you have to understand. So this is not just something where we throw Marty and Larry at it and add a twiddle in it or, or an epicycle. This is really deep in the standard model. So let's just take the basic question. What happens if we raise the real interest rate? Well, don't look at the, at the, at the slides. Econ 1 0 1, if you raise the real interest rate, you raise consumption growth, right? That's the standard first order condition for consumption growth, higher interest rates, raise consumption, growth going forward, walk into the Fed and say, oh, what happens if you raise the real interest rate? You raise consumption growth. And they will look at you like, oh God, are you one of those modern monetary theorists or some other wackadoodle here? So well,

- Consumption falls today,

- Consumption can fall. That's it. We can get a jump down today, but then it rises going forward. The policy belief and the vector auto regressions, I have the expert here say it's like the left graph, not the middle graph. So you can get a jump down, an equilibrium change, and then it rises. But you cannot get outta that first order. It's deep in that first order condition that it goes up after the, after the jump. The same thing is true in the Phillips curve. So the standard Phillips curve says inflation is expected, future inflation plus K times output. So let's raise output that raises inflation. Yeah, Phillips curve. Wait, wait, wait. It raises inflation relative to future inflation. So that means higher output means inflation goes down looking forward. So, you know, go into the Fed and say, if we raise, if output goes up, that means we're gonna have declining inflation. Well, well maybe some of the new appointees to the Fed will think that, but the old ones will throw you out. So this is really deep in the mechanics of the standard model and, and so it, it's gonna take heart surgery to change that. So here I'm gonna advertise the, the last paper that I've written, which if, if I can ever get free on a Monday to present, I'll present the whole paper at the background lunch. But I'll give you the, the short version of it. You remember, I hope you remember I've been going through equations really fast. The difference between the adaptive and rational expectations was where's the reference point in the Phillips curve? It's inflation minus in one case, lagged inflation. In the other case, inflation minus future inflation. And I rem and, and these are the fundamental tension I went back to remembering Bob Lucas, where it was inflation minus yesterday's expectation of today's inflation. Hmm. Maybe we can get the best of both worlds by just moving the, the reference point to the middle. Now, Lucas's Phillips curve was, was, was disparaged because it was said it provides no persistence, only unexpected inflation gives you an out output gap. But why don't we generalize Lucas? And because Lucas never said what a period is. So why don't we have different firms for whom a period is a different amount of time? You know, out, out in my glider operation out in Williams in the northern Sacramento county, you know, it doesn't get the word real fast from DC about what's going on. So they would have a, a big Alpha J So that's just a natural generalization of Lucas Phillips Curve, where a fraction AJ affirms their period is a month, two months, a year and, and so forth. So all I did was combine that Phillips curve with the standard is curve in, in, in which higher interest rates, lower output. And what this does, first of all, it has analytics solutions, which is really nice. So, so I'll pass along. I see a couple of students. The, the secret of success in life is to produce something that can go into a three equation linearized model. There are a thousand theoretical models of price stickiness and they get sites, but no one ever uses them. You, you gotta come up with something simple and calculable if you ever wanna get used. So I, I want that. So yeah, the result is, it's really cool. It gives you what we were looking for. It gives you the final infl dynamics. I put the equation on on the slide there is that inflation is depends on lagged inflation and the interest rate and delta is positive, but gamma starts greater than zero and turns around to be less than zero. So it starts unstable the way the old doctrine said and then it turns around after a while to become stable. So you gotta come to see that equation. You gotta come to the next workshop maybe. And here's, here's a a real answer. So this is, this is with long-term debt. So there is no change to fiscal policy. A persistent blue line raise an interest rate. And what happens, we've still got the, we've still got a slight downward jump. I wasn't able to get rid of that. But you have a period of instability where a small downward jump increases and then it turns around and becomes stable. So very much, very much closer to the picture we were looking for. Yeah. So I think where we can get to is, is models that are simple and interpretable. There's two lines of very simple algebra and they give you the result of what policymakers think. But I have to warn you, there is nothing like the standard mechanism going on here. This is not higher interest rates, lower aggregate demand, lower output through the Phillips curve, lower inflation. This is still this long, crazy, long-term debt mechanism smoothed out with sticky prices and, and then inducing an initial instability. If you were a, if you grew up in MIT in 1970s, you would see this and say, oh yeah, this is the 1976 edition of Dorn Bush and Fisher, just like I always thought. But that's not at all what's happening. So if you wanna model that incorporates that mechanism, you gotta go somewhere else. Yeah, I have a different react. Another reaction,

- Not, not a, not disagreeing with what you said. You've injected a small, small deviation from the representative agent framework in a way that leads to an analytically tractable solution. But even that very small deviation from the representative agent framework, which you've otherwise stuck with, hasn't massive effects on the performance of the model, which makes, which is one more reason among many that I I I wonder whether the representative agent framework is really the right way to approach these questions.

- Absolutely. And, and as Gali and Crucell and all of them are shown, once you have heterogeneity and sticky wages, you get all kinds of differences in the, in determinacy region and all of that. And in fact, the, the, the NK model that's based on sticky prices should really be called the non Keynesian model because the way that it gets an output boom as para christel and as co-author showed yeah. Is through a, a negative wealth effect because countercyclical markups lead to decrease in profits, which leads people to work harder, which is crazy.

- No, and, and I'm, I'm with you. I'm actually book hopefully two equation models that gets the basic sign of monetary policy. And if I dunno how how many other, what's the minimal set of ingredients we need

- Substitute sticky wages for sticky prices at least. 'cause that's,

- Yeah, I'm working on that. Yeah, that, that's exactly right.

- That's a huge effect call I,

- I, I'm, I'm sort of wrapping up here. I do wanna say here's what we do not know about monetary policy. This is a graph the ECB put up about how does monetary policy work you that basic, what if it's wages the basis that every undergraduate can under understand? And our only job is to add refinements about the transmission mechanism through these various things. And we understand how all these transmission mechanisms work. And so we know how to diagnose when sovereign debt markets are dysfunctional and improve transmission that there's just no basis for, for that view. I'm not gonna do this 'cause I can do that in the winter. The future obviously doesn't look great if you worry about fiscal fiscal problems. Some of the big over, we're seeing that right now, interest costs on the debt, the models, every model we wrote down higher in new Keynesian models, whatever, central banks cannot lower inflation with higher interest rates unless fiscal policy tightens to pay those interest costs on the debt. And if Powell goes to Congress and says, I'm raising interest rates, I need you, I'm raising interest rates 2%, I need $600 billion of, of fiscal tightening to pay the interest costs on the debt. Good luck to Powell footnote for falls apart. So let me just, this is the summary slide. Where are we in the quest of simple model that that replicates, you know, explains how monetary policy works. We finally have a complete simple economic theory of inflation consistent with current institutions and in particular for the new Keynesian fans. Central banks do not destabilize the economy to select equilibria like MV equals py. We have something where mu inflation is determinant, stable and neutral. There is a nominal anchor, which the ISLM view, there is no nominal anchor. The nominal anchor is yesterday's inflation. It just is, there's a reason they like supply shocks 'cause it's just the sum sum of prices. There's a sensible flexible price model, which, which illustrates long run properties just like mvs py. We finally have something that looks like mvs py in how, how it works. And, and you can, you can marry it to, to simple price stickiness, explicit models to get reasonable dynamics. What have I shown you a, a nice X post story of 20 21, 20 22. There will never be proof. Many other episodes, which I have not shown you for lack of time, but there's lots of episodes here. The immense recent experiments of QE versus COVID and the zero bound. I think it's kind of funny, you know, you, you run a thousand, a thousand formally estimated mark of switching models testing one thing for the other and you miss this elephant in the room. We set interest rates to zero for a decade and nothing happens. We printed money and gave it to people versus we did open market operations at immense scale. It should have been an atom bomb and nothing happens. So it survives those and both the fiscal theory and, and the facts are overturning as we sit here. Classic doctrines. So is passive money or a real doc bills doctrine, okay? Or does that lead to uncontrolled inflation Fiscal theory, passive money is necessary if there's m vehicles po there's nothing wrong with money demand curve. We just have to, you know, fill it with passive money. So it's, it's not only, okay, it's good simple fiscal theory inside money doesn't matter at all. Do we need reserve requirements? Do we need to control M two? No. All that matters is government liabilities inside liabilities has zero net wealth effect. An interest rate can pe peg can be okay if it's not trying to, if it's not trying to lower interest costs on an unsustainable fiscal policy, that too is a, a dramatic, you know, Milton Friedman is a pretty serious guy. 1968. Do not run an interest rate peg, it will fall apart. Well, theory and facts are now suggesting an interest rate peg is okay, can we pay interest on reserves? Serious question 2007 theory and facts seem to say, yeah, interest rates on ample reserves is fine. We can live the Freedman rule and the uncomfortable implication, you, you just cannot get, if it's stable and long run neutral, a higher interest rate peg with no fiscal change, that means U Turkey will eventually raise inflation is very hard to get around that fact. And conversely, maybe trump's not wrong. A lower interest rates if you stick to it and fiscal policy doesn't, doesn't, you know, that will lower inflation. Where do we need to go? How do higher interest rates without fiscal policy, lower inflation sticky wages coming next? I I have heard this. Just lack of time to, to get there. You're welcome to beat me to it, please. We've made some progress a as you see, but the agenda, I'm very unhappy with this long-term debt mechanism. So a better rest of the model and deeply why are prices and wages sticky I think is something we we're guilty of. The drunk who looks for his car keys where light is next to the car rather than things that make much sense. And of course there's much to do once you realize that fiscal and monetary policy are always coordinated. Something that sergeant told you back when you're in diapers. But we need to start taking seriously how should center BA central banks be structured? How should an ideal ECB work, the corporate finance of government debt? Should we be, you know, issuing indexed foreign long debt, short debt, floating rate debt? How should we do that? Better Policy rules, I hate to say this with John and the audience, but it's always worth thinking as there are better things that we could do based the fact that central banks don't fully control inflation always monetary and fiscal coordination. That's a nut to swallow that, that our challenge going forward is not gonna be classic. Do we wanna boost, boost the Phillips curve? It's going to be that fiscal policy wants monetization and monetary policy wants to resist. So so that's the separate compact. Okay, that's the end. Two minutes to go. It's the first time I've ever finished my slides. I'm fine.

- Well, a couple of thoughts. You focused on inflation and the change in the intertemporal budget constraint primarily. What, what if you go back and look at lots of episodes of fiscal consolidation and what happened, there's a lot of data about that. I think the IMF has a data bank, Allina done many and, and azi have done many studies this and it would seem there's gotta be kind of a flip side of this that ought to be explainable. Now whether that's disinflation or deflation or something else, or it seems to me that's something that's really worth thinking about. And then the other thing is, there's, there's kind of a, a vague distant cousin of this in John Geno's views of, or theories of collateral cycles and people worrying about being repaid and so on and so forth. Obviously not focused so much on the government debt, but just in general. And I, I haven't looked at it in a long time. I remember seeing seminars 20 years, 30 years ago by John. But I dunno if there's anything there that sheds any light or can give you some insight or not, but it might be taken a look at if you've never looked at it.

- You, your, your first question is, is a good one. Now, I think it's true that every, every successful disinflation includes a fiscal reform. Think, think of the inflation targeting experiments or argent, you know, when every Latin American stabilization has a fiscal reform. Now your question is are there fiscal reforms that in, you know, does every fiscal reform produces disinflation? I don't know the answer.

- Yeah, I think the answer is probably not. And also you focused on the level and, and, and affected growth and repayment and not the structure of the spending and tax component of the primary surplus.

- Well that, that's all so very important. Taxes are not lump sum. Yeah. Taxes distort.

- Yeah.

- And government is always faced,

- And in fact, in the real world, money isn't neutral because of that. Because they, we don't fully index the definition of income and the tax code

- And stuff like that. No abs In fact, a lot of these surpluses, a lot of that, I gave you a very simplified version, but you want the value of nominal depreciation allowances over on the right hand side and you want, you know, slow indexation of government salaries you wanna do if it's right. So I I just gave you the undergraduate version, David.

- Yeah. So given the, given the question about fiscal responsibility in the eighties, the policy was brought about by Bar Baron coalitions that did do, we're relatively consistent with what you talked about fiscal responsibility. What effect does the, that fact that neither party today seems in any way willing to be fiscally responsible, how does that impact what, what what you're able to do?

- We're on an unsustainable path and when the bond vigilantes give up hope that sooner or later after America's tried everything else, we'll do the right thing. Here comes the deluge.

- Okay. That's what I was afraid you'd say

- That Yeah, even inflating away or defaulting on our debt would not solve our problem because then the next day we've defaulted on our debt, we've inflated away and we go back to pond markets, say, oh, now, ah, that was fun. I need 5% of GDP to pay for this year's budget deficit. And who's gonna lend us any money then?

- Do you, have you, you had the graph that's from the article about the coming collapse in the market or whatever that would in foreign affairs about a month ago or so month or, and that is key to the federal debt going up as a percentage of GP as far as I read it is, do you subscribe to that?

- Well, this, this is not hard to fix. I mean, this room could put together a stabilization plan in about 10 minutes that would fix it. So, you know, I, I got, I'm, I'm George Schultz always taught me, you know, end on an optimistic note.