The Deflation Threat in the New
Neoclassical Synthesis
Marvin Goodfriend
Federal Reserve Bank of Richmond
November 2003
Introduction
• Benchmark NNS model
• Classical features: intertemporal
optimization, rational expectations, real
business cycle core
• Keynesian features: monopolistic
competition, markups, sticky prices
2
Components of the Core Real
Business Cycle Model:
Households
• Household lifetime consumption:
C2/C1 = (1 + r)/(1 + rho)
• Household labor supply:
Ns = 1 - (C/w)
• C1,C2 = current and future consumption;
r = real interest rate; rho = time preference
Ns = labor supply; w = real wage
3
Components of RBC Model:
Firms and Production
• Monopolistically competitive firms adjust
prices flexibly to maintain constant profit
maximizing markup of price over marginal
cost of production: M* = P/MC
• The production technology is C = AN,
where C = output; A = productivity per
hour; N = hours worked
4
The Determination of
Employment and Output
• Since MC = W/A, then M* = P/W/A
• M* = A/w
• So the real wage is determined by
w* = A/M*
• And labor supply Ns = 1- (AN/AM*)
• Equating labor supply Ns and hours worked
N, yields employment: N* = 1/(1+M*)
• And output: C* = A/(1+M*)
5
Comment on Employment and
Output in the RBC Model
• Flexible price setting firms stabilize
employment by maintaining the constant
profit maximizing markup
• Employment depends only on the markup
and does not fluctuate with productivity
• Output and the real wage grow and fluctuate
with productivity, A
• Satisfies the basic facts of long run growth
6
Real Interest Rate: Coordinating
Demand and Supply
• Households have enough income to buy all
the output--wage and profit income equals:
wN* + (AN* - w*N*) = AN*
• The real interest rate adjusts to make
desired household lifetime consumption
match the intertemporal supply of
consumption goods
7
The Real Interest Rate
• Current and future consumption supplied:
C1* = A1(1/(1 + M*))
C2* = A2(1/(1 + M*))
• Substituting these into desired household
lifetime consumption yields:
A2/A1 = (1 + r)/(1 + rho)
• The real interest rate r adjusts to the
expected growth of labor productivity
A2/A1 to coordinate demand with supply
8
The Real Interest Rate (2)
• The real interest rate induces the
representative household to consume its
current income exactly
• The real interest rate does so by clearing the
economy-wide credit market, making the
representative household neither a borrower
nor a lender
9
The New Neoclassical Synthesis
• The NNS takes account of costly price
adjustment within the core RBC model
• Firms do not adjust prices to maintain the
constant profit maximizing markup
• Instead, firms let the markup fluctuate
temporarily in response to demand and
productivity shocks
10
New Neoclassical Synthesis (2)
• Markup variability plays a dual role in the
new neoclassical synthesis
• As a guide to profit maximizing pricing
decisions, the markup is central to inflation
• As a ‘tax’ on production and sales, the
markup is central to fluctuations in
employment and output
11
Firm Pricing Practices, Inflation,
and the Markup
• A firm will change its product price to
restore the profit maximizing markup the
larger and more persistent it expects a
deviation of its actual markup from the
profit maximizing markup M* to be
• Firms move their prices with expected
inflation or deflation of the general price
level, independently of the average markup
12
Firm Pricing Practices (2)
• Absolute price stability: expected inflation
(deflation) is zero, the current and expected
future markup equal the profit maximizing
markup: M1= M2 = M*
• Deflation potential: expected deflation is
zero, but current markup elevated relative to
the profit maximizing markup, although the
future markup is not: M1 > M2 = M*
13
Firm Pricing Practices (3)
• Price stability is said to be “credible” in
these situations
• Firms are disinclined to change prices in
response to a deviation of the current
markup from the profit maximizing markup
expected to be temporary
• The current price level is nearly invariant to
current shocks and monetary policy actions
14
Employment Fluctuations and the
Markup
• Output is demand determined in the short
run when price level stability is credible
because prices are sticky and (1) each firm
can only sell as much as households wish to
buy at the going price, and (2) firms are
happy to sell as much as they can, since
labor productivity exceeds the real wage w*
= A/M* < A, since M* > 1
15
Employment Fluctuations (2)
• Keynesian perspective: if aggregate demand
decreases, firms require less labor to meet
demand, and weak labor market causes the
nominal (real) wage to fall
• Classical perspective: lower wage reduces
marginal cost and elevates the markup; the
higher markup acts like a tax increase to
shrink employment and production
16
Employment Fluctuations (3)
• In the flexible price RBC model:
(1) firms insulate employment from
fluctuations by adjusting prices to maintain
markup constancy and
(2) the real interest rate automatically
adjusts to equilibrate the credit market,
making aggregate demand conform to
fluctuations of productivity
17
Employment Fluctuations (4)
• In the NNS model:
(1) fluctuations in aggregate demand can
induce fluctuations in employment and
output. In that sense,the model is Keynesian
(2) but since the NNS model has the
classical RBC model at its core, we call it
the new neoclassical synthesis
18
Employment Fluctuations (5)
• Firms maintain the profit maximizing
markup on average over time in the NNS
• Hence, the NNS model behaves like the
classical, flexible price RBC model on
average
• But with leeway for monetary policy to
influence aggregate demand and stabilize
employment and inflation
19
Interest Rate Policy
• Suppose that price stability is credible so
that expected inflation (deflation) is zero
• And the public expects the future markup to
be at its profit maximizing level: M2 = M*
• Then the central bank’s nominal interest
rate target translates into a real interest rate
target
20
Interest Rate Policy (2)
• It follows that expected future consumption
is anchored by future income prospects at
C2* = A2(1/(1 + M*))
• Substitute for C2 in the household lifetime
consumption plan to get:
• C1 = [(1 + rho)/(1 + r)]A2(1/(1 + M*))
• Here we see the leverage that interest rate
policy exerts on aggregate demand C1--21
Interest Rate Policy (3)
• Current aggregate demand is inversely
related to the real interest rate target when
expected future consumption is anchored by
credible price stability, which means that
expected M2= M*
• Interest rate policy actions influence
employment, in turn, because temporary
departures of output from potential are
demand determined
22
Monetary Policy Objectives
• The benchmark NNS model recommends
that interest rate policy should stabilize the
markup at its profit maximizing value M* in
order to stabilize the price level and make
employment and output behave as in the
core RBC model with flexible prices
• We call this ‘neutral’ monetary policy
because neutralizes fluctuations in
employment and output that would
otherwise occur due to sticky prices
23
Monetary Policy Objectives (2)
• Neutral monetary policy maximizes
household welfare because (1) firm price
adjustments preclude markup stabilization
anywhere but M*, (2) interest rate policy
can stabilize the markup at M*, (3) desired
household labor supply is invariant to
productivity at M*, and (4) welfare would
be reduced if monetary policy allowed the
markup to fluctuate
24
Monetary Policy Objectives (3)
• Neutral policy stabilizes employment at the
‘natural rate’
• Neutral policy eliminates any ‘output gap’
between actual and potential output
• The pursuit of neutral policy perpetuates
price stability if the central bank has already
acquired credibility for stabilizing the price
level
25
Monetary Policy Objectives (4)
• Price stability confers additional benefits:
minimal costly price adjustment; minimal
relative price distortions; lower incidence of
inflation or deflation scares; and low
nominal interest rate tax on currency and
bank reserves
26
Monetary Policy Objectives (5)
• Neutral policy can be implemented by
maintaining price stability--there is no need
to target the profit maximizing markup
directly in practice
• An economy in which firms show little
inclination to raise or lower prices is one in
which the profit maximizing markup is
realized on average
27
Monetary Policy Objectives (6)
• Activist interest rate policy that consistently
achieves price stability implicitly shadows
the real interest rate that moves with
expected productivity growth as in a real
business cycle
• Real interest rate must fluctuate over the
business cycle to maintain markup
constancy and price stability
28
The Deflation Threat
• Arises if markup (M) is elevated above
profit maximizing markup (M*) and firms
doubt that monetary policy will stimulate
demand to restore M = M* promptly
• Firms respond by lowering prices to restore
profit maximizing markup themselves
• Deflation can be associated with protracted
period in which markup tax is elevated and
output remains below potential
29
Sources of Deflation Threat
• Ongoing, surprisingly high productivity
growth so that demand is insufficient to
absorb added output at M = M* and at
initial central bank interest rate target, weak
labor demand means MC = W/A falls and
the markup rises over time
• Pessimism about future taxes, productivity,
or war, negative effect on current demand
• Aftermath of excessive investment boom
30
Sources of Deflation Threat (2)
• In principle, the central bank can reduce its
real interest rate target to maintain markup
constancy and price stability in the presence
of such deflationary shocks
• The zero bound on nominal interest rates
could prevent the central bank from
achieving the required real interest target if
(1) the required rate is negative or (2) the
public already expects some deflation
31
Sources of Deflation Threat (3)
• Proximity to zero bound creates doubt that
interest rate policy can restore the profit
maximizing markup promptly and deter
deflation
• That credibility problem has the potential to
create a “deflation scare,” i.e., deflation
expectations that make the zero bound
constraint more severe
32
Overcoming the Zero Bound
• In principle, monetary policy can defeat
deflation at the zero bound--otherwise the
government could eliminate explicit taxes
and finance expenditure forever with money
creation
• Credibly sustained money financed
government spending could defeat deflation
in two ways
33
Overcoming the Zero Bound (2)
• Money growth could defeat deflation
without creating inflation by increasing
aggregate demand, closing the output gap,
and restoring the profit maximizing markup
• Or money growth could create inflation and
inflation expectations, make interest rates
negative at the zero bound, and enable the
central bank to eliminate the output gap
through interest rate policy
34
Overcoming the Zero Bound (3)
• Establishing central bank credibility for
dealing with deflation at the zero bound will
be difficult for the following reasons:
• Inexperience and nervousness about
creating excessive inflation makes a central
bank reluctant to use quantitative monetary
policy aggressively to fight deflation at the
zero bound
35
Overcoming the Zero Bound (4)
• Independent open market ops in short term
securities have no effect--central bank must
buy long bonds, or other assets--OMO
alternatives have credibility problems, too
• A central bank may need cooperation from
the Treasury to credibly inject enough
money into the economy to defeat deflation
and then drain the money to control
inflation
36
Overcoming the Zero Bound (5)
• Inclination to do nothing unusual at the zero
bound creates a policy vacuum which could
encourage ill-advised fiscal actions such as
occurred in the US in the 1930s and in
1990s Japan
• Wasteful government spending, inefficient
credit subsidies, anti-competitive measures
could lower potential output and growth,
and exacerbate the deflation problem
37
A Reasonable Inflation Target
• Until central banks learn how to overcome
the zero bound on monetary policy, and
acquire credibility for doing so, it is
reasonable for central banks to defend a 1
percent lower bound on inflation
• For log utility, 2 to 3 percent trend
productivity growth and a 1 to 2 percent
inflation target would yield nominal interest
rates around 4 percent on average, sufficient
leeway to deal with deflation
38