The Inflation and Rising Interest Rates

The Inflation and Rising Interest Rates

piece for the New York Times, “The Inflation and Rising Interest Rates
That Never Showed Up” Paul Krugman examines the successes and failures of policymakers to
assess our economy. Specifically, he advocates the Keynesian account and calls for our
government to take further action to empower the workforce and the economy. He begins by
providing context for today’s economy and explaining what he refers to as a ‘Liquidity Trap’. In
years leading up to the 2008 recession, the Federal Reserve had begun to cut interest rates in
anticipation of the crash. Eventually, the interest rate target reached 0.
25%, where it has been
since December 2008. At this point, the value of a bond is almost as valuable as cash, and
monetary policy is largely ineffective in changing inflation or interest rates. Thus, this socalled
“zero lower bound” is the basis of Krugman’s Keynesian case. As the federal funds rate is
effectively 0% , he states that increasing government spending will have a significant positive
effect on employment and national GDP without crowding out investors. He concedes that many
policymakers disagree with this theory, arguing in favor of costcutting
techniques to make
business environments more favorable without deficit spending. His opponents argue that his
suggested policy would not only crowd out potential investment, but also aggravate the existing
budget deficit.
Starting in February 2009, President Obama’s stimulus package took effect, and upwards of
$780 billion was invested in the US economy. This graph illustrates Krugman’s point and a
significant fiscal success. Following the policy’s implementation, the economy quickly stopped
contracting by late 2009, and has been expanding every quarter since then. As dictated by the
Fed, the federal funds rate has not risen above (effectively) 0, and the 10year
treasury constant
maturity rate reflects normal rates of inflation. Based on this graph, Krugman appears to be
correct: the increase in government spending from 2009 until 2013 had a positive effect on real
Gross Domestic Product.
This graph addresses the other main concern of Krugman’s opposition, the budget deficit. In
2008, Krugman’s critics were convinced that deficit spending would result in massive public
debt, and questioned whether it would be worthwhile in the long run. This may have been a valid
concern, but based on the data, Krugman was right again. The labor market continues to thrive as
a result of the stimulus even today, and GDP has increased since late 2009. The deficit has
decreased accordingly.
Connection to EC 313:
A “Liquidity Trap” as Krugman mentions in his article has a direct connection to the IS/LM
model we have studied over the term. A liquidity trap occurs when the interest rate is targeted at
0% (or very, very close to 0%). In the model, because the LM curve intersects the IS curve at
such a low interest rate, the IS curve can shift left significantly without increasing the interest
rate. This is why Krugman offers a suggestion to increase government spending. Normally, an
expansionary fiscal policy would increase output, but also raise interest rates (in response to
higher levels of consumption). This increase in the interest rate would crowd out potential
investors, and inflate the economy in the long run. In the case of our economy since the last
recession, however, Obama’s stimulus plan shifted the IS curve far to the right, but not enough to
raise interest rates and decrease investment.
“The Inflation and Rising Interest Rates That Never Showed Up”, Paul Krugman, 11/23/14


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