Lecture 5: Secular Stagnation

Luca Fornaro

1
The secular stagnation debate

 Secular stagnation (Hansen, 1939; Summers, 2013)

I Protracted period of weak demand and high unemployment

I No self-correcting force toward full employment

 Two complementary causes:

I Secular fundamental factors, such as demography,

technological progress, inequality (A model of secular
stagnation - Eggertsson, Merhotra and Robbins 2019)

I Pessimistic animal spirits (Stagnation traps - Benigno and

Fornaro, 2018)

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lnterest rates in advanced economies (Rachel and Smith,
2015)

3
Long-run downward trend in interest rates

 Which structural factors can explain this trend?

I Slowdown in productivity and population growth
I Lower dependency ratios
I Higher inequality

 What are the implications for policy?

I Monetary policy frequently constrained by zlb
I Bigger role for fiscal policy

4
Slowdown in productivity growth

TFP
90

85

80
log

75

70

65

60
1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

5
Slowdown in population growth

6
Lower dependency ratio

7
Higher inequality

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A model of secular stagnation

 Eggertsson and Merhotra (2019) study secular stagnation

using an OLG framework

 We will look at a slightly different model, based on Fornaro

and Romei (AER, 2019)

 Both frameworks emphasize the importance of financial

markets imperfections to generate persistently low real
rates

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Model

 Infinite-horizon closed economy

 Agents

I Continuum of measure one of households that supply labor

and consume

I Firms hire labor and produce

I Central bank that sets monetary policy

 No uncertainty

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Households

 Heterogeneous households with expected lifetime utility

∞
X
β t log Ci,t
t=0

 Simple form of income heterogeneity

I Workers: 2L̄ units labor endowment, pay taxes T

Pt Ci,t + Bi,t = Wt Li,t − Tt + Bi,t−1 (1 + it−1 )

I Out of labor force: receive subsidy b

Pt Ci,t + Bi,t = bt + Bi,t−1 (1 + it−1 )

 No borrowing allowed Bi,t ≥ 0

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Households

 Optimality conditions

1 (1 + it )Pt 1
=β + µi,t
Ci,t Pt+1 Ci,t+1
| {z }
1+rt

µi,t Bi,t = 0
 A useful assumption
I 1/2 of HH are workers in odd periods and out of the labor
force in even periods
I 1/2 of HH are workers in even periods and out of the labor
force in odd periods

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Firms, productivity growth and wage rigidities

 Large number of competitive firms producing according to

Yt = At Lt , Pt = Wt /At

 Productivity grows at rate g ≡ At /At−1

 Nominal wages grow at the same rate as productivity

Wt
= g → Pt = Pt−1
Wt−1
 Then inflation is zero (Pt = Pt−1 = 1) and i = r

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Market clearing

 Goods market Z 1
Yt = Ci,t di
0
 Labor market Z 1
Lt = Li,t di
0
 Bonds market Z 1
Bi,t di = 0
0

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Monetary and fiscal policy

 Monetary policy seeks to maintain the economy at full

employment, but might be constrained by zlb

it (Lt − L̄) = 0

 Government runs a balanced budget

bt = Tt

 Subsidy proportional to productivity and smaller than

workers’ income

bt = bAt < Wt Lt − Tt

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Equilibrium consumption

 Since nobody can borrow it must be that Bi,t = 0 for all i

 So workers consume

Cw ,t = At Lt − Tt

 While non-workers consume

Cnw ,t = bAt

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Aggregate demand and output

 Non-workers would like to borrow but run against their

borrowing limit (µnw ,t > 0)

 Workers would like to save, so they are on their Euler

equation
Cnw ,t+1
Cw ,t =
β(1 + it )
 Equilibrium output is then
   
1 Cnw ,t+1 1 bAt+1
At Lt = Cnw ,t + = bAt +
2 β(1 + it ) 2 β(1 + it )

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Steady state: IS and MP curves

 The economy jumps immediately to its steady state

 The IS curve captures households’ demand

 
b g
L= 1+ (IS)
2 β(1 + i )
 The MP curve captures monetary policy

i (L − L̄) = 0 (MP)

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Secular stagnation

i
IS MP

IS’

L* L

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Secular stagnation

 If i ∗ is negative we are in secular stagnation

I Monetary policy is always constrained by zlb (i = 0)
I Output is always below potential (L < L̄)

 Forward guidance does not work, since the trap is

permanent

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The natural rate

 The natural rate i ∗ is given by

g b
1 + i∗ =
β 2L̄ − b
 Factors that can depress i ∗
I Lower productivity growth ↓ g
I Demographic factors ↑ β
I Higher inequality ↑ 2L̄ − b

 i ∗ can easily be negative

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Stagnation traps (Benigno and Fornaro, 2018)

 Liquidity traps are typically characterized by slowdowns in

investment and productivity growth (see appendix)

 Now imagine that productivity growth is increasing in

aggregate demand

g = f (L) , f 0 (·) > 0

 Intuition: ↑ demand, ↑ profits, ↑ investment, ↑ productivity

growth

 This is typically the case in endogenous growth models

(market size effect)

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Multiple steady states

 Now the IS curve might no longer be monotonic in L

 
b f (L)
L= 1+ (IS)
2 β(1 + i )
 Two stable steady states may coexist
I Full employment: L = L̄, i > 0, strong growth
I Stagnation trap: L < L̄, i = 0, weak growth

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Multiple steady states

i MP
IS

L* L

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The importance of expectations

 Equilibrium is determined by expectations and sunspots

I Suppose agents expect that growth will be low
I Low expectations of future income imply low aggregate
demand
I Due to zero lower bound, central bank is not able to lower
the interest rate enough to sustain full employment
I Firms’ profits are low, weak investment in innovation
I Expectations of weak growth are verified

 Pessimistic expectations can give rise to long lasting

stagnation traps

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Fiscal policy - government debt

 Let’s go back to the model with exogenous growth

 Suppose that the government issues a constant (relative to

At ) stock of debt At D/2

D(1 + g) + T = b + (1 + i )D

 Rearranging gives

T = b + (i − g)D

 If i < g the government earns some fiscal revenue on its

stock of debt! (see Blanchard AEA presidential address)

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Fiscal policy - government debt

 Say government increases D, but keeps constant b

 Government debt is bought by workers

Cw /A = L − T − D

 While non-workers consume

Cnw /A = b + (1 + i )D

 Natural rate is now given by

g b + (1 + i ∗ )D
1 + i∗ =
β 2L̄ − b + − (1 + i ∗ )D

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Fiscal policy - government debt

g b + (1 + i ∗ )D
1 + i∗ =
β 2L̄ − b − (1 + i ∗ )D

 i ∗ is increasing in D
I Higher government debt increases the supply of assets
I More assets help households to smooth consumption
I Positive impact on aggregate demand

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Fiscal policy - transfers

g b + (1 + i ∗ )D
1 + i∗ =
β 2L̄ − b − (1 + i ∗ )D

 i ∗ is increasing in b
I More transfers toward poor households sustain demand
I They can be financed either with more taxes on rich
households...
I ... or with higher government debt

 Biden’s relief bill is characterized by a large increase in

transfers

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Fiscal policy - public investment

g b + (1 + i ∗ )D
1 + i∗ =
β 2L̄ − b − (1 + i ∗ )D

 Now imagine that the government implements a program

of public investment, leading to an increase in g
I Higher g means higher potential output...
I But also higher aggregate demand (i.e. higher i ∗ )

 If successful, higher public investment can boost output

both in the present and in the future

 Aggressive policies to restore productivity growth can rule

out stagnation traps, by anchoring agents’ expectations on
the high growth equilibrium
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References

 Benigno, G. and L. Fornaro (2018) Stagnation Traps,

Review of Economic Studies
 Eggertsson, G., Mehrotra, N. and J. Robbins (2019) A
Model of Secular Stagnation, AEJ: Macro.
 Hansen, Alvin H (1939) Economic Progress and Declining
Population Growth, The American Economic Review
 Rachel, L. and T. Smith (2015) Secular Drivers of the
Global Real Interest Rate, Bank of England Working
Paper.
 Summers, Lawrence (2013) Why Stagnation Might Prove
to Be the New Normal, The Financial Times.

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Japan (1980-2014)

Central Bank p olicy rate (%) Lab or productivity

8
6
7
5
6

5 4

gr owth
4 3
3
2
2
1
1

0 0

−1 −1
1980 1985 1990 1995 2000 2005 2010 1980 1985 1990 1995 2000 2005 2010 2015

Unemployment rate (%) R&D intensity

6 25

4
percent 20
3

1 15
1980 1985 1990 1995 2000 2005 2010 1980 1985 1990 1995 2000 2005 2010
32
GDP per capita (log) - Japan (1980-2015)

Japan

0.4

0.3

0.2

0.1

−0.1

−0.2

−0.3

−0.4
1985 1990 1995 2000 2005 2010

33
United States (1998-2014)

Central Bank policy rate Lab or productivity

8 4

7 3.5
6
3
5
2.5
percent

gr owth
4
2
3
1.5
2
1
1

0 0.5

−1 0
1998 2000 2002 2004 2006 2008 2010 2012 2014 1998 2000 2002 2004 2006 2008 2010 2012 2014

Unemployment rate R&D intensity

10 20

19.5
9
19
8
18.5
percent

7 percent
18

6 17.5

5 17

16.5
4
16
1998 2000 2002 2004 2006 2008 2010 2012 2014 1998 2000 2002 2004 2006 2008 2010 2012 2014
34
GDP per capita (log) - United States (1998-2014)

United States

0.1

0.05

−0.05

−0.1

−0.15
1998 2000 2002 2004 2006 2008 2010 2012 2014

35
Euro area (1998-2014)

Central Bank policy rate Lab or productivity

3
5
2.5

2
4
1.5
3
percent

gr owth
1

0.5
2
0
1
−0.5

−1
0
−1.5
1998 2000 2002 2004 2006 2008 2010 2012 2014 1998 2000 2002 2004 2006 2008 2010 2012 2014

Unemployment rate R&D intensity

13 19

12
18.5

11
18
percent

10 percent
17.5
9

17
8

7 16.5
1998 2000 2002 2004 2006 2008 2010 2012 2014 1998 2000 2002 2004 2006 2008 2010 2012 2014
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GDP per capita (log) - Euro area (1998-2014)

Euro area
0.1

0.05

−0.05

−0.1

−0.15
1998 2000 2002 2004 2006 2008 2010 2012 2014

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