policymakers demonstrate

Fiscal and Monetary Policies after the Crises 445
to lower the real interest rate through its effect on π t+1 , and to deflate the real
value of outstanding debt. The effect of the latter is to reduce net savings incentives,
and thus raise the natural rate of interest, relative to an inflation-targeting
policy regime.
Importantly, optimal policy in the Benigno et al. (2014) setting is qualitatively
different from a case in which the natural rate of interest is exogenous,
as in the original contribution by Eggertsson and Woodford (2003). There, it
is best to promise above-target inflation after the exogenous negative shock
to the natural rate (positive shock to β t ) has disappeared, but not before. This
suggests some care should be taken in interpreting optimal policy results from
papers that treat the natural rate as exogenous. Few observers would attribute
the fundamental cause of Europe’s current weakness to a psychological shift
in preferences towards saving – though higher net savings rates may have followed
from disruption in financial and real estate markets. More work is needed
to understand exactly what the mechanisms driving a reluctance of consumers
to spend are, and how best to overcome them.
10.5.2 The Possibility of Secular Stagnation
Yet even when allowing for these richer explanations for ‘savings shocks’, there
is a growing concern in the literature that an account of low equilibrium interest
rates dependent on shocks to the natural rate is, by its very nature, too temporary.
As highlighted above, the nominal interest rate has now been near zero for
more than six years in the US and much of Europe, and for around two decades
in Japan. It is extremely hard to account for such long-lasting episodes by reference
to a transitory disturbance, whether a deleveraging process or a short-term
shock to individuals’ willingness to save. The challenge that the incipient secular
stagnation literature is attempting to meet is how to explain long-lasting
liquidity traps. 35
The central secular stagnation thesis is that a binding zero bound can be
explained by long-term (‘secular’) downward pressures on the equilibrium real
rate of interest, rather than transitory shocks. Among the candidate explanations
for this downward trend are: (1) a lower population growth rate; (2) a permanent
tightening of credit conditions; (3) a decline in the relative price of investment
goods; and (4) a decline in the relative supply of safe assets. The paper by
Eggertsson and Mehrotra (2014) treats the first three of these, whilst the work
by Caballero and Farhi (2015) addresses the fourth. In both cases the modelling
approach departs from the common assumption of infinitely-lived consumers,
in order to allow for meaningful variations in consumers’ demand for assets
over the life cycle.
Eggertsson and Mehrotra (2014) consider a simplified economy in which
individuals belong to three distinct generations: young, middle-aged and old.