In one of his regularly e-mailed think pieces ("The Economic Policy World
Turned Topsy-Turvy"), Brad deLong wrote:
>The Federal Reserve Chair [Greenspan] seems most interested in the big
>Treasury problems of government debt and asset management rather than in
>what the equilibrium real rate of interest is, and whether the interest
>rates that the Federal Reserve sets should be higher or lower than the
>equilibrium rate.
The "equilibrium real rate of interest"? what's that? It can't be where the
IS and LM curves intersect, since most macro economists see that
equilibrium as attained automatically, without help from the Fed. So, is
that the same as the "natural rate of interest"? one macro textbook (by RJ
Gordon) once defined the latter as the interest rate at which the IS curve
intersects the vertical line corresponding to the "natural level of real
GDP" (what more scientifically-minded economists call "potential output").
If we define the natural or equilibrium interest rate in this way, there
are two major problems.
(1) we don't know what the level of potential output is, especially now
that we can't identify the level of the NAIRU (what's known as the "natural
rate of unemployment" by economic mystics) -- even if it exists. Even if we
knew the NAIRU, we don't know exactly what the level of labor productivity
is, so that it's hard to figure out the level of output would be at the
level of employment corresponding to the NAIRU. [NAIRU = the
non-accelerating inflation rate of unemployment, the alleged threshold
unemployment rate below which inflation tends to explode.]
(2) The IS curve might intersect the vertical line corresponding to
potential output at negative real interest rates, as might be happening in
Japan. Further, the slope of the IS changes over time, so the IS curve
might become vertical (or close to it) due to unused capacity, excessive
private-sector debt, and extreme pessimism, so that the IS curve doesn't
intersect the vertical line at potential, so that the natural real interest
rate _doesn't exist_. Even ignoring such dire cases, given the way in which
the state of long-term expectations ("animal spirits," expected
profitability) change over time, the equilibrium interest rate would change
a lot over time as the IS curve shifts around.
Maybe the "equilibrium real rate of interest" is defined more simply, as
the interest rate that prevents inflation from taking off while avoiding
deflation. But that rate should move around a lot over time, with supply
shocks and the like, and shouldn't be thought of as an equilibrium
phenomenon. What is the model behind this theorizing?
Finally, in practice, what the Fed does depends on political pressure --
from the banks, financial markets, etc. -- so that to focus solely on the
Fed's self-portrayal as seeking some holy grail of an equilibrium real
interest rate is deceiving.
Jim Devine [EMAIL PROTECTED] & http://bellarmine.lmu.edu/~jdevine
