tag:blogger.com,1999:blog-4979477022008569617.post1124368116155603177..comments2023-05-02T06:38:35.510-07:00Comments on Roger Farmer's Economic Window: A Tale of Two Natural RatesRoger Farmerhttp://www.blogger.com/profile/05213844698773859392noreply@blogger.comBlogger3125tag:blogger.com,1999:blog-4979477022008569617.post-86636033911750213762015-08-25T18:39:35.634-07:002015-08-25T18:39:35.634-07:00Clearly, economy A is at its PPF, while economy B ...Clearly, economy A is at its PPF, while economy B has a lot of slack. Imagine a policy whereby the central bank in B holds interest rates below R* so businesses will be willing to borrow to finance capital expansion. Suppose also that helicopter drops of money are evenly distributed amongst consumers. Consumers will increase demand for current goods and services. To meet the demand, businesses will need to hire more employees. This is all possible without causing inflation, because of the slack in economy B. Firms will, however, have higher earnings, which translates into higher dividends and share prices. R2 will increase even as R1 falls. So as long as the central bank can lower interest rates and drop money on consumers shouldn't the central bank not worry about inflation until the economy approaches the PPF? In this sense, the central bank policy can target U* by deliberately holding R1 < R* until inflation starts to pick up. I don't think anyone is saying that when R1 = R* U = U*. They are advocating holding R1 < R* until U approaches close enough to U* to generate inflation. Ibnyaminhttps://www.blogger.com/profile/02200468798337178145noreply@blogger.comtag:blogger.com,1999:blog-4979477022008569617.post-25833707739304198222015-08-23T08:54:52.472-07:002015-08-23T08:54:52.472-07:00Yes Ben, I am. Imagine two economies in parallel u...Yes Ben, I am. Imagine two economies in parallel universes. I will call them economy A and economy B. Both economies are populated by identical copies of the same people. They have the same endowments of land labor and capital. And each economy has access to identical technologies for producing goods. In economic jargon: they have the same fundamentals.<br /><br />But although these economies have identical fundamentals, the people in economy A are naturally optimistic. They believe that shares in their stock market are worth PA. And PA is a large number. The people in economy B are pessimists. They believe that their stock market is worth PB. And PB is a small number. Importantly, PB < PA.<br /><br />In economy A, as a consequence of the optimism of population, households have a high demand for goods and services. To meet that demand, firms require a high labor force. The unemployment rate in economy A is 2%. <br /><br />In economy B, as a consequence of the pessimism of the population, households have a low demand for goods and service. To meet that demand, firms require a low labor force. The unemployment rate in economy B is 10%.<br /><br /> In each economy, the households and firms believe, correctly, that the value of a share is equal to the discounted present value of a claim to the dividends that will be paid by the firm. And in each economy people discount the future at rate 1/R*, where R* is Wicksell’s ‘natural rate of interest’. <br /><br />Dividends, in each economy, are a fraction of GDP. Because employment is higher in economy A than economy B, GDP is also higher. And so are dividends. The valuations placed on the stock market in both economies are rational. PA is equal to the present value of the dividends paid in economy A, discounted at rate 1/R*. PB is equal to the present value of the dividends paid in economy B, also discounted at rate 1/R*. Optimism or pessimism is a self-fulfilling prophecy.<br /><br />How can this be? Surely the unemployment rate is determined by fundamentals. Not so. I explain in my published academic work, how there can be many unemployment rates, all of which are consistent with the conditions I described in this blog. In a labor market where people must search for jobs, there are not enough price signals, to lead market participants to the optimal unemployment rate.<br />Roger Farmerhttps://www.blogger.com/profile/05213844698773859392noreply@blogger.comtag:blogger.com,1999:blog-4979477022008569617.post-6782336963622571562015-08-23T08:04:28.469-07:002015-08-23T08:04:28.469-07:00Are you seriously suggesting that stock market P a...Are you seriously suggesting that stock market P and D are functions of U? I would think that P is largely determined as a function of expectations. If the stock market believes that the economy is going to improve very soon, the price will be relatively high. D is a function of the present and future prices. For D to be high relative to P, the future expectations must improve relative to the current expectations. I don't think U decides P or D. U could be very high, but if the market expects U to drop very quickly, P will be high. If the market expects far worse U a year from now P will be low. D will be low if expectations were better a year ago than today and high if today's expectations are better than last year. <br /><br />I think Narayana, Paul, and Steve would all agree that R2 = R* does not imply that U = U*. I think they would also claim that this unusual stock market based measure of the interest rate is not a going to be very helpful in determining convergence to long term trends. Why would anyone think R2 = R* implies a macro steady state?Ibnyaminhttps://www.blogger.com/profile/02200468798337178145noreply@blogger.com