Friday, June 16, 2017

The standard inflation argument

Macromania on the zero bound:

Raising the inflation target reduces the likelihood that interest rates will hit the ZLB. To see why, note first that the long run (economists often say ‘equilibrium’ or ‘natural’) real interest rate is positive. Let’s say it is 2%. If the inflation target is 2%, and the ZLB is 0%, that would mean that in normal times the average nominal interest rate is 4% (2% inflation target + 2% to get to a 2% real interest rate). That means nominal interest rates can be cut by a maximum of 4% if the economy falters. That may be enough for a mild downturn, but as we saw in 2008 icant is not enough for a major recession. However if the inflation target was 4%, nominal rates would now be able to fall by a maximum of 6%. That is probably enough to combat all but the worst kind of recession.
If Simon were correct the the Fed should just set the IOR to 4%. In that case, the Fed would be setting the rate on loans to about 4.5%,   Remember the Fed keeps a fixed wedge between deposit interest earnings and loan interest expenses.

Is the Fisher equation correct?

Not at the moment, inflation is a very skewed distribution and will not move. 

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