As I told my undergraduates yesterday:
Y = μ[co + Io + NX] + μG - μIrr
where:And as I am going to tell them next Monday, real GDP Y will be equal to potential output Y* whenever "the" interest rate r is equal to the Wicksellian neutral rate r*, which by simple algebra is:
- Y is real GDP
- μ = 1/(1-cy) is the Keynesian multiplier
- co is consumer confidence
- cy is the marginal propensity to consume
- C = co + cyY is the consumption function--how households' spending on consumption goods and services varies with consumer confidence, with their income which is equal to real GDP Y, and with the marginal propensity to consume
- Io is businesses' and banks' "animal spirits"--their confidence in enterprise
- r is "the" long-term risky real interest rate r
- Ir is the sensitivity of business investment to r
- NX is foreigners' net demand for our exports
- And G is government purchases. Read MOAR
r* = [co + Io + NX]/Ir + G/Ir - Y*/μIr
If interest rates are low and inflation is not rising it is not because monetary policy is too easy, but because r* is low--and r* can be low because:
Grasping RealityThe central bank's task in the long run is to try to do what it can to stabilize psychology and so reduce fluctuations in r*. The central bank's task in the short run is to adjust the short-term safe nominal interest rate it controls i in such a way as to match the market rate of interest r to r*. For only then will Say's Law, false in theory, be true in practice….
- consumers are terrified (co low)
- investors' animal spirits are depressed (Io low)
- foreigners' demand for our exports inadequate (NX low)
- or fiscal policy too contractionary (G low)
- for the economy's productive potential Y*.
