The Journey of the Fed rate through a false natural level of real GDP
The story of how the Fed controlled inflation after the 1970’s is long. Below I present a perspective that you probably have never seen. I have never seen it presented.
The story uses the monetary model of effective demand to show how the Fed lost control of inflation in 1978 and then was able to bring inflation back under control by 1995. In the process, the Fed manufactured a false lower natural level of real GDP with an unnatural real interest rate of 6%. They maintained that false lower level until inflation was under control.
In the end, the Fed brilliantly coordinated the Fed funds rate into perfect balance with their original targets.
Will the Fed now try to create a higher unnatural level of real GDP in order to reach full employment? As Larry Summers says, they would have to target a negative natural real interest rate. But would the effective demand limit allow real GDP to pass its natural level? That has never happened in the US at least since the 1960’s.
Further analysis to come…
Maybe our current Fed is not brilliant and sticks at the lower bound as the economy never reaches “full employment.” What happens then? Do we get stagflation?
I will be posting a video about just that issue on Monday.
Ed, I promised you a link to a post on AngryBear about trade:
Not sure if you remember out discussion of variables. I took exception to your reduction of everything to two variables. And your subsequent dismissal of trade as anything of importance.
I am playing with a piece that you are welcome see in the AngryBear dashboard: China’s 5 year policy. In the draft, I included an exchange between us. I will most probably leave that exchange out.
I will email you so that you can respond via email if you want.
You should post that piece again… It is great. You wouldn’t even have to update it much.
I will re-post in 2014. Thanks. I will update it.