R star, intro Macro and envelopes

Everyone nowadays is talking about r star. (when I say everyone…I mean economists and finance people, not interesting people).

Why is that?

Maybe because the almighty FED started reporting about that. (As Gavyn Davies noted on his most recent FT column “What investors should know about r star”).

So…what is R star? I guess Wicksell could give you a help with that, but Gavyn gives us a very good and comprehensive explanation in his column. But shortly, is the real interest rate that achieves “full employment” in an economy, the goal of a Central Bank to let it reach its potential.

As an economist, I started (re-started) to think about it…and came to a usual conclusion..it depends!

Of course it depends (you may say).. basic Taylor rules have already been criticized.

But how does it depend? I started to think and for starters it depends on the fiscal position of the Government (yeah I know crowding out, but whatever…), and it depends on investment decisions, and exports…well it basically depends on every component of GDP.

So I did, a back of the envelope model (literally):


I guess I may have some things to explain:

r is the real interest rate, r* is its natural value. Y is GDP, Ypot is its potential. C stands for Private Consumption, I for Investment, NX for Net Exports andG for Government Consumption. I made the former three depending negatively on the interest rates (Net Exports by the exchange rate channel) and G depending on the output gap (difference between potential and actual GDP).

If I assume r=r*, then Ypot=Y.

I run the model and reach that neat, intro macro, solution.

Two conclusions about that (the most relevant ones):

  1. As even (the Super Saiyan of current Monetarists) Scott Sumner admits in David Beckworth’s MacroMusings, the increase in Government Spending during WW2 raised the natural interest rate and made monetary policy more effective. So basically…fiscal policy works.
  2. Structural Reforms aimed at increasing the potential of an economy (ceteris paribus) will decrease the natural interest rate, and further widen (the current) interest rate gap, and accentuate the output gap.

I know, I know…this is a very crude macro model…but is made in the back of an envelope so I am forgiven, right?


Fishing for Fisher

The best (or worst) thing about economics is that you constantly have different groups of very intelligent people saying exactly the opposite and not reaching a consensus.

The great hype recently is Neo-Fisherism, which can be roughly translated in “All Central Banks got it wrong”.


A Central Bank that wants to achieve a higher level of inflation will usually issue more money or decrease its policy interest rate, to stimulate aggregate demand…and eventually inflation! No big deal.

But a Neo-Fisherite will say that, as real interest rates should not be affected by monetary shocks an increase in nominal interest rates causes a similar increase in inflation. So…the opposite of Central Bank’s thinking.

I guess the main hypothesis in NF is the stability of the real interest rate, if you assume that away, basic macroeconomics functions in the “right” direction, as Nick Rowe would say.

Let’s break it in parts then:

When a Central Bank is “feeling expansionary” and tries to increase monetary expansion, that will have (at least) two important effects (one direct, the other success-dependent):

1.The first one, the liquidity effect will decrease interest rates as more money pursuing the same number of assets increase their prices and therefore reduces interest rates.

2. The second one, (success dependent) is the famous Fisher effect. So…will it reverse the first one? I guess it can. Imagine that your monetary expansion reduces interest rates directly through the liquidity effect but increases inflation expectations so much that investors will demand a higher interest rate (to guarantee the stability of the real interest rate). Success!! (as proved by the figure used in Larry Summers blog) Each round of QE (“money injection”) increased interest rates after all.figure-3-10-year-3-month-spread-and-qe-768x557

Maybe it’s just me that still can’t understand Steven Williamson’s argument, but I guess Central Banking has been very successful here.

And in the end it’s all about Milton Friedman’s “high interest rates means money has been loose” and not “high interest rates causes loose money”.

Please don’t twist your causalities!

(Not being a NF I don´t get Roger Farmer’s argument to raise interest rates, but then again… he is too smart for me)