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):

r-star

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?

 

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