I am not as smart as, say, Simon Wren-Lewis, who knows the one approach that has any validity in macro. * But I ain’t that dumb either. I know what David Andolfatto is up to when he tweets out this aww shucks invitation:
Suppose U.S. had 3% target prior to crisis. Describe counterfactual unemployment rate dynamic. Big quantitative difference? Why? Thx!
Oh, what glib and lazy priors I have! All the better to be eaten with.
I suspect he was going for some high-quality guys to eat, but none having responded I will jump in to present a nice fat target. I actually believe what I am about to say as the least unlikely of the stories I have heard. This is not just for shits and giggles.
So, if the target were 3%, then I will assume that inflation would have been 3% from 1994 through 2007. Under the 2% target, inflation was precisely target on average over that period. So my first counterfactual is that inflation would have been a percent higher and inflation expectations too, by late 2007.
The change of inflation expectations early on, I will assume, would have been whatever actually happened between late 2007 and early 2009, because the Fed was initially confused, acted late and delivered its effects with a lag.
So “the” default-free real interest rate would have a percent lower for the early periods, after the Fed recognized the crisis and made the determination that they would try to put in as much “stimulus” – can I use that word? – as was plausible.
In late 2009 and 2010 “the” real rate might have been more than a percent lower than it was because inflation expectations might have returned towards 3% more quickly.
Therefore, we would have had more stimulus, particularly between when the crisis was fully recognized and the Fed started even to think about dialing back, say around 2013.
The unemployment rate would have peaked only very slightly lower, because the cause of rising unemployment in the early going – and also its cure – had to do with financial stability and the alphabet soup and not the level of default-free real interest rates.
But after the financial markets stabilized by mid-2009, the unemployment rate would have come down more quickly than it did in our actual experience.
And for the past two or three years, the unemployment rate would have been roughly what it has been. The reason is that the Fed does not pick labor market conditions consistent with full employment and that the logic of liquidity trap went away two or three years ago, even though the funds rate itself was at zero for much of the immediately subsequent period.
DA knew somebody would be just dumb enough to set out the standard story. And so now I will pay the price.
FWIW, this does not bother me much, at least in the context of the story I have been telling about how the Fed might hit the target it has. Why the Fed has this target and what cost there might be to undershooting it is a separate issue. A harder issue. Incidentally, that the “mainstream” cannot even agree on this is evidence that the mainstream is not unified on important issues. I say this as a would-be mainstreamer.
* Mainstream economists need to internalize one approach only because without that one approach they are not by definition mainstream economists. This is the intellectual “authority” we are working with. The circle is the most elegant geometry, and circular reasoning is the most irrefutable sort.