Which is it Paul: Natural Rate or Not? (Nerdy)

This will only interest the super nerds in the audience, but Roger Farmer has a great post up in which he discusses the idea of multiple equilibria in the economy and the underlying models at work. Roger is talking about how the economy doesn’t have a single equilibria, but instead shifts into differing equilibria at times. This is very different from the traditional sort of thinking where we assume that the economy basically moves in some sort of cyclical trend.  As I’ve stated in the past, I really like this line of thought even though I don’t explain it nearly as well as someone like Roger.

But that’s just the groundwork in the debate. The interesting part is that Roger, like myself, rejects the concept of the natural rate of interest. He calls this the “supply side theory”.  Here’s the key piece of Roger’s post:

My answer is that aggregate demand, driven by animal spirits, is pulling the economy from one inefficient equilibrium to another. My theoretical work explains how that idea is consistent with the rest of economic theory.

The orthodox answer, one we have taught to graduate and undergraduate students alike for the past fifty years is that aggregate supply is shifting from one decade to the next, pushed by changing demographics, shifting tax policies and technological change.

If permanent movements in the unemployment rate are caused by shifts in aggregate demand, as I believe, we can and should be reacting against these shifts by steering the economy back to the socially optimal unemployment rate. If instead, these movements are caused by shifts in aggregate supply, the moving target is the socially optimal unemployment rate.

He later refers to Paul Krugman’s post on the subject from earlier in the weekend (see here) and asks if Paul Krugman is using the demand side or supply side model.  But I think we already know the answer. I would venture to guess that Dr. Krugman will say that the Liquidity Trap has rendered the natural rate of interest too low. And this means monetary policy isn’t as effective as usual which means that this is a time where we should use demand side policies like deficit spending. So, in this specific environment, deficit spending should be used to increase aggregate demand.

The problem is, if the natural rate of interest doesn’t really exist then that renders the Liquidity Trap distinction to be rather muddled. And it means that fiscal policy isn’t just effective in this theoretically unique environment. It means that it should be effective outside of this environment as well. And more interestingly, it means that monetary policy is a lot less effective than most of us generally think.  And that’s the strange thing here. Paul Krugman might be more inclined to lean towards what Roger would call the “supply side theory” if this weren’t a liquidity trap in his mind. That is, because Dr. Krugman is using a model of the world that includes a natural rate then he might be more inclined to make policy recommendations that are more along the lines of the supply side theory outside of a Liquidity Trap. This makes sense since Keynes rejected the natural rate theory and the natural rate is an inherently Wicksellian concept.

So, Roger might be asking the wrong question. It’s not about supply and demand because Paul Krugman will almost certainly agree in this unique environment that it’s a demand side issue. Roger should be asking:

“Which is it Paul, Natural Rate or Not?”

If Dr. Krugman answers natural rate, as would be consistent with his past views, then he’s got a lot more Monetarist and supply side economist in him than is generally perceived. And that’s kind of a big deal because it just goes to show how much the econ profession has shifted away from Keynesian economics. That is, when the leading publicly perceived “Keynesian” actually uses a substantial amount of Monetarism in his work then we’re really working right of center. So far right of center that it’s not just the economics profession that has veered into its own extreme equilibria, but perhaps we have this supply side dominated econ thinking for the new weak inefficient equilibria that the US economy appears to be in….

* Roger is referring to the natural rate of unemployment.  NAIRU and the natural rate of interest are a similar underlying premise both extending from Monetarist perspectives of the economy.