Suppose that the Fed\'s inflation target is 2%, potential output growth is 3.5%,

Question

Suppose that the Fed's inflation target is 2%, potential output growth is 3.5%, and velocity is a function of how much the interest rate differs from 5%: %^V= 0.5 X (i-5). Suppose that a model of the economy suggests that the real interest rate is determined by the equation r= 8.35-%^Y where Y is the level of output, so %^Y is the growth rate of output. Suppose that people expect the Fed to hit its inflation target

what policy do you think is better in the short run? Which is better in the long run?

Explanation / Answer

In a series a recent research paper1(here), I have shown that there is stable connection between the stock market and the unemployment rate and I have argued2(here) that this connection is causal. The stock market crash of 2008 caused the Great Recession. If this relation is truly causal, then central banks can do a great deal to alleviate persistent unemployment. The nearby chart, based upon a recent NBER paper (here),3 shows that in normal times the Fed balance sheet consists mainly of treasury securities. But after the collapse of Lehman Brothers in September of 2008, the Fed charged to the rescue by creating an array of new lending programs. At this point the stock market was in free fall and, in response, the Fed embarked on a policy of quantitative easing known as QE1. The Fed’s balance sheet went from $800bn to over $2,000bn in the space of a month. The chart shows that when the Fed began to purchase mortgage backed securities in March of 2009, the stock market began to rally. When QE1 ended a year later, the market tanked and equities did not recover until the Fed saw the error of its ways. When the Fed announced the beginning of QE2, at the Jackson Hole conference in April of 2010, there was a third turning point in the market and the beginning of a new bull market. The coincidence of these market turning points with the beginning and ending of Fed asset purchase programs is not accidental. The Fed moves markets! So what! Who cares if a bunch of Wall Street investors make money? If that were the end of the story then perhaps we should not be concerned. But it is not the end of the story. There is a connection between the stock market and the welfare of the average citizen since all forms of wealth move up and down together. For most of us, our wealth is tied up with our future earnings; economists call this human wealth. When the stock market plummets, so do the prospects of the average worker. My research has shown that when the stock market is rising, unemployment falls and when the market crashes, a recession follows. This notion will not sound farfetched to anyone who invests in markets. But the strength and stability of the connection is not widely appreciated. Suppose that an economist working in the 1970s were to try to predict the unemployment rate three months ahead, using only the average unemployment rate and the real value of the stock market for the past two quarters. The first half of Chart 2, I have labeled this “estimation period”, shows that the prediction made by that economist would be highly accurate. For this period, the dotted line representing the forecast and the solid line representing the actual unemployment rate are virtually indistinguishable. Now suppose that this same economist fell asleep in the fall of 1979, when Paul Volcker took over as chairman of the Fed, and that she woke again in 2000. The second half of Chart 2 shows that this economist’s forecasts would be nearly as accurate in the noughties they had been in 1970s. This is despite the fact that she is using the same forecast equation that she filed in her drawer in 1979. Should you be surprised by this connection? Yes. There are very few relationships in economics that retain this degree of stability over long periods of time and that in itself might make you take notice. But what does the connection imply for central bank policy? The fact that changes in the value of the stock market precede changes in the unemployment rate does not necessarily imply that one causes the other. That requires a causal theory of the kind I have provided in my academic work. Some economists have argued that the financial markets are efficient and the stock market crash of 2008 was simply a signal that smart investors foresaw that there were bad times ahead. I do not agree.

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