I was trying to be completely serious for one thread. It’s more than sound. It’s absolutely 100% correct.

It’s what I liked about the ridiculousness of the example, with all the logical components being so far apart. I can arb everything right to where it should be and illustrate how int connects to inflation. No theory, no behavior, simply EMH doing its thing.

If one were to bid interest rates towards to 15% based on NGDP growth of 18% with 0% inflation, everything not nailed down would be sold for cash, that cash would be invested at 15%, and then when the paper retired, considering the price of everything is the same, you would buy 1.15 times what you had before, the NGDP guy with his undefined investment that captures NGDP (a proposed free call nonetheless) would get his 3% on the investment he refuses to explain, and MF would be relatively correct as he would be getting a 15% gain in purchasing power. The market would keep doing this until the 2 merged. AS IT DOES ALREADY!!! simple. Taylor rule makes complete sense. Interest rate and inflation MUST be connected.

“The large gap would discourage saving and encourage borrowing”

Why would I borrow at near 18% to buy any asset that I know will be the same price at the time my paper expires? I buy a house for 1 million, pay 1 million in carrying costs over the next 5 years, to have a house still worth a million… No thanks!

But in the same respect, with a big smile on my face, I’d lend a million, wait 5 years, and have a house for free and my original 1 million left over that still buys me what a million did 5 years ago… it’s a WIN WIN WIN!!!

“BC hit on my cursory objections, but let me go in a different direction — what circumstances allow an 18% RGDP growth and only a 7% interest rate? I think this is where your example falls apart.”

I think you missed my point. It was just a thought experiment to think about which one is more important. In the real world there gap would probably be much smaller. The large gap would discourage saving and encourage borrowing, which would put upward pressure on interest rates.

]]>With a flat population, what are the sources of RGDP growth?

1) Capital accumulation (human or physical)

2) Technical change

First, let’s assume no technical change…

We’ve created a situation where RGDP growth encourages people to time-shift labor into the future. However, we’re using a representative agent so there’s no lending between agents. The only way an individual can work tomorrow and consume today is to reduce investment. But that reduction in investment **increases** interest rates and **reduced** RGDP growth.

I’m a little rusty, but I’m pretty sure a 7% interest rate means that the marginal investment produces a 7% risk-adjusted return. So the interest rate indicates that the representative agent is willing to pass on $100 in consumption to make an investment that gives him $107 in the next time period. This is a horrible way to increase current consumption. Does this match your intuition about the representative agent?

It would follow that the *only* way this happens is an agent that prefers a consumption path HEAVILY OVER-WEIGHTED into the future. In theory, this preference could/should exist for someone like a professional athlete. Even if they get 18% RGDP growth throughout their career, they must save since they’re forced to “retire” long before they die.

In a real economy, however, your example — high NGDP and low interest rates — just isn’t realistic.

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I don’t think the addition of technology makes any difference. Technology is also the product of investment. The marginal investment in technology is only producing a 7% return or the interest rate would be higher. Thus it behaves exactly like capital.

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I’m probably missing some subtleties, but long story short is:

– The gap between RGDP growth and real interest rates is — at least largely — *determined* by an individual’s preferred consumption path.

– The level of that consumption is determined by the supply of investment products (including technology) since these opportunities increase the clearing level of RGDP growth.

Since both are adjusted by the same inflation rate, all of this can also be said of NGDP and N-interest rates… but I don’t see how the N- helps us. Interest rate estimates can be horrible and the relevant gap (GDP vs interest rates) is unaffected.

]]>“your money is increasing in purchasing power … Your money will not grow, but you will be able to buy quadruple the goods in 20 years.”

“No, that would mean deflation. You are assuming that the same number of nominal dollars buys more goods. But Sumner’s example explicitly stated 0% inflation, not deflation. Real GDP (and NGDP) is growing 18% annually … but the price level stays fixed, so the same number of nominal dollars buys the same real goods throughout all time.”

That is true, I misspoke. I was referring to the growth in purchasing power from lending, which means your cash balance is increasing. When I said “your cash” is not increasing, I should have said the aggregate money supply is not increasing. Society has no more dollars, but purchasing power is increasing, which yes, is about falling prices here.

If price inflation were 0%, and real growth was 18%, then the money supply and volume of spending must be increasing.

“Now, if you don’t lend, and sit on your cash, then with 0% price inflation your total real return is 18%.”

“You’ve completely misunderstood the hypothetical example. In the example, if you sit on your cash, your real return is 0%, not 18%. Big difference.”

No that is wrong. If you sit on your cash, and real growth is 18%, then your purchasing power is increasing, provided that prices are falling.

With 0% price inflation, total cash balances would be increasing with 18% real growth.

At the end of the day, we cannot infer from NGDP and nominal interest rates a real rate. They are incomplete. That is the key point you don’t seem to get. We need price inflation/deflation as a concept. Sumner used it in his own allegedly price inflation free example when he switched nominal rates to real rates due to the numbers being identical wih 0% price inflation.

]]>Ray, You said:

“BTW when the commentators to a blog make better comments that the host, that’s a sign of senility by the host.”

Don’t you have that backwards? Wouldn’t the commenters be senile in that case?

Kevin, I’m not saying your theory is wrong, I just wonder how important it is in terms of changes in labor’s share.

Todd, You’d want to use the expected future inflation rate.

Brian, Yes, I agree. It’s clearly incomplete, and other factors certainly play a role.

njnnja, I see my role as spurring others to create such models. So far I’m still waiting for good NGDP targeting models.

BC, Just to be clear, I was suggesting there are several trade-offs that are possible, those involving shifts in consumption but not work effort, or those involving shifts in work effort but not consumption.

]]>Interesting perspective, but I don’t think it’s quite right. The opportunity cost of lending money is that one gives up consumption now. Lending money does not require that one give up the opportunity to work 8 minutes more in the future. One could still do so and get even more consumption.

Having said that, I think i minus inflation and i minus NGDP both should matter. In Scott’s example, i, inflation, and NGDP growth are all known. Inflation=0 for simplicity so that there is no difference between real and nominal interest rates and real and nominal income growth. Given known future prices and wages, a person can decide his future path of working hours and consumption subject to constraint that present value of lifetime income must equal or exceed present value of future consumption. Then, he can just borrow or lend (save) to match his income cash flow stream to his desired consumption stream. Holding income (NGDP) fixed, a higher interest rate makes future consumption cheaper relative to current consumption, so he will consume more in the future relative to present, i.e., higher interest rate minus inflation leads to more savings.

On the other hand, suppose we hold interest rates, lifetime income, and path of consumption fixed and raise NGDP growth. The effect of raising NGDP growth while holding lifetime income fixed is to push more of the person’s lifetime earnings into the future relative to now. Because consumption path is fixed, the person will need to borrow more or save less to match his income stream to his preferred consumption stream. Thus, higher NGDP growth or lower interest rate minus NGDP growth leads to less savings, same as for interest rate minus inflation.

The point here is that with borrowing and lending, one needs only match one’s *lifetime* income with *lifetime* consumption; the timing of the two don’t need to match. Interest rates determine the relative price of current vs. future consumption and, hence, affect one’s preferred consumption path. NGDP growth affects the timing of one’s income and, hence, affects the saving or borrowing needed to handle mismatches between income and consumption timing.

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