I know this conversation is getting tired but it has forced me to think about the difference between the way I talk about the economy and the pictures I draw. The way I talk is likely better represented in an economy that looks like this

 

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Combine this with an expectations augmented Phillips Curve a NAIRU Phillips curve where movements away from sustainable unemployment cause changes in the inflation rate. and a Taylor Rule to close the model to consider the effects of inflation. Only now think of unexpected changes in unemployment pulling on inflation.

A couple key ideas

  • Bankers are the gate keepers on Aggregate Demand. If you are willing to lend someone is willing to borrow. This is because of the fundamental asymmetry between borrowers and lenders.
  • The Fed Funds rate is the key rate in the economy because it determines the opportunity cost of reserves.
  • Central Government borrowing pushes out the BL curve by offering a risk free lending opportunity.
  • Riskiness in the economy contracts the BL curve by making most loans a worse deal.
  • Losses to bank balance sheets drags the BL curve way in
  • A Fed that targets only inflation (horizontal MP curve) will give more power to the fiscal authorities and make fiscal policy inflationary/deflationary
  • A Fed that targets on inflation will also be very vulnerable to bank sector shocks.
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