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Nick,

I was with you up until you said "High or low real interest rates, even relative to an unchanged natural rate of interest, are a very bad measure of whether monetary policy is tight or loose. It's the NGDP expectations that matter." -- which seems to have nothing to do with what you talked about before. NGDP wasn't even mentioned in your model previously, and of course when we talk about monetary policy, we don't mean that the CB adjusts to make expectations rational, but that the CB adjusts to change expectations. For example, in a recession, there is panic and fear, and people are supposed to regain their animal spirits, or otherwise update their expectations to be more positive. That's at least what the CB has been doing all these years -- including it's lender of last resort role. So can you connect the dots a little more -- for example, add NGDP to your model to show that it's the thing that matters?

rsj: yep. I was afraid that bit of the post might not be as clear as it should be. But I'm still really pleased you were OK up to there!

Let's switch back to the old ISLM model for a bit, where the central bank sets the money supply, not the rate of interest. Start at full employment. Then suppose the central bank suddenly cuts the money supply, creating a recession. The standard IS curve slopes down, and says that the real interest rate will rise in this case. And I'm saying the IS curve might slope the wrong way, if people expect the recession to last a long time, or I/Y is big relative to the size of the recession.

Now lets change it to a New Keynesian model, where the CB sets a nominal interest rate. But it doesn't set that nominal interest rate in a vacuum. It looks at expected inflation, because it realises it's the real interest rate that counts. And it doesn't set that real interest rate in a vacuum either, because it's got some underlying target for prices and/or real output. And the simplest way to think about that underlying target (if prices are sticky in the short but not long run) is to simply multiply P and Y together to get NGDP. Now suppose something happens that causes people to expect the CB's target path for NGDP has dropped. Or that a shock hits, and people expect the CB will not respond to that shock to prevent NGDP falling. So people expect a recession. What happens to the real interest rate, relative to a world in which people were confident the CB would keep NGDP growing at trend?

Or you might prefer Miles Kimball's way of doing it, where the CB has a sort of Taylor Rule reaction function, and something causes it to shift left, a bit like the LM curve shifting left.

How much actual EVIDENCE is there that NGDP expectations are of significance? NGDP expectations are similar to Ricardian equivalence in that they both assume households are forward looking. There is very little evidence for RE far as I know.

Ralph: for this post, it wouldn't matter if half the agents were "Hand-To-Mouth", who consume all of their current income C=Y. (Which is my working assumption anyway.) All you need is that *some* are forward-looking.

I think to be abundantly clear, you might want to make explicit that you're talking about the real rate of debt. For a few paragraphs I was confused and thought you were thinking of the Wicksellian natural real rate. If monetary policy can affect this (and it might, if we include a continuum of investment opportunities in our model?), then that would be even more interesting.

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