I'm optimistic about US recovery. If I'm reading the signs right, the market is also optimistic about US recovery. But that's not what makes me optimistic. Again, if I'm reading the signs right, the market is more optimistic about US recovery than the Fed is. And the market believes it is more optimistic about US recovery than the Fed is. That's what makes me optimistic about US recovery.
Let's start with a bit of Wicksell. If the Fed sets a market interest rate above/below some natural rate, there will be a cumulative decline/rise in the price level. Throw in a bit of Keynes. And there will also be a decline/rise in real output too.
Now let's throw in some expectations. The actual natural rate matters. But what the market believes the natural rate is matters too, and probably matters even more than the actual natural rate. Start in equilibrium. Hold the actual natural rate constant. Hold what the Fed does constant. Now suppose the market changes its beliefs and (falsely) believes that the natural rate has increased. And suppose the market also believes that the Fed does not share the market's view, so will not change what it does. And suppose the market understands Wicksell, and Keynes. What happens?
Since the actual natural rate has not changed, and since the market rate set by the Fed has not changed, you might think that no individual will want to change his desired savings or investment. But, because each individual (falsely) thinks that the natural rate has increased, relative to the market rate, each individual thinks that every other individual will increase desired investment and reduce desired saving. So each individual expects the Wicksellian/Keynesian cumulative process will cause rising prices and output. And this is what causes each individual to increase his own desired investment and reduce his own desired saving. And so there is a Wicksellian/Keynesian cumulative process of rising prices and output.
Somewhere, deep in the metaphysical vaults of preferences and technology, there exists a true natural rate. And if everybody knew what it was, and the Fed did too, and set the market rate equal to it, the economy would be in metastable equilibrium, with no cumulative process in either direction. But the true natural rate matters much less than what the market believes the natural rate is. Because even if you are impatient, or have a good investment opportunity, you will not consume or invest as much if you expect falling prices and falling spending by everyone else.
And beliefs about the future matter too. If the market believes the Fed will set a market rate below the natural rate in future, then the market will expect a Wicksellian/Keynesian cumulative rise in prices and output in the future. And that causes a rise in desired investment and a fall in desired savings today. And so the cumulative process starts today, not in the future. And the Fed would have to raise the market rate right now, to prevent it.
It's the gap that matters. In the simplest Wicksellian story, the gap is the gap between the natural rate and the market rate. Throw in expectations about the future, and what matters is the gap between what the market believes will happen and what the market believes the Fed believes will happen. I think we have just such a gap right now. The market believes the Fed is too pessimistic. That creates an upside cumulative process. That's what makes me optimistic.
I wonder if the Fed might be deliberately making pessimistic noises (Tim Duy, via Mark Thoma) just to make the market optimistic, like me?
Worthwhile Canadian Initiative 
Thanks for the help with the italics.
Yep, but it’s not that current wages go up while simultaneously expected future wages go down. It’s a statement about the time t value of the conditional function that determines the entire path of labour supply.
I have some stochastic path of lifetime real wages {w(t)}, the whole path. That path in conjuction with my choice of labour supply will define my lifetime consumption. I have a lifetime utility function that looks like Expectation[SUM(t=0 to inf) of {B^t*U(c(t),l(t))} ] where B is the discount factor, c(t) is consumption at t, l(t) is leisure at time t.
Maximizing the lifetime utility function entails solving a dynamic programming problem whose solution will imply that I arrange my leisure to be higher when real wages are lower than average and lower when real wages are higher than average. That is I work more when wages are higher than average and less when they’re lower than average. (Since the series is stochastic the solution will be a conditional map from time t information to time t labour supply).
The labour supply curve for time t that results from the solution to my programming problem says trace out my labour supply as w(t) varies while holding the rest of the sequence the same. The conditional rule will say that the higher is w(t) the more labour I should supply at time t.
OK: now take a finite-lived version of that problem, where the person lives n periods. The income effect of a 1 period change in w will be 1/n times the income effect of a permanent change (ignoring discounting for simplicity). In the limit, as n goes to infinity, we approach your problem, and the income effect goes to zero.
yep.
But notice that even if the positive wage shock increases my total lifetime income there is still no income effect like Bill thinks.
The reason is that the intertemporal maximization will mean that my reaction to the extra income will be to take more lifetime leisure. I don’t take the extra leisure when real wages are higher than average!
Any income effect from the higher time t wage will only mean I reduce my labour supply for future times. So the labour supply curve at time t is unambiguously upward sloping in the time t real wage!
Any increase in lifetime expected income that shifts some or all future labour supply curves down.
Correction: Any increase in lifetime expected income then shifts some or all future labour supply curves down.
Hang on, there’s gotta be some way we can torture the model to make current leisure a Giffen Good. Or is that ruled out by assuming you’re maximising Expectation[SUM(t=0 to inf) of {B^t*U(c(t),l(t))} ], rather than a non-time-separable function? I don’t think it is.
If B approaches zero, then in the limit your model approaches the one-period model, and it’s possible for an increase in w to reduce labour supply in a one-period model. So it ought to be possible to get the same result if B is small enough?
I’m not sure.
No, you can’t Nick. It comes from assumptions that say the marginal utility of consumnption is infinity at zero consumption, so you always plan to supply some labour at some time.
Given that it will always be the case that, since you’re gonna work at some time, you choose to work when the real wage is higher than average.
Well, an individual can have that happen with a large enough stock of assets, claims on the output of other peoples labour.
But it can’t happen in aggregate, so it would never apply to the representative agent.
actually I was wrong, it can’t happen at all. Even with a gift of a large stock of assets.
Giving an individual claims ot other peoples output would shift his labour supply curve, it would still slope up.
If the gift of assets to an individual was so large that he stopped working completely, for the rest of his life, then he’d stop having a labour supply curve. It wouldn’t slope down.
And of course, in aggregate it anyway couldn’t happen. (general v partial equilibrium).
BTW, the original question is still open:
I was looking for an explanation of this quote from Scott Fullwiler: “On the real rate, as Nick suggested, MMT’ers reject that real rates matter,”
Do MMTers really think relative prices don’t effect relative demands?
The point about “real rates don’t matter” isn’t about relative prices, etc. It’s about real vs. nominal rates. According to Keynes and Minsky, it’s not the real rate that matters.
“The point about “real rates don’t matter” isn’t about relative prices,”
But the real rate is what determines the price of future consumption relative to current consumption. So it makes no sense to say that it isn’t about relative prices.
If the real rate doesn’t matter than neither do relative prices. You can’t say “real rates don’t matter but relative prices do”. That’s utter nonesense.
And I was asking for a defense or explanation, not a restatement, of the position that “it’s not the real rate that matters.”
Click to access GIBSDURA.pdf
Click to access wp_483.pdf
OK, I was not arguing that inflation has no impact, or that the real consumption stream delivered to households doesn’t affect their consumption/savings plans.
At the aggregate level, nothing forces capital goods to have the same price deflator as consumption goods, and nothing forces an increase in investment demand to lead to higher market clearing rates, as increased investment demand also increases the supply of loanable funds available to finance the investment, and decreased investment demand decreases the supply of funds available to finance the investment. There is no a priori reason to believe that there exists such a thing as an aggregate supply curve of loanable funds that isn’t the same exact curve as the demand curve for loanable funds, even if, on a micro level, each individual may have a separate supply and demand curve.
This is a specific criticism of a “real” rate of interest set in the loanable funds market, so that the market clearing nominal rate is equal to this rate plus an inflation expectations term, and the implicit assumption that the real rate is relatively constant, so that adjustments to the market clearing nominal rate boil down to adjustments in inflation expectations.
I think that’s a already strong enough attack on the mainstream so that you don’t need to blow this out of proportion and argue that the PK view is that “relative prices don’t matter”.
Perhaps Scott was arguing something else — that real rates don’t matter for anything, but if he was, then the papers he cited don’t make this argument.