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The TC Rule for Monetary Policy [Updated]

April 15, 2011

I woke up this morning and had a bit of time to thing about a fiscal policy rule for MMT.

c(u-u) + (i-i) + f*Population Growth = %G [Update: This is %G Deficit]

Where :

c(u-u) is Okun’s law, relating the change in GDP to change in unemployment.  According to most people, c is about 1.8 and (u-u) is the difference between the “natural” rate of unemployment and current unemployment.

(i-i) is the difference between the current core inflation rate and the target inflation rate

% Population growth is for the entire currency area – we might want to include China in this area given the current policy of China.  f is a multiplier, set to 1 for now.

Note this rule also spits out projected rates of inflation.   %G is the target rate, but we know the actual rate of %.   The difference between the two should be the observed inflation rate.

What do you all think?

[Update 6/21/2011:  I expand the idea behind the rule to include where to spend the money.  Hint: Payroll tax Cuts!]

[Update: probably needs to be some adjustment for spending multipliers]

Update 4/17/2011: More extensive yet incomplete thoughts here.]

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  1. Tom Hickey
    April 15, 2011 at 10:23 am

    “% Population growth is for the entire currency area – we might want to include China in this area given the current policy of China.”

    Bill Mitchell often says that the dollar zone is America.

    • TC
      April 15, 2011 at 11:07 am

      Hmm – I’ll have to think about that. I will go with Bill’s statement for now, it seems reasonable. I just put that we might want to consider other places, given the reserve currency status of the U.S. Dollar.

      Would the CAD expressed in %GDP also be part of this equation?

  2. beowulf
    April 16, 2011 at 1:38 am

    Two of your definitions may need redefining.
    Arthur Okun’s original law (in the 60s) was every 1% change in unemployment equates to a 3% change in GDP, 20 years ago Bill Vickrey said it was 1 to 2.5, Ben Bernanke did a study a a decade ago saying it was 1 to 2.0, now “most people” are apparently saying its 1.8%. OK is this decaying ratio reflecting the heat death of the universe or is it due to some other process that your MMT fiscal rule may inadvertently accelerate or possibly even reverse? Pavlina Tcherneva mentions Okun in her recent paper, “Fiscal Policy Effectiveness: Lessons from the Great Recession” (beginning on p. 3).

    Related to that is, how do you define “natural rate of unemployment”? The CBO output gap estimates are based on a NAIRU of 5.0%, whie Tcherneva says in her paper (with Employer of Last Resort policies in place), it could be as low as 1.0%.

    Wikipedia has a line that makes me wonder if a MMT fiscal rule use of NAIRU is self-defeating– An early form of NAIRU is found in the work of Abba P. Lerner, who referred to it as “low full employment”, to contrast with the “high full employment” achievable under his theory of functional finance.

    • TC
      April 16, 2011 at 8:24 pm

      That is a great paper – thanks for passing it along.

      I do not want to let the perfect be the enemy of the good, that’s why I proposed a rule that could be implemented in a relatively short time frame. We could shift to using this rule within 1 year with a few simple tax code changes.

      NAIRU isn’t easy to define. It appears from the late 1990’s and 2000 that this rate could be 4%. Under an ELR, (u-u) goest to 0 as someone very smart pointed out to me in a private conversation about this rule. My thinking was to use 4% as the NAIRU. Additionally, in a perfect world, I’d probably adjust the observed unemployent rate for changes in the labor force participation rate.

      Okun’s multiplier has been unstable over years – right now I’d go with 1.8 as the multiplier.

      Also, we have to choose a target rate and level of inflation. I’d choose core or trimmed as the target; level is still unknown for me. Higher than 2% due to risks of deflation, but exactly where? I do not know yet.

      There are many open questions to answer on the rule. I had been thinking about it for a few months, and just wrote it out in 10 minutes Friday morning.

  1. April 17, 2011 at 9:12 am
  2. May 11, 2011 at 6:45 am
  3. June 21, 2011 at 2:40 pm
  4. July 4, 2011 at 9:35 am
  5. August 9, 2011 at 1:22 pm
  6. August 10, 2011 at 2:03 pm
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