In my previous post, I discussed some poorly defined concepts in macro, such as “aggregate demand” and “monetary policy”. A recent David Beckworth interview of Jonathon Hazell touched on some of these issues, and added a few more. Here Hazell discusses the role of demand shocks in the Phillips Curve model:

Between the end of 2020 and roughly now, the United States underwent a gigantic and very persistent demand shock. Even with a flat Phillips curve, one might expect that very big demand shock to have large effects on inflation. . . .

Now, one challenge with the story of a flat Phillips curve and a big demand shock is the behavior of unemployment. Unemployment in the United States is roughly 3%. It was also roughly 3% in 2019, but, of course, in 2019, inflation was not very high.

And so I think that if we’re going to go down the big demand shock story, we do need some explanation for why unemployment wasn’t incredibly low, because that’s what you would need for this story to work. But one can think of reasons why, perhaps, unemployment has reached its rock bottom and slack was showing up elsewhere in the labor market, for instance by workers doing lots of job-to-job switching. So, I guess, to summarize, to come back to your original question, I think it’s quite possible that a nonlinear Phillips curve could be what’s going on.

Hazell seems to be presenting two ways of understanding AD shocks.  One is associated with the amount of spending in the economy, and the other is associated with the amount of slack in the labor market.  An economist taking the later approach might assume that since unemployment in 2023 was no lower than in 2019, excess aggregate demand was not a problem.  Hazell correctly points out that there might be some other factor explaining this situation—perhaps 3% is the minimum possible unemployment rate in the modern US economy, even with demand overheating.

In this case, you could say that two economists “disagree” about the role of aggregate demand in the recent inflation, because one focuses on economic slack and one focuses on nominal spending.  But are they actually disagreeing about the role of AD, or are they defining AD in different ways?  I agree with an economist who says that excessive nominal spending mostly explains the high inflation of 2021-23, and I also agree with an economist that says the low unemployment rate does not explain the high inflation.  They are both correct with respect to the way that they define an AD shock.

Here’s another comment that caught my eye:

Okay, so, just to set the scene, so why do we care about this thing called the R-star? Most of your readers are probably familiar with it, but just to be clear, we think there’s this idea, which I think goes back to Wicksell, which is what he calls the natural rate of interest. This is what clears the market for saving and investment while ensuring stable inflation and full employment. It’s the interest rate at which the economy is at a steady equilibrium. 

Hazell has accurately described how conventional macroeconomists think about R-star, but it’s not a definition that I particularly like.  What if the interest rate that generates stable prices fails to generate full employment (or vice versa)?  I prefer to view (nominal) R-star as the interest rate consistent with 4% NGDP growth expectations if we had a NGDP futures market (assuming level targeting).  If that market doesn’t exist, then it’s the interest rate consistent with our best guess as to where rates would be if market participants expected a 4% NGDP growth path. 

But even this definition is somewhat vague.  Suppose we start from a position where the economy has drifted off course.  There is a “natural rate” that pushes us back toward the target path, and another “natural rate” that represents where interest rates would be if we had not drifted so far off course.  If I am correct, then you might not expect much consensus among economists as to the natural rate of interest, and that seems to be the case:

Of course, it’s very difficult, because to use these structural techniques, one has to be sure that the structure of the economy is correctly specified. And we, macroeconomists, know that we rarely understand the structure of the economy correctly, and so it’s quite difficult to know what R-star is. In practice, this is going to lead to real issues. And so— I actually saw this tweet from you, David— different measures of R-star disagree now, or at least when you tweeted, by something like 200 or 300 basis points, like really big amounts. Some measures of R-star say we’re in the low-interest rate world, some say we’re in the high-interest rate world. And so there’s a theoretical lure to R-star, but in practice, when we try to measure it, [it’s] really difficult to do so. And so, that one challenge is just that the point estimates disagree a lot between these different structural models. A second one would be nerdier, but I think equally important, which is that the standard errors associated with these estimates are giant.

So, the last time I checked the Laubach and Williams measure, it spans something like the 95% confidence interval span, something like five or six percentage points of interest rates, really big amounts. Now, again, I don’t mean to be mean-spirited. I think it’s a crucial object to measure and these people like Laubach and Williams, and successors like Lubik and Matthes, but, you know, really breaking the frontier. What we wanted to do is see if we can come up with different measures to come out of that. So, that’s the preamble, why we should care about R-star.

Unlike Hazell, I do mean to be mean-spirited.  I would like to see the profession abandon the concept of the natural rate of interest, and I’d like to see central bankers stop trying to target interest rates.

Those huge standard errors are a red flag.  It’s not so much that economists don’t agree as to the natural rate of interest, they don’t even seem to agree as to what it is they are trying to measure.  You can think of each model of R-star as a sort of definition of the underlying concept.  The fact that these models generate such radically different estimates tells me that this vaguely defined concept is not useful for policy purposes. 

Yes, many central banks do target short-term interest rates.  But they do not do so on the basis of structural models of R-star.  Instead, they are mostly feeling their way along in the dark, nudging rates higher or lower in reaction to a wide range of data, both slow moving macro data and high frequency financial market data. 

Macroeconomics is full of vague concepts, including various “multipliers”, velocity, the IS and LM curves, monetary policy, fiscal policy, aggregate supply, aggregate demand, bubbles, and the natural rates of interest, unemployment and output.

Because these concepts are so poorly defined, we end up with lots of tiresome debates about essentially nothing.  Consider the money multiplier.  Some economists say it exists and some economists say it doesn’t exist.  Both are correct.  Those that say it exists can point to the existence of the ratio of M2 to the monetary base.  Those that say it doesn’t exist point to the fact that this ratio is not stable.  They are not disagreeing about whether the money multiplier exists, they are disagreeing about how best to define the concept.

Another example is saving.  MMTers define national saving in a way that is radically different from how conventional economists define saving.  Debates between the two groups end up being about nothing, as they lack a common language to communicate.

I like to focus on concepts that are measured, such as PCE inflation, average hourly earnings, the unemployment rate and the currency stock.  One reason I focus so much on measured NGDP is that it something that is relatively unambiguous.  If I say that I regard NGDP as aggregate demand, another economist knows exactly how I view recent trends in aggregate demand, without even asking me.  In contrast, I have no idea how most economists interpret aggregate demand.  Perhaps Larry Summers thinks AD increased by more than Paul Krugman thinks it increased.  But I’d have no way of knowing that unless they told me.  Most of modern macro is a black box to me.

PS.  The Hazell interview is excellent.  I’ll do another post later—with a more upbeat message.