Monday, October 12, 2009

Krugman, Taylor Rule and Okun's Law

Very interesting post by Paul Krugman on why the Fed should not raise rates anytime soon.
Solving the Taylor Rule for a Fed Fund Target of 0% and the current inflation rate gives the unemployment rate level at which the fed should start raising rates.

The table below shows the different unemployment rates at which the fed should tighten assuming different inflation rates.

Change in PCE 0.0% 0.5% 1.0% 1.6% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0%
Unemployment 5.8% 6.2% 6.6% 7.0% 7.3% 7.7% 8.1% 8.4% 8.8% 9.2% 9.6%

Mr Krugman then looks at Okun's law which says that GDP growth 2 points above potential of 2.5% reduces unemployement by 1% and concludes: "So say we have 5 percent growth for the next 2 years — which would be hailed as a stunning boom. Even so, unemployment should fall only 2.5 points, to 7.3. In other words, even with a really strong recovery (which almost nobody expects), the Fed should keep rates on hold for at least two years."

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