Wednesday, September 2, 2015

Canada's new recession


An anonymous commenter brought up my Canada model yesterday apropos of Canada "officially" going into a recession. Scott Sumner has some issues with the designation (calling it a pseudo-recession), something I've responded to here.

Coincidentally, I was preparing a post in response to Nick Rowe's question of why inflation targeting worked in 1996 in Canada but not 2008 (or 2015).

There is a simple reason in the information equilibrium model. The central bank can target any more inflation rate up to a rate π₀ (I put the model results this way once before). That rate π₀ steadily falls (unless there are large supply shocks like the oil shocks of 1973/4 and 1979 or hyperinflation intervening).

If your target is π then there are two scenarios:
  • π < π₀ : Inflation targeting works fine
  • π > π₀ : Inflation targeting doesn't work because π is not achievable.
Canada was once (in 1996) well in the π < π₀ regime. Now it's nearer π ~ π₀. Therefore 1996 worked out (no recession), but 2008 did not. And now we have 2015.

However, I have just shifted Nick's question to:
Why does π₀ fall?
As I like to say there are more ways an economy can be organized when it is made up of lots of low growth states than a few high growth states. That is to say it is increasingly likely that a given dollar will be facilitating a transaction in a low growth industry.

Low growth goes hand in hand with low inflation and a large economy is more likely to be made up of many slowly growing prices than a few quickly growing ones.

All of these statements are basically saying a larger economy has higher entropy than a smaller one.

1 comment:

  1. I left a comment somewhere (I think Cochrane's blog) in response to another commentator pointing out that I knew some people making a few forecasts (I mentioned both you and Vincent Cate, and your bet). I think I mentioned the Canada prediction. Yep, I did:
    http://johnhcochrane.blogspot.com/2015/08/whither-inflation.html?showComment=1441058466061#c8056005951325473929

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