Monday, March 30, 2015

The four percent solution

I wrote a post that seems to have fallen by the wayside back about two months ago about what the US would have looked like had it focused like a laser on an inflation target of 2% starting in 1960. Anyway, I was reminded of it when I read Tony Yates on inflation targets over lunch today.

In that post, Yates mentioned India's prospective inflation target:
[Cecchetti and Schoenholz] make an interesting point about the fact that the Reserve Bank of India has just chosen to target 4% [inflation].
So naturally I asked -- what would the US have looked like had it been capable of focusing like a laser on 4% inflation. The results are below. The thing to keep in mind is that this isn't how an economy would behave under a sustained 4% inflation target for 50 years -- it is how an economy would have had to look in order to produce sustained 4% inflation for 50 years. The simplest way to understand this distinction is to realize a sustained 4% inflation target would have actually been impossible -- the required hyper-exponential increase in RGDP (shown in the graph) is a reductio ad absurdum. Here are the graphs -- the required path is in blue and the actual path is in red (or green):

What is funny is that the quantitative easing sort of looks like the required hyper-exponential growth -- I include it as a curiosity as reserves have little to no impact on inflation. [Update: added link.]

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