Chapter 9

Long-Run Prices and Interest Rates

IN THIS CHAPTER

Using the quantity equation with the long run growth model

Preferencing time, savings, and the real interest rate

Targeting inflation

Digressing internationally

Three is a special number. It’s how many bears Goldilocks encountered. It’s the number of doors in Let’s Make A Deal. The big, bad wolf chased three little pigs, and there were three parts of the Deathly Hallows. One may be the loneliest number, and two may be the loneliest next to one, yet from fairy tales to complicated romantic relations to Christian religious doctrine, three is key.

Three is an important number in macroeconomics, too. That’s because a lot of macroeconomic models are focused on three central variables:

  • Real GDP
  • Prices
  • Interest rates (real and nominal)

In Chapter 8, we discuss a model of real GDP that most macroeconomists believe gives a good description of the evolution of real GDP over time. In this chapter, we build on that same model, along with the quantity equation of Chapter 5, to address the remaining two issues: prices and interest rates. As you’ll see, we’ve actually hinted at a lot of this material before. We’re just being a bit more thorough here.

By the end of the chapter, you’ll understand why the Fed’s influence over the real interest rate is limited in the long run and what the quantity equation implies about long-run inflation. You’ll also see why a lot of countries have adopted a policy of inflation targeting to guide ...

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