Prof. Olivier Blanchard (of M.I.T., currently at the I.M.F.) has a long history of getting it wrong when it comes to macroeconomic policy. His most recent pronouncement, unfortunately, continues this trend. Even worse, his policy prescriptions are now being made from the lofty pulpit of the International Monetary Fund where he is chief economist.[1]

Let’s see what Dr. Blanchard has to say. This from an interview in the Wall Street Journal:

“**So should we change the inflation target? **

**Blanchard: **If I were to choose inflation target today, I’d strongly argue for 4%. But we have started with 2%, so going from 2% to 4% would raise issues of credibility. We should have a discussion about it.”[2]

Blanchard’s argument is that by raising the inflation target, nominal interest rates would be higher. This, he proposes, would give central banks more room to reduce interest rates to stimulate the economy.

Unfortunately, Prof. Blanchard has made an error that should make him blush. It is the real interest rate, not the nominal interest rate, that affects most economic activity. The only way Prof. Blanchard’s model can work is by appeal to the long-discredited “money illusion” hypothesis.

For those who are a bit rusty, recall that the nominal interest rate is made up of two parts. The first is the real interest rate. This is the net transfer of purchasing power from borrowers to lenders. The second part is the expected future inflation rate. Changes in the expected future inflation rate, however, have no – zero – impact on the real rate.

This is especially true if (or when) the central bank announces the new inflation target in advance. Thus by publishing his paper Prof. Blanchard has destroyed any possible impact from the very policy he is advocating.

This stuff ain’t all that hard. Frankly, it’s embarrassing when highly-placed economists get it this wrong.

[1] Technically his title is Economic Counsellor and Director of the Research Department of the International Monetary Fund. For more biographical information see http://www.imf.org/external/np/bio/eng/ob.htm. Accessed March 9, 2010.

[2] “Q&A: IMF’s Blanchard Thinks the Unthinkable” by Bob Davis. *Wall Street Journal* Real-Time Economics blog, February 11, 2010. Available at http://blogs.wsj.com/economics/2010/02/11/qa-imfs-blanchard-thinks-the-unthinkable/?KEYWORDS=Blanchard+IMF. Accessed March 9, 2010. Those who want more details should see Blanchard, Olivier J. ; Dell’Ariccia, Giovanni ; Mauro, Paolo, “Rethinking Macroeconomic Policy,” Staff Position Note No. 2010/03, International Monetary Fund, February 12, 2010. Full text available at http://www.imf.org/external/pubs/ft/spn/2010/spn1003.pdf. Accessed March 9, 2010.

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#1 by Daniel on March 11, 2010 - 11:08 am

Not sure if I got Blanchards idea correct, but I still see a mechanism that might work..Ac to Fisher: Nom.IR= RIR+Expected Inf. (short term). A high expected interest rate would lead us to a high Nom.IR,so we have a NIR and a high expt.InflationR at the same time..If Real-Int-Rate = Nom.Int rate – expected Inflation-Rate then we would have a high real interest rate caused by a high nominal interest rate with high expt.Inflation rate. When Mr.Blanchards argues in the short term,expt Inflation rate would be fixed,as I said we have high real interest rates and high nominal interest rates in this situation,so it would be possible (short term) to cut nominal interest rates -> real interest rates would sink in the same amount..if this works,a higher expt.inflation rate would provide us with a higher nominal interest rate (which we can cut directly,and effects ST directly our Real IR),with this higher number we would have much greater margin to effect (help) the economy throught cutting the nom.interest rate (effects on real IR).much more room till we are at the zero % bottom line…

#2 by Tony Lima on March 11, 2010 - 11:10 am

Nice try, Daniel. Let’s take a simple example. Suppose the initial real interest rate is 2% and expected inflation is 3%. Nominal interest rate is 5%, no problem.

Now suppose expected inflation rises to 7%. This could, for example, be caused by the central banking announcing its new inflation target as 7%. The nominal interest rate will rise to 9%. The real interest rate won’t change.

There’s a basic idea in monetary economics that’s true nearly all the time: only unexpected changes in monetary policy can affect the economy in unexpected ways.

I won’t go so far as to say that an announcement by the Fed that they will set the growth rate of the money supply at 4% will cause people to expect 4% inflation. There’s way too much slippage between the monetary growth rate and the short-run inflation rate. But announcing an inflation target is a different batch of sardines. I think it’s safe to assume that if the Fed announced a 7% inflation target, inflation expectations would adjust pretty rapidly.

As long as inflation expectations match actual inflation (more or less) the real interest rate stays constant. I’ll add the usual exception for technological change.

Tony Lima

#3 by Daniel on March 11, 2010 - 11:13 am

Hmm so a high Inflation rate would provide us with a a high nominal interest rate,while the real interest rate stays uneffected,correct?:

Nom.Interest rate (high) = Real Interest rate + Exp. Inflation rate ( high) –>

Real Interest rate = Nominal Interest rate (high) – Exp. Inflation rate (high)

So we have a situation where our real interest rate is still uneffected,but consists of a higher nom.interest rate minus a higher expt.inflation rate,right?Imagine at this situation our economyy gets into real trouble caused by a negative demand shock for example.As the exp.Inflation rate should be fixed short time,wouldn´t we have a higher nominal interest rate which we can cut directly to effect the real interest rate?Only if the CB doesn´t announce any changes in their inflation target…

#4 by Tony Lima on March 13, 2010 - 1:16 pm

Daniel, the point is that the level of expected inflation does not matter. Whether it’s two percent or twenty percent, a cut of one percentage point in the interest rate will, in the short run, reduce the real interest rate by one percentage point (more or less). Naturally, this only works if the central bank does not announce the policy in advance.

Your turn! – Tony

#5 by

Danielon March 13, 2010 - 2:14 pmHmm ok what I though of is:

Two examples:

1. (low inflation rate)

Nominal.IR 7% = R.IR 5% + Inflation R. 2%

Some years later a demand shock occurs,politicians want to support the economy by cutting the R.IR

R.IR 5% = N.IR 7% – Inf.R. 2%

So the CB cuts the N.IR,BUT as they can´t cut it below the 0% line we might have a problem,there could be just not enough % points we can cut to help the economy..

R.IR -2 % =N.IR 0% – Inf.R.2%

2. 2nd scenario (high Inflation rate policy)

Nominal IR 10 % = R.IR 5% + 5% Inf.R

Now the demand shock occurs…Politicians want us (CB) again to effect the RIR to help our economy…

R.IR – 5% = N.IR. 0 % – Inf.R 5%

So wouldn´t a high (higher) inflation rate policy give us a bigger range to act as a CB?Couldn´t we cut the R.IR in the short term in a greater number?I think that´s what Blanchard means.?Might be wrong

#6 by Tony Lima on March 13, 2010 - 3:19 pm

OK, let’s suppose the inflation rate is zero. Real and nominal interest rates are 2 percent. The best the Fed can do is reduce the real interest rate to zero — by two percentage points. (You could argue that the real interest rate is negative today, but I won’t believe it. There’s too much excess capacity in the economy right now for the real interest rate to be much different from zero — the marginal rate of return on physical capital.)

In any case, the best the Fed can hope to do is reduce the real interest rate to zero. I don’t see how that’s affected by the level of the nominal interest rate. For any inflation rate greater than zero you can always reduce the nominal interest rate by the exact amount of the real interest rate.

#7 by

Danielon March 13, 2010 - 6:36 pmHmm but shouldn´t a greater cut from 8% to 0% vs. 3% to 0 % effect the economy a bit more in the short run?the R.IR couldt go deeper into the “negative area” with a 0% N.IR and a high Inflation rate (fixed at that moment)?

#8 by Tony Lima on March 14, 2010 - 10:11 am

In either case the real interest rate is simply reduced from, say, 2 percent to zero. The difference between an 8% nominal rate and a 3% nominal rate is expected inflation. The economy doesn’t respond to reductions in expected inflation — only changes in the real interest rate count.