Brad DeLong (the simple model he is using is in the original post):
We Are so S---ed. Econ 1-Level Edition: ...And as I am going to tell [my undegraduates] next Monday, real GDP Y will be equal to potential output Y* whenever "the" interest rate r is equal to the Wicksellian neutral rate r*...
If interest rates are low and inflation is not rising it is not because monetary policy is too easy, but because r* is low--and r* can be low because:
- consumers are terrified (co low)
- investors' animal spirits are depressed (Io low)
- foreigners' demand for our exports inadequate (NX low)
- or fiscal policy too contractionary (G low)
for the economy's productive potential Y*.
The central bank's task in the long run is to try to do what it can to stabilize psychology and so reduce fluctuations in r*. ...
One way of looking at it is that two things went wrong in 2008-9:
- Asset prices collapsed.
- And so spending collapsed and unemployment rose.
The collapse in asset prices impoverished the plutocracy. The collapse in spending and the rise in unemployment impoverished the working class. Central banks responded by reducing interest rates. That restored asset prices, so making the plutocracy whole. But while that helped, that did not do enough to restore the working class.
Then the plutocracy had a complaint: although their asset values and their wealth had been restored, the return on their assets and so their incomes had not been. And so they called for austerity: cut government spending so that governments can then cut our taxes and so restore our incomes as well as our wealth.
But, of course, cutting government spending further impoverished the working class, and put still more downward pressure on the Wicksellian neutral interest rate r* consistent with full employment and potential output.
And here we sit.