J: I don't want to keep discussing the EMH, so let me just close that tangent by pointing out that
you cannot test a theory by its assumptions. If you want to show the EMH is not a good model, you have to test its predictions: how much serial correlation is there in the market? Can market participants on average make better returns than the market over the long run? Are the marginal trades low-volume and low-profit? And so on.
To elaborate, the Fed neither rules by decree nor does it have a magic wand. It can influence interest and by extension inflation rates with the help of its primary dealers through various market operations to add or withdraw liquidity, money, and credit from the system. With this in mind, what actions by the Fed are required to, as you say, reflate the economy back to trend?
The Fed needs to declare that it will begin unlimited asset purchases (probably T-bills, maybe distressed securities, whatever) starting at, say, $100 billion per month and rising 10% every month thereafter until income has risen back to the 1985-2005 trend line.
The key point is that it won't actually have to make those purchases, since investment demand will jump on the expectation of higher future incomes. In fact, as per standard monetary theory, the Fed's balance sheet grows when monetary policy is tight and the Fed's balance sheet shrinks when monetary policy is loose, so we can expect the Fed's balance sheet to shrink drastically. (Only the Fed can cause an asset's price to fall by increasing demand for it!)
aerius:
Surlethe, I figured out my math error when I redid it on my TI-85 about 5 minutes after the edit limit expired. Turns out the calculator on my computer doesn't do what I think it does. This is why I don't work in math or accounting, though I'd probably make a pretty good Enron accountant.
lols, all good
What both of us forgot is that consumer loans aren't indexed to inflation, they're fixed and locked down at the time you take them out.
Right: in particular, they're determined by the
expected rate of inflation. More precisely, (loan rate) = (real rate) + (expected inflation rate). With that in mind, let's trace through your example.
So I think where you're going wrong is computing debt-to-income versus present-value-of-debt to present-value-of-income-stream. In other words, the bank doesn't care about your *current* income-to-expected-interest-payment ratio; it cares whether every month going forward you'll be able to make your payment. Since at 8% interest, your income is rising at 8% per year, the bank will take that into account, which is why it tacks on the 8% inflation premium to the 4% interest rate in the first place.
(Again, general price inflation is distinct from supply-shock induced inflation, which is really a decrease in the
relative price of labor as measured in other goods and services.)
