Is The Engine Of The Economy Flooded?

When one hears talk about the Wicksellian natural rate of interest, one hears that a real rate below the natural rate will cause inflation and economic heating. Then a real rate above the natural rate will lead to disinflation and economic cooling.

“Wicksellian analysis is an older tradition; it argues that there is at any given time a “natural” rate of interest in the sense that keeping rates below that level leads to inflation, keeping them above it leads to deflation.” Paul Krugman, July 7, 2014

So the logic looks simple, if we lower rates to below their natural level, the economy will heat up. That is like pushing down on the accelerator to speed up a car. OK… But does pushing down on the accelerator always speed up a car’s engine?… No.

Case in point, Flooding a Car’s Engine.

“A flooded engine is an internal combustion engine that has been fed an excessively rich air-fuel mixture that cannot be ignited. This is caused by the mixture exceeding the upper explosive limit for the particular fuel. An engine in this condition will not start until the excessively rich mixture has been cleared. It is also possible for an engine to stall from a running state due to this condition.” (Link)

When an engine is flooded, pushing more and more on the accelerator does no good.

Low interest rates are an excessively rich air-fuel mixture. The Federal Reserve and most central banks around the world are trying their hardest to fuel their economies with ever lower interest rates. But the economies are not heating up. So real rates must obviously be above the Wicksellian natural rate, right?

But what if economies are “flooded” with a multitude of subsidies, while wages stagnate? Businesses receive benefits from sources other than consumption by labor income, namely low interest rate costs, lower taxes and direct subsidies. I am implying that real rates can be below the Wicksellian natural real rate, and the economic environment will not ignite while labor income is so weak. So even with the rich fuel of extremely low interest rates, the economy does not respond.

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Author: Travis Esquivel

Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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