In my last post I pointed out that it is not enough for monetary policy to guide the economy back to the natural rate of interest. Central banks and national treasuries must use financial policy to guide us back to the natural rate of unemployment.

Imagine two economies in parallel universes. I will call them economy A and economy B. Both economies are populated by identical copies of the same people. They have the same endowments of land labor and capital. And each economy has access to identical technologies for producing goods. In economic jargon: they have the same fundamentals.

But although these economies have identical fundamentals, the people in economy A are naturally optimistic. They believe that shares in their stock market are worth PA. And PA is a large number. The people in economy B are pessimists. They believe that their stock market is worth PB. And PB is a small number. Importantly, PB < PA.

In economy A, as a consequence of the optimism of the population, households have a high demand for goods and services. To meet that demand, firms require a high labor force. The unemployment rate in economy A is 2%.

In economy B, as a consequence of the pessimism of the population, households have a low demand for goods and service. To meet that demand, firms require a low labor force. The unemployment rate in economy B is 10%.

In each economy, the households and firms believe, correctly, that the value of a share is equal to the discounted present value of a claim to the dividends that will be paid by the firm. And in each economy people discount the future at rate 1/R*, where R* is Wicksell’s ‘natural rate of interest’.

Dividends, in each economy, are a fraction of GDP. Because employment is higher in economy A than economy B, GDP is also higher. And so are dividends. The valuations placed on the stock market in both economies are rational. PA is equal to the present value of the dividends paid in economy A, discounted at rate 1/R*. PB is equal to the present value of the dividends paid in economy B, also discounted at rate 1/R*. Optimism or pessimism is a self-fulfilling prophecy.

How can this be? Surely the unemployment rate is determined by fundamentals. Not so. I explain in my published academic work, how there can be many unemployment rates, all of which are consistent with the conditions I described in this example. In a labor market where people must search for jobs, there are not enough price signals, to lead market participants to the optimal unemployment rate.

Roger Farmer's Economic Window