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As a rule of thumb, I try not to get in the habit of pointing out oversights made by Harvard professors. Having said that, I have a minor quibble with Professor Greg Mankiw.

In the interest of full disclosure, Professor Mankiw is the Robert M. Beren Professor of Economics at Harvard, and he’s also the former chairman of the President's Council of Economic Advisors.

Me? I often blog while wearing bunny slippers.

Anywho, Dr. Mankiw developed the “Mankiw Method,” which is a simple back-of-the-envelope equation for determining the appropriate target for the Fed funds rate:

Federal funds rate = 8.5 + 1.4 (Core inflation - Unemployment)

The Mankiw Method certainly has its benefits. It’s easy to follow, and in my opinion, it would have done a better job than the Fed over the past few years.

There is, however, one major problem with the Mankiw Method. According to the equation, inflation’s impact on interest rates is greater than 1.0. I feel this is a big mistake. What it means is that for every 1% increase in inflation, interest rates rise by 1.4%. Consequently, as inflation increases, real interest rates also rise independent of unemployment.

As long as inflation is low, the equation works well. But once inflation starts creeping up, then we start seeing problems. In February 1991, unemployment stood at 6.6% and core inflation reached 5.6%. According to the Mankiw Method, real interest rates should be 1.5%. In July 2004, unemployment was at 5.5% and core inflation was running at 1.8%. Again, the Mankiw Method would recommend a real rate of 1.5%.

To restate my earlier sentence, for everyone 1% increase in inflation, real rates rise by 0.4%. This seems like extra punishment for an economy just for inflation.

The blog, Political Calculations, also has some issues with the Mankiw Method, which the professor addresses.

Posted by edelfenbein at August 3, 2006 6:31 AM