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How "Goldilocks" Contributes to Economic Policymaking

Writes on central banking, he covers a wide range of topics on finance.

how-goldilocks-contributes-to-economic-policymaking

In the story of Goldilocks and the Three Bears, the idea behind the phrase "just the right amount" refers to the scene in the story where a little girl tastes three different bowls of porridge and finds she prefers porridge that's neither hot nor cold.

The words "just the right amount", relate to the concept of a "neutral rate of interest" in economic policymaking where central bank policy is neither accommodative nor restrictive.

It's "just the right amount", hence the phrase "neutral rate of interest" in central bank policy.

The phrase can trace itself back to 18th century literature. But it's often regarded as the work of a Swedish economist by the name of Knut Wicksell.

Wicksell's publication on the topic of a "neutral rate of interest" has come to define the term as we know the phrase in modern economics today. As a result, the story of Goldilocks and the Three Bears is perhaps one of the most common metaphores in finance.

how-goldilocks-contributes-to-economic-policymaking

In a "Goldilocks" economy; sustained economic growth allows for market-friendly policies where price levels rest between a bear and a bull's market.

According to Wicksell, fluctuations in short-term interest rates were a major cause for concern. Especially when it came to economic policymaking.

Wicksell draws on two analogies.

For starters, if money market interest rates were somewhere below a "neutral rate of interest", then Wicksell believed investments would exceed savings & aggregate demand could surpass aggregate supply.

On the contrary, Wicksell argued, aggregate supply would in fact exceed aggregate demand if and when money market interest rates were above a "neutral rate of interest" in the market.

It's the ultimate challenge for policymakers.

But there was a much broader message to Wicksell's analysis. That is, in order to determine a "Goldilocks" economy, policymakers would need to distinguish between the two rates of interest.

They would need to draw on comparisons & establish whether central bank policy was indeed accommodative or restrictive.

But more importantly, central bank policy would need to determine if short-term interest rates were in fact "just the right amount" or whether economic policymakers have reached a "neutral rate of interest" where economic growth was neither hot nor cold.

It's much like the story of Goldilocks and the Three Bears & a sign that economic growth is consistent with full employment and price stability.

This content is accurate and true to the best of the author’s knowledge and is not meant to substitute for formal and individualized advice from a qualified professional.

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