Guest post: Why I Support NGDP Targeting (by David Eagle)

Welcome to David Eagle

I am extremely happy that professor David Eagle have accepted to write a series of guest blogs on my blog. I only recently became aware of David’s impressive research, but consider it to be truly original and in my view his research presents an extremely strong theoretical and empirical case for Nominal GDP level targeting, which of course is at the core of Market Monetarist thinking.

I have already written a number of posts on David’s research and even tried to elaborate on his research specifically in terms of suggesting a method – based on David’s research – to decompose inflation between demand inflation and supply inflation based on what I strongly inspired by David has termed a Quasi-Real Price Index (QRPI) and it is my hope that my invitation to David to write the guest blogs will help give exposure to his very interesting research. Furthermore, I hope that other researchers will be inspired by David’s truly path-breaking research to conduct research into the advantages of NGDP level targeting and related topics.

So once again, thank you David. It is an honour to host your guest blogs.

Lars Christensen  

 

Why I Support NGDP Targeting

By David Eagle

Nominal GDP (NGDP) represents the total spending in the economy, which in essence is the total aggregate demand in the economy.  The term “nominal” means that we ignore the effect of inflation on the value of the spending.  If we adjust for the effect of inflation, we then get a “real” value.  In particular, real GDP (RGDP) represents the total spending adjusted for the effect of inflation on the purchasing power of that spending.  RGDP also represents the conventional measure of total real supply in the economy because usually demand equals supply in a free economy.  I believe that, for most contingencies in the economy, both monetary policy and fiscal policy (as far as its aggregate-spending effects) should focus on targeting the total spending in the economy as measured by NGDP.  That way we will (i) reduce the prolonged high unemployment that has usually followed past recessions, (ii) minimize the demand-caused inflation uncertainties people experience while maintaining the role inflation or deflation plays in the sharing of aggregate-supply risk, (iii) reduce the likelihood of the economy experiencing a liquidity trap, and (iv) eliminate the “stimulate-the-economy” excuse for perpetual fiscal deficits when NGDP is at or above its target.

While I support nominal-GDP targeting (NT), I do not support nominal-GDP-growth-rate targeting (ΔNT).  I have long been an opponent of inflation targeting (IT), and I view ΔNT to be almost as bad as IT.  Both ΔNT and IT expose the economy to negative NGDP base drift, which is the source of several economic problems: (i) prolonged unemployment following recessions, (ii) greater uncertainty for borrowers, lenders, and other payers and receivers of fixed nominal future payments, and (iii) price-level indeterminacy, which can manifest itself in a liquidity trap like what many central banks throughout the world are currently facing.

I also am an opponent of price-level targeting (PLT) even though the NGDP base drift under PLT will be substantially less than under IT.  The reason is because Pareto efficiency requires people with average relative risk aversion to proportionately share in the risks of changes in real aggregate output.  Nominal contracts under NT naturally lead to this proportionate sharing.  However, PLT circumvents that proportionate sharing so that borrowers and other payers of fixed nominal payments absorb all the aggregate-supply risk of those payments in order to protect lenders and other receivers of fixed nominal payments from this risk.

I find that NT Pareto dominates PLT, IT, and ΔNT.  The only reason why NT is not Pareto efficient is a central bank cannot always meet its NGDP target.  I also find through empirical simulations that NT can eliminate the vast majority of the higher-than-normal, long-term unemployment that has usually plagued our economies following recessions.  Hence, I look at NT as the most desirable targeting regime from both a theoretical, Pareto-efficiency standpoint and from an empirical standpoint.

In the upcoming weeks, I plan to write several more guest blogs for “The Market Monetarist” to explain the theoretical and empirical justification for the points I have made in this introduction.  In some cases I will explain the full basis for that justification; in other cases, I will refer to other papers I or others have written.  My proposed blogs (which may change as I write this blogs) are as follows:

  1. Understanding NGAP, NGDP Base Drift, and Growth Vs. Level Targeting
  2. The Two Fundamental Welfare Principles of Monetary Economics
  3. Why Price-Level Targeting Pareto Dominates Inflation Targeting
  4. NGDP Base Drift – Why Recessions are followed by Prolonged High Unemployment
  5. NGDP Base Drift, Price Indeterminacy, and the Liquidity Trap
  6. Three Reasons to Target the Level of rather than the Growth Rate of Nominal GDP

My second blog will use examples to explain the concepts of NGAP, NGDP base drift, and the difference between targeting the level of NGDP and Targeting the growth rate of Nominal GDP.  This blog will also summarize the difference between price-level targeting and inflation targeting, and discuss the concepts of PGAP and price-level base drift.

© Copyright (2012) David Eagle

 

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8 Comments

  1. Martin

     /  January 6, 2012

    “Pareto efficiency requires people with average relative risk aversion to proportionately share in the risks of changes in real aggregate output.”

    How does this change when for example most creditors are risk-neutral? IT would still dominate PLT, but is there are policy conceivable that is even better than IT? I am thinking IT+: a little bit of extra demand inflation to get above target.

    Reply
  2. Martin

     /  January 6, 2012

    I look forward to seeing your future posts Prof. Eagle. It looks very promising.

    Reply
  3. David Eagle

     /  January 17, 2012

    Dale Domian raised the same question when we were writing our papers. Many times economists treat businesses as risk neutral, as a result, you may think banks are businesses and therefore, banks or creditors are risk neutral.

    However, Dale and I both are Finance professors and we teach and apply the Capital Asset Pricing Model (CAPM), including applying it to the credit market. CAPM breaks down risk into two types – idiosyncratic risk and systematic risk. The idiosyncratic risk is the risk that investors can diversify away whereas the systematic risk is undiversifiable risk. Because large institutional investors are such a large part of the market and are able to diversify away much of the idiosyncratic risk, CAPM concludes that the only risk that the market rewards is systematic risk.
    CAPM also concludes that to maximize shareholder well being, firms should maximize the net present value of the projects they invest in (which should include taking into account real options they may face) using a required rate of return that reflects this systematic risk. Under the theory of CAPM, firms are not risk neural; but because the investors can diversify away their idiosyncratic risk, the firms should only be sensitive to systematic risk, not idiosyncratic risk. As such, firms should reflect the risk adversity of their investors; they should not be risk neutral.

    What is the primary source of systematic risk in our economies? In the pure-exchange economies with no storage or capital which provide the simplistic theoretical basis for much of Dale Domian’s and my research, the only form of systematic risk is aggregate-supply risk. When we include storage and capital, economists such as Chen, Roll, and Ross (1986) find that aggregate-supply is still the predominate source of systematic risk in the economy (actually many of the other systematic risks would disappear if the central bank successfully targeted Nominal GDP).

    In summary, I do not agree that we should treat firms as risk neutral. We should also not treat creditors as risk neutral. In the pure theory of finance, we do not treat creditors as risk neutral; we treat them as being sensitive to systematic risk, which is predominately caused by aggregate-supply risk.

    Reference:
    Chen, Nai-Fu, Richard Roll, Stephen A. Ross (1986), “Economic Forces and the Stock Market,” The Journal of Business, 59(#3):383-403

    Reply
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