Horwitz, McCallum and Markets (and nothing about Rush)

Alex Salter has made a forceful argument that there are strong theoretical similarities between Market Monetarist thinking and Austrian School Monetary Equilibrium Theorists (MET). I on my part have noted that METs like Steven Horwitz have similar policy recommendations as Market Monetarists – particularly NGDP targeting.

Steve Horwitz makes a strong case for NGDP targeting (and ultimately Free Banking) in his excellent book“Microfoundations and Macroeconomics: An Austrian Perspective”.

I have earlier suggested that a modified version of the so-called McCallum rule to implement NGDP target. Here is Steve’s take on the McCallum rule:

“Of particular interest is the rule proposed by Bennett McCallum (1987). He explicitly argues that the monetary authority should adopt a rule that targets a stable level of nominal income. Given the equation of exchange, such a rule amounts to maintaining monetary equilibrium by stabilizing MV. Unlike a Friedman-type rule, McCallum’s proposal would allow the monetary authority to adjust the monetary base as needed to offset changes in payments technology and the like. McCallum’s proposal also requires that the monetary authority make a guess at what the future growth rate in real GDP will be in order to know at what rate to change the base. This particular rule has several advantages, mainly that it does take complete discretion away from the monetary authority and it does bind it to the attempt to maintain monetary equilibrium.”

So far so good, but Steve has some highly relevant objections:

“However, it faces the same sorts of problems that plague central banking in general: can it know with certainty what the growth rate in real GDP will be and can it know exactly how changes in the monetary base will translate into changes in the overall supply of money? Even though the central bank is being bound to a rule, it still must possess a great deal of information, centralized in one place, in order to be able to execute the rule effectively.”

Hence, the McCallum rule might be an overall good starting point, but it is essentially backward-looking and we can not forecast future NGDP based on “centralized information” like a central bank try to do, but rather our monetary regime should be based on “decentralized information” and that is why Steve prefers a privatization of the supply of money – aka Free Banking.

This is pretty much in the spirit of the Market Monetarist’s dictum that money matters and markets matter. But what if the central bank’s monopoly on the supply of money is maintained? How do we ensure an outcome, which emulates the Free Banking outcome?

The obvious answer is to introduce a forward-looking version of the McCallum rule, where expectations for NGDP growth is based on market data – equity prices, commodity prices, bond yields and the currency. The best solution obviously would be a future markets for NGDP, but since that does not exist a second best solution is to estimate NGDP expectations on other market prices.

I have earlier suggested such a modified version of the McCallum rule, but I not entire happy with how that came out, but nonetheless I think it beneficial for Market Monetarist research to focus on the empirical relationship between NGDP, the expectations for monetary policy and policy rules.

Challenge for aspiring Market Monetarist econometricians: Estimate a VAR system based on NGDP, the money base (MZM), velocity and S&P500 (as a measure of market expectations) with US data for the period 1985-2007. Use the model to simulate money base growth from early 2008 and until today and compare this “optimal” money base growth with the actual growth in the money. This could provide empirical support for or against the Sumnerian thesis that the Fed caused the Great Recession.

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  1. Jroc

     /  October 18, 2011

    Hi. I was wondering if you could explain fundamentally what it would mean to purchase an NGDP futures contract? What is the underlying asset you agree to purchase at the specified date, and what determines the price?

  1. The Economist comments on Market Monetarism « The Market Monetarist

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