Today I got up one hour later than normal. The reason is the same as for most other Europeans this morning – the last Sunday of October – we move our clocks back one hour due to the end of Daylight saving time (summertime).
That reminded me of Milton Friedman’s so-called Daylight saving argument for floating exchange rates. According to Friedman, the argument in favour of flexible exchange rates is in many ways the same as that for summer time. Instead of changing the clocks to summer time, everyone could instead “just” change their behaviour: meet an hour later at work, change programme times on the TV, let buses and trains run an hour later, etc. The reason we do not do this is precisely because it is easier and more practical to put clocks an hour forward than to change everyone’s behaviour at the same time. It is the same with exchange rates, one can either change countless prices or change just one – the exchange rate.
There is a similar argument in favour of NGDP level targeting. Lets illustrate it with the equation of exchange.
M*V=P*Y
P*Y is of course the same as NGDP the equation of exchange can also be written as
M*V=NGDP
What Market Monetarists are arguing is that if we hold NGDP constant (or it grows along a constant path) then any shock to velocity (V) should be counteracted by an increase or decrease in the money supply (M).
Obviously one could just keep M constant, but then any shock to V would feed directly through to NGDP, but NGDP is not “one number” – it is in fact made up of countless goods and prices. So an “accommodated” shock to V in fact necessitates changing numerous prices (and volumes for the matter). By having a NGDP level target the money supply will do the adjusting instead and no prices would have to change. Monetary policy would therefore by construction be neutral – as it would not influence relative prices and volumes in the economy.
So when you (re)read Friedman’s “The Case for Floating Exchange Rates” then try think instead of “The Case for NGDP Level Targeting” – it is really the same story.
See my posts on Friedman’s arguments for floating exchange rates:
Milton Friedman on exchange rate policy #1
Milton Friedman on exchange rate policy #2
Milton Friedman on exchange rate policy #3
David Beckworth
/ October 30, 2011Lars,
This reminded me of the Milton Friedman analogy of monetary policy being like setting a thermostat. Here is a post where I explored that: http://macromarketmusings.blogspot.com/2011/06/how-effective-is-monetary-policy.html
Lars Christensen
/ October 30, 2011David, interesting you note it – I in fact had a sentence in the text to begin with that mentioned exact that story, but decided to take it out because the sentence didn’t work. But yes it is an variation of the thermostat and I well remember you excellent note on it.