Exchange rate based NGDP targeting for small-open economies

The debate about NGDP targeting is mostly focused on US monetary policy and the focus of most of the Market Monetarist bloggers is on the US economy and on US monetary policy. That is not in anyway surprising, but this is of little help to policy makers in small-open economies and I have long argued that Market Monetarists also need to address the issue of monetary policy in small-open economies.

In my view NGDP level targeting is exactly as relevant to small-open economies as for the US or the euro zone. However, it terms of the implementation of NGDP level targeting in small open economies that might be easier said than done.

A major problem for small-open economies is that their financial markets typically are less developed than for example the US financial markets and equally important exchange rates moves is having a much bigger impact on the overall economic performance – and especially on the short-term volatility in prices, inflation and NGDP. I therefore think that there is scope for thinking about what I would call exchange rate based NGDP targeting in small open economies.

What I suggest here is something that needs a lot more theoretical and empirical work, but overall my idea is to combine Irving Fisher’s compensated dollar plan (CDP) with NGDP level targeting.

Fisher’s idea was to stabilise the price level by devaluing or revaluing the currency dependent on whether the actual price level was higher or lower than the targeted price level. Hence, if the price level was 1% below the target price level in period t-1 then the currency should devalued by 1% in period t. The Swedish central bank operated a scheme similar to this quite successfully in the 1930s. In Fisher’s scheme the “reference currency” was the dollar versus gold prices. In my scheme it would clearly be a possibility to “manage” the currency against some commodity price like gold prices or a basket of commodity prices (for example the CRB index). Alternatively the currency of the small open economy could be managed vis-à-vis a basket of currencies reflecting for example a trade-weighted basket of currencies.

Unlike Fisher’s scheme the central bank’s target would not be the price level, but rather a NGDP path level and unlike the CDP it should be a forward – and not a backward – looking scheme. Hence, the central bank could for example once every quarter announce an appreciation/depreciation path for the currency over the coming 2-3 years. So if NGDP was lower than the target level then the central bank would announce a “lower” (weaker) path for the currency than otherwise would have been the case.

For Emerging Markets where productivity growth typical is higher than in developed markets the so-called Balassa-Samuelson effect would say that the real effective exchange rate of the Emerging Market economy should gradually appreciate, but if NGDP where to fall below the target level then the central bank would choose to “slowdown” the future path for the exchange rate appreciation relative to the trend rate of appreciation.

I believe that exchange rate based NGDP level targeting could provide a worthwhile alternative to floating exchange (with inflation or NGDP targeting) or rigid pegged exchange rate policies. That said, my idea need to be examined much closer and it would be interesting to see how the rule would perform in standard macroeconomic models under different assumptions.

Finally it should be noted that the there are some clear similarities to a number for the proposal for NGDP growth targeting Bennett McCallum has suggested over the years.


Six central banks take action, but where is Chuck Norris?

Today, the Federal Reserve, the ECB, Bank of Canada, Bank of England, Bank of Japan and the Swiss National Bank announced a coordinated action to lower the pricing on the existing temporary US dollar liquidity swap arrangements by 50bp.

This is especially important the European financial sector, which remains underfunded in US dollars and as such the move from the central banks easing strains in the European financial markets.

Judging from the initial market reaction this is rightly taken to be monetary easing – especially easing of US monetary policy – stock prices rose, the dollar weakened and commodities prices spiked.

Monetary policy, however,  works primarily through expectations and since the six central banks who took action today have said nothing about what they want to achieve in terms of monetary policy targets we are unlikely to have a strong and long lasting impact of this. What we are missing here is the Chuck Norris effect. The central banks need to announce a target – for example that they want to increase NGDP in the euro zone by 10 or 15%.

I have already discussed a “crazy idea” to for the major global central banks to take action to ease monetary policy with a coordinated “devaluation” of the dollar, the euro, the yen etc. against a basket of commodities. Today’s action from the six central banks show that it can be done. Monetary policy is very powerful – so why not use it?
Update 1: Scott Sumner also has a comment on the global monetary action.

Update 2: I have in a number of previous post argued against discretionary monetary “stimulus” and argued that NGDP targeting is not about “fine tuning”. In that regard Market Monetarists should be skeptical about today’s monetary easing even though it is helpful in demonstrating the power of monetary policy and is at least helps curb the crisis – at least in the short-term. See my earlier comments: “Adam Posen calls for more QE – that’s fine, but…”, “NGDP targeting is not a Keynesian business cycle policy” and “Roth’s Monetary and Fiscal Framework for Economic Stability”

This is how deep the European crisis is

Polish foreign minister Radoslaw Sikorski (yesterday in the Financial Times):

“You know full well that nobody else can do it. I will probably be the first Polish foreign minister in history to say so, but here it is: I fear German power less than I fear German inactivity. You have become Europe’s indispensable nation.”


The Vitali Klitschko effect and “speculative attacks”

Here is Hungarian central bank governor Andras Simor:

“As for speculative attacks, I keep saying that [Ukrainian heavy weight champion boxer] Vitali Klitschko doesn’t get smacked on the street corner but the scrawny, bespectacled kid who is exempt from physical education classes does get beaten up, because they reckon he won’t hit back”

Recently the Hungarian forint has been “smacked”. Mr. Simor seems to indicate that the forint is no “Klitschko currency” – or rather that the reason for the sell-off in the forint is bad Hungarian fundamentals.

Hence, what Mr. Simor is saying is that there is no such thing as a “speculative attack”. Currencies does not just weaken out of the blue – there is always a reason and conspiracy theories rarely can explain market movements. Luckily for Hungary the country has a central bank governor who understand economics and markets.

The question is, however, who is the strongest – Chuck Norris or Vitali Klitschko? So while the Chuck Norris effect is saying that “You don’t have to print more money to ease monetary policy if you are a credible central bank with a credible target” the Vitali Klitschko effect says that “a central bank can only be credible if it has the proper firepower”.


Ramesh Ponnuru: For Fed NGDP Could Spell More Economic Stability

Senior editor at National Review and Bloomberg View columnist Ramesh Ponnuru is well-known for his Market Monetarist views Now he is out with a new comment NGDP targeting.

For those not familiar with NGDP targeting Ponnuru has a good explanation:

“Nominal GDP (NGDP) is simply the size of the economy measured in dollars, with no adjustment for inflation. In a year when the inflation rate is 2 percent and the economy grows by 2 percent in real terms, NGDP rises 4 percent. The NGDP targeters say that the Fed should aim to keep this growth rate steady. Christina Romer, the former chairman of President Barack Obama’s Council of Economic Advisers, suggested in the New York Times recently that NGDP should grow at 4.5 percent a year. If the Fed overshoots one year, it should undershoot the next, and vice- versa, so that long-term NGDP growth stays on target…Like the more familiar concept of inflation targeting, NGDP targeting seeks to stabilize expectations about the future path of the economy, making it easier for people to make long-term plans. Keeping nominal spending, and thus nominal income, on a relatively predictable path is especially important because most debts, such as mortgages, are contracted in nominal terms. If nominal incomes swing wildly, so does the ability to service those debts.”

Ponnuru highlights some of the advantages with NGDP targeting compared to inflation targeting:

“The chief advantage of targeting NGDP, rather than inflation, is that it distinguishes between shocks to supply and shocks to demand. With either approach, the central bank should respond to a sudden drop in the velocity of money by expanding the money supply. If people are holding on to money balances at a higher rate than usual — because of a financial panic, just to pick a random example — both inflation and NGDP would fall below target and the Fed would have to loosen money in response.

But the two approaches counsel opposite responses to a negative supply shock, such as a disruption in oil markets. That shock would tend to increase prices and reduce real economic growth, thus changing the composition of NGDP growth but not its amount. With an NGDP target, the Fed would accordingly leave its policy unchanged. With a strict inflation target, on the other hand, the Fed would tighten money — and thus the real economy would take a bigger hit from the supply shock.

A positive supply shock, such as an improvement in productivity, would also elicit different responses. Under an NGDP target, the rate of inflation would decrease and real growth would increase. A strict inflation target would force the Fed to loosen money and thus risk creating bubbles.

In other words, inflation targeting makes the boom-and-bust cycle worse following supply shocks, while NGDP targeting doesn’t.

From the standpoint of macroeconomic stability, then, NGDP targeting is superior because it allows inflation to accelerate and slow to counteract fluctuations in productivity. It moves the money supply only in response to changes in the demand for money balances, and not to supply shocks that mimic the effect of these changes on prices but call for a different monetary response.”

Ponnuru finally reminds the reader that NGDP targeting in the US basically would be a return to the familiar and successful monetary policy of the “Great Moderation”:

“A major obstacle for NGDP targeters is that our idea is novel even to most well-informed followers of economic-policy debates. But we do have some experience with it. Josh Hendrickson, an assistant professor of economics at the University of Mississippi, has shown that from 1984 to 2007 the Fed acted, for the most part, as though it were trying to keep NGDP growing at a stable rate. Whether by design or accident, it did so — and the result has come to be called “the great moderation” because of the gentleness of business cycles in that period. We should target NGDP again, and this time reap the benefits of predictability by saying so.”

The paper Ponnuru is mentioning is Josh’s excellent 2010-paper “An Overhaul of Federal Reserve Doctrine: Nominal Income and the Great Moderation” – read it before your neighbour!

HT David Levey


Sumner and Glasner on the euro crisis

Recently the Market Monetarist bloggers have come out with a number of comments on the euro crisis. It’s a joy reading them – despite the tragic background.

Here is a bit of brilliant comments. Lets start with Scott Sumner:

“Many people seem to be under the illusion that Germany is a rich country. It isn’t. It’s a thrifty country. German per capita income (PPP) is more than 20% below US levels, below the level of Alabama and Arkansas. If you consider those states to be “rich,” then by all means go on calling Germany a rich country. The Germans know they aren’t rich, and they certainly aren’t going to be willing to throw away their hard earned money on another failed EU experiment. That’s not to say the current debt crisis won’t end up costing the German taxpayers. That’s now almost unavoidable, given the inevitable Greek default. But they should not and will not commit to an open-ended fiscal union, i.e. to “taxation without representation.”

Scott as usual it is right on the nail…further comments are not needed.

But it is not really about whether Alabama…eh Germany… is rich enough to bail out the rest of Europe. The question is why some (all?) euro zone are in trouble. David Glasner has the answer:

“…the main cause of the debt crisis is that incomes are not growing fast enough to generate enough free cash flow to pay off the fixed nominal obligations incurred by the insolvent, nearly insolvent, or potentially insolvent Eurozone countries. Even worse, stagnating incomes impose added borrowing requirements on governments to cover expanding fiscal deficits. When a private borrower, having borrowed in expectation of increased future income, becomes insolvent, regaining solvency just by reducing expenditures is rarely possible. So if the borrower’s income doesn’t increase, the options are usually default and bankruptcy or a negotiated write down of the borrower’s indebtedness to creditors. A community or a country is even less likely than an individual to regain solvency through austerity, because the reduced spending of one person diminishes the incomes earned by others (the paradox of thrift), meaning that austerity may impair the income-earning, and, hence, the debt-repaying, capacity of the community as a whole.”

See also my comment on Ambrose Evans-Pritchard.

David Friedman on the price of money

I always considered David Friedman to be very special. I have read all his books and I seldom find myself disagreeing with him (we even have a odd interest in Iceland in common). However, I have a slightly controversial interpretation of David Friedman’s thinking – I think his views really is a reflection of what Milton Friedman really would have liked to say if he had been truly free to express his views. Milton Friedman was the one who with his writings both turned me into a monetarist and a libertarian, but David Friedman’s views in many ways are probably closer to what I think about most things. David Friedman as his father of course also is a fantastic writer and thinker.

David’s thinking in my view is the best illustration of what I in my book on his father called the pragmatic revolutionary. His views might on the surface not be all that radical, but once you understand the logic of his thinking you yourself become a radical. David is the best example of this and I hope I am as well.

David, however, has been carefully not writing or speaking too much about monetary issues – his dad’s speciality. However, his latest post on his blog is exactly about that.

David comments on a very import topic – the general misunderstanding that interest rates is the price of money. This is a key monetarist insight that Market Monetarists often also would put forward. Unfortunately David’s comments in Tim Congdon’s new book “Money in a Free Society”. David seems to think that Tim does not understand that money is the price of money. Contrary to this I think that Tim is very much aware that it is a fallacy to say to low interest rates is the same as easy money. I think the misunderstanding is due to Tim’s discussion of the institutional difference between UK and US monetary policies in the 1980s, but I don’t want to be the judge on that. Therefore, I will just concentrate on David’s argument, while I don’t think Tim should be held accountable for a fallacy that he obviously don’t believe in.

Here is David:

It is said that “interest rate” is “the price of money.”

“This is a very common error, and one that is not only wrong but dangerously wrong…If the price of an apple is fifty cents, that means that if I give a seller fifty cents he will give me an apple in exchange. If the interest rate is five percent and that is the price of money, I ought to be able to buy money for five cents on the dollar. I doubt … anyone else, will be willing to sell it to me at that price…The price of money is what you have to give up to get it—the inverse of the price level. If the price of an apple is fifty cents, the price of a dollar is two apples. The interest rate is the rent on money, measured in money. A change in the price of money affects both the money you are renting and the money you are paying as rent, leaving the ratio of the two unchanged…Suppose that at midnight tonight every dollar bill in the world twins, along with a similar change in the accounting entries for bank deposits, other forms of money, and all obligations denominated in money. By morning, there is twice as much money as before—and nothing else has changed…I would ask Congdon (it should be Mr. X!) whether, under those circumstances, he would expect the interest rate to drop. If his answer is yes, my next question is whether he would expect a much more extreme drop if we relabeled pennies as dollars and dollars as hundred dollar bills, thus increasing the money supply, measured in “dollars,” a hundredfold…The reason the description of the interest rate as the price of money is not only wrong but dangerously wrong is that it implies a simple relation between money and the interest rate—in the extreme (but not uncommon) version, the belief that interest rates are set by central banks, with high interest rates the result of a tight monetary policy…A central bank can create money and lend it out, increasing the supply of loans (which reduces the interest rate) and increasing the money supply. That is the one element of truth to the relationship. But what is affecting the interest rate is not the amount of money but the amount of loans; the government could get the same effect by collecting more in taxes than it spends and lending out the difference…The interest rate is a market price—the price paid for the use of capital—and the central bank controls it only in the same sense in which the government can control the price of wheat by choosing to buy or sell some of it. The central bank does not have an unlimited amount of capital from money creation to lend and so has only a limited ability to shift interest rates from what they would otherwise be. Furthermore, a continued expansion of the money supply creates the expectation of future price rises, which pushes the nominal interest rate up, not down.”

I wish more people would understand this, but most of all I would hope that David would write much more about monetary theory.

For those interested I have a discussion of the price for money and interest rates in my paper on Market Monetarism.


Update: I was a bit too fast – I did not read David’s none-economic books like Harald and Salamander.

Ambrose Evans-Pritchard comments on Market Monetarism

The excellent British commentator Ambrose Evans-Pritchard at the Daily Telegraph has a comment on the Euro crisis. I am happy to say that Ambrose comments positively on Market Monetarism. Here is a part of Ambrose’s comments:

“A pioneering school of “market monetarists” – perhaps the most creative in the current policy fog – says the Fed should reflate the world through a different mechanism, preferably with the Bank of Japan and a coalition of the willing.

Their strategy is to target nominal GDP (NGDP) growth in the United States and other aligned powers, restoring it to pre-crisis trend levels. The idea comes from Irving Fisher’s “compensated dollar plan” in the 1930s.

The school is not Keynesian. They are inspired by interwar economists Ralph Hawtrey and Sweden’s Gustav Cassel, as well as monetarist guru Milton Friedman. “Anybody who has studied the Great Depression should find recent European events surreal. Day-by-day history repeats itself. It is tragic,” said Lars Christensen from Danske Bank, author of a book on Friedman.

“It is possible that a dramatic shift toward monetary stimulus could rescue the euro,” said Scott Sumner, a professor at Bentley University and the group’s eminence grise. Instead, EU authorities are repeating the errors of the Slump by obsessing over inflation when (forward-looking) deflation is already the greater threat.

“I used to think people were stupid back in the 1930s. Remember Hawtrey’s famous “Crying fire, fire, in Noah’s flood”? I used to wonder how people could have failed to see the real problem. I thought that progress in macroeconomic analysis made similar policy errors unlikely today. I couldn’t have been more wrong. We’re just as stupid,” he said.”

So Market Monetarism is now being noticed in the US and in the UK – I wonder when continental Europe will wake up.


Update: Scott Sumner also comments on Ambrose here – and in he has a related post to the euro crisis here.

November 1932: Hitler, FDR and European central bankers

The headline of most stock markets reports yesterday said something like “Stocks: Worst Thanksgiving Drop Since ’32”. That made me think – what really happened in November 1932?

As is the case this time around European worries dominated the financial headlines back in November 1932. The first of two key events of November 1932 was the German federal elections on November 6 1932. We all know the outcome – Hitler’s National Socialist Germans Workers’ Party (NSDAP) won a landslide victory and got 33.1% of the vote. As the Communist Party won 16.9% the totalitarian parties commanded a firm majority – what at the time was called the “negative majority”. This eventually led to the formation of Hitler’s first cabinet in January 1933.

The second key event of November 1932 of course was the US presidential elections. Two days after the German in elections Franklin D. Roosevelt won the US presidential elections defeating incumbent president Herbert Hoover on November 8 1932. FDR of course in 1933 took the US of the gold standard, but also introduced the catastrophic National Industrial Recovery Act (NIRA).

Going through the New York Times articles of November 1932 I found a short article on the gold standard in which it said the following:

“Governors of Europe’s central banks who met today (November 13 1932) at the Bank of International Settlements expressed the unanimous opinion that the gold standard was the only basis on which the world economic situation could be bettered”

Obviously we today’s know that the failed gold standard was the key reason for the Great Depression and especially European central bankers’ desperate attempt to save the failed monetary regime created the environment in which Hitler and his nazi party was able to win the German elections in November 1932. What would have happened for example if Germany had been given proper debt relief, the European central banks had given up the gold standard and the French central bank had stopped the hoarding of gold?

Had I been a Marxist I would had been extremely depressed today because then I would had believed in historical determinism. Fortunately I think we can learn from history and avoid repeating past mistakes. I hope today’s European central bankers share this view and will learn a bit from the events of November 1932.

If European central bankers this time around decide not to learn from events of 1932 then they might be interested in learning about the dissolution of the Austro-Hungarian currency union in 1919. Then they just have to read this excellent paper by Peter Garber and Michael Spencer.

Schuler on money demand – and a bit of Lithuanian memories…

Here is Kurt Schuler over at

“During the financial crisis of 2008-09, many central banks expanded the monetary base. In some countries, the base remains high; in the United States, for instance it is roughly triple its pre-crisis level. Such an expansion, unprecedented in peacetime, has convinced many observers that a bout of high inflation will occur in the near future. That leads us to the lesson of the day:

To talk intelligently about the money supply, you must also consider the demand for money. Starting from a situation where supply and demand are in balance, the supply can triple, but if demand quadruples, money is tight. Similarly, the supply can fall in half, but if demand is only one-quarter its previous level, money is loose.

In normal times, it is a fairly safe assumption that demand is roughly constant or changing predictably, but in abnormal times, it is a dangerous assumption. No high inflation occurred in any country that expanded the monetary base rapidly during the financial crisis. Evidently, demand expanded along with supply. In fact, Scott Sumner and other “market monetarists” think supply did not keep up with demand. Similarly, nobody should be perplexed if a case arises where the monetary base is constant or even falling but inflation is rising sharply. Absent a natural disaster or some other nonmonetary event, it is evidence that demand for the monetary base is falling but supply is not keeping pace.”

Kurt is of course very right – the way to see whether monetary policy is tight or loose is to look at the money supply relative to the money demand. Since, we can not observe the difference between the money supply and the money demand directly Market Monetarists recommend to look at asset prices. We know that tight money (stronger money demand growth than the money supply growth) leads to a drop in equity prices, lower bond yields (due to lower inflation expectations), a stronger currency and for large economies like the US or China lower commodity prices.

One thing Kurt did not mention – and I a bit puzzled about that as it is a very important argument for Free Banking – is that in a world with Free Banking the total privatisation of the money supply means that the money supply (ideally?) is perfectly elastic and that any increase in money demand is meet by a equally large increase in the money supply. The same will be the case in a world with central banks targeting the NGDP level. With a perfectly elastic money supply crisis like the Great Depression and the Great Recession is likely to be much more unlikely.

PS I am writing this while I am in Lithuania – a country where Kurt’s (and George Selgin’s) work played a key role nearly 20 years ago in the introduction of the country’s currency board system. See more on this here.

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