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”.


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