Quasi-Real indexing – indexing for Market Monetarists

This morning when I was looking for something else on the internet I by coincidence came across Dr. David Eagle’s website. Dr. Eagle is an Associate Professor of Finance at the Eastern Washington University.

I regret to say that I had never heard of David Eagle before and I have never seen any of his research before and I had never heard about an idea that he has developed with Dr. Dale L. Domian a Professor of Finance in the School of Administrative Studies at York University. The idea is what Eagle and Domian call Quasi-Real Indexing (QRI).

I am quite delighted, however, that I have now come across Eagle’s and Domian’s research and I am happy to share some of it with my readers. I think their work on QRI will be of interest Market Monetarists and QRI could be a interesting and useful supplement to NGDP targeting.

The idea behind QRI is that normal inflation indexing of wage contacts, bonds etc. is imperfect as it does not differentiate between the causes of inflation. Hence, it is crucial whether inflation is caused by demand or supply shocks. A parallel discussion to this is George Selgin’s discussion of the so-called productivity norm, which also argues that one should differentiate between the causes of inflation (or deflation).

Here is Eagle and Domian (from the abstract in a recent working paper: “Immunizing our Economies against Recessions – A Microfoundations Investigation”)

“We find that, instead of using derivatives or expensive fiscal stimuli, we can achieve recession protection through indexing wages, mortgages, bonds, etc., to changes in nominal GDP but not to aggregate-supply-caused inflation. This type of indexing we call, “quasi-real indexing.”

Hence, the idea is to shield economic agents from swings in nominal GDP. This can be done as Market Monetarists argue with NGDP targeting (something Eagle and Domian agrees on and support), but also with QRI.

Here is a bit more on QRI (from another paper “Unsticking those Sticky Wages To Mitigate Recessions Without Expensive Fiscal Stimuli”):

The conventional form of inflation indexing, also known as cost of living adjustments (COLAs), is based on price changes no matter what the cause… there are two and only two determinants of inflation: (1) aggregate demand as measured by nominal GDP, and (2) aggregate supply as measured by real GDP. QRI is linked to only one of these causes — nominal GDP, but not to real GDP. Because QRI is based on a cause, not the price level itself. QRI is proactive; if the price level is sticky as most economists believes, then QRI can respond to changes in nominal GDP prior to the price level being affected by those changes.”

I think this makes quite a bit of sense – and it is pretty much how Market Monetarists think.

Everything Eagle and Domian write on the topic of QRI seems to be a bit of a gold mine for Market Monetarists thinking and their modelling could be helpful in the further theoretical development of Market Monetarism. See here for example:

”Many economists may criticize QRI because it only responds to aggregate-demand-caused inflation and not to aggregate-supply-caused inflation. They may cite the almost universally accepted goal in monetary policy and macroeconomic policy of minimizing an objective function involving inflation (or the price level) and output gap (or unemployment or output). In fact, this objective function has been institutionalized into the legislative mandate for the Federal Reserve… However, that objective function, which is an ad hoc assumption of economists, has blind economists from what microfoundations says should be the objective of monetary and macroeconomic policy. Later in this paper, we present Pareto-efficiency arguments why we should only adjust for aggregate-demand-caused inflation and not for aggregate-supply caused inflation. At this point in the paper, realize that at one time medical science considered all cholesterol as bad; now they consider there to be both good cholesterol and bad cholesterol. Up to now, economists have considered any inflation above the targeted inflation rate to be bad inflation. Our view, supported by microfoundations involving Pareto efficiency is that unexpected aggregate-demand-caused inflation (or deflation) is bad but aggregate-supply-caused inflation (or deflation) is necessarily for the economy to efficiently handle the lower (or higher) supply.”

This is exactly what Market Monetarist are saying – and this discussion gives an excellent input to for example the discussion of the Taylor rule versus NGDP targeting.

There are many aspects of QRI and as I state above I have only become familiar with the topic today so I will not go in to it all in this post. However, as I see it the (for now) small literature seems very interesting and the QRI could sheet a lot of light on the advantages of NGDP targeting and it also seems like QRI could be helpful in crisis resolution in both Europe and the US. In that regard Eagle’s and Domian’s papers on QRI linked bonds seem especially of interest.

I sincerely hope that my fellow Market Monetarist bloggers will have a look at Eagle’s and Domian’s interesting work on QRI and finally I would like to quote an appeal from David Eagle’s website posted on February 26 2009:

“I write this internet note with the hope that it gets to someone with influence. That someone could be a state or other local legislator struggling with how to cut their budget. That someone could be an administrator with a federal government trying to find some way to help their economy get through the current financial debacle. That someone could be working in a bank with the task of figuring out a way to refinance mortgages to avoid foreclosures and make it more affordable for homeowners to stay in their houses. That someone could work for a firm who is struggling to meet payroll in this time of lower demand for their product. That someone could even be President Obama as he struggles with many of these issues on the macroeconomic level. All these people are looking for ways to either better deal with the current recession or help others better deal with the current recession. I write this note, because I have a solution, a cheap solution, although the solution involves a major change in how businesses, governments, workers, lenders, and borrowers deal with each other. The solution is quasi-real indexing, a type of inflation indexing Dale Domian and I have designed.
Many of you will be skeptical and will ask, “What does inflation indexing have to do with the current recession?” A quick economic lesson will answer this question for you. Remember the debate between the Keynesian economists and the classical economists in the 1930s during the Great Depression. The classical economists criticized Keynesian economics by arguing that in the long run, prices and wages will adjust to return real output to its normal level. In response, John Maynard Keynes said, “In the long run, we all are dead!” The essence of Keynesian economics is that prices and wages are sticky, especially in the downward direction. Inflation indexing can then be very relevant if that indexing causes prices and wages to adjust very quickly.

However, the current recession makes this indexing really relevant. If most contracts were quasi-real indexed, then the current financial crisis would not be having such a negative effect on the overall economy.

Why is the financial crisis having such a negative effect on the economy? Because the financial crisis has caused nominal aggregate spending to decline. This can be explained relatively simply with one equation, N=PY, where N is the level of nominal aggregate spending, P is the general price level, and Y is real GDP. When N decreases, either P or Y must decrease. Prior to Keynesian economics, the classical economists thought that the decline in N would be felt by a decline in P, with no effect on Y. However, in the 1930s during the Great Depression, John M. Keynes challenged that premise, by arguing that in the short run, prices and wages would be sticky, which means that a drop in N will lead to a drop in Y. Even Milton Friedman and the Monetarists would not argue with this statement, but Friedman put the blame for the drop in N during the Great Depression on an over 30% decrease in the money supply between 1929 and 1933.

The important lesson to learn from the above paragraph is that a drop in nominal aggregate spending (N), as is occurring today, impacts the real output (Y) because prices and wages do not adjust much in the short run. This is where quasi-real indexing can help. If wages and some prices were quasi-real indexed, they will immediately respond to changes in nominal aggregate spending, one of the major causes of inflation. This is one of the advantages of quasi-real indexing over traditional inflation indexing — quasi-real indexing responds almost immediately to changes in nominal aggregate spending, rather than waiting for the price effects to occur.

A second advantage of quasi-real indexing is that it does not filter out the inflation caused by aggregate-supply shocks. Why is this advantage? Realize that 30 years ago, medical professionals thought that all cholesterol was bad. Now, they have come to recognize that some cholesterol is good while other is bad. Our research indicates that aggregate-supply-caused inflation is actually good; only aggregate-demand-caused inflation is bad. Quasi-real indexation filters out the bad inflation while leaving the good inflation intact. When all wages, prices, mortgages, bonds, and other contracts are quasi-real indexed; the economy becomes immune to fluctuations to nominal aggregate spending. In this sense quasi-real indexation immunizes an economy against recessions caused by drops in nominal aggregate spending. It also protects workers, employers, lenders, and borrowers from the uncertainties caused by unexpected changes in nominal aggregate spending. Hence, quasi-real indexation improves the economic efficiency of an economy.

One concern in the current economy that is contributing to the financial crisis are mortgages. An objective of the Obama administration is to help households refinance their mortgages in such a way to make them more affordable for people to stay in their homes and avoid foreclosure. Quasi-real mortgages can do just that. Realize that quasi-real mortgages are a lot like Price-Level-Adjusted Mortgages (PLAMs), except quasi-real mortgages do not have the defect of increasing monthly mortgage payments when aggregate-supply-caused inflation occurs. The initial payment on both quasi-real mortgages and PLAMs is significantly lower than with a fixed-nominal-rate, fixed payment mortgage. The literature on mortgages calls this effect the “tilt” effect. For example, the initial payment on a 7.2%, fixed-rate, fixed-payment 30-year, $200,000 mortgage is $1357.58. However, the initial payment on a 3.6%, quasi-real 30-year, $200,000 mortgage is $909.29, which is over 30% less than under a traditional mortgage.

Wages are difficult to reduce in a recession, but they really should come down for economic efficiency. One reason why workers may be reluctant to give in to wage cuts is because of their fixed obligations like mortgages, although if they refinanced with a quasi-real mortgage, that would be less of an issue. A second reason why workers may be reluctant to give in to wage cuts is because once their wage is cut, they may think it will be difficult to get their wage raised when the economy returns to normal. That is part of the reason that quasi-real indexing would work so well; quasi-real indexing would automatically increase wages when the economy (nominal aggregate spending) recovers. Also, if nominal aggregate spending increases too much, leading to high inflation, the quasi-real indexing will take care of that, usually before the inflation took place.

Furthermore, employers may try to bring down wages down or make other cuts so that they are prepared for even bleaker times. However, quasi-real indexing of wages would do those reductions automaticly when nominal aggregate spending falls, so there would be no need for employers to bring down the wages below where they otherwise should be. Also, employees may be more willing to accept these wage cuts in return for quasi-real indexing being there to protect them in the future when the economy rebounds.

In the past, I have been frustrated with the publication barriers put up by economic journals, which have prevented me from getting my ideas exposed. With this note, I am bypassing those journals (although Dale and I will still try to publish in those journals). I hope that someone in Cyberland will find our message and investigate and try to contact us. Dale and I are currently writing more papers to help communicate these very important ideas. However, our previous papers were written at a very high theoretical level; we are now trying to bring these papers down to earth, making them more readable to more people. When we get those papers in more polished forms, I will try to make them available on this web site.”

Well Dr. Eagle – now I done a bit to spread your idea, which I find intriguing and I am sure my fellow Market Monetarist bloggers will take up the idea as well and discuss it. I don’t think QRI will take us out of this recession – we probably need NGDP level targeting for that – but I am pretty sure that the QRI literature will help us understand the present crisis better and could be very helpful in the crisis resolution.

PS When I read about Dr. Eagle’s frustrations I am reminded of how Scott Sumner felt back in 2009.


Eagle’s and Domian’s papers on QRI and NGDP targeting:

Immunizing our Economies against Recessions — A Microfoundations Investigation

Unsticking those Sticky Wages To Mitigate Recessions Without Expensive Fiscal Stimuli

Nominal Income Targeting for a Speedier Economic Recovery

Quasi-Real-Indexed Mortgages to the Rescue

Using Quasi-Real Contracts to Help Mitigate Aggregate-Demand-Caused Recessions and Inflations

Quasi-real Government Bonds — Inflation Indexing With Safety 

Leave a comment


  1. Integral

     /  December 3, 2011

    Excellent find Lars. You have certainly given me quite a bit of reading for the weekend!

    I find the micro-perspective interesting and intriguing. Most Market Monetarists focus on how the Fed should set policy; Eagle and Domian are focused, it seems, on the firm-level decision-making process and then aggregating up. It’s a new approach and one that has merit.

  2. Thanks Integral…this was exactly my thinking. I think the micro-perspective has a lot of merit. As I said it remind me of how George Selgin is thinking of the world.

    I hope to do more posts on their research going forward and I would also be happy to hear from anybody who find more gems in Eagle’s and Domian’s research.

    Their paper in Nominal Income Targeting is also excellent and hope to do a post on that soon.

  3. Carl Lumma

     /  December 7, 2011

    [my reply on the facebook NGDP level targeting group]
    Yes, of course Eagle and Domian are right. But it is rather like telling everyone to change their schedules in the winter. It proved more practical to simply move the clocks by one hour (daylight saving time).

    Of course it does point out one of the two flaws in NGDP targeting. As Selgin noted, NGDP targeting behaves better than inflation targeting during a supply shock. But it still cannot distinguish the two types of inflation as Dr Eagle would want. (The other flaw is that the ‘magic number’ of which trend line or growth rate to target is a free parameter. And once chosen, it becomes a self-fulfilling prophecy that might suppress potentially favorable fundamental changes in the productivity of society, such as that experienced by China in recent decades.)

    The solution to both these problems — without resorting to the impractical advice that we should change the way all contracts are negotiated — is of course the TIPS/SPX beta:
    (second graph)
    It simply tells us when inflation is bad and when it is good. The policy rule is simple: target the beta at zero.

    • Carl, I agree – as you will from my later post – We don’t needed to worry about indexing if we have NGDP targeting. My point is that Eagle’s and Domian’s work provides an excellent microfoundation for NGDP targeting.

      I think the SPX/TIPS beta is an excellent market measure of the mess we are in. It is by the way very simliar to the work David Glasner has done on why “the Stock Market loves inflation”.

      • Carl Lumma

         /  December 7, 2011

        I agree it provides a good micro justification for NGDP targeting. I also agree Glasner’s paper provides a good explanation for why markets like inflation right now. But note that the spread beta was negative in 2003, so it is more than just a policy tool for right now. (There has been a lot of debate over whether inflation was too high at the end of the Greenspan era; now we know that it was.)

        In addition to the advantages I mention above (including that it does not have a free parameter like NGDP targeting), SPX/TIPS is a rich source of real time data that happens to already exist. There is no waiting a quarter for NGDP (or NGDI) estimates to arrive, only to be revised later. There is no new futures market (Sumner) to establish. The stock and TIPS markets have high volumes, regulatory frameworks in place, etc. I am not sure why market monetarists have so far mostly ignored the SPX/TIPS beta as a potential policy target.

        I’ll go on. Falling short of an NGDP growth rate or level is bad. Overshooting is not so bad. There is a discontinuity. It is probably less severe than the discontinuity between inflation and deflation, but it is similar. There is no such discontinuity at the SPX/TIPS beta zero line. The central bank can over- or under-shoot slightly without causing the sky to fall.

      • Carl,

        I must admit that I am intrigued by this idea of the TIPS/SPX beta. It make fully sense and I would like to explore it even further in a future blog post. Market Monetarism afterall mean that money matters AND markets matter.

        I don’t think any of the Market Monetarist bloggers have been ignoring TIPS/SPX beta on purpose – I rather think that we was unaware of the idea in the form you formulate it. That said, I have writen numerous posts on how to use market data for the conduct of monetary policy.

        I will mention two examples. First, my argument that the McCallum rule could (should!) be reformulated with the used of market estimate NGDP (where I suggest using both SPX and TIPS in the estimate of future NGDP) and second my post on Keleher’s and Johnson’s book “Monetary Policy, A Market Price Approach”. A search “McCallum” and on “Keleher” should give you my previous posts on these topics.

      • Carl Lumma

         /  December 7, 2011

        Oh, I didn’t mean to say they did it on purpose… ok, maybe I am a bit put out that Scott seemed to dismiss it when I first brought it up

        As you can probably tell, I’m only a computer programmer who reads about economics in his spare time. I think it would be wonderful if you did a post exploring the TIPS/SPX beta!

    • Carl Lumma

       /  December 7, 2011

      Dear Lars, I’ve read every post on this wonderful blog since you started it (likewise Money Illusion) and there’s no doubt I subconsciously recalled your Oct. 30 post when I wrote my comment above!

  1. A simple housing rescue package – QRI Mortgages and NGDP targeting « The Market Monetarist
  2. David Eagle on “Nominal Income Targeting for a Speedier Economic Recovery” « The Market Monetarist
  3. David Eagle’s framework and the micro-foundation of Market Monetarism « The Market Monetarist
  4. A method to decompose supply and demand inflation « The Market Monetarist
  5. Guest post: Why I Support NGDP Targeting (by David Eagle) « The Market Monetarist
  6. TheMoneyIllusion » David Eagle on NGDP targeting
  7. Guest Blog: The Two Fundamental Welfare Principles of Monetary Economics (By David Eagle) « The Market Monetarist
  8. Three terrible Italian ‘gaps’ | The Market Monetarist
  9. 3 Terrible Italian 'Gaps' - True Investment Research
  10. Jens Weidmann should be promoting (some of) Varoufakis’ ideas | The Market Monetarist
  11. St. Louis Fed’s Bullard comes out in support of NGDP targeting | The Market Monetarist

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: