The Integral Reviews: Paper 1 – Koenig (2011)

I am always open to accept different guest blogs and I therefore very happy that “Integral” has accepted my invitation to do a number of reviews of different papers that are relevant for the discussion of monetary theory and the development of Market Monetarism.

“Integral” is a regular commentator on the Market Monetarist blogs. Integral is a pseudonym and I am familiar with his identity.

We start our series with Integral’s review of Evan Koeing’s paper “Monetary Policy, Financial Stability, and the Distribution of Risk”. I recently also wrote a short (too short) comment on the paper so I am happy to see Integral elaborating on the paper, which I believe is a very important contribution to the discussion about NGDP level targeting. Marcus Nunes has also earlier commented on the paper.

Lars Christensen

The Integral Reviews: Papers 1 – Koenig (2011)
By “Integral”

Reviewed: Evan F. Koenig, “Monetary Policy, Financial Stability, and the Distribution of Risk.” FRB Dallas Working Paper No.1111

Consider the typical debt-deflation storyline. An adverse shock pushes the price level down (relative to expected trend) and increases consumers’ real debt load. This leads to defaults, liquidation, and general disruption of credit markets. This is often-times used as justification for the central bank to target inflation or the price level, to mitigate the effect of such shocks on financial markets.

Koenig takes a twist on this view that is quite at home to Market Monetarists: he notes that since nominal debts are paid out of nominal income, any adverse shock to income will lead to financial disruption, not just shocks to the price level. One conclusion he draws out is that the central bank can target nominal income to insulate the economy against debt-deflation spirals.

He also makes a theoretical point that will resonate well with Lars’ discussion of David Eagle’s work. Recall that Eagle views NGDP targeting as the optimal way to prevent the “monetary veil” from damaging the underlying “real” economy, which he views as an Arrow-Debreu type general equilibrium economy. Koenig makes a similar observation with respect to financial risk (debt-deflation) and in particular the distribution of risk.

In a world with complete, perfect capital markets, agents will sign Arrow-Debreu state-contingent contracts to fully insure themselves against future risk (think shocks). Money is a veil in the sense that fluctuations in the price level, and monetary policy more generally, have no effect on the distribution of risk. However, the real world is much incomplete in this regard and it is difficult to imagine that one could perfectly insure against future income, price, or nominal income uncertainty. Koenig thus dispenses of complete Arrow-Debreau contracts and introduces a single debt instrument, a nominal bond. This is where the central bank comes in.

Koenig considers two policy regimes: one in which the central bank commits to a pre-announced price-level target and one in which the central bank commits to a pre-announced nominal-income target. While the price-level target neutralizes uncertainty about the future price level, it provides no insulation against fluctuations in future output. He shows that a price level target will have adverse distributional consequences: harming debtors but helping creditors. Note that this is exactly the outcome that a price-level target is supposed to avoid. By contrast a central bank policy of targeting NGDP fully insulates the economy from the combination of price and income fluctuations. It will not only have no adverse distributional consequences, it obtain a consumption pattern across debtors and creditors which is identical to that which is obtained when capital markets are complete.

At an empirical level, Koenig documents that loan delinquency is more closely related to surprise changes in NGDP than in P, providing corroborating evidence that it is nominal income, not the price level, which matters for thinking about the sustainability of the nominal debt load.

Koenig’s conclusion is succinct:

“If there are complete markets in contingent claims, so that agents can insure themselves against fluctuations in aggregate output and the price level, then “money is a veil” as far as the allocation of risk is concerned: It doesn’t matter whether the monetary authority allows random variation in the price level or nominal value of output. If such insurance is not available, monetary policy will affect the allocation of risk. When debt obligations are fixed in nominal terms, a price-level target eliminates one source of risk (price-level shocks), but shifts the other risk (real output shocks) disproportionately onto debtors. A more balanced risk allocation is achieved by allowing the price level to move opposite to real output. An example is presented in which the risk allocation achieved by a nominal-income target reproduces exactly the allocation observed with complete capital markets. Empirically, measures of financial stress are much more strongly related to nominal-GDP surprises than to inflation surprises. These theoretical and empirical results call into question the debt-deflation argument for a price-level or inflation target. More generally, they point to the danger of evaluating alternative monetary policy rules using representative-agent models that have no meaningful role for debt.”

Leave a comment


  1. David Beckworth

     /  December 28, 2011

    Thanks for the summary Integral. Isn’t this similar to our earlier discussion on how a price level and nominal GDP level target both handle demand shocks, but only a NGDP level target properly handles a supply shock?

  2. Koenig’s conclusion “If there are complete markets in contingent claims, so that agents can insure themselves against fluctuations in aggregate output and the price level, then “money is a veil” as far as the allocation of risk is concerned” is interesting.

    In a free market with no CB then agents who are good at “adjusting to fluctuations in aggregate output and the price level” will thrive, others may not survive. When a CB assumes this task then business will believe they do not need to. However if the CB then fails to deliver upon its commitment we may get a long and deep recession. The experience of the “great moderation/recession” shows this clearly.

    Market Monetarists obviously believe they have found the key to stable AD heaven. However what happens when another black-swan comes along and . NGDP targeting fails to deliver for unforeseen reasons? There is a risk we will get another deep recession.

    I argue that it is better to allow the market to develop “markets in contingent claims” and other forms of price flexibility that would avoid the dependency on CB policy which has a tendency to fail just when you need it most.

  3. David, I think where both Evan Koeing and David Eagle is contributing to the discussion is getting a proper microperspective on the discussion and at the same time is telling us why we are getting financial crisis when we are not targeting NGDP. I hope you will pick up this issue as well. I particularly think David Eagle has a number of contributions that are highly relevant for Market Monetarists.

    Liquidationist, I think there are a number of contradictions in what you say. First of all, arguing in favour of NGDP targeting is exactly arguing that monetary policy should conduct as if there is a privatised supply of money. I have addressed this quite often and I am certainly not hostile to Free Banking (See for example

    Second it seems like you are skeptical about the stability NGDP targeting will bring and that a stable NGDP will bring excessive risk taking. However, NGDP targeting is exactly the same thing as what will be the outcome in the ideal Free Banking world. There is no difference so if you think NGDP targeting will lead to excessive risk taking then you should expect the same to be the case in a Free Banking world. This I surely disagree with as I happen to believe that a Free Banking system likely would deliver great stability if implemented correctly.

    Third, from reading your blog it seems like you have a rather keynesian understanding of the monetary transmission mechanism as you seem to think that monetary policy works through interest rate changes. I strongly disagree with that. See more on the transmission mechanism here

    Forth, is the term “Liquidationist” in stark contrast to the thinking of Free Banking theorists like George Selgin? “Liquidationist” as a positive is use by Austrian economists who are strongly in opposition to the kind of Free Banking George is in favour of.

    Anyway, thank you for commenting I am happy to see the opposing view to the Market Monetarist position and we need to challenged all the time.

  4. Martin

     /  December 28, 2011

    “A more balanced risk allocation is achieved by allowing the price level to move opposite to real output. An example is presented in which the risk allocation achieved by a nominal-income target reproduces exactly the allocation observed with complete capital markets.”

    In other words, any policy rule that mimics complete capital markets is a policy rule worth implementing. This, is the role of the central bank. And you can insure that the central bank fulfills its role by making it a market maker for any financial products that have an expected pay-off of zero as long as the central bank maintains monetary equilibrium.

  5. Thanks for your detailed response.

    I think there are a number of problems with seeing NGDP-targeting as a CB-version of free banking. The most obvious one is that as banks increase lending and other asset purchases in response to an increase in demand for money then interest rates will fall. Under FRB it is possible that banks will stop lending at some point when interest rates are too low for the levels of perceived risk but when AD is still below its previous level. The price mechanism will then have to make the required adjustments to reestablish equilibrium.

    Under NGDP-targeting however when this “zero bound” is hit the CB will continue to grow the money supply by “unconventional means” that would not occur under FRB and (in my view) would cause inflation and other distortions to the structure of production.

    Your article on the transmission mechanism was very interesting. I believe that there are two variables that need to be kept in line in the economy – the rate of interest that is used to clear the money market and the rate of profit (represented by the spread between inputs – mainly wages – and sales prices) that drives the level of investment. Eliminating banks from the model does not eliminate the rate of interest from its role as the transmission mechanism between savings and investments. A fall in AD that leads to a fall in the demand for labor will need an increase in the rate of profit and/or a fall in the rate of interest to reestablish equilibrium. If sticky wages prevent wages from falling then simply increasing the money supply and driving up assets prices will (beyond a certain point) not cause businesses to expand investment if they do not see profitable opportunities because the rate of profit has not increased (that is wages have not fallen).

    Of course to continue to increase the money supply in this scenario (or indeed just to set expectations that it will be increased) will cause inflation. This will cause a negative real interest rate and the AD curve to move right which combined will probably increase output at least in the short run. But this seems a very dangerous way of “curing” a recession (and thats before we have even looked at possible “structural” reasons for the recession that will not be solved by increasing AD)

    I am a supporter of free banking but believe that even in a free banking world variations in AD are a healthy part of economic regeneration and an NGDP-targeting regime that eliminates the need for businesses to be responsive to market signals is likely to result in an economy less able to meet consumer demand and prone to deep-recessions when CB-policy fails. I hope this partially explains why I chose the name “liquidationist”.

  6. David Pearson

     /  December 28, 2011

    Eagle seems to ignore the feedback loop that occurs between stability and insurance. NGDP targeting drives actors to abandon insurance against liquidity, duration and credit risk, thus exposing the system to catastrophic losses in response to even small NGDP shocks. It is like asking developers to build homes near a forest because aggressive fire-control measures eliminate the risk of property damage from small fires. This, of course, merely increases the amount of fuel available for a catastrophic fire, such that the risk of property damage is ultimately much greater. It also reduces the amount of insurance homeowners have on hand against the resulting losses. In the end, the least-loss producing system for forest management is “managed burn”, and not “no burn”.

    For much more on this topic, I recommend Ashwin Parameswaran’s “Macroeconomic Resilience” blog:

  7. David,

    I understand the concept that there is a trade-off between between stability and insurance, but what is the policy implication? Should central banks create uncertainty and volatility to reduce risk taking?

    By the way Ashwin’s blog looks quite interesting – so thanks for the heads up. I will have a look at it – also in the future.

  8. David Pearson

     /  December 28, 2011

    The level of financial institution insurance-taking is a function of the credibility and transparency of Fed commitments. An opaque, ad hoc Fed would produce a more robust financial system with more insurance. Essentially, this was the regime we had from the post-War period until the late ’90’s, when Greenspan began to make explicit commitments about the path of policy. I sympathize with the MM view that the 2008 crisis was caused by the failure of the Fed to make good on its commitments to markets. “Don’t make promises that you might be unwilling to deliver on,” seems like a rule we would both agree on. The problem is, a stability-seeking regime must deliver on its implicit promise to bail out banking system creditors in order to maintain stable velocity. When push comes to shove, such a large transfer of wealth to bank creditors becomes politically very difficult to carry out. Just ask Hank Paulson or Angela Merkel.

  9. David, I am not sure that we can talk about the Fed in any way doing the right thing in the post WWII period. Rather the the performance until the mid-1960s was ok and the Fed again performed successfully from 1983-5. Then the question is when the Fed started to fail again.

    We often tend to think of the Great Moderation as one period. However, I think Greenspan increasingly started to work as a firefighter from around the Asian-Russian crisis 1997-98. A look at NGDP graph for the Great Moderation will show this quite clearly – after 1997/98 Greenspan allowed NGDP to overshoot the GM trend significantly. This is when the markets started to expect the “Greenspan put”. To me NGDP targeting should not be a “put” and NGDP targeting is not about bailing out investors that makes the wrong decisions.

    Furthermore, NGDP targeting is not a promise to the banking sector. NGDP targeting is a promise to the “economy”. I think some time our position is misunderstood to mean that we want to bailout everybody and to prop up bubbles. That is certainly not the MM position. Rather most of us are strongly against bailouts and then clearly increase moral hazard and misallocation.

  10. David, I might add that I do not think the efforts to stabilise velocity should be focused on the financial sector. I guess that is the Bernanke view, but it is certainly not my view. Rather I think policy makers should take the level of velocity as a given. The central bank should not try to regulate velocity. Rather with an explicit NGDP target velocity will become self regulating.

    Furthermore, I favour circumventing the banking system when QE is used and that is why I increasingly think that QE might best be implemented via the currency markets. See for example my recent comment on NGDP targeting in Small Open Economies:

  11. Integral

     /  December 29, 2011

    Nice to see so many comments! I’d like to particularly address David Beckworth’s.

    DB: It’s similar but with an important difference that I still need to mull over.

    Typically one gets the result that “if the central bank can target output and prices in the same period, NGDP targeting outperforms inflation targeting; if there is a lag, IT outperforms NGDPT.” This is because if the CB can’t hit output and prices in the same period, one often gets undesirable fluctuations in the two as the bank alternately influences one, then the other, keeping NGDP on target but causing disturbances in the “underlying” variables, Y and P.

    However with Koenig (2011) we have a paper in which the CB cannot affect output at all: it’s a two-period endowment economy where second-period output is stochastic and independent of the monetary authority. So the timing assumption is one that favors IT/PLT, but Koenig shows that NGDPT is optimal. I plan to address this point in the coming weeks, reviewing two papers which perform IT vs NGDPT simulations.

  12. David Pearson

     /  December 29, 2011

    I like the currency/commodity QE idea. However, given the very small size of the U.S. treadeables sector, I’m not sure it would have much effect on velocity in the face of a systemic banking crisis. This is one reason the gold-exit analogy is a problematic one for today’s crisis.

    Even if MM’s do not make the explicit promise of bank bail-outs, M*V requires that V be a target of policy when there is no demand for marginal bank reserves. With total credit at 350% of gdp, it is unlikely that maintaining V could be achieved by anything other than a banking system bail out (except perhaps large money-financed deficits). A less stable monetary regime cleans out bad banks periodically, such that the lemons problem does not have a chance to grow to threaten velocity.

  13. I posted a more detailed analysis of NGDP-targeting seen from a free-banking perspective in case you are interested.

  14. David,

    I do not think that it is overly important that the US tradable sector is relatively small. The important impact exchange rate based monetary policy is not the “competitiveness channel” and QE to weaken the currency is not improve exports, but rather to increase money supply growth and inflation expectations.

    Lets as an example say that the Fed tomorrow announced 15% devaluation of the dollar against a basket of commodities and at the same time announced that it would continue to devalue the dollar by additional 5% against the commodity basket every month until it is was clear that NGDP was safely on the way back to the “old” NGDP trend.

    What would happen? Well, obviously that would lead to a improvement in competitiveness of US companies, but lets get rid of that effect (we are not really interested in real effects, but rather nominal effects) by assuming all countries in the world followed the US’s strategy. With that assumption there would obviously not be any impact on exports. However, that is not really important. Rather what is important is that when a central bank tries to weaken it’s currency it will do it by increasing the money supply. If the commitment to devaluation is credible then it will surely increase inflation expectations and that would undoubtedly increase velocity.

    Finally, this policy triggered “currency war” where all countries compete to weaken their currencies then some would say that that will have no effect. These people are keynesians. The focus on real effects rather than monetary effect. The fact is the currency war is a positive sum game as it leads to a competition to print more money and that is positive in a deflationary world. Obviously currency is not positive in a high-inflation world like the one we had in the 1970s, but logic of what I am arguing is that the Fed obvious then would announce the opposite policy – to revalue the dollar against commodities until inflation is brought under control.

  15. dwb

     /  December 29, 2011

    I do not see that NGDP targeting causes more bailouts. I would not confuse stability with promotion of excessive risk. It is not whether there is more or less risk, but whether rational actors can correctly price it. Banks do not fail because they make risky loans, they fail because they are not holding enough capital/liquidity against nonperforming loans. Risk is endogenous to the banking system.

    In my mind the story of this paper (which I agree with) is that ngdp targeting improves the information content of the economy. Suppose we have Bank A and Bank B. Bank A makes loans to consumers and checks documents. Bank B makes loans and does not check, so some consumers lie. Both banks a priori think they are holding enough capital to fund the loans. Of course, bank B is not. If the Fed targets NGDP, eventually bank B will fail as the lies turn out. Bank A will survive.

    Now suppose the Fed does not target NGDP, and NGDP falls unexpectedly. In that case both banks A and B are now in trouble. Ex post one cannot tell the difference between someone who lied about their income and someone who merely had a bad turnout of income. Its entirely possible that some consumers at bank A are better off in real terms (because demand for their services went up) but worse off in nominal terms – which could lead to delinquency – because debt is denominated in nominal terms.

    In either case, under NGDP targeting, banks will price risk differently than under non-NGDP targeting. Risk is endogenous. It’s not about having more or less insurance, its about having the right amount for the right reasons. In other words, bank capital is endogenous. Banks have to hold more capital under scenario 2 and I would argue they are holding capital against screwed up Fed policy, a deadweight loss. Another way to this about this is to split the risk into systemic and idiosyncratic risk. Insuring against systemic risk caused by an NGDP drop to everyone equally is a deadweight loss.

    So if anything, NGDP targeting should result in fewer (or no) bailouts by reducing systemic risk.

  16. David Pearson

     /  December 29, 2011

    If you trace out the terms of trade effect of rising treadeables prices on U.S. corporate profits and middle-class real wages, it is not clear that this source of inflation will produce enough employment growth to offset the decline in real spending (from reduced forecasts of real income growth). This has to do with the propensities to consume (domestic products) of the various sectors affected. The situation was vastly different in the 30’s.

  17. David, I would call in my good friend Chuck Norris here. I think that the expectations would do the job. We don’t need to see any impact on export at all to get the pick up in NGDP. See here: and here

  18. David Eagle

     /  January 5, 2012

    Lars Chistensen sent me Evan Koenig’s paper because it is related to my own research. I have read it as well as Integral’s review and I would like to make a couple of comments. This is my fist comment, Integral’s review states that Koenig “notes that since nominal debts are paid out of nominal income, any adverse shock to income will lead to financial disruption, not just shocks to the price level.” This drew my attention for reasons I will state in a moment so I looked at what Koenig wrote on p. 1, which is “Households and firms obligated to make fixed nominal payments are exposed to financial stress whenever nominal income flows deteriorate relative to expectations extant when the obligations were accepted, independent of whether the deterioration is due to lower-than-expected inflation or to lower-than-expected real income growth.” Both of these statements seem to indicate that the financial distress from an aggregate-supply shock is due to the income being in nominal form. I disagree; the financial distress related to aggregate-supply shocks will occur on average to people regardless whether their income is in real terms or nominal terms. The reason is because real aggregate supply is basically also real income. If real aggregate supply falls so must real income and so must average real income, by the same proportion. Hence what happens to a household’s income on average is the same whether the income is in real or nominal terms. Now we look at two households A and B where B is making a nominal payment to A. Also, assume that these households are average in the sense that both of their real incomes not including this nominal payment change proportionately to real aggregate supply as they do in Koenig’s model. Under successful price-level or inflation targeting, the real value of that nominal payment will be unchanged. Hence household B will be squeezed between his declining real income and the constant real payment he must make to A. On the other hand, while A is only exposed to her own real income declining, not the real value of the payment she is receiving from B. Therefore, under price-level or inflation targeting, the payer of the nominal payments absorbs more of the aggregate-supply risk than does the receiver.

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