European policy makers still seem to be far from finding a solution to the euro crisis. However, there are solutions. The best solutions in my views does not come from Europe, but rather from our friend David Beckworth at the Texas State University. Here is his interview with Stephen Evans on BBC Radio (around 8 minutes into the program).
All posts in category David Beckworth
The best insight on the euro crisis – you will find in Texas
Posted by Lars Christensen on December 12, 2011
https://marketmonetarist.com/2011/12/12/the-best-insight-on-the-euro-crisis-you-will-find-in-texas/
“Monetary Policy, Financial Stability, and the Distribution of Risk”
I have recently been giving a lot of attention to the work of David Eagle and his Arrow-Debreu based analysis of monetary policy rules. This is because I think David’s work provides a microfoundation for Market Monetarism and adds new dimensions to the discussion about NGDP targeting – particularly in regard to financial stability.
I have now come across a paper that is using a similar model as David’s model. However, this might be a slightly more interesting for the conspiratorial types as this paper is written by a Federal Reserve economist – Evan F. Koeing of the Federal Reserve Bank of Dallas.
Here is that abstract of Koeing’s paper “Monetary Policy, Financial Stability, and the Distribution of Risk”:
“In an economy in which debt obligations are fixed in nominal terms, but there are otherwise no nominal rigidities, a monetary policy that targets inflation inefficiently concentrates risk, tending to increase the financial distress that accompanies adverse real shocks. Nominal- income targeting spreads risk more evenly across borrowers and lenders, reproducing the equilibrium that one would observe if there were perfect capital markets. Empirically, inflation surprises have no independent influence on measures of financial strain once one controls for shocks to nominal GDP.”
This paper obviously is highly relevant and as the euro crisis just keeps getting worse day-by-day we can always hope that some influential European policy makers read this paper.
After all the euro crisis is mostly a monetary crisis rather than a fiscal crisis – which David Beckworth forcefully demonstrates in a recent comment.
HT Arash Molavi Vasséi
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Posted by Lars Christensen on December 11, 2011
https://marketmonetarist.com/2011/12/11/monetary-policy-financial-stability-and-the-distribution-of-risk/
Dubai, Iceland, Baltics – can David Eagle explain the bubbles?
It’s Sunday night in Copenhagen and I have just returned from a trip to Dubai. I should really write a long post about Dubai, but I will keep it short.
Dubai really reminded me of Iceland – in the sense that both places should NOT really have seen the bubbles we saw. Both Dubai and Iceland had a property market boom, but one can hardly say that there is any serious supply constrains in either Dubai or Iceland. Both Dubai and Iceland seem simply to be “unreal” – or at least that was the case in the boom years.
To me it is pretty clear that we had a bubble in both places and the bubbles have now busted. But why did we have bubbles in Iceland and Dubai? Well, the easy answer is easy money, but I think that that explanation is too simple. And was it local monetary policy or was it US monetary policy that was too easy?
Fundamentally I think that moral hazard played a large role in both Iceland and Dubai – and guess what, both Iceland and Dubai have been bailed out by better off cousins – in the case of Iceland primarily by the other Nordic governments and in the case of Dubai by the big bother in the UEA – Abu Dhabi. But then why did we not have bubbles in other places where the risk of moral hazard was equally big? Again I like to stress that one should never underestimate the importance of luck or the opposite and this is probably also the explanation this time around.
However, Dubai made me think that Market Monetarists really need to take the issues of it bubbles serious. Market Monetarists disagree on this issue. Scott Sumner tends downplay the risk of bubbles – or rather that monetary policy cannot do much to avoid bubbles (other than target NGDP). David Beckworth on the other hand has done interesting work with George Selgin on why overly loose monetary policy might lead to misallocation. My own position is that I used to think that it mostly was easy monetary policy that was to blame and that is what led me – in my day-job – to warn against boom-bust in Iceland and Central and Eastern Europe in 2006-7. I have since come to think that moral hazard also play a role in this, but I am now returning to the monetary issue. However, while I think overly easy monetary policy led to misallocation in Iceland and Dubai and I am not really sure that that is the case in the US as NGDP never really increased above it’s Great Moderation trend prior to the outbreak of the Great Recession in 2008. That might, however, be due to measurement problems and other measures nominal spending seem to indicate that monetary policy indeed was too loose prior to 2008.
So what kind of model can explain the kind of bubbles we saw in for example the Baltic economies in 2004-8? And here I return to David Eagle – an economist whose work has not been fully appreciated, but I have been trying to change that recently.
David’s starting point is an Arrow-Debreu (A-D) model in which he analyse the impact of changes in nominal spending on the economy and on allocation. Furthermore, David uses his model(s) to analyse how different monetary policy rules – NGDP targeting, Price level targeting and inflation targeting – influence allocation (including lending).
David mostly has used his theoretical set-up to look at the impact of negative shocks to NGDP, but my thesis is that David’s model set-up might be useful in analysing what went wrong in Iceland and Dubai – and In Central and Eastern Europe and Southern Europe for that matter. It should be noted that NGDP outgrew its prior trends in the “boom” years – contrary to the situation in the US.
I have not looked at this formally, but here is the idea. We have an A-D model, we introduce sticky prices and wages and a central bank with an inflation target (as Iceland have). Most of the economies that have had boom-bust have seen some kind of structural reforms that have led to positive supply shocks – for example banking reform in Iceland and a general opening of the economies in Central and Eastern Europe – or believe it or not euro membership for countries like Spain and Greece.
What happens in Eagle’s set-up? I have not done the math, but here is my intuition. A positive supply put downward pressure on prices and with the central bank targeting inflation the central bank will ease monetary policy – as inflation is inching down. In Eagle’s model this will lead an (in-optimal?) increase in lending. This increase in lending will last as long as the positive supply shocks continues. However, once the shocks come to an end then the process is reversed – and this is when the “bubble” burst (yes, yes this is somewhat beyond that scope of David’s model, but bare with me…). This by the way is very similar to what George Selgin and David Beckworth have suggested for the US economy, but I think this discussion is much more relevant for Dubai, Iceland and the Baltic States (or the the PIIGS for that matter) than for the US.
Again, I have not gone through this formally with David Eagle’s model set-up, but I think it could be a useful starting point to get a better understanding of the boom-bust in Iceland, Dubai and other places. That said I want also to stress the extent of the present global crisis is not a result of bubbles bursting (that might however been the crisis started), but rather too tight monetary policy is to blame for the crisis. David Eagle’s framework can also easily explain this.
——
PS I should really write something about the euro crisis, but lets just remind people that I think that we are in 1931. By the way the UK left the gold standard in 1931 and the Scandinavian countries followed the lead from the UK. Germany, France, Austria and other continental European countries stayed on the gold standard. We all remember how that story ended. Oddly enough the monetary faultline is more or less the same this time around. Why should we expect a different outcome this time around?
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Posted by Lars Christensen on December 11, 2011
https://marketmonetarist.com/2011/12/11/dubai-iceland-baltics-can-david-eagle-explain-the-bubbles/
David Eagle’s framework and the micro-foundation of Market Monetarism
Over the last couple of days I have done a couple of posts on the work of David Eagle (and Dale Domian). I guess that there still are a few posts that could be written on this topic. This is the next one.
Even though David Eagle’s work has been focusing on what he and Dale Domian have termed Quasi-Real Indexing I believe that his work is highly relevant for Market Monetarists. In this post I will try to draw up some lessons we can learn from David Eagle’s work and how it could be relevant to formulating a more consistent micro-foundation for Market Monetarism.
There are a no recessions in a world without money
The starting point in most of Eagle’s research is an Arrow-Debreu model of the world. Similarly the starting point for Market Monetarists like Nick Rowe and Bill Woolsey is Say’s Law – that supply creates its own demand. (See for example Nick on Say’s Law here).
This starting point is a world without money and both in the A-D model and under Say’s Law there can not be recessions in the sense of general glut in the product and labour markets.
However, once money and sticky prices and wages are introduced – both by Market Monetarists and by David Eagle – then we can have recessions. Hence, for Market Monetarists and David Eagle recessions are always and everywhere a monetary phenomenon.
N=PY – the simple way to illustrate some MM positions
In a number of his papers David Eagle introduces a simplified version of the equation of exchange where he re-writes MV=PY to N=PY. Hence, Eagle sees MV not some two variables, but rather as one variable – nominal spending (N), which is under the control the central bank. This is in fact quite similar to Market Monetarists thinking. While “old” monetarists traditional have assumed that V is constant (or is “stationary”) Market Monetarists acknowledges that this position no longer can be empirically supported. That is the reason why Market Monetarists have focused on the right hand side of the equation of exchange rather than on the left hand side like “old” monetarists like Milton Friedman used to do.
I, however, think that Eagle’s simplified equation of exchange has some merit in terms of clarifying some key Market Monetarist positions.
First of all N=PY gets us from micro to macro. Hence, PY is not one price and one output, but numerous prices and outputs. If N is kept constant that is basically the Arrow-Debreu world. That illustrates the point that we need changes in N to get recessions.
Second, N=PY can be a rearranged to P=N/Y. Hence, inflation is the “outcome” of the relationship between nominal spending (N) and real GDP (Y). In terms of causality this also illustrates (but it does not necessary prove) another key Market Monetarist point, which often has been put forward by especially Scott Sumner that nominal income (N) causes P and Y and not the other way around (See here and here). This is contrary to the New Keynesian formulation of the Phillips curve, where “excessive” growth in real GDP relative to “trend” GDP increases “price pressures”.
Third, P=N/Y also illustrates that there are two sources of price changes – nominal spending (N) and supply shocks. This lead us to another key Market Monetarist position – also stressed strongly by David Eagle – that there is good and bad inflation/deflation. This is a point stressed often by David Beckworth (See here and here). David Eagle of course uses this insight to argue that normal inflation indexing is sub-optimal to what he has termed Quasi-Real Indexing (QRI). This of course is similar to why Market Monetarists prefer NGDP targeting to Price Level Targeting (and inflation targeting).
The welfare economic arguments for NGDP targeting
In an Arrow-Debreu world the allocation is Pareto optimal and with fully flexible prices and wages changes in N will have no impact on allocation and an increase or a drop in N will have no impact on economic welfare. However, if we introduce sticky prices and wages in the model then unexpected changes in N will reduce welfare in the traditional neo-classical sense. Hence, to ensure Pareto optimality we have two options.
1) The monetary institutional set-up should ensure a stable and predictable N. We can do that with a central bank that targets the NGDP level or with a Free Banking set-up (that ensures a stable N in a perfect competition Free Banking system). Hence, while Market Monetarists mostly argue in favour of NGDP from a macroeconomic perspective David Eagle’s framework also gives a strong welfare theoretical argument for NGDP targeting.
2) (Full) Quasi-Real Indexing (QRI) will also ensure a Pareto optimal outcome – even with stick prices and wages and changes in N. David Eagle and Dale Domian have argued that QRI could be used to “immunise” the economy from recessions. Market Monetarists (other than myself) have so far as I know now directly addressed the usefulness of QRI.
Remaining with in the simplified version of the equation of exchange (N=PY) NGDP targeting focuses on left hand side of the equation, which can be determined by monetary policy, while QRI is focused on the right hand side of the equation. Obviously with one of the two in place the other would not be needed.
In my view the main problem with QRI is that the right hand side of the equation is not just one price and one output but millions of prices and outputs and the price system plays a extremely important role in the allocation of resources in the economy. It is therefore also impossible to expect some kind of “centralised” QRI (god forbid anybody would get such an idea…). I am pretty sure that my fellow Market Monetarist bloggers feel the same way. That said, I think that QRI can useful in understanding why the drop in nominal spending (N) has had such a negative impact on RGDP in the US and other places.
Furthermore, as I stressed in an earlier post QRI might be useful in housing funding reform in the US – as suggested by David Eagle. Furthermore, it is obviously QRI based government bonds could be used in the conduct of NGDP targeting – as in line with what Scott Sumner for example has suggested and as in fact also suggested by David Eagle.
David Eagle should inspire Market Monetarists
In conclusion I think that David Eagle’s and Dale Damion’s on work on both NGDP targeting and QRI will be a useful input to the further development of the Market Monetarist paradigm and I especially think it will be helpful in a more precise description of the micro-foundation of Market Monetarism.
PS David Eagle has also done work on interest rates targeting and is highly critical of Michael Woodford’s New Keynesian perspective on monetary policy. This research is relatively technical and not easily assessable, but should surely be of interest to Market Monetarists as well.
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See my other posts on David Eagle and Dale Domian:
Quasi-Real indexing – indexing for Market Monetarists
A simple housing rescue package – QRI Mortgages and NGDP targeting
David Eagle on “Nominal Income Targeting for a Speedier Economic Recovery”
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Posted by Lars Christensen on December 4, 2011
https://marketmonetarist.com/2011/12/04/david-eagles-framework-and-the-micro-foundation-of-market-monetarism/
Market Monetarism comes to Hong Kong
Dr. Yue Chim Richard Wong Professor at the University of Hong Kong has an excellent comment on Market Monetarism on his great blog. Dr. Wong is a specialist among other things on the Hong Kong property market and a well-known economics commentator in Hong Kong.
In his comment “Easy Money, Tight Money, and Market Monetarism” he explains the background for Market Monetarism and explain the key theoretical insights and policy recommendations from Market Monetarism. It is an excellent introduction to Market Monetarism – to some extent a parallel description to my own working paper on the foundation for Market Monetarism.
Dr. Wong has some interesting observations about the main Market Monetarist thinkers/bloggers:
The Market Monetarist blogger are “(a)n assorted group of economists, mostly of the free market persuasion, (who) have joined Sumner in developing and elaborating the subtle logic behind NGDP targeting and they continue to debate the new Keynesians and old Monetarists…”
Dr. Wong continues: “The amazing fact about the group is that most of the members are relatively junior in the economics profession and are concentrated in the teaching universities. For me this was an absolutely delightful finding. I have always wondered if the pressure to publish research in ever more specialized and compartmentalized fields in the major research universities is an unqualified healthy outcome for academia.”
This I think is a very interesting observation. Scott Sumner spend more than 20 years teaching without anybody in the economics profession really noticing his important research (I did!). But once he started blogging he became the main force behind the creation of a new economic school. A school I am proud to belong to – Market Monetarism.
There is no doubt that Dr. Wong is highly sympathetic to Market Monetarism and in that regard I don’t think it is a coincidence that Wong has his PhD from the University of Chicago as is the case for Scott Sumner. To me the link to the University of Chicago is key to the intellectual development of Market Monetarism. It is, however, not today’s University of Chicago, but the 1960s and 1970s when Milton Friedman still was a professor at the University. Friedman retired in 1977. The economic and monetary theory that Friedman was teaching at the University of Chicago was policy oriented and “practical”. Contrary to the focus at most universities where students spending most of their time with advanced mathematically models with little or no relevance to the real world – and if the models are relevant the students and professors alike often don’t realise it themselves and the policy conclusions are often not spread to a wider audience.
Scott Sumner, David Beckworth and the other Market Monetarist bloggers have made monetary theory accessible to policy makers, market participants, commentators and journalists. This in my view is the real achievement of Market Monetarism and I am happy to say that Dr. Wong now is helping spreading the word.
PS Dr. Wong write comments in both English and Chinese. He writes a weekly political economy column for the Hong Kong Economic Journal.
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Posted by Lars Christensen on December 1, 2011
https://marketmonetarist.com/2011/12/01/market-monetarism-comes-to-hong-kong/
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
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Posted by Lars Christensen on November 29, 2011
https://marketmonetarist.com/2011/11/29/ramesh-ponnuru-for-fed-ngdp-could-spell-more-economic-stability/
The Fed can save the euro
David Beckworth has a excellent comment on the correlation between NGDP in the US and the euro zone.
David shows that US NGDP growth leads NGDP growth in the euro zone. This means that if the Federal Reserve were to move to push NGDP back to the pre-crisis trend level then it would likely lead to a similar increase in the NGDP level in the euro zone.
Hence, if the Fed were to introduce a NGDP level target then because the US is a “global monetary superpower” then the ECB would effective be forced to do the same thing. Interestingly this would probably mean that the ECB would overshoot it’s 2% inflation in the short-run as NGDP shifts from on level to another. How would the ECB react to that? Well, first of all the EUR/USD would undoubtedly spike, which would curb short time inflationary pressures and the question is really whether the ECB would have time to do anything about the jump in NGDP. Paradoxically because the ECB is targeting future inflation then it could say “well, inflation is now at 5%, but that is really not something we can do anything about and inflation nonetheless be back to 2% once US NGDP settles down at the new (old) NGDP trend level so no tightening of monetary policy is needed”.
For now the ECB refuses any easing of monetary policy, but if the Fed were to act decisively then the ECB probably would import an easing of monetary policy – and that would probably save the euro. So please Ben can you help us?
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Posted by Lars Christensen on November 15, 2011
https://marketmonetarist.com/2011/11/15/the-fed-can-save-the-euro/
Friedman provided a theory for NGDP targeting
A distinct feature of Market Monetarist thinking is that our starting point for monetary analysis is nominal income and that monetary policy determines nominal income or nominal GDP (NGDP). This is contrary to New Keynesian analysis where monetary policy determines real GDP, which in turn determines inflation via a Phillips curve.
Hence, to Market Monetarists the split between prices and quantities is not a monetary matter. Monetary policy determines NGDP and that is all that monetary policy can do. While we acknowledge that there is a high correlation between real GDP and NGDP in the short-run the causality runs from NGDP to RGDP and not the other way. In the long run inflation is determined as a residual between NGDP, which is a monetary phenomenon, and RGDP, which is determined by supply side factors.
Milton Friedman came to the same conclusion 40 years ago. In a much overlooked (or should I say a forgotten) article from 1971 “A Monetary Theory of Nominal Income” he discusses this topic. The paper is a follow up on “Milton Friedman’s Monetary Framework” in which Friedman discusses his monetary framework with his critics. I have always felt that he failed to explain what he really meant in his “Monetary Framework”. Friedman seems to have realised that himself and his 1971 try to make up this failure.
Here is Friedman:
“In … “A Theoretical Framework for Monetary Analysis,” I outlined a simple model of six equations in seven variables that was consistent with both the quantity theory of money and the Keynesian income-expenditure theory…The difference between the two theories is in the missing equation the quantity theory adds an equation stating that real income is determined outside the system (the assumption of “full employment”); the income-expenditure theory adds an equation stating that the price level is determined outside the system (the assumption of price or wage rigidity)…The present addendum to my earlier paper suggests a third way to supply the missing equation. This third way involves bypassing the breakdown of nominal income between real income and prices and using the quantity theory to derive a theory of nominal income rather than a theory of either prices or real income. While I believe that this third way is implicit in that part of my theoretical and empirical work on money that has been concerned with short-period fluctuations, I have not heretofore stated it explicitly. This third way seems to me superior to the other two ways as a method of closing the theoretical system for the purpose of analyzing short-period changes. At the same time, it shares some of the defects common to the other two ways that I listed in the earlier paper.”
Hence, Friedman here acknowledges that the problem in the “Framework” papers was that he tried to come up with a monetary theory that followed a Keynesian route from RGDP to prices rather than “bypassing the breakdown of nominal income between real income and prices and using the quantity theory to derive a theory of nominal income”.
This is something completely lost in modern macroeconomic thinking, which see monetary policy working through a Phillips curve. This is somewhat odd given the weak empirical foundation for the existence of a Phillips curve.
I will not get into the details of Friedman’s model, but I would note that it could be interesting to see how it would look in a rational expectations version.
Back to Friedman:
“I have not, before this, written down explicitly the particular simplification I have labeled the monetary theory of nominal income-although Meltzer has referred to the theory underlying Anna Schwartz’s and my Monetary History as a “theory of nominal income” (Meltzer 1965, p. 414). But once written down, it rings the bell, and seems to me to correspond to the broadest framework implicit in much of the work that I and others have done in analyzing monetary experience. It seems to me also to be consistent with many of our findings. I do not propose here to attempt a full catalog of the findings, but I should like to suggest a number and, more important, to indicate the chief defect that I find with the framework.”
Here Friedman acknowledges that his empirical work for example on the Great Depression is based on a monetary theory of nominal income rather than on a quasi-Keynesian model (like the one he presents in his “Framework”). Any Market Monetarist would of course agree that a monetary theory of nominal income is needed to explain the Great Depression and the Great Recession for that matter. Friedman continues:
“One finding that we have observed is that the relation between changes in the nominal quantity of money and changes in nominal income is almost always closer and more dependable than the relation between changes in real income and the real quantity of money or between changes in the quantity of money per unit of output and changes in prices. This result has always seemed to me puzzling, since a stable demand function for money with an income elasticity different from unity led me to expect the opposite. Yet the actual finding would be generated by the approach of this paper, with the division between prices and quantities determined by variables not explicitly contained in it.”
This empirical result is highly interesting – the correlation between money and NGDP is stronger than between money and prices and income. In that regard it seems odd that Friedman never endorsed NGDP targeting – after all it would be natural to endorse a monetary policy rule that actually is directed towards something monetary policy can determine. However, there is no doubt that Friedman’s 1971 paper clearly provides the theoretical foundation for NGDP targeting. It is only too bad Friedman never came to that conclusion.
Finally I should say that Market Monetarists like David Beckworth and Josh Hendrickson are working on developing a modern monetary theory of nominal income determination.
PS Scott Sumner in a recent comment also discuss the relationship between NGDP, prices and quantities in Keynesian and (Market) Monetarist models.
PPS It should be noted that Bennett McCallum in a number of papers refers to Friedman’s 1971 paper when he argues in favour of nominal income targeting. See for example “Nominal Income Targeting in an Open-Economy Optimizing Model”
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Posted by Lars Christensen on November 6, 2011
https://marketmonetarist.com/2011/11/06/friedman-provided-a-theory-for-ngdp-targeting/
Friedman’s thermostat and why he obviously would support a NGDP target
In a recent comment Dan Alpert argues that Milton Friedman would be against NGDP targeting. I have the exact opposite view and I am increasingly convinced that Milton Friedman would be a strong supporter of NGDP targeting.
Ed Dolan as the same view as I have (I have stolen this from Scott Sumner):
“I see NGDP targeting as the natural heir to monetarist policy prescriptions of the 1960s and 70s…If we look at the textbook version of monetarism, the point is almost trivial. Textbook monetarism begins from the equation of exchange, MV=PQ, where M is money (M1, back in the day), V is velocity, P is the price level, Q is real GDP, and PQ is NGDP. Next it adds the simplifying assumption that velocity is constant. It follows that targeting a steady rate of money growth is identical to targeting a steady rate of NGDP growth.”
Dolan’s clear argument reminded me of Friedman’s paper from 2003 “The Fed’s Thermostat”.
Here is Friedman:
“To keep prices stable, the Fed must see to it that the quantity of money changes in such a way as to offset movements in velocity and output. Velocity is ordinarily very stable, fluctuating only mildly and rather randomly around a mild long-term trend from year to year. So long as that is the case, changes in prices (inflation or deflation) are dominated by what happens to the quantity of money per unit of output…since the mid ’80s, it (the Fed) has managed to control the money supply in such a way as to offset changes not only in output but also in velocity…The improvement in performance is all the more remarkable because velocity behaved atypically, rising sharply from 1990 to 1997 and then declining sharply — a veritable bubble in velocity. Velocity peaked in 1997 at nearly 20% above its trend value and then fell sharply, returning to its trend value in the second quarter of 2003.…The relatively low and stable inflation for this period …means that the Fed successfully offset both the decline in the demand for money (the rise in V) before 1973 and the subsequent increase in the demand for money. During the rise in velocity from 1988 to 1997, the Fed kept monetary growth down to 3.2% a year; during the subsequent decline in velocity, it boosted monetary growth to 7.5% a year.”
Hence, Friedman clearly acknowledges that when velocity is unstable the central bank should “offset” the changes in velocity. This is exactly the Market Monetarist view – as so clearly stated by Ed Dolan above.
So why did Friedman man not come out and support NGDP targeting? To my knowledge he never spoke out against NGDP targeting. To be frank I think he never thought of the righthand side of the equation of exchange – he was focused on the the instruments rather than on outcome in policy formulation. I am sure had he been asked today he would clearly had supported NGDP targeting.
The only difference I possibly could see between what Friedman would advocate and what Market Monetarists are arguing today is whether to target NGDP growth or a path for the NGDP level.
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PS I am not the first Market Monetarist to write about Friedman’s Thermostat – both Nick Rowe and David Beckworth have blogged about it before.
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Posted by Lars Christensen on November 5, 2011
https://marketmonetarist.com/2011/11/05/friedman%e2%80%99s-thermostat-and-why-he-obviously-would-support-a-ngdp-target/
Beckworth and Ponnuru: Tight budgets, Loose money
David Beckworth and Ramesh Ponnuru just came out with a new article on the economic policy debate in the US. Beckworth and Ponnuru lash out against both left and right in American politics. Let me just say that I agree with basically everything in the article, but you should read it yourself.
However, what I find most interesting in the article is not the discussion about the US political landscape, but rather the very clear description of both the Great Moderation and the causes for the Great Recession:
“The Fed did a pretty good job of stabilizing the economy. The result of its monetary policies was that the economy, measured in current-dollar or “nominal” terms, grew at about 5 percent a year, with inflation accounting for 2 percent of the increase and real economic growth 3 percent. Keeping nominal spending and nominal income on a predictable path is important for two reasons. First, most debts, such as mortgages, are contracted in nominal terms, so an unexpected slowdown in nominal income growth increases their burden. Also, the difficulty of adjusting nominal prices makes the business cycle more severe. If workers resist nominal wage cuts during a deflation, for example, mass unemployment results…During the great moderation, people began to expect spending and incomes to grow at a stable rate and made borrowing decisions based on it. But maintaining this stability requires the Fed to increase the money supply whenever the demand for money balances—people’s preference for cash over other assets—increases. This happened in 2008 when, as a result of the recession and the financial crisis, fearful Americans began to hold their cash. The Federal Reserve, first worried about increased commodity prices as a harbinger of inflation and then focused on saving the financial system, failed to increase the money supply enough to offset this shift in demand and allowed nominal spending to fall through mid-2009″
I wish a lot more people would understand this – Beckworth and Ponnuru are certainly not to blame if you don’t understand it yet.
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UPDATE: See this interesting comment on Niskanen and Beckworth/Ponnuru by Tim B. Lee.
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Posted by Lars Christensen on November 3, 2011
https://marketmonetarist.com/2011/11/03/beckworth-and-ponnuru-tight-budgets-loose-money/