Guest post: Nick Rowe, Barter, and Free Banking (By Lee Kelly)

I have for some time wanted the young and talented Lee Kelly to write a guest post for The Market Monetarist. I am happy that he now has done so. Anybody who follows the market monetarist blogs will be familiar with Lee’s name and his always insightful comments.

So thank you Lee and I hope you in the future will write many more posts for my blog.

Lars Christensen

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Guest post: Nick Rowe, Barter, and Free Banking

By Lee Kelly

Nick Rowe recently wrote about the increasing use of barter and makeshift monies during recessions. The market monetarist explanation for the last recession describes how attempts to engage in mutually beneficial exchange are frustrated by a shortage of money; this suggests that people would seek alternatives–such as barter and makeshift monies – to realise desired transactions. While such incentives would be expected to increase with the severity of the shortage, there are unfortunately too many other factors at play to draw precise quantitative predictions. That said, if there were no increase in barter or even a decrease, then I would tentatively consider the market monetarist explanation falsified, and it would require one heck of a good counterargument for me to reverse that judgement.

Alex Tabarrok has presented some evidence comparing the Great Depression and the recent recession. Evidence that barter and makeshift monies increased during the Great Depression is very strong–market monetarism passes the test. However, evidence regarding the last recession is less conclusive; there are suggestions of an increase in barter and makeshift monetary arrangements but nothing substantial.

Although I wouldn’t have expected anything comparable to the Great Depression, like Tabarrok, I’m surprised at just how weak of an effect appears to have been. My own observations are of a slight increase in barter, and the relative success of Bitcoin during the recession is suggestive, but there is little more than anecdotal evidence to go on for now. The evidence–or lack thereof–presented by Tabarrok should pose an interesting challenge to market monetarists.

In any case, my purpose here is actually to explain a little about the underlying theory of this explanation and how it dovetails with an arguments for free banking. An increasing use of barter and makeshift monies in during a shortage of money takes on a whole different meaning when viewed from the perspective of free market in money and banking. But first, let me try and keep everyone on the same page by clarifying just what is meant by a ‘shortage of money’ or an ‘excess demand for money’?

What is an Shortage or Excess Demand for Money?

The term ‘shortage’ has a precise meaning in economics. A shortage occurs when the market price of some good is below its equilibrium price. In such cases, there are more people willing to buy at the prevailing price than are willing to sell, leaving an excess demand. Holding supply and demand constant, the market normally clears such disequilibria by increasing prices until shortages are eliminated. However, a shortage may persist indefinitely when there is a price ceiling, i.e. an upper limit to some price usually mandated by a government. If the equilibrium price of some good is greater than its price ceiling, then rising prices are unable to entirely eliminate shortages.

Normally, when demand is frustrated by a price ceiling, the excess goes somewhere else. For example, a binding price ceiling on apples would frustrate demand, leaving some people who want to buy apples unable to find willing sellers at the prevailing price. What do people who want apples do instead? Maybe they buy pears, oranges, bananas, or whatever–probably something that serves a similar purpose. In any case, the excess demand for apples spills over into higher demand for other kinds of fruit.

Money is special. All else being equal, an increase in the demand for money is automatically a shortage of money. An excess demand for money cannot be cleared by increasing its price, because money doesn’t have a price of its own. To reach equilibrium, every other price must haphazardly grope its way there by a roundabout path of deflation. A shortage of money is unlike a shortage of anything else, because money is the medium of exchange. An excess demand for apples will probably just result in more spending on other fruit, but an excess demand for money results in less spending altogether. With an insufficient quantity of the medium of exchange to facilitate desired transactions, potential output is sacrificed–this manifests as the temporary lull in economic activity called a recession.

Barter and Makeshift Monies From a Free Banking Perspective

The relation between a shortage of money and barter is similar to the relation between a shortage of cars and cycling. Suppose the government imposes a binding price ceiling on cars and supply is elastic. While there will always be some driving and some cycling, the shortage of cars results in people cycling more than if the supply of and demand for cars were in equilibrium. However, cycling cannot substitute for all journeys that would otherwise be taken by car, and so those journeys simply never happen. Likewise, only a fraction of transactions frustrated by a shortage of money can be completed using substitutes like barter or makeshift monies.

What does this have to do with free banking? In a world where central banks operate an effective monopoly over money, there is only one monetary policy. If the central bank pursues bad monetary policy, then the economy is constantly rocked by surpluses or shortages of money. But what if people had a better alternative than barter or makeshift monies? What if there were multiple competing issuers of money? What if our eggs weren’t all in one basket?

Free banking theory envisions a world where each money issuer has their own “monetary policy”, and a shortage or surplus created by one issuer is a profit opportunity for all others. When attempts to engage in mutually beneficial exchange are frustrated by a shortage of money, then people will seek alternatives. In an ideal free banking scenario, those alternatives are readily available monies created by institutions poised to soak up any excess demand for money. A free banking system is, in this way, robust against errors of monetary policy that can devastate an economy dependent on a central bank.

No system is perfect, and I’m aware of the futility of advocating free banking. However, I’m very much in favour of theorising about free banking. It is often only when ideas are contrasted with alternatives that we tease out hidden assumptions. Insights that seem deep and elusive from one perspective can become trivial and obvious from another.

Normally, economists understand market failure and government intervention in the light of ideal markets, but all such norms are reversed when it comes to money and banking. Many insights that are hard to come with conventional thinking, such as nominal GDP targeting, are relatively straightforward when understood in the light of free banking. The idea that people will seek alternatives to a given money when it’s suffering from a shortage of surplus is not just implicit in free banking, but is at the the core of what it means for there to be monetary competition in the first place.

© Copyright (2012) Lee Kelly

Guest post: Central Banks Should Quit “Kicking Them While They Are Down!” (by David Eagle)

Guest post: Central Banks Should Quit “Kicking Them While They Are Down!”

– Abandon Inflation Targeting! Embrace NGDP Level Targeting!

By David Eagle

Homeowners in the U.S. and many other places in the world are struggling to meet their mortgage payments while their average nominal income has fallen in the aftermath of one of the worst recessions since the Great Depression of the 1930s.  Many sovereign governments in Europe are struggling to meet their debt obligations in the midst of reduced tax revenue caused by this recession.  On Monday, Feb. 13, 2012, many Greek citizens rioted in Athens against the austerity measures being passed by the Greek government under pressure from the European Union.  What do these homeowners, sovereign governments, and the Greek people have in common?  They are all victims.  They are victims of well-intentioned, but misguided central banks.

By explicitly or covertly targeting inflation, these central banks including the Federal Reserve of the U.S. and the European Central Bank have been “kicking these victims while they are down.”  These central banks are promising to continue kicking them while they are down in perpetuity.  I write this blog in hopes of ending the madness of this economic self-destruction.

In a previous guest blog at The Market Monetarist, I discussed why Price-Level Targeting (PLT) Pareto dominates Inflation Targeting (IT).  That blog’s conclusion followed from the realization that the uncertainty that borrowers and lenders face is not “inflation risk” but rather price-level risk.  It is then obvious that the long-term price-level risk faced by both borrowers and lenders is less under PLT than under IT.  Whenever the price level deviates from what was expected, either the borrower or the lender experiences a loss while the other experiences a gain.  Under PLT the central bank tries to reverse those losses or gains, whereas under IT the central bank tries to make those gains or losses permanent.  By making the losers’ losses permanent, IT “kicks them while they are down.”

IT is not the only monetary target that “kicks them while they are down.”  Many market monetarists and I have great respect for Bennett McCallum.  However, McCallum advocates what I nickname “ΔNT,” which is targeting the growth rate of nominal GDP.  The truth is that ΔNT “kicks them while they are down” just as much as does IT.  As I explained in one of my guest blogs at The Market Monetarist, both IT and ΔNT lead to NGDP base drift.  It is this evil NGDP base drift that “kicks them while they are down.”  As a result, central banks need to try to reverse any NGDP base drift in order to help lift economic agents back up after they have been knocked down by recessions.  The targeting regime designed specifically to eliminate NGDP base drift is what I nickname “NT.”  Under NT central banks target the level (not the growth rate) of NGDP; NT is the targeting regime advocated by most market monetarists.

The Evil NGDP Base Drift:

Let Xt be a prearranged nominal loan payment, and let xtXt/Pt be the real value of this nominal loan payment.  By the equation of exchange (MV=N=PY), we know that P=N/Y. Therefore, the real value of Xtis (Xt/Nt)Yt, which implies that the real value of Xt is proportional to Yt when Nt=E[Nt], which it will be under perfectly successful NT.

Define αtXt/Nt to be the actual proportion that the real value of this nominal payment is to RGDP.  Multiply the right side by Nt*/Nt* (which equals one) where Nt* is defined as the prerecession trend for NGDP (Under NT, Nt* would be the NGDP target).  Rearranging slightly gives:

(1) αt=(Xt/Nt*)(Nt*/Nt)

Define NGAP to be the percentage deviation of NGDP from its prerecession trend.  Hence, NGAPt≡(Nt─Nt*)/Nt*.  We can also write that NGAPt=Nt/Nt*-1, or 1+NGAPt = Nt/Nt*, which is the reciprocal of the last ratio in equation (1).  Define αt*Xt/Nt*, which is what αt would if Nt=Nt*, i.e., when NGAPt=0.  With this new definition and our understanding of NGAP, we can rewrite equation (1) as:

(2) αt= αt*/(1+NGAPt)

This states that the proportion that the real value of the nominal loan payment is of RGDP equals the proportion it would be if NGDP is on its prerecession trend divided by 1+NGAP.  Equation (2) is useful to show how borrowers and lenders are affected when NGDP deviates from its trend.  When NGDP rises above trend, NGAP becomes positive, decreasing this proportion, making borrowers better off at the expense of lenders; in other words, borrowers gain while lenders lose.  When NGDP falls below trend, NGAP becomes negative, increasing this proportion, making borrowers worse off and lenders better off; in other words, borrowers lose while lenders gain.

NGDP base drift occurs when NGAP becomes positive or negative, and the central bank accepts this NGAP and commits to keeping this NGAP in the future as it does both with IT and ΔNT.  This NGDP base drift then makes the effects on borrowers and lenders permanent.  On the other hand, under NT, the central bank tries to reverse these effects by returning NGAP to zero as soon as possible so that the effects on borrowers and lenders are temporary not permanent.

Because NGDP base drift causes the effects of NGAP on borrowers and lenders to be permanent, this NGDP base drift “kicks the loser when the loser is down.”  Hence, I view NGDP base drift as evil.

NGDP Targeting (NT) – The “Pi” or “e” of Monetary Economics

In my previous guest blog post where I explained why IT “kicks them while they are down,” I restricted that discussion to where real GDP (RGDP) remains the same.  That is because the First Principle from my blog on the Two Fundamental Welfare Principles of Monetary Economics states that Pareto Efficiency requires the consumption of individuals to be the same only as long as RGDP remains the same.  When RGDP changes, the Second Principle applies, which states that Pareto efficiency requires that the consumption of an individual with average relative risk aversion be proportional to RGDP.

NT helps individuals achieve this consumption proportional to RGDP by trying to make the real value of prearranged nominal payments (such as loan payments) proportional to RGDP.  NT does this by trying to keep NGAP equal to zero.  As seen in equation (2), as long as NGAP is zero and consumers expect NGAP to be zero, then this proportion will be proportional to RGDP.

Nominal contracts work efficiently in a Pareto sense whenever NGDP is as expected.  People are not trying to guarantee real payments between each other; rather they want to let the natural feature of nominal contracts properly distribute the RGDP risk among the parties of the contract.  As long as NGDP is as expected, the real value of the nominal contract’s payment will be proportionate to RGDP, which is what an individual with average relative risk aversion needs according to the Second Principle.

In a previous guest blog post, I noted that when RGDP remains the same, the uncertainty borrowers and lenders face is not inflation risk, but rather price-level risk.  While simple and obvious, that statement nevertheless has profound implications concerning the issue of price-level targeting (PLT) vs. IT.  However, when we broaden our perspective to include when RGDP changes, we need to go beyond the concept of price-level risk.  Instead of inflation risk or price-level risk, economic agents should really be concerned about NGDP risk.

NGDP risk is what I view to be the true monetary risk in an economy.  Minimizing NGDP risk helps meet both The Two Fundamental Welfare Principles of Monetary Economics.  First, by minimizing NGDP risk we minimize the price-level risk when RGDP does remain the same.   Second, minimizing NGDP risk helps consumption levels be proportional to RGDP by helping the real value of nominal payments to be proportional to RGDP.

Many proponents of NGDP targeting have described NGDP targeting as a reasonable compromise to the dual mandate of monetary policy.  That is not my view.

My view is that NGDP targeting is the ideal, not a compromise.  NGDP targeting comes out of theory as the Pareto-efficient monetary policy, much as in mathematics the numbers “pi” and “e” come out of pure theory.

Why NT Pareto Dominates ΔNT:

NT targets the level of NGDP whereas ΔNT targets the growth rate of NGDP.  As explained in my second guest blog post, as long as the central bank meets its target, NT and ΔNT have the same effect.  The difference between NT and ΔNT occurs when the central bank misses its target.  Under NT, when NGDP is less (greater) than its trajectory, the central bank tries to increase (decrease) NGDP back to its original trajectory.  However, with ΔNT the central bank “lets bygones be bygones” and shifts its NGDP trajectory to be consistent with its targeted NGDP growth.

When the central bank misses its target under NT or ΔNT, borrowers and lenders experience zero-sum gains and losses as a result of NGDP differing from expected NGDP.  For example, assume NGDP initially is 10 (trillion monetary units), the targeted growth rate for NGDP under ΔNT is 5%, and the targeted level of NGDP under NT is 10(1.05)t.  Then the initial NGDP trajectory under both NT and ΔNT is 10(1.05)t, and the public’s initial expectation of NGDP at time t is this NGDP trajectory of 10(1.05)t.  In particular, the public’s expectation of NGDP at time t=1 is 10.50.  However, assume NGDP1=10.29 instead of 10.50.  This means NGAP is -2%, which causes the proportion in equation (2) to rise, causing the borrowers to lose and the lenders to gain.  Under NT, the central bank tries to return NGDP back up to its initial trajectory where NGAP will be 0%.  On the other hand, under ΔNT the central bank shifts its NGDP trajectory from 10(1.05)t to 10.29(1.05)t-1, which means that the expected future NGAP will be -2%, meaning the borrower’s loss will be made permanent.  In other words, central banks following ΔNT “kick the losers (the borrowers in this case) when they are down.”

On the other hand, suppose NGDP1=10.71 instead of the 10.50 expected NGDP.  This is a positive NGAP of 2%, which implies that the proportion in equation (2) decreases, making the borrower better off at the expense of the loser.  With NT, the central bank will try to reverse its mistake and return to its initial NGDP trajectory, return NGAP to 0%, and return the proportion of the real payment to RGDP back to as originally expected.  However, with ΔNT, the central bank tries to make its mistake permanent, trying to keep NGAP at +2%, thus making the borrower permanently better off and the lender permanently worse off.

Thus, the difference between NT and ΔNT is that under NT, the central bank tries to reverse the losses and gains faced by both borrowers and lenders, whereas under ΔNT, the central bank tries to make those losses and gains permanent.  Thus, ΔNT “kicks the losers when they are down.”  A priori, both the borrower and lender are better off knowing that the central bank is going to reverse its mistakes rather than making its mistakes and the resulting gains and losses permanent.  Therefore, NT Pareto dominates ΔNT.

Real life example #1: Homeowners and Mortgages:

During the last recession, NGDP sharply fell and central banks have been experiencing significant negative NGDP base drift.  While some say that this negative NGDP base drift is due to central banks being unable to increase NGDP, the fact is that negative NGDP base drift has been associated with most U.S. recessions even when the Federal Reserve was by no means considered impotent (I will report these empirical findings in a later blog post).

The negative NGDP base drift has made borrowers worse off and the continuing of that NGDP base drift continues those borrowers’ misery.  For example, consider homeowners who before the recession bought homes and financed those with fixed-payment mortgages.  When NGDP fell below its expected trend, average nominal income fell below what the homeowners had expected.  On average, these homeowners were squeezed between reduced nominal income and their fixed mortgage payments.  With central banks continuing rather than reversing the negative NGDP base drift, these homeowners will continue to be squeezed until (i) they finally pay off their mortgage after greater financial strain than they expected, or (ii) they default on their mortgages because of their inability to pay them.   If central banks were to pursue NT, eliminating this NGDP base drift, reducing NGAP to 0%, then average nominal income would again be as initially expected, ending the squeeze on the average homeowner once the central bank returns to its NGDP target path.

However, as they have in past recessions, central banks are letting the negative NGDP base drift continue and are therefore kicking these borrowers while they are down.

Real life example #2: European Sovereign Governments:

When NGDP fell during the last recession in Europe, the reduction of NGDP resulted in lower tax revenues to sovereign governments, but these governments’ nominal loan payments were fixed, squeezing these governments.  The European Central Bank by allowing this NGDP base drift to continue are committing these governments to a perpetual squeeze; the European Central Bank is kicking these governments while they are down.

How bad is this negative NGDP base drift in Euro area?  See the following graph:

The negative NGDP base drift in the aftermath of the last recession in the Euro area is very significant.  However, this NGDP base drift is even more evil than normally.  Not only is NGAP significantly negative, but it keeps getting worse.  In the second quarter of 2009, NGAP was -10.28%.  Since then NGAP has continued to get worse reaching -14.90% in the third quarter of 2011.

If instead the European Central Bank were to target NGDP and try to return NGDP to its prerecession trend and were successful, these governments’ tax revenue should increase to initially expected levels, eliminating the squeeze.  Many will claim that the European Central Bank is impotent, unable to eliminate this NGAP.  However, as the following graph shows, the European Central Bank has experienced NGDP base previously when it was not impotent.

Because of my work with the issue of price determinacy, I know that expectations is very important to a central bank’s ability to meet its targets.  Since the European Central Bank has let NGDP base drift persist in the past, then the public’s expectation is that they will let the NGDP base drift persist now.  To succeed in eliminating this NGDP base drift, to return NGAP to zero, we need to change expectations.  By committing to NT and following other suggestions the market monetarists and I have, the European Central Bank can change these expectations and eliminate the evil of NGDP base drift.  Rather than kicking the sovereign government borrowers and other debtors while they are down, central banks can return NGAP to zero and help lift these debtors to their feet, which is a lot nicer than kicking them while they are down.

Making Both Borrowers and Lenders Worse off

Up until now I have described the negative NGDP base drift caused by ΔNT and IT as making borrowers worse off while making lenders better off.  However, the latest recession has made so many borrowers so worse off as to cause many borrowers be unable to pay, leading to loan defaults.  Hence, not only has this negative NGDP base drift made borrowers worse off, it has also made lenders worse off.  Reversing the negative NGDP base by following NT rather than IT or ΔNT would thus help not only borrowers, but lenders as well.

Unfortunately, the central banks have either committed to inflation targeting or acted as if they were inflation targeters.  As a result, the expectation of those who recently entered into loan contracts after the negative NGAP occurred is that the central banks would not reverse this NGAP.  If they central banks do reverse this NGAP, then it will make these recent borrowers better off and the recent lenders worse off.  Had the central banks instead committed to a nominal GDP target, then these recent borrowers and lenders would have anticipated the elimination of NGAP.  This then does put the central banks in a difficult position.  Should they reverse the NGAP and return the borrowers and lenders back to their original expected proportions at the expense of more recent borrowers and lenders?  Or should they keep to their promise of nonreversal of NGAP which is consistent with more recent loans, but which will continue to kick the original borrowers while they are down.  It is a difficult decision.  Perhaps they can compromise and partially reverse the NGAP and then commit to a nominal GDP target in the future.

© Copyright (2012) David Eagle

Guest post: GDP-Linked Bonds (by David Eagle)

Guest post: GDP-Linked Bonds, Another Whole Literature to Synthesize into Market Monetarism

by David Eagle

As Dale Domian and I have been frustrated at our continuous attempts to publish our quasi-real indexing research, I have kept reminding myself of one thing and that is that we were the first to design quasi-real indexing (Eagle and Domian, 1995. “Quasi-Real Bonds–Inflation-Indexing that Retains the Government’s Hedge Against Aggregate-Supply Shocks,” Applied Economic Letters).  However, I have recently encountered some good news and some bad news concerning quasi-real indexing.

First, the bad news: It turns out that Dale and I were not the first to come up with the notion of quasi-real indexing.  Somebody actually beat us by two years.  The reference is is Robert Shiller’s Macro Markets: Creating Institutions for Managing Society’s Largest Economic Risks”.

Actually, Shiller did not use the term “quasi-real indexing.”  Instead, he used “GDP-linked bonds.”  Shiller shares the same origins for these bonds as Dale and I do.  We all started thinking about government bonds.  At the time of our 1995 paper, the U.S. government was considering inflation-indexed bonds.  Instead, we proposed an alternative bond that would be safer for the government.  Unfortunately, the U.S. government decided to issue TIPS, an inflation-indexed bond, rather than either Shiller’s proposal or Dale’s and my proposal.

Now the good news: A significant literature has evolved concerning GDP-linked bonds.  The existence of this literature provides the market monetarists another literature to bring into the Market Monetarism literature.  In particular, I have come to recognize that quasi-real indexing basically provides insurance against the central bank not meeting its nominal GDP target even if the central bank is not targeting GDP.  If those in the GDP-linked-bond literature can recognize that that is what their GDP-linked bonds do, they will then realize that George Selgin was right in Less than Zero about how risk on loans should be shared between borrowers and lenders.  Also, they should realize that nominal bonds will achieve the same effect as GDP-linked bonds as long as the central bank successfully targets nominal GDP.

You can find GDP-linked bonds in Wikipedia; unfortunately, you cannot find “quasi-real indexing” there (yet).  More recently Professor Shiller joined Mark Kamstra in a paper proposing “Trills,” which are a GDP-linked bond.  Other literature concerning GDP-linked bonds include:

Mark Kamstra and Robert J. Shiller: “The Case for Trills: Giving Canadians and their Pension Funds a Stake in the Wealth of the Nation.”

Kruse, Susanne, Matthias Meitner and Michael Schroder, “On the pricing of GDP-linked financial products.” Applied Financial Economics 15: 1125-1133, 2005.

Griffith-Jones, Stephany, and Krishnan Sharma, “GDP-Indexed Bonds: Making It Happen.” DESA Working Paper No. 21, 2006.

Schröder, Michael; Heinemann, Friedrich; Kruse, Susanne; Meitner, Matthias; “GDP-linked Bonds as a Financing Tool for Developing Countries and Emerging Markets”

Travota, Alexandra “On the Feasibility and Desirability of GDP-Indexed Concessional Lending,”

Also, some blog posts exist on GDP-linked bonds:

Jonathan Ford: The Case for GDP Bonds

: GDP-Linked Securities

Also, a very recent blog post in the WSJ.com just covered Robert Shiller’s proposal of these GDP-linked bonds:

“Worried About U.S. Debt? Shiller Pushes GDP-Linked Bonds”

I myself am still reading these other papers, books, and blog posts.

The reality is that if not only the U.S. government issued quasi-real bonds or GDP-linked bonds, but also European governments issued them as well, then the European sovereign debt crisis would not be at all as serious a problem as it is today.  Also, as most market monetarists know, if the European Central Banks had been targeting nominal GDP successfully, then the European sovereign debt crisis would be of a much smaller magnitude than it has become.  Paul Krugman has noted how the increase in European sovereign debt coincided with the beginning of the last recession.  I hope that Professor Krugman will look into the GDP-linked-bond and quasi-real-indexing literatures to learn how these types of bonds would have prevented this increase to happen.

Actually, Argentina has recently issued some GDP-linked bonds as one of the above blogs points out.

In economics, we have a lot of unconnected literatures that needs to be brought together. Obviously, Dale and my “quasi-real indexing” needs to be synthesized into the GDP-linked bond literature.  However, synthesizing both of these literatures along with the wage-indexation literature and the nominal GDP targeting literature leads to the incredible conclusions: (1) Much of the Pareto-efficiency associated with complete markets can be achieved either through quasi-real indexing of all contracts or by the central bank (successfully) targeting nominal GDP, (2) Most of the negative economic effects of the business cycle would be eliminated either through quasi-real indexing  or nominal GPD targeting.

I hope this post encourages those involved in the GDP-linked bond literature, wage indexation literature, and the literature on NGDP targeting to work on synthesizing all of their literatures together.

© Copyright (2012) by David Eagle

Guest blog: The Integral Reviews: Paper 3 – Hall (2009)

Guest blog – The Integral Reviews: Paper 3 – Hall (2009)
by “Integral”

Reviewed: Robert Hall (2009), “By How Much Does GDP Rise If the Government Buys More Output?” NBER WP 15496

Executive summary

The average government purchases multiplier is about 0.5, taking into account empirical and structural evidence. The only way to get “large” multipliers of 1.6 is to assume a large degree of non-optimizing behavior, an inflexible wage rate, at the zero lower bound on nominal interest rates, and assuming monetary policy is completely ineffective at influencing aggregate demand but the fiscal authority retains that influence.

The key ingredients to generating a large output multiplier are sticky wages/prices, a highly countercyclical markup ratio, and “passive” monetary policy which does not counteract the fiscal expansion.

The assumptions that underlie “the effectiveness of monetary policy” (sticky prices and a countercyclical markup) also drive “the effectiveness of fiscal policy.” The two are similar in that respect.

Summary

Hall provides a convenient overview of the state of economic knowledge about the government purchases multiplier. He does this in four steps: simple regression evidence, VAR evidence, structural evidence from RBC models, and structural evidence from various sticky-price/sticky-wage models.

Empirical evidence begins with the simple OLS regression framework. Hall obtains the output multiplier by regressing the change in military expenditures (a proxy for the exogenous portion of government spending) on the change in output. He finds multipliers significantly larger than zero but less than unity, mostly in the neighborhood of one-half. This estimate of the “average multiplier” is confounded by two problems: (1) the implied multiplier be taken as a lower bound rather than an unbiased estimate due to omitted variable bias, and (2) the estimates are driven entirely by observations during WWII and the Korean War.

The VAR approach produces a range of estimates. Hall surveys five prior studies and finds that the government purchases multiplier is non-negative upon impact across all studies and consistently less than unity, but there is much variation in the exact point estimate. The VAR approach typically suffers the same omitted variable bias as OLS.

Hall then turns to a review of the structural evidence. He first shows the standard RBC result that if wages and prices are flexible, the output multiplier is essentially zero or even negative. While a useful benchmark this is not particularly useful for applied work.

Adding wage frictions forces laborers to operate off of the labor supply curve, so output could plausibly expand from an increase in government demand. Hall indeed finds that the multiplier is higher in small-scale NK models and depends on consumer behavior. With consumers pinned down by the permanent-income/life-cycle model, multipliers tend to range around 0.7. If consumers are rule-of-thumb or iiquidity constrained, one finally finds multipliers above unity, in the neighborhood of 1.7, in the presence of the zero lower bound on nominal interest rates.

Review

The empirical evidence is plagued by persistent endogeniety and omitted-variable bias, which Hall frankly acknowledges. Identification is extraordinarily difficult in macroeconomics; as a practical matter it is impossible to untangle all of the interrelated shocks the economy experiences each year.

On the theory side, Scott Sumner would consider this entire exercise a waste of time: the Fed steers the nominal economy and acts to offset nominal shocks; government shocks are a nominal shock, so the Fed will act so as to ensure that the government expenditures multiplier is zero, plus or minus some errors in the timing of fiscal and monetary policy.

Is this a good description of the world? On average over the postwar period, a $1 exogenous change in government spending has led to a $0.50 increase in output; excluding the WWII and Korean War data drive this number down significantly. As a first-order approximation the fiscal multiplier is likely zero on average. But we don’t care about the average, we care about the marginal multiplier, at the zero bound. In that scenario, multipliers are on average higher but still below unity. A crucial open question is to what degree the monetary authority “loses control” of nominal aggregates at the zero lower bound, and to what degree fiscal policy is impacted if the monetary authority is “helpless”. (If we are in a situation where the Fed cannot move nominal aggregates, why wouldn’t Congress be similarly constrained?)

Hall’s paper does not explicitly discuss monetary policy. However, adding a monetary authority to his models would only reduce the already-low multipliers that Hall uncovers. His point, that one cannot plausibly obtain multipliers in excess of unity in a modern macro model, is already well-established even without explicitly accounting for the central bank.

Guest Blog: The Two Fundamental Welfare Principles of Monetary Economics (By David Eagle)

I am extremely happy that David Eagle is continuing his series of guest blogs on my blog.

I strongly believe that David’s ideas are truly revolutionary and anybody who takes monetary policy and monetary theory serious should study  these ideas carefully. In this blog David presents what he has termed the “Two Fundamental Welfare Principles of Monetary Economics” as an clear alternative to the ad hoc loss functions being used in most of the New Keynesian monetary literature.

To me David Eagle here provides the clear microeconomic and welfare economic foundation for Market Monetarism. David’s thinking and ideas have a lot in common with George Selgin’s view of monetary theory – particularly in “Less than zero” (despite their clear methodological differences – David embraces math while George use verbal logic). Anybody that reads and understands David’s and George’s research will forever abandon the idea of a “Taylor function” and New Keynesian loss functions.

Enjoy this long, but very, very important blog post.

Lars Christensen

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Guest Blog: The Two Fundamental Welfare Principles of Monetary Economics

by David Eagle

Good Inflation vs. Bad Inflation

At one time, doctors considered all cholesterol as bad.  Now they talk about good cholesterol and bad cholesterol.  Today, most economists considered all inflation uncertainty as bad, at least all core inflation uncertainty.  However, some economists including George Selgin (2002), Evan Koenig (2011), Dale Domian, and myself (and probably most of the market monetarists) believe that while aggregate-demand-caused inflation uncertainty is bad, aggregate-supply-caused inflation or deflation actually improves the efficiency of our economies.  Through inflation or deflation, nominal contracts under Nominal GDP (NGDP) targeting naturally provide the appropriate real-GDP risk sharing between borrowers and lenders, between workers and employers, and more generally between the payers and receivers of any prearranged nominal payment.  Inflation targeting (IT), price-level targeting (PLT), and conventional inflation indexing actually interfere with the natural risk sharing inherent in nominal contracts.

I am not the first economist to think this way as George Selgin (2002, p. 42) reports that “Samuel Bailey (1837, pp. 115-18) made much the same point.”  Also, the wage indexation literature that originated in the 1970s, makes the distinction between demand-induced inflation shocks and supply-induced inflation shocks, although that literature did not address the issue of risk sharing.

The Macroeconomic Ad Hoc Loss Function vs. Parerto Efficiency

The predominant view of most macroeconomists and monetary economists is that all inflation uncertainty is bad regardless the cause.  This view is reflected in the ad hoc loss function that forms the central foundation for conventional macroeconomic and monetary theory.  This loss function is often expressed as a weighted sum of the variances of (i) deviations of inflation from its target and (ii) output gap.  Macro/monetary economists using this loss function give the impression that their analyses are “scientific” because they often use control theory to minimize this function.  Nevertheless, as Sargent and Wallace (1975) noted, the form of this loss function is ad hoc; it is just assumed by the economist making the analysis.

I do not agree with this loss function and hence I am at odds with the vast majority of the macro/monetary economists.  However, I have neoclassical microfoundations on my side – our side when we include Selgin, Bailey, Koenig, Domian, and many of the market monetarists.  This ad hoc social loss function used as the basis for much of macroeconomic and monetary theory is basically the negative of an ad hoc social utility function.  The microeconomic profession has long viewed the Pareto criterion as vastly superior to and more “scientific” than ad hoc social utility functions that are based on the biased preconceptions of economists.  By applying the Pareto criterion instead of a loss function, Dale Domian and I found what I now call, “The Two Fundamental Welfare Principles of Monetary Economics.”  My hope is that these Fundamental Principles will in time supplant the standard ad hoc loss function approach to macro/monetary economics.

These Pareto-theoretic principles support what George Selgin (p. 42) stated in 2002 and what Samuel Bailey (pp. 115-18) stated in 1837.  Some economists have dismissed Selgin’s and Bailey’s arguments as “unscientific.”  No longer can they legitimately do so.  The rigorous application of neoclassical microeconomics and the Pareto criterion give the “scientific” support for Selgin’s and Bailey’s positions.  The standard ad-hoc-loss-function approach in macro- and monetary economics, on the other hand, is based on pulling this ad hoc loss function out of thin air without any “scientific” microfoundations basis.

Macroeconomists and monetary economists have applied the Pareto criterion to models involving representative consumers.  However, representative consumers miss the important ramifications of monetary policy on diverse consumers.  In particular, models of representative consumers miss (i) the well-known distributional effect that borrowers and lenders are affected differently when the price level differs from their expectations, and (ii) the Pareto implications about how different individuals should share in changes in RGDP.

The Two Direct Determinants of the Price Level

Remember the equation of exchange (also called the “quantity equation), which says that MV=N=PY where M is the money supply, V is income velocity, N is nominal aggregate spending as measured by nominal GDP, P is the price level, and Y is aggregate supply as measured by real GDP.  Focusing on the N=PY part of this equation and solving for P, we get:

(1) P=N/Y

This shows there are two and only two direct determinants of the price level:

(i)             nominal aggregate spending as measured by nominal GDP, and

(ii)           aggregate supply as measured by real GDP.

This also means that these are the two and only two direct determinants of inflation.

The Two Fundamental Welfare Principles of Monetary Economics

When computing partial derivatives in calculus, we treat one variable as constant while we vary the other variable.  Doing just that with respect to the direct determinants of the price level leads us to The Two Fundamental Welfare Principles of Monetary Economics:

Principle #1:    When all individuals are risk averse and RGDP remains the same, Pareto efficiency requires that each individual’s consumption be unaffected by the level of NGDP.

Principle #2:    For an individual with average relative risk aversion, Pareto efficiency requires that individual’s consumption be proportional to RGDP.[1]

Dale Domian and I (2005) proved these two principles for a simple, pure-exchange economy without storage, although we believe the essence of these Principles go well beyond pure-exchange economies and apply to our actual economies.

My intention in this blog is not to present rigorous mathematical proofs for these principles.  These proofs are in Eagle and Domian (2005).  Instead, this blog presents these principles, discusses the intuition behind the principles, and gives examples applying the principles.

Applying the First Principle to Nominal Loans:

I begin by applying the First Principle to borrowers and lenders; this application will give the sense of the logic behind the First Principle.  Assume the typical nominal loan arrangement where the borrower has previously agreed to pay a nominal loan payment to the lender at some future date.  If NGDP at this future date exceeds its expected value whereas RGDP is as expected, then the price level must exceed its expected level because P=N/Y.  Since the price level exceeds its expected level, the real value of the loan payment will be lower than expected, which will make the borrower better off and the lender worse off.  On the other hand, if NGDP at this future date is less than its expected value when RGDP remains as expected, then the price level will be less than expected, and the real value of the loan payment will be higher than expected, making the borrower worse off and the lender better off.  A priori both the borrower and the lender would be better off without this price-level risk.  Hence, a Pareto improvement can be made by eliminating this price-level risk.

One way to eliminate this price-level risk is for the central bank to target the price level, which if successful will eliminate the price-level risk; however, doing so will interfere will the Second Principle as we will explain later.  A second way to eliminate this price-level risk when RGDP stays the same (which is when the First Principle applies), is for the central bank to target NGDP; as long as both NGDP and RGDP are as expected, the price level will also be as expected, i.e., no price-level risk..

Inflation indexing is still another way to eliminate this price-level risk.  However, conventional inflation indexing will also interfere with the Second Principle as we will soon learn.

That borrowers gain (lose) and lenders lose (gain) when the price level exceeds (fall short of) its expectations is well known.  However, economists usually refer to this as “inflation risk.” Technically, it is not inflation risk; it is price-level risk, which is especially relevant when we are comparing inflation targeting (IT) with price-level targeting (PLT).

An additional clarification that the First Principle makes clear concerning this price-level risk faced by borrowers and lenders is that risk only applies as long as RGDP stays the same.  When RGDP changes, the Second Principle applies.

Applying the Second Principle to Nominal Loans under IT, PLT, and NT:

The Second Principle is really what differentiates Dale Domian’s and my position and the positions of Bailey, Selgin, and Koenig from the conventional macroeconomic and monetary views.  Nevertheless, the second principle is really fairly easy to understand.  Aggregate consumption equals RGDP in a pure exchange economy without storage, capital, or government.  Hence, when RGDP falls by 1%, aggregate consumption must also fall by 1%.  If the total population has not changed, then average consumption must fall by 1% as well.  If there is a consumer A whose consumption falls by less than 1%, there must be another consumer B whose consumption falls by more than 1%.  While that could be Pareto justified if A has more relative risk aversion than does B, when both A and B have the same level of relative risk aversion, their Pareto-efficient consumption must fall by the same percent.  In particular, when RGDP falls by 1%, then the consumption level of anyone with average relative risk aversion should fall by 1%.  (See Eagle and Domian, 2005, and Eagle and Christensen, 2012, for the basis of these last two statements.)

My presentation of the Second Principle is such that it focuses on the average consumer, a consumer with average relative risk aversion.  My belief is that monetary policy should do what is optimal for consumers with average relative risk aversions rather than for the central bank to second guess how the relative-risk-aversion coefficients of different groups (such as borrowers and lenders) compare to the average relative risk aversion.

Let us now apply the Second Principle to borrowers and lenders where we assume that both the borrowers and the lenders have average relative risk aversion.  (By the way “relative risk aversion” is a technical economic term invented Kenneth Arrow, 1957, and John Pratt, 1964.)  Let us also assume that the real net incomes of both the borrower and the lender other than the loan payment are proportional to RGDP.  Please note that this assumption really must hold on average since RGDP is real income.  Hence, average real income = RGDP/m where m is the number of households, which means average real income is proportional to RGDP by definition (the proportion is 1/m).

The Second Principle says that since both the borrower and lender have average relative risk aversion, Pareto efficiency requires that both of their consumption levels must be proportional to RGDP.  When their other real net incomes are proportional to RGDP, their consumption levels can be proportional to RGDP only if the real value of their nominal loan payment is also proportional to RGDP.

However, assume the central bank successfully targets either inflation or the price level so that the price level at the time of this loan payment is as expected no matter what happens to RGDP.  Then the real value of this loan payment will be constant no matter what happens to RGDP.  That would mean the lenders will be guaranteed this real value of the loan payment no matter what happens to RGDP, and the borrowers will have to pay that constant real value even though their other net real incomes have declined when RGDP declined.  Under successful IT or PLT, borrowers absorb the RGDP risk so that the lenders don’t have to absorb any RGDP risk.  This unbalanced exposure to RGDP risk is Pareto inefficient when both borrowers and lenders have average relative risk aversion as the Second Principle states.

Since IT and PLT violate the Second Principle, we need to search for an alternative targeting regime that will automatically and proportionately adjust the real value of a nominal loan payment when RGDP changes?  Remember that the real value of the nominal loan payment is xt=Xt/P.  Replace P with N/Y to get xt=(Xt/Nt)Yt, which means the proportion of xt to Yt equals Xt/Nt.  When Xt is a fixed nominal payment, the only one way for the proportion Xt/Nt to equal a constant is for Nt to be a known in advance.  That will only happen under successful NGDP targeting.

What this has shown is that the proportionality of the real value of the loan payment, which is needed for the Pareto-efficient sharing of RGDP risk for people with average relative risk aversion, happens naturally with nominal fixed-payment loans under successful NGDP targeting.  When RGDP decreases (increases) while NGDP remains as expected by successful NGDP targeting, the price level increases (decreases), which decreases (increases) the real value of the nominal payment by the same percentage by which RGDP decreases (increases).

The natural ability of nominal contracts (under successful NGDP targeting) to appropriately distribute the RGDP risk for people with average relative risk aversion pertains not just to nominal loan contracts, but to any prearranged nominal contract including nominal wage contracts.  However, inflation targeting and price-level targeting will circumvent the nominal contract’s ability to appropriate distribute this RGDP risk by making the real value constant rather than varying proportionately with RGDP.

Inflation Indexing and the Two Principles:

Earlier in this blog I discussed how conventional inflation indexing could eliminate that price-level risk when RGDP remains as expected, but NGDP drifts away from its expected value.  While that is true, conventional inflation indexing leads to violations in the Second Principle.  Consider an inflation indexed loan when the principal and hence the payment are adjusted for changes in the price level.  Basically, the payment of an inflation-indexed loan would have a constant real value no matter what, no matter what the value of NGDP and no matter what the value of RGDP.  While the “no matter what the value of NGDP” is good for the First Principle, the “no matter what the value of RGDP” is in violation of the Second Principle.

What is needed is a type of inflation indexing that complies with both Principles.  That is what Dale Domian’s and my “quasi-real indexing” does.  It adjusts for the aggregate-demand-caused inflation, but not to the aggregate-supply-caused inflation that is necessary for the Pareto-efficient distribution of RGDP among people with average relative risk aversion.

Previous Literature:

Up until now, I have just mentioned Bailey (1837) and Selgin (2002) without quoting them.  Now I will quote them.  Selgin (2002, p. 42) states, ““ …the absence of unexpected price-level changes” is “a requirement … for avoiding ‘windfall’ transfers of wealth from creditors to debtors or vice-versa.”  This “argument … is perfectly valid so long as aggregate productivity is unchanging. But if productivity is subject to random changes, the argument no longer applies.”  When RGDP increases causing the price level to fall, “Creditors will automatically enjoy a share of the improvements, while debtors will have no reason to complain: although the real value of the debtors’ obligations does rise, so does their real income.”

Also, Selgin (2002, p. 41) reports that “Samuel Bailey (1837, pp. 115-18) made much the same point.  Suppose … A lends £100 to B for one year, and that prices in the meantime unexpectedly fall 50 per cent. If the fall in prices is due to a decline in spending, A obtains a real advantage, while B suffers an equivalent loss. But if the fall in prices is due to a general improvement in productivity, … the enhanced real value of B’s repayment corresponds with the enhanced ease with which B and other members of the community are able to produce a given amount of real wealth. …Likewise, if the price level were … to rise unexpectedly because of a halving of productivity, ‘both A and B would lose nearly half the efficiency of their incomes’, but ‘this loss would arise from the diminution of productive power, and not from the transfer of any advantage from one to the other’.”

The wage indexation literature as founded by Grey and Fischer recognized the difference between unexpected inflation caused by aggregate-demand shocks and aggregate-supply shocks; the main conclusion of this literature is that when aggregate-supply shocks exist, partial rather than full inflation indexing should take place.  Fischer (1984) concluded that the ideal form of inflation indexing would be a scheme that would filter out the aggregate-demand-caused inflation but leave the aggregate-supply-caused inflation intact.  However, he stated that no such inflation indexing scheme had yet been derived, and it would probably be too complicated to be of any practical use.  Dale Domian and I published our quasi-real indexing (QRI) in 1995 and QRI is not that much more complicated than conventional inflation indexing.  Despite the wage indexation literature leading to these conclusions, the distinction between aggregate-demand-caused inflation and aggregate-supply-caused inflation has not been integrated into mainstream macroeconomic theory.  I hope this blog will help change that.

Conclusions:

As the wage indexation literature has realized, there are two types of inflation:  (i) aggregate-demand-caused inflation and (ii) aggregate-supply-caused inflation.  The aggregate-demand-caused inflation is bad inflation because it unnecessary imposes price-level risk on the parties of a prearranged nominal contract.  However, aggregate-supply-caused inflation is good in that that inflation is necessary for nominal contracts to naturally spread the RGDP risk between the parties of the contract.  Nominal GDP targeting tries to keep the bad aggregate-demand-caused unexpected inflation or deflation to a minimum, while letting the good aggregate-supply-caused inflation or deflation take place so that both parties in the nominal contract proportionately share in RGDP risk.  Inflation targeting (IT), price-level targeting (PLT), and conventional inflation indexing interfere with the natural ability of nominal contracts to Pareto efficiently distribute RGDP risk.  Quasi-real indexing, on the other hand, gets rid of the bad inflation while keeping the good inflation.

Note that successful price-level targeting and conventional inflation indexing basically have the same effect on the real value of loan payments.   As such, we can look at conventional inflation indexing as insurance against the central bank not meeting its price-level target.

Note that successfully NGDP targeting and quasi-real indexing have the same effect on the real value of loan payments.  As such quasi-real indexing should be looked at as being insurance against the central bank not meeting its NGDP target.

A couple of exercises some readers could do to get more familiar with the Two Fundamental Welfare Principles of Welfare Economics is to apply them to the mortgage borrowers in the U.S. and to the Greek government since the negative NGDP base drift that occurred in the U.S. and the Euro zone after 2007.  In a future blog I very likely present my own view on how these Principles apply in these cases.

References:

Arrow, K.J. (1965) “The theory of risk aversion” in Aspects of the Theory of Risk Bearing, by Yrjo Jahnssonin Saatio, Helsinki.

Bailey, Samuel (1837) “Money and Its Vicissitudes in Value” (London: Effingham Wilson).

Debreu, Gerard, (1959) “Theory of Value” (New York:  John Wiley & Sons, Inc.), Chapter 7.

Eagle, David & Dale Domian, (2005). “Quasi-Real Indexing– The Pareto-Efficient Solution to Inflation Indexing” Finance 0509017, EconWPA, http://ideas.repec.org/p/wpa/wuwpfi/0509017.html.

Eagle, David & Lars Christensen (2012). “Two Equations on the Pareto-Efficient Sharing of Real GDP Risk,” future URL: http://www.cbpa.ewu.edu/papers/Eq2RGDPrisk.pdf.

Sargent, Thomas and Neil Wallace (1975). “’Rational’ Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule”. Journal of Political Economy 83 (2): 241–254.

Selgin, George (2002), Less than Zero: The Case for a Falling Price Level in a Growing Economy. (London: Institute of Economic Affairs).

Koenig, Evan (2011). “Monetary Policy, Financial Stability, and the Distribution of Risk,” Federal Reserve Bank of Dallas Research Department Working Paper 1111.

Pratt, J. W., “Risk aversion in the small and in the large,” Econometrica 32, January–April 1964, 122–136.

© Copyright (2012) by David Eagle

 


[1] Technically, the Second Principle should replace “average relative risk aversion” with “average relative risk tolerance,” which is from a generalization and reinterpretation by Eagle and Christensen (2012) of the formula Koenig (2011) derived.

Guest blog: Growth or level targeting? (by David Eagle)

We continue the series of guest blogs by David Eagle on his research on NGDP targeting and related topics.

See also David’s first guest post “Why I Support NGDP Targeting”.

Enjoy the reading.

Lars Christensen

—————————-

Guest blog: Growth vs. level targeting

by David Eagle

In my first guest blog for “The Market Monetarist” I stated that I am in favor of targeting the level of Nominal GDP (NGDP) and not the growth rate of NGDP.  Some economists such as Bennett McCallum (2011) are in favor of NGDP-growth-rate targeting (ΔNT) over NGDP Targeting (NT).

I have long opposed inflation targeting (IT) and I view ΔNT as almost as bad as IT because both cause what we call negative NGDP base drift. In order to understand my arguments against ΔNT and against IT, we need to understand the concepts of NGAP and NGDP base drift.

In this blog, I use an example to illustrate these concepts and the difference between NT and ΔNT.  It also uses another example to help us understand the concepts of PGAP and price-level base drift, and the difference between price-level targeting (PLT) and IT.

Growth vs. Level NGDP Targeting

To see the similarities and differences between targeting the growth rate of NGDP (ΔNT) and the level of NGDP (NT), assume the central bank’s target for NGDP growth  would be 5%.  As long as the central bank (CB) meets that target, NGDP would follow the path Nt = N0 (1.05)t where N0 is the NGDP for the base year and Nt is the NGDP occurring t years after the base year.

For consistency, assume that the CB’s target for NGDP (if it targets the NGDP level) would be Nt* = N0 (1.05)t.  Hence, as long as the central bank meets its target, then NGDP will be the same whether the central bank targets the growth rate or the level of NGDP.

The difference between growth rate targeting and level target occurs when the central bank misses its target.  Assume for example N0 = 10.  Initially, both NT and ΔNT have the same intended NGDP trajectory of Nt = 10(1.05)t; in particular, both NT and ΔNT aim for N1 to be 10.5.  However, assume the central bank misses its target and N1 = 10.08, which is 4% below its targeted level of NGDP.  We define NGAPt as the percent deviation at time t of NGDP from its previous trend; hence in this example NGAP1 = -4%.  Under NT, the central bank will try to make up for lost ground to reduce NGAP to zero and return NGDP back to its targeted path of Nt = 10(1.05)t.

In contrast, under NGDP growth targeting, the central bank will only try to meet its targeted NGDP growth rate of 5% in the future. Hence, under NGDP growth targeting, the central bank will shift its NGDP trajectory to Nt = 10.08(1.05)t-1, which is 4% below the initial NGDP trajectory of Nt = 10(1.05)t. In other words, under NGDP growth targeting, the central bank would let the 4% NGAP continue indefinitely. NGDP base drift occurs when the central bank allows NGAP to continue rather than trying to eliminate that NGAP in the future.

Price Level Targeting vs. Inflation Targeting

The concept of NGDP base drift is related to the concept “price-level base drift,” which many economists such as Svensson (1996) and Kahn (2009) have long recognized to be the theoretical difference between price-level targeting (PLT) and inflation targeting (IT).

In particular, Mankiw (2006) states, “The difference between price-level targeting and inflation-targeting is that price-level targeting requires making up for past mistakes,” while Taylor (2006) states, “Focusing on a numerical inflation rate tends to let bygones be bygones when there is a rise [or fall] in the price level” [brackets added].

Also, Meh, et al (2008) state, “Under IT, the central bank does not bring the price level back and therefore the price level will remain at its new path after the shock.” They go on to say that under PLT, “the central bank commits to bringing the price level back to its initial path after the shock.”

To see the similarities and differences between PLT and IT, assume the central bank’s target for inflation (if it follows IT) would be 2%.  Then the CB’s trajectory for the price level will be Pt = P0 (1.02)t where P0 is the price level for the base year and Pt is the price level occurring t years after the base year.  Similarly assume that the central bank’s price-level target (if it follows PLT) would be Pt* = P0 (1.02)t.  Hence, when the central bank meets its target, the price level will be the same regardless if the central bank follows PLT or IT.

The difference between PLT and IT occurs when the central bank misses its target.  For this example, assume P0 = 100.  Initially, both PLT and IT have the same price-level trajectory of Pt = 100(1.02)t.  In particular, under both PLT and IT, the CB is aiming for Pt  to be 102 at time t=1.  However, assume that the central bank misses its target and Pt = 100.47, which is 1.5% less than its targeted price level of 102.  We define PGAPt to be the percent deviation of the price level at time t from its previous trend; hence, in this example; PGAP1 = ‑1.5%.

Under PLT, the central bank will try to return PGAP back to zero by increasing the price-level back up to its targeted price-level path of Pt = 100 (1.02)t.  Under IT, the central bank will “let bygones be bygones” and merely try to meet its inflation target of 2% in the future.  Hence, under IT, the central bank shifts its price-level trajectory to Pt = 100.47 (1.02)t-1, which is 1.5% below its initial trajectory.  In other words, the central bank lets the -1.5% PGAP continue into the foreseeable future.  Price-level base drift occurs when the central bank allows PGAP to continue rather than trying to eliminate that PGAP in the future.

Price-level base drift implies NGDP base drift

Because IT leads to price-level base drift, it also leads to NGDP base drift.  To illustrate with an example, assume the long-run growth rate in real GDP (RGDP) is 3% and RGDP in the base year is Y0 = 10 trillion dollars.  Therefore, when the central bank expects RGDP to grow at its long-run growth rate, it expects Yt = 10(1.03)t.

Initially in this example when the central bank has a 2% inflation target, the central bank’s trajectory for the price level under inflation targeting is Pt = 100 (1.02)t.  Since Nt=PtYt/100 when we use 100 as the price level in the base year, this means that the CB’s trajectory for NGDPt is Nt = 10 (1.02)t(1.03)t.  When it turned out that P1 was 100.47 instead of 102, the central bank following IT would shift its price level trajectory to Pt = 100.47 (1.02)t-1 and its NGDP trajectory to Nt = 10.047 (1.02)t-1(1.03)t, which is 1.5% below its initial NGDP trajectory.  Therefore, NGAP under this trajectory will be -1.5%, which means a negative NGDP base drift.

“Inflation targeting” can be many things

In practice, inflation targeting is not as simple as I described above or even as several of the economists I quoted described it.   In practice, central banks following inflation targeting target a long-run rather than a short-run inflation rate.  They also try to target “core inflation” rather than general inflation.  Also, they do consider output gap and unemployment as well as inflation.  Therefore, the question whether IT in practice leads to NGDP base drift is primarily an empirical one.

According to my empirical research that I plan to report in a later blog, past U.S. monetary policy has on average resulted in a significant negative NGDP base drift.  Also, that research indicates that the primary reason for the prolonged high unemployment following a recession is this negative NGDP base drift.

References:

Kahn, George A. (2009). “Beyond Inflation Targeting: Should Central Banks Target the Price Level?” Federal Reserve Bank Of Kansas City Economic Review (Third quarter), http://www.kansascityfed.org/PUBLICAT/ECONREV/pdf/09q3kahn.pdf

Mankiw, Greg (2006). “Taylor on Inflation Targeting,” Greg Mankiw’s Blog (July 13) http://gregmankiw.blogspot.com/2006/07/taylor-on-inflation-targeting.html

McCallum, Bennett, “Nominal GDP Targeting” Shadow Open Market Committee, October 21, 2011, http://shadowfed.org/wp-content/uploads/2011/10/McCallum-SOMCOct2011.pdf

Meh, C. A., J.-V. Ríos-Rull, and Y. Terajima (2008). “Aggregate and Welfare Effects of Redistribution of Wealth under Inflation and Price-Level Targeting.” Bank of Canada Working Paper No. 2008-31, http://www.econ.umn.edu/~vr0j/papers/cvyjmoef.pdf

Svensson, Lars E. O. (1996). “Price Level Targeting vs. Inflation Targeting: A Free Lunch?” NBER Working Paper 5719, http://www.nber.org/papers/w5719.pdf, accessed on January 4, 2012.

Taylor, John (2006). “Don’t Talk the Talk: Focusing on a numerical inflation rate tends to let bygones be bygones when there is a rise in the price level.” The Economist (July 13), http://online.wsj.com/article/SB115275691231905351.html?mod=opinion_main_commentaries

© Copyright (2012) David Eagle


Guest post: Why I Support NGDP Targeting (by David Eagle)

Welcome to David Eagle

I am extremely happy that professor David Eagle have accepted to write a series of guest blogs on my blog. I only recently became aware of David’s impressive research, but consider it to be truly original and in my view his research presents an extremely strong theoretical and empirical case for Nominal GDP level targeting, which of course is at the core of Market Monetarist thinking.

I have already written a number of posts on David’s research and even tried to elaborate on his research specifically in terms of suggesting a method – based on David’s research – to decompose inflation between demand inflation and supply inflation based on what I strongly inspired by David has termed a Quasi-Real Price Index (QRPI) and it is my hope that my invitation to David to write the guest blogs will help give exposure to his very interesting research. Furthermore, I hope that other researchers will be inspired by David’s truly path-breaking research to conduct research into the advantages of NGDP level targeting and related topics.

So once again, thank you David. It is an honour to host your guest blogs.

Lars Christensen  

 

Why I Support NGDP Targeting

By David Eagle

Nominal GDP (NGDP) represents the total spending in the economy, which in essence is the total aggregate demand in the economy.  The term “nominal” means that we ignore the effect of inflation on the value of the spending.  If we adjust for the effect of inflation, we then get a “real” value.  In particular, real GDP (RGDP) represents the total spending adjusted for the effect of inflation on the purchasing power of that spending.  RGDP also represents the conventional measure of total real supply in the economy because usually demand equals supply in a free economy.  I believe that, for most contingencies in the economy, both monetary policy and fiscal policy (as far as its aggregate-spending effects) should focus on targeting the total spending in the economy as measured by NGDP.  That way we will (i) reduce the prolonged high unemployment that has usually followed past recessions, (ii) minimize the demand-caused inflation uncertainties people experience while maintaining the role inflation or deflation plays in the sharing of aggregate-supply risk, (iii) reduce the likelihood of the economy experiencing a liquidity trap, and (iv) eliminate the “stimulate-the-economy” excuse for perpetual fiscal deficits when NGDP is at or above its target.

While I support nominal-GDP targeting (NT), I do not support nominal-GDP-growth-rate targeting (ΔNT).  I have long been an opponent of inflation targeting (IT), and I view ΔNT to be almost as bad as IT.  Both ΔNT and IT expose the economy to negative NGDP base drift, which is the source of several economic problems: (i) prolonged unemployment following recessions, (ii) greater uncertainty for borrowers, lenders, and other payers and receivers of fixed nominal future payments, and (iii) price-level indeterminacy, which can manifest itself in a liquidity trap like what many central banks throughout the world are currently facing.

I also am an opponent of price-level targeting (PLT) even though the NGDP base drift under PLT will be substantially less than under IT.  The reason is because Pareto efficiency requires people with average relative risk aversion to proportionately share in the risks of changes in real aggregate output.  Nominal contracts under NT naturally lead to this proportionate sharing.  However, PLT circumvents that proportionate sharing so that borrowers and other payers of fixed nominal payments absorb all the aggregate-supply risk of those payments in order to protect lenders and other receivers of fixed nominal payments from this risk.

I find that NT Pareto dominates PLT, IT, and ΔNT.  The only reason why NT is not Pareto efficient is a central bank cannot always meet its NGDP target.  I also find through empirical simulations that NT can eliminate the vast majority of the higher-than-normal, long-term unemployment that has usually plagued our economies following recessions.  Hence, I look at NT as the most desirable targeting regime from both a theoretical, Pareto-efficiency standpoint and from an empirical standpoint.

In the upcoming weeks, I plan to write several more guest blogs for “The Market Monetarist” to explain the theoretical and empirical justification for the points I have made in this introduction.  In some cases I will explain the full basis for that justification; in other cases, I will refer to other papers I or others have written.  My proposed blogs (which may change as I write this blogs) are as follows:

  1. Understanding NGAP, NGDP Base Drift, and Growth Vs. Level Targeting
  2. The Two Fundamental Welfare Principles of Monetary Economics
  3. Why Price-Level Targeting Pareto Dominates Inflation Targeting
  4. NGDP Base Drift – Why Recessions are followed by Prolonged High Unemployment
  5. NGDP Base Drift, Price Indeterminacy, and the Liquidity Trap
  6. Three Reasons to Target the Level of rather than the Growth Rate of Nominal GDP

My second blog will use examples to explain the concepts of NGAP, NGDP base drift, and the difference between targeting the level of NGDP and Targeting the growth rate of Nominal GDP.  This blog will also summarize the difference between price-level targeting and inflation targeting, and discuss the concepts of PGAP and price-level base drift.

© Copyright (2012) David Eagle

 

Guest post: J’Accuse Mr. Ben Bernanke-San

Benjamin Cole is well-known commentator on the Market Monetarist blogs. Benjamin’s perspective is not that of an academic or a nerdy commercial bank economist, but rather the voice of the practically oriented advocate of Market Monetarist monetary policies.

I greatly admire Benjamin for his always frank advocacy for monetary easing to pull the US economy out of this crisis. I often also disagree with Benjamin, but my blog is open to free and frank discussion of monetary policy issues. I have therefore invited Benjamin to share his views on US monetary policy and to outline his monetary plan for revival of the US economy.

Benjamin’s advocacy brings memories of the 1980s where the US right had a pro-growth agenda that spurred optimism not only in the US, but around the world.  I am grateful to Benjamin for his contribution to my blog and hope my readers will enjoy it.

Benjamin, the floor is yours…

Lars Christensen

Guest post: J’Accuse Mr. Ben Bernanke-San

By Benjamin Cole

Regime Uncertainty? The business class of the United States needs a clear picture of where the Federal Reserve Board plans to go, and assurance that the Fed is will brook no obstacle or political interference in its journey.

Moreover, the Fed must define our future not only in terms of policies, but clear targets.  Lastly, the Fed must eschew any regime that places prosperity below other related goals.  The Fed’s obligations are catholic, enduring and immediate—and cannot be dodged by citing adherence and slavish rectitude towards “price stability,” however defined. Beating inflation is easy—the Bank of Japan has proved that, and redundantly.

Providing a regime for prosperity is another matter.

Recent events prove that the Fed, like the Bank of Japan, has failed in its true mission—sustained economic prosperity—perhaps aided by mediocre federal regulatory and tax policies.

The Cure—Market Monetarism

Ben Bernanke, Fed chieftain, must forthrightly embrace the targeting of growth in nominal gross domestic product, or NGDP, then publicly set targets, and then identify the appropriate, aggressive and sustained policies or mechanisms to reach the NGDP targets.  These are basic market monetarism principles.  Feeble dithering is not Market Monetarism.

Transparency, clarity and resolve in government are tonics upon markets, as they are upon democracies.  There is no better way to govern, whether from the White House or the Federal Reserve.   Ergo, Bernanke needs to directly, with resolve and without equivocation, dissembling or qualifiers, adopt of NGDP target of 7.5 percent annual growth for the next four years.  To get there, Bernanke needs to affirm to the market that the Fed will conduct quantitative easing to the tune of $100 billion a month until quarterly readings assure that we have reached the 7.5 percent level of NGDP growth—a policy very much in keeping with what the great economist Milton Friedman recommended to Japan, when he advised that nation in the 1990s.  Forgotten today is not only did Friedman advocate tight money for restraining inflation, but he also advocated aggressive central bank action to spur growth in low-inflation environments.

The recommended concrete sum of $100 billion a month in QE is not an amount rendered after consultation with esoteric, complex and often fragile econometric models.  Quite the opposite—it is sum admittedly only roughly right, but more importantly a sum that sends a clear signal to the market.  It is a sum that can be tracked every month by all market players.  It has the supreme attributes of resolve, clarity and conviction. The sum states the Fed will beat the recession, that is the Fed’s goal, and that the Fed is bringing the big guns to bear until it does, no ifs, ands, or buts.

At such time that the NGDP growth targets are hit, the Fed should transparently usher in a new rules-based regime for targeting NGDP going forward, drawing upon the full range of tools, from interest rates to QE to limiting interest on excess reserves at commercial banks.

At the present, the Fed needs to stop rewarding banks to sit on their hands, as it does when it pays banks 0.25 percent annual interest on excess reserves.  This is not a time for “do nothing” policies, or to promote caution and inaction on the part of our nation’s banks.  Bankers always want to lend, especially on real estate, in good times—oddly enough, when risks to capital are highest. In bad times (after property values have cratered) banks don’t want to lend.  No need to the Fed to exacerbate this market curiosity.

Consider the current economic environment: Our countrymen are too much unemployed; indeed they are quitting the labor force, and labor participation rates are falling.  Our real estate industry is in a shambles, and the Dow Jones Industrial Average is languishing at levels breeched 13 years ago.  Ever more we resemble Japan.  In the United States, real GDP is 13 percent below trend, with attendant losses in income for businesses and families.  Investors have been kicked in the head—it is precisely the wrong time for do-nothing leaders, timid caretakers or kowtowing to the Chicken Inflation Littles.

That said, certain policies seem to reward unemployment, most notably the extended unemployment insurance.  The record shows people tend to find jobs when insurance runs out.  Ergo, unemployment insurance should not be extended—harsh medicine, but necessary for harsh times.

The American Character

The worst course of action today is to allow a peevish fixation—really an unhealthy obsession—with inflation to undercut a confident and expansionary monetary policy.

The United States economy flourished from 1982 to 2007—industrial production, for example, doubled, while per capita rose by more than one-third—while inflation (as measured by the CPI) almost invariably ranged between 2 percent and 6 percent. That is not an ideology speaking, that is not a theoretical construct.  It is irrefutably the historical record.  If that is the historical record, why the current hysterical insistence that inflation of more than 2 percent is dangerous or even catastrophic?

Why would Bernanke genuflect to 2 percent inflation—even in the depths of the worst recession since the days of Franklin Delano Roosevelt?  It is an inexplicably poor time to pompously pettifog about minute rates of inflation.

Add on: Americans like boom times; investors take the plunge not when they sense a pending 2 percent increase in asset values, but that home runs will be swatted. Few invest in real estate or stocks assuming values will rise by 2 percent a year.  Americans need the prospect of Fat City.  We have the gambling streak in us.  The Fed and tax and regulatory code must reward  risk-taking, a trait deep in the American character, but suffocated lately by the Fed’s overly cramped, even perversely obstinate monetary policy.  Is there anything more deeply annoying than prim announcements from the Fed that it could do more for the economy, but is not?

While the American business class needs assurance of a pro-growth monetary policy, instead the Fed issues sermonettes that caution, to the point of inaction, is prudent.  Every commodities boom—and commodities prices are determined in global markets and speculative exchanges—chills the American business class, who then fear the monetary noose of the Fed will draw tight.  That sort of regime uncertainty destroys investment incentives.

Some say the Fed cannot stimulate, as the economy cannot expand under he current regulatory regime, and thus only inflation will result. To be sure, the U.S. federal government needs to radically reconsider its posture towards business, and abandon any hint of an adversarial stance.  It is the private sector, for of all its flaws, that generates innovations and a higher standard of living.  The private sector, every year, does more with less, while the opposite is true of the federal government, civilian and military. Shrinking the federal government share of GDP to 18 percent or less should also be a goal.

However, in no way should monetary policy be held captive to the fiscal policy objectives or outcomes.  Whatever the share of federal spending of total outlays, or whatever the size of the federal deficit, or whatever regulatory regime is in place, the Fed must always target NGDP, to give at least that level of regime certainty to our business class.  By and large, today’s tax and regulatory regime is better than that of the 1970s, and on par with that of the 1980s and 1990s.  And most concede the United States has a better regulatory posture than the governments of Europe, or even that of mainland China.  The productivity of US workers is still rising, and unit labor costs are actually falling.  The regulatory environment could be improved, but that is no grounds to add to woes by an unpredictable and restrictive monetary policy.

Conclusion

There are times in history when caution is not rewarded, and for the crafters of monetary policy, this is one of those times.  What appears prudent by old shibboleths is in fact precarious by today’s realities.   Feeble inaction, and stilted moralizing about inflation are not substitutes for transparent resolve to reinvigorate the United States economy.

Market Monetarism is an idea whose time has come.  It offers a way to prosperity without crushing federal deficits, and offers regime stability to the American business class.

The only question is why Bernanke instead chooses the pathway cleared by the Bank of Japan.

Guest blog: Central banking – between planning and rules

I have asked Alex Salter to give his perspective on the ongoing debate about “Central banking is (not) central planning” in the blogosphere.

David Glasner also has a new comment on the subject.

But back to Alex…

……………

Guest blog:  Central banking – between planning and rules

Alex Salter
asalter2@gmu.edu

I’ve been reading about the central banking vs. central planning debate on the blogosphere; the more I think about it the more interesting it becomes. Whether central banking is a form of central planning depends on what exactly the central bank does.  There are two broad scenarios.  In the first, the central bank is following some sort of rule or trying to hit a target.  This can be a Taylor rule, inflation target, NGDP level target, or anything else.  In this case the central bank is trying to provide a stable economic setting so that individuals can effectively engage in the market process.  If this is what the central bank is doing, I don’t think it makes sense to call it central planning. All the central bank is trying to do is lay down the “ground rules” for economic behavior. If this is central planning, you could just as easily say any institution such as property rights or the rule of law is central planning too. This obviously isn’t a useful definition of central planning!

However, a central bank may be engaging in a type of central planning if it tries to bring about a specific allocation of resources.  For example, if the central bank thinks equities prices should be higher for some reason, and they start purchasing equities, you could make an argument that this is a type of central planning.  If the central bank explicitly tries to monetize the debt and acts as an enabler for the nation’s treasury department, you could also say this is a form of central planning.  It’s still not 100% clear, since presumably the central bank is not using coercion or the threat of coercion to get market participants to behave in the way it wants; there’s voluntary assent on the other side of the agreement, even if that voluntary assent is a response to warped incentives.

In closing: if a central bank is trying to create a specific framework in which agents can operate, it’s not central planning, it’s rule setting.  If on the other hand the central bank is trying to allocate specific resources, it may be a form of central planning.  In either scenario, the usual knowledge and incentive problems still apply.

Guest blog: An Austrian Perspective on Market Monetarism

Alex Salter
asalter2@gmu.edu

Due to my insistence on the relevance of Austrian economics to monetary theory, and to Market Monetarism in particular, in the comments section of this blog, Lars has invited me to do a guest post on how Austrian conceptions of the market economy and the role of money lead to conclusions shared by many Market Monetarists.

As a disclaimer, I should note that scholars who identify as Austrian or Austrian-influenced hold an incredibly diverse set of beliefs, at least as diverse as adherents of other schools such as New Keynesianism, and the degree to which these scholars endorse what I write below varies widely. That being said, this is my best attempt to characterize what I believe are the uniquely Austrian contributions to economics and how they relate to Market Monetarism. I can think of no better way to do this than by relating these contributions to the two key tenets of Market Monetarism: markets matter and money matters.

All That…
Markets Matter
The coordinating role of markets is appreciated by many scholars of many schools of economic thought. What makes the Austrian conception unique is its particular focus on the market not as a Walrasian allocator or some other trading institution, but as a process. Whereas other schools focus on analyzing conditions of market equilibrium, the Austrian conception of the market process is a theory of disequilibrium. (Most Austrians believe there is an overall trend towards equilibrium due to entrepreneurial individuals constantly reallocating resources such that their value to society in finished goods and services asymptotically approaches their opportunity cost.)

The analysis centers on individuals pursuing given ends using specific means within the constraints imposed by imperfect knowledge and institutional context. Emphasizing purposeful action amidst a constellation of disequilibrium prices focuses the analysis on how the self-interested interactions of many, many agents brings about an extended order which reconciles each individual’s plans with those of everyone else, even when those plans are initially contradictory.

The massive web of trade relationships coordinated by a functioning price mechanism which economizes on the knowledge any one actor needs is central to market process economics. Fundamental to this idea is the concept of economic calculation –the process by which profit-driven individuals rationally allocate resources to their highest-valued uses through the ex ante expectation of profit and the ex post realization of profit. Economic calculation, with the profit and loss system as the feedback mechanism, is the way which individuals integrate themselves within the extended order to satisfy their own wants while simultaneously transmitting information back to the system. In order for economic calculation to be possible, society must have achieved a division of labor extensive enough for the adoption of a widely-used medium of exchange –in a word, money.

Without money as a common denominator, economic calculation could not extend beyond the provision of final consumption goods and the simplest capital goods. Technological progress, and hence economic growth, would progress at a snail’s pace if it progressed at all. The extensive capital structure of an economy could not exist without the medium of money. Thus we have a clear segue to the second of Market Monetarism’s core tenets: money matters

Money Matters
Since all goods are priced in terms of money, money is the cornerstone of economic calculation. When the money market is in equilibrium (when the supply of money equals the demand to hold it) the purchasing power of money is stable and the prices of various goods and services reflect real (as opposed to nominal) factors. However, the money market is not always in equilibrium. The supply of money can exceed the demand to hold it and vice versa. This is the root of many Austrians’ rejection of the (short-run) neutrality of money. Consider an excess supply of money brought about by a central bank unnecessarily engaging in open market operations.

This intervention gives an advantage to the first recipient of the new money relative to all other market actors, and the first recipient’s spending on his or her preferred consumption bundle creates a (admittedly very small) distortion in relative prices. As the new money spreads throughout the economy, these relative price discrepancies grow; since prices are the chief signals to which market actors respond, these price discrepancies lead to a misallocation of resources. (This phenomenon is known as the Cantillon effect, named after the Irish economist who first wrote about it in the early 18th century.) Thus an irresponsible central bank can be a source of significant economic disturbance.

What we want is a monetary framework which is stable enough to facilitate rational economic calculation while still allowing prices to reflect real factors. This is why many Austrians view Market Monetarism favorably: Given the existence of a central bank, pursuing a policy of nominal income targeting stabilizes the money market by supplying market actors with money when their demand to hold money exceeds its supply, and soaking up excess money when the supply of money exceeds the demand to hold it. This can be achieved either through a static or dynamic nominal income target. To see how, consider Marshall’s conception of the money market, where the purchasing power of money –its “price” –is determined by the supply and demand of money:

(1) Ms=M*
(2) Md=φPy

These two equations say the supply of money (Ms) is exogenously set at M* (as under a central bank), and the demand to hold money (Md) is proportional to nominal income. φ is called fluidity, which can be thought of as the fraction of nominal income (the price level P multiplied by real output y) held by individuals as money balances in a given time period. It is by definition the inverse of velocity (V):

φ≡1/V

Setting equal the supply and demand of money yields M*=φPy; substituting in the definition of fluidity and multiplying both sides by V yields the familiar quantity theory equation:

M*V=Py

Some Market Monetarists, Scott Sumner being the most notable, have called for a nominal income target, level targeting, with nominal income growing at five percent per year. This too is consistent with maintaining monetary equilibrium since the above equality also holds, conditional upon the correct expectations of market actors, in its dynamic form:

%∆M*+%∆V=%∆P+%∆y

%∆X means “The percentage change in Variable X per time period.” In the above equation the combined growth rate of P and y would, in Sumner’s world, equal five percent. Conditional upon constant velocity, this means supplying relatively less additional money when real output increases relatively more.

Stabilizing nominal income (Py or its growth rate) means supplying more money when the velocity of money falls (and hence fluidity rises, meaning money demand rises) and doing the opposite when the velocity of money rises. This has the advantage of stabilizing the purchasing power of money in the event of monetary disequilibrium (disequilibrium in the money market) while still allowing price fluctuations due to changing real factors which reflect relative scarcity. (This latter point is the key advantage nominal income targeting has over price level targeting.)

In other words, a nominal income target yields the stability necessary for rational economic calculation without the distortions which monetary disequilibrium causes and otherwise could only be corrected by a market-wide reallocation of misused resources, which is bound to include unnecessary unemployment and reduced production.

…And a Bag of Chips
Many Austrians and Austrian-influenced economists view Market Monetarism favorably due to its emphasis on maintaining a stable monetary framework, which means making money as neutral as it possibly can be. Of course, there are always going to be small distortions in relative prices depending on the injection point. The central bank by its very nature is an imperfect institution and lacks the incomprehensibly large stock of knowledge necessary to implement perfectly a policy of absolute monetary neutrality. Many Austrians’ support of free banking, mine included, as a first-best alternative to a central bank is in part motivated by the versatility and robustness of a decentralized versus centralized banking system. In addition, public choice considerations may also cut against having a central bank.

Nevertheless, an explicit static or dynamic nominal income target would be a massive improvement over the current state of affairs and is closer to being a feasible point on the policy possibilities frontier. The key point to take away from all this is that the Austrian conception of the market process and the importance of economic calculation leads naturally to the desirability of maintaining a stable monetary framework. Although there is certainly debate over which institutions best promote monetary equilibrium, Market Monetarists and sympathetic Austrians have a clear common ground and there is much we can learn from each other going forward.

————————————————————————

Lars Christensen

I am very happy that that Alex has accepted my invitation to write a guest blog on marketmonetarist.com. Alex’s excellent and insightful post shows that Austrians and Market Monetarists indeed share many views and I hope to continue the dialogue with open-minded Austrians like Alex in the future.

Furthermore I am happy to invite others who want to discuss the merits of Market Monetarism to contribute with guest blogs here on this blog and I hope that Alex also in the future will share his views on both the development of the Austrian school as well as on Market Monetarism.

 

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