All posts in category Monetary policy rules

How I would like to teach Econ 101

Recently our friend Nick Rowe commented on what he considers to be wrong arguments by Joseph Stiglitz and Bryan Caplan. Nick obviously is a busy bee because he had time to write his comment in between exams (you might have noticed that the blogging among the Market Monetarist econ professors has gone down a bit recently – they have all been busy with exams I guess…). Nick’s comment and the fact that he was busy with exams inspired me to write this comment.

The purpose of my comment is not to comment on Nick’s view of Stiglitz and Caplan – Nick is of course right as usual so there no reason to try to disagree. However, something Nick said nonetheless is worthwhile commenting on. In his comment Nick states: “Macro is not the same as micro.”

That made me think – and this not to disagree with Nick but rather he inspired me to think about this – that maybe it is exactly the problem that the “normal” view is that macro and micro is not the same thing.

The fact is that when I started studying economics more than 20 years ago at the University of Copenhagen we where taught Micro 101 and Macro 101. There was basically no link between the two. In Micro with learned all the basic stuff – marginalism, general equilibrium, Walras’ Law and the Welfare theorems etc. In Macro 101 there was (initially) no mentioning of what we learned in Micro, but we instead started out with some Keynesian accounting: Y=C+I+G+X-M. Then we moved on to the IS-LM model. The AD-AS model did not get much attention at that time as far as I remember. Then we were told about some “crazy” people who thought that money matters, but that did not really fit into the models because we didn’t really differentiate between real and nominal. Why should we? Prices where fixed in our models. As a consequence most students of my time chose either to specialise in the highly technical and mathematically demanding microeconomic theory (that seemed very far away from the real world) or you focused on real world problems and specialised in macroeconomics which at that time was quite old school Keynesian. Things have since changed with the New Keynesian revolution and macroeconomics have now adopted a lot of the mathematical lingo and rational expectations have been introduced, but it is my feeling that most economics students both in Europe and the US to a very large degree still study Micro and Macro as very separated disciplines and that I think is a huge problem for how the average economist come to see the world.

While macroeconomics as discipline undoubtedly today has much more of a micro foundation than use to be the case the starting point often still is Y=C+I+G+X+M. So yes, we might have a micro foundation for how C (and I for that matter) is determined but we still end up adding up C (and I) with the other variables on the right hand side of the equation – leaving the impression that the causality runs from the right hand side of the equation to the left hand side of the equation. The next thing we do is to come up with some theory for inflation and then we add that on top of Y to get nominal GDP, but again this is rarely discussed. The world is just real to most econ students (and their professors). That then leave the impression that real GDP determines inflation (most often via a Phillips curve of some kind).

So what would I do differently? Well nothing much in terms of microeconomics. I guess that is more or less fine (To my Austrian friends: Maybe if somebody could elaborate on the entrepreneur and give a Nobel prize to Israel Kirzner for that then that could be part of Micro 101 as well). For the purpose of moving from micro the macro I think the most important thing is to understand general equilibrium and that in Arrow-Debreu world there are no recessions. Prices clear all markets. There are never over or under supply of goods and services.

“And then we move on to macroeconomics” the professors says. And instead of telling about Y=C+I+G+X-M he instead says…

“You remember that we had n goods and n prices and that one agent’s income was another person’s consumption/expenditure. Well, that is still the case in macroeconomics, but in the macroeconomy we also have something we call money!”

Lets assume we maintain the assumption that prices are flexible (wages are also prices). Then the professors tells about aggregation so instead we can aggregate prices into one price index P and all goods into one index Y.

And then professor smiles and says “its time to hear about the equation of exchange”:

(1) MV=PY

“Wauw!” screams the students. “You have just introduced money to the Arrow-Debreu World! Amazing!”. Did we just go from micro to macro? Yes we did!

The professor explains to the students that (1) can be rearranged into

(1)’ P=MV/Y

The professor tells the students that we call (1)’ the AD curve and that we can write a AS curve Y=f(K,L) (“you remember production functions from Micro 101” the professors notes).

The students are obviously very impressed, but they also think it is completely logical.

The professor has now introduced the AD-AS model (and the dynamic AD-AS model). Since AD is just (1)’ the professor has not started to talk about fiscal policy (what multiplier??). In his head the AD curve can be shifted by shocks to M or V, but that has nothing to do with fiscal policy. In “his” AD-AS model fiscal policy does really not exist, as it is basically a micro phenomenon – fiscal policy might have an impact on relative prices, but it has no impact on the PY aggregate and fiscal policy might impact the supply side of the economy, but not the AD-curve? No, of course not.

The students are of course eager to hear what their new tool “money” can be used for and a clever student asks “Professor, what is the optimal monetary policy?”.

The professors answers “Do you remember the welfare theorems?”.

Student: “Yes, of course professor”.

Professor: “Good, then it is simple – we need a monetary policy that ensures a Pareto optimal allocation of consumption between different goods (including capital goods) and periods”.

Student: “But professor in the Arrow-Debreu world the market (relative prices) took care of that”.

Professor: “Exactly! So we should ‘emulate’ that in the macro world – how do we do that?”

Student: “That’s easy! We just fix MV!”

Professor: “Correct – you are absolutely right. In the world of monetary policy we call that Nominal Income Targeting or NGDP level targeting. It is one of the oldest ideas in monetary theory”.

Student: “Wauw that is cool. So when we fix that we don’t really have to think about aggregation and the macroeconomy anymore – correct?”

Professor: “Correct – and we could easily move back to Micro now”

That is of course not the whole story – the professor will of course introduce rigid prices and rational expectations. And of course when the NGDP targeting is sorted out then the students realise that generating wealth and prosperity is about increasing productivity – and of course they will learn about the supply side, but again they learned about production functions and savings and investments in Micro 101. But there is no need to introduce Y=C+I+G+X-M. Obviously it still holds formally, but it is not really interesting in the sense of understanding macroeconomics.

So Nick is not totally correct – macro and micro is basically the same thing if we have NGDP targeting. Where things go wrong is when we mess up things with another monetary policy rule (for example inflation targeting), but that kind of imperfects we will introduce in the next semester!

—-

PS The very clever student might ask “who produces money?” – Professor Selgin would answer “that is up to the market” and the student will reply “that makes sense – the market produces and allocates other goods very well so why not money?”.

21 Comments
by Lars Christensen on December 23, 2011  •  Permalink
Posted in Economic and monetary history, Free Banking, General economic theory, George Selgin, MM Research agenda, Monetary institutions, Monetary policy, Monetary policy rules, NGDP Targeting, Nick Rowe, Nominal Income Targeting
Tagged

Posted by Lars Christensen on December 23, 2011

https://marketmonetarist.com/2011/12/23/how-i-would-like-teach-econ-101/

Scott is right: Recessions are always and everywhere a monetary phenomenon – just look at QRPI

Scott Sumner has a couple of fascinating posts on recessions on his blog (see here and here).

Scott argues strongly that recessions are a result of nominal shocks rather than real shocks. Scott uses an innovative measure to identify US recessions since 1948. Scott claims that the US economy can be said to be in recession if the unemployment rate increases by 0.6% or more over a 12 months period. That gives 11 recessions since 1948 in the US.

I have compared the timing of these recessions with my measure of “demand inflation” based on my Quasi-Real Price Index (QRPI). If Scott is right that nominal shocks are the key (the only?) driver of recessions then there should be a high correlation between demand inflation and recessions.

The correlation between the two measures is remarkably strong. Hence, if we define a negative nominal shock as a drop in demand inflation below 0% then we have had 7 negative nominal shocks since 1948 in the US. They all coincide with the Sumner-recessions – both in timing and length.

The only four of Scott’s recessions not “captured” by the QRPI development are the recessions in 1970s and the 1980s where demand inflation (and headline inflation) was very high. Furthermore, it should be noted that in two out of four “unexplained” recessions demand inflation nonetheless dropped significantly – also indicating a negative nominal shocks. This basically means that 9 out of 11 recessions can be explained as being a result of nominal shocks rather than real shocks.

Hence, the evidence is very strong that if demand inflation drops below zero then the US economy will very likely enter into recession.

So yes, Scott is certainly right – recessions are always and everywhere a monetary phenomenon! (at least in 80%  of the time). So if the Fed want to avoid recessions then it should pursuit a target for 2% growth path for QRPI or a 5% growth path for NGDP!

1 Comment
by Lars Christensen on December 21, 2011  •  Permalink
Posted in David Eagle, Deflation, Economic and monetary history, Federal Reserve, Inflation, MM Research agenda, Monetary policy, Monetary policy rules, Quasi-Real Indexing, Quasi-Real Price Index, Scott Sumner
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Posted by Lars Christensen on December 21, 2011

https://marketmonetarist.com/2011/12/21/scott-is-right-recessions-are-always-and-everywhere-a-monetary-phenomenon-just-look-at-qrpi/

Defining central bank credibility

In a comment to my previous post on QE and NGDP targeting Joseph Ward argues that the Federal Reserve has “relatively solid central bank credibility”. The question is of course how to define central bank credibility.

To me a central bank is credible if the markets (and the general public) expect the central bank to hit the targets it have. The problem of course for the Fed is that it does not have a target. That makes it pretty hard to say whether it is credible or not.

Another way of saying whether a central bank is credible or not is to look at the predictability of nominal variables: money suppy, velocity, nominal wages, prices, inflation, NGDP, the exchange rates etc. I am pretty sure that if you estimate of example simple AR-models for these variables you will see the error-term in the models has exploded since 2008. I must, however, say I am guessing here. but I am pretty sure I am right – maybe an econometrician out there would try to estimate it?

In the case of the ECB the collapse in credibility is pretty clear. The ECB used to have a two-pillar policy – targeting directly or indirectly M3 growth and inflation. Judging from market expectations for medium term inflation the credibility is not good – in fact it has never been this bad. Medium-term inflation expectations are well-below the 2% inflation target. In terms of M3 the ECB has normally targeted a reference rate around 4.5% y/y. The actual growth rate on M3 is much below this “target”.

HOWEVER, if the central banks were indeed so credible then the markets should fully believe any nominal target they would announce. So if the Fed is 100% credible and announce that it will increase NGDP by 15% over the coming two years then there should be no problem meeting this target – without printing more money. What would happen is the money-velocity would jump, which with an unchanged money supply would increase NGDP.

During the Great Moderation there was a very high degree of negative correlation between M and V growth in the US. This indicates in my view that markets expected the Fed to meet a NGDP “target” and in that sense monetary policy became endogenous – pretty much in the same way as in a Selgin-White Free Banking model.

4 Comments
by Lars Christensen on December 14, 2011  •  Permalink
Posted in Chuck Norris, Monetary institutions, Monetary policy, Monetary policy rules, MV=PY, NGDP Targeting, Nominal Income Targeting, The Great Moderation
Tagged , ,

Posted by Lars Christensen on December 14, 2011

https://marketmonetarist.com/2011/12/14/defining-central-bank-credibility/

Friedman should have supported NGDP targeting, but never did

I found yet another gold nugget in David Eagle’s research:

“In 2005 at the WEAI conference in San Francisco, Milton Friedman participated in panel where he strongly endorsed IT. After the panel presentations, an economist from the audience asked Friedman how he thought the Federal Reserve should respond to a broad-based 10% drop in real GDP. After spending some time trying think about what could possibility cause such a drop, Friedman responded by saying that the Federal Reserve should respond with a 10% drop in the money supply. However, immediately thereafter, Friedman inserted, “If you ask a foolish question, you get a foolish answer.””

Eagle continues:
“We disagree with Friedman concerning the foolishness of considering unexpected deviations in real GDP because that is when NIT (NGDP targeting) diverges from PLT (Price Level Targeting). Only by considering such unexpected real deviations can we see the differences in central bank responses under IT (Inflation targeting) or PLT from NIT (which we consider to be the equivalent of Friedman’s k percent rule). According to the new equation of exchange, N=PY, if Y unexpectedly increased while N (Nominal spending) remained as expected, the price level would unexpectedly fall. Under NIT, the central bank would be content to do nothing since N is on target. However, under PLT, the central bank would try to interject funds into the monetary system to try to raise N to match the increase in Y in order to return P to its targeted level. Similarly, if Y unexpectedly decreased while N remained as expected, the price level would unexpectedly increase. Under NIT, the central bank would be content to do nothing since N is on target. However, under PLT, the central bank would try to withdraw funds to try to cause N to fall to match the decline in Y in order that the price level not change.”

Hence, shortly before his dead Friedman indirectly said that he was not in favour of NGDP targeting. In my view that is not overly surprising. At that time official inflation targeting had been a success around the world for more than a decade and Friedman undoubtedly saw it as an vindication of his view that central banks should follow rules. So as always Friedman was the pragmatic revolutionary he simply support the successfully (at that time) version of a monetary rule, but I think that was on purely pragmatic reasons. Furthermore, one have to remember that at that time the primary monetary mistakes in recent history was too loose monetary policy rather than too tight monetary policy so from a pragmatic perspective it made “sense” to support inflation targeting.

As I have earlier argued Milton Friedman also acknowledged that velocity was no longer stable and that probably moved him from the left hand side to the right hand side of equation of exchange. By the way that shows that John Taylor’s use of Friedman to criticizing NGDP targeting by stating that Friedman argued that rules should be instrument rules really does not live up to what Friedman came believe in the final years of his life. Yes, Friedman endorsed inflation targeting, but NOT the Taylor rule (See David Glasner’s excellent critique of John Taylor views here). Furthermore, acknowledging that he did not think that velocity was stable (anymore) really makes it hard to use Friedman as an argument against NGDP targeting. BUT, BUT Friedman nonetheless to the end of his life preferred inflation targeting more than anything else.

Would that have change if he had live to see the Great Recession? I really don’t know and does it really matter? I still consider myself a Friedmanite and to me the best pupil of Friedman around is Scott Sumner!

——

See also my earlier post on related topics:

Friedman provided a theory for NGDP targeting
Friedman’s thermostat and why he obviously would support a NGDP target

4 Comments
by Lars Christensen on December 7, 2011  •  Permalink
Posted in David Eagle, David Glasner, Milton Friedman, MM Research agenda, Monetary institutions, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, Scott Sumner
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Posted by Lars Christensen on December 7, 2011

https://marketmonetarist.com/2011/12/07/friedman-should-have-supported-ngdp-targeting-but-never-did/

Selgin’s Monetary Credo – Please Dr. Taylor read it!

Ok, there is no reason to hide it – I love George Selgin or at least his thinking on monetary theory. George of course is the source to go to on Free Banking theory and history (ok, Larry White is also pretty cool…) and he is of course an expert and a true pioneer on nominal income targeting. His work on the so-called Productivity Norm should be standard reading for anybody with the slightest interest in monetary theory. And now George is out with a comment on NGDP targeting. It is primarily a response to John Taylor’s recent critique of NGDP targeting.

Here is Selgin:

“Thus Professor Taylor complains that, “if an inflation shock takes the price level and thus NGDP above the target NGDP path, then the Fed will have to take sharp tightening action which would cause real GDP to fall much more than with inflation targetting.” Now, first of all, while it is apparently sound “Economics One” to begin a chain of reasoning by imagining an “inflation shock,” it is crappy Economics 101 (or pick your own preferred intro class number), because a (positive) P or inflation “shock” must itself be the consequence of an underlying “shock” to either the demand for or the supply of goods. The implications of the “inflation shock” will differ, moreover, according to its underlying cause. If an adverse supply shock is to blame, then the positive “inflation shock” has as its counterpart a negative output shock. If, on the other hand, the “inflation shock” is caused by an increase in aggregate demand, then it will tend to involve an increase in real output. Try it by sketching AS and AD schedules on a paper napkin, and you will see what I mean.”

Damn, I would not like to be on the receiving end of a critique from Dr. Selgin! But he is of course ever so right…inflation is alway and everywhere a monetary phenomenon (as is recessions) and the problem with the economics of John Taylor and other New Keynesians (yes guys, he is a New Keynesian!) is that they see inflation fluctuations as basically non-monetary shocks or at least think that monetary policy should be used to “counteract” non-monetary shocks.

John Taylor and other New Keynesians therefore see monetary policy as responding either with rules (as Taylor prefers) or with discretionary monetary policy to “shocks”. However, fluctuations in nominal GDP, the price level and inflation are monetary phenonoma. Therefore, monetary policy do not need to “respond” to “shocks”. Monetary policy should not create the shocks in the first place and that is the purpose of NGDP targeting. As I have earlier tired to explain – NGDP is not a form of monetary “fine tuning”. It is in fact the direct opposite.

Or say George explains: “We shall have no real progress in monetary policy until monetary economists realize that, although it is true that unsound monetary policy tends to contribute to undesirable and unnecessary fluctuations in prices and output, it does not follow that the soundest conceivable policy is one that eliminates such fluctuations altogether. The goal of monetary policy ought, rather, to be that of avoiding unnatural fluctuations in output–that is, departures of output from its full-information level–while refraining from interfering with fluctuations that are “natural.” That means having a single mandate only, where that mandate calls for the central bank to keep spending stable, and then tolerate as optimal, if it does not actually welcome, those changes in P and y that occur despite that stability“

Any Market Monetarist (in fact anybody with interest in monetary theory and policy) should remember these words. So lets repeat them (in a shorter version) and let us call it Selgin’s Monetary Credo:

“The goal of monetary policy ought to be that of avoiding unnatural fluctuations in output…while refraining from interfering with fluctuations that are “natural.” That means having a single mandate only, where that mandate calls for the central bank to keep spending stable, and then tolerate as optimal, if it does not actually welcome, those changes in P and y that occur despite that stability“

So one more time – the goal of monetary policy is NOT to fine tune the economic development, but to avoid creating “unnatural” fluctuations in nominal spending and prices.

I have often been critical about the call for “monetary stimulus” from some Market Monetarists as it has lead many to think that we are in favour of activist monetary policies. We are not in favour of activist policies, we are in favour of “Selgin’s monetary credo”!

—–

See my earlier overview of the Market Monetarist response to John Taylor’s critique of NGDP targeting here.

—–
Marcus Nunes also has a comment on Selgin as do Scott Sumner.

10 Comments
by Lars Christensen on December 1, 2011  •  Permalink
Posted in George Selgin, MM Research agenda, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, Selgin's Monetary Credo
Tagged ,

Posted by Lars Christensen on December 1, 2011

https://marketmonetarist.com/2011/12/01/selgins-monetary-credo-please-dr-taylor-read-it/

Adam Posen calls for more QE – that’s fine, but…

Adam Posen who sits on the Bank of England’s Monetary Policy Committee (MPC) has a comment in on New York Times’ website.

Adam Posen is known to favour aggressive quantitatively easing in the present situation and in his piece he argues strongly that both the ECB and the Federal Reserve should follow the lead from the BoE and step up aggressive QE.

Posen rightly criticize the Fed, the BoE and the ECB with being too reluctant to do the “right thing” and in many ways his comments resembles my own critique of policy makers as being “Calvinist” in their thinking.

Posen is also right in arguing that more definitely is needed in both Europe and the US in terms of easing monetary conditions, but I have often argued that Market Monetarists are not in favour of discretionary policies (See here and here). We want to see QE within a proper framework of NGDP level targeting and not discretionary monetary “stunts”. The experience with both QE1 and QE2 in the US shows that unless is anchored within a proper framework then the impact on NGDP expectations are likely to be relatively short-lived.

I think that there might be some disagreement among Market Monetarists here and I guess that for example Scott Sumner would be happy to take whatever we can get, while I personally is more skeptical. If QE is done in an ad hoc fashion outside of a clearly defined policy framework then I fear it will undermine the longer-term arguments for NGDP level targeting. Some are already arguing that QE did not work – I think QE works very well if it is done within a proper framework, but how can we convince the skeptics?

That does of course not mean that I would vote against more QE if I for example was on the BoE’s MPC or the FOMC (there is no chance that will ever happen…). And it is quite obvious that the ECB need to ease monetary policy right now and rather aggressively – even within ECB’s present framework.

Anthony Evans seem to share my concerns about QE without a proper framework. See Anthony’s comment here and here.

See also Marcus Nunes and Scott Sumner on Adam Posen’s comment.

PS Theoretically I also disagree quite a bit with Posen as it seems like he think that the monetary transmission mechanism works primarily via lower bond yields. It’s basic MM knowledge that successful monetary easing (increased NGDP expectations) will increase bond yields. See my previous comment the transmission mechanism here. Even though I am skeptical about Posen’s call for ad hoc monetary easing I in fact think that monetary policy with the help of the Chuck Norris Effect is much more powerful than Posen seems to think.

9 Comments
by Lars Christensen on November 22, 2011  •  Permalink
Posted in Chuck Norris Effect, euro crisis, MM Research agenda, Monetary policy, Monetary policy rules
Tagged ,

Posted by Lars Christensen on November 22, 2011

https://marketmonetarist.com/2011/11/22/adam-posen-calls-for-more-qe-thats-fine-but/

The Fed can save the euro

David Beckworth has a excellent comment on the correlation between NGDP in the US and the euro zone.

David shows that US NGDP growth leads NGDP growth in the euro zone. This means that if the Federal Reserve were to move to push NGDP back to the pre-crisis trend level then it would likely lead to a similar increase in the NGDP level in the euro zone.

Hence, if the Fed were to introduce a NGDP level target then because the US is a “global monetary superpower” then the ECB would effective be forced to do the same thing. Interestingly this would probably mean that the ECB would overshoot it’s 2% inflation in the short-run as NGDP shifts from on level to another. How would the ECB react to that? Well, first of all the EUR/USD would undoubtedly spike, which would curb short time inflationary pressures and the question is really whether the ECB would have time to do anything about the jump in NGDP. Paradoxically because the ECB is targeting future inflation then it could say “well, inflation is now at 5%, but that is really not something we can do anything about and inflation nonetheless be back to 2% once US NGDP settles down at the new (old) NGDP trend level so no tightening of monetary policy is needed”.

For now the ECB refuses any easing of monetary policy, but if the Fed were to act decisively then the ECB probably would import an easing of monetary policy – and that would probably save the euro. So please Ben can you help us?

Leave a comment
by Lars Christensen on November 15, 2011  •  Permalink
Posted in David Beckworth, euro crisis, Federal Reserve, MM Research agenda, Monetary institutions, Monetary policy, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, Reading recommendations, The euro, The Great Recession
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Posted by Lars Christensen on November 15, 2011

https://marketmonetarist.com/2011/11/15/the-fed-can-save-the-euro/

Roth’s Monetary and Fiscal Framework for Economic Stability

Steve Roth over at http://www.asymptosis.com has a comment on my previous post ”Be right for the right reasons”, which in itself was a comment on Richard Williamson who had commented on one of my previous comments (“NGDP targeting is not a Keynesian business cycle policy”) so you might consider this as ponzi-commenting…Anyway, Steve’s comment deserves an answer. He has some intriguing ideas.

What Steve suggests is what he calls “the MMTer’s guaranteed employment scheme”. For those who are not following the monetary debate in blogosphere it might be helpful to tell that MMT means Modern Monetary Theory – or what in the old days was known as Chartalism. I don’t want to use too much time explaining Chartalism (I am not really that strong on what they think), but lets just say that MMTer’s fundamentally think that monetary policy and fiscal policy is the same thing and that money enters circulation through government spending.

Steve’s idea is the following:

“My personal preferred stabilizer is to up the EITC bigtime, expand it up the income spectrum, pay it on weekly paychecks, and index its benefit levels to some measure of unemployment.”

EITC for those who don’t know it means “Earned Income Tax Credit” and is a Federal tax credit given to low income families in the US.

Steve does not say it directly, but I guess that his idea is that the Federal Reserve should fund this scheme. Or at least for a monetarist or a Market Monetarist this is crucial if the programme is going to “work”.

Some would consider Steve Roth’s idea to be completely insane. I do not. However, I have a number of reservations, but most important I have serious trouble with Steve’s premise.

I fundamentally think that recessions are always and everywhere a monetary phenomenon and hence monetary and fiscal policy should not be designed to be “countercyclical”. Monetary policy should be designed not mess with Say’s Law or said in another way monetary policy should not create recessions in the first place. If central banks where to engage in countercyclical policies then it basically end up fighting against it’s own past mistakes. This is also why I so strongly oppose when some Market Monetarists call for “monetary stimulus” as it exactly sounds as if we would like central banks to follow some kind of “countercyclical” policy.

Therefore there is no need for an “employment scheme” if central banks stop messing with Say’s Law by introducing credible NGDP level targeting.

That said, Roth’s scheme might not be in conflict with the idea of NGDP target. In fact if the Federal Reserve said that it in the future would say it would send each a American a cheque of the same size as the average EITC (hence doubling the EITC cheque) and that it would do so until NGDP had returned to the pre-crisis level then that in my view most likely would be a successful mechanism for returning NGDP to the pre-crisis trend. That does not mean that I endorse Steve’s scheme and and the fact that I think it would “work” does not mean that I in anyway agree with MMT theories – I don’t. The only thing it really means is that I think monetary policy is very powerful and that NGDP always can be increased by the use of monetary policy – then it is less important how you inject the money into the economy.

Fundamentally I think it is a pretty bad idea to have the central bank funding government expenditure and given central banks exist I believe they would be made independent of political pressures.

Finally, a comment on my headline. When I read Steve’s comment I came to think of a paper Milton Friedman wrote back in 1948 “A Monetary and Fiscal Framework for Economic Stability”. In the paper Friedman suggests something similar to Steve. Friedman’s suggestion is basically that the government should balance its budgets over the “business cycle”, but in downturns the central bank should print money to finance the public deficits. That in Friedman’s view creates a monetary-fiscal stabiliser of the economy. Friedman luckily became wiser as he aged. Here is a he said about in 1960 in “A Program for Monetary Stability” about his 1948 proposal:

“I have become increasingly persuaded that the proposal is more sophisticated and complex than is necessary, that a much simpler rule would also produce highly satisfactory results and would have two great advantages: first, its simplicity would facilitate the public understanding and backing that is necessary if the rule is to provide an effective barrier to opportunistic “tinkering”; second, it would largely separate the monetary problem from the fiscal and hence would require less far-reaching reform over a narrower area.”

So Steve, I don’t think we need to get the central bank involved in getting NGDP back on track and monetary policy should not be funding government programmes – especially not programmes that are not to great to begin with.

PS Steve, you have one advantage in the debate with me. Friedman suggested in 1948 to use a monetary-fiscal stabiliser and the EITC is of course a (bad) variation of Friedman’s suggestion for a Negative Income Tax and I hate arguing against any of Friedman’s ideas.

PPS Steve got my surname slightly wrong – it is Christensen and not Christiansen.

4 Comments
by Lars Christensen on November 13, 2011  •  Permalink
Posted in MM Research agenda, Monetary institutions, Monetary policy rules, Reading recommendations, Say's Law
Tagged ,

Posted by Lars Christensen on November 13, 2011

https://marketmonetarist.com/2011/11/13/roth%e2%80%99s-monetary-and-fiscal-framework-for-economic-stability/

NGDP targeting is not a Keynesian business cycle policy

I have come to realize that many when they hear about NGDP targeting think that it is in someway a counter-cyclical policy – a (feedback) rule to stabilize real GDP (RGDP). This is far from the case from case and should instead be seen as a rule to ensure monetary neutrality.

The problem is that most economists and none-economists alike think of the world as a world more or less without money and their starting point is real GDP. For Market Monetarist the starting point is money and that monetary disequilibrium can lead to swings in real GDP and prices.

The starting point for the traditional Taylor rule is basically a New Keynesian Phillips curve and the “input” in the Taylor rule is inflation and the output gap, where the output gap is measured as RGDP’s deviation from some trend. The Taylor rule thinking is basically the same as old Keynesian thinking in the sense that inflation is seen as a result of excessive growth in RGDP. For Market Monetarists inflation is a monetary phenomenon – if money supply growth outpaces money demand growth then you get inflation.

Our starting point is not the Phillips curve, but rather Say’s Law and the equation of exchange. In a world without money Say’s Law holds – supply creates it’s own demand. Said in another way in a barter economy business cycles do not exist. It therefore follows logically that recessions always and everywhere is a monetary phenomenon.

Monetary policy can therefore “create” a business cycle by creating a monetary disequilibrium, however, in the absence of monetary disequilibrium there is no business cycle.

So while economists often talk of “money neutrality” as a positive concept Market Monetarists see monetary neutrality not only as a positive concept, but also as a normative concept. Yes, money is neutral in that sense that higher money supply growth cannot increase RGDP in the long run, but higher money supply growth (than money demand growth) will increase inflation and NGDP in the long run.

However, money is not neutral in the short-run due to for price and wage rigidities and therefore money disequilibrium and monetary disequilibrium can therefore create business cycles understood as a general glut or excess supply of goods and labour. Market Monetarists do not argue that the monetary authorities should stabilize RGDP growth, but rather we argue that the monetary authorities should avoid creating a monetary disequilibrium.

So why so much confusing?

I believe that much of the confusing about our position on monetary policy has to do with the kind of policy advise that Market Monetarist are giving in the present situation in both the US and the euro zone.

Both the euro zone and the US economy is at the presently in a deep recession with both RGDP and NGDP well below the pre-crisis trend levels. Market Monetarists have argued – in my view forcefully – that the reason for the Great Recession is that monetary authorities both in the US and the euro zone have allowed a passive tightening of monetary policy (See Scott Sumner’s excellent paper on the causes of the Great Recession here) – said in another way money demand growth has been allowed to strongly outpaced money supply growth. We are in a monetary disequilibrium. This is a direct result of a monetary policy mistakes and what we argue is that the monetary authorities should undo these mistakes. Nothing more, nothing less. To undo these mistakes the money supply and/or velocity need to be increased. We argue that that would happen more or less “automatically” (remember the Chuck Norris effect) if the central bank would implement a strict NGDP level target.

So when Market Monetarists like Scott Sumner has called for “monetary stimulus” it NOT does mean that he wants to use some artificial measures to permanently increase RGDP. Market Monetarists do not think that that is possible, but we do think that the monetary authorities can avoid creating a monetary disequilibrium through a NGDP level target where swings in velocity is counteracted by changes in the money supply. (See also my earlier post on “monetary stimulus”)

I have previously argued that when a NGDP target is credible market forces will ensure that any overshoot/undershoot in money supply growth will be counteracted by swings in velocity in the opposite direction. Similarly one can argue that monetary policy mistakes can create swings in velocity, which is the same as to say hat monetary policy mistakes creates monetary disequilibrium.

Therefore, we are in some sense to blame for the confusion. We should really stop calling for “monetary stimulus” and rather say “stop messing with Say’s Law, stop creating a monetary disequilibrium”. Unfortunately monetary policy discourse today is not used to this kind of terms and many Market Monetarists therefore for “convenience” use fundamentally Keynesian lingo. We should stop that and we should instead focus on “microsovereignty”

NGDP level targeting ensures microsovereignty

A good way to structure the discussion about monetary policy or rather monetary policy regimes is to look at the crucial difference between what Larry White has termed a “macroinstrumental” approach and a “microsovereignty” approach.

The Taylor rule is a typical example of the macroinstrumental approach. In this approached it is assumed that it is the purpose of monetary policy to “maximise” some utility function for society with includes a “laundry list” of more or less randomly chosen macroeconomic goals. In the Taylor rule this the laundry list includes two items – inflation and the output gap.

The alternative approach to choose a criteria for monetary success (as Larry White states it) is the microsovereignty approach – micro for microeconomic and sovereignty for individual sovereignty.

The microsovereignty approach states that the monetary regime should ensure an institutional set-up that allows individuals to make decisions on consumption, investment and general allocation without distortions from the monetary system. More technically the monetary system should ensure that individuals can “capture” Pareto improvements.

Therefore an “optimal” monetary regime ensures monetary neutrality. Larry White argues that Free Banking can ensure this, while Market Monetarists argue that given central banks exist a NGDP level targeting regime can ensure monetary neutrality and therefore microsovereignty.

This is basically a traditional neo-classical welfare economic approach to monetary theory. We should choose a monetary regime that “maximises” welfare by ensuring individual sovereignty.

A monetary regime that ensures microsovereignty does not have the purpose of stabilising the business cycle, but it will nonetheless be the likely consequence as NGDP level targeting removes or at least strongly reduces monetary disequilibrium and as recessions is a monetary phenomenon this will also strongly reduce RGDP and price volatility. This is, however, a pleasant consequence but not the main objective of NGDP level targeting.

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Marcus Nunes has a similar discussion here.

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UPDATE: There are two follow up article to this post:

“Be right for the right reasons”

“Roth’s Monetary and Fiscal Framework for Economic Stability”

28 Comments
by Lars Christensen on November 12, 2011  •  Permalink
Posted in Chuck Norris Effect, Free Banking, Larry White, MM Research agenda, Monetary institutions, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, Reading recommendations, Say's Law, Scott Sumner
Tagged , , , , , ,

Posted by Lars Christensen on November 12, 2011

https://marketmonetarist.com/2011/11/12/ngdp-targeting-is-not-a-keynesian-business-cycle-policy/

Repeating a (not so) crazy idea – or if Chuck Norris was ECB chief

Recently I in a post came up with what I described as a crazy idea – that might in fact not be so crazy.

My suggestion was based on what I termed the Chuck Norris effect of monetary policy – that a central banks can ease monetary policy without printing money if it has a credible target. The Swiss central bank’s (SNB) actions to introduce a one-sided peg for the Swiss franc against the euro have demonstrated the power of the Chuck Norris effect.

The SNB has said it will maintain the peg until deflationary pressures in the Swiss economy disappears. The interesting thing is that the markets now on its own is doing the lifting so when the latest Swiss consumer prices data showed that we in fact now have deflation in Switzerland the franc weakened against the euro because market participants increased their bets that the SNB would devalue the franc further.

In recent days the euro crisis has escalated dramatically and it is pretty clear that what we are seeing in the European markets is having a deflationary impact not only on the European economy, but also on the global economy. Hence, monetary easing from the major central banks of the world seems warranted so why do the ECB not just do what the SNB has done? For that matter why does the Federal Reserve, the Bank of England and the Bank of Japan not follow suit? The “crazy” idea would be a devaluation of euro, dollar, pound and yen not against each other but against commodity prices. If the four major central banks (I am leaving out the People’s Bank of China here) tomorrow announced that their four currencies had been devalued 15% against the CRB commodity index then I am pretty sure that global stock markets would increase sharply and the positive effects in global macro data would likely very fast be visible.

The four central banks should further announce that they would maintain the one-sided new “peg” for their currencies against CRB until the nominal GDP level of all for countries/regions have returned to pre-crisis trend levels around 10-15% above the present levels and that they would devalue further if NGDP again showed signs of contracting. They would also announce that the policies of pegging against CRB would be suspended once NGDP had returned to the pre-crisis trend levels.

If they did that do you think we would still talk about a euro crisis in two months’ time?

PS this idea is a variation of Irving Fisher’s compensated dollar plan and it is similar to the scheme that got Sweden fast and well out of the Great Depression. See Don Patinkin excellent paper on “Irving Fisher and His Compensated Dollar Plan” and Claes Berg’s and Lars Jonung’s paper on Swedish monetary policy in 1930s.

PPS this it not really my idea, but rather a variation of an idea one of my colleagues came up with – he is not an economist so that is maybe why he is able to think out of the box.

PPPS I real life I am not really a big supporter of coordinated monetary action and I think it has mostly backfired when central banks have tried to manipulate exchange rates. However, the purpose of this idea is really not to manipulate FX rates per se, but rather to ease global monetary conditions and the devaluation against CRB is really only method to increase money velocity.

11 Comments
by Lars Christensen on November 10, 2011  •  Permalink
Posted in Chuck Norris, Chuck Norris Effect, euro crisis, Exchange rate policy, Exchange rates, Fantasy, Federal Reserve, Gold Standard, Japan, MM Research agenda, Monetary policy, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, The euro
Tagged , , , ,

Posted by Lars Christensen on November 10, 2011

https://marketmonetarist.com/2011/11/10/repeating-a-not-so-crazy-idea-or-if-chuck-norris-was-ecb-chief/

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