All posts in category Monetary policy

NGDP level targeting and the Fed’s mandate

Renee Haltom has an interesting article in the recent edition of Richmond’s Fed’s magazine Region Focus on “Would a LITTLE inflation produce a BIGGER recover?”.

Renee among other things discusses NGDP targeting – it is unclear from the article whether it is a reference to growth or level targeting and somewhat surprisingly Market Monetarists such as Scott Sumner is not mentioned in the discussion. Rather Renee Haltom has interviewed Bennett McCallum. Professor McCallum is of course the grandfather of Market Monetarism so Renee is forgiven for not mentioning Scott.

What I found most interesting in Renee’s discussion was actually the relationship between NGDP targeting and the Fed’s legal mandate:

“NGDP is everything that is produced times the current prices people pay for it. It is similar to “real” GDP, the measure of economic growth reported in the news, except NGDP isn’t adjusted for inflation. One appeal is that growth in NGDP is the sum of exactly two things: inflation and the growth rate of real GDP (the amount of actual goods and services produced). Thus, it captures both sides of the Fed’s mandate in a single variable.”

So what Renee is basically suggesting is a that NGDP targeting would be fully comparable with the Federal Reserve’s mandate – to ensure price stability as well as to maximize employment. Unlike Scott Sumner I don’t think the Fed’s mandate is meaningful. The Fed should not try to maximize employment. In the long run employment is determined by factors completely outside of the Fed’s control. In the long run unemployment is determined by supply factors. In my view the only task of the Fed should be to ensure nominal stability and monetary neutrality (not distort relative prices) and the best way to do that is through a NGDP level target. However, lets play along and say that the Fed’s mandate is meaningful.

In his 2001 paper “U.S. Monetary Policy During the 1990s” Greg Mankiw suggested that Fed’s policy reaction function (for interest rates) could be seen as a function of the rate of unemployment minus core inflation. Lets call this measure Mankiw’s constant. The clever reader will of course notice that we now capture Fed’s mandate in one variable.

The graph below shows Mankiw’s constant and the ‘NGDP gap’ defined as percentage deviation from the trend in nominal GDP from 1990 to 2007 (the Great Moderation period).

The graph is pretty clear – there is a very strong correlation between the Fed’s mandate and NGDP level targeting. If the Fed keeps NGDP on trend then it will also ensure that Mankiw constant in fact would be a constant and fulfill it’s mandate. The graph of course also shows very clearly that the Federal Reserve at the moment is very far from fulfilling its mandate.

Given the very strong correlation between Mankiw’s constant and the NGDP gap it should be pretty easy for the Fed to argue that NGDP level (!) targeting is fully comparable with the Fed’s target. So Ben why are you still waiting?

14 Comments
by Lars Christensen on February 26, 2012  •  Permalink
Posted in Ben Bernanke, Federal Reserve, McCallum, MM Research agenda, Monetary institutions, Monetary policy, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, Scott Sumner
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Posted by Lars Christensen on February 26, 2012

https://marketmonetarist.com/2012/02/26/ngdp-level-targeting-and-the-feds-mandate/

Do we have a problem if it works?

Recently I have become more positive on the outlook for the European and US economies. It seems like the ECB has finally recognised that it need to ease monetary policy to avoid a deflationary disaster and judging from the development in broad monetary aggregates in the US there are signs that things are also moving in the right direction in the US economy.

If investors and consumers are jumping on the happy-go-lucky bandwagon then we might even see the money velocity in the US and the euro zone  begin to inch up. If both broad money supply growth is picking up and velocity would be inching upward then nominal GDP and inflation would also be accelerating and as any Market Monetarist will tell you expectations are key so the recovery could be very swift if market participants start to think that central banks are willing to accept as short-term pick up inflation to achieve a higher level of NGDP.

Lets be really optimistic and say that US inflation jumps to 5% in the coming half year and real GDP also increases to 5% (there are no signs that that is happening). That would give us 10% NGDP growth and we would finally be closing the “NGDP gap” and start to return to the pre-crisis trend. What would happen in that situation? Well, some of us would happy, but there is no doubt that the fears of “runaway inflation” would increase. As somebody asked me the other day “will you be able to stop inflation getting out of control if you have 2 years in a row with 5 or 7% inflation?” My answer was “Clearly!”, but I must also admit that I am more worried than that answer reflected.

Hence, in my view there is a real risk that if monetary policy is eased in the present “stealth” fashion then it will be much harder to anchor expectations – and more importantly it might be harder to get policy makers back to the idea that high inflation is bad. No, please do remember that we are not inflationists. Inflation is bad – at least demand inflation is bad.

Therefore, I think that even if nominal GDP growth starts to pick up I think is extremely important that we keep arguing in favour of NGDP level targeting. We don’t want “stimulus” to bring us out of the present mess. No, we want a monetary regime that ensures us against ever to get into this situation again. So yes, we should clearly argue for monetary easing now, but it is much more important that sound monetary regimes are implemented.

Lets say I had the choice between increasing euro NGDP with 15% right now but also maintain the overall present monetary regime in Europe (with all its faults) or have a monetary regime based NGDP level targeting (but from present levels) then I surely would prefer the later.

9 Comments
by Lars Christensen on February 9, 2012  •  Permalink
Posted in Monetary institutions, Monetary policy, Monetary policy rules, NGDP Targeting, Nominal Income Targeting
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Posted by Lars Christensen on February 9, 2012

https://marketmonetarist.com/2012/02/09/do-we-have-a-problem-if-it-works/

Market Monetarism vs Krugmanism

Here is an interesting comment from ‘JJA’ over at Scott Sumner’s blog:

“Scott, I have enjoyed reading your blog. As a practitioner (firm level decisions regarding export related efforts) I find you (and other market monetarists, especially Christensen and Nunes) very understandable and convincing. But… But I find Krugman and DeLong very understandable and convincing also… From my micro-level point of view it seems to be the case that both sides are right, but something is missing in-between.

Well, I am not an economist, but I think that I see NGDP as the ultimate aim in order to manage stable and prosperous economy. At the same time I see the importance of fiscal activity (from the state or whatever public body), and that is at the same time when I think that the monetary policy is the most important part of the situation. But I feel that monetary policy alone is not enough in order to achieve good results in a reasonable time. Therefore fiscal.

From my practical point of view, both market monetarists and old-style keynesians seem to be right at the same time. It may be that I am mad or something vital is missing from our understanding of economics.

But in any case, I just make decisions in practice. By the way, I am from the Eurozone (unfortunately).”

I think JJA raises a number of interesting questions about the similarities between Market Monetarism and “Krugmanism”. Yes, Krugman has endorsed NGDP level targeting as do Market Monetarists. However, just because we share the policy recommendation (and I am not sure we really do…) that does not mean that our theoretical thinking is close.

I do fundamentally think that Keynesians (including Krugman) and Market Monetarists (and old style Monetarists) are quite far away from each other theoretically.

I have three earlier posts that might clarify this:

On our macro/micro foundation: How I would like to teach Econ 101

On why we don’t think fiscal policy is effective. There is no such thing as fiscal policy

On why we favour a RULES based monetary policy: NGDP targeting is not a Keynesian business cycle policy

These three posts should make it clear what the key theoretical differences between Market Monetarists and Keynesians are.

That said, for the US and the euro zone Market Monetarists and New Keynesians (at least Krugman, DeLong and Romer) agree that monetary easing is warranted and that this could be done within the framework of NGDP level targeting. That said, Market Monetarists do not want to “fix” the economy and unlike keynesians we do not think that the problems are real, but rather nominal. The crisis is a result of a monetary policy mistakes rather than a “market failure”.

In regard to fiscal policy I might add that Market Monetarists probably are less concerned about the general fiscal troubles in the US and the euro zone than many “establishment” economists (and particularly European policy makers). David Beckworth have a number of good posts on this issue (See for example here). We agree that the present fiscal path is unsound in both the US and the euro zone, but if we get monetary policy right (target the NGDP level of the pre-crisis trend) then that would reduce the fiscal stress very significantly – not to speaking of reducing banking problems. Get monetary policy right and then the European and US banking problems and the fiscal policy problems will become manageable (on an overall level).

That said, Market Monetarists do in general not think that fiscal policy on its own can increase nominal spending in the economy so even though we think that fiscal policy should not be a major concern if monetary policy is “right” we also don’t think it is useful to spend a lot of time trying to “stimulate” the economy with fiscal measures. The only role we see for fiscal policy is to ensure long-term productivity growth and growth in the labour supply, but that is certainly not what Paul Krugman has in mind.

11 Comments
by Lars Christensen on February 1, 2012  •  Permalink
Posted in David Beckworth, Fiscal policy, MM Research agenda, Monetary policy, NGDP Targeting, Nominal Income Targeting, Paul Krugman, Scott Sumner
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Posted by Lars Christensen on February 1, 2012

https://marketmonetarist.com/2012/02/01/market-monetarism-vs-krugmanism/

Guest blog: Why Price-Level Targeting Pareto Dominates Inflation Targeting (By David Eagle)

Guest blog: Why Price-Level Targeting Pareto Dominates Inflation Targeting

– And a Bizarre Tale of Blind Macroeconomists

By David Eagle

Some central banks throughout the world, including the Central bank of Canada and the Federal Reserve, have been considering Price-Level Targeting (PLT) as an alternative to Inflation Targeting (IT). In this guest blog, I present my argument why PLT Pareto dominates IT.  My argument is simple, and one that many readers will consider so obvious that they would expect most monetary economists to be already aware of this Pareto domination.

Please read the following quotation from Shukayev and Ueberfeldt (2010):

Various papers have suggested that Price-Level targeting is a welfare improving policy relative to Inflation targeting. … Research on Inflation targeting and Price-level Targeting monetary policy regimes shows that a credible Price-level Targeting (PT) regime dominates an Inflation targeting regime.

Reading the above quotation indicates that economists already know that PLT Pareto dominates IT.  However, there is a bizarre twist to this literature, which we will discuss later in this blog.  I ask you to continue patiently reading and trust that the ending to the blog will be well worth the journey, even to market monetarists who oppose both PLT and IT.

In my last guest blog for The Market Monetarist, I discussed what I called the Two Fundamental Welfare Principles of Monetary Economics.  The First Principle concerned the Pareto implications when nominal GDP (NGDP) changes, but real GDP (RGDP) does not.  The Second Principle concerned the Pareto implications when RGDP changes, but NGDP does not.  Since PLT and IT have the same Pareto implications when RGDP changes, but NGDP does not; let us focus on the First Principle.  To do so, assume an economy where RGDP is known with perfect foresight; then the First Principle always applies.

A Nominal-Loan Example – Initial Expectations

Let us again consider a long term nominal loan.  This time, I will explain my argument with an example.  For this example, assume a €200,000 nominal mortgage with a 7.2% p.a. interest rate, compounded monthly, and a term of 15-years, and fixed, fully amortizing nominal monthly payments.  The monthly payment would then be a nominal €1820.09.  Let us assume that individual B borrowed the €200,000 from individual A.   The €1820.09 is the nominal amount B must pay A each month.

Let us also assume that both A and B expect inflation to be 2.4% p.a., compounded monthly, during this period.  They therefore built that expected inflation rate into their 7.2% p.a. negotiated nominal interest rate.[1]   Please note that in Finance, we second-naturedly convert per annum rates to per month rates when the rate is compounded monthly.  Thus, the 7.2% p.a. is actually 0.6% per month, and the 2.4% p.a. inflation rate is 0.2% per month.  While this monthly compounding adds an extra step and a source of confusion, I believe the gain in the realism of the example is worth it.

If inflation is the 2.4% p.a. expected rate, then the real value of the monthly payment at time t will equal 1820.09/(1.002)t where t is the number of months from the loan’s origination.  Since both A and B expect the inflation rate to be 2.4% p.a., compounded monthly, their expected real value[2] of this monthly loan payment at time t will be 1820.09/(1.002)t

As I discussed in my second guest blog on the Market Monetarist, PLT and IT have the same effect on the economy as long as the central bank is successful at meeting its target, whether that target is a price-level target or an inflation target.  Let us assume that under IT, the central bank’s inflation target is 2.4% p.a., whereas under PLT, the central bank’s price-level target at time t is 100(1.002)t.  Hence, under both PLT and IT, the central bank’s initial price-level trajectory is 100(1.002)t.

Scenarios of Missing the Target

When PLT and IT differ is when the central bank misses its target.  Suppose inflation on average over the first year turns out to be 1.2% p.a. instead of the expected  2.4% p.a (both rates are compounded monthly).  To be more clear given the monthly compounding issue, the central bank’s initially trajectory of the price level at one year (or at time t=12 months) was 100(1.002)12 = 102.43; however, the actual price level at one year turned out to be 100(1.001)12 = 101.21.  Under PLT, the central bank will try to return the economy to its initial price-level target of 100(1.002)t.  However, under IT, the central bank would shift its price-level trajectory to 101.21(1.002)t-12, which is less than the initial price-level trajectory of 100(1.002)t.  This is the phenomenon we call price-level base drift, which is caused by the central bank under IT letting bygones be bygones and merely aiming for future inflation to be consistent with its inflation target; the central bank under IT does not try to make up for lost ground.

The real value of the nominal loan payment at time t=12 when the actual inflation rate turns out to be1.2% 1820.09/1.00112 = €1798.39, which is greater than the expected nominal loan payment of €1776.97.

On the other hand, assume that the inflation rate on average over the first year was 3.6% p.a. rather than the targeted 2.4% p.a. This means that the actual price level at one year turned out to be 100(1.003)12 = 103.66.  Under PLT, the central bank would have tried to return the economy to its initial price-level target of 100(1.002)t.  However, under IT, the central bank would shift its price-level trajectory to 103.66(1.002)t-12, which is greater than the initial price-level trajectory of 100(1.002)t.

The real value of the nominal loan payment at time t=12 when the actual inflation rate was 3.6% instead of 2.4% is 1820.09/1.00312 = €1755,83, which is less that the initially expected value of €1776.97.

Comparing Actual to Expectations Beyond 12 Months

Because we are talking about four different scenarios, let PLT– and IT– represent PLT and IT when the inflation rate on average for the first year turns out to be 1.2% rather than 2.4%.  Let PLT+ and IT+ represent PLT and IT when the inflation on average for the first year turns out to be 3.6% rather than the expected 2.4%.  Under all four scenarios, assume that starting in at time t=24, which is 2 years after the loan began, the central bank is able to perfectly meet is price-level trajectory whether under PLT or IT and it does so for the remaining of the 15 years.

Under these assumptions, the real value of the monthly payment under PLT starting at time t=24 will be the same as expected because the central bank will get the price level back to its preannounced price-level target.  However, when the actual inflation rate for the first year turned out being 1.2%, the real value of the nominal monthly payment under IT would be 1820.09/((1.001)12(1.002)t-12) for t≥24 under the assumption the central bank (CB) then meets its target.  On the other hand, when the actual inflation rate for the first year turned out being 3.6%, the real value of the nominal monthly payment under IT would be 1820.09/((1.003)12(1.002)t-12) for t≥24 assuming the CB then meets its target.

The table below shows how the actual real values of these nominal loan payments compare to A and B’s original expectation under all four scenarios.

Note: This table only reports the payment at the end of each year.

That PLT Pareto dominates IT should be obvious from the table.  Under PLT, the central bank (CB) tries to get the real value of nominal loan payments to be back to what borrowers and lenders initially expected.  In other words, under PLT, the CB tries to reverse its mistakes.  Under IT, the CB makes its mistakes permanent.  Note that in the table under PLT, the real value of the nominal loan payments are as expected from time t=24 months on.  However, under IT, the real value of the nominal loan payments are either 1.21% less than expected when the CB fell short of its target, or 1.19% higher than expected when the CB overshot its target.  Clearly, both risk-averse borrowers and risk-averse lenders will be better off with the temporary deviations from expectations under PLT than under the permanent deviations under IT.

Kicking Borrowers or Lenders When They are Down

John Taylor referred to the price-level basis drift as the CB “letting bygones be bygones.”  After writing this blog, I have another view:  I view IT as meaning that when the CB hurts either borrowers or lenders because it is unable to meet its target, then the CB turns around and kicks that down borrower or lender again and again to make them suffer for the duration of their loan.  I have long opposed IT, but writing this blog makes me oppose it even more.  Why cannot other economists see IT for the Pareto damaging regime it is?

The issue of why PLT Pareto dominates IT is simple.  The risk to borrowers and lenders is not inflation risk; it is price-level risk.  To minimize price-level risk, we should not minimize inflation, we should minimize the deviation of the price-level from its expected value.  As such, when a central banking missing its target, it should not keep kicking those suffering from the CB’s past mistakes; the central bank should not make that miss permanent as in IT, but rather the CB should try to reverse that damage as it will try to do under PLT.  Hence PLT Pareto dominates IT.

The Bizarre Tale of the Blind Economists

Thank you all for bearing with me through my argument.  However, from the quote by Shukayev and Ueberfeldt, you knew that the economic profession already knew this.  After all, this is obvious.  (Lars, drink something before you read on; we don’t want your blood to boil too much.)

However, the argument that I gave is not the argument that the literature that Shukayev and Ueverfeldt cited.  That literature did not use the Pareto criterion; it used a loss function that included inflation.  (Yes, Lars, that xxxx loss function again.)

What the literature starting with Svenson (1999) found is that paradoxically when the central bank is trying to minimize a loss function involving inflation, it may actually be better able to do that through PLT than with IT.  That is what Shukayev and Ueverfeld (2010) meant when they said that the literature had found PLT welfare dominates IT.  That literature was referring to “welfare” as defined by their ad hoc loss function, not by their applying the Pareto criterion to the well being of borrowers and lenders.

Economists have been blinded from the obvious by their ad hoc assumption of a loss function involving inflation.  This bizarre twist to this literature is an example of the dangers that economists’ prejudices can enter into their ad hoc loss functions, causing them to miss the obvious.  In this case they have missed the obvious impacts on individual borrowers and lenders of PLT vs. IT.

Of course, there are other targeting regimes than just PLT and IT, but this blog focused on those two.  In my future writing, I plan to explain why NGDP level targeting Pareto dominates NGDP growth rate targeting, although the logic of that is really the same as I have just discussed; we just allow RGDP to vary so that the Second Fundamental Principle of Monetary Economics also applies.

Also, think about how the “kick them while they are down” characteristic of IT is relevant to the aftermath of the Financial crisis concerning the sovereign debt issues in Europe and the debt burdens on mortgage borrowers in the U.S. and elsewhere.  I guess I have to be careful here as I might be accused of starting riots.

References

Eagle, David and Dale Domian (2011), “Quasi-Real-Indexed Mortgages to the Rescue,” working paper delivered at the Western Economic Associating Meetings in San Diego, CA, http://www.cbpa.ewu.edu/~deagle/WEAI2011/QRIMs.doc

Shukayev, Malik and Alexander Ueberfeldt (2010).  “Price Level Targeting: What Is the Right Price?” Bank of Canada Working Paper 2010-8

Svensson, Lars E O, 1999. “Price-level Targeting versus Inflation Targeting: A Free Lunch?,”

Journal of Money, Credit and Banking, Blackwell Publishing, vol. 31(3), pages 277-95, August.

© Copyright (2012) by David Eagle

[1] The traditional Fisher equation states that i @ r + E[π] where i is the nominal interest rate, r is the real interest rate, and π is the inflation rate.  A more exact relationship we use in Finance is (1+i)=(1+r)(1+E[π) where these rates are per compound period, in this case per month.  According to the approximate and traditional Fisher equation, the real interest rate would be 4.8%, which equals the 7.2% nominal rate less the 2.4% expected inflation (the more precise Fisher equation using the monthly rates concludes the real rate will be 4.79%).

[2] You may note that the real value of the monthly nominal payment is expected to decline over time.  In the mortgage literature, this is known as the “tilt effect” (See Eagle and Domian, 2011).


5 Comments
by Lars Christensen on January 29, 2012  •  Permalink
Posted in David Eagle, Lars E. O. Svensson, Monetary policy, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, Price Level Targeting
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Posted by Lars Christensen on January 29, 2012

https://marketmonetarist.com/2012/01/29/guest-blog-why-price-level-targeting-pareto-dominates-inflation-targeting-by-david-eagle/

It’s time to get rid of the ”representative agent” in monetary theory

“Tis vain to talk of adding quantities which after the addition will continue to be as distinct as they were before; one man’s happiness will never be another man’s happiness: a gain to one man is no gain to another: you might as well pretend to add 20 apples to 20 pears.”

– Jeremy Bentham, 1789

I have often felt that modern-day Austrian economists are fighting yesterday’s battles. They often seem to think that mainstream economists think as if they were the “market socialists” of the 1920s and that the “socialist-calculation-debate” is still on-going. I feel like screaming “wake up people! We won. No economist endorses central planning anymore!”

However, I am wrong. The Austrians are right. Many economists still knowingly or out of ignorance today endorse some of the worst failures of early-day welfare theory. Economists have known since the time of Jeremy Bentham that one man’s happiness can not be compared to another man’s happiness. Interpersonal utility comparison is a fundamental no-no in welfare theory. We cannot and shall not compare one person’s utility with another man’s utility. But this is exactly what “modern” monetary theorists do all the time.

Take any New Keynesian model of the style made famous by theorists like Michael Woodford. In these models the central banks is assumed to be independent (and benevolent). The central banker sets interest rates to minimize the “loss function” of a “representative agent”. Based on this kind of rationalisation economists like Woodford find theoretical justification for Taylor rule style monetary policy functions.

Nobody seems to find this problematic and it is often argued that Woodford even has provided the microeconomic foundation for these loss functions. Pardon my French, but that is bullsh*t. Woodford assumes that there is a representative agent. What is that? Imagine we introduced this character in other areas of economic research? Most economists would find that highly problematic.

There is no such thing as a representative agent. Let me illustrate it. The economy is hit by a negative shock to nominal GDP. With Woodford’s representative agent all agents in the economy is hit in the same way and the loss (or gain) is the same for all agents in the economy. No surprise – all agents are assumed to be the same. As a result there is no conflict between the objectives of different agents (there is basically only one agent).

But what if there are two agents in the economy. One borrower and one saver. The borrower is borrowing from the other agent at a fixed nominal interest rate. If nominal GDP drops then that will effectively be a transfer of wealth from the borrower to the saver.

This might of course of course make the Calvinist ideologue happy, but what would the modern day welfare theorist say?

The modern welfare theorist would of course apply a Pareto criterion to the situation and argue that only a monetary policy rule that ensures Pareto efficiency is a good monetary policy rule: An allocation is Pareto efficient if there is no other feasible allocation that makes at least one party better off without making anyone worse off. Hence, if the nominal GDP drops and lead to a transfer of wealth from one agent to another then a monetary policy that allows this does not ensure Pareto efficiency and is hence not an optimal monetary policy.

David Eagle has shown in a number of papers that only one monetary policy rule can ensure Pareto efficiency and that is NGDP level targeting (See David’s guest posts here, here and here). All other policy rules, inflation targeting, Price level targeting and NGDP growth targeting are all Pareto inefficient. Price level targeting, however, also ensures Pareto efficiency if there are no supply shocks in the economy.

This result is significantly more important than any result of New Keynesian analysis of monetary policy rules with a representative agent. Analysis based on the assumption of the representative agent completely fails to tell us anything about the present economic situation and the appropriate response to the crisis. Just think whether a model with a “representative country” in the euro zone or one with Greece (borrower) and Germany (saver) make more sense.

It is time to finally acknowledge that Bentham’s words also apply to monetary policy rules and finally get rid of the representative agent.

——

For a much more insightful and clever discussion of this topic see David Eagle’s paper “Pareto Efficiency vs. the Ad Hoc Standard Monetary Objective – An Analysis of Inflation Targeting” from 2005.

14 Comments
by Lars Christensen on January 23, 2012  •  Permalink
Posted in David Eagle, General economic theory, Inflation Targeting, John Taylor, MM Research agenda, Monetary institutions, Monetary policy, Monetary policy rules, NGDP Targeting, Nominal Income Targeting
Tagged , , ,

Posted by Lars Christensen on January 23, 2012

https://marketmonetarist.com/2012/01/23/its-time-to-get-rid-of-the-representative-agent-in-monetary-theory/

Allan Meltzer’s great advice for the Federal Reserve

Here is Allan Meltzer’s great advice on US monetary policy:

“Repeatedly, the message has been to reduce tax rates permanently… A permanent tax cut was supposed to do what previous fiscal efforts had failed to do — generate sustained expansion of the American economy. 

No one should doubt that an expansion is desirable for US… and the rest of the world…The US government has watched the economy stagnate much too long. A policy change is long overdue. 

The problem with the advice (about fiscal easing) is that few would, and none should, believe that the US can reduce tax rates permanently. US has run big budget deficits for the past five years and accumulated a large debt that must be serviced at considerably higher interest rates in the future … And the US must soon start to finance large prospective deficits for old age pensions and health care. There is no way to finance these current and future liabilities that will not involve higher future tax rates… 

It is wrong when somebody tells the American to maintain the value of the dollar…The fluctuating rate system should work both ways. Strong economies appreciate; weak economies depreciate. 

What is the alternative? Deregulation is desirable, but it will do its work slowly. If temporary tax cuts are saved, not spent, and permanent tax cuts are impossible, the US choice is between devaluation and renewed deflation. The deflationary solution runs grave risks. Asset prices would continue to fall. Investors anticipating further asset price declines would have every reason to hold cash and wait for better prices. The fragile banking system would face larger losses as asset prices fell. 

Monetary expansion and devaluation is a much better solution. An announcement by the Federal Reserve and the government that the aim of policy is to prevent deflation and restore growth by providing enough money to raise asset prices would change beliefs and anticipations. Rising asset prices, including land and property prices, would revive markets for these assets once the public became convinced that the policy would be sustained. 

The volume of “bad loans” at US banks is not a fixed sum. Rising asset prices would change some loans from bad to good, thereby improving the position of the banking system. Faster money growth would add to the banks’ ability to make new loans, encouraging business expansion.

This program can work only if the exchange rate is allowed to depreciate. Five years of lowering interest rates has shown that there is no way to maintain the exchange rate and generate monetary expansion…

…Some will see devaluation as an attempt by the US to expand through exporting. This is a half-truth. Devaluation will initially increase US exports and reduce imports. As the economy recovers, incomes will rise. Rising incomes are the surest way of generating imports of raw materials and sub-assemblies from US trading partners.

Let money growth increase until asset prices start to rise.”

I think Allan Meltzer as a true monetarist presents a very strong case for US monetary easing and at the same time acknowledges that fiscal policy is irrelevant. Furthermore, Meltzer makes a forceful argument that if monetary policy is eased then that would significantly ease financial sector distress. The readers of my blog should not be surprised that Allan Meltzer always have been one of my favourite economists.

Meltzer indirectly hints that he wants the Federal Reserve to target asset prices. I am not sure how good an idea that is. After all what asset prices are we talking about? Stock prices? Bond prices? Or property prices? Much better to target the nominal GDP target level, but ok stock prices do indeed tend to forecast the future NGDP level pretty well.

OK, I admit it…I have been cheating! Allan Meltzer did indeed write this (or most of it), but he as not writing about the US. He was writing about Japan in 1999 (So I changed the text a little). It would be very interesting hearing why Dr. Meltzer thinks monetary easing is wrong for the US today, but right for Japan in 1999. Why would Allan Meltzer be against a NGDP target rule that would bring the US NGDP level back to the pre-crisis trend and then there after target a 3%, 4% or 5% growth path as suggested by US Market Monetarists such as Scott Sumner, Bill Woolsey and David Beckworth?

 

12 Comments
by Lars Christensen on January 22, 2012  •  Permalink
Posted in Allan Meltzer, Bill Woolsey, David Beckworth, Federal Reserve, Japan, Monetary institutions, Monetary policy, NGDP Targeting, Nominal Income Targeting, QE, Scott Sumner
Tagged , , , , ,

Posted by Lars Christensen on January 22, 2012

https://marketmonetarist.com/2012/01/22/allan-meltzers-great-advice-for-the-federal-reserve/

There is no such thing as fiscal policy – and that goes for Japan as well

Scott Sumner has a comment on Japan’s ”lost decades” and the importance of fiscal policy in Japan. Scott acknowledges based on comments from Paul Krugman and Tim Duy that in fact Japan has not had two lost decades. Scott also discusses whether fiscal policy has been helpful in reviving growth in the past decade in Japan.

I have written a number of comments on Japan (see here, here and here).

I have two main conclusions in these comments:

1)   Japan only had one “lost decade” and not two. The 1990s obviously was a disaster, but over the past decade Japan has grown in line with other large developed economies when real GDP growth is adjust for population growth. (And yes, 2008 was a disaster in Japan as well).

2)   Monetary policy is at the centre of these developments. Once the Bank of Japan introduced Quantitative Easing Japan pulled out of the slump (Until BoJ once again in 2007 gave up QE and allowed Japan to slip back to deflation). Se especially my post “Japan shows QE works”.

This graph of GDP/capita in the G7 proves the first point.

Second my method of decomposition of demand and supply inflation – the so-called Quasi-Real Price Index – shows that once Bank of Japan in 2001 introduced QE Japanese demand deflation eased and from 2004 to 2007 the deflation in Japan only reflected supply deflation while demand inflation was slightly positive or zero. This coincided with Japanese growth being revived. The graph below illustrates this.

Obviously the Bank of Japan’s policies during the past decades have been far from optimal, but the experience clearly shows that monetary policy is very powerful and even BoJ’s meagre QE program was enough to at least bring back growth to the Japanese economy.

Furthermore, it is clear that Japan’s extremely weak fiscal position to a large extent can be explained by the fact that BoJ de facto has been targeting 0% NGDP growth rather than for example 3% or 5% NGDP growth. I basically don’t think that there is a problem with a 0% NGDP growth path target if you start out with a totally unleveraged economy – one can hardly say Japan did that. The problem is that BoJ changed its de facto NGDP target during the 1990s. As a result public debt ratios exploded. This is similar to what we see in Europe today.

So yes, it is obvious that Japan can’t not afford “fiscal stimulus” – as it today is the case for the euro zone countries. But that discussion in my view is totally irrelevant! As I recently argued, there is no such thing as fiscal policy in the sense Keynesians claim. Only monetary policy can impact nominal spending and I strongly believe that fiscal policy has very little impact on the Japanese growth pattern over the last two decades.

Above I have basically added nothing new to the discussion about Japan’s lost decade (not decades!) and fiscal and monetary policy in Japan, but since Scott brought up the issue I thought it was an opportunity to remind my readers (including Scott) that I think that the Japanese story is pretty simple, but also that it is wrong that we keep on talking about Japan’s lost decades. The Japanese story tells us basically nothing new about fiscal policy (but reminds us that debt ratios explode when NGDP drops), but the experience shows that monetary policy is terribly important.

——–

PS I feel pretty sure that if the Bank of Japan and the ECB tomorrow announced that they would target an increase in NGDP of 10 or 15% over the coming two years and thereafter would target a 4% NGDP growth path then all talk of “lost decades”, the New Normal and fiscal crisis would disappear very fast. Well, the same would of course be true for the US.

5 Comments
by Lars Christensen on January 22, 2012  •  Permalink
Posted in Japan, Monetary policy, NGDP Targeting, Nominal Income Targeting, Paul Krugman, QE, Quasi-Real Price Index, Scott Sumner
Tagged , , , ,

Posted by Lars Christensen on January 22, 2012

https://marketmonetarist.com/2012/01/22/there-is-no-such-thing-as-fiscal-policy-and-that-goes-for-japan-as-well/

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

—————–

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.

15 Comments
by Lars Christensen on January 20, 2012  •  Permalink
Posted in David Eagle, Deflation, Evan Koeing, George Selgin, Guest blog, Guest post, MM Research agenda, Monetary institutions, Monetary policy, Monetary policy rules, MV=PY, NGDP Targeting, Nominal Income Targeting, Price Level Targeting, Productivity Norm, Quasi-Real Indexing, Quasi-Real Price Index, Reading recommendations
Tagged , , , , , ,

Posted by Lars Christensen on January 20, 2012

https://marketmonetarist.com/2012/01/20/guest-blog-the-two-fundamental-welfare-principles-of-monetary-economics-by-david-eagle/

Don’t forget the ”Market” in Market Monetarism

As traditional monetarists Market Monetarists see money as being at the centre of macroeconomic discussion. To us both inflation and recessions are monetary phenomena. If central banks print too much money we get inflation and if they print to little money we get recession or even depression.

This is often at the centre of the arguments made by Market Monetarists. However, we are exactly Market Monetarists because we have a broader view of monetary policy than traditional monetarists. We deeply believe in markets as the best “information system” – also about the stance of monetary policy. Even though we certainly do not disregard the value of studying monetary supply numbers we believe that the best indicator(s) of monetary policy stance is market pricing in currency markets, commodity markets, fixed income markets and equity markets. Hence, we believe in a Market Approach to monetary policy in the tradition of for example of “Manley” Johnson and Robert Keheler.

In fact we want to take out both the “central” and “banking” out of central banking and ideally replace monetary policy makers with the power of the market. Scott Sumner has suggested that the central banks should use NGDP futures in the conduct of monetary policy. In Scott’s set-up monetary policy ideally becomes “endogenous”. I on my part have suggested the use of prediction markets in the conduct of monetary policy.

Sometimes the Market Monetarist position is misunderstood to be a monetary version of (vulgar) discretionary Keynesianism. However, Market Monetarists are advocating the exact opposite thing. We strongly believe that monetary policy should be based on rules rather than discretion. Ideally we would prefer that the money supply was completely market based so that velocity would move inversely to the money supply to ensure a stable NGDP level. See my earlier post “NGDP targeting is not a Keynesian business cycle policy”

Even though Market Monetarists do not necessarily advocate Free Banking there is no doubt that Market Monetarist theory is closely related to the thinking of Free Banking theorist such as George Selgin and I have early argued that NGDP level targeting could be see as “privatisation strategy”. A less ambitious interpretation of Market Monetarism is certainly also possible, but no matter what Market Monetarists stress the importance of markets – both in analysing monetary policy and in the conduct monetary policy.

—-

See also my earlier post from today on a related topic.

13 Comments
by Lars Christensen on January 13, 2012  •  Permalink
Posted in Free Banking, George Selgin, Monetary institutions, Monetary policy, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, Scott Sumner
Tagged , , , , , ,

Posted by Lars Christensen on January 13, 2012

https://marketmonetarist.com/2012/01/13/dont-forget-the-market-in-market-monetarism/

Forget about the “Credit Channel”

One thing that has always frustrated me about the Austrian business cycle theory (ABCT) is that it is assumes that “new money” is injected into the economy via the banking sector and many of the results in the model is dependent this assumption. Something Ludwig von Mises by the way acknowledges openly in for example “Human Action”.

If instead it had been assumed that money is injected into economy via a “helicopter drop” directly to households and companies then the lag structure in the ABCT model completely changes (I know because I many years ago wrote my master thesis on ABCT).

In this sense the Austrians are “Creditist” exactly like Ben Bernanke.

But hold on – so are the Keynesian proponents of the liquidity trap hypothesis. Those who argue that we are in a liquidity trap argues that an increase in the money base will not increase the money supply because there is a banking crisis so banks will to hold on the extra liquidity they get from the central bank and not lend it out. I know that this is not the exactly the “correct” theoretical interpretation of the liquidity trap, but nonetheless the “popular” description of the why there is a liquidity trap (there of course is no liquidity trap).

The assumption that “new money” is injected into the economy via the banking sector (through a “Credit Channel”) hence is critical for the results in all these models and this is highly problematic for the policy recommendations from these models.

The “New Keynesian” (the vulgar sort – not people like Lars E. O. Svensson) argues that monetary policy don’t work so we need to loosen fiscal policy, while the Creditist like Bernanke says that we need to “fix” the problems in the banking sector to make monetary policy work and hence become preoccupied with banking sector rescue rather than with the expansion of the broader money supply. (“fix” in Bernanke’s thinking is something like TARP etc.). The Austrians are just preoccupied with the risk of boom-bust (could we only get that…).

What I and other Market Monetarist are arguing is that there is no liquidity trap and money can be injected into the economy in many ways. Lars E. O. Svensson of course suggested a foolproof way out of the liquidity trap and is for the central bank to engage in currency market intervention. The central bank can always increase the money supply by printing its own currency and using it to buy foreign currency.

At the core of many of today’s misunderstandings of monetary policy is that people mix up “credit” and “money” and they think that the interest rate is the price of money. Market Monetarists of course full well know that that is not the case. (See my Working Paper on the Market Monetarism for a discussion of the difference between “credit” and “money”)

As long as policy makers continue to think that the only way that money can enter into the economy is via the “credit channel” and by manipulating the price of credit (not the price of money) we will be trapped – not in a liquidity trap, but in a mental trap that hinders the right policy response to the crisis. It might therefore be beneficial that Market Monetarists other than just arguing for NGDP level targeting also explain how this practically be done in terms of policy instruments. I have for example argued that small open economies (and large open economies for that matter) could introduce “exchange rate based NGDP targeting” (a variation of Irving Fisher’s Compensated dollar plan).

18 Comments
by Lars Christensen on January 12, 2012  •  Permalink
Posted in Austrian economics, Banking crisis, Ben Bernanke, Exchange rate policy, Federal Reserve, Irving Fisher, Lars E. O. Svensson, Liquidity trap, MM Research agenda, Monetary institutions, Monetary policy, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, Reading recommendations, Transmission mechanism
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Posted by Lars Christensen on January 12, 2012

https://marketmonetarist.com/2012/01/12/forget-about-the-credit-channel/

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