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The Integral Reviews: Paper 1 – Koenig (2011)

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

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

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

Lars Christensen

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

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

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

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

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

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

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

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

Koenig’s conclusion is succinct:

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

22 Comments
by Lars Christensen on December 27, 2011  •  Permalink
Posted in "Integral", David Eagle, Evan Koeing, MM Research agenda, Monetary policy, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, Reading recommendations
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Posted by Lars Christensen on December 27, 2011

https://marketmonetarist.com/2011/12/27/the-integral-reviews-paper-1-koenig-2011/

“The Great Recession: Market Failure or Government Failure?” BUY IT NOW!

Robert Hetzel’s new book “The Great Recession: Market Failure or Government Failure?” is now available for pre-order at Amazon.com (and Amazon.co.uk). Did you order it!? Needless to say I have ordered my version and hope it will arrive in my mailbox sometime around my birthday in early March!

Here is that official book description:

“Since publication of Robert L. Hetzel’s The Monetary Policy of the Federal Reserve (Cambridge University Press, 2008), the intellectual consensus that had characterized macroeconomics has disappeared. That consensus emphasized efficient markets, rational expectations, and the efficacy of the price system in assuring macroeconomic stability. The 2008-2009 recession not only destroyed the professional consensus about the kinds of models required to understand cyclical fluctuations but also revived the credit-cycle or asset-bubble explanations of recession that dominated thinking in the 19th and first half of the 20th century. These “market-disorder” views emphasize excessive risk taking in financial markets and the need for government regulation. The present book argues for the alternative “monetary-disorder” view of recessions. A review of cyclical instability over the last two centuries places the 2008-2009 recession in the monetary-disorder tradition, which focuses on the monetary instability created by central banks rather than on a boom-bust cycle in financial markets.”

I am very much looking forward to reading this book that I am pretty sure will have a very significant impact on the understanding of the causes of the Great Recession among economists and is likely to become a piece that economic historians will study in the future.

If you can’t wait then I recommend you to read Hetzel’s fantastic paper on the causes of the Great Recession: “Monetary Policy in the 2008–2009 Recession”

 

3 Comments
by Lars Christensen on December 27, 2011  •  Permalink
Posted in Reading recommendations, Robert Hetzel, The Great Recession
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Posted by Lars Christensen on December 27, 2011

https://marketmonetarist.com/2011/12/27/the-great-recession-market-failure-or-government-failure-buy-it-now/

US Monetary History – The QRPI perspective: 1970s

I am continuing my mini-series on US monetary history through the lens of my decomposition of supply inflation and demand inflation based on what I inspired by David Eagle have termed a Quasi-Real Price Index (QRPI). In this post I take a closer look at the 1970s.

The economic history of the 1970s is mostly associated with two major oil price shocks – OPEC’s oil embargo of 1973 and the 1979-oil crisis in the wake of the Iranian revolution. The sharp rise in oil prices in the 1970s is often mentioned as the main culprit for the sharp increase in US inflation in that period. However, below I will demonstrate that rising oil prices actually played a relatively minor role in the increase in US inflation in that period.

The graph below shows the decomposition of US inflation in 1970s. As I describe in my previous post demand inflation had already started to inch up in the second half of 1960s and was at the start of the 1970s already running at around 5%.

After a drop in demand inflation around the relatively mild 1969-70 recession demand inflation once again started to pick up from 1971 and reached nearly 10% at the beginning of 1973. This was well before oil prices had picked up. In fact if anything supply inflation helped curb headline inflation in 1970-71.

The reason for the drop in supply inflation might be partly explained by the Nixon administration’s use of price and wage controls to curb inflationary pressures. These draconian measures can hardly be said to have been successful and to the extent it helped curb inflation in the short-term it provided Federal Reserve chairman Arthur Burns with an excuse to allow the monetary driven demand inflation to continue to accelerate. It is well known that Burns – wrongly – was convinced that inflation primarily was a cost-push phenomenon and that he in the early 1970 clearly was reluctant to tighten monetary policy because he had the somewhat odd idea that if he tightened monetary policy it would signal that inflation was out control and that would undermine the wage controls. Robert Hetzel has a very useful discussion of this in his “The Monetary Policy of the Federal Reserve”.

As a result of Burn’s mistaken reluctance to tighten monetary policy demand inflation kept inching up and when then the oil crisis hit in 1974 headline inflation was pushed above 10%. However, at that point almost half of the inflation still could be attributed to demand inflation and hence to overly loose monetary policies.

Headline inflation initially peaked in 1974 and as oil prices stopped rising headline inflation gradually started to decline. However, from 1976 demand inflation again started inching and that pushed up headline inflation once again.

In 1979 Paul Volcker became Federal Reserve chairman and initiated the famous Volcker disinflation. Scott Sumner has argued that Volcker didn’t really tighten monetary policy before 1981. I agree with Scott that that is the conclusion that if you look at market data such as bond yields and the US stock market. Both peaked in 1981 rather than 1979 indicating that Volcker didn’t really initiate monetary tightening before Ronald Reagan became president in 1981. However, my measure for demand inflation tells a slightly different story.

Hence, demand inflation actually peaked already in the first quarter of 1979 and dropped more than 5%-point over the next 12 month. However, as demand inflation started to decline the second oil crisis of the decade hit and that towards 1980 pushed headline US inflation up towards 13%.

So there is no doubt that rising oil prices indeed did contribute to inflation in the US in the 1970s, however, my decomposition of the inflation data clearly shows that the primary reason for the high and increase through the decade was the Federal Reserve’s overly loose monetary policy.

Finally it should be noted that the 1970s-data show some strength and weaknesses in my decomposition method. It is clearly a strength that the measure shows the impact of the oil price shocks, but it is also notable that these shocks takes 3-4 years to play out. So while oil prices spiked fast in for example 1974 and then settle at a higher level the supply shock to inflation seems to be more long lasting. This indicates some stickiness in prices that my decomposition method does not fully into account. As one of my commentators “Integral” has noted in an earlier comment it is a weakness with this decomposition method that it does not take into account the upward-sloping short-run AS curve, but rather it is assumed that all supply shocks shifts the vertical long-run AS curve left and right. I hope I will be able to address this issue in future posts.

In my next post I will have a closer look at how Paul Volcker beat the “Great Inflation”.

2 Comments
by Lars Christensen on December 19, 2011  •  Permalink
Posted in David Eagle, Economic and monetary history, Federal Reserve, Inflation, MM Research agenda, Monetary institutions, Monetary policy, Quasi-Real Indexing, Quasi-Real Price Index, Reading recommendations, Robert Hetzel, Scott Sumner
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Posted by Lars Christensen on December 19, 2011

https://marketmonetarist.com/2011/12/19/us-monetary-history-the-qrpi-perspective-1970s/

US Monetary History – The QRPI perspective: 1960s

In my previous post I showed how US inflation can be decomposed between demand inflation and supply inflation by using what I term an Quasi-Real Price Index (QRPI). In the coming posts I will have a look at use US monetary history through the lens of QRPI. We start with the 1960s.

In monetary terms the 1960s in some sense was a relatively “boring” decade in the sense that inflation remained low and relatively stable and growth – real and nominal – was high and relatively stable. However, the monetary policies in the US during this period laid the “foundation” for the high inflation of the 1970s.

In the first half of the 1960s inflation remained quite subdued at not much more than 1%, however, towards the end of the decade inflation started to take off.

What is remarkable about the 1960s is the quite strong growth in productivity that kept inflation in check. The high growth in productivity “allowed” for easier monetary policy than would otherwise have been the case an demand inflation accelerated all through the 1960s and towards the end of the decade demand inflation was running at 5-6% and as productivity growth eased off in 1966-67 headline inflation started to inch up.

In fact demand inflation was nearly as high in the later part of the 1960s in the US as was the case in the otherwise inflationary 1970s. In that sense it can said that the “Great Inflation” really started in 1960 rather than in the 1970s.

My favourite source on US monetary history after the second War World is Allan Meltzer’s excellent book(s) “A History of the Federal Reserve”. However, Robert Hetzel’s – somewhat shorter – book “The Monetary Policy of the Federal Reserve: A History” also is very good.

Both Meltzer and Hetzel note a number of key elements that were decisive for the conduct of monetary policy in the US in the 1960s. A striking feature during the 1960s was to what extent the Federal Reserve was very direct political pressure by especially the Kennedy and Johnson administrations on the Fed to ease monetary policy. Another feature was the most Federal Reserve officials did not share Milton Friedman’s dictum that inflation is a monetary phenomenon rather the Fed thinking was strongly Keynesian and so was the thinking of the President’s Council of Economic Advisors. As a consequence the Federal Reserve seemed to have ignored the rising inflationary pressures due to demand inflation and as such is fully to blame for the high headline inflation in the 1970. I will address that in my next post on US monetary history from an QRPI perspective.

1 Comment
by Lars Christensen on December 18, 2011  •  Permalink
Posted in David Eagle, Federal Reserve, Inflation, MM Research agenda, Monetary policy, Quasi-Real Indexing, Quasi-Real Price Index, Reading recommendations, Robert Hetzel
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Posted by Lars Christensen on December 18, 2011

https://marketmonetarist.com/2011/12/18/us-monetary-history-the-qrpi-perspective-1960s/

“The Wages of Destruction”

It is always nice to open the mailbox and see a new book in the mail. The latest arrival at the Christensen household is “The Wages of Destruction” by Adam Tooze on “The Making and Breaking of the Nazi Economy”.

I have not read it yet, but my feeling is that is will be an interesting read. Most of the reviews of the book I have seen are very positive.

Here is from Richard Tilly’s review of the book:

“The narrative follows a broad chronology. Part one, covering the early 1930s, examines the country’s recovery from the Depression, the reorganization of its economy, and the beginnings of rearmament. Perhaps the most striking feature of these years was the extent to which Germany was driven to reorganize its international economic relations in response to the hegemony of its main creditor, the United States. In part two, “The War in Europe,” Tooze describes the Four Year Plan of 1936–1939 to mobilize the economy for war, culminating in Germany’s successful campaigns against Poland and France. Tooze points out that these triumphs were the result less of superior economic preparedness and more advanced technology than of luck and skillful military leadership. The net gains to Germany’s war economy from these victories were meager, and it could even be said in retrospect, since they accelerated Anglo-American cooperation, that they had a negative impact. Part three describes the economic costs and benefits to Nazi Germany of widening the conflict by invading the Soviet Union in June and declaring war on the United States in December of 1941. These hostile acts, Tooze reminds us, reflected both economic considerations—a desire to gain access to Russia’s oil and grain reserves—and racist ideology—as home to millions of Jews, the Soviet Union was the object of future “Germanization,” and the United States was considered to be the headquarters of “world Jewry.”

If any of my readers have read the book I would be interested in hearing what you think? And can we draw any lessons from the book? Does it tell us anything about today’s euro crisis?

6 Comments
by Lars Christensen on December 12, 2011  •  Permalink
Posted in euro crisis, Reading recommendations
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Posted by Lars Christensen on December 12, 2011

https://marketmonetarist.com/2011/12/12/the-wages-of-destruction/

David Eagle’s framework and the micro-foundation of Market Monetarism

Over the last couple of days I have done a couple of posts on the work of David Eagle (and Dale Domian). I guess that there still are a few posts that could be written on this topic. This is the next one.

Even though David Eagle’s work has been focusing on what he and Dale Domian have termed Quasi-Real Indexing I believe that his work is highly relevant for Market Monetarists. In this post I will try to draw up some lessons we can learn from David Eagle’s work and how it could be relevant to formulating a more consistent micro-foundation for Market Monetarism.

There are a no recessions in a world without money

The starting point in most of Eagle’s research is an Arrow-Debreu model of the world. Similarly the starting point for Market Monetarists like Nick Rowe and Bill Woolsey is Say’s Law – that supply creates its own demand. (See for example Nick on Say’s Law here).

This starting point is a world without money and both in the A-D model and under Say’s Law there can not be recessions in the sense of general glut in the product and labour markets.

However, once money and sticky prices and wages are introduced – both by Market Monetarists and by David Eagle – then we can have recessions. Hence, for Market Monetarists and David Eagle recessions are always and everywhere a monetary phenomenon.

N=PY – the simple way to illustrate some MM positions

In a number of his papers David Eagle introduces a simplified version of the equation of exchange where he re-writes MV=PY to N=PY. Hence, Eagle sees MV not some two variables, but rather as one variable – nominal spending (N), which is under the control the central bank. This is in fact quite similar to Market Monetarists thinking. While “old” monetarists traditional have assumed that V is constant (or is “stationary”) Market Monetarists acknowledges that this position no longer can be empirically supported. That is the reason why Market Monetarists have focused on the right hand side of the equation of exchange rather than on the left hand side like “old” monetarists like Milton Friedman used to do.

I, however, think that Eagle’s simplified equation of exchange has some merit in terms of clarifying some key Market Monetarist positions.

First of all N=PY gets us from micro to macro. Hence, PY is not one price and one output, but numerous prices and outputs. If N is kept constant that is basically the Arrow-Debreu world. That illustrates the point that we need changes in N to get recessions.

Second, N=PY can be a rearranged to P=N/Y. Hence, inflation is the “outcome” of the relationship between nominal spending (N) and real GDP (Y). In terms of causality this also illustrates (but it does not necessary prove) another key Market Monetarist point, which often has been put forward by especially Scott Sumner that nominal income (N) causes P and Y and not the other way around (See here and here). This is contrary to the New Keynesian formulation of the Phillips curve, where “excessive” growth in real GDP relative to “trend” GDP increases “price pressures”.

Third, P=N/Y also illustrates that there are two sources of price changes – nominal spending (N) and supply shocks. This lead us to another key Market Monetarist position – also stressed strongly by David Eagle – that there is good and bad inflation/deflation. This is a point stressed often by David Beckworth (See here and here). David Eagle of course uses this insight to argue that normal inflation indexing is sub-optimal to what he has termed Quasi-Real Indexing (QRI). This of course is similar to why Market Monetarists prefer NGDP targeting to Price Level Targeting (and inflation targeting).

The welfare economic arguments for NGDP targeting

In an Arrow-Debreu world the allocation is Pareto optimal and with fully flexible prices and wages changes in N will have no impact on allocation and an increase or a drop in N will have no impact on economic welfare. However, if we introduce sticky prices and wages in the model then unexpected changes in N will reduce welfare in the traditional neo-classical sense. Hence, to ensure Pareto optimality we have two options.

1)   The monetary institutional set-up should ensure a stable and predictable N. We can do that with a central bank that targets the NGDP level or with a Free Banking set-up (that ensures a stable N in a perfect competition Free Banking system). Hence, while Market Monetarists mostly argue in favour of NGDP from a macroeconomic perspective David Eagle’s framework also gives a strong welfare theoretical argument for NGDP targeting.

2)   (Full) Quasi-Real Indexing (QRI) will also ensure a Pareto optimal outcome – even with stick prices and wages and changes in N. David Eagle and Dale Domian have argued that QRI could be used to “immunise” the economy from recessions. Market Monetarists (other than myself) have so far as I know now directly addressed the usefulness of QRI.

Remaining with in the simplified version of the equation of exchange (N=PY) NGDP targeting focuses on left hand side of the equation, which can be determined by monetary policy, while QRI is focused on the right hand side of the equation. Obviously with one of the two in place the other would not be needed.

In my view the main problem with QRI is that the right hand side of the equation is not just one price and one output but millions of prices and outputs and the price system plays a extremely important role in the allocation of resources in the economy. It is therefore also impossible to expect some kind of “centralised” QRI (god forbid anybody would get such an idea…). I am pretty sure that my fellow Market Monetarist bloggers feel the same way. That said, I think that QRI can useful in understanding why the drop in nominal spending (N) has had such a negative impact on RGDP in the US and other places.

Furthermore, as I stressed in an earlier post QRI might be useful in housing funding reform in the US – as suggested by David Eagle. Furthermore, it is obviously QRI based government bonds could be used in the conduct of NGDP targeting – as in line with what Scott Sumner for example has suggested and as in fact also suggested by David Eagle.

David Eagle should inspire Market Monetarists

In conclusion I think that David Eagle’s and Dale Damion’s on work on both NGDP targeting and QRI will be a useful input to the further development of the Market Monetarist paradigm and I especially think it will be helpful in a more precise description of the micro-foundation of Market Monetarism.

PS David Eagle has also done work on interest rates targeting and is highly critical of Michael Woodford’s New Keynesian perspective on monetary policy. This research is relatively technical and not easily assessable, but should surely be of interest to Market Monetarists as well.

—-

See my other posts on David Eagle and Dale Domian:
Quasi-Real indexing – indexing for Market Monetarists
A simple housing rescue package – QRI Mortgages and NGDP targeting
David Eagle on “Nominal Income Targeting for a Speedier Economic Recovery”

9 Comments
by Lars Christensen on December 4, 2011  •  Permalink
Posted in Bill Woolsey, David Beckworth, David Eagle, MM Research agenda, Monetary institutions, NGDP Targeting, Nick Rowe, Nominal Income Targeting, Quasi-Real Indexing, Reading recommendations, Say's Law, Scott Sumner
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Posted by Lars Christensen on December 4, 2011

https://marketmonetarist.com/2011/12/04/david-eagles-framework-and-the-micro-foundation-of-market-monetarism/

Market Monetarism comes to Hong Kong

Dr. Yue Chim Richard Wong Professor at the University of Hong Kong has an excellent comment on Market Monetarism on his great blog. Dr. Wong is a specialist among other things on the Hong Kong property market and a well-known economics commentator in Hong Kong.

In his comment “Easy Money, Tight Money, and Market Monetarism” he explains the background for Market Monetarism and explain the key theoretical insights and policy recommendations from Market Monetarism. It is an excellent introduction to Market Monetarism – to some extent a parallel description to my own working paper on the foundation for Market Monetarism.

Dr. Wong has some interesting observations about the main Market Monetarist thinkers/bloggers:

The Market Monetarist blogger are “(a)n assorted group of economists, mostly of the free market persuasion, (who) have joined Sumner in developing and elaborating the subtle logic behind NGDP targeting and they continue to debate the new Keynesians and old Monetarists…”

Dr. Wong continues: “The amazing fact about the group is that most of the members are relatively junior in the economics profession and are concentrated in the teaching universities. For me this was an absolutely delightful finding. I have always wondered if the pressure to publish research in ever more specialized and compartmentalized fields in the major research universities is an unqualified healthy outcome for academia.”

This I think is a very interesting observation. Scott Sumner spend more than 20 years teaching without anybody in the economics profession really noticing his important research (I did!). But once he started blogging he became the main force behind the creation of a new economic school. A school I am proud to belong to – Market Monetarism.

There is no doubt that Dr. Wong is highly sympathetic to Market Monetarism and in that regard I don’t think it is a coincidence that Wong has his PhD from the University of Chicago as is the case for Scott Sumner. To me the link to the University of Chicago is key to the intellectual development of Market Monetarism.  It is, however, not today’s University of Chicago, but the 1960s and 1970s when Milton Friedman still was a professor at the University. Friedman retired in 1977. The economic and monetary theory that Friedman was teaching at the University of Chicago was policy oriented and “practical”. Contrary to the focus at most universities where students spending most of their time with advanced mathematically models with little or no relevance to the real world – and if the models are relevant the students and professors alike often don’t realise it themselves and the policy conclusions are often not spread to a wider audience.

Scott Sumner, David Beckworth and the other Market Monetarist bloggers have made monetary theory accessible to policy makers, market participants, commentators and journalists. This in my view is the real achievement of Market Monetarism and I am happy to say that Dr. Wong now is helping spreading the word.

PS Dr. Wong write comments in both English and Chinese. He writes a weekly political economy column for the Hong Kong Economic Journal.

 

1 Comment
by Lars Christensen on December 1, 2011  •  Permalink
Posted in David Beckworth, MM Research agenda, Reading recommendations, Scott Sumner
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Posted by Lars Christensen on December 1, 2011

https://marketmonetarist.com/2011/12/01/market-monetarism-comes-to-hong-kong/

Ramesh Ponnuru: For Fed NGDP Could Spell More Economic Stability

Senior editor at National Review and Bloomberg View columnist Ramesh Ponnuru is well-known for his Market Monetarist views Now he is out with a new comment NGDP targeting.

For those not familiar with NGDP targeting Ponnuru has a good explanation:

“Nominal GDP (NGDP) is simply the size of the economy measured in dollars, with no adjustment for inflation. In a year when the inflation rate is 2 percent and the economy grows by 2 percent in real terms, NGDP rises 4 percent. The NGDP targeters say that the Fed should aim to keep this growth rate steady. Christina Romer, the former chairman of President Barack Obama’s Council of Economic Advisers, suggested in the New York Times recently that NGDP should grow at 4.5 percent a year. If the Fed overshoots one year, it should undershoot the next, and vice- versa, so that long-term NGDP growth stays on target…Like the more familiar concept of inflation targeting, NGDP targeting seeks to stabilize expectations about the future path of the economy, making it easier for people to make long-term plans. Keeping nominal spending, and thus nominal income, on a relatively predictable path is especially important because most debts, such as mortgages, are contracted in nominal terms. If nominal incomes swing wildly, so does the ability to service those debts.”

Ponnuru highlights some of the advantages with NGDP targeting compared to inflation targeting:

“The chief advantage of targeting NGDP, rather than inflation, is that it distinguishes between shocks to supply and shocks to demand. With either approach, the central bank should respond to a sudden drop in the velocity of money by expanding the money supply. If people are holding on to money balances at a higher rate than usual — because of a financial panic, just to pick a random example — both inflation and NGDP would fall below target and the Fed would have to loosen money in response.

But the two approaches counsel opposite responses to a negative supply shock, such as a disruption in oil markets. That shock would tend to increase prices and reduce real economic growth, thus changing the composition of NGDP growth but not its amount. With an NGDP target, the Fed would accordingly leave its policy unchanged. With a strict inflation target, on the other hand, the Fed would tighten money — and thus the real economy would take a bigger hit from the supply shock.

A positive supply shock, such as an improvement in productivity, would also elicit different responses. Under an NGDP target, the rate of inflation would decrease and real growth would increase. A strict inflation target would force the Fed to loosen money and thus risk creating bubbles.

In other words, inflation targeting makes the boom-and-bust cycle worse following supply shocks, while NGDP targeting doesn’t.

From the standpoint of macroeconomic stability, then, NGDP targeting is superior because it allows inflation to accelerate and slow to counteract fluctuations in productivity. It moves the money supply only in response to changes in the demand for money balances, and not to supply shocks that mimic the effect of these changes on prices but call for a different monetary response.”

Ponnuru finally reminds the reader that NGDP targeting in the US basically would be a return to the familiar and successful monetary policy of the “Great Moderation”:

“A major obstacle for NGDP targeters is that our idea is novel even to most well-informed followers of economic-policy debates. But we do have some experience with it. Josh Hendrickson, an assistant professor of economics at the University of Mississippi, has shown that from 1984 to 2007 the Fed acted, for the most part, as though it were trying to keep NGDP growing at a stable rate. Whether by design or accident, it did so — and the result has come to be called “the great moderation” because of the gentleness of business cycles in that period. We should target NGDP again, and this time reap the benefits of predictability by saying so.”

The paper Ponnuru is mentioning is Josh’s excellent 2010-paper “An Overhaul of Federal Reserve Doctrine: Nominal Income and the Great Moderation” – read it before your neighbour!

HT David Levey

 

Leave a comment
by Lars Christensen on November 29, 2011  •  Permalink
Posted in David Beckworth, NGDP Targeting, Nominal Income Targeting, Ramesh Ponnuru, Reading recommendations, Scott Sumner
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Posted by Lars Christensen on November 29, 2011

https://marketmonetarist.com/2011/11/29/ramesh-ponnuru-for-fed-ngdp-could-spell-more-economic-stability/

The Fed can save the euro

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

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

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

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

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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/

The Fisher-Friedman-Sumner-Svensson axis

Here is Scott Sumner in 2009:

“People like Irving Fisher had a perfectly good macro model.  Indeed, except for Ratex it’s basically the model that I use in all my research.  But the problem is that these pre-1936 models didn’t use Keynesian language.  And they didn’t obsess about trying to develop a general equilibrium framework. A GE framework is not able to predict any better than Fisher’s models, and is not able to offer more cogent policy advice than Fisher’s model.  Indeed in many ways Fisher’s “compensated dollar plan” was far superior to the monetary policy the Fed actually implemented last October.  (Although I would prefer CPI futures target to a flexible gold price, at least Fisher’s plan had a nominal anchor.)”

I used to think of that Scott mostly was influenced by his old teacher Milton Friedman, but I increasingly think that Scott is mostly influenced by Irving Fisher.

Well of course this is not really important and Friedman undoubtedly was hugely influenced by Irving Fisher. Fisher’s influence on Friedman is excellently explained in a paper by Bordo and Rockoff from earlier this year,

Here is the abstract:

“This paper examines the influence of Irving Fisher’s writings on Milton Friedman’s work in monetary economics. We focus first on Fisher’s influences in monetary theory (the quantity theory of money, the Fisher effect, Gibson’s Paradox, the monetary theory of business cycles, and the Phillips Curve, and empirics, e.g. distributed lags.). Then we discuss Fisher and Friedman’s views on monetary policy and various schemes for monetary reform (the k% rule, freezing the monetary base, the compensated dollar, a mandate for price stability, 100% reserve money, and stamped money.) Assessing the influence of an earlier economist’s writings on that of later scholars is a challenge. As a science progresses the views of its earlier pioneers are absorbed in the weltanschauung. Fisher’s Purchasing Power of Money as well as the work of Pigou and Marshall were the basic building blocks for later students of monetary economics. Thus, the Chicago School of the 1930s absorbed Fisher’s approach, and Friedman learned from them. However, in some salient aspects of Friedman’s work we can clearly detect a major direct influence of Fisher’s writings on Friedman’s. Thus, for example with the buildup of inflation in the 1960s Friedman adopted the Fisher effect and Fisher’s empirical approach to inflationary expectations into his analysis. Thus, Fisher’s influence on Friedman was both indirect through the Chicago School and direct. Regardless of the weight attached to the two influences, Fisher’ impact on Friedman was profound.”

I wonder if Bordo and Rockoff would ever write a paper about Fisher’s influence on Sumner…or maybe Scott will write it himself? I especially find Scott’s “link” to the compensated dollar plan intriguing as I fundamentally think that Scott’s intellectual love affair with “Market Keynesian” Lars E. O. Svensson has to be tracked back to exactly this plan.

PS I am intrigued by the compensated dollar plan (CDP) and I increasingly think that variations of the CDP could be a fitting monetary policy set-up for Emerging Markets and small open economies with underdeveloped financial markets. One day I might get my act together and write a post on that topic.

 

 

 

4 Comments
by Lars Christensen on November 14, 2011  •  Permalink
Posted in Irving Fisher, Milton Friedman, MM Research agenda, Reading recommendations, Scott Sumner
Tagged , , , ,

Posted by Lars Christensen on November 14, 2011

https://marketmonetarist.com/2011/11/14/the-fisher-friedman-sumner-svensson-axis/

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