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.”

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”.

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.

A method to decompose supply and demand inflation

It is a key Market Monetarist position that there is good and bad deflation and therefore also good and bad inflation. (For a discussion of this see Scott Sumner’s and David Beckworth’s posts here and here). Basically one can say that bad inflation/deflation is a result of demand shocks, while good inflation/deflation is a result of supply shocks. Demand inflation is determined by monetary policy, while supply inflation is independent of whatever happens to monetary policy.

The problem is that the only thing that normally can be observed is “headline” inflation, which of course mostly is a result of both supply shocks and changes in monetary policy. However, inspired by David Eagle’s work on Quasi-Real Indexing (QRI) I will here suggest a method to decompose monetary policy induced changes in consumer prices from supply shock driven changes in consumer prices. I use US data since 1960 to illustrate the method.

Eagle’s simple equation of exchange

David Eagle in a number of his papers QRI starts out with the equation of exchange:

(1) M*V=P*Y

Eagle rewrites this to what he calls a simple equation of exchange:

(2) N=P*Y where N=M*V

This can be rewritten to

(3) P=N/Y

(3) Shows that consumer prices (P) are determined by the relationship between nominal GDP (N), which is determined by monetary policy (M*V) and by supply factors (Y, real GDP).

We can rewrite as growth rates:

(4) p=n-y

Where p is US headline inflation, n is nominal GDP growth and y is real GDP growth.

Introducing supply shocks

If we assume that we can separate underlining trend growth in y from supply shocks then we can rewrite (4):

(5) p=n-(yp+yt)

Where yp is the permanent growth in productivity and yt is transitory (shocks) changes in productivity.

Defining demand and supply inflation

We can then use (5) to define demand inflation pd:

(6) pd=n- yp

And supply inflation, ps, can then be defined as

(7) ps=p-pd (so p= ps+pd)

Below is shown the decomposition of US inflation since 1960. In the calculation of demand inflation I have assumed a constant growth rate in yp around 3% y/y (or 0.7% q/q). More advanced methods could of course be used to estimate yp (which is unlikely to be constant over time), but it seems like the long-term growth rate of GDP has been pretty stable around 3% of the last couple of decade. Furthermore, slightly higher or lower trend growth in RGDP does not really change the overall results.

We can of course go back from growth rates to the level and define a price index for demand prices as a Quasi-Real Price Index (QRPI). This is the price index that the monetary authorities can control.

The graph illustrates the development in demand inflation and supply inflation. There graph reveals a lot of insights to US monetary policy – for example that the increase in inflation in the 1970s was driven by demand inflation and hence caused by the Federal Reserve rather than by an increase in oil prices. Second and most interesting from today’s perspective demand inflation already started to ease in 2006 and in 2008 we saw a historically sharp drop in the Quasi-Real Price Index. Hence, it is very clear from our measure of the Quasi-Real Price Index that US monetary policy turning strongly deflationary already in early 2008 – and before (!) the collapse of Lehman Brothers.

Lets target a 2% growth path for QRPI

It is clear that many people (including many economists) have a hard time comprehending NGDP level targeting. However, I am pretty certain that most people would agree that the central bank should target something it can actually directly influence. The Quasi-Real Price Index is just another modified price index (in the same way as for example core inflation) so why should the Federal Reserve not want to target a path level for QRPI with a growth path of 2%? (the clever reader will of course realise that will be exactly the same as a NGDP path level target of 5% – under an assumption of long term growth of RGDP of 3%).

In the coming days I will have a look at the QRPI and US monetary history since the 1960s through the lens of the decomposition of inflation between supply inflation and demand inflation.

“Monetary Policy, Financial Stability, and the Distribution of Risk”

I have recently been giving a lot of attention to the work of David Eagle and his Arrow-Debreu based analysis of monetary policy rules. This is because I think David’s work provides a microfoundation for Market Monetarism and adds new dimensions to the discussion about NGDP targeting – particularly in regard to financial stability.

I have now come across a paper that is using a similar model as David’s model. However, this might be a slightly more interesting for the conspiratorial types as this paper is written by a Federal Reserve economist – Evan F. Koeing of the Federal Reserve Bank of Dallas.

Here is that abstract of Koeing’s paper “Monetary Policy, Financial Stability, and the Distribution of Risk”:

“In an economy in which debt obligations are fixed in nominal terms, but there are otherwise no nominal rigidities, a monetary policy that targets inflation inefficiently concentrates risk, tending to increase the financial distress that accompanies adverse real shocks. Nominal- income targeting spreads risk more evenly across borrowers and lenders, reproducing the equilibrium that one would observe if there were perfect capital markets. Empirically, inflation surprises have no independent influence on measures of financial strain once one controls for shocks to nominal GDP.”

This paper obviously is highly relevant and as the euro crisis just keeps getting worse day-by-day we can always hope that some influential European policy makers read this paper.

After all the euro crisis is mostly a monetary crisis rather than a fiscal crisis – which David Beckworth forcefully demonstrates in a recent comment.

HT Arash Molavi Vasséi

Dubai, Iceland, Baltics – can David Eagle explain the bubbles?

It’s Sunday night in Copenhagen and I have just returned from a trip to Dubai. I should really write a long post about Dubai, but I will keep it short.

Dubai really reminded me of Iceland – in the sense that both places should NOT really have seen the bubbles we saw. Both Dubai and Iceland had a property market boom, but one can hardly say that there is any serious supply constrains in either Dubai or Iceland. Both Dubai and Iceland seem simply to be “unreal” – or at least that was the case in the boom years.

To me it is pretty clear that we had a bubble in both places and the bubbles have now busted. But why did we have bubbles in Iceland and Dubai? Well, the easy answer is easy money, but I think that that explanation is too simple. And was it local monetary policy or was it US monetary policy that was too easy?

Fundamentally I think that moral hazard played a large role in both Iceland and Dubai – and guess what, both Iceland and Dubai have been bailed out by better off cousins – in the case of Iceland primarily by the other Nordic governments and in the case of Dubai by the big bother in the UEA – Abu Dhabi. But then why did we not have bubbles in other places where the risk of moral hazard was equally big? Again I like to stress that one should never underestimate the importance of luck or the opposite and this is probably also the explanation this time around.

However, Dubai made me think that Market Monetarists really need to take the issues of it bubbles serious. Market Monetarists disagree on this issue. Scott Sumner tends downplay the risk of bubbles – or rather that monetary policy cannot do much to avoid bubbles (other than target NGDP). David Beckworth on the other hand has done interesting work with George Selgin on why overly loose monetary policy might lead to misallocation. My own position is that I used to think that it mostly was easy monetary policy that was to blame and that is what led me – in my day-job – to warn against boom-bust in Iceland and Central and Eastern Europe in 2006-7. I have since come to think that moral hazard also play a role in this, but I am now returning to the monetary issue. However, while I think overly easy monetary policy led to misallocation in Iceland and Dubai and I am not really sure that that is the case in the US as NGDP never really increased above it’s Great Moderation trend prior to the outbreak of the Great Recession in 2008. That might, however, be due to measurement problems and other measures nominal spending seem to indicate that monetary policy indeed was too loose prior to 2008.

So what kind of model can explain the kind of bubbles we saw in for example the Baltic economies in 2004-8? And here I return to David Eagle – an economist whose work has not been fully appreciated, but I have been trying to change that recently.

David’s starting point is an Arrow-Debreu (A-D) model in which he analyse the impact of changes in nominal spending on the economy and on allocation. Furthermore, David uses his model(s) to analyse how different monetary policy rules – NGDP targeting, Price level targeting and inflation targeting – influence allocation (including lending).

David mostly has used his theoretical set-up to look at the impact of negative shocks to NGDP, but my thesis is that David’s model set-up might be useful in analysing what went wrong in Iceland and Dubai – and In Central and Eastern Europe and Southern Europe for that matter. It should be noted that NGDP outgrew its prior trends in the “boom” years – contrary to the situation in the US.

I have not looked at this formally, but here is the idea. We have an A-D model, we introduce sticky prices and wages and a central bank with an inflation target (as Iceland have). Most of the economies that have had boom-bust have seen some kind of structural reforms that have led to positive supply shocks – for example banking reform in Iceland and a general opening of the economies in Central and Eastern Europe – or believe it or not euro membership for countries like Spain and Greece.

What happens in Eagle’s set-up? I have not done the math, but here is my intuition. A positive supply put downward pressure on prices and with the central bank targeting inflation the central bank will ease monetary policy – as inflation is inching down. In Eagle’s model this will lead an (in-optimal?) increase in lending. This increase in lending will last as long as the positive supply shocks continues. However, once the shocks come to an end then the process is reversed – and this is when the “bubble” burst (yes, yes this is somewhat beyond that scope of David’s model, but bare with me…). This by the way is very similar to what George Selgin and David Beckworth have suggested for the US economy, but I think this discussion is much more relevant for Dubai, Iceland and the Baltic States (or the the PIIGS for that matter) than for the US.

Again, I have not gone through this formally with David Eagle’s model set-up, but I think it could be a useful starting point to get a better understanding of the boom-bust in Iceland, Dubai and other places. That said I want also to stress the extent of the present global crisis is not a result of bubbles bursting (that might however been the crisis started), but rather too tight monetary policy is to blame for the crisis. David Eagle’s framework can also easily explain this.

——

PS I should really write something about the euro crisis, but lets just remind people that I think that we are in 1931. By the way the UK left the gold standard in 1931 and the Scandinavian countries followed the lead from the UK. Germany, France, Austria and other continental European countries stayed on the gold standard. We all remember how that story ended. Oddly enough the monetary faultline is more or less the same this time around. Why should we expect a different outcome this time around?

Friedman should have supported NGDP targeting, but never did

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

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

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

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

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

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

——

See also my earlier post on related topics:

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

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”

David Eagle on “Nominal Income Targeting for a Speedier Economic Recovery”

I am continuing my mini-review of the research done by Dale Domian and David Eagle. The next paper in the “series” is a truly excellent paper on an empirical investigation of the impact of different monetary policy targets (inflation targeting, Price Level Targeting and Nominal Income Targeting) on the speed of recovery in the US economy.

Here is the abstract of the paper “Nominal Income Targeting for a Speedier Economic Recovery”:

“Using panelled time-series event studies of U.S. recessions since 1948, this paper studies the speed at which the unemployment rate recovers from a recession. This paper identifies recessions (such as the 1990s and 2001 recessions) as ones consistent with inflation targeting, whereas other recessions are more consistent with nominal-income targeting. We then find that the unemployment recovery time is significantly faster for those recessions consistent with nominal-income targeting than for those recessions consistent with inflation targeting. We then discuss the theoretical superiority of nominal income targeting from a Pareto-efficient micro foundations standpoint. Also, by studying the time path of nominal aggregate spending, we find definite empirical evidence of the “let bygones be bygones” property of inflation targeting.”

The paper is extremely innovative in its method. The characteristics of the three types of targeting are used to identify what type of targeting the Federal Reserve (implicitly) has used during different recessions since World War II.

It is then shown that in those recessions the Fed has targeted nominal income the recovery was speedier than in those periods when the Fed targeted inflation.

The very innovative methods in my view clearly should inspire Market Monetarists to adopt these methods in future research to test and demonstrate the merits of Nominal Income Targeting.

Furthermore, David Eagle demonstrates in a numbers of his papers that Nominal Income Targeting (NGDP targeting) is Pareto optimal. Hence, contrary to most Market Monetarists who focus on the macroeconomic advantages of NGDP Targeting Dr. Eagle demonstrates the microeconomic advantages and has a clear welfare perspective on NGDP Targeting. I think this is a tremendous strength in his (and Domian’s) research. Eagle’s and Domian’s research in many ways remind me of George Selgin’s argument for the so-called Productivity Norm.

I certainly hope that Eagle and Domian will continue to pursue research in this area (and the related area of Quasi-Real Indexing) and I hope that the future will lead to exchange of ideas between Eagle and Domian and the Market Monetarists. Maybe one day they might even join the “club”.

A simple housing rescue package – QRI Mortgages and NGDP targeting

This is from Eagle’s and Domian’s paper “Quasi-Real-Indexed Mortgages to the Rescue”:

“With the U.S. Federal Government owning so many mortgages through its bailout of Fannie Mae and Freddie Mac, there may be a unique opportunity for the government to provide a principal break to mortgage holders in return for converting the mortgages to QRIMs. Based on a old January 2009 estimate, the principal reduction would be about 7.8%. With a principal reduction of 7.8% and QRIM payments being 22% below traditional mortgage payments, we are talking about approximately 30% reduction in the monthly mortgage payments relative to the traditional mortgage payment.

Some readers might consider this a government give away. However, if the central bank was trying to target nominal aggregate demand (nominal income targeting), then the fact that nominal GDP is 7.8% below its target means that the central bank will be trying in the future to get nominal GDP back up to its nominal GDP target. To do so, the central bank will need to increase nominal GDP 7.8% in addition to the long-run growth rate in real GDP and the “targeted” inflation rate of 2.5%. Thus, if the central bank was committed to a nominal-GDP target, then if the central bank meets its target eventually, then nominal GDP will recover which means that through quasi-indexing, the principal will also recover.”

I am certainly no expert on the US housing market, but to me this seems like a great idea for a US housing rescue package.

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Note:

QRIMs are Quasi-Real-Indexed Mortgages which “index mortgage payments to one and only one of the two causes of inflation. That cause is aggregate-demand-caused inflation. QRIMs share an advantage of its cousin Price-Level-Adjusted Mortgages (PLAMs) in that the initial mortgage payments are smaller than with conventional mortgages making the mortgages more affordable.”  

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