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.”*