I meant to do so weeks ago, but I only just got around to reading the little flurry of posts concerning NGDP targeting that was set off by John Taylor's critical remarks on the topic. And now, despite the delay, I can't resist putting-in my own two cents, because it seems to me that much of the discussion misses the real point of targeting nominal spending, either entirely or in part; what's more, some of the discussion is just-plain nonsense.
Thus Professor Taylor complains that, "if an inflation shock takes the price level and thus NGDP above the target NGDP path, then the Fed will have to take sharp tightening action which would cause real GDP to fall much more than with inflation targetting." Now, first of all, while it is apparently sound "Economics One" to begin a chain of reasoning by imagining an "inflation shock," it is crappy Economics 101 (or pick your own preferred intro class number), because a (positive) P or inflation "shock" must itself be the consequence of an underlying "shock" to either the demand for or the supply of goods. The implications of the "inflation shock" will differ, moreover, according to its underlying cause. If an adverse supply shock is to blame, then the positive "inflation shock" has as its counterpart a negative output shock. If, on the other hand, the "inflation shock" is caused by an increase in aggregate demand, then it will tend to involve an increase in real output. Try it by sketching AS and AD schedules on a cocktail napkin, and you will see what I mean.
Good. Now ask yourself, in light of the possibilities displayed on the napkin, what sense can we make of Taylor's complaint? The answer is, no sense at all, for if the "inflation shock" is really an adverse supply shock, then there's no reason to assume that it involves any change in NGDP. On the contrary: if you are inclined, as I am (and as Scott Sumner seems to be also) to draw your AD curve as a rectangular hyperbola, representing a particular level of Py (call it, if you are a stickler, a "Hicks-compensated" AD schedule), it follows logically that an exogenous AS shift by itself entails no change at all in Py, and hence no departure of Py from its targeted level. In this case, although real GDP must in fact decline, it will not decline "much more than with inflation targetting," for the latter policy must involve a reduction in aggregate spending sufficient to keep prices from rising despite the collapse of aggregate supply. A smaller decline in real output could, on the other hand, be achieved only by expanding spending enough to lure the economy upwards along a sloping short-run AS schedule, that is, by forcing real GDP temporarily above its long-run or natural rate--something, I strongly suspect, Professor Taylor would not wish to do.
If, on the other hand, "inflation shock" is intended to refer to the consequence of a positive shock to aggregate demand, then the "shock" can only happen because the central bank has departed from its NGDP target. Obviously this possibility can't be regarded as an argument against having such a target in the first place! (Alternatively, if it could be so regarded, one could with equal justice complain that similar "inflation shocks" would serve equally to undermine inflation targeting itself.)
But lurking below the surface of Professor Taylor's nonsensical critique is, I sense, a more fundamental problem, consisting of his implicit treatment of stabilization of aggregate demand or spending, not as a desirable end in itself, but as a rough-and-ready (if not seriously flawed) means by which the Fed might attempt to fulfill its so-called dual mandate--a mandate calling for it to concern itself with both the control of inflation and the stability of employment and real output. And this deeper misunderstanding is, I fear, one of which even some proponents of NGDP targeting occasionally appear guilty. Thus Scott Sumner himself, in responding to Taylor, observes that "the dual mandate embedded in NGDP targeting is not that different from the dual mandate embedded in the Taylor Rule," while Ben McCallum, in his own recent defense of NGDP targeting, treats it merely as "one way of taking into account both inflation and real output considerations."
To which the sorely needed response is: no; No; and NO.
We should not wish to see spending stabilized as a rough-and-ready means for "getting at" stability of P or stability of y or stability of some weighted average of P and y: we should wish to see it stabilized because such stability is itself the very desideratum of responsible monetary policy. The belief, on the other hand, that stability of either P or y is a desirable objective in itself is perhaps the most mischievous of all the false beliefs that infect modern macroeconomics. Some y fluctuations are "natural," in the sense meaning that even the most perfect of perfect-information economies would be wise to tolerate them rather than attempt to employ monetary policy to smooth them over. Nature may not leap; but it most certainly bounces. Likewise, some movements in P, where "P" is in practice heavily weighted in favor, if not comprised fully, of prices of final goods, themselves constitute the most efficient of conceivable ways to convey information concerning changes in general economic productivity, that is, in the relative values of inputs and outputs. A central bank that stabilizes the CPI in the face of aggregate productivity innovations is one that destabilizes an index of factor prices.
We shall have no real progress in monetary policy until monetary economists realize that, although it is true that unsound monetary policy tends to contribute to undesirable and unnecessary fluctuations in prices and output, it does not follow that the soundest conceivable policy is one that eliminates such fluctuations altogether. The goal of monetary policy ought, rather, to be that of avoiding unnatural fluctuations in output--that is, departures of output from its full-information level--while refraining from interfering with fluctuations that are "natural." That means having a single mandate only, where that mandate calls for the central bank to keep spending stable, and then tolerate as optimal, if it does not actually welcome, those changes in P and y that occur despite that stability.
While I agree with your view that P and y are not appropriate things to target its less obvious to me why a stable level of spending is seen as the optimal policy goal. I understand that within a MET framework deviations in total spending are caused by changes the in demand for money. This will cause situations of monetary disequilibrium that can only be addressed by either an increase in the money supply or a change in the price level.
Are there not some situations where a change in the price level is not better than an increase in the money supply ? For example:
- When AD changes are reflected in lower demand facing a particular industry are there not some advantages in having those firms that can respond faster to this change gaining a bigger market share as a result ?
- When increased demand for money is caused by an increased perception of risk as entrepreneurs choose to hold cash rather than invest. With no increase in the money supply input factor prices would need to fall and price spreads (and profits) must increase to the level where entrepreneurs will invest again. If instead the money supply increases to stabilize AD would this not cause inflation as supply moves along the AS curve in response to the new AD curve causing a combination of increased supply and increased prices?
I would welcome your views on this.
When the fall in AD is not symmetrical (some sectors suffer more than others), there will be a global recession with one sector suffering more than the others. If a central bank (or free banking system) is targeting constant NGDP, there will be no global recession, but there can be a structural change nevertheless. The current recession and situation in the housing market is the best example. If the FED have been targeting NGDP, there would be no global recession, but the housing market would suffer anyway.
Thanks, I was really thinking of a situation where an industry does not necessarily "suffer" more than others (say demand falls the same in this industry as overall AD). Wouldn't consumers overall be better served if prices fell in that industry and the marginal firms were eliminated, as opposed to the CB increasing the money supply to bring AD back to trend and all firms surviving? I understand that in a MET world there can be a "cascading effect" as falling demand in one area (due to increased demand for money) infects demand in other areas, and that this can lead to recessions. It just seems there may be a trade off between efficiency of firms v stable AD that would not necessarily always favor stable AD over the long term.
Rob, except for the last part, where you seem to have AD being stabilized and shifting at the same time, I don't see any argument here pointing to the desirability of AD changes. For instance, yes, there are times when a change in P is better than an increase in M. For instance, when productivity improves, raising y, its better that the consequent increase in money demand be accommodated by a decline in P. But all that is perfectly consistent with stability of Py.
Let me add that under a system of free banking, this entire subject of NGDP targeting would be irrelevant. Free banks would be led, as if by an invisible hand, to provide the right quantity of money. Individual banks should be no more concerned with targeting the correct total amount of money than individual farmers are concerned with targeting the correct total amount of wheat.
How would free banking respond in a situation where increased demand for money gives the banks higher balances to lend, but at the same time a higher perception of risk by entrepreneurs reduces demand for loans. Potentially this could push IRs negative until price spreads accommodate the increased risk. I don't see how banks will increase the money supply to match the demand in these circumstances.
What would cause greater uncertainty perception? Presumably not monetary policy! And if the State were reduced in size and scope to "anarchy plus the constable," fiscal policy probably wouldn't be the source of it either. And once we get there, we can debate what to do about the constable.
War, natural disaster, demographic changes. I can think of many non-monetary factors that could cause increased risk-aversion and increased demand for money. I support free banking and believe that one of its main benefits is in providing an "elastic money supply" that can help in times of unstable AD. I'm just trying to understand if it is capable of totally stabilizing AD in every circumstances, and if if in fact such an outcome would be optimal anyway.(see my initial comment above).
War wouldn't be much of a factor in a free society. Wars are as pervasive and as big as they are because the State has become a virulent cancer, supported by the secular religion of statism. I don't see how natural disasters and demographic changes could cause more than a blip in increased uncertainty. To cite one example, markets worked well in the San Francisco earthquake of 1906, and were credited in speeding the pace of recovery and rebuilding.
I assume that by "higher balances" you mean "excess reserves." If demand to borrow declines, banks must reduce loan rates all the more to shed the excess. C'est la vie. But to posit a situation in which demand for loans is so feeble that only negative rates can serve to rid banks of their excess liquidity isn't to posit a circumstance in which some particular banking arrangement might fail to combat a recession: it is to assume that a recession is already underway!
Rob:
Did you mean to say "increased demand for money gives the banks higher balances to lend"? Increased demand for money would leave the banks with less cash to lend, not more.
Anyway, suppose consumers want to spend more money, but entrepreneurs want to borrow less. Banks will lend to consumers but not to entrepreneurs. Where do you see the problem?
Mile Sproul hit the nail on the head. Let me add that, for the benefit of any libertarian/free banker who might be suffering from Stockholm syndrome, in a free society there would be no central bank and therefore no monetary policy "hell below us," as John Lennon might have said. Nor would there be a foreign policy, education policy, etc. Where is John Lennon now that we need him?
George, this is excellent!
I have a small comment on your comment at my blog: http://marketmonetarist.com/2011/12/01/selgins-monetary-credo-please-dr-taylor-read-it/
George -
You say an "inflation 'shock' must itself be the consequence of an underlying 'shock' to either the demand for or the supply of goods." Huh? This suggests that you believe inflation to be a real, not a monetary phenomenon. But that's not your view, is it? The Theory of Free Banking? What am I missing? I say inflation is to be traced to shifts in the supply of and demand for money (not of real goods). If inflation's origin is in the "real" economy, we'd have to end up claiming bumper crops cause "deflation" while crop failures cause "inflation." But that's not so, is it?
Best, Richard M. Salsman InterMarket Forecasting, Inc.
As a matter of strict logic, Richard, an unexpected increase in the rate of inflation could be due to an unexpected deterioration of AS. That's not to say that shrinking AS is just as likely to be a cause as expanding AD, just that these are both possible causes. The upward movements of inflation in the 70s, for instance, were partly due to OPEC, though mostly they were caused by Fed-fueled demand growth.
And what's wrong with claiming that bumper crops can cause deflation? The deflation of 1873-96 was itself due to "bumper crops" in all kinds of things. Unless one doesn't believe in m + v = p + q (where the lower cases are for growth rates), I don't see how one can deny the logical possibility of a supply innovation (that is, an innovation to q) causing an opposite innovation to p. In any event, I'm quite certain I've never denied it, either in The Theory of Free Banking or anywhere else.
Thank you, George.
As always, illuminating.
There's simply no way not to learn from you. So I pay attention - and it pays.
Highest respects,
Richard Salsman
You are very welcome as always, Richard--and thanks for the kind words.
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