Nominal GDP Targeting and Supply Shocks: Again.

Adam P. has kindly responded again. After bringing up instability of prices and output initially, an absurd result, he now insists that it is irrelevant. Now, the only question is optimality.

Of course, he is giving up on explosive results or perpetual oscillations, and wants to insist that dampened oscillations to equilibrium is the consequence of nominal GDP targeting. Why? Because if prices are set based upon past inflation rates, overshooting is inevitable. In other words, a macro cobweb based upon myopia.

This result still requires periods of stagflation alternating with deflationary booms. Stagflation is something that has been observed, though I don't think that firms have been especially profitable during those periods. On the other hand, these deflationary booms in output where firms suffer losses--how likely are those?

I don't agree that myopic cobwebbing that eventually settles down to equilibrium is a likely result of a regime of nominal GDP targeting. I think it is entirely possible that the introduction of the new regime might include some undesirable errors in pricing and production.

Adam P. accepted my argument that the equilibrium price level is the target for nominal GDP divided by potential output and the equilibrium for real output is potential output. (Which leads to equilibrium reverting price expectations.) He then claims:

I certainly don't disagree but the problem is that his argument actually implies that an inflation target is superior. The reason is that potential output is neither constant nor observable, as it varies around the value of NGDP that is optimal changes as well unless you want inefficient, and welfare reducing, volatility in inflation. On the other hand, if you stabilize relative prices so that price/wage stickiness doesn't distort the real outcome then you get exactly the outcome Bill describes. If you target NGDP with any variability in all in potential output then you don't get the outcome Bill describes.

The implications of "supply shocks" play a key role in market monetarist thinking. If potential output changes, then firms will need to adjust their prices to clear markets. Adam P. argues that this will create welfare reducing fluctuations in inflation.

Consider what Adam P.'s argument implies. If there is an adverse supply shock, with potential output falling or growing less than the expected amount, then nominal GDP targeting will imply excessive inflation. With nominal GDP remaining on target, the equilibrium level of the prices of output rises. (Nominal incomes, including nominal wage rates, continue to grow at trend.)

How would inflation targeting fix this problem? The monetary authority would slow nominal GDP growth when there is an adverse supply shock, so inflation rate would remain at trend.

Now, consider a specific example--a bad harvest for corn. According to Adam P., what should happen is that the monetary authority slow nominal expenditure in the economy, to keep the inflation implied by the higher price of corn from "reducing welfare" due to its arithmetic impact on the price level. What that really means is that all the other prices in the economy, including nominal incomes like wages, must grow more slowly. The price of corn, then, rises slightly less than it would with nominal GDP targeting, and all the other prices are slightly lower than they would otherwise be. If those other prices, for example, wages, are sticky, then the effort to reduce the "welfare loss" from inflation causes a recession. Not only is potential output lower because less corn is being produced, but the falling sales in the rest of the economy that are needed to signal the necessary reduction in prices (or more moderate price increases) reduces output in those markets too. Real output falls below potential.

George Selgin's "Less Than Zero," discusses these matters, though most Market Monetarists believe he worries too much about the optimal trend growth rate in nominal GDP. While Selgin advocates a trend growth rate of nominal expenditure to match the trend growth rate of factor supplies, the more general aspects of his arguments regarding productivity shocks apply to any trend growth rate in nominal expenditure.

Consider a bumper harvest of corn. With nominal GDP targeting, nominal wages continue to grow at trend, and the price of corn falls. Arithmetically, the price level falls (or grows more slowly.) Real wages rise. Workers have higher real incomes and can consume more corn, but they are suffering a welfare loss from "inflation volatility." With inflation targeting, the central bank should expand nominal GDP growth so that other prices rise enough so that the inflation rate does not fall. Now, if this results in nominal wages growing more quickly, then real wages rise and workers can consume more corn. But if wages are sticky, then real wages don't rise. Other product prices rise enough to offset the deflation (or disinflation) in the corn market. Nominal wages grow at trend. Relative prices do change and so workers presumably purchase more corn and fewer other goods. And real and nominal profits expand. The owners of the firms can purchase more corn and more other goods. And what do the workers get out of this? They don't suffer welfare losses from inflation variability.

In the real world, supply shocks are microeconomic events where specialist firms respond to changes in their particular supply conditions by changes in their prices and production. These changes have an impact on the price level/inflation rate and aggregate output. A model that ignores this, and treats price level variance and potential output variance as independent stochastic processes is fundamentally flawed. While a negative covariance between price level shocks and potential output shocks helps add an element of reality, there is no alternative to considering the microeconomics. If the good with the supply shock has unit elastic demand, then nominal GDP targeting is perfect. Otherwise, a sufficiently clever monetary authority might do better by allowing nominal GDP to change. And while stabilizing nominal expenditure in the rest of the economy appears the least disruptive approach, the elasticity of supply for the good with the supply shock matters as well. The allocation of resources should change.

Unfortunately, in the real world, we have monetary authorities who lack this God-like knowledge. Worse, they respond to negative supply shocks with worries about inflation expectations becoming unanchored. At best, the monetary authority just ignores goods and services that have historically suffered from supply shocks, But they don't always stick to their "core inflation" target. And, of course, supply shocks can occur in markets for goods other than food and energy.

My view is that slow steady growth of money expenditure on output is the least bad environment for microeconomic coordination--in the real world. Inflation targeting was tried. It worked pretty well--until there was a massive decrease in nominal expenditures on output. It is time for a new monetary regime.