Thursday, October 20, 2011

DeLong on Nominal GDP targeting

DeLong commented on Krugman's support of nominal GDP targeting. (He had already advocated the regime change, along with quantitative easing and negative interest rates on reserve balances.)

The thrust of his comment is that money creation and fiscal stimulus should be used together. Either monetary policy alone or fiscal policy alone have doubtful consequences, but by creating money and having the government spend it, there is no doubt it can work.

I am much more confident that monetary policy can do it alone.

What are his doubts? What is the market process he describes?

If you are--as we are right now--in a liquidity trap, with extremely interest-elastic money demand, then expansionary monetary policy that involved the Federal Reserve buying financial assets for cash:
  1. will have next to no effect on the short-term safe nominal interest rate--it's already zero.
  2. will decrease the long-term safe nominal interest rate to the extent that your open-market operations today change people's expectations of what your target for the short-term safe nominal interest rate in the future.
  3. will decrease the long-term safe real interest rate to the extent that it decreases the short-term nominal interest rate and changes expectations today of what inflation will be in the future.
  4. will decrease the long-term risky real interest rate to the extent that it decreases the long-term safe real interest rate and to the extent that the assets purchased for cash by the Federal Reserve free up the risk-bearing capacity of private investors and lead to a reduction in risk spreads.
  5. will increase spending to the extent that it decreases the long-term risky real interest rate and to the extent that private spending responds positively to decreases in the long-term risky real interest rate.

Lots of steps here, some of which may well be weak.

Other than 5, all of these steps involve a decrease in the real interest rate, and then 5 is the idea that a lower real interest rate would cause firms and households to spend more. At least some of the steps involve creating expectations about future interest rates and inflation.

An alternative process is that expectations of a higher future flow of money expenditures on output will result in an increase in the profit-maximizing level of output and employment. The increase in the future profit-maximizing level of output increases the demand for capital goods now at any given level of real interest rate.

The increase in the future profit maximizing level of employment decreases the risk of future involuntary unemployment. This results in a decrease in saving now at any given level of real interest rate. (Or, we could simply say that an increase in expected future real income lowers current saving.)

In other words, the increase in present investment demand and decrease in saving supply results in an increase in the natural interest rate. Given the level of real interest rate generated by the first 4 steps described by DeLong, the present flow of money expenditures on output rises.

Using IS-LM analysis, the IS curve shifts to the right because of an increase in expectations of future real output and income, so that it crosses the full employment level of real output at a higher real interest rate. (Nick Rowe goes with a positively sloped IS curve to get at this.)

Why is this process ignored? It does, of course, have a "confidence fairy" element. But so does the process based upon higher expected inflation. Expected inflation can only be created if, somehow, nominal expenditure is going to increase in the future.

Suppose that no one believes that nominal expenditure will rise. Sadly, this forecloses both the higher future real output and higher present natural interest rate path, as well as the higher expected inflation and lower real interest rate path.

Does that only leave us with the pathways described above? Expectations about future policy rates and "free up the risk-bearing capacity of private investors and lead to a reduction in risk spreads?"

I believe that DeLong's approach is too deeply tied to the new Keynesian modeling strategy. The market monetarist approach is that the Fed must commit to purchase whatever quantity of assets needed to reach and stay on the target growth path.

That does not involve convincing anyone that policy rates will be lower in the future. They can expect what they want. The Fed will lower long rates by purchasing long term to maturity assets at higher prices. Sure, if the private sector continues to hold some too, and they don't expect nominal GDP to rise, those particular investors holding them must be expecting that future short term rates will be low. But that isn't what the Fed would be trying to do by purchasing the long term to maturity assets.

And, if necessary, the Fed would start purchasing risky assets (and yes, seeking changes in the law if necessary.) Freeing up the risk bearing capacity of private investors is probably not the best way to look at the situation. The Fed would be taking however much risk as is needed to generate sufficient consumption and and investment to get nominal GDP to target.

But just because the Fed would be committed to increase the quantity of base money to an amount equal to the nominal GDP target (or twice that amount,) if necessary, doesn't mean that there is a need to worry about base money being $15 or $30 trillion. It is not realistic to expect nominal GDP won't rise to target, which means that the higher natural interest rate and/or the lower real interest rate through higher expected inflation paths will kick in. And when they do, nominal and real interest rates can rise.

That Woodford and other neo-Wicksellians/new Keynesians developed simple models that show how a central bank can manipulate a short and safe interest rate according to a rule, and thereby manipulate long term risky real interest rates in a way that stabilizes inflation and closes output gaps is very interesting. Those rules very much depend on everyone understanding how the central bank will manipulate future short term interest rates in response to output gaps and inflation.

However, it is a mistake to assume that the only way that central banks can operate is by creating expectations about how short term interest rates will behave in the future in response to future output gaps and inflation. Since telling people that the Fed expects its policy rate to stay low for an extended period of time and even until 2013 hasn't generated a strong recovery, perhaps there is a problem with the model. But more importantly, imagining that heroic quantitative easing works by creating expectations about future short term rates is very implausible.

Why is it that the effect on the "IS" curve is ignored? If the new Keynesian approach works, then we would never get into a situation where saving rises and investment falls because people don't believe that the levels of short and safe interest rates that the central bank will set in the future won't generate a recovery. The only way that an output gap can be generated is if real interest rates are too high. The only way to fix it is to generate expectations of lower real interest rates.

But we know that strong recoveries create strong credit demand which raises equilibrium real interest rates. In my view, the new Keynesian models are just too tied to a regime of a central bank that adjusts a short and safe interest rate according to output gaps and inflation. They are poorly suited to considering an alternative regime where current and future interest rates can be at any level, and what is stabilized is the growth path of nominal GDP.

I don't deny that if no one expects the policy will raise nominal GDP, then lower nominal interest rates are what make massive quantitative easing work despite perverse expectations. But this hybrid approach where real long term interest rates must be lower is wrongheaded. And it matters from a practical perspective, because if and when people expect the policy to work, nominal and real interest rates should rise. And no one must expect that future "policy rates" will be low.


  1. Really excellent blogging of late. I have enjoyed many of your posts. Even the ones with math scribbles in them.

  2. There's one bit I'm having trouble understanding. It's clear to me that if the fed is credible enough to change expectations, that the amount of actual buying they need to do will be small, or even negative (Nick's Chuck Norris analogy was excellent).

    The problem I see is that the bank is not currently credible in this direction. Whether it will magically be credible as soon as it announced an NGDP target is questionable. So therefore, it needs to have a way to back up it's claim forcefully.

    When it comes to short term interest rate targets, clearly it can do this, and banks know it, so there rarely need to be a lot of open market purchases to meet the interest rate targets.

    On the other hand, QE was not expected to be permanent or tied to any kind of expectation target, so in order to achieve significant traction, the fed had to purchase a *lot* of long term bonds.

    Now, if the fed can print money and buy *anything*, and its power to do so is unlimited, then clearly it can meet an NGDP target whether the market believes it or not, and eventually bettors against will be squeezed and forced to submit to the target.

    But given the current operational authority of the fed, I'm not sure it can do enough to meet an NGDP target unless the expectations channel works well. You mention "seeking changes in the law if necessary". If it turns out to be necessary, then the fed alone does not have the power to target NGDP, and if a critical mass of the market thinks it will be necessary and a political non-starter, then the expectations won't kick in properly and the policy will fail.

    This is my main worry with NGDP targeting: Can the existing fed credibly promise to move NGDP against the market if necessary.

    Am I missing something?

  3. Bill: very good post. Paul Krugman also missed the IS shift to the right (or upward-sloping IS curve).

    I'm really not sure why this is. I'm sure both Brad and Paul are perfectly familiar with e.g. Old Keynesian arguments why an increase in expected future RGDP would increase current investment demand. Plus it would increase current consumption demand in any theory of the consumption function which was even vaguely full-employment.

    It might be that Paul's Japan model has IIRC only a 1 period recession (for simplicity), so everyone knows the economy will be back at the full equilibrium level of output next period.

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