Wednesday, October 26, 2011

Nominal GDP Targeting and Stagflation

John Carny wrote a post critical of nominal GDP targeting on the CNBC blog.

The headline was pretty awful: Nominal GDP Targeting: A Policy for Stagflation?


Carny seems to think that the purpose of nominal GDP targeting is to raise inflation. Then he makes a series of arguments that are best understood if nominal expenditure remains unchanged and inflation rises.

In reality, the goal of the policy is to raise the flow of expenditure on output. More dollars spent on goods and services produced in the U.S.

It is possible that firms will respond to this increase in the dollar volume of sales by raising prices. To the degree that they do this, the increase in the actual volume of products that can be purchased with that growing dollar expenditure will be smaller. The increase in what the firms actually produce will be smaller. And the expansion in employment will be smaller.

If there were no increase in prices, then the volume of production and employment would grow in proportion to the increase in nominal expenditure. If, on the other hand, prices rise in strict proportion to the rise in nominal expenditure, then production and employment would not be influenced at all.

Advocates for nominal GDP targeting are not simply saying that the Fed will be "loose" for an extended period of time, even if the result is inflationary. Advocates are saying that the Fed will purchase or sell whatever amount of assets are necessary to get nominal GDP to the target growth path and keep it there. Inflation will be controlled by the limited increase in spending along the target growth path. Those who propose a 5% target for nominal GDP are proposing a 2% trend inflation rate. My own preference for a 3% growth path implies long run price level stability.

Carny recognizes that the policy involves an aggressive program of asset purchases, and then begins to discount the ability of the policy to impact expectations. However, he makes a error. He thinks that the expectations of the policy of asset purchases will lower long term interest rates. On the contrary, to the degree the policy is expected to work, expectations of higher future expenditures on output will result in increased credit demand and reduced credit supply, and so higher long term interest rates.

It is rather when the "Chuck Norris" effect fails to work that long term interest rates fall because the Fed is buying assets and paying higher prices for them. The possibility that the consequence of the policy would be expected and result in higher interest rates--short term and long term, isn't necessary. It is just a possible benefit of having the Fed make an explicit commitment to target for a nominal GDP growth path. The explicit commitment reduces the needed increase in the size of the Fed's balance sheet or decrease in short term or long term interest rates.

Carny claims that the policy just won't work when households have too much debt. Again, he imagines that the goal of the policy is to cause inflation and reduce the real value of the debts. But that isn't the point of the policy. The immediate effect on households earning wages is a reduction in worries about future unemployment. Or, more importantly, reduced worries about extended future unemployment. Increased spending in the economy implies increased sales, and increased employment opportunities.

Firms seeing these increased sales will be more inclined to add on employees when they understand that this is the first step in new policy to raise the volume of money expenditures to a target growth path. The most important source of expenditure is by newly employed workers.

Further, for every debtor there is a creditor. Creditor households faced with inflation have an incentive to reduce lending and instead spend on real assets. For example, if the price of a new car or washing machine is going up, it is time to purchase one now rather than wait.

Still further, to the degree that rapid growth in spending impacts prices and not wages, then profits earned by small business will be flush. This should result in increased consumption expenditure by small business owners. Even dividend payouts to stockholders should not be dismissed.

Carny claims that inflation will not cause firms to expand unless they expect "real" profits. Supposedly, they will passively accept a real losses on holding "cash," but will only spend if they earn real profits. Actually, it is entirely sensible for firms to spend cash on real assets to reduce real losses.

I think the best way to understand Carny's confusion is to think about a basic supply and demand problem. Suppose the demand for apples rises. The result of this is a higher price of apples as well as a higher quantity of apples. But doesn't a higher price of apples lower the demand? So, it must be that a higher demand for apples cannot raise the price or the quantity of apples.

The correct analysis is that an increase in the demand for apples causes a shortage at the current price. As the price rises, the quantity demanded falls and the quantity supplied rises until they match. The end result is a higher price and a higher quantity. The most likely process is that the increase in demand results in both a higher price and quantity. The higher price doesn't lead to a decrease in demand.

Higher spending in the economy leads to higher sales for firms, which respond by both expanding production and raising prices. But doesn't the inflation cause people to reduce their purchases? So prices and production cannot rise. No. The higher inflation dampens the increase in real output--it doesn't prevent expenditures from rising.

Finally, Carny's final statement has to be quoted:

In short, its not at all clear that nominal targeting will work as promised—much less generate real economic growth. And it could set off a deflationary spiral that would lead up into low growth and rising prices. In other words, stagflation.

A deflationary spiral that leads to rising prices? What a contradiction!

But stagflation is a possibility. The problem won't be a deflationary spiral. It is rather that if the productive capacity of the economy has been greatly depressed, and the current level of real output is approximately equal to productive capacity, then a shift to a higher growth path for nominal GDP will generate higher inflation. Real GDP will remain at its current low level (relative to the trend of the Great Moderation.) Presumably employment would remain low and unemployment would remain high. Inflation would be high for a time, before settling back to a slower trend rate once nominal GDP reaches the target growth path. High unemployment and temporarily high inflation--stagflation.

However, the problem wouldn't too much debt or odd arguments where people accumulate money that is losing value. The problem won't be that increased demand reduces demand and creates inflation.

The problem would be that firms cannot expand production because they will face bottlenecks. Perhaps there are key employees they cannot find, or special machinery, or some other kind of resource. And so, if the impact of nominal GDP targeting is simply more inflation and little or no real growth or employment, what would be observed is shortages of output as firms struggle unsuccessfully to meet rising sales.

It is important to understand that the problem wouldn't be excessive debt. The problem would be that the productive capacity of the economy fell in about 2007. Nominal GDP targeting keeps the flow of spending on output steady in the face of shifts in the productive capacity of the economy. The result is a higher price level and temporarily higher inflation. Advocates of nominal GDP targeting believe that this is the least bad environment to make the needed adjustments to such a decrease in productive capacity.


  1. All terribly sensible. Of course, there is the even more elementary point that stagflation was characterised by double digit nominal spending growth. Who is proposing that? Not the Market Monetarists.

  2. "If, on the other hand, prices rise in strict proportion to the rise in nominal expenditure, then production and employment would not be influenced at all."

    Would this constitute a failure of NGDP targeting vis a vis its ability to resuscitate the economy? Would you be disappointed if this was the result?

    What are the odds that the reaction to the announcement of a target plays out purely through prices and not quantities?

    In order for there to be an affect on quantities, you're assuming some degree of money illusion and sticky prices, right?

  3. I see nominal GDP targeting as a regime and not a one time fix for the current situation. I think it is a better regime than inflation, price level, or quantity of money targeting.

    If this particular episode was solely one of reduction in productive capacity, and nominal GDP just happened to drop in parallel, so that rising nominal GDP had no positive impact on output, then this would be a particular episode where nominal GDP targeting provides no benefit. But as a regime, it would provide benefits in other possible scenarios and should be maintained.

    I don't expect that the announcement effect will solely impact prices.

    Sticky prices, including resource prices like wages, are the key reason why nominal GDP targeting is a better regime that targeting the price level or the quantity of money. If all prices (and wages) were instantly and perfectly flexible, then price level targeting would probably be better than targeting the growth path for nominal GDP.

  4. Thanks Bill. You answered those so well that I don't have any more questions.

  5. It will be really hard if the inflation raises, but I think it’s highly unlikely to be happening, so got to be very wise and sure with how we go about doing everything. This is ever easy with broker like OctaFX because of their world class features and facilities with low spreads from 0.2 pips to high leverage up to 1.500 while there is also smooth trading platform in cTrader, it’s all picture perfect and helps out with working for us in big way.