Thursday, October 20, 2011

Playing with the Goldman-Sachs Toy

I was very pleased that two economists at Goldman Sachs have advocated nominal GDP targeting. They used a "toy" model to simulate the effects.

I spent most of yesterday (between classes,) playing with their toy.

Perhaps I am making some error, but it seemed to me that their model simulates a rapid recovery over the next year given the status quo policy of a target federal funds rate of .25 percent and a level of base money at $2.6 trillion. The output gap is mostly closed in a year, and inflation remains moderate, gradually rising towards the Fed's implicit 2% target.

On the other hand, when I tried a target for nominal GDP, my results were awful. With the best case, a boom develops after about one year, with very high positive output gaps. While inflation does slowly pick up, the price level stays well below what I would think is the "equilibrium" value, the target for nominal GDP divided by potential output. Worse, it didn't take much tinkering to generate explosive results.

This doesn't make me less supportive of nominal GDP targeting. It does make me doubt the value of the "toy" model, which is really very standard. First, the economy is not recovering rapidly, which suggests there are some problems with the model. Second, that such models simulate a rapid recovery explains why the Fed keeps holding policy steady. It is just about to work. And finally, these sorts of models do a very bad job in modeling a very different regime--nominal GDP targeting.

Unfortunately, it is hard to escape the conclusion that two models are necessary. One to capture the process of a shift to a new regime. And then the second to model the operation of the new regime.


  1. Lars Svensson wrote a paper where he tried NGDP targeting (without the level part) in a model and concluded that it might be unstable.

  2. It is worse than you say.

    Targeting the level of nominal GDP also results unstable inflation and output.

    The "problem" is that this year's interest rate determines next year's output gap which generates the following year's inflation rate.

    I would think that the way to deal with the problem is to set this year's interest rate to keep nominal GDP in two years on target.

    But I also think that the model just doesn't apply to the regime.

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