FOMC Minutes on Nominal GDP targeting

FOMC on Nominal GDP and Price Level Targeting:

The Committee also considered policy strategies that would involve the use of an intermediate target such as nominal gross domestic product (GDP) or the price level. The staff presented model simulations that suggested that nominal GDP targeting could, in principle, be helpful in promoting a stronger economic recovery in a context of longer-run price stability. Other simulations suggested that the single-minded pursuit of a price-level target would not be very effective in fostering maximum sustainable employment; it was noted, however, that price-level targeting where the central bank maintained flexibility to stabilize economic activity over the short term could generate economic outcomes that would be more consistent with the dual mandate. More broadly, a number of participants expressed concern that switching to a new policy framework could heighten uncertainty about future monetary policy, risk unmooring longer-term inflation expectations, or fail to address risks to financial stability. Several participants observed that the efficacy of nominal GDP targeting depended crucially on some strong assumptions, including the premise that the Committee could make a credible commitment to maintaining such a strategy over a long time horizon and that policymakers would continue adhering to that strategy even in the face of a significant increase in inflation. In addition, some participants noted that such an approach would involve substantial operational hurdles, including the difficulty of specifying an appropriate target level. In light of the significant challenges associated with the adoption of such frameworks, participants agreed that it would not be advisable to make such a change under present circumstances.

Yes, a price level target is a bad idea--big problems with supply shocks.

Yes, picking a growth path of nominal GDP is difficult.

But nominal GDP targeting results in stable inflation in the long run, so there should be no problem with inflation expectations becoming unanchored. That is the danger of inflation targeting. When the rule is to do nothing about inflation surprises, then there must be a constant worry about inflation expectations.

Not yet? Perhaps one day.

Does Nominal GDP Exist?

Taylor claims:

But it introduces another problem: 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 and most likely result in abandoning the NGDP target.

Market Monetarists treat nominal GDP as something that really exists--the flow of money expenditures on current output. Critics treat nominal GDP as the product of real output and the price level. "If an inflation shock takes the price level and thus GDP above the NGDP path, then the Fed will have to take sharp tightening action."

Given the growth path of the flow of money expenditures on output, an inflationary shock pushing the price level above its trend growth path will reduce what firms and households will buy and so what firms can sell and produce. While the price level rises to a higher growth path, real output falls to a lower growth path. Nominal GDP remains on target.

If this "inflationary shock" pushed real output below capacity, the resulting surpluses would put downward pressure on prices--automatically reversing the "inflationary shock." Prices would grow more slowly and fall back to their previous growth path and real output would rise again to the growth path of capacity. On the other hand, if the reason for the inflationary shock was a reduction in capacity, then the price level remains on the higher growth path and real output remains on the lower growth path with capacity. Still, nominal expenditures and nominal GDP remain on the target growth path.

On the other hand, suppose nominal GDP is nothing that really exists. It is just the product of the price level and real output. For example, suppose the policy interest rate determines real output in the next period, and then the output gap causes inflation the period after. Of course, we assume some stochastic process that causes inflation shocks during the current period too. Given real output, which was determined by last period's policy rate and its own idiosyncratic shocks, and multiply by the price level, which is already determined by last periods output gap, then multiply and an inflationary shock pushes the product--nominal GDP--above target. How to get the nominal GDP back down? A higher policy rate reduces real output next period, which lowers nominal GDP. And then the period after, the resulting output gap will get the price level back down too. (And will all of this manipulation of the policy rate lead to cycling? Will it be explosive?)

Now, how does this all work? Why does a lower policy rate cause output to change next period? Could it be that it directly causes money expenditures on output to change and firms respond to changes in sales? What happens to the amount that firms can sell next period if the great random number generator in the sky mandates that they charge higher prices? Can they really sell the same amount of output at higher prices? Does the quantity of money rise? Does the demand to hold real money balances fall? Is it that people borrow more? At what interest rate? The last period's interest rate that is supposedly determining output? Or is it the current period's interest rate--the one that will be determining output next period?

If the purpose of a model is to trace out how a given policy rate will impact nominal expenditure, real output, and the inflation rate over time, then perhaps skipping the nominal expenditure step, and going from real output (gaps) in the next period and the inflation rate in the subsequent period will do. But the flow of nominal expenditure on output is the true causal factor in the process. Right? Or are there people who really believe that the policy rate determines output next "period" and output (gaps) determine inflation the following period?

In my view, there is no such thing as an "inflation shock." There are supply shocks where the supply of some particular good or service changes. If the supply of a good decreases, the price rises and the quantity falls. As a matter of arithmetic, the price level rises and real output falls. A price level target requires a monetary contraction to push the price level back down.

An inflation target does nothing to reverse this periods random shock to the price level. But, in the real world, where supply shocks are not produced by stochastic processes but rather reductions in the supply of some particular good, then an inflation target implies a monetary contraction to prevent a developing supply shock from generating inflation. (To pull an example out of thin air, rising oil prices cause worries about inflation expectations becoming unanchored, deterring a decrease in policy rates.)

With a nominal GDP target, the results are more complicated. If the demand for the particular good whose supply decreased is unit elastic, then the increase in the price of the good is inversely proportional to the decrease in the quantity. The arithmetic increase in the price level is inversely proportional to the arithmetic decrease in real output. There is no tendency for nominal GDP to move away from target. Given flow of expenditures in the economy, there is no change in spending in the rest of the economy. There is no need for prices or output to change in other markets.

But if the demand for the good whose supply decreased is inelastic, then the increase in the price of that good is more than proportional to the decrease in quantity. Arithmetically, the price level rises more than in proportion to the decrease in real output. This tends to raise nominal GDP, perhaps pushing it above target. However, if the flow of nominal expenditure on output is already determined, then nominal GDP doesn't rise above target. What happens is that spending rises in the market where supply decreased and falls in the rest of the economy. This decrease in demand tends to depress prices and output in other markets. That is how nominal GDP remains on target despite the sharp increase in the price of the good whose supply decreased.

If demand for the good with the decrease in supply is elastic, then the analysis is reversed. The increase in price is less than in proportion to the decrease in quantity. The arithmetic increase in the price level is less than in proportion to the arithmetic decrease in real output. Nominal GDP tends to fall below target. To the degree that aggregate spending is already determined, then spending on the good whose supply decreased goes down, and spending in the rest of the economy expands. The increase in demand in the rest of the economy tends to raise prices and output for those goods. That is how nominal GDP remains on target despite the sharp decrease in the quantity of the good whose supply has decreased.

In my view, nominal GDP targeting is imperfect. However, the other alternatives are worse. But thinking about random "inflation shocks" in a simple new Keynesian model where the policy rate determines next period's output and this period's output gap determines inflation is highly misleading. It is just as misleading as thinking about random shocks to this periods real output and imagining that inflation must be generated in subsequent periods to return nominal GDP to target.

Negative Interest Rates

Why is there a zero nominal bound on interest rates?

According to Todd Keister, from the New York Fed:

Given the markets’ limited experience with very low interest rates, it is difficult to predict with any degree of certainty how they will react to them. If the types of disruptions described above turn out to be significant, taking steps to lower short-term interest rates could actually make financial conditions tighter rather than looser and thus hinder the economic recovery. To avoid this outcome, policymakers tend to choose policies that keep market interest rates positive.

In other words, the potential for negative interest rates to disrupt financial markets limits the extent to which policymakers can stimulate economic activity by lowering interest rates. This limit is known as the zero lower bound.

In other words, the reason there is a zero nominal bound is that the Federal Reserve chooses to keep interest rates above zero.

Keister had already pointed out how interest rates have been below zero for limited periods of time. He also explains why. It is costly to store currency, especially large quantities. As I have explained in the past, this makes the lower bound on nominal interest rates equal to the cost of storing currency.

Of course, the Federal Reserve is very committed to framing its actions in terms of setting interest rates. From that perspective, the Fed chooses to keep interest rates above zero.

If, for example, the Fed was targeting the quantity of base money, and there were a shortage of T-bills at a nominal interest rate of zero--perhaps because of a flight to safety--then the interest rate would fall until storing currency is cheaper. In other words, paying for safes, guards, and the like.

However, to avoid "money market disruptions," the Fed would seek to prevent this. The most obvious course would be to change its target for base money, reducing the quantity of base money. The resulting excess demand for base money should create a liquidity effect that would at least temporarily raise short term money market yields.

What would be the disruptions that would justify engineering an imbalance between the quantity of money and the demand to hold it? As is usual, there is an air of "only the central bankers know."

Still, Keister provides three possible problems.

Money market funds operate under rules that make it difficult for them to pay negative interest rates to their investors, either directly or by assessing fees. Many of these funds would likely close down if the interest rates they earn on their assets were to fall to zero or below, possibly disrupting the flow of credit to some borrowers.

Since ordinary mutual funds have no difficulty in charging for their services when the underlying portfolio suffers looses, this is a bit of a puzzle. The marketing material for money market funds claims they work very hard to prevent capital loss, and in the Fall of 2008, the "breaking the buck" by Primary Reserve fund, suggests it is possible. Do mutual funds charge for their services as a percent of yield rather than total assets managed like stock mutual funds. Regardless, perhaps it is time for mutual funds to change their rules.

Keister continues:

The auction process for new U.S. Treasury securities does not currently permit participants to submit bids associated with negative interest rates. If market interest rates become negative, new Treasury securities would be issued with a zero interest rate—effectively a below-market price—and bids would be rationed if demand exceeds supply. Such rationing, which has occurred in recent auctions, would generate an incentive for auction participants to bid for more than their true demand, leading to even more rationing. This situation could generate market volatility, as unexpected changes in the amount of rationing in each auction could leave some investors holding either many more or many fewer securities than they desire.

The New York Fed (along with the Office of the Public Debt,) operates the T-bill auctions. The Fed generates monetary disequilibrium to avoid the inconvenience of modifying their procedures in operating the auctions to clear markets? How hard could it be to allow bids of negative yields?

And finally:

A decrease in the IOR rate would also likely affect the federal funds market, where banks and certain other institutions lend funds to each other overnight. A lower IOR rate would give banks less incentive to borrow in this market, which would likely decrease the amount of activity. When less activity takes place, the market interest rate will be influenced more by idiosyncratic factors, making it a less reliable indicator of current conditions. This decoupling of the federal funds rate from financial conditions could complicate communications for the FOMC, which operates monetary policy in part by setting a target for this rate.

So, if market interest rates become negative, then banks would not be motivated to borrow overnight. It is difficult to see why that is true. Certainly, the problem would be the opposite. If the interest rate on reserves is zero, and the federal funds rate is negative, then holding reserves is better than lending them. If the interest rates paid on reserves were negative, along with other short term interest rates, then lending reserves at less negative rate would be desirable. Of course, if the interest rate on overnight loans (or the interest rate on reserves) approaches the cost of holding vault cash, then there would be no motivation to lend.

Frankly, these reasons for keeping interest rates above market clearing levels look to be excuses....bad excuses. Unfortunately, as long as the Fed frames its activity as setting interest rates rather than avoiding imbalances between the quantity of money and the demand to hold it, creating monetary imbalances to manipulate interest rates will seem natural.

HT Mark Thoma

Post Apocalyptic Nominalism

Karl Smith takes issue with my argument that the monetary authority should solely focus on keeping nominal expenditure on target, and should not serve as "lender of last resort" to the government or the banks. Smith believes that the consequence of this approach will be "Post-Apocalyptic Nominalism." Apparently, a few will become vastly wealthy because they will be able to borrow at negative nominal interest rates.

I don't consider this likely. (I hope it is a joke.)

Smith accepts a scenario where a policy aimed at 4 percent nominal GDP growth creates expectations such that all European governments can "self-finance," and the euro-zone economy rapidly recovers.

It seems that the key element of this favorable scenario is that none of the PIGS default. The apocalyptic scenarios both include actual defaults. In one scenario, nominal expenditure is expected to grow on target, but default occurs anyway. The other occurs when nominal expenditure is not expected to grow on target, and default occurs.

Why does government default lead to such a disaster? In my view, the effect is that those governments that lose confidence of creditors default, reduce government spending to current tax revenues, make minimal payments on interest and principal, and presumably reduce the provision of government services. Not exactly pleasant, but hardly apocalyptic.

So why the disaster? Smith assumes the banking system "collapses." Why? Presumably, it is because all the banks in Europe hold the debt of the PIGS. If any of the governments default, then the banks become insolvent. The ECB, then, is supposed to commit to lending to the PIGS so that they will be able to repay banks. And that means that the banks remain solvent. Otherwise, the banks collapse and then it is the apocalypse.

I suppose in Smith's world, when the banks are insolvent they are closed and liquidated, and the depositors receive some partial payment. And then there is a world without banks. Presumably, everyone uses hand-to-hand currency to make all payments. And the ECB creates money solely by purchasing bonds from people they consider solvent. There being so few such people, in order to get them to issue and sell enough bonds, the nominal interest rate is negative.

My view is that permanently closing and liquidating all banks is a very bad idea. If there are many small banks and a few of them are insolvent, closing and liquidating those banks is a reasonable approach. However, when a substantial portion of the banking system is insolvent, reorganizing and reopening those banks is important. If all banks are insolvent, rapid reorganization and reopening is essential.

The simplest approach is that the banks close on Friday, and Monday morning they open again and all of the depositors have substantially lower deposits and shares of stock in the reorganized bank. The banks open and then carry on operations as usual.

If the governments of France or Germany instead want to bail out their banks, then they can purchase the bonds of the governments that default. If, on the other hand, they want to only bail out the depositors in their banks, they can do the same, but reorganize the banks--sell stock to new owners. If they want to solely avoid runs, and bail out all the short term depositors, then they can again do the same, reorganize the banks, and impose haircuts on long term creditors too.

But who exactly is bailed out and how should be the determination of the fiscally sound governments. The ECB should focus on expanding the quantity of money, currency if necessary, enough to meet the demand to hold currency with nominal GDP growing on target. It should not be the responsibility of the monetary authority to lend money to governments so that they can pay off their debts to banks. Nor should it be the responsibility of the monetary authority to lend money to insolvent banks so that they can pay off their depositors.

Taylor on Nominal GDP Targeting

John Taylor still opposes nominal GDP targeting. The Market Monetarist response was rapid. Scott Sumner still hopes that Taylor will get to work developing a "rule" for Nominal GDP rather than inflation. Nick Rowe's post contrasted instrument rules with target rules.

Taylor complains that advocates of nominal GDP targeting have failed to provide a simple formula for a central bank to follow--like the Taylor rule. One version of the Taylor rule is that the target interest rate should be set at 1 + 1.5*(inflation - 2) + .5(output gap.) Taylor favors dropping the output gap term, so that the nominal interest rate should be set at 1 + 1.5*(inflation - 2).

The Taylor rule implicitly makes the target 2 percent inflation. Market Monetarists favor a target for the growth path of nominal GDP. The target is a series of levels of nominal GDP that head off into the future. The goal is to keep (NGDP - NGDP*) equal to zero for each and every future date, where NGDP* is the target level at each future date. NGDP* is growing at a constant rate. The proposed growth rates vary from 5.4% to 2%. However, the key to the proposal is to choose a growth path and stick to it.

How can a central bank actually accomplish this? In my view, if a central bank finds some simple relationship between the short term interest rate in the near future, and nominal GDP in the more distant future, then that would be great. However, it must always be recognized that finding such a regularity is a matter of luck and circumstance. As soon as the regularity breaks down, then adjustments must be made. This is especially true when a short term nominal interest rate is being manipulated.

Taylor claimed that Milton Friedman would have opposed nominal GDP targeting.

For this reason, as Amity Shlaes argues in her recent Bloomberg piece, NGDP targeting is not the kind of policy that Milton Friedman would advocate. In Capitalism and Freedom, he argued that this type of targeting procedure is stated in terms of “objectives that the monetary authorities do not have the clear and direct power to achieve by their own actions.” That is why he preferred instrument rules like keeping constant the growth rate of the money supply. It is also why I have preferred instrument rules, either for the money supply, or for the short term interest rate.

I am not sure what Milton Friedman would do, but Taylor's appeal to rules is confused. Milton Friedman is best known for proposing that the M2 measure of the quantity of money be kept growing at a 3 percent annual rate. But M2 is not directly controlled by the Federal Reserve. From Taylor's perspective, this money supply rule was no rule at all. Where was the actual rule? For example, the policy interest rate is equal to 1 + 1.5*(growth M2 - 3%)?

Of course, during the period when he advocated an M2 money supply rule, Friedman was very critical of the use of short term interest rates as an instrument. He favored looking at the monetary base, which is even more directly controlled by the Fed than interest rates. Did he develop or advocate a rule for the base? Bt = Bt-1 + 1.5*(M2t - M2t*)?

I don't think so. My understanding of "old monetarism," was that the Fed should be given discretion to adjust the monetary base however much is needed to offset any change in the M2 money multiplier so that M2 remains on target. In particular, if bank runs resulted in a decrease in the money multiplier, like in the Great Depression, Friedman insisted that it was the Fed's duty to undertake whatever quantity of open market purchases needed to raise base money enough so that the reduction in the money multiplier is fully offset and the M2 measure of the quantity of money continues on its target path. It has always been my understanding that any errors should be promptly reversed, so that if M2 falls below its trend growth path because of a decrease in the money multiplier, base money should be increased enough to return M2 to the target growth path.

Market monetarists have a view roughly similar to what is outlined above, but taking into account that the observed regularity that M2 velocity was very stable no longer holds. And so, the market monetarist approach is that the least bad replacement target is nominal GDP, and the Fed must adjust the monetary base enough to offset both changes in the money multiplier and velocity.

In my view, the task is inherently more challenging. Statistics of the money supply are reported weekly. While the relationship between depositors, banks, and their borrowers is complicated, the relationship between the demand to hold money and the quantity of money is vastly more complicated. If there is a more or less constant relationship between nominal GDP and some measure of the quantity of money, then adjusting the quantity of base money so that this broader measure of money stays on a constant growth path would be a useful approach to exercising discretion. Similarly, if there is some simple relationship between a short term interest rate and the growth path of nominal GDP, then following a "rule" based on that interest rate would be sensible.

But it must always be understood that there is no reason to expect that any constants will hold in the market system. And when these "instrumental rules" break down, it is the rules that need to change.

While watching some short term interest rate or conglomeration of bank liabilities should not be made into an end in itself, it is essential that the monetary order be based on something other than whatever the central bank likes. "Flexible inflation targeting," means letting the central bank do what it wants.

For many years, I advocated a stable price level. I now believe that this approach is flawed. When the price level is shifted due to changes on the goods side, creating monetary disequilibrium to force it back to a target is disruptive. In my view, keeping total spending on output on a slow, stable growth path is the least bad option. That is the proper rule for the monetary authority. Exactly how best to accomplish that rule where discretion is necessary.

Investment in Equipment and Software

Karl Smith claims that what most people think of as "Investment" is investment in equipment and software, and that it has performed well during the current modest recovery. Real investment in equipment and software has reached its previous peak. The broader measures of investment remain below their previous peaks, but this is due to residential investment and investment in structures. In Smith's view, the problem is construction.

To some degree, Smith is seeking to respond to those "free market" economists, centrally Robert Higgs, who point out that real consumption expenditures has reached its previous peak, so that consumption isn't a problem. Smith has also shown that real retail sales remain below its previous peak, and that the recovery in real consumption expenditures has largely been in implicit rental payments by homeowners, health care paid by Medicare and Medicaid, and the difference between the interest rates banks earn and the very low interest paid on deposits.

My view is that comparing any element of real expenditure to a peak four years ago is really beside the point. As a rule of thumb, each element of real expenditure should by now be about 12 percent higher than its previous peak. (Yes, my rule of thumb doesn't take into account compounding.) More importantly, given that nominal GDP is 14 percent below its growth path of the Great Moderation, my first question is always to compare the nominal value of some type of expenditure to its growth path of the Great Moderation. For example, nominal consumption is nearly 15 percent below its growth path of the Great Moderation. (Real consumption is nearly 12 percent below its growth path of the Great Moderation.)

What about investment in equipment and software? It's current value is $1,137 billion, which has just surpassed its peak of the third quarter of 2007. The trend growth rate of investment in equipment and software during the Great Moderation was 5.92 percent. (From quarter 1 1985 to quarter 4 2007.) This is slightly higher than the trend growth rate of nominal GDP, which was 5.4 percent.

And so what would investment in equipment and software be if it had continued to grow at trend? It's current value would be $1,517 billion. It is currently 24 percent below its trend growth path from the Great Moderation.

Looking at the diagram, perhaps the trend is pushed up by the huge increase right before the 2001 recession. (On the other hand, it is possible that the "problem" was that investment in equipment and software was crowded out by investment in housing.) Interestingly, only a slightly reduced growth rate, to 5.7 percent, puts actual investment very close to this modified trend before the Great Recession.

Even with this slightly slower growth path for investment in equipment and software, it currently remains 17.8 percent below trend. (And if it had been growing with the rest of nominal GDP at 5.4 percent, its current value would be 10% below trend.)

And what about real investment in equipment and software?

Real investment in equipment and software is 28 percent below the trend of the Great Moderation! Like the nominal series, it just passed its previous peak. And while there have been some very high quarterly growth rates during the recovery, (21 percent in the second quarter of 2010,) the collapse was steep during the recession (37 percent in the first quarter of 2009.)

What about the price index for equipment and software? The trend for the Great Moderation was 1.2 percent deflation. And while the price index is currently 5 percent above trend, it has been remarkably stable since 2002 (at 100!) Remarkably, something like the modified nominal series, showing investment 18 percent below trend is likely much more "real" than deflated (that is inflated,) series.

In my view, monetary disequilibrium has depressed nominal expenditure on output across the board. Both consumption and investment in equipment and software have been depressed. That the real value of some element has finally passed its previous peak provides approximately no reason to believe that its current nominal value is appropriate.

Are Nominal Wages Sticky?

Arnold Kling and Bryan Caplan are back to debating aggregate demand and supply. Kling is a skeptic. Caplan supports the "sticky wage" version monetary disequilibrium. Excess demand for money results in reductions in nominal expenditure that should result in lower prices and wages and unchanged output and employment. Prices are flexible and would fall enough to clear markets, but wages only adjust sluggishly. Falling prices and sticky wages imply rising

real wages. Employment and output fall. Easing the monetary disequilibrium would result in higher nominal expenditure, higher prices of final goods, lower real wages, and greater output and employment.

Kling's views are harder to categorize. In my view, they are inconsistent with scarcity. But whether or not his PSST (Patterns of Sustainable Specialization and Trade) makes sense as an explanation for the Great Recession, his most recent argument involved criticism of Caplan's sticky wages approach. ( Sumner also emphasizes sticky wages.) Kling generated the following table:

What Kling sees is that the rate of increase in employment cost slowed more than than the rate of increase in consumer prices. Kling thinks that if employment costs are sticky, then they would have perhaps slowed some (due to growing unemployment) but less than the supposedly flexible consumer prices.

While reasonable enough, what I "see" is that the demand for labor grew faster than the supply of labor resulting in modest growth in real labor compensation (cost to the employers,) during the first period. And then, it would seem, the demand for labor continued to rise, but only slightly more rapidly than the supply of labor during the second period, resulting in even more modest growth in real labor compensation.

But there is some missing information. What happened to employment? My explanation of the above would suggest more rapid growth in employment during the first period and then slower growth in employment in the second period. (The assumption would be that labor supply is growing at a constant rate so that it is the rate of growth of labor demand driving the faster and then slower increases in real compensation.)

Of course, starting in 2007, employment dropped. It is certainly possible that labor supply fell more than demand, and the result was a slight increase in equilibrium real labor compensation. However, a much more plausible explanation is that supply continued to grow and demand fell, and the equilibrium level of real labor compensation fell significantly. But rather than fall with equilibrium real labor compensation, the actual level of real labor compensation grew slightly.

The problem with Kling's reasoning is that during the first period, real labor compensation should have been rising, and in the second period, it should have been falling. It didn't. On the other hand, if product prices are perfectly flexible, then why didn't consumer prices fall? If they are being forced up by growing labor costs, then why didn't they rise by less than labor costs?

Here is a graph of the employment cost index:

It looks like it continued to rise until well after the recession started, and then slowed before rising again at perhaps a slower rate. It looks like it moved to a lower growth path.

What was the growth path of this index during the Great Moderation? What is its current level relative to that growth path? Unfortunately, the series only begins in 2001.

There is a series for wages that exists during all of the Great Moderation--wages of production and nonsupervisory workers. Obviously, this series doesn't include the expense of benefits and it only includes some workers. Still, what has happened to those nominal wages during the Great Moderation?

This measure of nominal wages is 1.39 percent below the trend growth path of the Great Moderation. The price level, as measured by the GDP chain-type price index, is 1.79 percent below its trend growth path. While both prices and wages have risen continuously, this approach and measure suggests that prices are slightly more flexible relative to trend than wages--but not much.

What about compensation? The wage cost index Kling reports only goes back to 2001, but aggregate labor compensation and trend for the Great Moderation are shown below:

Like other nominal measures, the amount firms spend on wages and benefits fell below the trend of the Great Moderation and remains well below trend. However, at 16.47 percent, it has fallen further than nominal GDP, which is "only" 13.87 percent below trend. The other noticeable deviation was in 1999 and 2000, when a positive the gap grew to nearly 5 percent before rapidly disappearing in the 2001 recession.

Employment has fallen during the Great Recession as shown below:

Employment is 9.53 percent below the trend of the Great Moderation. (This is level of employment from the household survey.) There is a very noticeable "boom" in employment right before the 2001 recession. Employment was nearly 3 percent above trend in the second quarter of 2000.

What has happened to compensation per employed person?

Compensation per employed person is currently 7 percent below the trend of the Great Moderation. It did drop significantly during the first quarter of 2009, at a 5% annual rate, but that was fully reversed after two quarters. A better characterization of the period is that compensation per worker quit growing during the recession, but when the economy began to recover in the third quarter of 2009, it began growing again, but remains on a lower growth path. Also note that the "boom" in employment is reflected in a boom in compensation per worker as well right before the 2001 recession.

During this period, there have been substantial changes in the hours worked. Unfortunately, the series going back to 1984 is for production and nonsupervisory workers. Still, the loss in average weekly hours for all private employees was about the same during the Great Recession (About one hour.) Government workers aren't included. (Some government workers were given furlough days. I was.) The following is the average hourly compensation calculated using the average weekly hours of production and nonsupervisory personnel.

When adjusted for the drop in hours worked, the compensation per hour did not drop in the first quarter of 2009. However, its growth certainly slowed with the onset of the Great Recession. It is currently 7.3 percent below the trend of the Great Moderation. It is not that different from the compensation per employed person. (The boom in total compensation, employment, and compensation per worker, also shows up in compensation per hour, though is lagged a bit, hitting 3 percent in the first quarter of 2000.)

These results show no evidence that firms are able (or willing) to significantly cut labor compensation per worker. However, like Kling's simpler analysis, it does suggest that the failure of final goods prices to drop significantly below the trend of the Great Moderation, in the face of a nearly 14 percent decrease in nominal GDP from trend, should not be blamed on labor costs. Nominal labor costs per employee have fallen much further from trend than the GDP chain-type price index.

Lender of Last Resort

Some of the discussion of the sovereign debt crisis in southern Europe has centered on the lack of a national central bank that can serve as a "lender of last resort." The European Central Bank, (ECB) is not playing that role, providing liquidity to government borrowers by purchasing, or standing ready, to purchase their debt.

In my view, one of the traditional roles of central banks has been to serve as "fiscal agent" of the government, and managing the national debt is one aspect of that role. "Lender of last resort," on the other hand, involves lending to banks, rather than to the government.

In my view, the role of the central bank/monetary authority should be to adjust the quantity of base money to accommodate any change in the demand to hold it. Base money is made up hand-to-hand currency issued by the central bank and reserve balances that banks hold with the central bank.

Members of the nonbanking public, households and firms other than banks, obtain hand-to-hand currency through banks. The demand for that part of base money often manifests as deposits or withdrawals of currency from banks. And it is banks themselves that demand reserve balances. The demand to hold base money is closely related to the banking industry. Perhaps the more fundamental reason is that banks borrow through issuing monetary liabilities, financial instruments like checkable deposits, that are close substitutes for base money.

The ordinary process of payments results in withdrawals and deposits of currency and the deposit and clearing of checks. This results in changes reserve balances at different banks--banks with adverse net clearings lose reserves to banks with favorable net clearings. Banks with adverse clearings can borrow from banks with favorable clearings, shifting reserves and currency to where it is needed. In an economy with liquid financial assets, straight sales and purchases of securities can serve the same purpose. Often, short term lending between banks is secured by relatively liquid securities, with repurchase agreements formalizing this hybrid between security transactions and lending.

If, on the other hand, there is an increased demand for base money, either currency or reserve balances, borrowing and lending between banks becomes imbalanced. For example, an increase in the demand for currency results in a withdrawal of currency from some banks that is not matched by additional deposits in other banks. Similarly, if a bank chooses to hold larger reserve balances, it can sell off securities or restrict new lending. Other banks will suffer the balancing reserve deficiencies, but the usual practice of borrowing to meet temporary imbalances doesn't work because the bank accumulating the reserves does not want to lend.

Because the central bank/monetary authority has a monopoly on the creation of base money, it is the only one able to accommodate this increase demand for its "product." Because these demands for base money often show up through the banking system as a demand to borrow without a matching supply of base money to lend, meeting the demand for base money involves serving as "lender of last resort."

In the situation of a bank run, or even a prospective bank run, where many banks seek to accumulate reserve balances to pay out if the run does materialize, the added demand for base money is large, and the consequences of a failure to meet this additional demand can be catastrophic. The market process that eventually returns the economy to equilibrium requires a reduction in the price level, including resources prices like wages. The real quantity of base money rises to meet the demand. While this could occur instantly (leaving aside the near impossibility of conceiving of a smooth and instant resolution of defaults caused by the transfer of wealth from debtors to creditors,) in reality, putting the economy through a deflationary wringer results in unnecessary disruptions in production and employment. Having the central bank/monetary authority serve as "lender of last resort" seems like an essential practice.

What exactly does this have to do with a government that needs to borrow? Generally, governments are not borrowing to accumulate base money, much less to meet the demands for base money by the public. Governments are borrowing to spend. Serving as "lender of last resort" to the government isn't about accommodating an increase in the demand to hold base money, but rather printing up money for the government to spend.

It is true that governments that borrow short to fund a large national debt must constantly borrow to repay debt as it comes due. If lenders loose confidence in the government's ability or willingness to repay, then they will stop lending. The government cannot repay debt as it comes due, and defaults.

Banks are in a similar situation in that their liabilities come due frequently, and banks must borrow again to repay these debts. With monetary liabilities issued by banks the process is more or less continuous. If depositors lose confidence in the ability (willingness is less of an issue with banks bound by contract to redeem in base money,) of banks to repay, then they will no longer lend. The bank defaults.

If, from the economist's God's eye point of view, the bank is really solvent, then going through the costs associated with default is a waste. Similarly, if General Motors is really a sound business, going through reorganization would be a waste, and government planners should fund the business. If the government as a whole really is able and willing to repay its debts, then someone should lend to the government to avoid the wasteful disruption caused by default.

In my view, there is no "God's eye" point of view, and when lenders lose confidence, default and bankruptcy is the proper response. For governments, this means giving existing creditors new bonds to replace the old bond at whatever interest rate the government believes it can pay, and bringing current expenditures in line with current receipts.

Similarly, while the monetary authority/central bank should always accommodate changes in the demand to hold base money, if depositors loose confidence in a bank, then it should be reorganized. With a very concentrated banking system, the loss of even a single large bank could be very disruptive. And it is also possible that many banks could have similar problems at the same time, leading to a loss of confidence by depositors, independent of an increase in the demand to hold base money. An increase in the demand to hold base money, not accommodated by an increase in the quantity of base money, will almost certainly cause difficulties for all banks. But it has become apparent that many banks can get into difficulty by treating sovereign debt or mortgages as if they are (nearly) risk free. Provisions for a rapid reorganization of many banks is important.

In my view, having a central bank/monetary authority create money because someone needs to borrow, is a mistake. "Lender of last resort" is the wrong perspective. Supplying the quantity of base money demanded is the proper role of a central bank/monetary authority.

Nominal GDP Targeting in 1982?

Marcus Nunes posted some FOMC minutes discussing nominal GDP in 1982. They were found by Ryan Sanchez.

Morris explains that the Fed needs to be looking to nominal GDP, but that an explicit target for nominal GDP would cause political problems. The argument for looking to nominal GDP is that M1 velocity was shifting, and so a target for M1 would be a mistake--it would result in the wrong level of nominal GDP.

What is the political problem? It had to do with the Fed creating less nominal GDP than the President proposed. If the President were to propose 12 percent nominal GDP, and the Fed said that it would only create 9 percent, this would put the Fed at cross purposes with the President. This is very closely related to Sumner's view that the central bank acts last. At least in 1982, the Fed was not willing to openly take this role. On the other hand, they did seem to be willing to really play the role--just not openly.

Interestingly, targeting interest rates was also considered unacceptable. Perhaps the problem was setting interest rates at historically high levels. The quantity of money was considered beneficial because it wasn't controversial. However, from context, that "benefit" apparently was that no one understood the disinflationary impact of low money supply growth targets.

Volcker downplays the ability of the Fed to control nominal GDP (and interest rates, of all things,) and suggests that the Fed watch exchange rates as well as inflation. Volcker also sees "obvious dangers" to targeting nominal GDP. What are those dangers exactly? Volcker doesn't say, but his next remark is "that there is great overemphasis on what monetary policy can do." To me, that looks like nominal GDP targeting creating too much accountability for the Fed.

Nominal GDP in the Seventies

Was nominal GDP growth stable in the seventies?

The following chart shows nominal GDP and the trend.

It doesn't seem that much worse than the Great Moderation. The growth rates are substantially different. The trend growth rate of nominal GDP in the Great Moderation was 5.4 percent. In the seventies, it was 10 percent.

Using the CBO estimates of potential output, the GDP gaps were quite large during the period.

There is a pattern between the gaps between nominal GDP and the trend of nominal GDP and real output and potential output.

While the NGDP gap between nominal GDP and trend and the RGDP gap between Real GDP usually move together, it looks like treating the seventies as a period with a constant trend growth rate of nominal GDP is a mistake. Irresponsible out-of-control monetary policy is probably a better description.

Inflation Expectations: A Two Edged Sword

New Keynesians (and sometimes Scott Sumner) have argued that the U.S. economy needs higher expected inflation. For the new Keynesians, the rationale is that real expenditures are below the productive capacity of the economy and lower real interest rates will help to raise real expenditures. Firms will respond by expanding production and employment, bringing real output towards potential. Usually, given expected inflation, lower nominal interest rates would have the same effect. With the Federal Reserve's target interest rate near zero, however, lowering nominal interest rates by lowering that target rate is no longer possible. The argument for higher expected inflation is an argument about aggregate demand.

New Classical economists have sometimes responded to these arguments by claiming that higher expected inflation will have no effect on real output. They aren't making an argument about aggregate demand. They are making an argument about aggregate supply. If inflation is equal to the expected level, then real output will equal potential. It is only when inflation deviates from the expected level that there is some transitory effect on the willingness to produce goods and so some impact on real output and employment.

New Keynesians generally have a different approach to aggregate supply. Inflation depends on past and expected future levels, and also on the output gap, the difference between real output and potential. Even so, an increase in expected inflation implies that more current inflation will be associated with any expansion of real expenditure necessary to close the output gap.

From a market monetarist perspective, both real output and inflation respond to more rapid growth of nominal expenditure on output. Higher expected inflation should result in a division more weighted towards current inflation and less towards real output. And so, generating higher inflation expectations to reduce real interest rates, or perhaps, increase the expected cost of holding currency (which amounts to the same thing,) in order to raise aggregate demand has undesirable effects on aggregate supply.

Now, turn this argument about. Currently, nominal GDP is on a much lower growth path compared to the Great Moderation. My measures show nearly 14 percent lower. If potential output is on the same growth path as before, then for real expenditures to return to potential, both prices and nominal wages need to fall to a 14 percent lower growth path as well. Wage rates have hardly budged and the price level is on a 2 percent lower growth path.

The CBO estimates of potential output show a growth slow down for the last decade. Using those measures, real expenditure is about 7 percent below potential. Given the current level of nominal GDP, a 7 percent decrease in the growth path of prices and nominal wages would raise real expenditures to close the output gap.

The natural rate hypothesis suggests that this should be occurring. The 2 percent drop in the growth path of prices is but a drop in the bucket. One possible explanation is that the CBO estimates are too optimistic, or more accurately, not pessimistic enough. It must be that potential output shifted to a 14 percent lower growth path.

However, suppose that there really is an substantial output gap. If there were a reasonably prompt decrease in the growth path of prices and wages, this would involve transitory deflation. For example, if the price level needed to shift down another 12 percent (14% minus the 2% already accomplished,) if this were done over 4 years, there would be 3 percent deflation each year. Unfortunately, this would imply higher real interest rates, at least for the short and safe assets with nominal rates currently near zero.

Of course, the Chairman of the Federal Reserve, Ben Bernanke, loudly proclaims that the Fed can and will prevent any such deflation. One reason for his insistence is to keep expected deflation from raising real interest rates and reducing aggregate demand. However, at the very same time, efforts to keep expected inflation up interfere with the deflation in prices and wages need for the current growth path of nominal expenditures to generate sufficient real expenditures to close the output gap.

Lower expected inflation, and the short run aggregate supply curve increases, raising real output and employment, given aggregate demand. But, lower expected inflation, raises the real interest rate, lowers aggregate demand, and so lower real expenditure results in reduced real output given short run aggregate supply.

Suppose the output gap is entirely ineffective in motivating disinflation. Past inflation rates and expected future inflation rates determine the actual inflation rate. The Fed, with all of its credibility and record, insists that the inflation rate will be 2 percent. Believing this, firms and workers set prices at 2 percent. Sure, the output gap implies surpluses of labor and even output, especially if we imagine nominal wages being forced down to market clearing levels, but even so, prices and wages just continue on the path they would if the credible, 2 percent target were consistent with market clearing. If prices (and wages) do rise more slowly, this is followed by actions by the Fed to convince people that this is just a one time fluke, and prices will again return to rising on target.

Could the Fed's effort to prevent disinflation from raising real interest rates and so reducing aggregate demand be interfering with the market process by which short run aggregate supply shifts and brings real output and unemployment to natural levels? Could this be the reason for the pattern of the Great Moderation where recoveries in employment were so gradual? Sure, the other two recessions were mild, but they were very persistent.

Could inflation targeting be responsible? Does inflation targeting (a growth rate target) generate expectations that make it difficult to close an output gap, (a problem with levels?) The gold standard fixed the level of the price of gold. A money supply rule fixed (I guess,) the growth path of the quantity of money. A price level rule fixes the growth path of prices. Of course, market monetarists advocate targeting the growth path of nominal GDP.

Nominal GDP Targeting and Supply Shocks

Adam P. continues his rather uncivil ways, claiming that my post is a "confused mess."

No doubt, this is due to my failure to communicate clearly. Adam P., think back to your principles of economics course, or, perhaps, to the many times you have taught the course over the years. An adverse aggregate supply shock shifts the aggregate supply curve to the left. The result is a higher price level and lower real output. To prevent the increase in prices, it is necessary to shift the aggregate demand curve to the left as well. While this partially or fully reverses or prevents the increase in prices, the decrease in real output is larger--at least if the short run aggregate supply curve has a positive slope.

He goes on about how "supply shocks" involve reductions in output that cannot be corrected by monetary policy. The standard approach would be that using monetary policy to prevent real output from falling in the face of an adverse supply shock requires that the aggregate demand curve be shifted to the right. This will at least temporarily dampen, prevent, or reverse the reduction in output. At least if the short run aggregate supply curve has a positive slope. Unfortunately, prices will rise by even more than would have occurred if there had been no monetary policy response.

Nominal GDP targeting approximates the "do nothing" response. The aggregate supply curve shifts to the left, and aggregate demand stays the same. The price level rises and real output falls.

I didn't mean to suggest that an aggregate supply shock won't lead to lower real output. My actual view is that a recession is a negative output gap, and so, if potential output falls, and real output was initially equal to potential output, then a recession would involve output falling by more than potential output. Further, it is possible, and perhaps likely, that supply shocks would raise the natural unemployment rate. A recession, on the other hand, would involve the unemployment rate rising above the natural unemployment rate. I believe this is exactly what would happen if aggregate demand is reduced in response to an aggregate supply shock to prevent inflation.

I think the best response to an aggregate supply shock would be one that leaves real output equal to the reduced level of potential output and the unemployment rate equal to the perhaps increased natural unemployment rate. It is almost certain that this would involve a higher price level.

I don't think that nominal GDP targeting will exactly accomplish this. It will if the demand for the particular market facing the decrease in supply is unit elastic. Otherwise, the situation is a ambiguous.

Adam P. shows some charts where he claims that the record of the seventies proves that a stable nominal GDP growth path would have adverse effects due to supply shocks. Of course, part of this was due to his odd assumption that I was claiming that aggregate supply shocks wouldn't impact unemployment if nominal GDP stayed on a stable growth path. He shows that the unemployment rate increased in the recession of 1974.

In reality, the growth rate of nominal GDP shows an upward trend during the period, but it is highly irregular. In particular, the recession of 1974 shows a clear reduction in the growth rate of nominal GDP. It looks like a 4 percentage point decrease out of 12%, and so that is about a 30% drop in growth. (When I get a chance I will look at growth paths.)

What is more incredible, is that he counts the sixties as a period of inflation targeting, where unemployment held stable at 5 percent due to the stable inflation rate. What? The U.S. was targeting real GDP growth and unemployment, trying to exploit a long run Phillips Curve to raise the first and lower the second. The resulting increase in inflation becomes quite pronounced at the end of the period. This was one of the most serious macroeconomic disasters of the twentieth century.

Is this supposed to be a joke?

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.

Milton Friedman on Nominal Income

Lars Christensen has an excellent post discussing Milton Friedman's A Monetary Theory of Nominal Income. Christensen quotes from Friedman:

In … "A Theoretical Framework for Monetary Analysis," I outlined a simple model of six equations in seven variables that was consistent with both the quantity theory of money and the Keynesian income-expenditure theory…The difference between the two theories is in the missing equation the quantity theory adds an equation stating that real income is determined outside the system (the assumption of "full employment"); the income-expenditure theory adds an equation stating that the price level is determined outside the system (the assumption of price or wage rigidity)…The present addendum to my earlier paper suggests a third way to supply the missing equation. This third way involves bypassing the breakdown of nominal income between real income and prices and using the quant ity theory to derive a theory of nominal income rather than a theory of either prices or real income.

In my view, "the Phillips curve" is not a theory of how prices influence output or output influences prices, but rather how nominal income influences output and prices. Generally, it is output and prices together in the short run, and then prices only in the long run.

There is nothing unusual about that approach, and having money determine output in period t+1 and then inflation in period t+2 seems like a simple way to illustrate this concept. Of course, if the model shows that a situation where nominal income remains unchanged (or on a constant growth path,) so that there are no fluctuations in nominal income, the process by which the short run/long run relationship is modeled generates fluctuations in real output and prices, simply shows that the model is flawed.

Does Nominal GDP Targeting Imply Instability?

Adam P, writing at Canucks Anonymous, claims that Greg Ip's citation of Lawrence Ball's 1999 paper shows that "targeting NGDP is simply a horrible idea." Why is it a horrible idea? According to Adam P.:

Well, I sat down this morning and worked out the implied policy rule for the interest rate that stabilizes expected NGDP two periods ahead (this took just a few minutes) and it generates exactly the large oscillations in real income and inflation that Ball obtained with the rule that actually would be correct in his model

He then quotes Ball:

The overshooting result appears robust; it arises, for example, in Dennis’s
model, as long as the lagged-inflation term in the Phillips curve has a positive
weight. In that model, the oscillations die out over time, implying finite variances.
But the variances are still large relative to efficient policies.

He criticizes Ryan Avent for thinking that the fluctuations were supposed to be in nominal GDP. Quite the contrary, he insists:

Ryan, you have to understand the paper to critique it intelligently! What happens in the model is not that NGDP swings above and below the target, NGDP stays basically on target, it's just that this isn't necessarily good! The reason it's bad is because while NGDP stays on target inflation and real output are oscillating above and below target and real output is the thing we actually care about most!

Adam P. was even so kind as to consider my position on the matter, I had said:

"I don’t believe this is realistic. That is, Ball did develop a model that has this consequence. His model of the macroeconomy was pretty standard. However, I don’t believe that it is realistic to expect inflation and real output to wander arbitrarily far from their long run levels when nominal GDP grows on a target growth path. Something is wrong with these models"

He responds:

That is an incredibly weak response, "I don't believe..." is hardly an argument. Where is the reasoning to believe something is wrong with "these models" instead of something being wrong with NGDP targeting?

Scott Sumner has responded to Adam P, and I share his irritation. Why would any economist take seriously the claim that a constant nominal GDP could possibly cause prices to veer off to infinity and output to zero, and then have output veer off to infinity and prices fall to zero?

Firms are going to produce nothing and charge infinite prices? Doesn't that seem a bit foolish? Worse., firms are going to produce infinite amounts of output and give it away? How is that consistent with maximizing profit?

Why would anyone worry that there is no solution to a system of equations that holds nominal GDP constant? What would that mean in the real world? Total spending on final output is $17 trillion dollars, and... what? Firms set no prices or quantities? Everyone just stands around not knowing what to do?

That is absurd.

If a model fails to have a solution for prices and output, then it is a problem with the model. Firms will do something and they must be setting prices and producing output in order for nominal GDP to be $17 trillion. The model evidently fails to tell us anything about what they are doing if there is no solution.

The infinite absurdities--the deflationary booms that are completely inconsistent with the scarcity of resources should create doubts about the value of the model. Do we just change the coefficients a bit so that our deflationary booms are not utterly absurd?

If nominal GDP targeting is successful, that is, nominal GDP stays on target, then it is like having a unit elastic demand curve in microeconomics. The profit maximum for a monopolist would be where marginal revenue equals marginal cost. The price is what the market will bear at that quantity. Quantity and price are determined. How likely would it be that a monopolist would oscillate between a price higher and quantity lower than the profit maximum and a price below and quantity higher than that maximum? And what about even more extreme oscillations between giving the product away for free and producing whatever buyers will take or else producing and selling nothing and setting a price of infinity? And then, suppose there is "no solution" to the equations. Does the monopolist just do nothing?

Now, suppose instead there is a competitive market with unit elastic demand. The usual micro approach is that quantity supplied equals quantity demanded. Is it possible that firms will set prices above equilibrium, and limit production to the quantity demanded? Then, they will respond to the surplus in the market by producing an amount beyond the equilibrium quantity and setting a price below equilibrium?

In microeconomics, this is called cobwebbing. And while having firms give away infinite amounts is a stretch, myopia can lead to cobwebbing.

Consider a microeconomics where firms set their prices, not at the level expected to clear the market, but rather based upon the past rate of price change. Overshooting would be inevitable, right? There is a shortage. Firms raise prices. Once the price reaches equilibrium and the market clears, they raise their prices because prices have been rising in the past. So, the price is above equilibrium.

Now, prices are cut. This clears up the surplus. When the price is at equilibrium, the firms continue to cut prices, even though markets are clearing, because prices have been falling. This creates a shortage.

With nominal GDP targeting, the equilibrium price level is the target for nominal GDP (if it actually will be reached,) divided by potential output. If the system is expected to work, the expected equilibrium price level is the target for nominal GDP divided by expected potential output. And, as usual, the equilibrium level of output is potential output. If the price level is set at the expected equilibrium price level, and nominal GDP is on target and potential income is at the expected level, then real expenditure will equal potential output. The price level will clear markets and real expenditures will purchase potential output.

That has to be the where any model begins. If you start with a model inconsistent with that result, especially one that requires cobwebbing, then nominal GDP targeting will not be "optimal."

NGDP vs. FSDP

William Niskanen advocated targeting nominal expenditure on output. However, he favored using Final Sales to Domestic Purchasers. While I advocated Final Sales of Domestic Product for some years, last February, I came to see that nominal GDP is the least bad measure of money expenditure on output. My post from last February (subtitle, Scott Sumner is right) is here.

Final Sales of Domestic Product is nominal GDP less inventory investment. The benefit of using Final Sales of Domestic Product is that unplanned inventory investment is not included as demand. With nominal GDP, goods that are produced with the intention to sell are counted as being "demanded" by the firms that fail to sell them.

The primary disadvantage of using Final Sales of Domestic Product is that planned inventory investment is not included either. Planned inventory investment is important because it is the only way that the demand for intermediate goods is included. For example, a rapid increase in the demand for "commodities" is largely a demand for intermediate goods. The increase in prices and quantities will show up as inventories. Second, while stabilizing nominal GDP growth does imply unstable growth in final sales, this can be desirable when the demand for final products expands so that planned inventory disinvestment uses up unplanned inventory investment from a past period.

A secondary problem is that Final Sales of Domestic Product can show a rapid increase due to disinvestment of inventories of imported goods. While current imports are subtracted from Final Sales of Domestic Product, inventories of those goods accumulated in the past are mixed with other inventories.

Niskanen, however, favors a third statistic, Final Sales to Domestic Purchasers. This takes away inventories, adds imports, and subtracts exports. Rather than measure spending on goods and services produced in the U.S., it is measuring spending by U.S. residents on output wherever it is produced.

In my view, nominal GDP targeting generally requires more exchange rate changes for external balance than Final Sales to Domestic Purchasers targeting. Final Sales to Domestic Purchasers targeting requires more adjustment in domestic nominal income, but allows for smaller adjustments in exchange rates.

Neither approach requires, or really allows, active exchange rate management. Base money controls some measure of nominal expenditure, and market forces determine exchange rates.

However, if trading partners want stable exchange rates, then nominal GDP targeting requires more domestic adjustments for them. Rather than explore these differences further, I want to first explore how much difference the two targets make in practice.

First, both are charted below:

From 1984 to 1998, the two are very close, but then begin to diverge. Leaving aside inventory investment, the difference is the trade deficit. Imports began growing more quickly than exports. It would seem that targeting Final Sales to Domestic Purchasers would have required slower growth in nominal incomes, slowing the growth of imports, reducing

the growing trade deficit. The slower growth in nominal incomes includes slower growth in nominal wages. This should reduce unit costs for U.S. goods, improving the competitiveness of U.S. products both as import competing goods and export goods.

With nominal GDP targeting, this is simply not an issue. As long as spending on U.S. products doesn't outstrip the productive capacity of the U.S., Americans can import what they like. If foreigners are willing to fund a trade deficit by accumulating U.S. assets, the monetary regime doesn't restrain expenditures. If, on the other hand, the foreigners spend their dollar earnings on U.S. products, this added demand for U.S. output would require monetary restraint so that total spending on U.S. products does not outstrip the productive capacity. U.S. imports would be brought into alignment with U.S. exports.

Examine nominal GDP and its trend growth path for the Great Moderation. (The trend is calculated from 1985 to the end of 2007.)

Compare now to Final Sales to Domestic Purchasers:

There is not much difference. Final Sales to Domestic Purchasers does show a slight deviation above trend in 2006, which makes no appearance in nominal GDP. But what is most striking is that both approaches clearly show the disaster of the Great Recession. A massive and growing deviation from the trend of the Great Moderation. Using the trend shown here, the deviation of Final Sales to Domestic Purchasers from trend is nearly 15 percent, while the gap of nominal GDP from trend is a mere 14 percent.

The growth rates of the two series track closely.

The growth rates diverge in 2005 and 2006, reflecting the "boom" in Final Sales to Domestic Purchasers that did not show up in nominal GDP.

The growth rate of nominal GDP and the trend is below:

And compare to the growth rate of Final Sales to Domestic Purchasers:

The trend growth rate for Final Sales to Domestic Purchasers is 5.5 percent, slightly higher than the trend growth rate of nominal GDP of 5.4 percent. Otherwise there are few significant differences. While further study is useful, and the difference between demand for U.S. output and demand by residents of the U.S. for output would seem significant, at first pass, there should not be too much difference between the regimes.