Thursday, September 18, 2014

Woodford on Nominal GPD Level Targeting

Woodford was interviewed by the Minneapolis Fed and has some positive things to say about Nominal GDP level targeting.

Sunday, September 14, 2014

Caton on Nominal GDP Level Targeting

James Caton defends nominal income targeting.   He is mostly concerned with "Austrian" critics and emphasizes the injection effects associated with a central bank targeting nominal income.

He argues that the ability of banks to adjust the quantity of money through credit creation remains operable with a central bank that targets nominal GDP.   He grants that central banks do cause injection effects when they change the quantity of base money.   However, he argues that a failure to adjust the quantity of base money when the demand for it changes leads to liquidity effects on interest rates that push the market rate away from the natural interest rate.   He emphasizes how an increase in the demand to hold base money not accommodated by an increase in the quantity of base money will tend to force the market rate above the natural rate, leading to distortions in inter-temporal coordination.   He notes that with a gold standard, the quantity of gold used as base money would tend to increase in response to an increase in demand, but argues that this adjustment is relatively slow.   For a single country in a  gold standard world, it is largely through gold imports.   For the world as a whole or for a country with a gold mining industry, there is an increase in mining.   According to Caton, either of these avenues for the expansion of base money involve injection effects.

Caton argues that there is a tradeoff--a slower adjustment in the quantity of base money and so less monetary disequilibrium along the injection effects implied by the gold standard, or else a more rapid adjustment in the quantity of base money and so less monetary disequilibrium but the injection effects associated with the creation of money by the central bank.

Caton points out that Hayek considered the stabilization of MV as a monetary policy ideal.   This would mean that the quantity of money should adjust to offset any shift in velocity.   However, Hayek insisted that the new money injected must enter at exactly the points where money is removed from circulation by the added demand to hold money.   If that doesn't occur, money is not neutral and there are injection effects.   Hayek was skeptical that money could be created in that fashion.

Caton has been carefully reading Hayek recently, and I have enjoyed reading his posts on the matter.   My view is that Hayek was correct that realistically money can never be neutral because new money will enter the economy in a different place than it leaves the stream of expenditure when the demand to hold money rises and so velocity falls.    However, I find it puzzling that Hayek or anyone else, would see this as a problem or else consider neutral money as particularly desirable.

When velocity, and so, the demand for money, changes, there is no reason to expect that there should be no change in the flow of expenditure or the allocation of resources.   For example, consider a situation where people choose to save by reducing spending on particular consumer goods and accumulate larger balances of base money.  This is an increase in the demand to hold base money and a reduction in base money velocity.   Perhaps Caton can correct me if I am wrong, but I have always understood Hayek as claiming that monetary neutrality would require that a central bank someone inject new base money into the economy such that it was spent on the very consumer goods that were not purchased.    But why is that the relevant standard of comparison?   If saving had occurred instead by the purchase of newly-issued corporate bonds, the sellers of the consumer goods would have had less money and those issuers of the corporate bonds would have more.   Presumably, the corporations would use those monies to fund some capital expenditure.    Why wouldn't the standard be that the central bank issue the new money by the purchase of those bonds?     Issuing the money so that it ended up in the hands of the sellers of consumer goods means that there is no change in patterns of expenditures in the economy, but if there is a decision to save whether by accumulating money or purchasing corporate bonds, there should be an adjustment.

I presume that since Caton agrees with the free bankers that when privately-issued monetary liabilities are accumulated, the shift of the funds to the bank's loan customers is not distortionary, he would accept the reasoning above.   But suppose rather than a corporate bond, the saver would have purchased a government bond.    If the saver instead accumulates base money, then why isn't a standard open market purchase of the government bond the non-distortionary standard?

Of course, when velocity falls due to an increase in the demand for money, those accumulating money balances are not obviously accumulating money rather than some other financial asset.   They are simply choosing to accumulate some kind of money.   They are choosing to reduce their expenditure on something (or perhaps sell some other asset) and instead hold additional money balances.   By this very decision, they are choosing to shift the expenditure from what they choose to whatever the issuer of money chooses.   Why is this distortionary.

Of course, because money serves as the medium of exchange, it can be issued and spent and those receiving it will accept it even if they do not desire to hold larger money balances.     This possibility of an excess supply of money and the injection effects due to the excess money entering the flow of expenditure at some point or other should never be confused with a scenario where the quantity of money, whether issued by private banks or a central bank, simply accommodates changes in the demand for money.   The difference isn't that there is no injection effect.   There is a change in the flow of expenditure and there ought to be.   However, there is no sense in which that change is someone more distortionary or less sustainable than any other change in the pattern of demands.

The Fed's New 4% NGDP Target

Lars Christensen appeared to congratulate the Fed on the 4% nominal GDP level target it has been following since 2009.    I have noted this apparent new path before, particularly during the debate about the fiscal cliff.   Some Keynesians argued that the tightening of fiscal policy must have prevented what would have been an expansion in nominal GDP due to various types of private spending recovering.   I noted that the data looked like the economy was on a stable growth path.   Still, I have continued to argue for a Reagan/Volcker nominal recovery before setting on a new 3%  growth path for nominal GDP.

Sumner responded by saying that in 2009 he would have been unhappy that the Fed had shifted to a lower growth path for nominal GDP, as well as a lower growth rate.    And further, he worries that the Fed is still not really targeting the level of nominal GDP.   If there is some shock, then nominal GDP with shift to a new growth path--one consistent with inflation remaining at 2%.    This would probably be close to nominal GDP growth at 4%, but the level could be anywhere.

Christensen's more recent post on the issue suggests that it is time to forget the old growth path and instead propose that the Fed formally commit to remaining on the growth path for nominal GDP that has been blazed since 2009.   In other words, he is rejecting any partial, much less total, return to the growth path of the Great Moderation.

If we believe the more recent estimates of real output being 2 percent below potential, then staying on the new growth path would require an approximate 2 percent deflation of output prices and matching decrease in wages an nominal incomes.   Presumably, something like zero inflation for a year and holding the line on pay increases to something like 1% should allow the needed adjustment in prices and wages to the new growth path to occur more gradually--over a single year.

Why not just shift the growth path up by 2 percent?   Of course, if you believe that the estimates of potential output are too high--perhaps real output is at potential now--then the upward shift in the growth of nominal GDP would at best just general a jump in the price level and at worse create an unsustainable boom in  real output.

Of course, the Fed's actual policy is that just such a jump in nominal GDP would be desirable, if it could occur with inflation remaining on target--in the medium run, anyway.   The Fed won't commit to shifting nominal GDP up to the higher path.   Nor will they commit to keeping it on the current path.  They instead will keep monetary policy accommodative--interest rates "relatively" low--until the output gap closes consistent with inflation remaining pretty much on target.    And so, an upward shift in nominal GDP is still a possibility.

I think the new 4 percent growth rate is desirable, but I continue to favor an upward shift in the growth path of nominal GDP.   Is it really 2 percent?   How much faith do I have in the potential output numbers?  Still, the more time that passes, the more I will have to adopt Christensen's view--have the Fed make a commitment to the new path for nominal GDP.    If the Fed continues with flexible inflation targeting and we have another recession, it could be worse.   And are we sure the Fed has learned its lesson regarding adverse supply shocks?    There are advantages to shifting to a new regime--even if some deflation is needed to get real output back to potential.