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.


  1. Bill,

    I'm not exactly sure what you are arguing about distortionary effects of money expansion. There are always injection effects. They may be worth accepting. Did you think I was arguing differently?



    1. Sorry about getting your name wrong. Well, "worth accepting?" Maybe there is no significant difference between that and "what's the problem?"

    2. Haha. There does not seem to be :)

      No worries about my name. Many people mistake my name for a city in China.

  2. I think there is a subtle but important distinction between Jim's "cost worth accepting" (which implies some deviation from the ideal of neutral money) and Bill's "what's the difference?".

    Under a (ideal) Free Banking system, a rise in the demand for money 'transfers credit' to the banking system, which uses the voluntary savings to issue new loans. NGDP is in effect stabilized through endogenous market forces.

    Under NGDP targeting in our current monetary and banking framework, the banking system's ability to accommodate this increase in money demand is constrained (due to RR and, especially if the increased demand manifest itself in an increased demand for currency, restrictions on note issue). The public's voluntary savings are in large part transferred to central banks, who expand their balance sheets to accommodate the shift in demand by buying treasuries and letting the newly created money filter through the banking system. NGDP is in effect stabilized through an endogenous NON-market force -- namely, the central bank expanding the money supply.

    In either case, monetary equilibrium is ultimately preserved at the aggregate level. But if you think private banks are better suited to allocate transfer credit than central banks, there is a cost in terms of efficiency. The Fed collects the float rather than the banking system. That cost, Jim points out (I think), is worth accepting so long as it maintains M.E. But it's still a suboptimal transfer of voluntary savings.

    Of course, this problem almost entirely vanishes if you remove existing restrictions on banks while moving to an explicit NGDP level targeting rule. Banks could then fully accommodate changes in money demand. Central Banks could limit themselves to simply increasing the monetary base to accommodate extensive growth in real factor inputs. I say let's root for that.

    1. Apologies for the long and delayed response. I'm just now catching up on a lot of my blog readings (as Jim can attest to!)

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