Scott Sumner  

NGDP targeting is not a "fragile" policy

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This post tries to tie together some diverse observations about the sticky wage/NGDP shock model. The motivation for this (unfortunately long) post was the observation that many non-economists seem to find the sticky wage/NGDP shock model to be appealing. I once met Britmouse, and he told me his background was a technical field, not economics. And yet he's been able to produce some of the best macro analysis of the British economy in the entire blogosphere. How does that happen? More recently a new blog popped up:

I am not an economist by trade. Instead, I have approached economics in the wake of the 2008 recession with the question of "what in the world explains this?" Paul Samuelson took a strong liberal bent to economics despite having traditional, classical economics teachers because he learned economics during the Great Depression. The equations and graphs on the chalkboard bore little relationship to the suffering outside the classroom. Similarly, at the start of 2008 I had strong libertarian ideals, but my ideals were confronted with many perfectly qualified people I knew out of work due to no fault of their own.

There is a fair question of what do I add when many bloggers hold similar views. Scott Sumner is likely the closest, . . .


His (or her) second post in on wage targeting, so I'm going to assume he/she has at least some similarity to Britmouse.

I think there is a reason for this, but I'm going to have to address it in a roundabout fashion. In the end I'll argue it has implications for modern DSGE models, as well as Nick Rowe's conversion to NGDPLT.

A while back I showed the correlation between (NGDP/hourly wages), and the unemployment rate. Arnold Kling dismissed the correlation as a sort of tautology. Let's think about what would have made Arnold's claim true. Suppose that instead of NGDP I had used total wages and salaries. And suppose that instead of the unemployment rate I had used total hours worked as my cyclical indicator. Then the graph would have shown (total wages/hourly wages) correlated with hours worked. But those are the exact same thing! That's why Kling viewed it as a sort of tautology; my model seemed very close to another "model" that was in fact a tautology. Was Kling correct in assuming that my model and this other model were roughly the same thing? I'd say he was. However I don't view that as a negative, but rather a point in favor of the sticky wage/NGDP shock model.

So let's say we target total wages and salaries instead of NGDP, and we use a low volatility in hours worked as our policy goal. (We will still allow secular changes in hours worked due to factors such as boomers retiring, just not the sort of sudden plunge in hours worked that we saw in 2008-09.) And let's say we are successful in stabilizing the path of total wages. Does the "tautological" nature of my correlation mean the policy will work? Unfortunately there is one other potential problem---monetary policy might affect the volatility of wages. The Lucas Critique. If we make total wage income (or NGDP) much more stable, then nominal hourly wages might suddenly become much less stable, making the business cycle just as bad, if not worse.

So you can think of the case for NGDP targeting being dependent on these three factors:

1. Hours worked and the unemployment rate being strongly (and negatively) correlated at high frequencies. That's pretty much a slam dunk; I doubt any business cycle experts would worry about that issue.

2. NGDP shocks being associated with similar total wage income shocks. That's also overwhelming likely. Think about what it would take for a stable path of NGDP to produce a recession, solely because total wage income fell as NGDP was stable. For that to happen you'd have to see profits rise sharply during the recession. But in the US profits tend to fall sharply during recessions. So that's pretty unlikely. And if it is a problem you can target total nominal wages and salaries, instead of NGDP.

3. Another possibility is that if you stabilized the path of NGDP or total wage income, it would suddenly make hourly wage growth much more unstable. Thus in 2008-09, if you kept NGDP growing at 5%, then hourly wage growth might have soared from 3.5% per year to 12%, driving unemployment sharply higher. There are actually new classical types who would claim that's exactly what would have happened. But I think it's extremely unlikely, and I believe most other sensible macroeconomists do as well.

What does all this mean? Well the effectiveness of NGDP targeting is not a tautology, but it can be turned into a tautology by making three pretty uncontroversial assumptions about hours/unemployment, about the wage share of national income over the cycle, and about the "inertial" nature of hourly wages. I'd like to emphasize "inertial" wages rather than "sticky" wages, because we don't really need to make any highly restrictive assumptions about why aggregate wages are so inertial.

Here's what we do know. Wage growth from year to year is pretty stable, unless inflation soars much higher. If inflation soars much higher (as in the 1970s), then nominal hourly wages will follow, with a lag. But the news is even better; it appears that nominal wages track NGDP at least as well as inflation, often better. When NGDP growth slowed during the Great Moderation, so did hourly wages. When NGDP growth became more stable during the great Moderation, so did hourly wages. When prices shot up in 2007-08, and NGDP growth remained slow, wage growth did not shoot upward. And most importantly, when NGDP growth plunged in 2008-09, wage growth did slow, but very slowly. From about 3.5%/year before the recession to 2%/year after the recession. That inertia is a fact, not a theory. Even those who reject sticky wages cannot reject inertial wages. They are a fact about the world, at least when inflation/NGDP growth rates are fairly low.

And since nominal wages tend to track NGDP with a lag, it's pretty hard to argue that stabilizing NGDP growth would destabilize wages. This makes the logical appeal of NGDP targeting almost overwhelming, and explains its popularity with newbies.

Here's another way of making the same point, which I hope will cause doubters to reconsider. I'm saying that a serious recession under stable NGDP growth is very unlikely, because at least one stylized fact (of the three above) would have to act very, very strangely, indeed in an almost completely implausible fashion.

In contrast, it's easy to imagine a serious recession under inflation targeting. The original idea of inflation or price level targeting goes back many decades, to a period where recessions were associated with deflation. That stylized fact was so important that progressive economists like Fisher and Keynes (and many others) were drawn to the idea of using monetary policy to stabilize prices. But that was when commodity prices were:

1. A much bigger share of the economy
2. Highly procyclical

So that made existing price indices in the 1920s and 1930s (like the WPI) very procyclical. More recently inflation got much more inertial, partly due to more comprehensive indices, partly due to us moving from a commodity economy to a service economy. Nonetheless you did still get mild disinflation during most recessions, which the new Keynesians put into their models. But it turns out that inflation targeting was a highly fragile policy. Here's why:

1. Modern SRAS curves are fairly flat as AD falls sharply. This means a fall of NGDP growth to 9% below trend (as we saw in America during mid 2008 to mid 2009) might be mostly a fall in RGDP, and not much disinflation.

2. The negative demand shock might occur in close proximity to an adverse supply shocks. Whereas AD shocks reduce inflation very gradually (by slowing nominal wage growth gradually), the supply shock causes the CPI to spike suddenly. One can imagine NGDP and RGDP both falling rapidly, even as inflation seems close to target. That's roughly 2008.

Something like that also happened in Canada during the recent recession, and helped convert Nick Rowe from inflation targeting to NGDPLT. More importantly, whereas a catastrophic failure of NGDP targeting is almost unthinkable (I know, famous last words . . . ) a catastrophic failure of inflation targeting is quite thinkable, and indeed just happened.

I believe this is what makes NGDP targeting so attractive to newbies. They are easily persuaded that nominal wages are sticky because it conforms to both common sense observation about the world, and also a simple glance at the time series data for wages. They also know that mass unemployment is the key business cycle problem. And they know that deep recessions tend to be associated with sharp declines in NGDP growth, but not necessarily sharp falls in inflation. Looking at all those stylized facts, how could someone new not be attracted to NGDP stability?

Modern macro looked for "micro foundations" that could explain business cycles. These models include "P" because prices are a micro variable. NGDP is not, so it doesn't really appear in the models. Their models are created by people who think in terms of what sort of shocks would give firms an incentive to produce less and lay off workers.

In contrast, the NGDP approach is a very naive model that treats NGDP sort of like a big pot of money, which is shared out among workers with sticky wages. If some day the pot is smaller, then there's less money to share, and some workers end up disappointed (unemployed.) It's completely agnostic about the micro foundations, not even yielding predictions about something like real wages (W/P). No behavioral assumptions beyond inertial wages.

But despite all these weaknesses, it's a very plausible model, because it's not fragile. It's very, very hard to imagine plausible scenarios where NGDP growth is stable and we have a lot of employment volatility. (You can imagine RGDP volatility (from say declining North Sea oil output), another mistake by the experts was to focus on RGDP rather than hours worked as the key measure of the business cycle.)

And this means that once the profession starts thinking about NGDP (and it has started) it can never stop thinking about it. NGDP growth will plunge again in the next recession, probably much more dramatically than inflation. This will again show inflation to be (as Nick Rowe puts) it "the dog that didn't bark." NGDP always barks. And when it doesn't bark, you almost never have employment instability. NGDP and sticky wages, they can't be put back in the bottle. The model is too simple and attractive. It's up to the math geniuses to catch up with their DSGE models.


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COMMENTS (25 to date)
Effem writes:

I think you're looking in the wrong places for instability. Let's assume first that you can produce stable NGDP. I agree this would probably create more stable employment. However, I believe it would also have the effect of creating an economy where capital increasingly flows towards industries that benefit from stable NGDP (banking comes to mind). I further believe that leverage would increase dramatically economy-wide (if you remove leverage from the business cycle you can add leverage to private balance sheets to essentially target no decrease in overall leverage with higher returns).

That all sounds good...UNTIL, one day you cannot hit your NGDP target (political change, war, plague, energy crisis, etc). At that point you will have truly massive instability as you would need to unwind years of capital misallocation. You haven't removed volatility you have simply stored it up for a later date.

You may argue you could ALWAYS hit your NGDP target but I would disagree. A few years of 0% RGDP and 6% inflation could easily produce a political change that simply forces the Fed to change...this is not outlandish at all.

I personally believe volatility is good for the economy as it keeps capital from getting too comfortable in any one place. In other words, our bets are spread.

RPLong writes:
And since nominal wages tend to track NGDP with a lag, it's pretty hard to argue that stabilizing NGDP growth would destabilize wages. This makes the logical appeal of NGDP targeting almost overwhelming, and explains its popularity with newbies.
I don't think you've quite overcome the tautology here. In order to "stabilize NGDP," you have to do monetary policy. If real wages are held stable by stable NGDP then something else must have become more volatile, otherwise you're not doing monetary policy.

Either everything is held constant, including monetary policy, or monetary policy changes and thus something else changes. I recall asking you at The Money Illusion whether you felt that monetary policy was always either expansionary or contractionary, and you said yes.

So I am trying to see how this works. If you make a change to the system under an NGDPLT scenario, then that change has to show up somewhere in the system. What changes? If not real wages, then what?

Rob Rawlings writes:

Doesn't NGDP also need price and wage stickiness to be somewhat uniform throughout the economy to be effective ?

Take an extreme example where 50% of goods have very flexible prices and 50% have very sticky prices.

A sudden demand shock causes NGDP to fall. Stimulus is used to bring NGDP back to trend. But as half the economy has already adjusted its prices the monetary stimulus will cause distortions, and RGDP will go above optimum levels.


Michael Byrnes writes:

Isn't the behavioral assumption that various economic actors (individuals and corporations) who engage in many different transactions involving money, will perceive the shortage of money (fall in NGDP) in various ways and act accordingly?

Kenneth Duda writes:

Scott, I am an econ newbie, a software engineer whose interest in economics started with the 2008 meltdown, propelled by a desire to understand what the heck happened. I first learned basic IS/LM from Krugman's writings, but when it became clear that the ZLB is only a problem for a CB that targets interest rates, and that Krugman is mixing economics with politics in calling for fiscal stimulus, you became my favorite blogger. I read Athreya's "big ideas in macroeconomics", and these ridiculous ADM models with their infinitely flexible prices and representative agents with full information and a Walrasian auctioneer leading to superneutrality of money, it's all so crazy. My company has thousands of long-term dollar-denominated contracts. I can't just cut wages and pay my employees less, and I have prices with suppliers locked in. If people stop buying, I don't lower prices; I stop producing. What else can I do? Money matters, end of story.

In contrast, you have a model that actually makes sense. When there is a positive demand shock for the medium of account, the CB had better increase the supply, or else NGDP will drop (people hoard cash instead of spending). And if we let NGDP drop (ahem, Ben Bernanke), then (because money matters) real output drops too. Target NGDP and (assuming you target it effectively), you match the supply with the demand for the medium of account, stabilizing the price level, avoiding both demand recessions and excessive inflation. What is hard to understand about this?

Thank you for expressing your ideas in a way that determined non-economists can understand, and please keep up the fight.

Thank you,

Kenneth Duda
Menlo Park, CA

Don Geddis writes:

@RPLong: NGDPLT doesn't stabilize real wages. It stabilizes nominal wages. That's a huge difference. What becomes more volatile? The money supply, interest rates, inflation, etc. But so what?

@Rob Rawlings: Yes, the LT part of NGDPLT is supposed to correct for past mistakes ... but in the ideal, the central bank would maintain NGDP in real time, and it would never fall in the first place. But then, even if it did, and your 50% prices "already" adjusted, why wouldn't they simply immediately adjust again, after NGDP returns to trend? Why, in your model, do they only "do the right thing" at the initial shock, but not with the subsequent recovery?

RPLong writes:

@Don Geddis - Oops, I said real wages when I should have said nominal. My bad.

I have to be honest with you: "So what?" is not a very convincing argument to me. Scott Sumner writes:

3. Another possibility is that if you stabilized the path of NGDP or total wage income, it would suddenly make hourly wage growth much more unstable. Thus in 2008-09, if you kept NGDP growing at 5%, then hourly wage growth might have soared from 3.5% per year to 12%, driving unemployment sharply higher. There are actually new classical types who would claim that's exactly what would have happened. But I think it's extremely unlikely, and I believe most other sensible macroeconomists do as well.
So between your "so what?" and Scott Sumner's, "nahh, that'll probably never happen" I am not getting a very good logical justification for NGDPLT. All I'm hearing is, "Sure, some people say it'll be bad, but so what?"

I think this is Kling's point, no? NGDPLT looks good because it's circular reasoning. If you disallow the circularity of the argument then you start to notice things like how changes in the inflation and interest rates and the money supply influence the economy.

Granted, I'm an economic newbie, but not one of the ones for whom NGDPLT resonates much. I keep looking for the "aha!" moment that everyone else seems to have, but the closer I look, the further I get. Why are changes in the money supply, interest rates, and inflation rates a "so what?"

Don Geddis writes:

@RPLong: "Why are changes in the money supply, interest rates, and inflation rates a "so what?""

Can you name any specific economic problem that you expect to observe, due to volatility in those three measurements?

You'll find lots of historical examples, where bad things happen in the economy when one or more of those measures gets out of control ... but you'll find that NGDP is unstable at the same time.

The "so what?" is a challenge to you: you need to explain why it ought to be a goal to keep those measures stable. What benefit does the economy get by having them stable? What harm comes from having them unstable?

Sumner's claim is that any damage you think those measures might cause, is actually caused by unstable NGDP. If you stabilize NGDP, then there is no harmful economic consequence to allowing volatility in money supply, interest rates, or inflation.

If you disagree, you can't just say "but I'm worried about it!" You have to give a concrete reason why.

"you start to notice things like how changes in the inflation and interest rates and the money supply influence the economy."

How, exactly? If NGDP is stable, how do those things influence the economy?

RPLong writes:
Can you name any specific economic problem that you expect to observe, due to volatility in those three measurements?

You'll find lots of historical examples, where bad things happen in the economy when one or more of those measures gets out of control ... but you'll find that NGDP is unstable at the same time.

Don, have you properly understood Kling's criticism that NGDPLT is a circular argument?

The point can be illustrated with an admitted reductio ad absurdum: Let's set the NGDP level target at 98%. Can you tell me why that either is or is not a better idea than setting the NGDPLT at 5%?

My assertion is that if you hold any opinion on 98% versus 5% NGDPLT, then whatever your reasoning is the same reasoning that explains why interest rates, inflation rates, the money supply, and "etc." affect the economy. Otherwise, we must be ambivalent between a 1% NGDPLT and a 98% LT.

Now, I have stated all of the above under the assumption that I am wrong and missing something. Please don't ask me to explain to you why I think I am right. I am not questioning my own beliefs - I am certain that I am wrong. Rather, I am questioning your reasoning for why NGDPLT can stabilize wages at the expense of greater volatility in " The money supply, interest rates, inflation, etc." and that this doesn't matter.

Can you explain it?

Don Geddis writes:

@RPLong: Not sure whether you want me to answer your question, or Kling's question. Here is Kling:

"If inflation remains absolutely constant, then any fluctuation in nominal GDP is arithmetically a fluctuation in real GDP. At that point, “explaining” changes in real GDP by changes in nominal GDP becomes completely circular."

The obvious answer is: if you target NGDP (instead of inflation), then inflation is no longer constant. (And in particular: Kling's graph shows that relatively stable inflation does not imply a stable economy or stable unemployment, which is actually evidence in favor of Market Monetarism!)

"Let's set the NGDP level target at 98%. Can you tell me why that either is or is not a better idea than setting the NGDPLT at 5%?"

You've confused volatility, with absolute levels. If real GDP growth is in the 2-3% range, then 5% NGDPLT gives you inflation also in the 2-3% range. The question is whether there is much economic difference between stable 2-3% inflation, vs. more volatile (say, 0-5% inflation), but with the same average inflation. The claim is: not much economic difference.

Your 98% vs. 5% is a different question. That's the difference between 2% inflation, vs. 95% inflation. Yes, high inflation (whether stable, or volatile) causes economic harm, because various prices (incl. taxes) are not indexed to inflation, and thus their economic impact changes quickly with high inflation.

So we want low inflation, yes. (Probably any low choice, say between 1%-5% inflation, wouldn't make much difference.) But if inflation has been trending at 2% (with 3% RGDP growth, so NGDP growth has been trending at 5%), and then suddenly a supply shock hits (skyrocketing oil prices from peak oil, tsunami in Japan, asteroid impact), and all of a sudden RGDP growth drops to 0% for one year, then which scenario causes the least economic harm over the next year? 2% inflation / 0% RGDP growth ... or 5% inflation / 0% RGDP growth? You can't have both, so you have to choose just one.

Market Monetarists claim that the costs of unstable NGDP growth (due to sticky wages/debt), are far higher than the costs of unstable inflation.

You may disagree, but then I need you to explain what are the direct costs of volatile (but not high) inflation (when NGDP is stable).

Scott Sumner writes:

Effem, I see no evidence at all that NGDP targeting would boost the size of the banking industry. On the other hand the benefits to unemployed workers is clear. I'll gladly take that risk.

Nor does NGDP targeting make big shocks more likely.

RPLong, Real wages can and would change under NGDP targeting.

Rob, It's not clear to me why RGDP would go above optimum in the case you cite. On the other hand NGDP targeting is not perfect, so I can't deny that might happen.

Thanks Kenneth, Well put.

RPLong, I think you are missing the point. There is lots of both empirical and theoretical evidence that nominal wages would not suddenly become highly unstable if we made NGDP more stable. It's not just wishful thinking on my part.


RPLong writes:

Don, I asked Scott Sumner a question: given that NGDP level targeting requires monetary policy, but that it stabilizes wages - where does impact of the policy-making ultimately end up? Given that the impact must be felt somewhere, I asked where?

You responded that it ended up in "the money supply, interest rates, inflation, etc." but that this was unimportant ("so what?").

I am not making a claim about the direct costs of inflation. I am asking where the impact of NGDPLT monetary policy is ultimately felt. YOU offered a few suggestions and said that it doesn't matter.

So my response is that one of the two must be true:

1) Either it actually does matter (implying that policy-induced changes to "the money supply, interest rates, inflation, etc." have an impact on the economy beyond their statistical correlation to measures of NGDP (this implies that the argument for NGDP is a circular one, i.e. the real issue is changes to the money supply, interest rates, inflation, etc., not merely changes to NGDP growth rates)

-OR-

2) It actually doesn't matter at all; only NGDP matters, in which case we must be ambivalent between a 98% NGDP level target or a 5% target, provided that the growth rate is stable.

So which is it?

Michael Byrnes writes:

Effem wrote:

"That all sounds good...UNTIL, one day you cannot hit your NGDP target (political change, war, plague, energy crisis, etc). At that point you will have truly massive instability as you would need to unwind years of capital misallocation. You haven't removed volatility you have simply stored it up for a later date."

NGDP targeting doesn't actually require absolutely stable NGDP growth - at minimum, all it requires is a commitment to make up for any past mistakes. A period of below target NGDP growth must be offset by a period of above target NGDP growth.

The stablilty of NGDP targeting is from maintaining a stable long term trend - not from avoiding short term fluctuations.

Fundamentally, NGDPLT is a way to ensure that the supply of money is equal to the demand for money. If the supply and demand for money get out of whack, then the real economy will suffer the consequences.

Joel Aaron Freeman writes:

RPLong, I'm not an economist, but I think the answer is your #1 interpretation. That is, the money supply, the interest rate, and inflation will have an economic impact that is distinct from NGDP.

Market monetarists assume that volatility in these characteristics may cause some harm (e.g. short-term hyperinflation). They also assume that NGDP targeting will make the labor market a lot more efficient.

Therefore, in order to get more labor market efficiency, they are will to accept volatility in these other parameters. The question of whether the benefit is worth the cost is empirical and up to interpretation.

I really like the whole approach primarily because it is rule-based. Even if it is a bad rule, we will find out soon enough and can correct it. The only thing we learn from discretionary monetary policy is "that guy was da bomb, but that other guy sucked."

Rob Rawlings writes:

@Don Geddis,

" But then, even if it did, and your 50% prices "already" adjusted, why wouldn't they simply immediately adjust again, after NGDP returns to trend?"

Yes, you are correct they probably would (assuming upwards stickiness is the same as downwards). However if you add some complexities to my model then NGDP/RGDP effects become indeterminate.


If demand for goods with flexible prices change relative to those without then you would have a tendency for rising prices and fixed quantities sold in one sector and falling qty and fixed prices in the other. Overall this would enable you to hit a NGDP target while RGDP is falling below optimum.

Don Geddis writes:

@RPLong: "where does impact of the policy-making ultimately end up? Given that the impact must be felt somewhere"

I was trying to suggest some answers to you, but maybe I really just don't understand your question. I honestly don't know what this quoted part means (e.g. "ultimately", "must be felt"). You state it as though it's some law of economics, but it's not any law I ever heard of. If you think you mean something technical, I'm not sure what that is.

A central bank can choose to stabilize any (single) nominal quantity. Money supply growth, inflation, interest rates, NGDP. Whichever one they choose, the rest of them become volatile / uncontrolled.

Whether any of this "matters" is a completely separate question. And then for your 98/5 example, absolute levels might or might not matter, completely independently from whether volatility at low levels matters. Stability isn't the same as magnitude.

Britmouse writes:

I think your views on what counts for good UK macro analysis are biased, Scott. :)

The way it was conventional to talk about unemployment in the UK in 2008/9 was that bankers in Nevada, USA in 2006 caused unemployment for hairdressers in Margate, England in 2009. There is still rarely any serious debate about that. Why was that true? Was it a result of the particular macro policy? Was it a policy error? Was it inevitable? It's a very complicated story to link Nevada with Margate.

NGDP and sticky wages is very simple. Occam's razor!

Scott Sumner writes:

Joel, No, market monetarists do not believe that short periods of hyperinflation might occur under NGDP targeting.

Britmouse, Good observation.

RPLong writes:

@ Joel - Yes, I agree with your interpretation of it (as long as we say "inflation" rather than "hyperinflation"). But of course NGDPLT is not the only rule-based monetary policy option. What is discretionary about NGDPLT is what level to target. Why 5% and not 4%? Why 4% and not 12%? Does it even matter? If so - and this is the important part - why does it matter? Otherwise, why not target a doubling of the economy every year? (Again I'm doing a reductio ad absurdum, but I have a point.)

@ Don - I have this crazy idea that if you resist the urge to reframe everything in terms of NGDP then interest rates start to look like prices and money supplies start to look like quantities of economic goods. I assume these things are more economically relevant than YOY growth rates of sum totals of transaction values. (C.f. britmouse re: Occam's Razor)

I want to know that NGDP is more economically relevant than "the money supply, interest rates, inflation, etc." because this would convince me that it is a better thing to target than anything else. I want to know why an esoteric floating growth rate is a better target for CB policy than an actual stock or an actual price.

If someone could make that argument - and not just reframe everything I think I know about economics (which is admittedly not much, but still...) in terms of NGDP - then I might be convinced.

I don't want to adopt a paradigm, I want to know about monetary policy. Sometimes I feel that the market monetarists are more about the paradigm than the policy. Maybe I'm just too "practical" or maybe I'm just too obsessed with "microfoundations," or maybe something else. But I'm still not seeing the advantage of NGDPLT over other mainstream - mainstream - monetary policy choices.

Don Geddis writes:

@RPLong: interest rates are just the price of credit. No more -- or less -- interesting than the price of any other single commodity, such as housing, or gold, or oil. Prices of commodities rise and fall with changes in supply and demand. The money supply is a stock, but one that can be created (by a monopoly) in arbitrary quantities for essentially zero cost. Its total size has little direct relevance.

The "real" economy is about physical atoms and services from human labor. The "nominal" economy is about the numbers we write down for accounting. If prices (/wages/debts) were perfectly flexible markets, then the nominal economy wouldn't matter at all. You see examples of this with planned currency depreciations. The peso loses a couple of orders of magnitude overnight, all prices are rewritten immediately in terms of new pesos, and the real economy is essentially completely unaffected.

So you need sticky wages and debts, plus an unexpected shock to NGDP, before the nominal economy matters at all to the real economy. Also, sustained high inflation (with non-indexed consequences like taxes) can cause nominal rules to affect real behavior.

It sounds like you need to back up, and start from the beginning. What makes something "money"? (It has elements of a Medium of Exchange for transactions, a long-term Store of Value, and a Medium of Account for future repayment of long-term contracts.) Then you need to split the macro economy into supply-side, and demand-side. Monetary policy only affects demand-side macro.

NGDPLT is addressing the specific failure, of an unanticipated change in the value of the Medium of Account, leading to too-high real wages and debts, but because of stickiness / inertia in wages and debts, rather than the price of wages and debts adjusting to a new equilibrium, instead we see excess unemployment and bankruptcies. So we solve this problem by having the central bank maintain a stable value for the Medium of Account.

If you think some other monetary policy (money supply targeting, inflation targeting, Taylor Rule) would be "better", I'd challenge you to explain what macro problem you think that policy would be superior at solving.

RPLong writes:

Don you make it sound as if NGDPLT is the only type of monetary policy that attempts to correct for "unanticipated demand-side changes in the medium of account." That is the underlying purpose of every kind of CB policy. What I am interested in is an argument for why NGDPLT is a superior method.

Saying, "If you think it's inferior, then tell me what's better" is not an answer to my question. All you're doing is asking me the same question I'm asking you. As a layman, my purpose is to learn about the pros and cons of each potential policy option and determine which one makes the most sense to me. I was under the impression that you had a specific reason why you thought NGDPLT was superior. If your decision criterion is "RPLong can't justify any other rule" then I would suggest that by this metric NGDPLT also fails. :)

Don Geddis writes:

@RPLong: All I can do, is compare NGDPLT to other proposals.

It's better than the 1920's gold standard as an MOA, because the value of gold can rise and fall for reasons unrelated to the overall economy (and thus you get the Great Depression).

It's better than the 1970's money supply growth policy suggested by monetarists, because the velocity of money is not as stable as they hoped, and the buying power of money (aka value of MOA) depends on how much money is chasing the supply of goods, but velocity (times money supply) determines how much money is out there trying to buy things.

It's better than naive inflation targeting, because some prices (energy, food) are very volatile, but not indicative of future long-term trends in inflation.

It's better than Taylor Rule core inflation targeting, because supply-side shocks can result in crashing RGDP while inflation remains stable (c.f. 2008).

Using expectations with forward guidance is better than secretly trying to use concrete "levers" to change the economy, because the concrete Fed actions are such a tiny part of the overall economy, but expectations of the future change everyone's behavior instantly, and are thus vastly more powerful.

Level targeting (LT) is better than not, because otherwise small errors over time accumulate to huge errors over the long term, and thus predicting the long-term value of the MOA is otherwise not feasible (in order to properly negotiate long-term contracts).

Interest rates are a poor tool for monetary policy, both because (1) people react to nominal rates, but if anything matters it is real rates; (2) there is a zero lower bound on interest rates, so the tool loses power right when you most need it to provide additional stimulus (in an economy verging on deflation).

So you want a monetary policy with no ZLB, which only listens to the demand side (because monetary policy doesn't affect the supply side anyway), which corrects over time for small errors, and which allows a stable and predictable value for the MOA.

There are some other choices besides NGDPLT. (Sumner has said that targeting nominal hourly wage income would probably be better, but only by a little bit, and is more difficult to implement.) But most of what central banks have tried to do in the past is worse, and for pretty obvious reasons.

So NGDPLT is not (necessarily) the theoretical best thing that can be imagined. (Perhaps a free market in money is, with no Fed at all!) It's simply much better than the handful of monetary policies that real-world central banks have actually used, in the last century or so.

RPLong writes:

So, Don, I can't help but notice that you listed cons for every alternative, but no pros. You also failed to mention any cons of NGDPLT.

Are we to believe that NGDPLT is (a) easily practicable, and (b) costless? This is a free lunch? Is that what you're saying? Every other form of monetary policy has drawbacks, but NGDPLT has none?

Don Geddis writes:

RPLong: I'm not a professional macroeconomist, and a blog comment is not the place to write a macro textbook anyway. That said, to first approximation, yes: NGDPLT is a free lunch.

Ben J writes:

RPLong,

Asking what the optimal level of NGDP growth rate is besides the point. It's exactly analogous to asking what the optimal rate of inflation is under IT, which is also besides the point.

The idea is to stabilise aggregate demand growth. The 'level' of the growth is a second-order concern. Usually people argue that the 'level' of that growth should be sufficiently low as to minimise menu-costs of price changes but also high enough to ameliorate the effects of sticky wages. But the important point is that these concerns are identical for both IT and NGDPT. If you want a full treatment, read Money, Interest and Prices.

If it helps, NGDP targeting is just price-level targeting with catch up, in exactly the way it is described in Woodford (2012) [both are again slightly different from NGDPLT]. But since they're so similar, I'm not sure why you seem to feel that moving from one to the other is such a big leap.

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