Sunday, September 29, 2013

Sumner on Summers

A real sarcastic gem from Scott Sumner:

"At the opposite extreme is someone like Larry Summers, who worries that low interest rates and a bloated balance sheet might lead to bubbles, and misallocation of investment.  In that case fiscal policy could be “effective.”  That sort of central banker would essentially be holding the economy hostage, much as the GOP radicals in the house are accused of doing.  A central banker with that objective function would intentionally hold NGDP below the optimal path, unless and until the Federal government would assure him or her that the extra NGDP growth would be in the public sector, where (unlike the private sector) the expenditures would not be wasted on foolish projects driven by a bubble mentality.  The Federal government spends money very wisely, especially when under pressure to quickly ramp up investment during temporary slumps in the economy."

So true. 

Saturday, September 28, 2013

McCallum on Growth vs. Level Targeting

Bennett McCallum has a short paper on growth vs. level targeting.   He again argues for targeting the growth rate of nominal GDP rather than the level.   To some degree he is criticizing Woodford's proposal to return nominal GDP back to something like the growth path of the Great Moderation.   However, his argument is more general.

It is great to see more new work from McCallum on nominal GDP level targeting.

He emphasizes discretionary and time invariant approaches to policy rules.    He also mentions a purported rule he calls strategically incoherent.   I am not sure I fully understand, but it looks to me that this is exactly the approach that Market Monetarists favor.   Right now, we have to decide where the initial growth path for nominal GDP will commence, and then we stick with it.   This is supposedly incoherent because why don't we start it all up again every period?    Next year, why don't we imagine we have no rule, and we will again choose a new starting point for the growth path.

Suppose we are considering the institution of  very strict gold standard.   In the future, the price of gold will be fixed.   The price next period will equal the price this period which equals the price last period.   Now, at what price do we set this fixed price of gold?   Is it strategically incoherent to use anything other than last period's market price of gold?   I don't think so.   The relative price of gold can easily be impacted by using it as medium of account.   We are instituting a regime.   The logic for choosing a rule initially is not the same as the logic for sticking to the rule.

Anyway, he refers to the literature that suggests that period by period optimization is a bad idea.   And then describes Woodford's approach of time invariant policy as imagining that the policy we follow now was introduced far in the past.  

He then notes that nominal GDP growth rate targeting has results more similar to this time invariant approach while level targeting would close output gaps more quickly,  which is also what would happen with the period by period optimization approach.

What would be so bad about a rule that closes output gaps more rapidly?   McCallum just states that lots of studies suggest that immediately closing output gap is rarely optimal on average.

But why?  The only other thing that could be a cost in this model is deviations of inflation from target.   In other words, if we get the output gap back to zero this period, then this will have a cost of causing inflation to deviate "too much" from target.

Could it really be so simple as the assumption that changes in the inflation rate are bad?

With nominal GDP level targeting, a positive aggregate demand shock will cause higher inflation this period and then lower inflation next period.    With a negative aggregate demand shock, there is lower inflation this period and then higher inflation next period.    What is happening is changes in the price level, or more generally, its growth path, are being reversed.

If it is deviations of inflation from target that is considered bad, then nominal GDP level targeting  would be inferior to nominal GDP growth rate targeting.  On the other hand, if it is changes in the expected value of the price level that cause a problem, then a deviation of inflation from target in the opposite direction is not to add insult to injury, but rather a corrective.

Ignore supply shocks and assume the trend inflation rate is zero.   A price level target for the GDP deflator is 100.   An inflation target is for its rate of change to be zero.    In a perfect world, it stays at 100.   Sadly, there is 1% inflation.   It is now 101.   If the "loss" is inflation, then there is a loss, and if the GDP deflator stays at 101 forever, there is no further loss.

But suppose the "loss" is the deviation of the price level from 100.   If  it stays at 101 forever, then there is an ever continuing loss that is only kept from being infinite by discounting.

If the loss is inflation, then a 1 percent deflation returning the price level to 100 just adds an additional loss to the first one.   A unavoidable 1% inflation plus an additional easily avoidable 1% deflation.   If the loss is the deviation of the price level from target, then the 1 percent deflation returning the price level to 100 limits the duration of the loss to one period.

Of course, this is the simple version of the model.   The studies McCallum refers to presumably use calculations of utility loss from inflation rather than a simple "loss" function.

But to what degree are these utility calculations based on the assumption of Calvo pricing?  That seems to me to put too much weight on an obviously unrealistic model whose only virtue is that it can be used to make calculations of utility in rational expectations models.

If instead, some prices are flexible and others are sticky, reversing the changes in the flexible ones so that the sticky ones don't have to change is desirable.   This reasoning also applies when the sticky prices are those of labor--wages.   And that seems much more plausible.   Rather than keep the price level change and then make wages adjust, it makes much more sense to reverse the price level change so that labor markets clear at the sticky wage levels.

What about supply shocks?   While nominal GDP level targeting is the same as price level targeting when there are no aggregate supply shocks, one of the chief virtues of nominal GDP level targeting is that it does much better than price level targeting when there is a supply shock.

The model McCallum uses has an inflation shock.   It is just a random term at the end of the quasi-Phillips curve.   It seems to me that any such shock would push nominal GDP above target.   A growth rate target would just leave nominal GDP on a new, higher growth path.   In my view, that would be best.   (At least if these price level shocks are really just random and not regime dependent.)   Pushing the price level back down the next period would be pointless.   Nominal GDP level targeting would require a return of nominal GDP to target, and would likely push output below capacity.

However, what these random shocks in the model represent are real microeconomic events that impact both prices and capacity.   Negative covariance is very likely, and so just when the price level is shocked up, real output and capacity are both pushed down.   Any deviation of nominal GDP from target is likely to be small.     Further, to the degree they are temporary, when they end, nominal GDP will return to target with no change in "monetary policy" at all.   It isn't always necessary to cause an output gap to get some disinflation.   When peace breaks out in the Persian Gulf, lower oil prices bring disinflation without a need to cause a recession and output gap.

So, there may be a case for nominal GDP growth targeting as opposed to level targeting, but McCallum didn't make it here.  

AEI on Market Monetarism

The American Enterprise Institute's website has had some excellent posts on monetary policy.   James Pethokoukis has been writing on monetary policy from a Market Monetarist perspective for some time.   He has a series of short posts that allowed several market monetarists to answer some questions about quantitative easing.    The last one is about the charge that quantitative easing is like central planning.   Check the links back to the previous four.

HT David Beckworth

Friday, September 20, 2013

QE Continues

Ryan Avant at the Economist has a good discussion of why quantitative easing has an impact.    It is all about expectations.    It isn't about how many and what type of securities the Fed purchases--how big its balance sheet will be.   It is rather hints about the outcomes for the economy that the Fed wants to acheive.   Market Monetarists, and Avant should be counted as one, want clear communication--a target for the growth path of nominal GDP.    Where does the Fed want spending on output to be, which is, necessarily, how much money income does the Fed want people to earn?   (Unfortunately, Avant, as does Sumner too often, plays to those tied to the status quo, talking about a commitment to full employment and higher inflation, with a mere passing reference to nominal income.)  

Nick Rowe has another in his series of posts about why interest rates are not fundamental to monetary policy.     Rowe has been arguing that New Keynesian models assume full employment in the long run, without there being any mechanism to get there.   In their models, the central bank sets an interest rate, which determines spending now relative to later.   In the model, real spending later is equal to potential output--the full employment level of output.    A lower interest rate now then results in more spending now.   However, if spending later is not tied down, then a lower interest rate now could just mean less spending later.    That a lower interest rate now means more spending now is based upon an assumption rather than any implication of the model. 

While all of this makes sense to me, it seemed to me that it was just about imperfections in New Keynesian modeling strategy.    In the real world, central banks create and destroy money.   Why can't the implications of the quantity of money the central bank creates be included as an assumption in the model, even if that part of the economy is not part of the model?   Sure, calling it "general equilibrium," is a misnomer, but can't partial analysis provide insight?

In this post, Rowe connects his critique to Leijonhufvud's theory of the corridor.   In Rowe's view, as long as most people believe that the economy will bounce back soon, then an interest rate policy will work well enough.   But if people do not believe that the economy will bounce back soon, then a policy based on interest rates can fail.   Leijonhufvud's theory was that the macroeconomy is reasonably stable within a corridor of small fluctuations, tending to revert to full employment.   On the other hand, if the economy is somehow pushed well outside the corridor, it won't return.

Rowe's argument suggests that the problem Leijonhufvud described as the corridor is with the traditional focus of central banks--interest rates.   The New Keynesian insistence that adjustmetns in short term interest rates, and promises about where their time path in the future, are all that is necessary to provide for macroeconomic stability, is mistaken.   It follows from this flaw in their model.   Instead, Rowe suggests that central banks need to emphasize the quantity of money.   It is the quantity of money, and not interest rates, that determines the nominal economy in a monetary economy.    When people sell goods for money and buy goods with money, the quantity of money matters.   

I think Rowe is correct, however, I would go one step further.     It is the nominal anchor that ties down the nominal economy.   A monetary regime that fixes the nominal quantity of money has a nominal anchor, but a poor one.   Of course, Rowe doesn't advocate a fixed quantity of money.  My point is that to provide for macroeconomic stability, a monetary regime must tie down the level of some nominal magnitude.  The price level or spending on output are much better than the quantity of money.

Do these nominal magnitudes require some commitment about the quantity of money?   Not really.   Changes in the quantity of money that are expected to be temporary have little effect on other nominal magnitudes.   Changes in the quantity of money that are perceived as inconsistent with the central bank's goals for other nominal magnitudes will be seen as temporary and so have little effect.  

And this brings us back to Avant's point.   How many bonds or what type of bonds the central bank purchases is not important.   The quantity of money is not important.  What is important is the nominal magnitude the central bank is aiming to achieve.

Tuesday, September 10, 2013

Taylor and Hall on Nominal GDP Targeting

John Taylor quotes Robert Hall approvingly about nominal GDP targeting.    Hall said

“A policy of stabilizing nominal GDP growth would require contractionary policies to lower inflation when productivity growth is unusually high. Such a policy might easily trigger a spell at the zero lower bound.”

What is Hall's framing?

One possibility is that "tight money" means lower inflation.   If productivity increases, then the central bank must lower its target for the inflation rate.   A lower target inflation rate will lower the nominal interest rate consistent with any given real interest rate.    A lower nominal interest rate is one more likely to be equal to zero. 

One problem with that framing is that it has the central bank targeting inflation.   With nominal GDP targeting, it is targeting nominal GDP.   More rapid productivity growth will result in lower inflation.   Given monetary policy, inflation depends on productivity growth.    It remains true that given the real interest rate, lower anticipated inflation results in lower nominal interest rates, but there is no contractionary monetary policy.

Another possible framing is that inflation is given, though not targeted, and the increase in productivity results in more real output growth.   The higher real output growth with given inflation results in above target nominal GDP growth.   The central bank must then tighten monetary policy to return nominal GDP to target.    If output is assumed to remain high, this requires disinflation.  Given the equilibrium real interest, the lower inflation would reduce the nominal interest rate.   If the nominal interest rate is already low, the result could be a nominal interest rate that hits zero.

One problem with this framing is that it seems inconsistent with basic microeconomics.   An increase in productivity reduces marginal costs for at least some firms.   With imperfect competition, each firm will maximize profit by expanding output and lowering its price to sell the output.   While the reason the lower price results in a larger quantity demand is due to a lower relative price, and this would not be true if all firms had the same improvement in productivity, the lower price level and increase in aggregate real output is roughly consistent with nominal GDP remaining on target.   

For a single firm to respond to a decrease in marginal cost by producing more at the same price, it would need to anticipate a rightward shift in its demand curve.    No single firm can expect that to occur as a consequence of its own improved productivity and reduced marginal cost.  

No, what would have to happen is that all firms would know that productivity has improved in aggregate, and that an inflation targeting central bank is going to cause aggregate spending to rise with the increase in real output.   And so, they can all expect a rightward shift in their demand curves.  

But with a nominal GDP targeting central bank, there is no  reason for there to be any such expectation.  And so, each firm can simply behave as if the improved productivity impacted them alone.

What does this imply for nominal interest rates?

If the improvement in productivity and disinflation was unanticipated, then there would be no impact on nominal interest rates for existing debt contracts.  The nominal interest rates are already determined.   The lower inflation rate causes an increase in realized real interest rates.   Creditors share in the unanticipated increase in real output and real income.   Does that mean that debtors are worse off?   Not at all.   The debtors make exactly the same nominal payment to creditors as before, and have the exact same nominal income, that is, profits or wages, remaining as before.   The disinflation means that their real incomes rise due to the unanticipated increase in productivity.

A policy of preventing (or reversing) the disinflation so that creditors share nothing of the increase in productivity would likely just blow up profit.   With wages being sticky, workers would receive no gain.  

What about nominal interest rates on contracts made once the increase in productivity materializes?  If the increase in productivity were permanent, then the price level is now on a permanently lower growth path.   However, its rate of change is the same.   Nominal interest rates are not impacted at all.

If the increase in productivity were temporary, then during the next period, the disinflation will be reversed.   The anticipated inflation as the price level returns to its previous growth path would tend to raise nominal interest rates.

Suppose that the improvement in productivity were anticipated.   With nominal GDP targeting, the result will be disinflation.   The effect on real interest rates would be anticipated.   If the equilibrium real interest rate is unchanged, then the anticipated disinflation would lower nominal interest rates.   If nominal interest rates were sufficiently low already, this could push the nominal interest rate to zero.

Let's explore a bit more the process by which nominal interest rates would fall.   Lenders would find it more attractive to lend at any given nominal interest rate because they will receive more real purchasing power in the future.   However, consider the lender's alternatives.   The lender might go into business or buy an equity claim to a business.     Assuming constant output, the lower product prices in the future imply lower nominal profits and so a lower value of equity claims.   A loan at a given nominal interest rate would avoid that and so there is a motivation to lend more rather than hold equity claims in business.

But output is not constant.   Output rises in inverse proportion to any disinflation leaving nominal profits and so the value of equity claims to those profits unchanged.    Because of the disinflation, the real purchasing power of those nominal profits will be higher.     And so, the notion that lending at a given nominal interest rate will be more attractive due to the disinflation is false.      

Of course, lenders are also sacrificing consumption today and making loans in order to fund consumption in the future.    With the anticipated deflation, any given nominal interest rate implies that more future consumption is provided for any sacrifice of current consumption.   It would seem that saving becomes more attractive, forcing down the nominal interest rate and returning the real interest rate to its previous equilibrium. 

This would make sense if future real income and so real consumption out of that real income were unchanged.   For example, if the disinflation just reduced nominal income while leaving real income the same.

But the increase in productivity raises real income in the future and also the real consumption can be funded out of that future real income.    If the real interest rate remained the same, then this effect would cause households to shift some of that added future consumption to the present, and so reduce saving.    The real interest rate must rise to bring today's saving and investment into balance and so current consumption and investment to a level consistent with today's potential output.

If the real interest rate must rise in exact proportion to the increase in the growth rate of real output, then the inversely proportional disinflation will generate exactly the needed increase in the real interest rate at an unchanged nominal interest rate.   While models that generate exactly that result might not be entirely realistic, they are certainly more realistic than just ignoring the effect of the increase in future real income.

How does the expected disinflation impact borrowers?   Supposedly there is a reduction in the willingness to borrow.     Again, this makes perfect sense if output is assumed constant.   For example, firms borrowing to fund production processes would find it more difficult to repay loans at any given nominal interest rate if they sold a given amount of output at a lower price.    But with productivity rising, they are selling more output at a lower prices, and with nominal GDP targeting, they are earning the exact same revenue.   Their ability to pay any given nominal interest claim is not reduced.   And further, their remaining nominal profit generates a larger real income because of the disinflation.  

The same occurs for household borrowing to fund consumption.    If future real income is assumed to be constant, then disinflation implies lower nominal income.   Nominal interest claims become more difficult to pay.   But with nominal GDP targeting, nominal income does not decrease, and the increase in productivity generates an increase in real income.   The nominal interest payments of the indebted households will be the same as will their nominal incomes.   Their nominal incomes net of interest payments are the same, and because of the disinflation, their real consumption increases.    As above, rather than this expected disinflation creating a deterrent to borrowing at any given nominal interest rate, it rather generates the needed increase in real interest rates to limit efforts to bring the added future real income into the present.

As long as the target growth rate for nominal GDP is greater than any difference between the natural interest rate and the growth rate of the productive capacity of the economy, there is no problem with the zero nominal bound.    For example, if the growth rate of potential output is 3% and the natural interest rate is 2%, and the target for nominal GDP is a 3% growth path, then the price level will be stable and the nominal interest rate will be 2%.

On the other hand, if the target for nominal GDP is a 3% growth path, and the productive capacity of the economy is growing 5%, and the natural interest rate is 1%, then the deflation rate is 2% and the nominal interest rate would need to be -1%.

Is it impossible that a shift in potential output growth from 3% to 5% would be associated with a reduction of the natural interest rate from 2% to 1%, rather than an increase?   I don't think it is impossible and so I favor monetary institutions that are not subject to the zero nominal bound.  But I also don't believe that nominal GDP level targeting should be dismissed when the more likely scenario is that anticipations of slower growth in potential output lead to a decrease in the natural interest rate so that inflation targeting would be more likely to result in problems with the zero nominal bound.

HT Scott Sumner.

Monday, September 9, 2013

Andolfatto on Nominal GDP Targeting

David Andolfatto again brought up the model he had used some time ago to criticize nominal GDP level targeting.  The shock in his model is a decrease in the expected productivity of capital.   If these expectations are correct, then the output of consumer goods will be lower during the next period.

In his model, the lower expected productivity of capital goods leads young people to accumulate money/government bonds.   This decrease in the demand for capital goods and increase in the demand for money "appears" to be a decrease in aggregate demand.

In comments on his blog, I reviewed what I take to be some of the ABC's of saving and investment.   He insisted that interest rates and inflation are policy variables, but I presume he was speaking of his model.

My "model" is the supply of saving and demand for investment.   Saving is positively related to the interest rate and investment is negatively related.   At the natural interest rate, saving and investment are equal.   That part of income not spent on consumer goods is saved.   Investment is spending on capital goods.   With saving  equal to investment, that part of income not spent on consumer goods is instead spent on capital goods.   Income is here potential output, the productive capacity of the economy.  

If the interest rate is below the natural interest rate, saving is less than investment.  Spending on consumer goods plus spending on capital goods outstrips the productive capacity of the economy.   If the interest rate is above the natural interest rate, investment is less than saving, and spending on consumer goods plus spending on capital goods is less than the productive capacity of the economy.

Andolfatto's shock using my simple model is a shift of the investment demand curve to the left.   At the initial natural interest rate, investment is less than saving and the sum of consumption and investment is less than the productive capacity of the economy.   

If we consider  the market interest rate adjusting from the initial natural interest rate to the new natural interest rate, as it falls, the quantity of investment demanded rises.    While the demand for capital goods initially fell, it partly recovers due to the lower interest rate.   The quantity of saving supplied decreases.   This is the same thing as an increase in spending on consumer goods.  

At the new natural interest rate, saving and investment are again equal, and the sum of investment and consumption equal the productive capacity of the economy.   However, the amount saved and invested are both lower and spending on consumer goods is higher.

There is no impact on total spending on output now.   Nominal GDP would remain on target.   There is no impact on the price level.   The prices of consumer goods might rise, but the prices of capital goods would fall.   (If consumer prices are targeted, which is not unrealistic, then it might be necessary to reduce spending on output and slightly depress the overall price level, further lowering the prices of the capital goods.)

What could go wrong?   Suppose there is a central bank targeting the nominal interest rate.   Sadly, this is is a very realistic assumption, and one that Aldofatto includes in his model.  The decrease in investment demand implies a lower natural interest rate, but should the market interest rate begin to fall, this pushes it below the central bank's target.   If necessary, it sells off some of the assets it holds and contracts the quantity of money enough to prevent the interest rate from falling.    If the demand to hold money is rising, then failing to expand the quantity of money enough to match the growing demand will also keep the market interest rate from falling.

Because the market interest rate fails to fall with the natural interest rate, investment falls below saving and the sum of consumption and investment is less than the potential output.   As their sales fall, firms cut back production, causing output and income to fall below potential.  

This decrease in spending on output and income is inconsistent with nominal GDP targeting.   Of course, these decreases could be relative to what nominal GDP would have been, and so amount to a smaller than usual increase.  A central bank targeting nominal GDP needs to expand the quantity of money and decrease its target for the interest rate.  

While firms are likely to respond to the decrease in spending by producing less, they also will likely lower their prices, though this could be solely a matter of lowering them relative to where they would have been.   In an inflationary environment, this amounts to raising their prices more slowly.   A central bank targeting the price level (perhaps a growth path for the price level) or inflation also needs to expand the quantity of money and lower its target for the interest rate.

Suppose the central bank doesn't target interest rates at all, but rather targets some measure of the quantity of money.   In that situation, the central bank takes no action to manipulate the quantity of money as the decrease in investment demand results in a lower market interest rate.   If money bears interest, and the interest rate paid on money falls with other market interest rates, then a money supply target would allow all market rates to adjust to the new natural interest rate.

Aldofatto, however, assumes that the both the yield on money and its quantity remains fixed.   A central bank following such a policy could keep the market interest rate from falling, and result in reduced investment expenditure, aggregate expenditures, production, and employment.   A central bank targeting the price level or nominal GDP would need to lower the interest rate paid on money or else increase the quantity of money or both.

The implications of nominal GDP level targeting, price level targeting, and inflation targeting are all very similar.   The market interest rate should be allowed to fall enough to match the new natural interest rate.   Nominal GDP, the price level, and inflation should all remain unchanged.  

What if the central bank fails to make the proper adjustment in its interest rate target and the quantity of money?   In the likely scenario where at least some prices are flexible, then the decrease in spending on output will be matched by a less than proportional decrease in the price level.   The central bank must return both spending on output and the price level to target.  

With inflation targeting, however, the change in the price level due to the adjustment of the flexible prices is allowed to persist.    The flexible prices can only increase again as the other, less flexible prices, especially including nominal wages, also adjust downward.

What about the future? 

In the future, the smaller increase in the capital stock, and a perhaps realized reduction in the productivity of capital, will tend to result in a smaller than otherwise increase in real output.   The reduced saving and the lower interest rate on accumulated wealth will reduce the claims on that output.  

With price level targeting, spending on output must grow more slowly to reflect the smaller expansion in output.     Since this effect is predictable, the result would be the same with inflation targeting.

However, with nominal GDP level targeting, spending on output in the future will continue growing as usual.  The smaller increase in production will result transitional inflation.   The price level will move to a higher growth path.

The smaller capital stock in the future would tend to result in lower real wages.  Any decrease in the growth path of nominal wages made necessary by the change in the growth path of the capital stock would be dampened by the increase in the growth path of the price level.   If wages are especially sticky, then this is a benefit of nominal GDP level targeting.

Because the inflationary implication of nominal GDP targeting can be expected, the nominal interest rate in the first period will fall by less than the real interest rate.    It is possible that the nominal rate would remain unchanged or even rise.   This effect of nominal GDP level targeting implies there is less chance of the reduction in the expected productivity of capital causing the nominal interest rate to fall to zero.  

Andolfatto's model is different.   There are overlapping generations.   The young choose to use their endowment of output to produce capital goods or else sell it to old people in exchange for  money/government bonds.   When they are old, then consume the output of their capital goods or "spend" the money/government bonds on the output that belongs to the next generation of young people.   The base line model has the quantity of money/government bonds and the nominal interest rate paid on them fixed.    The way the government stabilizes nominal GDP is to vary the nominal interest rate, lowering it when expected capital productivity is low, to maintain the demand for capital goods.

As far as I could tell, a reduction in the expected productivity of capital results in the current old generation receiving a bonanza of cheap consumer goods from the current young people.   Those young people try to obtain more money/government bonds but their quantity is fixed.  And more importantly, what the young people get from them when they are old is simply the tax payment of the next generation of young people.   That doesn't increase when the productivity of capital is low.   So, the current young people get less consumption when they are old and the current old people get a bonanza of extra consumption.     It seems to me that from the point of view of the current young people, the best strategy is to invest all of current output other than an infinitely small amount to exchange for all of the money/government bonds.  

But really, I don't think these specialized, highly unrealistic assumptions really add much to the basic supply of saving and demand for investment approach.

Wednesday, September 4, 2013

Some Thoughts on the Pigou Effect

The Pigou effect is that a lower price level increases real money balances, real wealth, and consumption.   It applies to outside money, and not inside money.

In a previous post, I argued that inflation targeting combined with Ricardian Equivalence means that there is no Pigou effect.   Inflation targeting makes base money into a type of inside money--fundamentally a type of government debt.   Ricardian Equivalence implies that while a lower price level raises the wealth of of those holding base money, it increases real tax liabilities.   There is no net effect on real wealth, and so no increase in real consumption.

For many years, the Fed almost entirely held government bonds.   But recently, the Fed has shifted to holding a large amount of mortgaged-backed securities.    If the price level is lower, then this increases the real wealth of those holding base money, but it reduces the real wealth of the indebted homeowners.   To a large degree, there is no longer a Pigou effect for a substantial portion of base money, even without Ricardian Equivalence.

Further, 100% gold reserve banking would substantially increase the proportion of total wealth that is "outside" money.   Such a monetary regime would have a much stronger Pigou effect.   That is, even if nominal interest rates couldn't fall, say because they were already zero, then a lower price level would have a relatively larger effect on real wealth.   The decrease in saving supply, increase in the natural interest rate, and increase in real consumption would be larger.   In other words, a smaller decrease in prices and wages would be necessary to bring real expenditure in line with capacity.

Sunday, September 1, 2013

Selgin on Market Monetarism

George Selgin takes Market Monetarists to task for discounting the problem of booms.   He recognizes that Scott Sumner and other Market Monetarists advocate a nominal GDP level target that is symmetrical.    If nominal GDP should rise above the target growth path, the monetary regime should reverse the upward deviation.

So what is the problem?   It is the skepticism among Market Monetarists that such an upward deviation in nominal GDP makes anything worth describing as a recession inevitable.   In particular, nominal GDP can be returned to its prior growth path.  There is absolutely no need for spending on output to fall below that growth path, much less drop to the level that existed before the upward deviation.

For example, suppose the target growth path for nominal GDP has a 3% growth rate.   Unfortunately, there is a 2% upward deviation resulting in a 5% growth rate.   Level targeting requires that the growth rate be approximately 1% the next year, so that it is now 6% greater than its level before the excessive spending growth two years before.     There was no decrease in nominal GDP at all.   Market Monetarists would insist that it is not necessary or desirable for nominal GDP to fall 5%, or even 2%, in the second year.  

While Market Monetarists favor a target growth path, few of us would argue that growth rate targeting is unfeasible.   In other words, it would be possible for nominal GDP to grow 5% one year, and then return to growing 3% in the future.   The extra large upward deviation could be allowed to shift the economy up to a permanently higher growth path for nominal GDP.  Not only would there be no decrease in nominal GDP, there would be no future slow down to return to the previous growth path.

What about real output?   Recessions are not usually defined in terms of spending on output, but rather in terms of the growth rate of real output.  Recessions are usually defined as a negative growth rate.   Now, suppose potential output, the productive capacity of the economy is growing 3% and production is at capacity.  Nominal GDP is on its target growth path, and the price level is stable.   Then, suppose nominal GDP grows 5% and that the more rapid than usual increase in sales motivates firms to expand production more than usual.   Rather than expanding their output by the usual 3%, they expand production 4%.     The following year, the growth rate of nominal GDP is 1%.   Nominal GDP returns to its initial growth path.

Is it necessary that real output fall 4%, reversing the expansion during the boom?  Or even that it fall1%, reversing the excess growth?    Or is it possible that real output might rise 2%, and return to its previous growth path?   That is, like nominal GDP, it would 6% higher than it was two years before, exactly in line with the growth path of potential output.   

One possible scenario is that during the year with nominal GDP growing 5%, the price level rises 1%.   And then, in the following year, when nominal GDP grew only 1%, the price level falls by 1%, returning to its initial level, as real output rose 2%.       At no point would real output fall.   It would just grow each and every year, and grow extra fast, 4%, in one year, and a bit slower, 2%, the next year, so that over the entire period, it grows 6%, exactly in line with potential output.

While recessions are usually defined in terms of the growth rate of real output, an alternative approach is to consider the output gap--real output minus potential output.   The phenomenon of concern is production below capacity, regardless of whether production is rising or falling.   In the scenario above, the more rapid growth of nominal GDP results in real output rising above potential.   And then in the next period, it returns to potential.    The increase in real output above potential the first year does not require that it fall below potential the following year.

Of course, the notion that real output can rise above potential is a bit of a puzzle.   How is it possible to produce more than there is the capacity to produce?    Selgin suggests that Market Monetarists follow Milton Friedman in having a "plucking" model.   When nominal GDP grows shifts down to a lower growth path, this causes real output to fall below potential.   And then, as inflation slows and the price level adjusts to a lower growth path, or nominal GDP recovers, real output returns to potential.     While real output falls below potential, on this view, it never rises above potential.

If potential output is assumed to stay on a 3% growth path, this would be a bit implausible.   But once it is recognized that potential output almost certainly sometimes grows faster and other times more slowly, then booms can be explained as periods where potential output is above trend.   Recessions then can either be potential output growing below trend or else real output falling below potential.   It seems reasonable to me that mild "growth recessions" could either be due to a slow down in the growth of spending on output or a slow down in the growth of potential output.   Deep recessions, on the other hand, would be due to decreases in spending on output.       

Still, I believe that real output can rise above potential, a view,which is shared by at least some other Market Monetarists.  With imperfect competition, firms have excess capacity in equilibrium and so can expand output.   If their prices are pre-set and there is an unexpected increase in demand, they will find in profitable to expand production.  And then, when they reset prices or demand decreases, they will return production to its initial level.   If potential output is growing, then it is possible to see real output rise more quickly when spending on output grows more quickly, and then grow more slowly as spending on output grows more slowly.  

Sumner emphasizes sticky wages, and it would seem that something similar is likely.   When demand grows more rapidly, firms with excess capital capacity use more labor and other variable inputs and produce and sell more output.   If the situation persisted, then they will adjust the wages they pay, causing this effect to dissipate.   How long does it take firms to recognizes that a higher growth path or rate of spending on output is going to persist and then respond by changing their labor compensation programs?   Of course, with nominal GDP level targeting, there is no need to make these adjustments in compensation programs.   When spending on output grows more slowly, the production and employment return to the previous growth paths.

The puzzling implication of this reasoning is that booms can be caused by more rapid spending growth, and they are times of enhanced production, employment, and human welfare.   It is just that changing the growth rate or path of spending on output to create a perpetual boom is impossible.

Anyway, the puzzle of the boom, with output rising beyond potential has no counterpart in the recession.   There is no technical problem with producing far below capacity.   It is only that this implies surpluses of products and labor and the result should be lower prices and wages.   The lower prices and wages increases real money balances and real expenditures on output.  Assuming firms respond to growing sales by producing more, then production will rise back up to capacity.   If prices and wages only adjust sluggishly and if the needed adjustment in prices and wages is large, then output can remain below capacity for a substantial period of time.

What happens if prices and wages are also sticky on the upside?   In the scenario above, spending grew 5% and production rose 4% and prices 1%.   Instead of the usual expansion of production by 3%, it was 1% higher and instead of the usual stable price level, there was 1% inflation.   What if prices instead did not increase at all and it was impossible to expand production by more than 4%?   Then there are shortages. 

Now, shortages are not harmless.   The story told in principles classes these days is that markets clear due to queuing costs.   Those who have low opportunity costs of standing in line, obtain the goods and others do without.    However, with a temporary upward deviation of spending on output, shortages are likely to show up as depletion of inventories and later delivery dates.   There may be queuing for services too.   Consumer goods and services don't go to those who value them most according to their willingness to pay.   Perhaps of more concern, capital goods don't go to firms who can use them most productively.

If spending on output was allowed to shift to a higher growth path, then these inefficiencies of shortages would only dissipate as prices and wages adjusted upwards.    If nominal GDP returned to its previous growth path, then any shortages would disappear, largely as growing productive capacity caught up with the level of spending.    The increase in spending above was 5%, which is 2% greater than the increase in capacity.    But the next year, capacity grows 3% as usual, which catches up with that 2% excess growth in spending, and then some.   Spending on output grows 1% more to match.

Anyway, the short answer to Selgin is that scarcity puts a limit on how much extra real output can be produced in a "boom" while putting no constraint on the negative impact of a recession on production and employment.     But as Selgin recognizes, Market Monetarists do favor keeping nominal GDP on the target growth path.   Just because upward deviations of nominal GDP from target are unlikely to cause significant increases in real output doesn't mean that such deviations are desirable.