Last week, David Andolfatto challenged proponents of NGDP targeting to provide the reasons for their belief that targeting NGDP, or to be more precise the time path of NGDP, as opposed to just a particular rate of growth of NGDP, is superior to any alternative nominal target. I am probably the wrong person to offer an explanation (and anyway Scott Sumner and Nick Rowe have already responded, probably more ably than I can), because I am on record (here and here) advocating targeting the average wage level. Moreover, at this stage of my life, I am skeptical that we know enough about the consequence of any particular rule to commit ourselves irrevocably to it come what may. Following rules is a good thing; we all know that. Ask any five-year old. But no rule is perfect, and even though one of the purposes of a rule is to make life more predictable, sometimes following a rule designed for, or relevant to, very different circumstances from those in which we may eventually find ourselves can produce really bad results, making our lives and our interactions with others less, not more, predictable.
So with that disclaimer, here is my response to Andolfatto’s challenge by way of comparing NGDP level targeting with inflation targeting. My point is that if we want the monetary authority to be committed to a specific nominal target, the level of NGDP seems to be a much better choice than the inflation rate.
As I mentioned, Scott Sumner and Nick Rowe have already provided a bunch of good reasons for preferring targeting the time path of NGDP to targeting either the level (or time path) of the price level or the inflation rate. The point that I want to discuss may have been touched on in their discussions, but I don’t think its implications were fully worked out.
Let me start by noting that there is a curious gap in contemporary discussions of inflation targeting; which is that despite the apparent rigor of contemporary macro models of the RBC or DSGE variety, supposedly derived from deep microfoundations, the models don’t seem to have much to say about what the optimal inflation target ought to be. The inflation target, so far as I can tell – and I admit that I am not really up to date on these models – is generally left up to the free choice of the monetary authority. That strikes me as curious, because there is a literature dating back to the late 1960s on the optimal rate of inflation. That literature, whose most notable contribution was Friedman’s 1969 essay “The Optimal Quantity of Money,” came to the conclusion that the optimal quantity of money corresponded to a rate of inflation equal to the negative of the equilibrium (or natural) real rate of interest in an economy operating at full employment.
So, Friedman’s result implies that the optimal rate of inflation ought to fluctuate as the real equilibrium (natural) rate of interest fluctuates, fluctuations to which Friedman devoted little, if any, attention in his essay. But from our perspective there is an even more serious shortcoming with Friedman’s discussion, namely, his assumption of perpetual full employment, so that the real interest rate could be identified with the equilibrium (or natural) rate of interest. Nevertheless, although Friedman seemed content with a steady-state analysis in which a unique equilibrium (natural) real interest rate defined a unique optimal rate of deflation (given a positive equilibrium real interest rate) over time, thereby allowing Friedman to achieve a partial reconciliation between the optimal-inflation analysis and his x-percent rule for steady growth in the money supply (despite the mismatch between his theoretical analysis of the rate of inflation in terms of the monetary base and his x-percent rule in terms of M1 or M2), Friedman’s analysis provided only a starting point for a discussion of optimal inflation targeting over time. But the discussion, to my knowledge, has never taken place. A Taylor rule takes into account some of these considerations, but only in an ad hoc fashion, certainly not in the spirit of the deep microfoundations on which modern macrotheory is supposedly based.
In my paper “The Fisher Effect under Deflationary Expectations,” I tried to explain and illustrate why the optimal rate of inflation is very sensitive to the real rate of interest, providing empirical evidence that the financial crisis of 2008 was a manifestation of a pathological situation in which the expected rate of deflation was greater than the real rate of interest, a disequilibrium phenomenon triggering a collapse of asset prices. I showed that, even before asset prices collapsed in the last quarter of 2008, there was an unusual positive correlation between changes in expected inflation and changes in the S&P 500, a correlation that has continued ever since as a result of the persistently negative real interest rates very close to, if not exceeding, expected inflation. In such circumstances, expected rates of inflation (consistently less than 2% even since the start of the “recovery”) have clearly been too low.
Targeting nominal GDP, at least in qualitative terms, would adjust the rate of inflation and expected inflation in a manner consistent with the implications of Friedman’s analysis and with my discussion of the Fisher effect. If the monetary authority kept nominal GDP increasing at a 5% annual rate, the rate of inflation would automatically rise in recessions, just when the real interest rate would be falling and the optimal inflation rate rising. And in a recovery, with nominal GDP increasing at a 5% annual rate, the rate of inflation would automatically fall, just when the real rate of interest would be rising and the optimal inflation rate falling. Viewed from this perspective, the presumption now governing contemporary central banking that the rate of inflation should be held forever constant, regardless of underlying economic conditions, seems, well, almost absurd.
Uneasy Money 
David
Radicalizing, I would take out the “almost” before “abusrd”.
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The rate of inflation is going to get out of control sooner or later. It’s ridiculous to think that the trillions of dollars that exist now are not going to come back in a form of inflation. I’m just waiting for that day so that I can sell my gold.
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Gleichen:
Is you assumption that the quantity of money never falls explicit or implicit?
David:
You analysis seems to be of real business cycles. Nominal GDP stays on target, productivity declines, and inflation rises, and the real interest rate on hand-to-hand currency turns negative (or more negative.) Of course, existing contracts also have lower real rates too. Recovery is the opposite.
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@David,
Interesting perspective, as always. I still sit somewhat on the fence, but your suggestion about changing inflation rates sounds very sensible to me. Why should the inflation target be fixed, when one would imagine that the target is to achieve/maintain full employment and modest inflation in a free society.
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“Following rules is a good thing; we all know that. Ask any five-year old. But no rule is perfect, and even though one of the purposes of a rule is to make life more predictable, sometimes following a rule designed for, or relevant to, very different circumstances from those in which we may eventually find ourselves can produce really bad results, making our lives and our interactions with others less, not more, predictable.”
It is just too bad Congress makes rules only to break them (aka Humphrey Hawkins act)
http://en.wikipedia.org/wiki/Humphrey%E2%80%93Hawkins_Full_Employment_Act
“The Act explicitly instructs the nation to strive toward four ultimate goals: full employment, growth in production, price stability, and balance of trade and budget.”
1. Explicitly states that the federal government will rely primarily on private enterprise to achieve the four goals.
2. Instructs the government to take reasonable means to balance the budget.
3. Instructs the government to establish a balance of trade, i.e., to avoid trade surpluses or deficits.
4. Mandates the Board of Governors of the Federal Reserve to establish a monetary policy that maintains long-run growth, minimizes inflation, and promotes price stability.
5. Instructs the Board of Governors of the Federal Reserve to transmit an Monetary Policy Report to the Congress twice a year outlining its monetary policy.
6. Requires the President to set numerical goals for the economy of the next fiscal year in the Economic Report of the President and to suggest policies that will achieve these goals.
7. Requires the Chairman of the Federal Reserve to connect the monetary policy with the Presidential economic policy.
Notice that maintaining a level of nominal GDP is not one of those goals.
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“The inflation target, so far as I can tell – and I admit that I am not really up to date on these models – is generally left up to the free choice of the monetary authority.”
I wouldn’t say this. In the simplest NK models, there is an optimal inflation target: zero. This arises because nonzero inflation causes inefficient price dispersion. To some extent this captures the intuition that it’s “difficult to do business” in an environment where the price level is always changing—you have to manage your prices with expectations about the overall level in mind—but I’m not convinced it’s really so important. Nevertheless, it’s the one normative statement about inflation that pops almost axiomatically out of the basic NK framework.
If the model includes a non-infinitesimal role for base money, then the optimal inflation target lies somewhere between 0 and the deflationary Friedman rule value.
Finally, if the model includes the zero lower bound, along with a parametrization that causes the zero lower bound to be reached a nonnegligible fraction of the time under low inflation, the optimal inflation target may become positive. Its magnitude, however, differs substantially depending on your other assumptions about monetary policy. If you assume that monetary policy can follow some kind of near-optimal commitment rule once it finds itself at the zero lower bound, then the inflation target itself adds almost nothing. (Different assumptions along these lines, and also about the stochastic process pushing the economy into the zero lower bound, are one of the reasons why papers find very different implications of the zero lower bound for optimal inflation.)
The recent Handbook of Monetary Economics had a paper on the optimal rate of inflation by Schmitt-Grohe and Uribe, which outlines the basic issues pretty well but has a bad treatment (in my view) of the zero lower bound: http://www.columbia.edu/~mu2166/Handbook/paper.pdf
There are lots of other papers on the topic—it’s a huge literature. Here is one offering by Coibion, Gorodnichenko, and Wieland: http://web.wm.edu/economics/wp/cwm_wp91.pdf
You might just want to look at Google Scholar’s “related papers” list for Schmitt-Grohe and Uribe:
http://scholar.google.com/scholar?q=related:PgtHnb2F_ooJ:scholar.google.com/&hl=en&as_sdt=0,22
Finally, on marginally related note, here is “Have we underestimated the likelihood and severity of zero lower bound events?” by Chung, Laforte, Reifschneider, and Williams from the San Francisco Fed: http://www.frbsf.org/publications/economics/papers/2011/wp11-01bk.pdf
Some good commentary regarding the treatments of the zero lower bound that we’ve traditionally seen in a lot of papers, like Schmitt-Grohe and Uribe’s.
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Last week, David Andolfatto challenged proponents of NGDP targeting to provide the reasons for their belief that targeting NGDP, or to be more precise the time path of NGDP, as opposed to just a particular rate of growth of NGDP, is superior to any alternative nominal target.
Because
1. Sometimes inflation is good
2. Sometimes deflation is good
3. Sometimes many people deleverage at the same time
4. The economy should be robust to bubbles
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Marcus, Well, I guess that makes me the conservative.
Tas, You could be right, but by paying interest on reserves, financed by selling the assets that they have purchased since the crisis, the Fed could keep all those dollars from going into circulation and causing inflation.
Bill, It’s consistent with a real business cycle, but it is also consistent with a monetary business cycle that induces a recession. Even a recession induced by monetary causes tends to depress the real interest rate once the economy slides into recession.
Julian, I agree.
Frank, Just because the Humphrey-Hawkins Act doesn’t mention targeting nominal GDP does not mean that targeting nominal GDP could not be the best way of achieving the goals explicitly set out by the Act. I also don’t think that it makes any sense for macroeconomic policy aim at equalizing imports and exports.
Matt, Thanks for that very useful survey, which triggered some memories of papers I have looked at previously but obviously not really absorbed very well. However, your discussion still leaves a basic disconnect between the notion that inflation expectations must anchored by an unvarying commitment to particular rate of inflation which seems to underlie the response by Bernanke that I quoted from his press conference when asked about Krugman’s charge that he had abandoned the position that he had taken when advising Japan in the 1990s.
Floccina, I agree with 1 and 2. I am not sure what 3 and 4 are adding.
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“I also don’t think that it makes any sense for macroeconomic policy aim at equalizing imports and exports.”
Gross domestic product is made up of just a few parameters:
GDP = Business Investment + Personal Expenditures + Government Spending + (Exports – Imports)
If increasing the last term (Exports – Imports) makes no sense to you concerning macro-economic policy then why should increasing any of the terms make any sense to you?
“does not mean that targeting nominal GDP could not be the best way of achieving the goals explicitly set out by the Act”
And exactly how does targeting nominal GDP achieve any of the other four goals – balance of budget, full employment, price stability, and growth in production?
Or are you just not interested in a broad set of macroeconomic goals?
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Frank, I am interested in a very broad set of goals, like nominal GDP. I want to target that not its composition between consumption spending, investment and the trade balance. I’ll leave that for consumers and businesses to work out.
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