In this post, Nick looked at this graph
and made the following comment:
In a counterfactual world, where the Bank of Canada was supposed to be targeting the level path of NGDP to follow that 5% trend line, what would we say? We would say that monetary policy was a little too loose in the years leading up to 2008, and then suddenly became much too tight in 2008, and stayed too tight thereafter.
In that counterfactual world, where the Bank was supposed to be targeting NGDP, but actually allowed NGDP first to rise a little above target, then suddenly fall well below target, we would all be looking at that third graph, and we would all be blaming the Bank of Canada for the 2008 recession.
(emphasis in the original)
In a one-good closed-economy model where output is 'GDP', we don't make the distinction between producer and consumer prices. But in a multi-good economy with trade, it's often important to make this distinction. Starting in 2002, the prices of commodities rose relative to those of consumer goods, and you see this in the divergence between the GDP deflator and the CPI:
The GDP deflator increased by about 22% in log terms between 2002 and 2008, while the CPI increased by 16%.
This looks a lot like that staple of TV and film: the chase scene in which one persuer is chasing two people. The obvious strategy for those on the run is to split up: you can only follow one person. This forces the person chasing them to make the choice of which one to track down.
What should a central bank do when producer and consumer prices diverge? My (possibly incomplete) understanding is about how inflation affects welfare is on its effect on the price of consumption goods, especially in a world where nominal wages are slow to adjust. So it makes sense to me to make consumer prices the focus of attention and let producer prices go.
I'm not sure how to interpret this next graph, but I made it and I may as well post it. It compares NGDP with the series you get when you multiply real GDP by the CPI. I guess it's the counterfactual NGDP series for the scenario where producer prices and CPI stayed together:
The NGDP series suggest that monetary policy may have been too loose in the years leading up to the recession. But I think the better interpretation is that when producer and consumer prices diverged, the Bank of Canada - wisely, in my view - chose to track consumer prices and let producer prices go.
But it also raises the question of what happens to the volatility of consumer prices if we adopted NGDP targeting. If the Bank of Canada decides to chase down NGDP and let the CPI go where it may, this may introduce welfare costs that may or may not be offset by gains elsewhere. (I think this is what Felipe was getting at in his comment on Nick's post.)
I'm pretty sure the people at the Bank of Canada are running exactly these sorts of scenarios through TOTEM. I wonder what sort of results they're getting.