Sticky prices vs sticky coordination; inflation vs NGDP targeting

Monetary policy matters (mainly) because of nominal rigidities.

The simplest story of nominal rigidities is that (some) prices (or wages) are sticky. Firms want to change prices when a shock hits, but there is some cost that makes it hard for them to do so. The object of monetary policy should then be to target the stickiest prices. Monetary policy should respond to shocks to try to ensure that firms don't need to change the prices that are costly for them to change. Adjust monetary policy to keep the equilibrium value of the stickiest prices equal to the actual value. This prevents disequilibrium in the markets for those goods with the stickiest prices.

An alternative story of nominal rigidities is sticky coordination. Each individual firm can adjust its price easily, but one firm's equilibrium price depends on the prices it expects other firms to set. And it is difficult for all firms to coordinate a change in all their prices. Each firm does not know whether the other firms will change their prices, and each waits for the others to go first. (My hunch is that "sticky expectation" stories of nominal rigidity are, at root, really stories of sticky coordination.)

There is a very small cost to each of us in changing our watches for daylight saving time. But we need someone (like the government) to help us coordinate so we all change our watches at the same time. When there is a currency reform, and one new peso is worth 100 old pesos, firms have little difficulty changing prices, because  that price change is coordinated. These two examples illustrate the sticky coordination story.

If the only shocks hitting an economy were Aggregate Demand (nominal, velocity) shocks, it doesn't matter for monetary policy which one of these two stories is correct. Monetary policy should try to exactly offset those AD shocks, so that firms don't need to change prices, and don't need to change their expectations of the prices that other firms will set. And if all shocks were AD shocks, it also doesn't matter whether monetary policy targets inflation or Nominal GDP. To see this graphically, if the Aggregate Supply curve never shifts, it doesn't matter whether the central bank makes the AD curve horizontal (inflation targeting) or a downward-sloping rectangular hyperbola (NGDP targeting). All that does matter is that the central bank tries to ensure that the AD curve never shifts, by offsetting all shocks to AD.

When there are AS shocks, it does matter which one of the two stories is correct. And it does matter whether monetary policy targets inflation or NGDP.

If the source of nominal rigidity is sticky prices, then monetary policy should target inflation. (If the sticky prices were sticky nominal wages, then monetary policy should target wage inflation.) If some price doesn't want to change, then adjust monetary policy in response to all shocks so that the equilibrium value of that price doesn't change, so the sticky price is always at the equilibrium level despite being sticky.

But suppose there are AS shocks and the source of nominal rigidity is sticky coordination rather than sticky prices?

Lets start with a partial equilibrium experiment. Suppose a "good" supply shock hits an individual firm (or industry). The individual firm, seeing its cost curve has shifted down, will want to increase output and cut its price.

Now let's switch to the general equilibrium experiment in a monetary economy. Suppose a "good" supply shock hits all firms at the same time. What happens? The answer depends on whether monetary policy is targeting inflation or NGDP.

Under inflation targeting, all firms should increase output, but keep their prices constant. Under NGDP targeting, all firms should increase output, and cut their prices.

Do you see the difference? Under inflation targeting, the general equilibrium experiment gives very different results to the partial equilibrium experiment. Under NGDP targeting, the general equilibrium experiment gives qualitatively the same results as the partial equilibrium experiment.

The whole idea behind sticky coordination is that people can solve partial equilibrium problems a lot more easily than they can solve general equilibrium problems. When a shock hits, each individual can solve for how his own reaction function should shift in response to that shock. But he can't easily solve for the new Nash equilibrium point, because that requires him to figure out how every individual's reaction function has shifted, solve for the new intersection point of all those reaction functions, assume everyone else will do the same, and expect everyone else will move to the new Nash equilibrium too. That's hard.

If its hard for people to solve general equilibrium experiments, monetary policy should try to ensure they don't have to solve general equilibrium experiments. Instead, monetary policy should try to ensure that the general equilibrium solution is as close as possible to the partial equilibrium solution, which individuals have a better chance of solving.

Under NGDP targeting, the general equilibrium solution to supply shocks is at least qualitatively similar to the partial equilibrium solution. To parallel the idea of targeting the stickiest price, monetary policy should try to make sure that people don't have to do those things that are hard for them to do, and will do badly or not at all.

(This post is inspired by a comment Bill Woolsey left here many months ago, and is a response to the Governor of the Bank of Canada's recent defence of inflation targeting over NGDP targeting, and is my attempt to get my head around the idea of "good deflation". I have ignored the important distinction between inflation vs price level targeting, and the parallel distinction between NGDP growth rate vs NGDP level path targeting.)

Comments

[Min]

"Adjust monetary policy to keep the equilibrium value of the stickiest prices equal to the actual value."

Does this imply counter-cyclical policy? Thanks. :)

[Nick Rowe]

Min: it all depends on what you mean by "countercylcical" which depends on what you mean by "holding monetary policy constant".

For example, if you think in terms of MV=PY, and if you think that "holding monetary policy constant" means holding M constant, then yes, this is countercyclical policy. If V goes down/up M should go up/down at the same time. If instead you think that "holding monetary policy constant" means holding MV constant, then it isn't countercyclical.

In short, "countercyclical" is too ambiguous a word to be useful.

[anon]

This is basically the argument George Selgin advances in _Less than Zero_. Most productivity variations happen locally at individual firms, and positive productivity shocks are often reached through intentional cost-cutting measures. Under inflation or price level targeting, any such shock requires _all_ prices to change so that the overall price level is unchanged. NGDP targeting ensures that the price impact of productivity variations is localized to the affected markets.

[Kevin Donoghue]

Thanks for an interesting post. Not for the first time, I'm regretting that I threw out my copy of Bruno and Sachs, Economics of Worldwide Stagflation. AFAICR it was a worthy effort at incorporating supply into macro (at a time when 'supply-side economics' mostly just meant "cut my taxes").

[Min]

Nick Rowe: "countercyclical" is too ambiguous a word to be useful."

How about "actual value"? That seems pretty ambiguous to me. :)

[Bill Woolsey]

Coordination...

Partial equilibrium vs. general equilibirum...

I like it. Good explanation.

[David Pearson]

Under inflation targeting, output is variable; under NGDP targeting, margins are more variable. Depending on the frequency and intensity of supply shocks, it may become difficult for firms to forecast real returns to investment projects as a result.

Further, how well does an NGDP target inform firms on pricing decisions? If an AS shock occurs that brings RGDP growth to a halt, inflation expectations must rise to 5%. As a chemical firm, do you run out and pre-buy feedstock? How much of an input price increase are you willing to tolerate given that 5% inflation expectation? How much can you raise prices? The inflation sensitivity of inputs and outputs for your firm have been quite different in the past; how will that difference -- your margin -- behave now and in the future?

I would argue we've seen quite-frequent supply shocks in the past six years (housing, shadow banks, oil in 2008, oil in 2011, oil now). I'm wondering how firms would have reacted to stable NGDP during that time. For instance, in June 2008 they would have seen the firm loosen despite $150 oil, which would have pushed their margins in what direction?

[Britmouse]

It depends what "flavour" of inflation targeting is used, though, right?

Under "flexible" inflation targeting the Bank of England has defended a temporary period of above-target CPI inflation caused in part by a negative AS shock (commodity prices, VAT). Would they also allow below-target CPI inflation under a positive AS shock? I suspect you are right that'd they'd prefer to goose up much faster NGDP growth to keep CPI closer to target, but it seems like poor policy. They describe their target as "symmetrical" in that being above-target is equally "bad" as being below.

[Nick Rowe]

anon: George Selgin is at or near the top of my "I really ought to read this" list. (I feel bad about not reading as much as I should, but at other times I wonder what the optimum trade-off is between reading and thinking, and about how I never really understand anything until I have reverse-engineered it for myself). But I'm not sure if my argument is exactly the same as George Selgin's. In a world of sticky prices, then if a random 1% of the firms had a good productivity shock every year, so that aggregate productivity was smoothly growing, you might argue for deflation so that the 99% of firms could keep their prices constant. What I'm talking about is different. In this post, I don't care about the long run inflation target or long run NGDP growth target. Given long enough, people can learn how to coordinate on any inflation rate or NGDP growth rate. I'm concerned with the aggregate shocks.

Kevin: thanks! I've put aside here the question of whether there really are AS shocks, and how big they are. My hunch is that most supply shocks are really the lagged effects of demand shocks and bad monetary policy. Not sure.

Min: "How about "actual value"? That seems pretty ambiguous to me. :)"

I meant "actual value" in the sense of "solve x+1=2x for the actual value of x". If the actual price of apples is $2, and it's a sticky price, then the BoC should adjust monetary policy until the equilibrium price of apples is also $2.

Bill: thanks! I can't model it though. How can you model the difficulty people have in finding the Nash equilibrium?? I sympathise with the Austrians.

David: at the macro level, firms care about both: what will the future price level be?; what will future real output be? They care not only about inflation/deflation, but also about boom/bust. NGDPLPT takes a simple average of the two. It's unlikely to be perfect, but presumably better than a 100%-0% weighted average.

Britmouse: The BoE's recently policy looks a bit like NGDP targeting. But they never announced it as such before the financial crisis hit. So I don't know what people are or were expecting the BoE to do.

All: my brain isn't working so great these days. My posting and responses to comments has been and probably will be slower than normal. Winter fever, or something.

[Jacques René Giguère]

Nick: hope you don't have fever in both your heads...
Take care and get well.

[jsalvatier]

How to model it: you could assume that there are two kinds of shocks, local ones and global ones. When firms experience a change in their cost curve, they don't know whether its local or global. Thus they assume it's partially local and partially global. Their reaction will be suboptimal for both situations, they'll either change their prices too little or change their prices too much.

[Nick Rowe]

Thanks Jacques Rene!

jsalvatier: that would be a variant on the Lucas signal-processing problem. I agree there are some similarities, but I don't think it's the same. Lucas (at least in that model) assumes people can solve for the Nash Equilibrium.

[Norman]

Like others on here, I'm interested in how to go about modeling this. It sounds a bit like you're describing agents who are forward looking when it comes to exogenous shocks, but backward looking when it comes to the endogenous behavior of other agents. Something like that would bring up a concern regarding the stability of the NE. It makes me think of a Leijonhufvud-style corridor model in which small enough shocks mean iterative moves by agents always move us closer to NE, but if the shock is big enough these moves don't point toward equilibrium anymore.

Did you have any particular papers in mind for this sticky coordination idea? I know there is work out there on macro and learning, but I'm not sure if that's where you were headed.

[Britmouse]

Nick, if you look at the UK in 2011, you would say that firms raised prices and held output roughly constant in the face of a negative supply shock. What monetary policy response were they expecting? I'm not sure. Maybe the demand side clouds the picture too much.

[Nick Rowe]

Norman: "It sounds a bit like you're describing agents who are forward looking when it comes to exogenous shocks, but backward looking when it comes to the endogenous behavior of other agents."

That might be a good way to think about it.

"Did you have any particular papers in mind for this sticky coordination idea? I know there is work out there on macro and learning, but I'm not sure if that's where you were headed."

I didn't have anything particular in mind. My mind isn't clear enough. The learning literature should be related. Plus the experimental game theory literature. My sense is that people don't jump immediately to the new Nash Equilibrium, but do eventually converge to it over time. They can figure out any pattern if it's repeated often enough, but not immediately. Maybe Austrian writings on the process by which agents converge on the equilibrium? Maybe those "agent based models" (about which I know very little) where they bung a whole load of "rule of thumb" agents into a computer and watch what happens?

Britmouse: A lot of things have been happening in the UK over the last few years: the demand-side recession; the VAT changes; the price of oil; the exchange rate; the whole Eurozone recession (UK's main trading partner); fiscal policy changes. Trying to make sense of it all is hard. My overall sense though is that inflation has been a lot higher than I would have expected it to be, given the recession.

[RebelEconomist]

Driving by and read this:

"Monetary policy matters (mainly) because of nominal rigidities....Firms want to change prices when a shock hits, but there is some cost that makes it hard for them to do so. The object of monetary policy should then be........to keep the equilibrium value of the stickiest prices equal to the actual value."

Does this not strike anyone else as a crazy way to proceed? Like one of those light bulb jokes. How many macroeconomists does it take to change a lightbulb? Forty one; one to hold the bulb and the other forty to jack up the house off the floor and rotate it!

This is why I am instinctively suspicious of arguments that monetary policy should seek to do anything other than target inflation with the aim of supplying just the right amount of money to facilitate transactions. If there are other macroeconomic problems, it seems to me that it would be preferable for the government to address these directly, by structural reform. In this case, to investigate why prices are sticky, and attempt to unstick them.

[W. Peden]

RebelEconomist,

Say there is a strong increase in production due to a major new technological development, pushing real GDP above nominal GDP for a while. Is targeting inflation going to provide the right amount of money to facilitate transactions? Or is it going to create excess transactions?

(The opposite, of course, holds where something e.g. a natural disaster drives real GDP down such that inflation goes up.)

I agree with the goal set out in your comment, but targeting inflation (short of something like a very flexible inflation target, which kind of ruins the appeal of having a restrictive rule) seems to be the wrong way of accomplishing it.

[Nick Rowe]

Rebel: The lightbulb metaphor actually works well! But if there really were no fixed point, then twisting the lightbulb would be observationally equivalent to twisting the house. It wouldn't matter which we did. All motion is relative.

If (say) the price of gold were sticky, and all other prices were perfectly flexible, and there were no other nominal rigidities of any kind, that would actually be a good argument for the gold standard! To prevent disequilibrium in the gold market.

If we target inflation, which measure of inflation? And why should targeting inflation necessarily give the right amount of money to facilitate transactions?

[RebelEconomist]

W.Peden, I am not quite sure what you are getting at. An inflation targeting central bank would supply a bit more money in the event of a positive supply shock to accommodate the increased volume of items being traded without a fall in the general price level.

Nick, I would favour a measure of inflation that covers everything that money is used to purchase, including asset prices, and that becomes the nominal anchor. Then, if sticky prices are generating some inefficiency, address that problem separately.

Look, I appreciate that I am being a bit vague here, but my thinking goes back to my early impressions of joining a central bank but as a science graduate rather than an economist. I would have expected to find at least some people treating monetary policy as an engineering problem like circulating oil in an engine. In fact, there was no-one like this; instead, the main concern was regulating real activity using interest rates (in these pre-financial-crisis days, some senior policy makers would even say that they did not care how interest rates were set), with inflation as something like a temperature gauge. I would like to see some shifting of monetary policy influence from racing drivers to mechanics.

[W. Peden]

RebelEconomist,

"An inflation targeting central bank would supply a bit more money in the event of a positive supply shock to accommodate the increased volume of items being traded without a fall in the general price level."

Doesn't that imply distorting prices, such that they fail to send signals of the general increase in production?

[RebelEconomist]

Perhaps, W. Peden. But then the central bank would also be obliged to generate deflation after a large negative supply shock, and I doubt whether that would be acceptable these days. Anyway, in practice, I would guess that such shocks are rarely so large that they cannot be dealt with within the acceptable range for inflation.

I would suggest that, to keep a central bank "honest", two vital features of its monetary policy remit should be:
(1) a focus on prices without regard to real activity (ie no NGDP targeting)
(2) targeting a broad price index (ie not core cpi).

[W. Peden]

RebelEconomist,

"But then the central bank would also be obliged to generate deflation after a large negative supply shock, and I doubt whether that would be acceptable these days."

I'm not sure that falling prices- if caused by an increase in supply, rather than a fall in demand- would be so politically unpopular. People tend to quite like individual prices falling, excepting their wages.

"Anyway, in practice, I would guess that such shocks are rarely so large that they cannot be dealt with within the acceptable range for inflation."

Take a case like the Japanese earthquake. Such an event CAN be accomodated for in an inflation-targeting regime, but only by ignoring the inflation target for a while. Of course, under that logic, just about ANY monetary regime can accomodate supply shocks to some degree.

I agree that, if a central bank is going to target inflation, it should target a broad price index because that will be a better measure of overall economic activity and as you say it will have restricting effects. However, I don't think that targeting NGDP will make a central bank more or less honest.

[RebelEconomist]

W. Peden, the reason why I am suspicious of NGDP targeting is that the target must embed some estimate of potential real growth, and that represents the thin end of an inflationary wedge. For example, if NGDP targeting was adopted in the US now, potential growth of about 3% would be assumed, which would probably force the Fed to drive inflation to 3 or 4%. I suspect that is the main reason why were are hearing so much about NGDP targeting now. And in an apparently non-inflationary boom, there would be pressure to recognise a "new paradigm" and "give growth a chance", and the "maestro" that adjusted the target would be so celebrated that politicians would jokingly promise to reappoint him as the head of the central bank even if he had died.

[Matt Young]

When we set Uncle Milt's thermostat so that fuel burned is decorrelated with inside temperature, then we have solved the general equilibrium problem.
http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/12/milton-friedmans-thermostat.html#more

How do we do this so fast? We set the error band larger during times of stress, and narrow it in times of plenty. The two settings are built in, we have prior agreement on the error bands in the two states.

[W. Peden]

RebelEconomist,

That's an interesting objection to NGDP targeting which I haven't heard before. However, the implied additional inflation in the scenario you set out is no different from the implied additional inflation in an inflation targeting regime where a supply-shock reduces inflation below target for a sustained period of time.

In fact, the scenario you set out seems to be one where people change an NGDP target into a sub-optimal situation, based on reasoning imported from... Inflation targeting ("Inflation is low now, so we can afford a looser monetary policy regime"). That doesn't seem to be a good argument for inflation targeting over NGDP targeting, in my book.

[RebelEconomist]

I doubt whether an (honest) inflation targeter would say "we can afford a looser monetary policy REGIME", W. Peden; they would say "we can afford a looser monetary policy". Note the difference.