Three arguments for NGDP targeting

This is in response to David Andolfatto's questions.

Nominal GDP is just one of an infinite number of variables that monetary policy might target. The probability that NGDP is exactly the best target variable is infinitesimal. I nevertheless support NGDP targeting, because I think it is probably reasonably close to that unknown best target variable; and I think NGDP level path targeting is probably better than reasonable alternatives like inflation or price level targeting.

Here are three reasons why I believe that:

1. Risk-Sharing. David has already noted this argument. I confess it is one that tends to slip my mind, even though I've known of it for a long time (I first heard it from a Deputy Governor at the Bank of Canada over a decade ago). So it's probably not the most important of my reasons for believing what I do.

There are lots of long-term contracts with payments fixed in nominal terms. Not just long term bonds, but things like pension plans and government transfer payments. We aren't very good at forecasting what real GDP wil be 10 or 30 years from today. Inflation or price level targeting gives the creditor full insurance against unforeseen changes in future real GDP, and puts all the risk upon the debtor. This doesn't seem to be an efficient or a fair way to allocate aggregate risk. NGDP targeting provides a 50-50 aggregate sharing of aggregate risk between creditors and debtors. If real GDP falls 10% below what was expected, the price level rises 10% above what was expected. The real incomes of both creditors and debtors fall by the same 10%.  It is unlikely that 50-50 sharing of that risk would be exactly first best in all circumstances, but it is probably better than a 0-100 allocation of that risk.

Sure, debt contracts can always be renegotiated. But the whole point of having a long-term contract is because you don't want to renegotiate it every year or every day when circumstances might change. If the expectation of renegotiation weren't a problem, we wouldn't have agreed to a long-term contract in the first place. "Here's $100; let's leave it open for future negotiation how much you pay me." That's not a contract. I might say that to my kids or close friends, but I wouldn't do business on that basis.

2. Divine Coincidence Failure. The Old Keynesians wanted to target real GDP. They wanted monetary (and/or fiscal) policy to target "full-employment output". It sounded like a good idea at the time. After all, real Y is what really matters. P doesn't matter at all. The rate of change of P (the inflation rate) only matters a little (unless it gets very big or very negative). But Friedman and Phelps, and the policy failures of the 1970's, taught us it couldn't work. A Y target lacks a nominal anchor.

So we switched to targeting P, or the rate of change of P.

Since NGDP=P.Y, you can think of NGDP targeting as a 50-50 compromise between the Old Keynesian Y target and the New Keynesian P target. It is probably a reasonably good compromise.

Many New Keynesian models assume Divine Coincidence. They assume that if monetary policy is successful in keeping P on target it will also, as a happy side-effect, keep Y on target too.

If there are only AD shocks, diving coincidence holds trivially; if monetary policy can prevent the AD curve fluctuating, P will stay on target, and Y will stay on the LRAS curve too. But if there are supply shocks, Divine Coincidence may or may not hold. It all depends on the model.

Suppose that a negative supply shock causes the LRAS and SRAS curves to shift left by exactly the same amount. In that case Divine Coincidence holds. Keeping P on target will keep Y equal to LRAS. I do not understand SRAS shocks very well at all, but I don't think the world is like that. I think that a typical supply shock shifts the SRAS curve left (or right) by a much greater amount than it shifts the LRAS curve left (or right). And if I'm right on that point, then NGDP will be a better target variable than P (though NGDP will only be exactly optimal under very special parameter values). That's because an unchanged target for P will cause Y to fall by the full amount of the leftward shift in SRAS, when we only want Y to fall by the amount of the leftward shift in LRAS. An unchanged target P.Y will allow P to rise so Y won't fall as much.

It is possible to build models in which real shocks cause SRAS to shift sideways by more than LRAS shifts sideways (or even make the two curves shift in opposite directions). A model with sticky nominal wages and flexible prices is one, because a negative productivity shock would usually require equilibrium real wages to fall, which can only happen if P rises. The Ball-Mankiw model(pdf) of skewed relative price changes plus menu costs is another. I am less than fully convinced by those models, but they do seem to match what I think I see usually happening. Things like oil price shocks, or changes in indirect taxes, seem to cause the SRAS curve to shift vertically up or down, without seemingly shifting the LRAS curve much at all.

Plus, SRAS shifts can also be the consequence of past failures to prevent AD shifts. When monetary policy fails, an AD shock plus nominal rigidity has real effects that persist for longer than the AD shock and nominal rigidity. We call this "hysteresis". I suspect that hysteresis acts much like other supply shocks, and causes the SRAS curve to shift by more than the LRAS curve shifts. The failure of inflation to fall significantly in the recent recession is one reason I believe this. Though I do not understand this anywhere nearly as well as I would like.

3. Self-stabilising AD. It is reasonably well understood that Price Level Path Targeting has a desirable property that Inflation Targeting lacks. Central banks are imperfect and not omniscient and will sometimes make mistakes. Suppose there's a negative AD shock, and that P falls relative to target. Under PLPT people will expect a temporarily higher than normal inflation rate going forward. This will automatically lower the real rate of interest relative to the natural rate of interest and make AD higher than it would otherwise be, so the fall in AD is less than it would be under inflation targeting.

PLPT beats IT in this case because it helps anchor expected future P. Anchoring expected future Y, if that were feasible, would also prevent AD from falling as much for exactly the same reason. The natural rate of interest is an increasing function of the expected growth rate of Y. The higher is expected future Y, the greater will be investment and consumption demand.

When a negative AD shock hits, both P and Y will fall. When AD recovers both P and Y will rise. But we know very little about how that rise in AD will be divided into a rise in P and a rise in Y. It depends on the slope of the SRAS curve, about which we know little. And we know even less about how people will expect any recovery to be divided between a rise in P and a rise in Y.

Relying on the self-stabilising properties of PLPT puts all our eggs into one basket. If the SRAS curve is fairly flat, P will fall little when AD falls, and will be expected to rise by little when AD recovers, and the self-stabilising properties will be weak. NGDP Level Path Targeting means convincing people that if PY falls then PY will rise back up again. And this means putting our self-equilibrating eggs into two baskets that are negatively correlated, which makes our portfolio of self-stabilisation much safer. When a negative AD shock hits, people will know for sure that PY will rise, and so will know for sure that either P will rise or that Y will rise, and either way they know for sure they should invest more and consume more now.

4. Scott Sumner. Not really a reason, but definitely influential in slowly changing my mind.

Comments

[Scott Sumner]

I should tell you that the arguments I use aren't really mine, they were etched on gold plates given to me by an angel.

[Frances Woolley]

NIck, interesting post. The risk sharing argument is interesting, but I'm not totally convinced - and it sounds like you aren't either - that 50-50 risk sharing is optimal. A 10% price level change is much more likely than a 10% real GDP change. Also, a one-time, unanticipated price-level shock has purely redistributive effects, while real GDP shocks have real effects - that seems to me to be a reason to be more concerned about avoiding real GDP shocks than price level shocks. A lot of pensions plans and government transfer payments are indexed to CPI or other indices anyways.

[K]

Great post! (Now I know why you hadn't gotten to my comment on the Short vs Long Run Natural Interest Rates. :-) I do look forward to hearing what you think, if you have any comment.)

Good reasons, all four. I think another important point (related to your first point) is that nominal rates are likely closely linked to NGDP growth. Keeping a stable NGDP path will stabilize asymptotic nominal yields and therefore the market value of long term fixed rate instruments which will reduce risks associated with debt (unless, of course, we use that as an opportunity to lever up some more).

On your point two, a minor quibble. New Keynesian models don't assume Divine Coincidence. It does happen with Calvo prices and without real rigidities. But it's easily broken in simple extensions of the model.

[David Andolfatto]

Nick,

Thanks for taking the time to reply to my query. However, I don't think you've answered my questions.

Let me first address this comment of yours:

Sure, debt contracts can always be renegotiated. But the whole point of having a long-term contract is because you don't want to renegotiate it every year or every day when circumstances might change. If the expectation of renegotiation weren't a problem, we wouldn't have agreed to a long-term contract in the first place. "Here's $100; let's leave it open for future negotiation how much you pay me." That's not a contract. I might say that to my kids or close friends, but I wouldn't do business on that basis.

A debt contract is characterized by a flat payoff schedule over most, but not all, states of the world. The "bankruptcy" state can be thought of as a form of renegotation, if you like. In this sense, debt contracts are state-contingent. And before we can talk sensibly about debt, we need a theory of debt. If the private sector has a rationale for the form that debt takes, why should the monetary authority do things that undoes these things? What are the consequences? How do you know without a theory of debt, or any evidence for that matter? (And who really cares about how you would do business...I was asking for evidence on how businessmen do business out there.)

I am not going to speak to your points 2,3 and 4. I'm willing to grant all those points to you (for now) and allow that an NGDP target is a good policy to adopt for all the reasons you state above. I am interested in a different question.

Sumner and Beckworth (and others) vehemently argue for the Fed to adopt a NGDP target *right now.* Immediately. That is, 3 years after the negative price level surprise. The theoretical justification for this (Beckworth, at least) view is what you call "risk sharing." I think that's a bad label for it. Clearly, what people have in mind right now is some "debt overhang" problem. The idea is that debt is crippling aggregate demand and that this is inefficient for a host of reasons.

And so, my question was really about the empirical evidence supporting the strongly held view that the Fed should adopt a NGDP target *right now* to stimulate the economy back to what people imagine to be "potential." (As opposed to adopting the policy to mitigate future business cycles.)

So to sum up, I think that you have given a nice summary as to why you believe a NGDP target is a good policy to adopt for the purpose of mitigating the bad effects of future business cycles. But I do not believe you answered the question I posed in my post. (I could have been clearer, of course!)

If you have some thoughts to share on this, please let me know.
Thanks again!

David

[Saturos]

David, don't you think the last paragraph of point 3 answers your question? Do you think there is sufficient AD in the US economy right now? And has "flexible" inflation targeting been of much help in getting us back to the right amount?

[Joe]

Would FDR 1933 devaluation count as adequate evidence? If not, then I don't know what could.

Here is Beckworth... http://macromarketmusings.blogspot.com/2010/10/qe-has-worked-before-my-reply-to-paul.html

Here is Sumner... http://www.themoneyillusion.com/?p=308

[Saturos]

Oh, and David, make sure you read Scott Sumner's response: http://www.themoneyillusion.com/?p=14092

[Nick Rowe]

David: "If the private sector has a rationale for the form that debt takes, why should the monetary authority do things that undoes these things? What are the consequences?"

Good point, of course. The Lucas point. As you no doubt suspect, I don't have a good answer. Why aren't all debt contracts indexed for inflation? Why aren't they indexed to NGDP? The best I can come up with is that there is some cost of doing so, and one possibility is simply that every clause you add to a contract just gives the lawyers one more thing to fight about. It's cheaper to target NGDP than to add NGDP clauses in all the contracts.

There might be some sort of externality argument as well.

But really, the risk-sharing argument is not the one that's at the front of my mind when I think about the benefits of NGDP targeting.

Frances: Yep. In a world of real shocks, it is unlikely that perfect indexation to NGDP, and 50-50 risk sharing, would be optimal in all cases. Not all people are equally risk-averse, and their other sources of income and expenses may or may not be perfectly correlated with NGDP. But prime facie 50-50 is probably better than 100-0 or 0-100.

K: Thanks! "On your point two, a minor quibble. New Keynesian models don't assume Divine Coincidence. It does happen with Calvo prices and without real rigidities. But it's easily broken in simple extensions of the model."

Yep. That's why I weaseled out and said that "many" NK models do this.

[Fred Broder]

What, Scott, the Pope didn't tell you what arguments to make?

The arguments didn't come on clay tablets from a Jewish banker?

Mormon jokes -- the new politically correct religious humor.

[Scott Sumner]

Fred, I was trying to come up with a papal infallibility joke, but couldn't think of one. I apologize if I insulted any Mormons, that wasn't my intent. I actually find criticism of Mormonism to be stupid, for reasons hinted at in your comment.

[RebelEconomist]

Nick,

As I just commented on David Andolfatto's post, I find your point 1 uncharacteristically unrigorous for you. Price targeting does not GIVE the creditor full insurance against unforeseen changes in future real GDP, and put all the risk upon the debtor - they voluntarily agree such a contract, and presumably the interest rate reflects this risk allocation. Why is this an inefficient or unfair way to allocate aggregate risk?

Let's be honest; much of the impetus behind NGDP targeting is coming from those who are looking for a way to let debtors (and the holders of bad debts) off the hook, not because debtors have been unlucky with their bet on inflation - which has remained roughly on target - but because now that they have enjoyed the consumption benefit of their borrowing, the debtors regret the amount of debt that they have undertaken to repay. They want a bailout more than they want better monetary policy.

[Nick Rowe]

Rebel: monetary policy can't do "nothing". There's no such thing as "doing nothing". We are always going to be targeting *something*. From the point of view of debtors and creditors, why should targeting inflation, or the price level, be better than targeting NGDP? If we lack a rigorous theory of debts, we lack a rigorous theory of why *any* target variable would be better than any other. We go with whatever we've got.

I could turn David's argument on its head. After all, if people don't want the risk sharing that comes with NGDP targeting, they can just re-write their contracts to add a clause with negative indexing to RGDP, or whatever.

If you say that switching to an NGDP target is like changing the rules of the game mid-stream, OK. But what were people expecting when they took out those debts? Were they expecting central banks would let NGDP fall by the amount they did?

[flow5]

The SRAS & LRAS curve shifts don’t exist.

The natural rate of interest is NOT an increasing function of the expected growth rate of Y.

MV does not equal PY.

[Nick Rowe]

flow5. They do too!

[Andrew F]

Scott, what if you think all religions are equally deserving of scorn?

[RebelEconomist]

"what were people expecting when they took out those debts? Were they expecting central banks would let NGDP fall by the amount they did?"

They should have been aware that it was a possibility. To me, it was clear that house prices, stock prices and risky debt prices were probably overvalued from the mid-1990s, and it was hard to imagine a major asset price correction that would not disrupt real economic activity. The Fed forestalled a couple of potential crashes in 1998 and 2000 with some measures which were more dovish than this investor at least had expected based on Fed commentary beforehand. Actually, I believe it might well have turned out better if there had been more short-term disruption in 2007-8 which had included a write-down of more assets, since it seems that financial institutions are still wary of exposure to each other for fear of what might still lie on their balance sheets. I think most people appreciated that asset prices were exposed, but they hoped to flip their own assets before they got caught or to get helped out (again) by monetary policy. Of course it is only natural that many of these people now say "hoocoodanode"!

[Nick Rowe]

OK. No more about religion. And I interpreted Scott as poking fun at himself, anyway.

[Jacques René Giguère]

Nick: policy failures of the '70's: once we misnamed a real price shock as "inflation", whatever policy we advocated would be wrong.

On a lighter note: since ,in polite company, we are not supposed to talk about religion and money, and we have just ruled out religion, should we close this blog? ;-)

[Nick Rowe]

Jacques Rene: If I had my druthers, we would only talk about money!

Yep, the 1970's were partly a SRAS shock, though how much of that oil price increase was just a belated catch-up to inflation and loose monetary policy, is debatable. But when we look back on it all, it is rather hard to see any sort of stable downward-sloping LR Phillips Curve in the data.

[Jacques René Giguère]

Yep. OPEC was trying to catch up but a lot of policies advocated by the "monetarists" would have frozen the terms of trade in OPEC's favor. Inflating once again restored in part the previous equilibrium.
We were not playing economics. We were playing politics.I am all for efficiency and fairness. I am also for my side winning...

[VKA]

Nick -this is a great explanation of some issues around NGDP targeting for those still on the fence. Thanks for posting.

[Declan]

I can see that NGDP might make a good target for the US, but Canada? In Australia our annual NGDP growth went from 9% to -1% in 2009 without a recession, mainly because of lower commodity prices. Aren't you similarly exposed?

[Nick Rowe]

Declan: somewhere very recently (last day or two) I thought I saw a graph of NGDP in Australia and several other countries. Now I can't find it. I am more interested in levels than growth rates. But this table from David Beckworth gives some help.

I do worry a bit though that NGDP might not be exactly right for a very open economy with a large percentage of exports to GDP. But CPI seems worse.

[Declan]

I am extremely suspicious of that table - I can't see how you can get a +7.8% deviation from trend for Australia.

CPI is bad, but for a commodity dependent country I suspect the GDP deflator is worse.