I did a post a while back that responded to John Taylor’s criticism of NGDP targeting. In the comment section Statsguy pointed out that Taylor’s argument was even more flawed than I assumed. And now George Selgin shows that it was even more flawed than Statsguy assumed:
Thus Professor Taylor complains that, “if an inflation shock takes the price level and thus NGDP above the target NGDP path, then the Fed will have to take sharp tightening action which would cause real GDP to fall much more than with inflation targetting.” Now, first of all, while it is apparently sound “Economics One” to begin a chain of reasoning by imagining an “inflation shock,” it is crappy Economics 101 (or pick your own preferred intro class number), because a (positive) P or inflation “shock” must itself be the consequence of an underlying “shock” to either the demand for or the supply of goods. The implications of the “inflation shock” will differ, moreover, according to its underlying cause. If an adverse supply shock is to blame, then the positive “inflation shock” has as its counterpart a negative output shock. If, on the other hand, the “inflation shock” is caused by an increase in aggregate demand, then it will tend to involve an increase in real output. Try it by sketching AS and AD schedules on a cocktail napkin, and you will see what I mean.
Good. Now ask yourself, in light of the possibilities displayed on the napkin, what sense can we make of Taylor’s complaint? The answer is, no sense at all, for if the “inflation shock” is really an adverse supply shock, then there’s no reason to assume that it involves any change in NGDP. On the contrary: if you are inclined, as I am (and as Scott Sumner seems to be also) to draw your AD curve as a rectangular hyperbola, representing a particular level of Py (call it, if you are a stickler, a “Hicks-compensated” AD schedule), it follows logically that an exogenous AS shift by itself entails no change at all in Py, and hence no departure of Py from its targeted level. In this case, although real GDP must in fact decline, it will not decline “much more than with inflation targetting,” for the latter policy must involve a reduction in aggregate spending sufficient to keep prices from rising despite the collapse of aggregate supply. A smaller decline in real output could, on the other hand, be achieved only by expanding spending enough to lure the economy upwards along a sloping short-run AS schedule, that is, by forcing real GDP temporarily above its long-run or natural rate–something, I strongly suspect, Professor Taylor would not wish to do.
If, on the other hand, “inflation shock” is intended to refer to the consequence of a positive shock to aggregate demand, then the “shock” can only happen because the central bank has departed from its NGDP target. Obviously this possibility can’t be regarded as an argument against having such a target in the first place! (Alternatively, if it could be so regarded, one could with equal justice complain that similar “inflation shocks” would serve equally to undermine inflation targeting itself.)
Another good reason to “never reason from a price change.” However it wasn’t all good news for me, as George also took me to task for sloppy reasoning about the dual mandate:
But lurking below the surface of Professor Taylor’s nonsensical critique is, I sense, a more fundamental problem, consisting of his implicit treatment of stabilization of aggregate demand or spending, not as a desirable end in itself, but as a rough-and-ready (if not seriously flawed) means by which the Fed might attempt to fulfill its so-called dual mandate–a mandate calling for it to concern itself with both the control of inflation and the stability of employment and real output. And this deeper misunderstanding is, I fear, one of which even some proponents of NGDP targeting occasionally appear guilty. Thus Scott Sumner himself, in responding to Taylor, observes that “the dual mandate embedded in NGDP targeting is not that different from the dual mandate embedded in the Taylor Rule,” while Ben McCallum, in his own recent defense of NGDP targeting, treats it merely as “one way of taking into account both inflation and real output considerations.”
To which the sorely needed response is: no; No; and NO.
We should not wish to see spending stabilized as a rough-and-ready means for “getting at” stability of P or stability of y or stability of some weighted average of P and y: we should wish to see it stabilized because such stability is itself the very desideratum of responsible monetary policy. The belief, on the other hand, that stability of either P or y is a desirable objective in itself is perhaps the most mischievous of all the false beliefs that infect modern macroeconomics. Some y fluctuations are “natural,” in the sense meaning that even the most perfect of perfect-information economies would be wise to tolerate them rather than attempt to employ monetary policy to smooth them over. Nature may not leap; but it most certainly bounces. Likewise, some movements in P, where “P” is in practice heavily weighted in favor, if not comprised fully, of prices of final goods, themselves constitute the most efficient of conceivable ways to convey information concerning changes in general economic productivity, that is, in the relative values of inputs and outputs. A central bank that stabilizes the CPI in the face of aggregate productivity innovations is one that destabilizes an index of factor prices.
We shall have no real progress in monetary policy until monetary economists realize that, although it is true that unsound monetary policy tends to contribute to undesirable and unnecessary fluctuations in prices and output, it does not follow that the soundest conceivable policy is one that eliminates such fluctuations altogether. The goal of monetary policy ought, rather, to be that of avoiding unnatural fluctuations in output–that is, departures of output from its full-information level–while refraining from interfering with fluctuations that are “natural.” That means having a single mandate only, where that mandate calls for the central bank to keep spending stable, and then tolerate as optimal, if it does not actually welcome, those changes in P and y that occur despite that stability.
I mostly agree with this, but I also think there is some ambiguity as to the meaning of “mandate.” Some view it as similar to “target,” but I don’t. Consider this from Congress’s perspective. They don’t understand the fine points of money/macro, but notice that it sure looks like there are suboptimal employment fluctuations and that at times inflation is excessively high and/or erratic. Now of course George might very reasonably argue I am being far too kind. They simply want MORE JOBS, and know nothing about “suboptimal employment fluctuations.” Nevertheless, inflation and unemployment can be viewed as two distinct problems. A monetary policy that produces optimal employment fluctuations with an average inflation rate of minus 1%, could probably have done the same with an average inflation rate of plus 1%. I.e., money is approximately super-neutral, and hence decisions about the average inflation rate (or preferably average NGDP growth rate) are logically distinct from how we vary the inflation (or NGDP growth) rate to avoid suboptimal employment fluctuations.
Of course we shouldn’t target inflation at all, but Congress doesn’t understand that. Nonetheless their intuition about “inflation” being bad is roughly correct; an average NGDP growth rate of 10% is also bad, even if employment is always at its Walrasian equilibrium level.
So let’s suppose that Congress tells the monetary authority to address those two vague goals. Is that reasonable? I think it is. But that doesn’t mean the Fed should actually target inflation and unemployment, or inflation and output gaps. They should address the dual mandate with something like an NGDP target (or productivity norm, or nominal wage target.) They should address the dual mandate with a single target.
The super-neutrality of money allows us to maintain optimal employment with either a high or low average inflation rate. Since inflation is costly, we might as well pick a low rate, and hence a fairly low NGDP target. But money may not be precisely super-neutral at very low inflation rates, as there is a sharp discontinuity in nominal wage gains at just below zero percent (which implies money illusion.)
To summarize, George Selgin is right that the goal should not be zero employment fluctuations; it should be to reproduce the employment levels of an economy with wage/price flexibility (or perfect-information, to use George’s characterization.) But that still doesn’t pin down the average inflation rate, or the average NGDP growth rate. So I do think that the concept of “dual mandate” makes some sense, at least as a sort of political aspiration. What we need to avoid is dual monetary policy targets.
PS. Elsewhere I’ve argued that the welfare costs assumed to flow from inflation are actually caused by high and unstable NGDP growth. I’ve used inflation in this post to avoid needlessly complicating the issues discussed by George Selgin.
Tags: Dual Mandate