In the standard national income accounting, gross domestic income equals gross domestic output. In the simplest model of all (with no government or trade) you have the following identity:
NGDI = C + S = C + I = NGDP (it also applies to RGDI and RGDP)
Because these two variables are identical, any model that explains one will, ipso facto, explain the other. Nonetheless, I think if we focus on NGDI we are more likely to be able to think clearly about macro issues. Consider the recent comment left by Doug:
Regarding Investment, changes in private investment are the single biggest dynamic in the business cycle. While I may be 1/4 the size of C in terms of the contribution to spending, it is 6x more volatile. The economy doesn’t slip into recession because of a fluctuation in Consumption. Changes in Investment drive AD.
This is probably how most people look at things, but in my view it’s highly misleading. Monetary policy drives AD, and AD drives investment. This is easier to explain if we think in terms of NGDI, not NGDP. Tight money reduces NGDI. That means the sum of nominal consumption and nominal saving must fall, by the amount that NGDI declines. What about real income? If wages are sticky, then as NGDI declines, hours worked will fall, and real income will decline.
So far we have no reason to assume that C or S will fall at a different rate than NGDI. But if real income falls for temporary reasons (the business cycle), then the public will typically smooth consumption. Thus if NGDP falls by 4%, consumption might fall by 2% while saving might fall by something like 10%. This is a prediction of the permanent income hypothesis. And of course if saving falls much more sharply than gross income, investment will also decline sharply, because savings is exactly equal to investment.
[Update: Lorenzo directed me to an excellent post by Andy Harless, explaining why S=I.]
This is where Keynesian economics has caused endless confusion. Keynesians don’t deny that (ex post) less saving leads to less investment, but they think this claim is misleading, because (they claim) an attempt by the public to save less will boost NGDP, and this will lead to more investment (and more realized saving.) In their model when the public attempts to save less (ex ante), it may well end up saving more (ex post.)
The Keynesian model probably works best in a gold standard world. An attempt to save more will depress nominal interest rates. If the stock of gold is approximately fixed in the short run, then the lower nominal interest rates will boost the demand for gold, and increase the value of gold. If gold is the medium of account then this will be deflationary. NGDI will decline, and if wages and prices are sticky this will ultimately lead to less saving and less investment. So there is a grain of truth in the Keynesian model, if you are in a gold standard world (as Keynes was when he developed the model.)
But we no longer live in a gold standard world, and today it makes more sense to view NGDI (and NGDP) as being determined by the central bank. In that world monetary shocks create (or worsen) investment volatility.
Here’s another example. Recent posts by Simon Wren-Lewis and Nick Rowe criticize new Keynesian models that feature a sort of “divine coincidence.” In these models (assuming Calvo pricing) when the central bank stabilizes inflation it also keeps output at potential. They kill two birds with one stone—price stability and no output gaps. This result follows from the NGDP (expenditure) approach–focusing on sticky prices and aggregate purchases of consumption and investment goods.
Both Wren-Lewis and Rowe rightly point out that these models did poorly in the Great Recession. Nick wants to shift to NGDP targeting (as do I.) But it might be easier to explain the advantages with the NGDI approach. Unlike the sticky-price NK model, the “musical chairs model” did beautifully during the Great Recession. In this model, when there is a sudden fall in NGDI, there is less income to allocate to workers. Because hourly wages are extremely sticky, this means many fewer hours worked. If the major central banks had kept inflation stable during the Great Recession, it probably would have been a bit milder, but we still might have experienced a pretty big recession.
In contrast, a stable path of NGDI would have led to fairly stable hours worked (unless hourly wages did something truly bizarre in response.) What about the Lucas Critique? If it applies at all (and I’m not sure it does), then I’d guess workers would respond to NGDI targeting with even stickier wages. Output gaps would probably be much smaller, but might be longer lasting. Indeed it’s quite possible that the “Great Moderation,” which produced results not too unlike NGDP targeting, has already made wages a bit stickier (especially when compared to the 1865-1929 period.) If so, that’s a price I am more than willing to pay.
PS. We finally succeeded in embedding the NGDP futures price at Hypermind in the right column of this blog. Please look for it when you tune in each day. And trade some contracts—you can win but you can’t lose. The specific price shown (about 4.2% last time I checked) is for 2014:Q4 to 2015:Q4.
The iPredict market is still progressing, but these things always take longer than I expect. It took us several weeks just to get the NGDP price embedded.
PPS. The winter from hell continues. Boston has gotten about 70 inches of snow in the past 17 days. Before that we had only gotten 5.5 inches all winter. In 17 days we’ve gone from a winter with almost no snow, to the 10th snowiest ever. And there are two months to go, with more snow on the way. To put that 70 inches in 17 days into perspective, the previous record was 31 inches in a week. So it’s roughly like we had 2 1/2 weeks in a row of snow intensity at the level of the very worst week in all of Boston history. A stock market analogy would be 17 days of decline at the rate of the worst week in NYSE history. Ouch.
If you start to see me endlessly typing:
All work and no play . . .
You’ll know that cabin fever has set in. Schools are closed as often then they are open, 6 days missed in the past 2 1/2 weeks.
Probably shouldn’t have watched Twin Peaks with my teenage daughter—definitely won’t be renting The Shining.