Basil Halperin on the logic behind NGDP targeting

James Alexander directed me to a recent post by Basil Halperin, which is one of the best blog posts that I have read in years.  (I was actually sent this material before Christmas, but it sort of fell between the cracks.)

Basil starts off discussing a program for distributing excess food production from manufacturers to food banks.

The problem was one of distributed versus centralized knowledge. While Feeding America had very good knowledge of poverty rates around the country, and thus could measure need in different areas, it was not as good at dealing with idiosyncratic local issues.

Food banks in Idaho don’t need a truckload of potatoes, for example, and Feeding America might fail to take this into account. Or maybe the Chicago regional food bank just this week received a large direct donation of peanut butter from a local food drive, and then Feeding America comes along and says that it has two tons of peanut butter that it is sending to Chicago.

To an economist, this problem screams of the Hayekian knowledge problem. Even a benevolent central planner will be hard-pressed to efficiently allocate resources in a society since it is simply too difficult for a centralized system to collect information on all local variation in needs, preferences, and abilities.

One option would simply be to arbitrarily distribute the food according to some sort of central planning criterion.  But there is a better way:

This knowledge problem leads to option two: market capitalism. Unlike poorly informed central planners, the decentralized price system – i.e., the free market – can (often but not always) do an extremely good job of aggregating local information to efficiently allocate scarce resources. This result is known as the First Welfare Theorem.

Such a system was created for Feeding America with the help of four Chicago Booth economists in 2005. Instead of centralized allocation, food banks were given fake money – with needier food banks being given more – and allowed to bid for different types of food in online auctions. Prices are thus determined by supply and demand. . . .

By all accounts, the system has worked brilliantly. Food banks are happier with their allocations; donations have gone up as donors have more confidence that their donations will actually be used. Chalk one up for economic theory.

Basil points out that while that solves one problem, there is still the issue of determining “monetary policy”, i.e. how much fake money should be distributed each day?

Here’s the problem for Feeding America when thinking about optimal monetary policy. Feeding America wants to ensure that changes in prices are informative for food banks when they bid. In the words of one of the Booth economists who helped design the system:

“Suppose I am a small food bank; I really want a truckload of cereal. I haven’t bid on cereal for, like, a year and a half, so I’m not really sure I should be paying for it. But what you can do on the website, you basically click a link and when you click that link it says: This is what the history of prices is for cereal over the last 5 years. And what we wanted to do is set up a system whereby by observing that history of prices, it gave you a reasonable instinct for what you should be bidding.”

That is, food banks face information frictions: individual food banks are not completely aware of economic conditions and only occasionally update their knowledge of the state of the world. This is because obtaining such information is time-consuming and costly.

Relating this to our question of optimal monetary policy for the food bank economy: How should the fake money supply be set, taking into consideration this friction?

Obviously, if Feeding America were to randomly double the supply of (fake) money, then all prices would double, and this would be confusing for food banks. A food bank might go online to bid for peanut butter, see that the price has doubled, and mistakenly think that demand specifically for peanut butter has surged.

This “monetary misperception” would distort decision making: the food bank wants peanut butter, but might bid for a cheaper good like chicken noodle soup, thinking that peanut butter is really scarce at the moment.

Clearly, random variation in the money supply is not a good idea. More generally, how should Feeding America set the money supply?

One natural idea is to copy what real-world central banks do: target inflation.

Basil then explains why NGDP targeting is likely to be superior to inflation targeting, using a Lucas-type monetary misperceptions model.

III. Monetary misperceptions
I demonstrate the following argument rigorously in a formal mathematical model in a paper, “Monetary Misperceptions: Optimal Monetary Policy under Incomplete Information,” using a microfounded Lucas Islands model. The intuition for why inflation targeting is problematic is as follows.

Suppose the total quantity of all donations doubles.

You’re a food bank and go to bid on cheerios, and find that there are twice as many boxes of cheerios available today as yesterday. You’re going to want to bid at a price something like half as much as yesterday.

Every other food bank looking at every other item will have the same thought. Aggregate inflation thus would be something like -50%, as all prices would drop by half.

As a result, under inflation targeting, the money supply would simultaneously have to double to keep inflation at zero. But this would be confusing: Seeing the quantity of cheerios double but the price remain the same, you won’t be able to tell if the price has remained the same because
(a) The central bank has doubled the money supply
(b) Demand specifically for cheerios has jumped up quite a bit

It’s a signal extraction problem, and rationally you’re going to put some weight on both of these possibilities. However, only the first possibility actually occurred.

This problem leads to all sorts of monetary misperceptions, as money supply growth creates confusions, hence the title of my paper.

Inflation targeting, in this case, is very suboptimal. Price level variation provides useful information to agents.

IV. Optimal monetary policy
As I work out formally in the paper, optimal policy is instead something close to a nominal income (NGDP) target. Under log utility, it is exactly a nominal income target. (I’ve written about nominal income targeting before more critically here.)

. . .  Feeding America, by the way, does not target constant inflation. They instead target “zero inflation for a given good if demand and supply conditions are unchanged.” This alternative is a move in the direction of a nominal income target.

V. Real-world macroeconomic implications
I want to claim that the information frictions facing food banks also apply to the real economy, and as a result, the Federal Reserve and other central banks should consider adopting a nominal income target. Let me tell a story to illustrate the point.

Consider the owner of an isolated bakery. Suppose one day, all of the customers seen by the baker spend twice as much money as the customers from the day before.

The baker has two options. She can interpret this increased demand as customers having come to appreciate the superior quality of her baked goods, and thus increase her production to match the new demand. Alternatively, she could interpret this increased spending as evidence that there is simply more money in the economy as a whole, and that she should merely increase her prices proportionally to account for inflation.

Economic agents confounding these two effects is the source of economic booms and busts, according to this model. This is exactly analogous to the problem faced by food banks trying to decide how much to bid at auction.

To the extent that these frictions are quantitatively important in the real world, central banks like the Fed and ECB should consider moving away from their inflation targeting regimes and toward something like a nominal income target, as Feeding America has.

The paper he links to contains a rigorous mathematical model that shows the advantages of NGDP targeting. He doesn’t claim NGDP targeting is always optimal, but any paper that did would actually be less persuasive, as it would mean the model was explicitly constructed to generate that result. Instead the result flows naturally from the Lucas-style archipelago model, where each trader is on their own little island observing local demand conditions before aggregate (NGDP conditions). This is the sort of approach I used in my first NGDP futures targeting paper, where futures markets aggregated all of this local demand (i.e. velocity) information. However Basil’s paper is light years ahead of where I was in 1989.

I can’t recommend him highly enough.  I’m told he recently got a BA from Chicago, which suggests he may be another Soltas, Wang or Rognlie, one of those people who makes a mark at a very young age.  He seems to combine George Selgin-type economic intuition (even citing a lovely Selgin metaphor at the end of his post) with the sort of highly technical skills required in modern macroeconomics.

Commenters often ask (taunt?) me with the question, “Where is the rigorous model for market monetarism”.  I don’t believe any single model can incorporate all of the insights from any half decent school of thought, but Basil’s model certainly provides the sort of rigorous explanation of NGDP targeting that people seem to demand.

Basil has lots of other excellent posts, and over the next few weeks and months I will have more posts responding to some of the points he makes (which to his credit, include criticism of NGDP targeting–he’s no ideologue.)



18 Responses to “Basil Halperin on the logic behind NGDP targeting”

  1. Gravatar of David Pinto David Pinto
    13. January 2017 at 11:24

    I remember reading about the food bank market a few months ago and being impressed. I also remember the article contained this:

    Though the market eventually flourished, getting it started was not easy. John Arnold, a director of a food bank in western Michigan who died in 2012, at first rejected the new approach: “I am a socialist,” he said. “That’s why I run a food bank. I don’t believe in markets.” But despite his initial objections, he became a champion of basic market reforms and continued to innovate, pioneering “free market” inventions like allowing food bank clients to choose their own food, instead of making everyone accept the same basket, as early as the mid-1990s.

  2. Gravatar of Scott Freelander Scott Freelander
    13. January 2017 at 11:47

    This is interesting. What seems like a lifetime ago, I set up some token economies for some local behavioral units. It was monetary policy on the ground. Allows for some very precise analysis of behavioral patterns.

  3. Gravatar of Peter Peter
    13. January 2017 at 12:38

    There was an econtalk about this:

  4. Gravatar of ssumner ssumner
    13. January 2017 at 13:59

    Everyone, Thanks for the info. I’m surprised I had not heard of this.

  5. Gravatar of George Selgin George Selgin
    13. January 2017 at 15:01

    I had a very nice exchange not long ago with Basil about his paper, which I also like very much. I asked permission to include a revised version in the CMFA’s Working Paper series. We need more people doing this sort of work.

  6. Gravatar of Benjamin Cole Benjamin Cole
    13. January 2017 at 16:27

    Target incomes. NGDP t a targeting g ok d too. Failing that, a inflation target range can mimic the same policies.

    In any event, print more money.

  7. Gravatar of Ray Lopez Ray Lopez
    13. January 2017 at 17:50

    Shut up all of you, JUST SHUT UP. This is soooo stupid. It’s a rehash of the old “Watergate Script Problem” and how it was supposedly solved. Are any readers here, mentally, over the age of ten? Certainly not our host. Supposedly (so the story goes, recounted dozens of times in economics) Watergate DC tenants wanted to issue vouchers for babysitting that were being hoarded. Solution: issue more script (increase liquidity) and the problem went magically away, the invisible hand only works when there is enough money to make the cost of hoarding not worth the effort. As for the ‘give extra food to the needy’ meme, it’s well known that 33% to 66% of food is wasted, from farm to table, due to the laws of entropy (Google this); in the USSR it was 90%. Gawd why am I reading this site? I’m learning nothing.

  8. Gravatar of Don Geddis Don Geddis
    13. January 2017 at 19:41

    @Ray Lopez: “DC tenants wanted to issue vouchers for babysitting that were being hoarded.” Great reference, Ray. Yes, indeed, the Capitol Hill babysitting co-op, made famous in the 90’s by Krugman, is a great and accessible story of the importance of aggregate demand and monetary policy.

    I’m learning nothing.” 2 for 2, Ray! I think we are all in violent agreement with you here.

  9. Gravatar of Postkey Postkey
    14. January 2017 at 01:45

    “Instead of centralized allocation, food banks were given fake money . . . ”
    Helicopter money?

  10. Gravatar of A A
    14. January 2017 at 06:38

    Don Geddis, The babysitting coop featured a known money supply combined with a price control. The food bank metaphor considers how to adjust money supply without obscuring price signals.

  11. Gravatar of Ray Lopez Ray Lopez
    14. January 2017 at 08:09

    @A – I think Don Geddis understands the differences between the two stories, he was just trying to make the point that I forget nothing and learn nothing. But since money is largely short-term neutral, both stories are wrong as you understand them. Reexamine your priors, and, start going to church and/or have faith in God/gods. In the long run you will thank me for letting the scales fall from your eyes.

  12. Gravatar of ssumner ssumner
    14. January 2017 at 08:22

    Don is right that the babysitting parable is a good analogy to what Basil did here. I had that same though last night, after I posed this.

  13. Gravatar of Ray Lopez Ray Lopez
    14. January 2017 at 08:25

    @myself – oh, I forgot to add, why did the famous “Monetary Theory and the Great Capitol Hill Baby-Sitting Co-op Crisis” by Joan and Richard Sweeney published in 1978 turn out the way it did? During the time the script was issued, the early 1970s, Washington DC and the rest of the USA were in an actual recession (Nov 1973 – Mar 1975), so naturally people did not want to go out, and that’s why baby-sitting script was hoarded (no demand for sitters). When the recession ended, people went out. Sweeney et al are ambiguous when the ‘Watergate baby script recession’ hit and how long it lasted, but the above speculation is consistent with the dates that Sweeney mention, “1973-74” in their short note. It’s also interesting that monetarism cannot be the solution to the baby-sitting script hoarding since Sweeney mentions that putting time restrictions on the script, to make then worthless unless used promptly, did not work. If that did not work, then you know issuing more script would not work either (would not change velocity). Simply put, as is true in the real world, the baby sitting script problem solved itself when animal spirits awoke again, when the recession passed in March 1975. Another bogus attempt at economic analogies by Sweeney, akin to the flawed ‘bee keeper and free-ridership’ problem if you know your economics literature.

  14. Gravatar of Mark Mark
    14. January 2017 at 08:46

    Help me understand the babysitting example. Under a nominal income target, vouchers would be printed until actual babysitting hours reached the desired level. Theoretically, unlimited hoarding could occur. You would eventually have inflation but there is no way to know how much hoarding would occur up to that point. Upon inflation, fewer vouchers would be printed and only families which had previously hoarded could afford any babysitting.

    Now let’s replace “babysitting” with things that society considers “basic rights” (e.g., food, healthcare). Upon an inflation outbreak it would be unacceptable to let the families who hadn’t hoarded go without basic needs. Therefore you either need to tolerate inflation (keep printing) or wealth redistribution (transfer from hoarders to the poor). But if the wealth turns out to be sufficiently mobile/hidden/politically-powerful that isn’t an option. At that point your past monetary decisions have forced you into accepting (potentially very high) inflation.

    That latter scenario feels like where society is headed. Am I wrong?

  15. Gravatar of Don Geddis Don Geddis
    14. January 2017 at 12:05

    @Mark: “only families which had previously hoarded could afford any babysitting” No. Non-hoarding families could simply provide babysitting services themselves, and so continue to earn future income. And thus still be able to afford future babysitting.

    Upon an inflation outbreak it would be unacceptable to…” Inflation has no (direct) effect on inequality. It is neither a cause of inequality, nor a solution to existing inequality.

    If you want people to have things that they can’t afford by themselves, it seems that wealth distribution is your only option. (Or perhaps have government provide the service itself, like public education.)

  16. Gravatar of Mark Mark
    15. January 2017 at 08:45

    @ Don
    You are assuming no skill mismatch . It’s very possible that after years of not “babysitting” the skill set has been lost….or would take very long to regain.

    Agree on inflation but it’s naive to assume it won’t be tried. It “sounds” like a solution at the time. Economics cannot ignore this.

    If wealth redistribution is impossible (possibly true for a variety of reasons), then you have essentially forced yourself into societal revolt or very high inflation or both. Of course economists will say they couldn’t have seen it coming but it’s pretty apparent to me. Economists will insist on tighter money to fight inflation but society won’t allow it. It will appear to be a political problem but really it was past monetary decisions being naive about how society works.

  17. Gravatar of ssumner ssumner
    15. January 2017 at 08:57

    Mark, I think you are confusing monetary policy with fiscal policy (but it’s been a while since I read that parable, and don’t recall the specifics.)

  18. Gravatar of flow5 flow5
    17. January 2017 at 03:39

    Bernanke is an example of someone who uses and teaches sophisticated economic modeling. And Bernanke is stupid. Keynes was much smarter (and just as lost). Neither could tell a debit from a credit.

    Keynesian economists have finally achieved their objective, – there is no longer a clear distinction between money and liquid assets. Money is now the equivalent of “mud pie”. It is obvious that money has no significant impact on prices unless it is actually being exchanged.

    Remember when BuB:

    (1) granted temporary exemptions from Section 23A to: “our goal was to increase the supply of short-term funding to the shadow banking system” ? and
    (2) invoking Section 13 (3) allowing NBs to participate in FRB-NY’s “trading desk’s” auctions ? and
    (3) eventually converting them to BHCs ? and
    (4) the adoption of FASB’s Financial Accounting Statements No. 166 (FAS 166), Accounting for Transfers of Financial Assets, and No. 167 (FAS 167), Amendments to FASB Interpretation No. 46(R), incorporated in the H.8 commercial bank balance sheet data for March 31, 2010?

    If an economist understood money and central banking then they would be complaining about the statistical releases.

    M1 is overstated since the DIDMCA (by the CUs and S&Ls – but not the MSBs). And it is vastly distorted on a weekly basis by the put and take in the Treasury’s General Fund Account.

    The incorporation of the investment banks into BHCs, into member banks, should have theoretically, changed the money stock, but their assets and liabilities weren’t reclassified.

    Commercial bank credit, i.e., the assets of the deposit taking, money creating, financial institutions, DFIs, should also include, MSB, CU, and S&L balances (like their liabilities are included in the money stock).

    And to debate N-gDp targeting, when you can’t define money, is stupid.

    Money is robust. And money can be “mopped up” and “washed out”. It’s called legal reserve management.


    And the distributed lag effects of money are mathematical constants.

    I denigrated Nassim Nicholas Taleb’s “Black Swan” theory 6 months in advance, and within 1 day of the May 6th 2010 “flash crash”:

    Subject: As the economy will shortly change, I wanted to show this to you again – forecast:
    Date: Wed, 24 Mar 2010 17:22:50 -0500
    Dr. Anderson:
    It’s my discovery. Contrary to economic theory and Nobel Laureate Milton Friedman, monetary lags are not “long & variable”. The lags for monetary flows (MVt), i.e., the proxies for (1) real-growth, and for (2) inflation indices, are historically, always, fixed in length.
    Assuming no quick countervailing stimulus:
    jan….. 0.54…. 0.25 top
    feb….. 0.50…. 0.10
    mar…. 0.54…. 0.08
    apr….. 0.46…. 0.09 top
    may…. 0.41…. 0.01 stocks fall
    Should see shortly. Stock market makes a double top in Jan & Apr. Then real-output falls from (9) to (1) from Apr to May. Recent history indicates that this will be a marked, short, one month drop, in rate-of-change for real-output (-8). So stocks follow the economy down.
    flow5 Message #10 – 05/03/10 07:30 PM
    The markets usually turn (pivot) on May 5th (+ or – 1 day).

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