Archive for the Category NGDP targeting


The actual problem

The global media seems endlessly fascinated by the question of whether monetary policy in the US is too easy or too tight, even as the Fed comes amazingly close to hitting its targets.  I suppose this interest can be partly justified by the size and influence of the US, which David Beckworth calls a “monetary superpower”.  Nonetheless, there should be more discussion of the fact that monetary policy in the Eurozone and Japan is way off course, and that these policy mistakes are a danger to the global economy.

Core inflation in the Eurozone is 1.0%, far below the ECB’s roughly 1.9% target:

Screen Shot 2019-01-23 at 12.20.01 PMAnd growth in the Eurozone is slowing as we go into 2019.

Core inflation in Japan is even further below the BOJ’s 2% target:

Screen Shot 2019-01-23 at 12.20.32 PMAnd growth in Japan is also slowing.

My suggestion is that both central banks consider switching to level targeting and adopt a “whatever it takes” approach to hit their targets.  These changes might require legislation, and I’m not expert on the political barriers to getting this done, which I presume are formidable.  Fortunately, these two changes might well be enough; I doubt they’d need to take any additional “concrete steps”.

PS.  Commenter LK Beland constructed a monthly series of wage income for the US, by multiplying average hourly earnings, average hours per week and payroll employment.  In some respects, this data is superior to NGDP as an indicator of the appropriateness of monetary policy. Interestingly, the graph shows even greater stability than NGDP growth, mostly hovering around 4% to 5%:

Screen Shot 2019-01-23 at 12.24.28 PMThis is what I’ve been advocating as a long run policy ever since I started blogging in early 2009.  However I would have liked to have seen faster “catch-up” growth in the early years of the recovery.  Even so, this is a good sign.  If they can keep roughly 4% growth going forward then . . . . we win.

My views on monetary policy: An update

It’s time to update my current preferences on monetary policy:

Monetary authority structure:

1.  As in the UK, monetary policy decisions should be made by a committee of monetary specialists.  They need not be economists, but they must be experts. Self-taught is fine. Financial regulatory decisions should be made by a separate (Treasury) committee, composed of experts on finance.

2.  The FR Board should continue to be independent.  The regional Fed banks should be abolished.

3.  The Fed balance sheet should be moved over to the Treasury so that the Fed does not incur any balance sheet risk.

4.  Anyone should be able to have a “reserve” account at the Treasury. It would pay no interest.  I.e., electronic cash.

5.  Paper currency should not be abolished (as it provides privacy.)

Policy Tool:

The Fed should use just one tool, open market operations.  Generally these operations should involve Treasury securities.  There’s no need for the Fed to recommend discount lending, reserve requirements and interest on reserves as tools of monetary policy.  Other assets should be purchased only if necessary.  If we don’t get my optimal NGDP level targeting strategy and the zero bound problem occurs frequently, then there is a much stronger argument for making the purchase of other (non-Treasury) assets a routine part of policy.  Bank bailouts should be done by the Treasury, if at all. (Hopefully not at all.)  There should be an iron curtain between the Fed and the banking system, like the separation of church and state.

Policy Target:

Nominal growth targets should be high enough to avoid the zero bound problem.  With level targeting, a 4% NGDP growth rate should be high enough.  We should target expected per capita NGDP growth, level targeting.  (Perhaps growth of one basis point a day is a nice round number, for that future time when “big data” allows us to know daily changes in NGDP.)  A nominal total labor compensation target is better for some countries.  The Fed should completely offset the impact of any fiscal policy action.

Policy Rule:

The Fed should commit to a “guardrails approach”, a willingness to sell unlimited NGDP futures contracts at a implied NGDP growth rate slightly above target and buy unlimited NGDP futures contracts at an implied NGDP growth rate slightly below target.

Policy Accountability and Transparency:

The Fed should report to Congress twice a year on the effectiveness of previous policy decisions.  They should explain whether, in retrospect, policy settings adopted 12 months earlier were too easy or too tight, even if only slightly so.  They should clearly explain the metrics they used to make this determination.  This form of accountability is especially important if NGDP targeting is not adopted, less so if it is.

What am I missing?  I may add a few items based on comments.

Should we target total wages or average hourly wages?

This post was inspired by a recent Nick Rowe post, which uses an AS/AD diagram to compare inflation and NGDP targeting under various sorts of shocks.  I learned some things from reading the post, and George Selgin’s comments following the post.  I recommend people take a look.  But in the end I find sticky price models too confusing.  Or maybe I just don’t have the energy to try to get over my confusion, because price stickiness doesn’t seem to me to be the key issue.  For me, business cycles are all about employment fluctuations and wage stickiness.

Let’s start with a graph where (for simplicity) we assume a vertical long run labor supply curve (LRLS), and an upward sloping short run labor supply curve (SRLS).  Total compensation (TC) is a rectangular hyperbola, representing $12 trillion in labor compensation.  I assume wages of $40 per hour (including benefits), and 300 billion total hours (2000 hours a year times 150 million workers.)  These are ballpark numbers for the USA.   The LRLS determines the natural rate of employment—which is optimal in the context of monetary policy decisions.

Screen Shot 2018-11-25 at 2.02.48 PMNow let’s consider two types of shocks.  In the first case, there’s a sudden 10% boost in the labor force, perhaps due to a flood of immigrants:

Screen Shot 2018-11-25 at 2.03.05 PMNotice that the optimal solution is a 10% rise in employment, with no change in nominal wages.  That’s what happens with nominal wage targeting.  Under total compensation targeting the employment level rises by only 6%, which is suboptimal.  NGDP targeting would be the same.  This example might help people to better understand George Selgin’s version of NGDP targeting, which adjusts for labor force changes.  (Nothing changes if we assume a positive trend rate for wages that is fully expected.)

Now let’s consider a nominal wage shock.  Say that workers get greedy and demand higher wages, because Bernie Sanders is elected President.  But the LRLS doesn’t shift, which means the workers will eventually scale back their wage demands, at least in real terms:

Screen Shot 2018-11-25 at 2.03.32 PMThis case is just the opposite.  Now a monetary policy aimed at stabilizing total compensation gives you a better result.  With nominal wage targeting, employment falls by 10%, relative to an unchanged LRLS curve.  With total compensation targeting (and perhaps NGDP targeting as well) the fall in employment is smaller (only 4%).

In my view, the most pragmatic option is to try to target total compensation (or NGDP), adjusted for changes in the labor force, which is sort of in the spirit of George Selgin’s proposal.  As I recall, he wanted a productivity norm that adjusted NGDP for both labor force and capital shock changes, but I don’t recall the exact details.  Because I see the labor market as key, I’ve left out the capital stock issue, which seems secondary to me.  But his basic intuition seems exactly right.

PS.  It’s likely that this is nothing new, or maybe it’s wrong.  It’s a framing that occurred to me after reading Nick’s post.  I welcome any comments you might have.

PPS.  I had the honor of writing a forward for the brand new addition to George’s Less Than Zero.

PPPS.  Don’t be discouraged if all this theoretical analysis makes NGDP targeting seem “wrong”.  It’s less far less wrong than anything else on offer from the major schools of thought in macroeconomics—close enough to optimal for the USA.

PPPPS.  I didn’t look at productivity shocks, because they affect the optimal price level, not the optimal wage rate.

If there’s a recession, would it be Trump’s fault?

The short answer is “probably not”. But this requires making some careful distinctions:

1. It’s possible that Trump’s policies might become so reckless as to create a “real shock” that is large enough to cause a recession. Say a massive all-out global trade war. That seems very unlikely.

2. More likely, Trump’s policies might create a real shock large enough to complicate the implementation of effective monetary policy. Think of the way that the housing bust complicated things for the Fed in 2006-08. In this scenario, it would still be the Fed’s fault, but it would be bad trade polices combined with a flawed monetary regime that led to recession.

In this second case, I still think it would be very important not to blame Trump for the recession. We are never going to fix the problem of bad monetary policy until we stop misdiagnosing the problem. Today, 99% of economists continue to misdiagnose what went wrong in 2008, absolving the Fed of blame for an excessively tight monetary policy. To fix that, we need to start talking honestly about what causes most recessions—falling NGDP, not real shocks. And we also need to implement a regime that prevents real shocks from spilling over and causing bad monetary policy—which means NGDPLT.

3. It might be argued that Trump is to blame because he appointed the top officials at the Fed, and they made serious policy errors. To be honest, I would not blame the Dems for blaming Trump for any recession. After all, he’ll take undeserved credit for anything good that happens, so it’s only fair. Nonetheless, impartial observers who want to get at the truth should be careful before blaming Trump for any Fed screw-ups. If a demand-side recession did occur, would it be because Powell, Clarida, Quarles and the others were poor choices, or because the Fed’s entire operating system is flawed, and has been for decades? Obviously, the latter is much more likely.

Some people blame Bernanke for the Great Recession, but Greenspan’s public comments during this period suggest that the Fed would have done even worse if he had still been chair. As long as we focus on personalities we won’t solve the underlying problem, which is a flawed monetary regime.

Hopefully, the Fed has learned from the mistakes of 2008.  But we won’t know for sure until the next real shock comes along—the next crisis that requires the Fed to take aggressive steps to stabilize expected NGDP growth.

Those suffering from TDS may find this post to be dispiriting.  It would feel good to blame Trump for any recession.  Don’t worry, the voters will always blame the government for recessions, no matter what I say.

Some people who like Trump may be surprised that I take this view.  If so, it’s probably because your thinking is corrupted by politics and you assume that everyone is similarly corrupt.  Just as habitual thieves assume that everyone else would steal if they could get away with it.

I’ve been very clear all along that presidents have very little impact on the business cycle. Trump has done some useful tax changes, and lots of bad policies in areas such as trade, immigration, deficit spending, global warming, promoting an unstable financial system, etc.  But none of that has much impact on the business cycle—those are things that impact long run trend growth.  That’s how the President’s impact on the economy should be judged.

PS.  I’m not currently predicting a recession, as I don’t believe recessions can be forecasted.

Teaching money/macro in 90 minutes

A few weeks ago I gave a 90-minute talk to some high school and college students in a summer internship program at UC Irvine.  Most (but not all) had taken basic intro to economics.  I need to boil everything down to 90 minutes, including money, prices, business cycles, interest rates, the Great Recession, how the Fed screwed up in 2008, and why the Fed screwed up in 2008.  Not sure if that’s possible, but here’s the outline I prepared:

1.  The value of money (15 minutes)

2.  Money and prices  (20 minutes)

3.  Money and business cycles (25 minutes)

4.  Money and interest rates (15 minutes)

5.  Q&A (15 minutes)


Inflation is currently running at about 2%.  It’s averaged 2% since 1990.  That’s not a coincidence, the Fed targets inflation at 2%.  But it’s also not normal.  Inflation was much higher in the 1980s, and still higher in the 1970s.  In the 1800s, inflation averaged zero and there were years like 1921 and 1930-32 where it was more like negative 10%!

We need to figure out how the Fed has succeeded in targeting inflation at 2%, then why this was the wrong target, and finally how this mistake (as well as a couple freshman-level errors) led to the Great Recession.

1. Value of Money  

Like any other product, the real value of money changes over time.

But . . . the nominal price of money stays constant, a dollar always costs $1

Value of money = 1/P (where P is price level (CPI, etc.))

Thus if price level doubles, value of a dollar falls in half.


Year      Height    Unit of measure   Real height

1980      1 yard           1.0                1 yard

2018      6 feet            1/3               2 yards

Switching from yards to feet makes the average size of things look three times larger.  This is “size inflation”.  But this boy’s measured height increased 6-fold, which means he even grew (2 times) taller in real terms.

Year      Income    Price level  Value of money   Real Income

1980     $30,000        1.0               1.0               $30,000

2018    $180,000       3.0               1/3               $60,000

The dollar lost 2/3rds of its purchasing power between 1980 and 2018, as the average thing costs three times as much.  This is “price inflation”.  But some nominal values increase by more than three times, such as this person’s income, which means the income doubled in real terms, or in purchasing power.

Punch line:  Don’t try to explain inflation by picking out items that increased in price especially fast, say rents or gas prices, rather think of inflation as a change in the value of money.  Focus on what determines the value of money . . .

2.  Money and the Price Level

. . . which, in a competitive market is supply and demand:

Screen Shot 2018-08-02 at 7.11.51 PM

Demand for Money: How much cash people prefer to hold.

Who determines how much money you carry in your wallet?  You?  Are you sure?  Is that true for everyone?

Who determines the average cash holding of everyone in the economy?  The Fed.

How can we reconcile these two perceptions?  They are both correct, in a sense.

Helicopter drop example:  Double money supply from $200 to $400/capita

==> Excess cash balances

==>attempts to get rid of cash => spending rises => AD rises => P rises

==>eventually prices double.  Back in equilibrium.

Now it takes $400 to buy what $200 used to buy.  You determine real cash holdings (the purchasing power in your wallet), while the Fed determines average nominal cash holdings (number of dollars).

Punch line:  Fed can control the price level (value of money), by controlling the money supply.

What if money demand changes?  No problem, adjust money supply to offset the change.

Fed has used this power to keep inflation close to 2% since 1991.  Before they tried, inflation was all over the map.  After they tried, they succeeded in keeping the average rate close to 2%.  That success would have been impossible if Fed did not control price level.

But, inflation targeting is not optimal:

3.  Money and business cycles

Suppose I do a study and find that on average, 40 people go to the movies when prices are $8, and 120 people attend on average when prices are $12.  Is this consistent with the laws of supply and demand?  Yes, completely consistent. But many students have trouble seeing this.

Explanation:  When the demand for movies rises, theaters respond with higher prices.  The two data points lie along a single upward-sloping supply curve.

Implication:  Never reason from a price change.  A rise in prices doesn’t tell us what’s happening in a market.  It could be more demand or less supply.  The same is true of the overall price level.  Higher inflation might indicate an overheating economy (too much AD), or a negative supply shock:

Screen Shot 2018-08-02 at 7.26.42 PM

In mid-2008, the Fed saw inflation rise sharply and worried the economy was overheating.  It was reasoning from a price change. In fact, prices rose rapidly because aggregate supply was declining.  It should have focused on total spending, aka “aggregate demand”, for evidence of overheating:

M*V = P*Y = AD = NGDP

This represents total spending on goods and services.  Unstable NGDP causes business cycles.

Example: mid-2008 to mid-2009, when NGDP fell 3%:Screen Shot 2018-08-02 at 7.43.04 PM

Here we assume that nominal GDP was $20 trillion in 2008, and then fell in 2009, causing a deep recession and high unemployment.

Musical chairs model:  NGDP is the total revenue available to businesses to pay wages and salaries.  Because wages are “sticky”, or slow to adjust, a fall in NGDP leads to fewer jobs, at least until wages can adjust.  This is a recession.

It’s like the game of musical chairs.  If you take away a couple chairs, then when the music stops several contestants will end up sitting on the floor.

The Fed needs to keep NGDP growing about 4%/year, by adjusting M to offset any changes in V (velocity of circulation).

Punch line:  Don’t focus in inflation, NGDP growth is the key to the business cycle

Why did the Fed mess up in 2008? Two episodes of reasoning from a price change:

1.  The 2008 supply shock inflation was wrongly viewed as an overheating economy.

2.  Low interest rates were wrongly viewed as easy money.

4.  Money and Interest Rates

Below is the short and long run effects of an increase in the money supply, and then a decrease in the money supply.  Notice that easy money causes rates to initially fall, then rise much higher.  Vice versa for a tight money policy.

Screen Shot 2018-08-02 at 7.26.56 PMWhen the money supply increases, rates initially decline due to the liquidity effect. The opposite occurs when the money supply is reduced.

Screen Shot 2018-08-02 at 7.43.15 PMHowever, in the long run, interest rates go the opposite way due to the income and Fisher effects:

Income effect: Expansionary monetary policy leads to higher growth in the economy, more demand for credit, and higher interest rates.

Fisher effect:  Expansionary monetary policy leads to higher inflation, which causes lenders to demand higher interest rates.

In 2008, the Fed thought lower rates represented the liquidity effect from an easy money policy.

Actually, during 2008 we were seeing the income and Fisher effects from a previous tight money policy.

Don’t assume that short run means “right now” and long run means “later”.  What’s happening right now is usually the long run effect of monetary policies adopted earlier.

Punchline:  Don’t assume low rates are easy money and vice versa.  Focus on NGDP growth to determine stance of monetary policy.  That’s what matters.

(I actually ended up covering about 90% of what I intended to cover, skipping the yardstick metaphor.)