# Playing with toy models

Back in 2002, Bennett McCallum did a really nice survey piece on contemporary monetary economics.  The best parts are his insights into some of the controversial issues, but I’d like to focus on something else (in the equations I changed the style a bit—I can’t do subscripts and deltas).  Here’s McCallum, with adjustments:

A striking feature of the typical models in the NBER and Riksbank conferences is that they include no money demand equations or sectors. That none is necessary can be understood by reference to the following simple three-equation system.

yt = Î±0 + Î±1Et(yt+1) + Î±2(Rt âˆ’ Et(dpt+1)) + Î±3(gt âˆ’ Et(gt+1)) + vt (1)
dpt = Et(dpt+1) + Î±4(yt âˆ’ ynt) + ut                                           (2)
Rt = µ0 + µ1(dpt âˆ’ dpâˆ—) + µ2(yt âˆ’ ynt) + et                               (3)

Here equations (1)-(3) represent an expectational IS equation, a price adjustment relationship, and a Taylor-style monetary policy rule, respectively. The basic variables are yt = log of output, pt = log of price level, and Rt = nominal one-period interest rate, so dpt represents inflation, Rt âˆ’ Et(dpt+1) is the real interest rate, and yt âˆ’ ynt â‰¡ Ëœyt is the fractional output gap (output relative to its capacity or natural rate value, whose log is ynt). Also, gt represents the log of government purchases, which for present purposes we take to be exogenous. In this system, Et denotes the expectations operator conditional on information available at time t, so Et(pt+1) is the rational expectation formed at t of pt+1, the inflation rate one period in the future.

(In the original dpt was “delta” pt.  I also corrected a typo in equation 2.)

Now let’s do something similar in the MM model.  In equation 3 we will replace R in the previous model with NGDP futures prices (NGDPF), which is the instrument of monetary policy.  (It’s not really the instrument, the base is.  But then the fed funds rate is also not really the instrument, the base is. Both NGDPF and R are financial market variables that are observable and controllable in real time.)  The NGDP futures price equals the target value, plus a systematic error (SE).  The systematic error is the predictable part of the central bank’s policy failure.

In equation 2, actual NGDP reflects both the predicted value (previous NGDPF), and an unforecastable error term (et.)  The employment gap in equation 1, more specifically the gap between actual hours worked and the natural rate of hours worked, is alpha times the NGDP gap. Alpha is probably roughly one.  The hours worked gap is thus roughly equal to the difference between actual and target NGDP growth.  Between mid-2008 and mid-2009, NGDP fell about 8% below trend, and hours worked also fell about 8% below trend

(Ht – Hnt) = Î±(NGDPt – NGDPTt)      (1)

NGDPt = NGDPFt-1 + et                      (2)

NGDPFt-1 = NGDPTt + SEt-1            (3)

And all this boils down to:

(Ht – Hnt) = Î±(SEt-1 + et)                    (1)

Where the monetary policymaker determines SEt-1.

If they do NGDP futures targeting, then SE = 0.  Let’s use an inflation targeting analogy.  The ECB is targeting inflation at 1.9%, and last time I checked the 5-year inflation forecast in the German TIPS market was about -0.1%.  So in the eurozone SEt-1 is roughly negative 2%.  If the ECB pegged CPI futures prices at 1.9% inflation, then the SE would rise from negative 2% to zero.  Actual eurozone inflation would be 1.9% plus et.  Under NGDP futures targeting, SE is equal to zero and the hours worked gap is a random walk.

Of course this oversimplifies everything (but then so does the 3 equation model described by McCallum.)  Hours worked would actually depend on Wage/NGDP, or even better Wage/(NGDP/person). Further refinement would include shocks to labor’s share of national income.  Nominal wages depend on expected future NGDP, but are also very sticky, adjusting slowly when pushed away from the desired Wage/NGDP ratio.  That would all have to be modeled.

The NGDPF market could be modeled as follows.  Define the ratio of next period’s NGDP and the current monetary base as “quasi-velocity” (QV.):

Mt*QVt = NGDPt+1

Then create a futures market in QV, and tell traders that the base will be set at such a level that the base times equilibrium QV (in the futures market) is equal to target NGDP (NGDPT.) That replaces the Taylor rule. And by using a velocity futures market, you avoid the circularity problem discussed by Bernanke and Woodford (1997). QV is obviously a function of the nominal interest rate. (This is based on a 2006 Economic Inquiry paper I did with Aaron Jackson.)

There is nothing at all like the IS relationship, as equation 2 is simply an application of the EMH (plus the assumption that the NGDP futures price is an unbiased forecast of future NGDP.) The hours worked gap is the closest thing to a Phillips Curve.  If you want output gaps, you can derive them from the hours gap equation using a variant of Okun’s Law.  Once you have real output, you can also derive the price level, as NGDP is already determined.  But why would you want those things?  The hours gap equation measures the business cycle, and NGDP is superior to the price level as a proxy for the welfare costs of inflation.  And if it’s long run economic growth you are interested in, then why mess around with monetary models?

I see several differences between the standard approach and my toy model:

1.  I use NGDP futures prices, which is not subject to the ambiguity associated with nominal interest rates.  NeoFisherites will not misinterpret my policy equation.  And it’s more efficient, as it cuts out the middleman and uses open market operations to directly target NGDP futures, which is what you care about.

2.  My “Phillips Curve” uses NGDP and not inflation (the switch from unemployment to hours is not so important.)  Inflation is problematic, because it might reflect either demand or supply shocks. So the standard model needs to account for supply shocks.  NGDP is better, as it only reflects demand shocks, which are what drive any Phillips Curve relationship.  It simplifies things.

This is just a toy model; perhaps someone else can create a real model along market monetarist lines.  As a blogger this is the approach I like best.  As director of the Mercatus Monetary Policy Program, I want the model that the rest of the profession finds most convincing.  I imagine that would be something more along the lines of a Nick Rowe model.

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50 Responses to “Playing with toy models”

1. What's wrong with macro?, Scott Sumner | EconLog | Library of Economics and Liberty
15. January 2015 at 08:01

[…] than I am. I want people to develop good technical models of NGDPLT. I took a stab at it over at TheMoneyIllusion. But there's also a need to check out the underlying assumptions of these highly technical […]

2. David de los Ãngeles BuendÃ­a
15. January 2015 at 08:23

Dr. Sumner,

This story reminds me of some lines by William Shakespeare.

GLENDOWER: I can call spirits from the vasty deep.

HOTSPUR: Why, so can I, or so can any man; But will they come when you do call for them?

The welsh rebel Owen Glendower could indeed call the fearful spirits of the lower realms but has his fellow rebel Henry “Hotspur” Percy rightly notes what is important is having them respond. The Federal Reserve Bank (FRB), indeed any central bank, can set any target it wants and create expectations that it will trying mightily to achieve those targets but at the end of the day, what happens in the economy is what matters. The FRB has been providing “forward guidance” on inflation expectations for years now and has yet to achieve them. After seven years of setting inflation expectations at 2% (The Taylor Rule)[1] and never getting too very close, does any really take this forward guidance too seriously? The economy of the United States does not seem capable of producing that much inflation so targeting 2% is no more useful than 3% or 4%.

Why would targeting Nominal Gross Domestic Product (The McCallum Rule) prove any more effective? If the US economy cannot produce 2% inflation, why would it be able to produce say 5% NGDP growth?[2] The problem is not setting the target or in provide forward guidance to the market place that they central bank wants to achieve the target. The problem is that the economy may simply not be *able* achieve those targets. The United States is economy that exports most new capital formation and new domestic capital is for activities with low economic multipliers. Such an economy might simply be unable to generate inflation, low employment, or high NGDP, i.e. has inherently limited growth potential.

The economy of the United States is principally about making goods and providing services and then selling those goods and services to people who need or want them. This is the engine of economic growth. Monetary policy is the lubricant that allows the engine to turn, it however does not make the engine turn. No amount of fiddling with monetary policy will overcome fundamental industrial problems.

Owen Glendower’s problem was not that he could not target the appropriate spirits to call or that he did not provide the aforementioned spirits with adequate forward guidance as to what he wanted them to do but that no such spirits actually existed. The FRB’s problem is not that they have chosen the wrong target but that the US economy is not able to achieve that or any other meaningful target.

3. J.V. Dubois
15. January 2015 at 09:00

David: After seven years of setting inflation expectations at 2% …

Maybe this is the problem? FED actually never tried to set inflation expectations at 2%. There is a very convincing article by David Beckworth that FED actually targets a range of 1-2% inflation in all its forecasts (1,2 and 3 years ahead) for several years now: http://macromarketmusings.blogspot.sk/2014/03/what-is-feds-real-inflation-target.html

And that is even using FED own forecasts that they have history of failing again and again (because they did not actually target the forecast). There is a very old but very nice article about this by Evan Soltas here: http://esoltas.blogspot.sk/2012/08/the-fed-as-little-orphan-annie.html

This has to be repeated – how can anybody reasonably expect that FED will meet some supposed target if even according to FEDs internal forecast (not market forecast) they are not nearly hitting their target? Central bank literally admits that they will fail to hit their target and that they know it – but they will not do anything about this hence low forecast. For even more insane predictions just go read some ECB speeches about “inflation expectations well anchored” or similar nonsense.

4. The danger in ignoring money and monetary policy | Historinhas
15. January 2015 at 09:34

[…] by “Inflation Targeting” and money has “disappeared” from the conversation (models). Scott Sumner just […]

5. ssumner
15. January 2015 at 09:36

David, I don’t see where your comment has any bearing on my post. The post discusses Fed policy with “systematic errors.” Isn’t that what you are talking about?

You said:

“After seven years of setting inflation expectations at 2% (The Taylor Rule)[1] and never getting too very close, does any really take this forward guidance too seriously?”

Never getting too very close? Except for early 2009 they have ALWAYS BEEN CLOSE. Sometimes above 2% and sometimes below. The Fed claims they’ve gotten close, which is why they tapered last year and will raise rates this year.

You said:

“The economy of the United States is principally about making goods and providing services and then selling those goods and services to people who need or want them. This is the engine of economic growth. Monetary policy is the lubricant that allows the engine to turn, it however does not make the engine turn. No amount of fiddling with monetary policy will overcome fundamental industrial problems.”

Exactly my view. 100% my view.

There are many other mistakes in your comment, starting with the assumption that the Fed has a single mandate to target inflation. They have a dual mandate, it’s the ECB that has (mostly) a single mandate.

6. John Hall
15. January 2015 at 10:25

You could use a Kalman Filter to NGDPTt and Hnt.

7. ssumner
15. January 2015 at 11:20

John, Explain why I would want to do that.

8. Nick Rowe
15. January 2015 at 11:49

Scott: my model is about the role of relative shocks in your equation 1 (or McCallum’s equation 2), comparing IT vs NGDPT. I left off the demand side (the other equations). I was trying to model a bit more formally the sort of ideas Bill Woolsey and George Selgin and the rest of us talk about.

9. Ashton
15. January 2015 at 12:23

Scott, what do you attribute the cause of the Great Moderation to? Do you buy into (I think) Josh Hendrickson’s thesis that Greenspan was actually targeting nGDP instead of a Taylor-rule type formula?

Or did we just get lucky that rGDP growth was fairly stable?

10. Edward
15. January 2015 at 13:06

An interesting tidbit from Matthew Yglesias .

More evidence that the intuition: (rising wages and increasing rate of raising wages) is the correct signal to go by when you want to determine of labor markets are tightening

11. Edward
15. January 2015 at 13:06

http://www.vox.com/2015/1/15/7551475/job-openings-rate

I forgot the link. Here it is above

12. David de los Ãngeles BuendÃ­a
15. January 2015 at 13:10

Hello J.V. Dubois

I am certain that I agree with you. What else could the Federal Reserve Bank (FRB) have done to drive inflation higher? They purchased vast quantities of United States Treasury (UST) securities as well as from government-sponsored agencies such as Fannie Mae or Freddie Mac. How much more Open Market Operations could the FRB have conducted, how many more UST securities could they have purchased? What would the FRB have done differently if it had “really” targeted 2% inflation?

13. David de los Ãngeles BuendÃ­a
15. January 2015 at 13:34

Dr. Sumner,

1) Yes, not very close indeed. If one were look at the quarter over quarter change in the Personal Consumption Expenditures: Chain-type Price Index Less Food and Energy[1] between 2006 and 2014 one would see that there was only one quarter where the q/q percent change was more than 2% (2.089). The same results are obtained if one uses a year over year percent change[2]. This was achieved following a monumental effort by the Federal Reserve Bank (FRB) to stimulate inflation through the Large Scale Asset Purchasing (LSAP) program (see my response to J.V. DuBois above). Despite three rounds of very aggressive LSAP activity, core inflation just slightly exceed the target in one quarter which coincided with a very large LSAP purchase. There was little effect for such might work.

2) So my main point is that if the FRB was unable stimulate any significant amount of inflation despite “going all in” (as they say in the poker industry)and despite targeting target inflation and providing more than adequate “forward guidance”, why would the FRB be any more successful at by targeting Nominal Gross Domestic Product (NGDP)? How would Open Market Operations be any different under a NGDP targeting environment as opposed to a inflation targeting environment? What would the FRB have done differently in 2008 had they targeted NGDP as opposed to inflation.

It seems to me that the McCallum Rule would suggest very similar results to the Taylor Rule in the environment of 2008.

14. Justin Irving
15. January 2015 at 13:39

You can actually do latex type setting in wordpress:

if you’d just do $y_t$ to get a ‘y’ with a ‘t’ subscript, it’d be easier to follow the equations above. ditto \delta for lower case delta and \Delta for big deltas.

15. Don Geddis
15. January 2015 at 14:04

@David: You seem to be a person of the concrete steppes.

How much more Open Market Operations could the FRB have conducted, how many more UST securities could they have purchased?” Expectations are far more important than concrete OMOs. It is not the case, that if $1T in OMOs produced 1% inflation, that it would take$2T in OMOs to create 2% inflation. That’s not how monetary policy works.

Sumner already pointed you to the answer, but you didn’t respond. Why is it, that the Fed (for years now) has claimed that their target was 2%, but their own forecasts suggested that they were going to fall short of their target, and yet they also decided to “hold policy steady”, rather than doing more? Why, when they have consistently failed to achieve their supposed 2% target, is all the talk instead about when they would “taper”, and when and how much they would “raise rates”? If they clearly have fallen short of their supposed target, why is the conversation all about tightening money, instead of loosening it?

Is it possible that the Fed’s actual policy and/or target, is not in fact the 2% that they sometimes publicly suggest?

the FRB was unable stimulate any significant amount of inflation despite “going all in”” Where did you get the idea, that the Fed ever went “all in”? In the depths of the recession, Bernanke readily admitted that the Fed was not “out of ammunition”. When did the Fed ever announce a program that said: “we will continue exponentially doubling bond purchases every month, until we hit our 2% inflation target”? There are $12T in Treasuries available; the Fed (with “massive” purchases) only bought$2T of them, in all these years of recession. If inflation was below their target, why didn’t they buy another \$2T in a single month?

As monopoly owner of a fiat currency, the Fed has essentially infinite power over nominal aggregates. Unfortunately, the Fed seems to think much like you: “we tried this, and it didn’t work, so I guess we failed.” You both need to learn from Yoda: “Do, or do not. There is no try.”

16. Charlie Jamieson
15. January 2015 at 14:26

To get inflation, the Fed would need to buy houses or minivans or pay fast food workers — T-bond exchanges (purchases) were never going to do this.
Or the Fed would need to signal that it is ready to support a massive stimulus by buying newly issued T-bonds.
The Fed may suspect that if it went all in to induce higher inflation it might lose control of inflation altogether. The fear is that you have low growth and add to that inflation. These guys all came of age during the 1970s, after all.

17. TravisV
15. January 2015 at 15:24

Joe Leider wrote some good stuff on stock valuations…..

http://joeleider.com/investing/how-monetary-policy-will-affect-investors-in-2015

http://joeleider.com/investing/are-american-stocks-overvalued

18. benjamin cole
15. January 2015 at 16:33

Scott Sumner–Models are fine. But I suggest more important work for you at Mason. See my post at Historinhas.

19. Ray Lopez
15. January 2015 at 21:06

David de los Ãngeles BuendÃ­a and Charlie Jamieson are 100% correct. Sumner et al ignore them. Japan is another example of a country that tried but failed to generate inflation, despite their best efforts. The only thing printing money does is increase public debt, which will have to be unwound with hyperinflation or default. As Jamieson says, only if the government employed fiscal policy, NRA-style, could it affect inflation and output, and we all know government is not the best steward for spending money.

20. Ray Lopez
15. January 2015 at 21:08

From the paper Sumner cites on the absence of money demand in the equations: “There is, however, no compelling theoretical basis for that assumption, which is presumably made for analytical convenience. Indeed, it could be argued that separability is not very plausible. Accordingly, the absence of any real balance term in (1), and the omission of monetary variables from model (1)-(3), hinges on the presumption that nonseparabilities of the relevant type are quantitatively unimportant””i.e., that the marginal utility of consumption is (for a given rate of consumption) virtually independent of the level of real money balances. The justification for that presumption has not been explicitly discussed in the studies cited. … Third, the profession’s poor level of understanding of the precise nature of the dynamic connection between monetary and real variables””i.e., of price adjustment relations””has tended to reflect discredit upon monetary economics, although this relation belongs to the realm of macroeconomics more broadly.”

In short, the models Sumner cites are simplistic caricatures. Also of interest from the paper: sticky prices were not expressly accounted for in the models during 1982-1992, showing how trivial it was considered to have sticky prices (which anyway the Real Business Cycle school correctly dismisses sticky prices).

21. Major.Freedom
15. January 2015 at 21:24

Denationalisation of Money: The Argument Refined

[Hayek] wrote this near the end of his career, after thinking through all the economic arguments for monetary reform and examining the political viability of various proposals. He shows the essential unviability of government money, and calls for a complete free market in the production and distribution and management of money.

This book is the very core of the Hayekian approach to monetary policy, and the book that drew the world’s attention to this radical thinker following his Nobel Prize in economics. The argument is substantively similar to Mises’s but rather than a gold standard, Hayek argues for completely abandoning government attempts to reform money. The result would be competitive private currencies that permits the market alone to choose the dominant currency the world over.”

22. Ray Lopez
15. January 2015 at 23:13

@Major.Freedom – at one level, Sumner’s Target NGDP proposal, with a viable futures market in NGDP, is somewhat like “crowd sourcing money” of the kind you and Hayek approve of. Remember, even with free banking and fractional reserves, you can have a vast expansion of the money supply. My problem with targeting NGDP is that I don’t think it will be stable due to volatile NGDP futures prices (and as I say in another post if you ‘peg’ the NGDP price you are no longer depending on crowd sourcing but rather simply adopting a discretionary monetary policy, as we have today), and, more importantly, I don’t think monetarism will really help real GDP, since I don’t really believe in sticky prices (at all) or sticky wages (that much, though granted for large corporations they do exist).

23. Ray Lopez
16. January 2015 at 01:00

@Major.Freedom – I am reading the Hayek book you provided, thanks again. Below is a passage that suggests, as I suspected, Hayek is essentially a sort of Monetarist like Friedman, like Sumner, and indeed, if you assume that nominal GDP affects real GDP (‘money illusion’), via either fiscal or monetary policy, like Keynes (through fiscal policy). Very interesting but I think ultimately flawed. – RL

“To dispel one kind. of doubt which I myself at one stage entertained about the possibility of maintaining a stable price level, we may briefly consider here what would happen if at one time most members of a community wished to keep a much larger proportion of their assets in a highly liquid form than they did before. Would this not justify, and even require, that the value of the most liquid assets, that is, of all money, should rise compared with that of commodities? The answer is that such needs of all individuals could be met not only by increasing the value of the existing liquid assets, money, but also by increasing the amounts they can hold. The wish of each individual to have a larger share of his resources in a very liquid form can be taken care of ***by additions [BY WHOM? CENTRAL BANKERS? – RL] to the total stock of money***” – Denationalisation of Money -The Argument Refined An Analysis of the Theory and Practice of Concurrent Currencies by F. A. HAYEK Nobel Laureate 1974 (emphasis added)

24. Ray Lopez
16. January 2015 at 03:34

@myself – re BY WHOM? above, I see Hayek is proposing more money be issued by competing private banks, not by central banks, citing even UK’s Nigel Lawson for considering this proposal (!).

My question to Sumner fans is this: does anybody know what the concrete steps are for the Sumner Targeting NGDP framework? Sumners writings are too vague. He could respond in a post and clarify things but he prefers I think to be vague. I see two forms of Sumner’s Target NGDP, a “good Sumner” and an “evil Sumner” version. First the good Sumner: Sumner’s central bank somehow sets a target NGDP (“peg”) from a futures market. Suppose the expected NGDP is low or negative, so the peg is set to some higher NGDP. The central bank then prints money / ‘open market operations’ buying bonds (either one is fine, either by using existing money or printing new money). The central bank stops doing this expansion when the futures market shows improved GDP (not the actual NGDP figures). Fine. This is sort of what is already occurring now with discretionary Fed rules and market sentiment gauged by the Fed. Now the evil Sumner: the central bank does the same as above, but instead of relying on the futures market for NGDP, the Fed awaits actual NGDP figures, which come out every quarter. The Fed will keep printing money until these actual figures come out and show the target has been reached. Since an economy is non-linear, often the data is not what you expect or erroneous, so imagine if the Fed keeps printing money when in fact NGDP has recovered (data error), or, just as bad, if there’s a lag between the correct NGDP figure and the initial NGDP figure. Now the Fed is irresponsibly printing money, causing potential malinvestment, stagflation, or even hyperinflation. Which is the real Sumner? Or is it none of the above? If Sumner wants the public to adopt Targeting NGDP, he best be more specific.

25. Nick
16. January 2015 at 04:03

Ray,
Are you trying to ask if prof sumner personally prefers using a rule-based framework built on market priced indicators of ngdp to a discretionary policy based on survey measures of ngdp? I don’t think he’s been vague about this at all. He prefers the first one.
It’s sort of interesting to ask how effective the second one might be. There’s a fine argument that ‘discretionary policy based on surveys of ngdp growth’ better describes Greenspan’s tenure than any of the rules he claimed to be following.

26. Ray Lopez
16. January 2015 at 05:42

@Nick – Ok I’ll take your word on it. If you have any more information other than the one paragraph you provide let me know. Hopefully Sumner will be more explicit when he works at Mercatus and has more time to blog.

In other news… Wood, G. Are central banks necessary?, in F. Capie & G. Wood (eds), Unregulated banking: chaos or order? (Basingstoke: Macmillan, 1991). – http://www.buckingham.ac.uk/directory/professor-geoffrey-wood/

A giant, a kind of UK Selgin. Compare to Sumner.

27. ssumner
16. January 2015 at 06:06

Nick, Yes, but I’d add that my “musical chairs” approach is based on wage stickiness and shocks to the total stream of nominal wage stickiness. That’s quite different from the structure of most other macro models.

Ashton, I have an open mind on that question, but I doubt it was luck. Other developed countries also achieved good results. I think most central banks, including the Fed, have discovered that it’s actually pretty easy to stabilize the economy when rates are positive. I also believe that it’s pretty easy when rates are zero, but others haven’t gotten there yet.

David, Good point, but they’ve generally been within 1%. And don’t forget they have the dual mandate. On the other hand I certainly agree they’ve been too tight. But if they missed on the low side by less than 1% under NGDPLT, I’d be thrilled. So your point is not a good argument against NGDP targeting.

You said:

“So my main point is that if the FRB was unable stimulate any significant amount of inflation despite “going all in” ”

This is simply factually incorrect, and it’s not even debatable. Bernanke said they could have done much more. I say they could have done much more. The markets say they could of done much more. You say they couldn’t, with no evidence. Who are we to believe? I say the markets? Why did they end QE1? Why end QE2? Why end QE3? Why are they planning on raising rates this year? The answer is always the same, they are satisfied with the pace of growth.

Are you going to claim the SNB did all they could yesterday?

Charlie, The higher the inflation rate the less QE—the smaller the ratio of the base to GDP.

Ray, You said:

“Japan is another example of a country that tried but failed to generate inflation,”

More humor??

You said:

“In short, the models Sumner cites are simplistic caricatures. Also of interest from the paper: sticky prices were not expressly accounted for in the models during 1982-1992, showing how trivial it was considered to have sticky prices (which anyway the Real Business Cycle school correctly dismisses sticky prices).”

Thanks for telling me these models are simplistic caricatures, I never would have guessed.
An award to anyone who is able to identify any cohesive point of view in Ray ramblings. Has he switched from left wing Keynesian to RBC economist?

28. David de los Ãngeles BuendÃ­a
16. January 2015 at 10:47

Hello Dr. Geddis,

I am not entirely certain that I understand your point. Are you saying that the Federal Reserve Bank had the ability to achieve a sustained 2% inflation rate but, contrary to their public states they “really” targeted 1.5% inflation or are you saying that they tried to achieve a 2% inflation rate but gave up too early?

The FRB has three elements to its inflation stimulating policy:

1) Signaling: The FRB can commit to a zero interest policy for a much longer period of time than normal monetary policy would suggest[1]. This is what Dr. Eggertsson called “committing to being irresponsible”[2].

2) Large Scale Asset Purchases: This will reduce interest rates through portfolio balancing channel[1].

3) Bank Lending: This can help resolve the time inconsistency the first two steps and when they have an impact on the economy.

The FRB has been applying all three of these actions since 2008.

You wrote:” Expectations are far more important than concrete OMOs.”

If this is so, the FRB has clearly been been working very diligently at developing increasing inflation expectations. What part of this strategy indicates either the FRB “gave up” on stimulating inflation or “really” never targeted a 2% inflation target? Only Open Market Operations (OMO) have been “tapered”, the other two elements have not been tapered. I will note that increases in OMO had measurable impacts on short term inflation[2].

To me at least, this would suggest that the FRB was indeed serious about targeting a 2% inflation rate and took extraordinary efforts to stimulate inflation. Could the FRB have conducted more OMO? There are risks to the economy by vastly increasing the spreadsheet of the FRB. The FRB appears to have been reluctant to increase that risk given the limited impact OMO was having on inflation. Since you seem to believe that OMO is less important than other channels, I do not see why that would be considered important.

However, my point is that ultimately, over the long term, inflation is driven by economic growth, not monetary policy. Using Fishers Equation (MV = PQ), deltaQ (Nominal Gross Domestic Product) is more important than deltaM (Money Stock). If the underlying economy is unable to grow, all of the monetary policy in world will not change that.

This is why I do not believe that it makes any difference to target NDGP versus inflation. An economy where most capital is exported simply cannot grow very fast (delta Q ~0) and thus inflation will similarly be low (delta P ~0)so noodling about with monetary policy (delta M)can at best have only small impacts.

[1]https://www.tumblr.com/blog/corepcevsfrbholdingsustdebt

29. CA
16. January 2015 at 13:28

Mike Konczal is trying to “finesse” his previous claim about what happened in 2013.

http://www.nextnewdeal.net/rortybomb/what-happened-2013-two-clarifications-among-current-debates

30. Don Geddis
16. January 2015 at 15:31

@Ray Lopez: “The only thing printing money does is increase public debt” Sorry, go through your model here in a little more detail? How, exactly, does printing money increase public debt?

Most people view monetary stimulus (printing money) as an alternative to fiscal stimulus (increasing debt). But somehow, you think one causes the other. Can’t wait to hear your explanation of how that works.

31. Don Geddis
16. January 2015 at 16:09

@David de los Ãngeles BuendÃ­a: “Are you saying that the Federal Reserve Bank had the ability to achieve a sustained 2% inflation rate” Yes.

but, contrary to their public states they “really” targeted 1.5% inflation or are you saying that they tried to achieve a 2% inflation rate but gave up too early?” No, neither of those. The Fed is a political organization, and decisions are compromises from multiple influences. The Fed’s actions are not necessarily a result of any single coherent macro model.

FRB has three elements to its inflation stimulating policy” Even here, you remain focused on interest rates (and banks). “zero interest” and “reducing interest rates” and “bank lending”. This is confusing you. Monetary policy is much clearer if you think instead about changes in the money supply (and ignore bank lending).

FRB has clearly been been working very diligently at developing increasing inflation expectations.” False, but Sumner already addressed this above. The Fed has taken numerous steps to reduce monetary stimulus, despite falling short of its supposed goal. (And this includes public conversations about “the risks of a large balance sheet” and “popping bubbles” and “risks of financial instability” — all of which are offered as justifications for reducing monetary stimulus.)

There are risks to the economy by vastly increasing the spreadsheet of the FRB.” That claim is often stated, but seems to have little justification (either theoretical or empirical). And now you yourself have given yet another reason why the Fed didn’t actually “go all in” to attempt to create inflation. You’ve begun to answer your own question.

inflation is driven by economic growth, not monetary policy” Really? Can you then explain the relative price level in Japan vs. the US? Why does a gallon of milk cost about 3 local currency units (dollars) in the US, but it costs about 750 local currency units (yen) in Japan? Are you trying to assert that Japan had real economic growth that was two and half orders of magnitude greater than the US?

(MV = PQ), deltaQ (Nominal Gross Domestic Product) is more important than deltaM (Money Stock)” Sure, I get MV=PQ. But how do you get from that, to conclude that dQ is more important than dM? It certainly doesn’t follow from the equation. [BTW: “deltaQ” is “change in real quantities”, not NGDP. NGDP is MV or PQ.]

If the underlying economy is unable to grow, all of the monetary policy in world will not change that.” I can’t see where you’ve provided any evidence of that. If I increase the money supply by a factor of 10, I certainly expect the price level to settle many multiples above its current values. Going back to MV=PQ, what do you expect to happen to the other variables, when M increases by a factor of 10?

32. ssumner
16. January 2015 at 19:30

Thanks CA.

Don, Please tell me Ray did not say that.

33. Ray Lopez
16. January 2015 at 21:16

@Don Geddis – You said: “@Ray Lopez: “The only thing printing money does is increase public debt” Sorry, go through your model here in a little more detail? How, exactly, does printing money increase public debt? Most people view monetary stimulus (printing money) as an alternative to fiscal stimulus (increasing debt). But somehow, you think one causes the other. Can’t wait to hear your explanation of how that works.”

Debt is debt, regardless of who holds it (whether held by the government–public debt–or held by Fed-member banks, private debt. Recall that the Fed has two ways to change the money supply (and hence debt): either print money, or, buy/sell existing government bonds by changing the interest rate paid. The first way has the potential to create inflation, since it’s ‘new money’ but so does the second way since changes in interest rates will also stimulate borrowing (unless, as now, people don’t want to borrow, but banks will take this Fed money and earn 0.25% interest on it, so it’s still absorbed by the economy). If the US Treasury is doing the borrowing, then it increases public debt, otherwise, the debt is increasing in the private sector. I hope that’s clear enough for you. And you did not do justice to David de los Ãngeles BuendÃ­a in your simplistic knee-jerk answers to him.

34. ssumner
17. January 2015 at 06:46

Ray, You said:

“Recall that the Fed has two ways to change the money supply (and hence debt): either print money, or, buy/sell existing government bonds by changing the interest rate paid.”

If you only knew how funny some of this stuff is. Everyone else is ROLF and you are missing out on all the fun.

35. David de los Angeles Buendia
17. January 2015 at 08:22

If what you write is true, then how would switching the monetary policy target to Nominal Gross Domestic Product (NGDP) produce better results than targeting inflation? If the Federal Reserve Bank (FRB) failed to adequately target inflation, then there is no way of knowing if targeting inflation is effective since they did not “really” target 2%. Further, if they failed to “really” target inflation, will they not also not “really” target NGDP? After all, the tools to target any monetary policy goals are the same, Signaling and Open Market Operations (OMO). If the FRB was unwilling or unable to adequately signal their intent to meet inflation targets and conduct the necessary OMO, why would they be able to adequately signal their intent to meet NGDP targets and conduct the necessary OMO? If the FRB will not cannot follow through on targets, what difference does it make what they target?

36. Ray Lopez
17. January 2015 at 09:07

@Sumner – “Ray, You said: “Recall that the Fed has two ways to change the money supply (and hence debt): either print money, or, buy/sell existing government bonds by changing the interest rate paid.” If you only knew how funny some of this stuff is. Everyone else is ROLF and you are missing out on all the fun.”

Sorry, but I don’t get it, and I suspect many of your readers don’t get it either. Do you deny that the Fed can print money out of thin air to expand the money supply? That it can buy/sell government bonds to expand/contract the money supply?

Jokes on you, Mr. Obscurantist.

37. Don Geddis
17. January 2015 at 09:11

@David de los Angeles Buendia: “If the FRB will not cannot follow through on targets, what difference does it make what they target?

I think that’s an excellent question, and worth a careful answer. I’m not sure that I have a perfect answer for you. I’ll give you my best guess; perhaps others here can offer you better ones.

1. The Fed made the mistake of treating interest rates (which have a zero bound) as their policy tool. So the public (and perhaps even the Fed itself) gets confused about what to do at the ZLB. Making a conceptual switch to use the money supply instead of interest rates, eliminates the “there’s nothing more we can do!” false barrier.

2. Inflation was the dog that didn’t bark in 2008. Under those economic conditions, IT central banks could delude themselves into thinking that they were correctly doing their jobs, even as the macro economy crashed. NGDP more accurately reflects the state of the economy, and prevents confused central banks for offering justifications to continue mismanaging the economy.

3. The usual MM proposal is NGDPLT. The “level target” is the third important point. We’ve now had seven years of below-target inflation. What goals do the central banks have for next year? They ignore their past failures, and just try to hit the same target again. With level targeting, each past failure would cause the very next target to rise steeply. Even if they kept inflation targeting, the conversation wouldn’t be “you’re trying to hit 2% inflation, but you only managed 1.5%; well, that was close.” The conversation would be: “due to past failures, you are now trying to hit 10% inflation this year. You have only managed 1.5%. You are far, far off target. What emergency measures will you now take in order to get closer to your 10% target?”

Those would be my answers: ignore interest rates, use a more accurate signal, and level target.

38. Ray Lopez
17. January 2015 at 09:39

@everybody– just to show what an obstructionist and obscurest Sumner is, apparently he is taking issue with this statement of mine: “Recall that the Fed has two ways to change the money supply (and hence debt): either print money, or, buy/sell existing government bonds by changing the interest rate paid”, since I suppose ‘by changing’ is not precise enough for Sumner, who prefers maybe ‘thus affecting’. The details can be found here http://en.wikipedia.org/wiki/Open_market_operation#Process_of_open_market – it is clear that OMO purchases and sales of securities through the System Open Market Account (SOMA) ‘affect’ the interest rate, which any reasonable person except Sumner would conclude ‘changes’ the interest rate. This is the sort of person that we are expected to trust with formulating a new framework for a 16 trillion dollar economy? Methinks not.

39. Negation of Ideology
17. January 2015 at 15:09

“An award to anyone who is able to identify any cohesive point of view in Ray ramblings. Has he switched from left wing Keynesian to RBC economist?”

I think I’ve got the cohesive point. Everything Scott Sumner thinks, Ray Lopez argues the opposite. Call it Sumner-contrarianism.

40. Negation of Ideology
17. January 2015 at 15:09

Do I win the award?

41. ssumner
17. January 2015 at 15:22

Ray, The joke was claiming that that single method was “two ways.”

Negation, You win, let’s shorten it to “Sumtrarianism.

42. Don Geddis
17. January 2015 at 15:35

@Ray Lopez: “Thus affecting” is not more precise than “by changing”. It’s totally different. It completely changes causality. The words you try to use have actual meaning, and the meaning you wrote was wrong. If you were honest, you’d admit that.

Oh, and also, for chuckles, why don’t you try to explain “(and hence debt)” also. I can’t wait.

43. Major.Freedom
17. January 2015 at 16:54

“”Thus affecting” is not more precise than “by changing”. It’s totally different. It completely changes causality.”

No it doesn’t. If an action affects something, then we can also say that the action is changing that something.

The causality is not different. The causality is still from action to the change in the something.

Words do have meaning, but you seem to want to engage in linguistic prescriptivism rather than address the point.

Sumner only calls Ray’s posts rambling so as to give himself an excuse not to engage the content which shows flaws in what he writes.

Everyone who posts to this blog are understandable. What is your shortcoming?

44. Major.Freedom
17. January 2015 at 17:00

When Ray spoke of CBs expanding the money supply by buying government debt, obviously the statement “by changing interest rates” does not mean the Fed buys debt by way of interest rates, or expands the money supply by way of interest rates. It just means that buying debt increases the money supply, which justs so happens to affects interest rates.

Sure it could have been written more clearly, but it is not as if you are the standard bearer for clarity. Sumner does not pick on the grammatical issues of his goons.

45. Major.Freedom
17. January 2015 at 17:25

Sumtrarianism: The act of refuting Sumner but with spelling/grammar mistakes.

46. Ray Lopez
17. January 2015 at 20:09

@MF -that’s right, correct. And BTW if more people knew how easily the Fed can print new money and expand the money supply, by the push of a button, they would be up in arms. It’s good that the Fed practices obscurity by keeping the details of Open Market Operations secret.

PS–reading George Selgin’s book “Less Than Zero”, written in 1997, and it is excellent. Advocates a monetary framework that lets prices *fall*, not just stay with zero inflation or rise as they have since WWII.

47. ssumner
19. January 2015 at 06:54

Ray, Glad you agree it’s an “excellent” idea to let prices fall. NGDPLT does that too.

48. Ray Lopez
19. January 2015 at 19:59

Sumner: “Ray, Glad you agree it’s an “excellent” idea to let prices fall. NGDPLT does that too.” – so you say.

You need to prove these claims with more explicit writing and with models. Right now you’re just making one-line assertions. The conventional wisdom from your critics (and one reason I’m against you, since me and my family have money, being in the 1%) is that your scheme is inflationary, a sort of disguised way to print boatloads of money. Maybe when you have more time at Mercatus Center you can show your framework allows for falling prices. N.B.–why are prices seemingly sticky? Well for one thing, the present inflationary monetary framework does not allow for falling wages that easily, since “Cost of Living” allowances increase the wage rate every year (especially for Federal workers, who are overpaid anyway). This however confuses ‘real’ price declines with ‘nominal’ price declines, not that the public is confused with such claims, since they understand inflation better than some economists.

49. ssumner
20. January 2015 at 06:27

Ray, I’m not the NGDP guy, the idea has been around forever. There are lots of “models”, lots of papers. Why not read George Selgin on why NGDP targeting lets prices fall? Why keep bothering me?

OK, here’s my model. Suppose RGDP growth > NGDP growth

Prices fall.

QED.

Was that too hard for you?

BTW, I don’t want to convince you that NGDPLT is a good idea. It would be a disaster having an idiot like you on our side.

50. Major.Freedom
22. January 2015 at 21:34

The NGDP guy just claimed that NGDPLT will let prices fall…

…provided productivity growth is higher than 4.5% per year.

I’m very happy I’m not on the intellectual side of primitive thugs who want monetary socialism, but I am happy that I’m on Sumner’s side in practise, because when it comes to practise, he’s anarcho-capitalist, which means peace and respect for property rights in his actions.

His words contradict his actions, mine do not. I don’t have to call anyone “idiots”, as I take comfort in knowledge and in thinking, rather than using it as a weapon as in MM.