This is basically a note to myself, but may be of interest to some of you. I have been thinking lately about nominal GDP targeting. The idea in itself is old, but it has received a lot of attention in the blogosphere post 2009. I want to know under which conditions NGDP targeting produces different results than an inflation targeting regime.
So, to get a first intuition about this, I took the standard ASAD model from the shelf. I transformed everything into growth rates or, if you want to look at it differently, into deviations from the steady state equilibrium. Then I plugged in simple characterizations of the two different policy regimes. And the result is this: A minimalist ASAD analysis of NGDP targeting.
The basic insight is that NGDP targeting requires that any shock to aggregate demand (positive or negative) be completely offset by monetary policy while supply side shocks be neglected. In other words, NGDP targeting fixes the position of the AD curve and doesn’t worry about the position of the AS curve. Inflation targeting, on the other hand, demands that monetary policy takes into account both AD and AS shocks. As my little modelling exercise shows, there is a tight correspondence between the two regimes in the sense that for every given NGDP target there is an inflation target that produces the exact same path of real output and inflation as the NGDP target, and vice versa. I also show that if there were no supply side shocks, only demand shocks, the two regimes are equivalent. The difference between the regimes lies only in how they react to AS shocks: an inflation target tends to amplify the effects of AS shocks on output, the NGDP target doesn’t. Hence NGDP targeting tends to produce smaller fluctuations in real output growth than an inflation target.
So, if you believe macroeconomic shocks are mainly due to aggregate demand, you should be indifferent between the two regimes.
My recent background reading on all things monetary economics has often led me to stumble on what is generally dubbed the Friedman rule for optimal monetary policy. As the name already implies, it is the result at which Friedman arrived when trying to derive how a central bank should set its nominal interest rate in order to achieve the best, most socially desirable outcome. The logic behind it is simple. Interestingly enough, even Friedman assumed that money was indeed not neutral, essentially for reasons similar to the mundell-Tobin effect: money always pays 0% nominal interest rates. Yet, people still both want and need to hold money, so the optimal policy in this world is one were the opportunity costs of holding cash is minimized, which means setting the nominal interest rate in the economy also to zero. This implies that the optimal inflation rate is should be negative – negative the real interest rate, to be precise. This finding seems odd, and is obviously very different from what central banks do in practice.
First of all, holding cash does indeed bring higher opportunity costs if the nominal interest rate set by the central bank is positive. Yet, of course, holding money also has benefits, the most important of which is liquidity. As such, it would seem that these benefits, that no other financial asset offers in the same degree, should seem to alter the optimality rule. Setting nominal interest rates to zero in this setting would seem to “unfairly” make money more attractive than comparable assets, and present a distortion in and of itself. The only way to argue that these benefits should not be taken into consideration would be if these private benefits were of the same magnitude as the social benefits they bring, which might but also might not be the case. Also, some have argued that inflation should be positive since it can be the only way to tax things that we would want to tax but often find hard to do (like tax evasion, for instance), but also for a whole slew of other reasons.
But, and more importantly, this “friction” from the demand of fiat money is the only friction entailed in the model. Yet probably one of the most vital things that Keynesianism taught us is that prices are sticky, particularly when it comes to the downside. This assymetry also means that the optimal inflation rate is not zero, but positive to take into consideration the natural “variance” of inflation. There is, of course, no way that a policy that calls for considerable negative inflation rates can be optimal in the real world, and even though the inflationary 70s did represent a major defeat of the type of Keynesianism found both in practice and in theory at the time, throwing all of it overboard, as evidently done by Friedman and others in coming up with this not-so-optimal monetary policy rule was a horrible idea that thankfully was never implemented. To be fair, even new Keynesian models find that the optimal inflation rate is considerably lower than the one used in practice, which is puzzling, but at least they include many of the real world issues we face to come to the conclusion.
Bear with me for a second – I obviously do not mean that literally. But at the same time, it wasn’t really strictly literally back then either. As Christina Romer puts it, what we needed back then and what we need now is a regime shift – while the precise nature of that regime shift is considerably less important. What the gold standard did was essentially limit the ability of central banks – which in many cases back then hadn’t even existed for all that long – to ease monetary policy when times most required it. In other words, it was a monetary regime that might work fairly well as long as everything else works fairly well. Put differently, it works at times when we might be just fine having no central bank at all to begin with. In that sense, the current strict inflation target by the ECB in particular (but also inflation targeting in general, as many other central banks around the world face similar issues) is actually remarkably similar, even if it does represent a vast improvement. The Fed’s fairly sluggish action in late 2007 and the beginning of 2008 was in large part due to fears of rising headline inflation. The ECB’s failure to act now is largely due to overall inflation in Europe remaining fairly stable – even while unemployment keeps rising and rising. Back in the 30s, central banks were held back by the supply of a metal the worth of which, for most intents and purposes, has baffled economist for centuries. Today’s central banks are held back by a basically randomly chosen number linked to a just as arbitrary basket of goods and services that is supposed to stabilize the overall economy – and yet has proven not to do so when needed the most.
As such, today, just as in the 1930s, what we need is for central banks to get rid of the chains that prevent them from doing their job when we need them the most. Let’s get off the gold standard. Not literally, of course – but it’s time, once again, to face the fact that our current way of doing things means, just as it did back then, strongly restrictive monetary policy when monetary policy should be loose. As pointed out by Katharina in the comments to one of my previous posts, having countries leave the Euro would of course be an option. I don’t think we have to go with the nuclear one though. Giving the ECB at least a dual mandate like that of the FED would be a start, if only a timid one. Nominal GDP targeting would certainly help as well.