Scott Sumner and David Beckworth are vocal in their defense of NGDP targeting over inflation targeting.

I want to start by saying I applaud the efforts of both economists to raise attention to the issue of insufficient aggregate demand and means by which the Federal Reserve can combat it. Economists and economic philosophers have long recognized the important role that the quantity of money plays in the business cycle.

Since the work of Milton Friedman, many of us have come to the conclusion that money and credit are the primary drivers of fluctuations in economic activity. Scott and David are calling our attention to the need to act on such knowledge to alleviate human suffering. This is the highest and best role for scholars within our society.

However, the case for supporting a target for Nominal GDP is by no means open and shut. There are at least four reasons why this is the case, two academic and two practical. I will begin with the academic.

First, instability. It is at least a theoretical possibility that Nominal GDP target could lead to instability because prices and output do not respond at the same time to a single action by the Fed.

Suppose that we enter a credit bubble where nominal spending expands rapidly as credit risk is underpriced. Such a bubble would show up as a rise in Nominal GDP. The Fed would respond by tightening the money supply.

Tightening would have the immediate impact of raising unemployment and bringing real GDP down. Nominal GDP would fall as well and the Fed will meet its target.

Over the next 18 months, however, the rate of inflation would trend down in response to tightening. This would lead the Fed to loosen money. Unemployment would fall, Nominal GDP would expand and the Fed would hit its target.

However, over the next 18 months, the rate of inflation would trend up wards in response to looser money. The Fed would tighten money. Unemployment would rise, Nominal GDP would fall and the Fed would hit its target.

However, over the next 18 months . . .

This process could in theory continue indefinitely. The Fed is hitting its target every time but because the same policy instrument effects the different parts of Nominal GDP at different times a permanent instability is induced. Both unemployment and inflation are high in one period. Both unemployment and inflation are low in the next. Nominal GDP is stable but the variables of interest are not.

There are perhaps ways of combating this but we should be aware of the risk.

Second, changes in productivity growth rates. We have seen at least two secular changes in productivity. The slowdown of the 1970s and the speed-up of the 1990s. Both of these changes in productivity will tend to alter the rate the trend rate of Nominal GDP.

In the 1970s the Fed would have responded to the change in trend with expansionary monetary policy raising the rate of inflation unnecessarily. In the 1990s the Fed would have responded with contractionary monetary policy leading to unnecessarily heightened unemployment.

Note that these are not the policy responses to simple shocks but the policy responses to changes in trend.

Those are two academic reasons for being somewhat wary of a Nominal GDP target. The next two reasons are more practical in nature.

First, we have extensive experience with inflation targets and we can even speak a little to practical aspects of creating them. For example, many have noted that point targets actually result in more monetary flexibility than ranges. These type of experience lessons are valuable. Moving to an NGDP targeting regime would eliminate them.

I recognize that this is merely a restatement of the “First Mover Disadvantage” inherent in policy making. It is always better if the other guy makes the mistakes first and you can learn from him. At the same time the disadvantage is real and cannot be ignored, especially when one is dealing with the largest economy in the world and the international reserve currency.

Second, inflation is a topic which the financial community has a lot of experience with and a lot of concern over. It is clearly and without a doubt meaningful when we speak to financial actors about inflation targets.

Moreover, the general public does not internalize the Phillips Curve. It is hard enough to convince them that inflation might be good. If we start saying that the Fed is going to target growth then I am certain they will accuse us of thinking that we can “print growth on the printing press” and that we don’t even understand that printing money just produces more inflation.

I would judge it easier start by focusing on the fact that money does cause inflation, a fact which the public accepts, and then try to convince them that a little inflation is a good thing. This is merely a judgment, however, and I have no hard data either way.

I will say, however, that I very much like David Beckworth’s framing of a “National Spending Target.” This seems like an idea that we could work from. Though, I still think we will run into the  “these guys think spending = growth” problem.

So, I recognize and very much appreciate the attention that both Sumner and Beckworth have brought to this problem. I hope the will continue with their excellent work. However, at the same time I do not think that we should be whole heartedly committed to an NGDP target especially when the relatively low hanging fruit of an inflation target may be within reach.

About these ads