Expectations and NGDP Targeting: Supply-Side Problems with Demand-Side Policy.

Author:Salter, Alexander William
  1. Introduction

    The aftermath of the Great Recession has revived the debate over macroeconomic stability and monetary policy. Some economists, such as John Taylor (2008, 2014), believe the Federal Reserve's monetary policy was too expansionary during the crisis, while others, such as Scott Sumner (2012a), believe it was not expansionary enough. Taylor and Sumner agree, however, that Fed policy would be improved by abandoning discretion and adopting a rules-based monetary policy. One such proposal is that the Fed should target nominal income (NGDP) rather than inflation and GDP growth separately. The goal of stabilizing nominal income was recommended by F. A. Hayek as early as the 1930s, (1) but has recently been revived as a promising proposal for rules-based monetary policy. (2)

    NGDP targeting can be thought of as the attempt by a monetary authority, typically a central bank, to provide a stable nominal anchor for the economy. Market forces are solely responsible for choosing the level of real variables, resulting in allocatively neutral demand stabilization. This situation minimizes the need for costly wage adjustments and other price adjustments across the economy in the event of a shock. If the shock is nominal (demand side), NGDP targeting reverses it. If the shock is real (supply side), NGDP targeting facilitates the least-cost transition to new equilibrium levels of familiar macroeconomic variables. In theory, NGDP targeting improves on existing programs for macroeconomic stability such as inflation (or price level) targeting, which yields suboptimal results in the presence of supply shocks, or variations on the Taylor rule, which place a significant knowledge burden on monetary policy makers and confine them to "steering the car while looking through the rear window."

    This paper discusses one potential problem with NGDP targeting. This problem is theoretical, rather than practical. (3) In other words, it has to do with NGDP targeting regimes at their most general, rather than any particular strategy for implementing such a regime (with one possible exception, discussed further in the conclusion). Stated briefly, the problem is that NGDP targeting has left unidentified the form of market-actor expectations necessary for it to achieve its intended purpose. If, for some reason, market actors have a different mental model of the economy than the monetary authority does, a given NGDP target can shoehorn the economy into a suboptimal inflation-growth breakdown. The purpose of this paper is to describe the problems that expectations asymmetry creates for NGDP targeting. Within the institutional framework of central banking, an NGDP targeting rule might be the best choice of policy, but as with any policy, it is important to fully understand the benefits and costs.

    The remainder of this paper is organized as follows. In section 2, we briefly recap the theoretical foundations of NGDP targeting in monetary equilibrium theory. This discussion is important for understanding why proponents of NGDP targeting believe that, in the event of shocks, a return to the preshock trend path is credible to market actors. Section 3 introduces supply-side concerns, which potentially cause the system developed in section 2 to break down due to market actors' structural beliefs about the economy. In section 4, we illustrate this issue in a simple three-equation New Keynesian model. Finally, in section 5, we conclude by discussing regimes that are least sensitive to these problems and the importance of understanding the link between the demand side and the supply side of the economy.

  2. Monetary Equilibrium, NGDP Targeting, and Trend Paths

    To understand why NGDP targeting can be effective in ameliorating shocks, but why this effectiveness is sensitive to market actors' expectations, it is necessary to briefly discuss the theory behind NGDP targeting. Monetary equilibrium theory--really just the extension of Marshallian insights to individuals' decisions to hold money balances--is the key to understanding NGDP targeting. Individuals chose to hold a portion of their income as cash balances; economy-wide, this translates into nominal money demand equaling a fraction of total nominal income:

    [M.sup.D] = kPy

    where k [member of] (0,1) and Py, the price level multiplied by real income, yields nominal income. The nominal money supply under current monetary institutions is set by the central bank and is invariant with respect to the price level:

    [M.sup.S] = M

    Equilibrium requires [M.sup.D] = [M.sup.S] and hence:

    M = kPy

    When monetary equilibrium prevails, individuals hold as much cash as desired at the current price level in a given time period. In monetary equilibrium, money is neutral. The existence of a medium of exchange facilitates mutually welfare-enhancing trade but does not alter the structure of relative prices in the economy, and hence does not affect the allocation of resources.

    Preserving monetary equilibrium, and hence monetary neutrality, is the goal of stabilization policy. Aggregate demand deficiencies occur when individuals attempt to build up their money balances. The Walrasian logic is that an excess supply of goods and services across the economy--a general glut--can only prevail if there is an excess demand for money (Yeager 1997). Prices (especially wages) are only imperfectly adjustable. Changing prices to match new economic realities is itself costly, so it is unrealistic to expect producers to engage in costly price-updating behavior beyond that dictated by their private interests. However, monetary equilibrium can be preserved not only by the (quite costly) process of letting economy-wide prices adjust in the event of an excess demand for money, but also by meeting individuals' desire to hold additional money balances through expansionary monetary policy. Achieving monetary equilibrium in a low-cost way is precisely the goal of NGDP targeting.

    The relationship between NGDP targeting and monetary equilibrium can be seen by modifying slightly the monetary equilibrium equation above. Importantly, k, the fraction of nominal income individuals desire to hold as cash balances, is by definition, the inverse of velocity:

    k [equivalent to] [1/V]

    Substituting into the monetary equilibrium equation, we arrive at the familiar equation of exchange:

    MV = Py

    This equation suggests formulating the problem in a way that is more intuitively appealing to agents of the monetary authority. Effective stabilization policy requires offsetting changes in V with corresponding and opposite changes in M. If velocity declines (and hence money demand increases), the monetary authority should engage in expansionary monetary policy up until the point where the injections of new money offset the fall in velocity. If velocity increases (and hence money demand falls), the monetary authority should engage in contractionary policy up until the point where the subtraction of money offsets the increase in velocity. Since changes in the money supply exactly offset changes in velocity, the result is a constant level of nominal income--that is, a targeted level of NGDP.

    Because the economy is generally growing, most proponents of NGDP targeting do not endorse a constant level of NGDP. Rather, they endorse a rule for NGDP targeting that sees NGDP grow at a constant rate in every time period, with the target level being the level of NGDP in a given time period consistent with that growth rate. It is fairly straightforward to see that this proposal is still consistent with the underlying theory of monetary equilibrium.

    Above, we assumed a static monetary equilibrium, but monetary equilibrium can also be dynamic So long as market actors' expectations are in line with the rate of variable changes, monetary equilibrium can prevail with constant growth rates in each of the variables. In terms of the equation of exchange, the dynamic version reads:

    gM + gV = gP + gy

    where g denotes growth rates. In this case, the monetary authority's job is to adjust the growth rate of the money supply such that it interacts with the growth rate of velocity to produce a constant level of nominal income growth (inflation plus real income growth) in every time period. This dynamic NGDP target is the general form of a static NGDP target, where the latter is just a version of the dynamic target with NGDP growth equal to zero. So long as market actors' expectations match the decision rule for the monetary authority, any breakdown between gP and gy is consistent with monetary equilibrium, and thus any NGDP...

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