More on NGDP Targeting (and Bubbles)

Left Outside has responded to my post on NGDP targeting, in which my major claim was that nominal income doesn’t drive the real economy. They note:

In 2007/8 asset prices fell because expectations of future NGDP fell which was priced into current asset prices. This lead to a fall in real GDP contemporaneous with a fall in NGDP, but both were caused by fall in expectations of future NGDP as is argued by adherents (cultists?) of NGDP targeting. Asset prices are forward looking and money is an asset, hence you have to look at expectations of future NGDP rather than looking at which moved first by a few months, RGDP or NGDP.

I’m not sure this is the full story. A bubble bursts when people realise that there is no real production underlying the growth of nominal income. If this sounds too economisty, I’ll phrase it in a different way: a bubble bursts when people realise that income is only rising because everyone expects it to rise. Ultimately, NGDP targeting relies on a claim that bubbles are not an important phenomenon for the macroeconomy.

The CB can continue buying assets – even housing – and so spur nominal income, by definition. But does pushing nominal income actually help the real economy? Take a look at this, via Bubbles and Busts:

During the 1970’s the US was plagued by high inflation that at times drifted into the double digits. This led to a brief stint of monetarism at the end of the decade into the early 1980’s. Monetarism, at the time, attempted to target a quantity of money rather than price. As can clearly be seen in this chart, the relationship between NGDP and RGDP is least correlated in the post-WWII period during this time of high inflation and quantity targeting.

For those convinced that NGDP targeting will be successful, the task is to explain why changing policy to promote higher inflation today will not cause a breakdown in the correlation of the past 30 years, similar to the 1970’s. Otherwise it seems perfectly reasonable to expect that NGDP targets will be met with increasing inflation, not real growth.

What’s the point in turning recessions into stagflation?

Left Outside asks what NGDP targeting failure would look like. My answer is either number 1:

NGDP does not reach trend because the bank lacks credibility and the policy is abandoned.

or number 3:

NGDP reaches trend but nominal growth consists (almost) entirely of price changes.

with the possibility that ‘price changes’ are predominantly in various assets, real production is marginally affected, and once the CB runs out of assets to buy we face the mother of all crashes.


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  1. #1 by Ron Ronson on May 14, 2012 - 6:47 pm

    In your original post you provided an excellent working definition for NGDPT

    “The rationale for NGDP targeting is roughly as follows: macroeconomic policy can only reliably influence the nominal; the distribution between real income and inflation is determined partly by long run supply-side factors and is partially out of our control. Hence, if we keep nominal spending constant then we will know there is never an AD deficiency – any problems lie elsewhere.”

    If a recession can be defined as a reduction in RGDP then these can be caused by either supply-side reasons (for whatever reason optimal levels of RGDP have fallen) or demand side-reasons (AD falls but the required fall in the price level that would be needed to compensate for this has not yet occurred).

    NGDPT only addresses the demand-side scenario. Bringing NGDP back to a target if the recession was caused purely by a supply-side issues would simply cause inflation and be dangerous.

    Supporters of NGDPT would say that all recessions have a demand-side element. Even if the trigger was initially supply-side the ensuing disruption would cause secondary demand-side driven recessionary effects. These secondary effects (they would argue) could be avoided by NGDPT. Any inflation caused as a side-effect of increasing the money-supply would be a price worth paying to avoid the (potentially snow-balling) effect of falling demand.

  2. #2 by Woj on May 15, 2012 - 6:37 pm

    Today Sumner was highlighting the relationship between the monetary base and NGDP to support targeting. I think its another example of policy changes altering the relationship:

    Paying IOR above the risk-free-rate has resulted in a surge of excess reserves and base money uncorrelated with any increase in the demand for credit. Changing Fed policy has altered the conditions under which the previous relationship existed. The supply of base money (which was correlated but didn’t drive NGDP) may therefore no longer even show any material correlation with NGDP (as long as current condition prevail).

  3. #3 by Unlearningecon on May 16, 2012 - 7:21 pm

    Both good points, not much to add!