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Nominal GDP Targeting: Is It Simply the Re-animation of Dead Tissue?

This morning Christina Romer sang her aria in the "Time to Level-Target Nominal GDP" opera, calling for the Federal Reserve to announce that it was going to push nominal GDP back to its pre-2009 track.

Would this work? Would this generate a rapid real recovery in employment and production without unleashing an uncontrollable inflationary spiral?

Steve Randy Waldmann says it may not:

interfluidity » Expectations can be frustrated: I think an NGDP path target is superior in nearly every respect to an inflation target, and so would represent a clear improvement over current practice. But… I do not believe that central banks can sustainably track their target… given the set of tools…. I think we need to add direct-to-household “helicopter drops” to our menu of instruments….

Self-fulfilling expectations lie at the heart of the market monetarist theory. A depression occurs when people come to believe that income will be scarce relative to prior expectations and debts. They nervously scale back expenditures and hoard cash, fulfilling their expectations of income scarcity. However, if everybody could suddenly be made to believe that income would be plentiful, everyone would spend freely and fulfill the expectations of plenty…. [T]o switch between the two scenarios, all that is required is persuasion…. As long as we all keep the faith, our faith will be rewarded. This is not a religion, but a Nash equilibrium.

If the market monetarists’ theory of depressions is correct, then their position is correct. They are famously vague and prickly on the question of what instruments or “concrete steps” central banks will use to achieve their objective. That is because it doesn’t matter one bit, as long as those instruments are persuasive. Whether police wield pistols or tanks or tear gas or nightsticks to keep the peace really doesn’t matter, as long as their choice is sufficiently intimidating….

I have a Minsky/Mankiw theory of depressions. The economy is divided into two kinds of people, spenders and savers…. Variation in aggregate expenditure is due mostly to changes in the behavior of the spenders. Savers spend at a relatively constant rate and save the rest. Spenders spend whatever they can earn or borrow…. [A] central bank that targets something — NGDP, inflation, whatever — doesn’t regulate behavior via expectations. Instead, the central bank regulates access to credit and wages…. When the economy is below potential, the central bank reduces interest rates and relaxes credit standards, encouraging spenders to borrow and leaving them with higher wages net of interest payments….

If my theory is right, absent significant structural change, attempting to restore demand merely by shocking expectations would be like trying to defibrillate a corpse….

I am all for targeting an NGDP path. I think it’s a great idea, and have more nice things to say about it. I hope the market monetarists are right…. But if we adopt an NGDP target and are serious about it, there is significant risk that we will be committing to chronic intervention. The market monetarists owe us a more serious conversation than they’ve offered so far about how monetary policy would be conducted if resetting expectations turns out not to be enough. Would the interventions they propose be fair, if pursued cumulatively over many years? Would they be wise? Would they help resolve the structural problems that have rendered it so difficult to sustain demand, or would they exacerbate those problems?

I agree: money printing-financed fiscal expansion in the service of nominal GDP targeting is by far the better policy.

Christina Romer agrees with this point, but hopes that the Federal Reserve can demonstrate that it is serious and so get the economy to jump from the bad equilibrium to the good one.

That is why her op-ed said that the Fed should not just announce this policy of nominal GDP targeting but also start buying bonds for cash, promise that it was going to keep interest rates lower for longer, and sell dollars to foreigners to push the value of the dollar down--and credibly promise it was going to keep doing all these things until nominal GDP was back to its pre-2009 track.

Others go further. Gauti Eggertsson and Michael Woodford [1] believe that right now even buying huge amounts of bonds for cash wouldn't do much if anything to boost the economy. To translate from the Formal Economese: Eggertsson and Woodford are saying that as long as people believe that the Federal Reserve will follow its normal Taylor-rule interest rate policies after the crisis is over and as long as people believe that the government's total debt path will be the same in the long run, buying bonds today does not change the equilibrium configuration [today] of the economy. There is then nothing the Federal Reserve can do to boost the economy right now if its promises are not believed. If there are two equilibria, Eggertsson and Woodford imply, having the Fed buy bonds does not give the economy any reason to jump from the bad one to the good one.

Paul Krugman says that shifting to nominal GDP targeting will be important only to the extent that it makes the Federal Reserve's promises that more bond purchases now mean lower interest rates and higher levels of government debt even in the long run more credible:

A Volcker Moment Indeed : NGDP is a much better target than M1, which (it turns out) is subject to wide swings in velocity. And the Fed’s goals [today], if frankly stated, wouldn’t be nearly as politically explosive as what it was doing in 1979-82. Still, NGDP is arguably mainly a relatively palatable way to state a strategy that’s ultimately about something else.

As I see it — and as I suspect many people at the Fed see it — the basic point is that to gain traction in a liquidity trap you must either engage in huge quantitative easing, raise the expected rate of inflation, or both. Yet saying this is very hard; people treat expansion of the Fed’s balance sheet as horrible money-printing, and as for the virtues of inflation, well, wear your body armor.

But say that we need to reverse the obvious shortfall in nominal GDP, and you’ve found a more acceptable way to justify huge quantitative easing and a de facto higher inflation target.

Don’t call it a deception, call it a communications strategy. And as I said, I’m for it.

I would say that I think Christy Romer has the best argument here. It seems to me that Eggertsson's and Woodford's argument is incomplete. To the extent that taxpayers are different from bondholders--and they are--portfolio-balance effects are real. Sufficiently large quantitative easing would make those portfolio-balance effects large enough to destroy the bad equilibrium--and then the economy would quickly transit to the good one. That is what Krugman means by "huge quantitative easing".

And, of course, once expectations coordinate on the good equilibrium, you don't need to do any quantitative easing at all--rather the reverse: the Fed will have to shrink its balance sheet relatively quickly in order to maintain a good and non-inflationary equilibrium.

[1] Eggertsson and Woodford: The Zero Bound on Interest Rates and Optimal Monetary Policy:

A Neutrality Proposition for Open-Market Operation…. [W]e suppose that the central bank's operating target for the short-term nominal interest rate [i] is determined by a feedback rule in the spirit of the Taylor rule… that the central bank supplies the quantity of base money that happens to be demanded at the interest rate given by this formula…. Under those conditions in which the value of [i] is zero, the policy commitment… [imposes] only a lower bound on the monetary base…. [W]e may ask whether it matters whether a greater or a smaller quantity of base money is supplied. We assume that the central bank's policy in this regard is specified by a base-supply rule… [with a] multiplicative factor ψ…. The use of quantitative easing as a policy tool can then be represented by a choice of a function ψ that is greater than 1 under some circumstances….

PROPOSITION. The set of paths for the variables {p*, P, Y, i, q, D} that are consistent with the existence of a rational expectations equilibrium is independent of the specification of [ψ]….

The reason for this is fairly simple. The set of restrictions… implied by our model can be written in a form that does not involve the… functions… ῳm, ῳf, ψ… and the result is established.

Discussion: The above proposition implies that neither the extent to which quantitative easing is employed when the zero bound binds, nor the nature of the assets that the central bank may purchase through open-market operations, has any effect on whether a deflationary price-level path represents a rational expectations equilibrium…. [E]xpansions of the monetary base [do not] represent an additional tool of policy, independent of the specification of the rule for adjusting short-term nominal interest rates. If the commitments of policymakers regarding the rule by which interest rates will be set, on the one hand, and the rule by which total private sector claims on the govemment will be allowed to grow, on the other, are fully credible, then it is only the choice of those commitments that matters. Other aspects of policy should matter in practice only insofar as they help to signal the nature of these policy commitments….

It might be suspected that an important omission is our neglect of portfolio-balance effects…. No such effects arise in our model…. The classic theoretical analysis of portfolio balance effects assumes a representative investor with mean-variance preferences. This has the implication that if the supply of assets that pay off disproportionately in certain states of the world is increased (so that the extent to which the representative investor's portfolio pays off in those states must also increase), the relative marginal valuation of income in those particular states is reduced, resulting in a lower relative price for the assets that pay off in those states. But in our general-equilibrium asset pricing model, there is no such effect. The marginal utility to the representative household of additional income in a given state of the world depends on the household's consumption in that state…. And changes in the composition of the securities in the hands of the public do not change the state-contingent consumption of the representative household.  [L]eaving aside the question of whether a clear theoretical foundation exists for the existence of portfolio balance effects, there is not a great deal of empirical support for quantitatively significant effects….

[I]t is more important to note that our irrelevance proposition depends on an assumption that interest rate policy is specified in a way that implies that these open-market operations have no consequences for interest rate policy, either immediately (which is trivial, because it would not be possible for them to lower current interest rates, which is the only effect that would be desired), or at any subsequent date. We have also specified fiscal policy in a way that implies that the contemplated open-market operations have no effect on the path of total government liabilities D either, whether immediately or at any later date. Although we think these definitions make sense, as a way of isolating the pure effects of open-market purchases of assets by the central bank from either interest rate policy on the one hand or fiscal policy on the other, those who recommend monetary expansion by the central bank may intend for this to have consequences of one or both of these other sorts…