Wednesday, May 27, 2015

Asset Price Inflation

Larry White mentioned that Alchain and Klein showed long ago that the measure of the purchasing power of money should include asset prices.

I don't agree.

I strongly agree that it is mistake to measure the purchasing power of money by solely by the prices of consumer goods and services--the CPI or CEP.

But I don't think that the prices of financial assets should be included in a measure of inflation.

As for real assets, I think that only the newly-produced ones should count.

In other words, I think that the GDP deflator, or something like it, is the least bad approach to measuring the purchasing power of money.

First, consider equities.   If we assume that a share of stock is a claim to a fixed quantity of goods, then any increase in the price of a share would imply a lower purchasing power of money.   However, suppose that a company is expected to become twice as profitable.   The price of  a share would rise, but it would not be a higher price for the same quantity of future goods.   It would be a higher price for a higher quantity of future goods.

Now, suppose the market interest rate should fall, and the lower discount of future returns results in higher prices of equities and existing long term bonds.   Superficially, the purchasing power of money is less.   It is necessary to pay more for the same quantity of future goods.

However, suppose we lived in a world where the only saving instrument was a saving account.   There is no possibility of capital gain or loss on financial assets.   If the interest rate should fall, then it true that money put into a saving account will provide less future consumption.   But is that a lower purchasing power of money?   Saving or accumulated wealth now generates a lower nominal and real income.    But is that  a lower purchasing power of money?     I don't think so.

I guess my thinking on the subject is very much influenced by some sort of presumption that  inflation is bad and the monetary regime should be stabilizing the purchasing power of money.   And so, I would ask if a monetary contraction would desirable to force down the prices of consumer goods and services enough to offset the increase in long term bond prices.   I don't think so.

The coordinating role of the lower interest rate is to raise the demand for both  consumer goods and services and capital goods.

For example, suppose there was an increase in saving supply.   The direct and immediate effect is a lower demand for consumer goods and services.   The coordinating role of the lower interest rate is to increase the quantity of consumer goods and services demanded as well as the quantity of capital goods demanded.    The result is what returns saving and investment back into balance.

I certainly grant that it would be inappropriate for this reallocation of resources to occur with stable prices of consumer goods and services.   Lower prices of consumer goods and services along with higher prices of capital goods should be expected.  

Now, the lower interest rates should result in higher prices of all the existing capital goods--not just the newly produced ones.   This doesn't require anyone to spend any money on all of these capital goods   It is just that entrepreneurs will be willing to offer more money for them and those using them now will insist on  higher payment to part with them.

Should the weighting of capital goods in the price level depend on all of the capital goods or just the newly produced ones?

Suppose consumption is $8000 billion and investment $2000 billion.   The capital stock, however, is $20,000 billion.    There is an increase in saving and a $200 billion shift in demand.    Suppose that this 2.5% decrease in demand results in 1% lower prices.   However, the 10% increase in the demand for capital goods requires 4% higher prices.    If we look at only currently produced goods, the price level remains the same.    But if all of the existing capital goods count, then there has been a very substantial inflation--about 2.5%.

Would it be better for the prices of  consumer goods to fall more and the increase in the prices of capital goods to rise less?    What would this be signalling?   That the production of consumer goods and services should be reduced by more?   That the expansion in the production of new capital goods should be less?

Presumably this would require that wages be reduced to return to equilibrium.   Why?   Is this signalling that people should work less?

In my view counting stock prices is more or less the same thing as counting the prices of existing capital goods--in theory.

In reality, is it really the best that if stock prices go up,  there is a deflation of consumer prices along with money wage cuts?   What is the point?   Do we need to get people to work less?   Or is it just to free up resources from the production of consumer goods and services to print up more shares of stock?

As for bonds--as old bonds mature and new ones are issued a par with lower coupon rates, does that count as deflation?    The prices of bonds are falling?   Should consumer prices and money wages rise to offset that deflation?   Clearly it should not.

Now, perhaps Alchain, Klein, and White have no presumption that the purchasing power of money should be stabilized.   If more saving supply or reduced investment demand results in a  lower natural interest rate, then that just lowers the purchasing power of money--and there is nothing bad about it.   Maybe.

And I must admit, I don't favor a stable price level of any sort, but rather a stable growth path for spending on currently produced output.   However, I do favor a growth rate of spending that is consistent with the expected trend growth rate of potential output.   And so, this would tend to result in a stable price level for currently produced output.  (And I know White does not favor stabilizing the price level, especially when there are changes in productivity.)

But it wouldn't tend to stabilize the prices of current output and existing capital goods and financial assets all together.

And it shouldn't.   Or at least, I don't think so.


Saturday, March 21, 2015

Are Open Market Operations Distortionary?

Many of my fellow free bankers agree that when banks accommodate changes in the demand to hold their monetary liabilities, the result is equilibrating and nondistortionary.   However, they believe that when a central bank adjusts the quantity of base money to accommodate changes in the demand for it, there is something problematic with the process.   The injection of base money is somehow distortionary.

Now, I don't want to claim that this could never be a problem.   The Fed's policy since 2008 has most certainly become very distortionary--intentionally   Perhaps there should be no surprise that the Fed has attempted to funnel money into housing.    Using government interventions of one sort or another to promote home ownership has been the norm for  nearly a century now.

Still, let us suppose that the government has a national debt because of past wars but that it now balances its budget.    The central bank always adjusts the quantity of money by buying and selling existing government bonds.  

If some household chooses to save by spending less on consumer goods and instead purchasing government bonds, then the result is a higher price of bonds and a lower yield.   The increase in price and decrease in yield has to be sufficient to persuade someone to reduce their holdings of the government bonds.   The most likely result is that those least attached to holding government bonds purchase some other sort of financial asset.   That results in higher prices and lower yields on those assets.   The final result is a decrease in the amount saved and increase in the amount invested.   This is an expansion in spending on consumer goods that only partly offsets the initial decrease and an expansion in spending on capital goods.  

An increase in supply creates a surplus at the initial price, but as the price decreases, quantity supplied decreases and quantity demanded increases returning to an equilibrium where quantity supplied and demanded are equal.   The price is lower and the quantity is higher.   Apply econ 101 to saving supply and investment demand.

While the existence of this national debt requires that interest be paid and so taxes collected, I find it difficult to see how the individual saver who purchases these bonds has created some kind of distortion.   While the result is unlikely to be exactly the same as it would have been if that household had saved by purchasing some private security--stock or bond--we can hardly expect that such purchases would have directly funneled resources into the firms that issued those particular securities.   The process of coordinating saving and investment occurs through adjustments in financial asset portfolios and interest rate signals that result in an appropriate decrease in the quantity of saving supplied and increase in quantity of investment demanded.

Now, suppose that instead of purchasing government bonds, the household that initially saved accumulated central bank issued hand-to-hand currency.   Income was earned and not spent on anything.   Paper notes are stuffed into a safe-deposit box.     Further suppose the central bank makes a standard open market purchase.   It creates new money out of thin air and purchases government bonds--just accommodating the increase in the demand to hold money.

The result after that point is exactly the same as what would have happened if the household had directly purchased the government bonds.   As explained above, this results in appropriate adjustments in the price and yield on those government bonds and on other financial assets such that the amount saved and invested adjust to coordinate the increase in saving.    Further, there is no significant difference as far as the adjustment to this additional saving than would have occurred if the household had purchased privately-issued stocks or bonds.

Given the dominant Keynesian (old or new) framing, a central bank that accommodates an increase in the demand to hold base money by expanding the nominal quantity issued through open market purchases of government bonds would be described as lowering the interest rate to stimulate consumption and investment spending.   The market coordination process to an increase in the supply of saving leading to lower interest rates and so a readjustment in the quantity of saving supplied and increase in the quantity of investment demanded is twisted into some kind of intervention by the Fed -- pushing interest rates too low in order to unnaturally stimulate spending.   That is an inappropriate framing.

Now, I will surely grant that the potential for a central bank to create an excess supply of money is much greater than that of private banks issuing any sort of money, and especially money redeemable in some other form of money currently being used.   My point is simply that to the degree a central bank limits its issue of new money to the amount demanded, there is nothing especially distorting about the process.   It is coordinating.   The proper comparison is not what would happen if the nominal quantity of money remained fixed and there was a deflation of prices and wages.  Nor is the proper comparison to what would have happened if there had never been an increase in the supply of saving.  The proper comparison is what would happen if there was a increase in the supply of saving by purchasing government bonds.

With an ordinary fractional reserve banking system, an increase in the demand to hold bank deposits is directly an increase in desired lending to a bank but indirectly funding for whatever projects the bank finds profitable.   That is the nature of the contract between bank and depositor and the logic of financial intermediation.    Similarly, an increase in the demand for base money under a monetary regime where the central bank makes ordinary open market purchases is directly a loan to the central bank, but indirectly a loan to the government.   If the government is balancing its budget, then the effect is simply a coordinating expansion in other sorts of private spending.    At least, as long as the central bank limits its issue of money to amounts that people choose to hold.

Friday, March 20, 2015

Salerno on Market Monetarism

Tom Woods and Joe Salerno explain what is wrong with Market Monetarism.

The most glaring error is Salerno's claim that any increase in the quantity of money pushes the market rate below the natural rate of interest  because the new money is injected into credit markets.   However, an increase in the quantity of money that matches an increase in the demand to hold money rather keeps the market interest rate equal to the natural interest rate.   If saving occurs by accumulation of money balances, then the natural and market interest rates decrease.   If instead, the added money balances are accumulated by reducing spending on capital goods or other financial assets or even selling capital goods or other financial assets, then the natural and market interest rates remain unchanged if newly created money is injected into credit markets.

The oddest portion of his argument is the admission that prices and wages are sticky but that this is OK because entrepreneurs can choose to adjust them if they want.   There was a rather odd notion that these are small little blips.   Well, I suppose some of them are minor and don't make much difference.  It is when a large change in the demand to hold money leads to a large change in market clearing prices that sticky prices and wages result in large changes in output and employment which are serious problems.

Also, the entire discussion carries on ignoring a decrease in the demand to hold money.  Market monetarists favor a decrease in the quantity of money in that circumstance.   The Salerno view is that the inflation (or reflation) of prices is harmless?   Entrepreneurs just need to take care of it?

Anyway, the key question is what sort of monetary regime is best.  Is it better to have a monetary regime that requires changes in the price and wage level so that real money balances adjust to the demand to hold them given a fixed nominal quantity of money, or is it better to have a nominal quantity of money that adjusts with changes in the demand to hold money.    While price and wage adjustments are still necessary to coordinate economic activity, they aren't necessary to provide for monetary equilibrium if the nominal quantity of money adjusts to changes in the demand to hold money.

Salerno also suggests that entrepreneurs should not be treated as fragile flowers unable to maintain monetary equilibrium.   "Unable" shows an unfortunate tendency of some Austrians to confuse sticky with stuck prices, and really, to continue to fight past battles regarding long run unemployment equilibrium rather than what is really at issue--whether sticky prices and wages result in temporary fluctuations in output and employment that are both painful and avoidable.

Again, the issue is what monetary regime is best.   One key issue is specialization.   Entrepreneurs specialize in particular products.   The requirement that everyone set their prices and wages to make the real quantity of money accommodate the demand to hold money balances requires every entrepreneur to specialize in two areas--the production and demand for their particular product, but also the production and demand for money.    (One of the goals of index futures convertibility is to allow some entrepreneurs to specialize in maintaining monetary equilibrium.)

The argument that I found most challenging is Salerno's claim that spending has no causal significance.   I think his description of the market process where buyers and sellers first negotiate a price and then choose the amount transacted and so spending is a bit off.   Though in another passage it seemed to be suggesting that prices and quantities are jointly negotiated--I want 3 units at $2 each.   Well, I will sell you 5 units at $1.50 each.   That this involves expenditure of $6 or $7.50 is of no causal significance.

Well, perhaps I am an unsophisticated consumer, but I operate on a relatively fixed nominal budget constraint.   My income both recently earned and expected in the near future is an aggregate nominal amount.   And that constrains my total spending on goods and services.   How much I can spend on this or that good or service must add up to what I have available to spend.   I care about how much of each product  I get, but what I spend on any one purchase is what determines what I have left to spend on other stuff.

My vision of the market process is each firm setting both its price and production.  And the nominal value of the firm's output is found by multiplying that price and quantity.   That is added up for all the firms to get the aggregate value of output.   Of course, service firms, which play too small a role in my vision compared to their actual role in the economy, involve choosing a price and then producing what is sold.

Still, I do think that anticipated revenues from this output and pricing decision is very important to firms.  Revenue is what they will need to cover costs and generate a residual profit,.   It seems to me that nominal sales, and especially, expected nominal sales do play a key role in entrepreneurial decisions.  

Now, suppose we have two individuals who are self-employed, consuming part of their own product and then bartering the excess for the product of the other.   I think it is fair to say that the amount of money earned and the amount available to spend would hardly matter.   It is a barter economy after all.   Isn't this Salerno's bargaining economy where "spending" means nothing and it is all about the scale of values?

In a monetary economy where people consume close to nothing of what they produce and instead sell nearly all of it to fund purchases, how much money they earn, and more importantly, what they expect to earn, means something.  In the two person barter economy, the key question is how much corn do I eat and how much will I trade for beans which I will then eat.  In a money economy, I sell my corn for money and then that money income determines how much I can spend on a huge variety of goods and services.    How much revenue I get from selling my corn is very important.    And if I am actually paying for seed corn and fertilizer and making payments on my tractors, how much money I will make from selling corn is more obviously important--it determines the residual, which will be how much I can spend on a variety of consumer products for my own use.

To me, it is obvious that it isn't the Market Monetarists who are foolishly assuming that we can separate the real economy and the monetary economy.   Our emphasis on spending on output and nominal income clearly shows that we consider the role of money in the market process very important.

Finally, suppose that the economy is made up of a gold miner who uses most his gold to fill his teeth and for jewelry.   He trades some for corn to eat.  The corn farmer eats most of his corn, but trades some of it for gold to fill his teeth and for jewelry.   Why is money expenditures more important in this economy than when the corn farmer is bartering with the bean farmer?

Well, it isn't.     It isn't a monetary economy, and so nominal income and expenditures are not important.  In such an economy, I don't think that the exchange of gold and corn would cause any special problems.  And I don't think that having the supply of gold be more elastic would be nearly as desirable as it would be in a world of many goods and services, where firms purchase resources such as labor and use it to produce goods for sale.  

Tuesday, March 10, 2015

Miles Kimball on the Primacy of the Unit of Account

Miles Kimball writes:
With the e-dollar as the unit of account, everything the central bank needs to do to have a nonzero paper currency interest rate can be done at the central bank’s cash window where banks come to deposit or withdraw paper currency from the central bank.
For good monetary policy, it is important that the central bank have control over the unit of account. And this e-dollar unit of account might have many of the aspects of a cryptocurrency—perhaps enough that it can be considered a cryptocurrency.
As far as private cryptocurrencies (like bitcoin) go, it is fine to have private cryptocurrencies perform the medium-of-exchange and store-of-value functions of money, but monetary policy requires control over the unit of account. So central banks need to retain control over the type of money that defines the unit of account—in this case the e-dollar.
Under an electronic money policy, 3 key things will insure that the e-dollar (or e-euro or e-yen or e-pound etc.) is the unit of account:
  • a requirement that taxes be calculated in e-dollars.
  • accounting standards that require accounting to be done in e-dollars.
  • the kind of need for coordination between businesses and between businesses and households that leads people to do daylight savings time (without any intrusive inspections of someone coming to look at your clocks)

This is good.

I was about to add in Sumner's emphasis that it is the "medium of account" that must be controlled.

However, I am less and less comfortable with emphasizing the medium of account when the growth path of nominal GDP is used as a nominal anchor.

A fixed weight of gold is the medium of account--clear.

A steel ingot is the medium of account and it has no medium of exchange function -- clear

A bundle of goods is the medium of account and it has no medium of exchange and no store of value function as a  bundle -- clear.

The bundle medium of account is practically the same as monetary regime that stabilizes a price index defined by the bundle  -- seems right.    A privatized system using index futures convertibility doesn't seem to have any alternative medium of account.

Some changing fraction of real output is the medium of account?   Not so clear.

A monetary policy that stabilizes the growth path of nominal GDP is possible.    A privatized system using index futures convertibility has nothing other than the unclear medium of account as some changeable fraction of real output.

And so back to Kimball, is it the unit of account that is the key to the monetary regime?

Wednesday, March 4, 2015

No Good Deflation?

David Beckworth commented on  a Greg Ip piece in the Wall Street Journal where Ip claims that there is no such thing as good deflation.

The Ip argument is solely based upon the preference by central banks to target some short and safe nominal interest rate.   Reasoning from the Fisher effect, the higher the inflation rate, the higher equilibrium nominal interest rates.   A lower inflation rate, and particular deflation, results in lower equilibrium short and safe interest rates.   This creates less room for the central bank to stimulate the economy by reducing those interest rates.

Ip does a decent job of describing "good" deflation.   Most importantly, he describes a scenario of improved productivity for some particular product.   He also describes a scenario where the price of some imported good falls, which from a narrow perspective amounts to the same thing.   However, I would be careful in describing lower prices of imported commodities due to a world depression as a benefit to any particular country.   Of course, as a rule, lower prices are better than lower production when demand decreases.

From a Market Monetarist perspective, Ip's argument is rather an argument against having a central bank use any interest rate target, and especially the interest rate on some short and safe debt instrument, such as the overnight lending rate traditionally used by the Fed.   If such a monetary policy approach is not robust when faced by even "good" deflation, then it should go.   This is especially important with Taylor testifying to Congress in favor of them legislating his "rule."

Sumner frequently argues that it is rather nominal GDP growth that is more relevant to nominal interest rates.   If he is correct, then as long as nominal GDP is expected to remain on its target growth path, then lower inflation or even deflation due to more rapid growth in productivity or lower import prices would have no impact on equilibrium nominal interest rates.   While Market Monetarists would hardly use this characterization, if a central bank were to determine that lower nominal interest rates now are necessary to keep expected nominal GDP on target, then they should be able to manage that despite lower inflation or deflation.

However, I am not quite willing to follow Sumner in this argument.   I agree with his practical concerns regarding the price indices used to measure inflation.   And maybe expected nominal GDP growth is a better rule of thumb for making judgments regarding expected nominal interest rates than the expected rate of change in the CPI, CEP, or GDP deflator.   Still, as macroeconomists, our goal should be understanding, and expected changes in real income and expected changes in the purchasing power of money could well have different effects on real and nominal interest rates in the future.

First, let us be clear that inflation or deflation in the recent past or even right this minute is irrelevant.   It is expected future inflation that should impact nominal interest rates.   Further, it does not occur through a Fisher relation equation but rather through changes in lending and borrowing behavior.   The Fisher relationship, of course, is based upon the results of rational lenders and borrowers when they expect inflation or deflation.  However, it assumes a given real interest rate.

With good deflation (or disinflation) there is an expected favorable productivity shock.   This means that real income is expected to be higher in the future.   With consumption smoothing, that should reduce the supply of saving  today.   This would result in a a higher real natural interest rate.   Further, if the expected improvement in productivity requires the introduction of additional capital equipment, then this would tend to raise the demand for investment, also increasing the real interest rate today.   For example, if we anticipate that fracking is going to generate lots of new oil, resulting in lower oil prices, we may need to be constructing various capital goods today that will be used for this fracking.

So, while a naive application of the Fisher relationship suggests that expectations of lower prices of some good, say gasoline, will result in lower nominal interest rates, the decrease in the supply of saving and increase in the demand for investment imply a higher real interest rate, which will tend to raise the nominal interest rate.   While I am doubtful that there is any reason to anticipate that the effects must be completely offsetting, there is some offset and it is at least possible that the equilibrium nominal interest rate should rise rather than stay the exact same or fall.

Consider credit markets.   The reason for the Fisher relationship is that if prices are expected to be lower, then borrowers will be less able and willing  to borrow.  The lower ability to borrow would be due to their incomes (or revenues) being less in the future.   However, with good deflation, this is simply false.   While the prices are lower, the quantities are higher.   This is where Sumner's argument is strongest.   Of course, their is also the willingness borrow.   The larger amount of real purchasing power that must be sacrificed would seem to still to be a deterrent to borrowing.

What about credit supply?   Since lenders will be paid back in dollars that purchase more, won't this motivate people to lend more?      It would seem so, but what is the alternative?   They certainly are not motivated to hold less money, since money also will increase in purchasing power.   Perhaps it is equities?   If the price level is expected to be lower, the nominal profits should be lower too, and so equities should be worth less now.   Perhaps they will sell equities and lend more.
But with "good" deflation that isn't true.  While some prices are lower, those quantities are higher.   But surely, this is just repeating the argument that the supply of saving should decrease if expected future income is higher.

Also, I find the multiple good scenario a bit puzzling.   Do people want to lend more because gasoline will be cheaper in the future so that each dollar lent will purchase more gasoline when it is paid back?   Will people be less willing to borrow now because gasoline will be cheaper in the future and so they will be giving up more gasoline in the future when they pay the money back?   It sounds so much less plausible than when there is a single consumer good and deflation means that lenders get more of it in the future and borrowers must give up more of it.      Even so, the fact that one good among many gets cheaper already implies that any deflation is less than a similar change in productivity for "the" product of the economy.

No, in the end it is best to think of the supply of saving and demand for investment as depending on the real purchasing power received and sacrificed, so that if the real interest rate changes with no shift in the supply of saving or demand for investment, the result will be disequilibrium.  With "good" deflation, there is just good reason to expect that the supply of saving decreases and the demand for investment increases, so that the natural real interest rate increases.   That the deflation raises the real interest rate just suggest that the appropriate change in nominal interest rates is less than otherwise would be necessary.

 



Sunday, March 1, 2015

Yates on Lags and a Balanced Budget

Well they are all a twitter.

Yates reports that Wiesenthal of Bloomberg asked what MaMos would think of a balanced budget rule.

He then added how Noah Smith twitted a link to a Scott Sumner post claiming that long and variable lags are a myth.

Yates then writes a blog post discussing how Sumner must be wrong--referring to characteristics of new Keynesian models.

Under current conditions, I believe the U.S government should run a surplus under "normal" conditions.   Government spending should be kept to a minimum and tax rates set to generate slightly more revenue.   It should then gradually pay down the national debt.

If the economy does poorly, then the government will collect less tax revenue.  I would strongly oppose having the government raise tax rates to balance the budget.   The budget surplus would, and should, decrease.   Now, if the problem is so severe that the result is a deficit, I do think the government should borrow and add to the national debt.   However, I favor a constitutional debt limit, and one reason for running a surplus under normal conditions is to reduce the national debt below the debt limit so that temporary deficits and borrowing would be consistent with the constitutional debt limit.

I am not too worried about the national debt being paid off, but if that did happen a balanced budget is appropriate and in that scenario, a temporary reduction in tax revenue should allow for a budget deficit and a temporary national debt.   Then a return to the rule of thumb that there should be a surplus when the economy returns to normal.

A permanent contraction in real output, on the other hand, should result in less government spending and a reduction in the provision of public goods.

I have no interest in using discretionary fiscal policy, including tax cuts, to return spending on output to a target growth path.   Even less do I favor introducing special government spending projects for the purpose of creating jobs.

Note that I don't worry much about the impact of taxes and spending on spending on output.

Yates apparently hasn't heard, but Market Monetarists favor targeting nominal GDP in the future.   We do not favor adjusting a target interest rate according to the past deviation of nominal GDP from a target level.

Now, for long and variable lags.

For Milton Friedman, the thought experiment was always a change in the growth rate of the money supply.   We are in equilibrium at one growth rate of the money supply   Suppose we shift to a higher growth rate?   How long will it be before the economy returns to long run equilibrium?   That is, a higher inflation rate, higher nominal nominal interest rate, with real interest rates, real output, and employment all back to their natural, long run equilibrium values?   Well, the lag between the new growth rate of the money supply and that final long run equilibrium is long.   And further, it appears to take longer sometimes than other times.

However, one problem with the use of empirical evidence to evaluate Friedman's claim is that there has never been a monetary regime that targets the growth rate of the money supply, much less one that has tried out various growth rates and allow adjustments to the new equilibrium.   Friedman tested this thought experiment in worlds with quite different monetary regimes.

Most importantly, with a gold standard, changes in the quantity of paper money and deposits (both demand and time) are unlikely to be new, persistent increases in the growth rate of the quantity of money.    Frequently they will be accommodating a temporary or even permanent change in the demand to hold money, and even if they are truly an excess demand for or supply of money given the existing trajectory of nominal income, there is a very good reason to expect they will be temporary.

This same reasoning applies to price level target.

Market Monetarists don't favor changing the growth rate of the money supply and letting the economy settle down to a new equilibrium,  How long it would take for a change in the quantity of money to have its full effect on inflation is of little concern.

What is of more concern is the lag between current monetary conditions and spending on output.   How changes in spending on output would be split between changes in prices and output is of less concern.   We are not concerned about inflation per se, but neither is the goal to goose demand to create output and employment.  Nominal GDP level targeting means that the goal is to get spending on output on target.

Years ago, Sumner advocated targeting the price level one month in the future.   But for the last decade or so he has advocated targeting nominal GDP one or even two years in the future.  The stabilization of current spending on output would largely be generated by the expectation that spending on output will be on target in the future.    And further, the reason that nominal GDP will be expected to be on target in the future will mostly be the expectation that future monetary conditions will be consistent with nominal GDP being on target in the future.

Milton Friedman and the old monetarists typically assumed that all changes in the quantity of money are permanent.   How long will it take for that permanent change to have its full impact on the price level?   How long will the transitory changes in real interest rates and real output and employment last?

But that tells us little about what happens if the quantity of money were to rise and then fall.   Should the analysis of a permanent increase in the quantity of money be transitioned over to a temporary increase in the quantity of money?   Suppose the quantity of money rises by $50 billion this quarter and then falls by $100 billion the following quarter.  Do we really expect that a year later there will be a quarter of higher real output growth followed by a quarter of lower real output growth?   And then a year after that a quarter of a higher price level followed by a quarter with a lower price level?    What possible market process would allow for such a result?

What firm would raise prices because of a boom in demand a year ago, especially when it was followed by a recession nine months ago?

Under a gold standard, the inflation rate depends on the supply and demand for gold.   Maybe projecting past experience into the future was a good enough rule of thumb    Current changes in the price level are likely to be reversed with long run stability.   Looking at what happens to various measures of the quantity of money says little.

Looking at data from a period where the central bank uses a smoothed interest rate target to keep inflation and unemployment from rising too high will provide little information about a regime that targets a growth path for spending on output.

Market Monetarists believe that the central bank should make no commitment regarding the future path of money market interest rates or the quantity of any measure of the quantity of money.   We certainly anticipate that nominal GDP will deviate from target.   The only commitment is that the quantity of money and interest rates will be at the level expected to keep future spending on output--future nominal GDP--on target.

Nominal GDP Stability and Coordination

A nominal GDP level target requires changes in the demand to hold money be accommodated by changes in the nominal quantity of money.   In my previous post in response to the Wagner and Viteel paper, I argued that there is no presumption that these changes in the quantity of money occur with no impact on the flow of expenditure through the economy or the allocation of resources.   Rather, the argument is that such changes are entirely appropriate and coordinating as long as the quantity of money increases such that it matches increases in the demand to hold money.   Rather than imagining some kind of perfect neutrality, the proper comparison is to an increase in the demand to hold some other type of financial asset.    Given that changes in the quantity of money, even if accommodating changes in the demand to hold money, involve some change in the pattern of expenditures and allocation of resources, why is it desirable to keep nominal GDP stable?

First, I would point out that there are some changes in the demand for money where the needed change in the allocation of resources is small.   The thought experiment of a reduction in consumption and increase in the demand to hold money, matched by an increase in the quantity of money that is used to fund additional investment involves a major shift in the pattern of expenditure and allocation of resources.   Suppose instead that households sell off financial assets to increase money balances and this is accommodated by a bank (commercial or central) making open market purchases, creating money by purchasing financial assets.   It is possible that the issuer of money would purchase the exact financial assets sold, resulting in no change in the flow of expenditure or the allocation of resources.   Of course, if a private bank purchases some other sort of financial asset (or makes a commercial bank loan,) the pattern of finance would be changed somewhat.   Only with stringent and unrealistic assumptions (which are not uncommonly made in finance theory,) would this have no impact on what particular investment projects are ultimately financed.     In my view, it is at least roughly similar to a household's choice to sell off bonds issued by corporation A with one more year to run to maturity, and purchasing bonds issued by corporation B with five more years to maturity.   Perfectly neutral, not likely.   But how neutral would be a deflation in prices and nominal incomes in response to a sale of financial assets to fund increased money balances?

Rather than continuing on to consider various scenarios regarding shifts in the demand and supply of money, I will use a different approach to explaining why stable spending on output is desirable.   First, consider a two consumer good economy.   A change in preference results in an increase in the demand for apples and a reduction in the demand for oranges.   I must admit that I find it most natural to consider this scenario as an increase in spending on apples and a reduction in spending on oranges.   Perhaps this is based upon a simplistic transfer of the reasoning of a single household with a budget constraint constructed from a given nominal income.   The household remains on the budget constraint and so shifting along it involves less spending on one good and more spending on the other.   Less spending on oranges and more spending on apples.

 Regardless, I would construct the market experiment as the demand curve for apples shifts to the right while the demand for oranges shifts to the left.   The price and quantity of apples rise.   The higher price of apples results in a move up the supply curve of apples.  Resources are pulled into apple production by higher prices and profits.   Meanwhile, the price and quantity of oranges fall.  The lower price of oranges results in a move down the supply curve of oranges.   Resources are pushed out of the orange industry by lower prices and profits, and perhaps even losses.

If, as is usual, the long run supply elasticity is greater than the short run elasticity, profits and prices will fall in the apple industry, with profits returning to normal and any long run increase in price reflecting higher rent on resources specific to apple production.   Similarly, any losses in orange production must disappear and prices will recover.  Any long run reduction in prices will reflect lower rents to resources specific to orange production.   These shifts from short run to long run supply can be represented by short run supply curves shifting--to the right for the apple industry and to the left for the orange industry.

Perhaps this is just my naive microeconomist thinking, but surely this is the way the market process is supposed to work?

However, it is clear that the same reallocation of resources and production would be possible if the demand for oranges fell, and the demand for apples stayed the same.   In this simple two good world, it might seem to make no difference..   The demand for oranges falls.   The price and quantity of oranges fall.  The lower price results in a shift down the supply curve for oranges.   Lower prices and profits, perhaps even losses, push resources out of the orange industry.   Where do the resources go?   To the apple industry.   The supply curve for apples shifts to the right.   The result is a shift down the apple demand curve, with the result being a lower price and higher quantity of apples.   The long run adjustment from the less elastic short run supply to the more elastic long run supply can be represented by further shifts in short run supply.   The short run supply of oranges shifts to the left and the short run supply of apples shifts further to the right.

So far, there has been no specific discussion of markets for resources, such as labor.  In the first scenario, the increase in the demand for apples results in a nigher imputed demand for labor while the reduction in the demand for oranges results in a lower demand for labor   While there is no guarantee that the two effects are exactly offsetting, there is some offset.   At least some of those workers pushed out of the orange industry can find new jobs in the apple industry.   Leaving aside a substitution from labor to leisure, all of the labor must shift from oranges to apples.  (That is my usual assumption, of course, real business cycle theory emphasized just this substitution to leisure that I usually ignore.)

On the other hand, in the second scenario, one key reason the supply of apples increases is because lower resource prices, including wages, results in a lower cost of production for apples.   The process requires a surplus of labor.   Both the apple and orange industry must cut the wages of all of their workers for there to be a return to equilibrium.   Compared to the shift in demand in product markets, the market process in the second scenario puts an additional burden of adjustment on resource markets, including labor markets.  In the end, just as in the first scenario, the workers are all shifting from the orange industry to the apple industry.

More importantly, if apples and oranges are but two products in an economy made up of thousands of products then the adjustment  process will inevitably impact other markets.   Substitutes and complements in production and consumption will be impacted, as well as the outputs of apples and oranges.   Still, in the second scenario, the reduction in wages and lower costs will impact all markets, raising their supplies and tending to result in lower prices and higher quantities too.   If their relative prices are to remain unchanged, the demands for each and every good in the economy must fall at least a little.   At least, they must do so if the entire adjustment is to be made with no increase in the demand for apples.

Now, back to the two good scenario.   It would be possible for the reallocation of resources to occur solely through an increase in the demand for apples, with the demand for oranges remaining constant.   The production of oranges would be curtailed by a decrease in the supply of oranges as resources are pulled into apple production.   With labor markets, this would involve a shortage of labor and higher wages.  The higher cost of production is what would cause the lower supply of oranges.   In a many good world, the result would be decreases in the supplies of all goods and at least slight increases in the demands for everything other than apples.  Worse, outside of the world of the Walrasian auctioneer, there might well be some overshooting of apple demand.

Wagner-Viteel seem to argue that increases in the demand for money should not be accommodated by increases in the quantity of money because it is better to coordinate a shift in demand solely by pushing resources out of firms with reduced demand, while surpluses of resources lower resource prices and so costs and thereby increase the supplies of other goods.   As explained above, it could happen that way, but why is it better to require these adjustments in prices and wages in all product and resource markets?

The Mises problem is directly a need to contract the production of capital goods and expand the production on consumer goods.    Why shouldn't this be accomplished by a simultaneous increase in spending on consumer goods (apples,) pulling resources in that direction, along with a push of resources out of capital goods (oranges?)     Why would it somehow be better for this reallocation to occur solely by pushing resources out of the production of capital goods so that surpluses of resources push down costs and so increase the supplies of consumer goods?

The Schumpeter problem has two parts.   Consider the introduction of a new product.   Why shouldn't the demand for the new product rise (apples) and the demand for the old, heading-to-obsolescence product (oranges) fall?  Why not have resources pulled to the innovative product and pushed out of the obsolete product?   While it would be possible to coordinate this solely by a reduction in demand for obsolete products.....

Well, it is actually hard to imagine how that would be possible.   The shift in expenditure would seem pretty much essential.   And, of course, Schumpeter's recession occurs when there are few (or no) innovations.   Given this simple thought experiment, what is the problem?   While there might sometimes be no added demand for new products, neither would there any decreases in demand for existing products due to their becoming obsolete.  

What about the other element of creative destruction?   Improved efficiency for producing existing goods    Suppose there is improved efficiency in producing apples.   There is little doubt that this should be associated with more apple production.   However, the direct effect is an increase in the supply of apples, shifting the supply curve to the right.   Output and profits rise, prices fall.

What happens to spending on apples depends on the elasticity of demand.   If demand happens to be unit elastic, then spending on apples remains the same.   If total income and expenditure is held constant, then the demand for oranges remain the same.

If the demand for apples is inelastic, then spending on apples fall.   Some of those involved in the apple industry must earn lower nominal incomes.   However, what this means is that some of those buying apples want to use part of their added real incomes to purchase other goods.  In a two good scenario, that is a higher demand for oranges.  Prices and profits rise in the orange industry as does the production of oranges.  Where do the resources come from?   Out of the apple industry.   Demand rises in the various industries where people want to buy more.  While "demand" remains the same in apple industry, spending falls.   Isn't that exactly what provides the proper signal and incentives?

On the other hand, if the demand for apples were elastic, then the increase in supply of apples results in more spending on apples.   That means that the lower price of apples motivates some of those purchasing other goods to spend more on apples.   In the two good scenario, that is less spending on oranges.  Prices, profits, and production fall in the orange industry.   This pushes resources out of the orange industry into the apple industry, where total spending and incomes are rising.

At least qualitatively, these adjustments appear appropriate.   Again, there is no guarantee that there would be no net change in the demands for resources, such as labor, there would surely be at least some offset.

And, of course, this is exactly how nominal GDP targeting works.

(Schumpeter's theory of the business cycle very much depends on credit demand and the quantity of money being driven by innovation.   More innovation results in more credit demand, an increase in the quantity of money and so nominal GDP.   The "problem" of recession occurs when innovation slows or stops.  Whether this could occur with a constant quantity of base money or even some broader measure of money hardly matters to Market Monetarists.   Our approach constrains the process of creative destruction to operate in an environment of stable nominal GDP.)

Anyway, we had nearly a half-century of Hayek and Mises, and their followers arguing that trying to generate "full employment" by increasing the quantity of money is a bad idea.   If there is a need to reallocate resources from capital goods production to consumer goods production, then trying to keep employment unchanged in capital goods industries is a bad idea.   Similarly, trying to maintain employment in industries producing obsolete product is a bad idea.   Trying to maintain employment in industries where productivity has increased and demand is inelastic is a bad idea.

Targeting total employment or unemployment is a bad idea.

Similarly, trying to maintain the real output of capital goods or obsolete products or import competing industries or housing or.... anything, is a bad idea.     If bottle necks limits expansion in some industries while decreases in output occur rapidly in shrinking industries, then real output will fall.   Nominal GDP level targeting does not try to keep aggregate real output from falling in that circumstance or any circumstance.   In particular, it does not propose increasing the quantity of money and nominal GDP to reach some target for real GDP.

Targeting real GDP is a bad idea.

 Nominal GDP level targeting is not the unemployment rate targeting.  Nominal GDP is not real GDP targeting.   Isn't that obvious?

Of course,  I don't favor keeping nominal GDP constant in a progressive, growing economy. (I don't favor Hayek's "ideal" policy.)  I favor a stable growth path for nominal GDP, with the growth rate based upon the estimated growth of potential output.   At any point in time, the level of nominal GDP is given and the above analysis applies.

I need to explain why this growing trend for nominal GDP is not especially disruptive, and more importantly, not more disruptive relative to the alternatives--including constant nominal GDP.  I'll get to that.

Returning to Wagner and Veetil, I need to explain why accumulating money balances due to uncertainty is saving and as such, implies a reduction in the natural interest rate.   In other words, it is appropriately coordinated with other households and firms by an adjustment in market interest rates.    There is nothing about a temporary increase in the demand for money due to uncertainty that makes reduced nominal GDP somehow coordinating and an expansion in the nominal quantity of  money discoordinating.