Wednesday, February 15, 2012

NGDP targeting, for beginners

What is nominal gross domestic product (NGDP)? It is, in principle, the level of money expenditures on the economy's output. If you buy a good produced by the economy for the price of $x, then you raise NGDP by exactly $x. Of course, the government does not track every money expenditure, but it estimates NGDP based upon various inputs.

What determines NGDP? In a word (really three words): the central bank. Why? The central bank is the monopoly producer of money (defined here to be paper notes and coins). It is legally permitted to produce however much money it sees fit to produce. Moreover, money's cost of production is nearly zero. Consequently, the central bank is in complete control of the money supply.

At any point in time, the public only wants to hold onto so much money (its money demand). The rest it wants to spend or invest (free up for others to spend). If the central bank provides more money than the public wants to hold onto, putting it in the public's hands by purchasing assets from them, then the public will spend the excess money, raising NGDP. If the central bank provides less money than the public wants to hold onto, removing it from the public's hands by selling assets back to them, then the public will cut back spending, lowering NGDP. Because the central bank determines the money supply, it by extension determines the level of money expenditures, or NGDP.

There is one exception to this relationship. Consider a case in which the quantity of money the public wants to hold onto becomes entangled with the quantity of money the central bank provides. To be more specific, suppose that every time the central bank expands the money supply by $x, the public's demand for money expands by $x, too. This situation is called a 'liquidity trap'. If the central bank tries to raise NGDP by expanding the money supply, it will fail to do so no matter how much money it creates.

The only way to raise NGDP in a liquidity trap is to contract the public's demand for money. The way to do this is to make holding onto money less appealing. How is the central bank supposed to do that? Liquidity traps do not last forever. Once the economy exits a liquidity trap, money demand becomes disentangled from the money supply. At that point, if the central bank expands the money supply, then the value of money will fall (the value of money equilibrates money demand with money supply). If the central bank credibly promises to do just that when the time comes, the public will expect the money they hold onto to decline in value. This makes holding onto money less appealing. The less money the public holds onto, the more it spends, raising NGDP.

Thus, by managing not only the contemporary money supply, but also expectations concerning the future money supply, the central bank is always the determinant of NGDP. Why, though, does NGDP matter?

Everyone's expenditure is someone else's sale. NGDP, therefore, also measures the economy's money-denominated output. Let P be the price level, the price of a typical good or service. Let Y be real output, the quantity of typical goods and services the economy produces. It follows from the preceding observations that NGDP = P*Y. Many economists posit sticky prices--that is, they believe that many prices adjust only sluggishly to various kinds of shocks. Price stickiness implies that P moves slowly in response to NGDP shocks. As a consequence, shocks to NGDP induce shocks to Y, or real gross domestic product (RGDP):

Monetary (NGDP) shocks have real (RGDP) effects. RGDP, or Y, is the economy's real output. Producing lower levels of real output does not require employing so many inputs--e.g., labor:

Monetary (NGDP) shocks drive the business cycle. Stable NGDP growth minimizes shocks to RGDP, smoothing the business cycle. In contrast, sudden, deep contractions in NGDP cause severe recessions:

At any point in time, there is only so much real output the economy can produce. Too fast NGDP growth maxes out Y, necessitating rapid growth in P--that is, inflation:

Stable, moderate NGDP growth maximizes employment while keeping prices stable, fulfilling the dual mandate of monetary policy. Targeting stable, moderate NGDP growth, therefore, is usually the best course for monetary policy. What, then, is the prescription for lowering the unemployment rate in the US, which has been experiencing slow NGDP growth? More money => more NGDP => more employment?

Looks like more money isn't doing the trick. Looks, therefore, like we're in a liquidity trap--the solution to which is the management of expectations concerning the future money supply. Suppose that, instead of targeting stable, moderate NGDP growth, the central bank targets a stable, moderately rising trajectory (or path) for NGDP. Under normal circumstances, the two policies work more or less similarly. The difference is that the former policy is forgiving of past failures, while the latter never forgets.

If, because of a liquidity trap, the central bank fails to keep NGDP growing at the usual rate, the former policy will continue to strive for NGDP growth at the usual rate once the liquidity trap is behind us. The latter policy, by contrast, will strive for faster than usual NGDP growth in order to catch up to the targeted path. Faster NGDP growth will require a bigger than expected money supply, post-liquidity trap. Thus, if the central bank targets a stable, moderately rising trajectory for NGDP, then encountering a liquidity trap automatically commits it to a bigger than expected future money supply (the longer the trap lasts, the bigger the commitment), which is precisely what our earlier discussion of liquidity traps called for.

Suppose that the Federal Reserve, the central bank of the United States, promises to do everything in its power to restore NGDP to its pre-crisis trend line (see the third figure above). Since we're in a liquidity trap, this commits it to expanding the future money supply until NGDP makes a full, speedy recovery, but to do no more than that. Doing so would cause the public to expect the value of their money to decline over time, discouraging them from holding onto so much of it, thereby stimulating NGDP right now. And more NGDP, given sticky prices, would increase employment right now. The way to reduce the unemployment rate in the US, therefore, is for the Federal Reserve to target a stable, moderately rising trajectory for NGDP--in particular, to promise to continue NGDP's pre-crisis trajectory in a timely manner. Welcome, friends, to NGDP targeting.

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