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.

What do central banks do?

The central bank (CB) is the monopoly producer of high-powered money (HPM), which makes up the monetary base. HPM comes in two flavors: (1) physical currency--paper notes, coins, etc.; (2) electronic bank reserves. In a typical developed economy, commercial banks must, by law, deposit some fraction of their customers' deposits into electronic vaults supervised by the CB. The funds put towards meeting this mandate constitute a bank's 'required reserves'. Any extra funds the bank deposits constitute its 'excess reserves'. The CB is the monopoly producer of HPM for two reasons: (1) it is the only entity legally permitted to create new physical currency; (2) it is the only entity legally permitted to electronically credit participating banks' reserves.

The CB is typically free to produce however much HPM it chooses, in either form. Additionally, HPM's cost of production is, approximately, zero. Consequently, the CB controls the supply of HPM in the relevant currency zone.

Why does HPM matter? The prices of goods and services are quoted in units of HPM--HPM is therefore the 'unit of account'. HPM is also what consumers use to buy goods and services--HPM is therefore the 'medium of exchange'. In equilibrium, the value of HPM is determined by the supply of, and demand for, HPM. Hence, in the long run the CB, through its management of the supply of HPM (its 'monetary policy'), determines the value of HPM, which is the flipside of the price level--the average price of goods and services. The higher the value of HPM, the fewer the units of HPM necessary to purchase a given bundle of goods and services. The lower the value of HPM, the greater the units of HPM necessary to purchase said bundle. As a result, monetary policy, executed by the CB, determines the price level, and therefore the rate of inflation (the rate of growth in the price level), in the long run.

If prices are perfectly flexible, then the economy equilibrates instantaneously, which means the CB determines the price level and the rate of inflation in the short run, too. Moreover, its policies are otherwise irrelevant to the evolution of the economy. Economists inclined towards a flexible-price view of the economy, therefore, believe that the sole objective of monetary policy ought to be 'price stability', usually defined to be a low and stable rate of inflation. If prices respond to shocks only sluggishly (that is, if prices are 'sticky'), however, then the economy takes time to equilibrate, which means that the CB plays a bigger role in the short-run evolution of the economy. Economists inclined towards a sticky-price view of the economy, therefore, believe that monetary policy ought to concern itself with more than mere price stability.

Suppose, for example, that the demand for HPM jumps (for whatever reason). This puts upward pressure on the value of HPM, meaning downward pressure on the price level. If prices are sticky, however, then many prices will remain too high in the face of this pressure. When the price of a good or service is too high, producers have the capacity to produce more than consumers want to consume. Producers react to this demand shortfall by contracting their output, rendering some of their inputs (e.g., labor) redundant. If wages are sticky, too, then redundant workers will continue to seek employment where there is none. As a consequence, output falls, while unemployment rises. If, in response, the CB expands the supply of HPM, this puts downward pressure on the value of money, meaning upward pressure on the price level. This offsets the downward pressure on prices, restoring the economy to equilibrium. As a consequence, output rises, while unemployment falls. Note that, in the process, the price level more or less stays put--monetary policy is impacting the economy without much impact upon price stability.

Considerations of such possibilities lead sticky-price economists to pin the blame for business cycles on the CB. When the CB does not provide the economy with enough HPM, it causes a recession. When it provides too much HPM, it causes high and/or unstable inflation. Monetary policy, therefore, has as its objective not only price stability in the long run, but also maximum output/employment in the short run.

What, then, do interest rates have to do with monetary policy? Interest is the price of a loan. A higher interest rate causes savers to save more, borrowers to borrow less. Savers make up the difference by building up their HPM reserves, expanding the demand for HPM, which (other things being equal) causes a recession. A lower interest rate causes savers to save less, borrowers to borrow more. Borrowers make up the difference by drawing down their HPM reserves, expanding the supply of HPM, which (other things being equal) stokes inflation. Thus, the stance of monetary policy may be equivalently characterized by either the supply of HPM, or a target for a benchmark interest rate. (The CB usually has no reason to interfere with the pricing of risk, so it typically manages a benchmark interest rate with reference to which financial markets fix other interest rates.) How, though, does the CB move the market rate of interest in line with its target?

An open market operation (OMO) is a transaction wherein the CB buys or sells assets in the marketplace, by drawing down or building up its HPM reserves. Since the CB can, in principle, expand the supply of HPM without limit, it can, in principle, buy or sell whatever quantity of assets is necessary to move the market rate of interest in line with its target. Because it can do this, however, it need not do this. If the CB declares a target for its policy rate (the benchmark interest rate it manages), market participants understand that there is no point doing battle with the CB. The CB always has more HPM than you, by design. Consequently, communication is usually enough to move interest rates towards the target, though the CB often engages in medium-scale OMOs to show its resolve.

The usual business of the CB, therefore, is to publicly set its target for the policy rate in a such a way as to maximize output/employment, while maintaining price stability over the long run. Sometimes, however, managing the policy rate isn't enough for the CB to fulfill its dual mandate. More on this issue to come...

Issue #1: Unemployment in America, Pt. III

The recipe for a lower unemployment rate, then, is lower interest rates. Why isn't the US government delivering? Well, the Federal Reserve, the central bank of the United States,  which is responsible for setting interest rate policy, lowered its policy rate to essentially zero in late 2008, in response to the bottom falling out of the US economy. But why didn't it lower it some more? Why didn't the Fed go negative?

Suppose you have cash on hand. Your decision is whether to lend it to others or not. The Fed has pushed interest rates below zero. What do you do? I dunno about you, but I'd hang onto my cash. Why? Simple--cash earns (nominal) interest at a rate of precisely 0% per year. Zero sounds pretty bad, but I'd prefer zero to, say, negative three. Thus, if the Fed tries to push its policy rate into negative territory, folks will just hoard their cash, which does nothing for the unemployed.

What, in that case, can the Fed do for the unemployed under these circumstances? The Fed may no longer be able to lower interest rates today, but don't forget about tomorrow. Interest rates won't remain at zero forever, so there is surely a time at which the Fed is expected to raise interest rates. What the Fed can do today is to convince the public that it will not raise interest rates until there is enough aggregate demand to fully employ America's labor force.

Here is a picture of aggregate demand, as measured by nominal gross domestic product (NGDP) over the last decade:



 

Notice that when NGDP plunged, so did employment. Notice also that even though it has stopped plunging, we never caught up with the pre-crisis trend. That's why unemployment has remained so stubbornly high.

What the Fed ought to do is to make a commitment to keep interest rates near 0% until NGDP recovers to its pre-crisis trend level. In short, the solution to high unemployment is NGDP targeting. Think I'm pulling this out of my ass? Here's Goldman motherfucking Sachs. (Note that I was totally on this first--Jan Hatzius, bow to your sensai.)

That, my fellow Americans, is what I would do to put you back to work. Just hang in there for 13 years.

Next up: fossil fuels, deforestation, global warming, etc...

[Earlier posts in this series:

Announcing my bid for the US presidency

Issue #1: Unemployment in America

Issue #1: Unemployment in America, Pt. II

]

Issue #1: Unemployment in America, Pt. II

Suppose that you expect to have a certain amount of funds at your disposal (you're expecting your next paycheck, for example). What may you plan to do with those funds? One option is to spend them today, consuming goods and services produced by the economy. Another option is to save them today, so that you may consume goods and services down the line. If you decide upon the latter, you have two more options to choose from. The first is to free up your savings so that someone else may make use of them, in exchange for a promise of repayment (with interest) when you're ready to spend. The second is to keep your savings to yourself--that is, to hoard money--until you're ready to spend.

Whether you decide to consume (spend your funds yourself) or to invest (let someone else spend your funds), you're contributing to the aggregate demand for goods and services produced by the economy. It's only if you engage in hoarding that you deprive the economy of aggregate demand. The job of financial markets is to match savers with borrowers. If interest rates are just right, savers want to save as much as borrowers want to borrow. Consequently, there is little hoarding, and aggregate demand is plentiful. If interest rates are too high, savers want to save more than borrowers want to borrow, causing hoarding, thereby reducing aggregate demand.

In my previous post, I contended that greater aggregate demand would reduce the unemployment rate, putting willing workers back to work. If the preceding discussion is correct, then, the recipe for stimulating aggregate demand is lower interest rates. What, then, my fellow Americans, is my diagnosis of our jobs crisis? The interest rate is too damn high!

In my final post on this subject, I'll explain why lower interest rates may not be so easy for the government to engineer, under the unusual circumstances of the present.

[Earlier posts in this series:

Announcing my bid for the US presidency

Issue #1: Unemployment in America

]