Before I start blogging at Notes on Liberty, I just want to say how happy I am to join this collaborative venture. I generally blog in French at the Journal de Montréal and my English writings are confined to my academic papers. Hence, I am very happy to communicate with English audiences.
Actually, this is an opportunity to write about NGDP targeting. In the anglosphere, this rule-based approach to monetary policy has been very popular. In the french world where I evolve, it is close to a fringe point of view (given a strong Old Keynesian/New Keynesian viewpoint). As a result, any effort to expand on the issue requires that the issue first be raised. Hence, I have avoided discussing monetary policy in my French writings. But there is a point that needs to be made about NGDP targeting as advanced by people like Scott Sumner, George Selgin, the late Bill Niskanen, Marcus Nunes, Benjamin Cole, David Beckworth, Lars Christensen and David Glasner : the idea of targeting nominal spending (me switching from the term NGDP to “nominal spending” is important) does not mean that we ought to target nominal gross domestic product.
The intuition behind NGDP target is that monetary policy should be aimed at reacting to changes in demand for money. Thinking of the equation of exchange (MV=PY), a change in V should be matched by an opposite change in M so that MV remains stable. Any increases in Y(output)should be met by reductions in P(rices) and no changes in MV. In practice, NGDP targeting is about avoiding deviations from long-term trends in NGDP. However, while the equation is often presented as MV=PY, the original papers by Irving Fisher and others present it as MV=PT where Y (output) is substituted by T (transactions).
But is PT the same as NGDP? At any point in time, total spending in the economy is much greater than the sum of final goods. There are intermediate goods which are being produced – intangible capital, capital inputs and producers goods. NGDP avoids calculating these because it would lead to double-counting. Work by Austrian-friendly scholars like Mark Skousen proposes that the double-counting is actually a strength in certain cases. This is because the double-counting gives greater weight to production. Skousen calls it “Gross Output”(GO) and he finds that GDP is generally a fraction of GO (at 53% in 1982).
Now, GDP is best for measuring welfare in the long-run. However, for short-run discussion, nominal GDP is not (at all) the sum of nominal spending. Imagine an easy monetary policy which incites firms to produce more, there might be a lag between the increased production and “arrival on shelves” for consumers to buy. This occurs as firms acquire new producer goods and/or gear themselves to producing goods for other producers. This means that in the short-run, the ratio of NGO to NGDP (nominal Gross Output) could vary. Easy monetary policy could make NGO grow faster than NGDP.
In a way, I am saying that NGDP is Y while the equation of exchange should be about all transactions (T in the original Irving Fisher papers) and transactions is best represented by NGO. As a result, NGO is a better proxy for trends of nominal spending. Let’s make a first test of this (and I hope this gets the ball rolling) by looking at the data.
The NGDP crowd claims that prior to 2008, monetary policy was easy, allowing NGDP to grow above trend. Tight monetary policy during 2008-2009 led to a significant drop below trend which was the cause of the recession. With NGO (gross domestic output for all industries as presented by St-Louis Fed), we see the same story but much more clearly!
From 2005 (when the data start for NGO) to 2008, NGO grows much more rapidly that NGDP (the ratio actually increases to 2008) and then it falls dramatically in 2008-2009 and barely recovers to remain stable thereafter. However, the drop from 2008-2009 is much more pronounced than that for NGDP. This suggests that “overall” nominal spending did fall more than NGDP suggests.
If monetary policy should shift to targeting nominal spending, NGDP is not the best indicator – NGO is.