My views on monetary economics
By Scott Sumner
In this post, I’ll use “(e)” to denote a (market) expected value.
1. NGDP(e) is the single most important variable in macro; it should be the centerpiece of modern macro. Unfortunately, it often doesn’t even appear in models.
2. NGDP(e) should be used as an indicator of the stance of monetary policy. Instead the highly misleading fed funds rate is often used. Some economists cite the difference between the actual and natural rate of interest, but the natural rate is unobservable, and hence not useful.
3. Interest rates and the price level should be dropped from macro models for “never reason from a price change” reasons. Changes in interest rates and changes in inflation don’t tell us anything useful about the economy, at least nothing that cannot be better demonstrated with alternative variables. Regarding the price level, Keynes agreed with me, ustilizing a nice analogy in the General Theory:
But the proper place for such things as net real output and the general level of prices lies within the field of historical and statistical description, and their purpose should be to satisfy historical or social curiosity, a purpose for which perfect precision — such as our causal analysis requires, whether or not our knowledge of the actual values of the relevant quantities is complete or exact — is neither usual nor necessary. To say that net output to-day is greater, but the price-level lower, than ten years ago or one year ago, is a proposition of a similar character to the statement that Queen Victoria was a better queen but not a happier woman than Queen Elizabeth — a proposition not without meaning and not without interest, but unsuitable as material for the differential calculus. Our precision will be a mock precision if we try to use such partly vague and non-quantitative concepts as the basis of a quantitative analysis.
4. There are welfare effects of changes in trend NGDP growth and also the volatility of NGDP. There are welfare effects from instability in hours worked. The “divine coincidence” that some economists believe applies to inflation and output, actually better applies to NGDP growth and hours worked. Low and stable NGDP growth minimizes the welfare costs of “inflation”, and also leads to approximately optimal hours worked. Not exactly, but more closely than for inflation and output.
5. NGDP fluctuations are monetary shocks, they are not financial or real shocks. But they do have financial and real effects.
6. The lesson of the Great Recession is that macroeconomists need to spend less attention on the financial system. Bernanke attempted to integrate the financial system into macro in his famous 1983 AER article, which argued that banking problems directly depressed output during the early 1930s. That led Bernanke and others to wrongly conclude that fixing the banking problem was the way to stabilize the economy in late 2008. In fact, the Fed needed to use monetary policy to try to prevent a steep fall in NGDP. It did not even attempt to do so. Indeed the (contractionary) monetary policy of interest on reserves (adopted in October 2008) was aimed at depressing the economy, while the Fed worked to rescue the banking system.
7. The New Keynesian/NeoFisherian debate is focused on the wrong set of issues. It’s not a question of who’s right—they are both wrong to focus on interest rates—it’s about how to determine which shocks have NK effects and which shocks have NF effects.
a. Sometimes monetary shocks have NK effects. This occurs when an easy money policy leads to lower interest rates, a weaker currency, and an increase in the expected rate of appreciation in the domestic currency (due to lower interest rates and interest parity). An example was the QE announcement of March 18, 2009.
b. Sometimes monetary shocks have NF effects. This occurs when a tight money policy leads to lower interest rates, a stronger currency, and an increase in the expected rate of appreciation in the domestic currency (due to lower interest rates and interest parity). An example was the Swiss currency appreciation of January 2015.
8. Most business cycles in large complex economies occur when NGDP moves unexpectedly in the presence of sticky nominal hourly wages. These monetary shocks cause a fluctuation in the ratio of NGDP to hourly wages, and this leads to a similar fluctuation in total hours worked—the essence of a business cycle:
9. There may be a zero lower bound of interest rates (or perhaps a slightly negative lower bound), but this is not a problem. There may be a problem of a zero lower bound of eligible assets not yet purchased by the central bank. But if so, it is a self-imposed problem. Make more assets eligible, or raise the trend rate of NGDP growth. Socialism or inflation.
PS. Ramesh Ponnuru and David Beckworth have an excellent piece in National Review, which discusses both the logic of a higher inflation target, and why a NGDP level target is the superior option. Highly recommended.