Real and monetary shocks, a numerical example
Here’s Tyler Cowen:
Closer to the central point I think is Scott’s claim: “Any “real shock” that reduces NGDP expectations because the Fed responded passively is also a monetary shock.” For me that is a real shock with insufficient monetary accommodation, not a “real shock,” as Scott gave it quotation marks, and also not a monetary shock. I prefer not to smush real and monetary shocks together in that fashion, and I think some ngdp theorists are trying to claim an explanatory victory by fiat by doing so. I do not think this matters for policy, and as I’ve stated I am very sympathetic to market monetarist recommendations. But in terms of explaining downturns, again, I think they are trying to claim some victories by fiat.
Here I think it would help clarify things to do some examples with numbers. Let’s assume a negative real shock—say the government orders companies to give everyone a 5% raise immediately. For simplicity, let’s assume that this policy shock reduced aggregate hours worked by 5%, for any given NGDP. (The specific numbers don’t matter; you simply need to assume some sort of negative real shock. If you don’t like mine, then assume something else, like mandated vacations.)
Of course real shocks often become entangled with monetary policy, and thus NGDP may also change. Here are three options:
a. The monetary base is not changed, and the wage shock causes V to fall by 3%, as there is less demand for credit to finance new investments. Now wages are up 5% and NGDP is down 3%, reducing hours worked by 8% (perhaps). I’d say the real shock reduced hours worked by 5%, and the monetary shock by another 3%. As we will see, it’s not clear what Tyler would claim.
b. The Fed increases the base enough to offset the shock to velocity, keeping NGDP unchanged. Now hours worked fall by 5%. I claim that’s now a 100% real shock.
c. The Fed increases the base enough to raise NGDP by 5%, and hours worked don’t change. Here we have a negative real shock and a positive monetary shock.
Now what would Tyler Cowen make of all this? You might be tempted to claim that he would regard the entire 8% decline in hours worked in case A as a real shock, as monetary policy was “passive” in that case. But I fooled you with framing techniques. There is no reason to assume that Tyler would consider a fixed monetary base as a “passive” monetary policy. Indeed in some of his recent posts he seems to suggest that a stable interest rate target is a passive monetary policy. Thus he characterizes the 1/4% rate increase in December as a small tightening.
The problem here is that policies that look passive in one dimension look active in another. A stable base will often be associated with changing interest rates, and vice versa. There is no generally agreed upon metric for determining whether a central bank is “doing something”, and how much it is doing. The Fed cut rates from 5.25% to 2% in late 2007 and early 2008, with doing anything to the base. Was that passive? I agree with people like Ben Bernanke and Michael Woodford, that the most useful policy indicators are outcomes indicators, such as inflation and NGDP growth (obviously I prefer NGDP growth.)
Suppose you have a knife wound that leads to an infection. I consider those to be two distinct problems. The knife wound needs sewing up. The infection needs antibiotics. We need a monetary policy that prevents real shocks from infecting NGDP, because when they do so it causes additional problems for the economy, above and beyond the losses directly attributable to the real shock. In the example above, the foolish wage policy cost us 5% worth of hours worked. But let’s not compound the damage with a monetary policy that fails to stabilize NGDP, and hence causes even greater losses.
In fairness, Tyler agrees with the logic of NGDP targeting, but not the logic of blaming the central bank for failing to do the optimal policy. So maybe it’s just a question of semantics. But semantics matter, and the more pressure we put on central banks to excel at their jobs, the more we demand from them in terms of stable NGDP growth, the better they will do.
Let’s start characterizing unstable NGDP expectations as “reckless monetary policy shocks.” It doesn’t matter if it’s true or not, it’s useful.
Update: Several commenters pointed out the medical metaphor was misleading. I didn’t mean to suggest the doctor caused the infection by failing to treat the illness. The point of the metaphor was that a given shock can product a completely unrelated problem. The Fed is more like a doctor who is hired to watch over you every single second of the day and make sure you have the optimal amount of antibiotics in your bloodstream at all times. (If we want to stretch the metaphor to absurd lengths.)