## Implementing Nominal GDP Targeting via Monetary Authorities Alone

Nick Rowe sends us to Bill Woolsey on implementing level nominal GDP targeting:

Monetary Freedom: Krugman Advocates Nominal GDP Targeting: I was much more guilty of ignoring the key role of expectations early on. The relationship between expected future nominal GDP and current nominal GDP played little role in my thinking. I certainly downplayed the problems associated with a liquidity trap.

On the other hand, I have never assumed that modest changes in the quantity of money would generate whatever nominal GDP the Fed wants. I have always thought that quantitative easing in heroic amounts might be needed to keep nominal GDP on target in a situation what would otherwise develop into a Depression….

There is no need for the Fed to say that it wants more inflation. However, it does need to be willing to accept higher inflation if that is the consequence of nominal GDP rising to the target growth path. The expectation that the Fed would respond to any increase in inflation that occurs by giving up on the target for nominal GDP would make it difficult and perhaps impossible to reach the target growth path.

The Fed cannot play at nominal GDP targeting. It must adopt the new regime. It should adopt the new regime--it is better.

And:

Monetary Freedom: DeLong on Nominal GDP targeting: DeLong commented on Krugman's support of nominal GDP targeting. (He had already advocated the regime change, along with quantitative easing and negative interest rates on reserve balances.)

The thrust of his comment is that money creation and fiscal stimulus should be used together. Either monetary policy alone or fiscal policy alone have doubtful consequences, but by creating money and having the government spend it, there is no doubt it can work. I am much more confident that monetary policy can do it alone.

What are his doubts? What is the market process he describes?

If you are--as we are right now--in a liquidity trap, with extremely interest-elastic money demand, then expansionary monetary policy that involved the Federal Reserve buying financial assets for cash:

1. will have next to no effect on the short-term safe nominal interest rate--it's already zero.
2. will decrease the long-term safe nominal interest rate to the extent that your open-market operations today change people's expectations of what your target for the short-term safe nominal interest rate in the future. 3/ will decrease the long-term safe real interest rate to the extent that it decreases the short-term nominal interest rate and changes expectations today of what inflation will be in the future.
3. will decrease the long-term risky real interest rate to the extent that it decreases the long-term safe real interest rate and to the extent that the assets purchased for cash by the Federal Reserve free up the risk-bearing capacity of private investors and lead to a reduction in risk spreads.
4. will increase spending to the extent that it decreases the long-term risky real interest rate and to the extent that private spending responds positively to decreases in the long-term risky real interest rate.

Lots of steps here, some of which may well be weak….

An alternative process is that expectations of a higher future flow of money expenditures on output will result in an increase in the profit-maximizing level of output and employment. The increase in the future profit-maximizing level of output increases the demand for capital goods now…. The increase in the future profit maximizing level of employment decreases the risk of future involuntary unemployment. This results in a decrease in saving now…. Given the level of real interest rate… the present flow of money expenditures on output rises…. [T]he IS curve shifts to the right because of an increase in expectations of future real output and income…. Why is this process ignored? It does, of course, have a "confidence fairy" element. But so does the process based upon higher expected inflation. Expected inflation can only be created if, somehow, nominal expenditure is going to increase in the future.

Suppose that no one believes that nominal expenditure will rise. Sadly, this forecloses both the higher future real output and higher present natural interest rate path, as well as the higher expected inflation and lower real interest rate path. Does that only leave us with the pathways described above? Expectations about future policy rates and "free up the risk-bearing capacity of private investors and lead to a reduction in risk spreads?"

I believe that DeLong's approach is too deeply tied to the new Keynesian modeling strategy. The market monetarist approach is that the Fed must commit to purchase whatever quantity of assets needed to reach and stay on the target growth path….

Why is it that the effect on the "IS" curve is ignored?… [We] know that strong recoveries create strong credit demand which raises equilibrium real interest rates. In my view, the new Keynesian models are just too tied to a regime of a central bank that adjusts a short and safe interest rate according to output gaps and inflation. They are poorly suited to considering an alternative regime where current and future interest rates can be at any level, and what is stabilized is the growth path of nominal GDP.

I don't deny that if no one expects the policy will raise nominal GDP, then lower nominal interest rates are what make massive quantitative easing work despite perverse expectations…

And:

Monetary Freedom: Williamson on NGDP targeting: Stephen Williamson has noticed nominal GDP targeting, but clearly hasn't paid much attention…. He tries to make sense of the proposal by discussing it in the context of the Taylor rule…. Nominal GDP targeting isn't about creating expectations about future short term rates and how those will impact output gaps and future inflation. It is about creating expectations about the future level of nominal GDP…. Williamson… e has described is a proposal to stabilize the growth rate of nominal GDP. The proposal is to target the growth path of nominal GDP….

Nominal GDP targeting doesn't require that output gaps be measured. Nor does it require choosing a measure of inflation. (By the way, the CBO estimate of potential output has been running below trend for more than five years. Williamson should get around a bit more.)

Williamson then comes to his conclusion:

Could the Fed actually achieve such a target, even if it wanted to? No. Under current circumstances, there are no actions the Fed can take that could necessarily achieve such an outcome. Indeed, it is possible that the Fed could promise to keep the policy rate at 0.25% for five years in the future, and NGDP growth could fall below the target.

Market monetarists don't… favor targeting interest rates at all. I suspect that in Williamson's model economies, the Fed really would have to purchase all assets, and if representative agents have the wrong preferences and technology, the price level would stay the same. But the problem is with his model…

And Nick Rowe:

Worthwhile Canadian Initiative: E(NGDP) level-path targeting for the people of the concrete steppes: You want me to tell you a story in which the central bank pulls a lever, and that lever causes another lever to move next, followed by another lever, then another, spelling out a causal chain from beginning to end, where the end is a higher level of NGDP. But economics isn't like that. Because people aren't like that. Sometimes the future causes the present, because people's expectations of the future affect what they do in the present….

The US economy is currently in equilibrium. It's not a market-clearing equilibrium. It's not a very good equilibrium. But it is an equilibrium. If it wasn't an equilibrium, it would be somewhere else. But it isn't somewhere else, so it must be. Given what people expect other people to do, both now and in the future, each person is choosing to do what he is currently doing.

But this isn't the only possible equilibrium. I can imagine a better equilibrium, in which Nominal GDP is higher and growing faster, and expected to remain higher and growing faster….It's a better equilibrium. And those of us who advocate E(NGDP) level-path targeting want the US economy to move to that better equilibrium.

What would the Fed be doing differently, in that other, better equilibrium? The Fed will be smaller than it is today, and the Fed's interest rate will be higher than it is today. Real interest rates will need to be higher, because consumption and investment demand will be higher, because consumers and investors will have higher expectations of future real income and real expenditure. Nominal interest rates will be higher because prices are expected to be growing faster. The Fed will be smaller, because people won't want to hold as much money, and banks won't want to hold as many reserves at the Fed, now the economy is growing and interest rates are higher.

So, all the Fed needs to do to get the economy to that new, better equilibrium is to pull the lever in the right direction, right? Raise interest rates, and reduce the money supply, right?

Of course not. If the Fed did that, without changing expectations, the result would be a a move even further away from the better equilibrium, as demand fell even further.

The Fed needs to change expectations. Get people to expect that NGDP will follow the higher path. That's what the "E" in "E(NGDP)" stands for.

"Right!" the people from the concrete steppes exclaim gruffly "and how exactly will the Fed do that?!"

• The Fed clearly announces its target path for NGDP. That's by far the most important bit. Everything else is secondary. And if the Fed had credibility, that would be enough.

"Why should anyone believe the Fed can hit that path?"

• The Fed makes a threat. On the first day the Fed will print $1 billion and use it to buy assets. On the second day the Fed will print$2 billion and use it to buy assets. On the third day the Fed will print \$4 billion and use it to buy assets. And the Fed will keep on doubling the amount it prints and buys daily, forever and ever, until E(NGDP) rises to the target path. (And will go into reverse and sells assets if E(NGDP) rises above the target path).

"What assets will the Fed buy?"

• The Fed puts on its best James Dean (oops, Marlon Brando, thanks Andy) voice and replies: "What have you got?"

There are two rooms at a party. The first room is nearly empty. The second room is nearly full. Because everyone wants to be where everyone else is. Then Chuck Norris enters the second room. He threatens to beat up 1 person at random in the first minute, 2 people in the second minute, 4 people in the third minute, and so on, until the room is empty. This is no longer an equilibrium.

A few people were nearly indifferent to being in the second room. So they leave even if the chance of them getting beaten up is tiny. That means there are fewer people left in the second room. This makes the second room slightly less attractive for those who want to be where everyone else is. And it slightly raises the probability of being beaten up by Chuck Norris. So more leave. Which repeats the process, so still more leave. And if you and I can see what's coming, so can the people in the room, who don't want to be the last to leave. There's a rush for the exits, and Chuck doesn't even have to lift a finger. OK, if someone didn't hear the threat, or doesn't recognise Chuck Norris, he might actually have to carry out his threat for a few minutes. But simply seeing all the others leave the room will be enough to induce most to leave the room very quickly.

Chuck Norris doesn't have to beat up everyone in the room. He just has to threaten to beat up as many as it takes to clear the room. The number of people he will actually beat up is a lot less than the number he threatens to beat up. If his threat is credible, and everyone hears it, he doesn't need to beat up anyone.

Eventually, if the Fed bought up every single asset in the economy, and swapped it for cash, NGDP would rise to the Fed's target path. Prices would rise without limit as the Fed bought up the last remaining assets because the sellers could name their price. And people would hire the unemployed to build factories which they could float on the stock and bond markets and sell to the Fed at any price they liked. Or sell to the people who had already sold all their assets to the Fed.

But there is no way it would ever get that far. That's like saying that Chuck Norris will eventually beat up everyone in the room. That's not an equilibrium.

Some people are just barely willing to hold cash in the current equilibrium. If they expect even the slightest rise in NGDP in even the distant future, they will get out of cash, and into real assets, or claims on real assets like commercial stocks and bonds. And this will increase the demand for goods today, either directly, or because firms find it easier to issue new stocks and bonds to finance investment. Which raises NGDP, and expected future NGDP, even if just a little. Which encourages additional people to exit cash too, and buy real assets and claims to real assets. Which raises NGDP and expected future NGDP still further. And so on. As soon as people figure out what's going on, and what's going to happen, expected NGDP rises to the target path. The Fed only has to carry out its threat until people catch on to what's happening. Then it has to reverse course and sell all the assets it bought, and then some more, to prevent the economy overshooting the new equilibrium…

The problem, I think, is that every time Nick Rowe writes "Chuck Norris won't have to lift a finger" he is changing the situation from one in which Chuck Norris enters the room into one where a six-foot cutout of Chuck Norris is carried into the room, and an economist says: "this cardboard cutout will beat you up unless you move." And people laugh.

Fiscal expansion financed by printing money is the better option.