Ed Dolan's Econ Blog

NGDP Targeting is the Natural Heir to Monetarism

In a recent post, Daniel Alpert enlists Milton Friedman as an ally against the newly popular (but not new) idea of targeting nominal GDP. On the contrary, I see NGDP targeting as the natural heir to monetarist policy prescriptions of the 1960s and 70s.

If we look at the textbook version of monetarism, the point is almost trivial. Textbook monetarism begins from the equation of exchange, MV=PQ, where M is money (M1, back in the day), V is velocity, P is the price level, Q is real GDP, and PQ is NGDP. Next it adds the simplifying assumption that velocity is constant. It follows that targeting a steady rate of money growth is identical to targeting a steady rate of NGDP growth.

Of course, Friedman himself propounded a more sophisticated monetarism, one in which the linkage between monetary policy and NGDP was not so tight. He saw two sources of slippage as potential problems for a monetary growth target.

One slippage stems from the fact that the Fed does not control the money stock itself, but rather, the monetary base, which consists of currency and commercial bank reserve deposits. The link between the two is the money multiplier, that is, the ratio of the money stock to the base. The money multiplier is subject to several sources of variation. Interest rates can change the opportunity cost of holding excess reserves. Changes in reserve requirements, and in the demand for various types of deposits with different reserve requirements, also affect the multiplier. So does the public demand for currency, which in turn can be affected by inflation and interest rates. Friedman favored reforms of banking regulation that would make the money multiplier less variable, thereby improving the ability of the Fed to control the money stock.

The second source of slippage is that, in the real world, velocity is variable. Friedman used two different lines of argument to defend his monetary growth rule in a world of variable velocity.

The first is that much of the observed variation in velocity is itself a result of erratic monetary policy. For example, when accelerating monetary growth causes inflation, inflation, in turn, increases velocity. That positive-feedback loop is a key element in the recurrent episodes of hyperinflation that plagued the twentieth century. If monetary growth is held steady, the feedback loop is deactivated. The same reasoning applies to variations in velocity that arise from changes in nominal interest rates. With more stable monetary policy, nominal interest rates would be less variable, hence velocity would also be less variable.

Friedman’s second argument for targeting money growth in a world of variable velocity, and the more important one, is that the Fed should not in any event attempt to stabilize either the P or Q variable individually, or their product, in the short run. He viewed the transmission mechanism from money to the PQ side of the equation of exchange as being subject to long, variable, and unpredictable lags. Trying to fine-tune monetary policy in pursuit of an inflation or real GDP target in the face of those lags would be more likely to destabilize the economy than to stabilize it.

The bottom-line argument for monetarism was always that in a world subject to unpredictable lags and shocks, the best a central bank can do is to provide a simple, transparent, and predictable framework within which market participants can make decisions. Steady growth of the money stock would not completely eliminate business cycles or external shocks. Inflation could accelerate when real growth slowed. Inflation could slow, or even become mild deflation, during episodes of rapid, productivity-driven real growth. The important thing is that self-fulfilling expectations that inflation would bring more inflation, or deflation more deflation,could not set in. If the rate of growth of the money stock were held to a constant path year in, year out, monetary policy would be a source of stability, not instability, , as had so often been the case in the past.

The specific idea of targeting the growth rate of M1, or of any monetary aggregate, did not stand the test of time. Policy changes and the internal evolution of financial institutions ended up making both the money multiplier and velocity less stable over time, not more so. Today, even the ultra-conservative European Central Bank has all but abandoned monetary aggregates as a policy target.

Still, the hope for a simple, transparent, and predictable policy framework lives on. In my view, NGDP targeting is a modern embodiment of that monetarist hope. It seems to me that were Friedman around to participate in the the current debate, he would be far more likely to weigh in as an advocate of NGDP targeting than as an opponent.



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