Sunday, April 29, 2012

Simplest argument for central banks to target money income

The economic school that Lars Christensen named market monetarism, and whose blogging doyen is Scott Sumner, argues that monetary policy should be based on targeting NGDP (nominal GDP, GDP in money terms).

It is based on the equation MV = Py (= NGDP):

Money supply x Velocity  = Price level x output.

Nick Rowe has advanced three clever arguments for monetary policy targeting NGDP here.

The simplest argument I can think of for NGDP targeting is that people have expectations about their future income and the future (average swap) value of money. The worst thing one can do, for the level of economic activity, is to make people nervous about their future income but confident in the future value of money. For then they will hold onto their money, depressing the level of economic activity. Which then reinforces poor income-expectations, and so the pattern continues. (The higher the level of current indebtedness, so the higher existing claims on people’s income, the more this will be so.)

Thus monetary policy that provides an anchor for income expectations (by targeting NGDP) both avoids that danger and still provides some anchor for price expectations, since they will be bounded by the income expectations. (Given that prices will rise by no more than the gap between income and output.)

Conversely, providing an anchor only for price expectations provides no anchor for income expectations and runs the risk of exacerbating any fall in transactions as money supply, and so income, follows output down. Hence inflation targeting is inferior to income targeting.

Or, to put it another way, what matters to people is not merely prices, but prices x transactions (i.e. income). The purpose of money is to facilitate transactions. If you worry only about the (average swap) value of money you can end up frustrating the use of money to facilitate transactions. And a monetary policy that frustrates the use of money to facilitate transactions is not doing its proper job; worse, it can thereby cause considerable social harm by driving down the level of economic activity.

ADDENDA  Inflation expectations in the US are very low.

1 comment:

  1. Nice article. Please tel me how i can create my own blog like this...