Need more behavioural relationships please

I started life as a microeconomist, which is why the sort of discussion about nominal shocks going on between Sumner, Kling, and Woolsey seems a little weird to me.

To horrendously oversimplify the positions in order to make this post easier to tie together, Sumner seems to state that the Fed needs to print money with a nominal GDP target in mind, Woolsey suggests that the Fed should change inflationary pressure given a set real GDP target, and Kling states that we only have real shocks and so the idea of a “nominal shock” is not of use.

These three views as regards nominal GDP seem to be:

  1. Sumner:  The Fed can change nominal GDP and keeping growth in this stable is good
  2. Woolsey:  Nominal GDP is pre-determined (within some bounds) and so monetary policy can be adjusted to keep us on a “real growth” path (which is related to potential)
  3. Kling:  Readjustment leads to shocks in real output.  Nominal factors are not important

The problem is that none of these theories are absolute – they are all right in part.  Why is this a “problem”?  Well the debate seems to view them as mutually exclusive when in reality bits and pieces of them are happening all the time.

I would say that a stable path of nominal GDP matters because people form expectations on the basis of nominal values.  This is similar to arguing for a stable path of inflation, it just takes it a step further when output exogenously declines.  Given people form contracts on the basis of future expectations regarding prices and the level of nominal activity it makes sense for the monetary authority (who do control nominal variables) to make the adjustment path as stable as possible.

On the other side, Woolsey effectively points out that this idea doesn’t give a clear transition path from nominal to real GDP.  If the Fed targeted nominal GDP instead of inflation, then the inflation target will be more variable.  A more variable inflation target creates uncertainty which could lower real output.

And finally, the idea of nominal targeting cannot explain why output may adjust.  A supply side (or recalculation style) shock such of that provided by Kling could provide this.  Of course, there are a number of other shocks that may do the same (eg undue tightening by the Fed, like bringing in interest on reserves when the optimal interest rate was already hitting at zero.  Or an exogenous, self-enforcing, change in expectations among agents).


In truth we will almost NEVER be able to clearly define whether we are facing a supply shock, a relative price shock, a macro-economic co-ordination failure, or a straight nominal shock.  Why?  Because we will always be facing a little bit of all these things.

What we should be doing is trying to understand the different transition paths these shocks work through.  If we understand how a shock functions, we can be sure to make better policy to limit the cost to society of said shock.

If anything, this indicates that using a DSGE style model (possibly with some room for non-linearities) IS the way to move forward – contrary to all the abuse mathmatical modeling has put up with in recent months.

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