Last time we noted the following regarding thinking about NGDP level targeting:
To understand what is going on we need to ask what expectations are being “set”, what is the “target” and how do these reflect what a central bank can “do”?
Expectations: We know they can be adaptive (backward looking) or rational (forward looking), but what do they refer to? Are people making choices based on expected prices, or are they making choices based on expected incomes? Do they view shocks as permanent or temporary?
Target: Is the goal to anchor the price level, or to anchor the level of expected nominal income growth? Is it to limit variability in prices and output?
What they do: If a central bank wants to increase prices can it, if it wants to increase nominal incomes can it? If they can do both, how does this influence their ability to “close output gaps”?
Here I want to discuss a little more about expectations.
The cases for NGDP targeting
Last time out we noted that flexible inflation targeting appeared to be able to do the same things – better – than NGDP level targeting. However, there are three reasons why NGDP targeting could be seen as preferable:
- During a downturn, where the economy has ended up in a “pareto inferior” equilibrium following a big shock, NGDP targeting works as a form of credible forward guidance for pushing the economy back to a superior equilibrium.
- NGDP prediction markets can, or could, exist. Such markets allow us to judge the stance of monetary policy, and the credibility of central bank actions, in real time – also making evaluation of central banks actions easier.
- NGDP/nominal income may refer to the expectations that individuals actually make decisions over.
Lets think about the last one a little more.
Nominal income expectations
Are average prices really what people base their choices on? When a firm invests it does so because it expects some return in the future. It will sign up to a debt burden to invest based on a nominal interest rate, expecting to be able to earn nominal sums in the future. This depends both on the price they can sell the good for and the amount they can sell.
Households buy durable goods based on a similar logic, they have some expectation of their future income and try to figure out how they can invest and spend given that constraint.
A nominal income target provides certainty about the nominal value of future incomes, thereby implying that if you are in an “average” situation that is how the income from your lifetime would grow. It is instability in this nominal variable that confuses people. Instability generates uncertainty suppressing investment. Uncertainty in turn makes investment incentives for households and firms unclear.
It is disappointing if the nominal growth was only prices – so that the 5% increase in your income in the future was because prices went up. However, when you have made spending plans based on nominal sums and borrowed and lent based on expectations of nominal sums, then it is the path of these nominal sums that you care about when making your choice.
Forcing the nominal sum to grow more slowly so that prices are stable will imply that, in a situation of secular stagnation, we would see inadvertently build up debt to income burdens as their nominal income rises less strongly than expected.
People who make poor investment decisions will still fail in this case, and people who make good decisions will earn returns about the target giving a signal that this is the right place to invest in. But the signal will be clear and certain given a target for average nominal growth.
This appears to be a stronger argument for NGDP targeting (as opposed to price level), but what about whether we target levels or growth rates?
In this case we can think about debt again. If we target the level, then people have an expectation that – at some point in the future – they will have a certain nominal income with more certainty than if it was a growth target. If the goal is to provide certainty for that path when people make a decision to invest, then level targeting makes sense.