A Beautiful Mind

The reasoning is from Marcus Nunes:

One of the effects of the ongoing crisis, characterized by an abrupt and steep fall in AD [Aggregate Demand] ... was to bring back the discussion of what should be the target of MP [Monetary Policy]. To the proponents of the view that the Central Bank should have as its objective the stability of AD, this is the “key” to macroeconomic stability – national or global.

(Marcus seems to be one of those proponents.)

For this group, shocks to AD are the true source of macroeconomic volatility while inflation is just a symptom of those shocks. Just like in medicine, symptoms may be related to different causes, so that prescribing the correct treatment is not trivial.

(I like that: Inflation is a symptom.)

Marcus sets up an example: an economy with "nominal expenditures growing at the rate of 5%" and "an RGDP growth of 3%" per year. The difference leaves us 2% annual inflation. Then he introduces a change:

Let us suppose that the economy experiences a real, or productivity shock that permanently raises the level of potential RGDP (fig. 8). In this case ... RGDP growth increases to 4% and inflation falls to 1% with AD growth remaining at 5%.

Tidy and simple and easy to understand: RGDP -- real output -- increases by 1%, inflation decreases by 1%, and the total remains the same.

Marcus Nunes' Figure 8

In Marcus's Figure 8, the green line represents the path of real output or RGDP. It is a straight line, meaning that the growth rate is constant. The angle or slope of the line represents the 3% growth rate. This "original path" is shown as a dotted green line continuing at 3% once the change begins.

The red line shows the effect of the change. The slope of the line is steeper and the rate of growth is more: 4% during the change, rather than 3%. But once the new, higher level is achieved, the rate of growth returns to 3%. So we see that the new, higher green line runs parallel to the original green line.

It is significant that Marcus supposes a change "that permanently raises the level of potential RGDP" -- the level, not the rate of growth. If it was a change to the rate of growth, the new green line would show a steeper slope, like the red line. This is not the argument. As Nunes puts it:

Note that in time the economy returns to point a with growth falling back to 3% and inflation moving back to 2%. The level of RGDP is permanently higher and the price level will be permanently lower.

The orange and purple lines on Figure 8 show what happens with inflation, during the changes to output described here.


Marcus continues:

This will be the outcome if the Fed keeps the growth of AD at 5%. However, if it strives to keep inflation at 2% after it falls to 1% as a result of the positive supply shock, increasing AD growth [implies that] the economy will be growing above its potential...

We begin with 5% AD realized as 3% real growth and 2% inflation. A new technology or something suddenly means we can have a higher (though not faster-growing) level of output. The economy temporarily grows at a faster rate to reach the new target level. The economy grows 1% faster, and prices go up 1% slower. So temporarily, we have 4% real growth and 1% inflation. The growth of AD remains at 5%.

But, Nunes says, suppose Monetary Policymakers rely on "Inflation Targeting". They see the decline of inflation from 2% to 1% and they are concerned that the economy is slowing. So they boost Aggregate Demand to compensate. As a result, RGDP growth increases from 4% to 5% and inflation increases from 1% to 2%. Total AD growth rises from 5% to 7%. (My numbers.)

Now, Nunes says, "inflation pressures will appear". "AD will have to be constrained". Policymakers will reduce interest rates and boost growth "in order to keep inflation on target. In this case RGDP and employment volatility will certainly be higher than if the Fed had operated to keep AD growth stable."

Rather than relying on inflation targeting, with Fed officials scurrying to outguess the economy's performance, Nunes would target NGDP on a reasonable path, and let economic forces duke it out to divvy up the spoils between inflation and real growth.

Marcus Nunes makes an awesome argument.


In his post, Nunes shows several graphs of US economic data, and ties the argument back to actual events:

AD instability after 1998 is associated with Fed actions. First the Fed reacted to a below target rate of inflation and then, in the opposite direction, reacted to an exuberant RGDP growth rate. This is indicative that an IT regime has an important flaw that manifests itself when the economy experiences supply shocks...

He summarizes:

[If monetary policy] is successful in keeping AD growth stable, the system adjusts while volatility remains low. If the Fed manipulates AD, influenced in turn by an inflation below target and then influenced by RGDP growth above potential, the system also adjusts – in the sense that inflation returns to target and growth to potential – but the shocks to AD resulting from these manipulations impart an undesired high level of volatility to the system...

In other words: Rather than relying on inflation targeting, with Fed officials scurrying to outguess the economy's performance, Nunes would target NGDP on a reasonable path, and let economic forces duke it out to divvy up the spoils between inflation and real growth.


Marcus, it's a great argument. Maybe I will stop saying NGDP Targeting does nothing for growth. Maybe I have to state my objection more clearly.

For the record, I really like the idea to let market forces determine the split between real growth and inflation, within the AD growth window that the Fed provides. I do like it. But the split will not be good, Marcus, until the cost push pressures are dealt with -- cost push pressures arising from the excessive reliance on credit.

Resolve those pressures, and your market forces will treat us well. Fail to resolve them, and we will find ourselves in the midst of another Great Inflation. We will find ourselves once again adopting Inflation Targeting as the more effective strategy. And this time it will be an argument with 30 years of evidence supporting it.

Marcus, the problem is that our economy is distorted by the costs arising from excessive debt, excessive reliance on credit, and excessive growth of finance. Those costs must be reduced.

We obviously cannot reduce those costs any longer by reducing interest rates. The only remaining option is to reduce accumulated debt, reduce our reliance on credit, and reduce the size of finance as a share of GDP.