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Wide Off the Mark, or, Nonsense about NGDP Targeting

I meant to do so weeks ago, but I only just got around to reading the little flurry of posts concerning NGDP targeting that was set off by John Taylor's critical remarks on the topic. And now, despite the delay, I can't resist putting-in my own two cents, because it seems to me that much of the discussion misses the real point of targeting nominal spending, either entirely or in part; what's more, some of the discussion is just-plain nonsense.

Thus Professor Taylor complains that, "if an inflation shock takes the price level and thus NGDP above the target NGDP path, then the Fed will have to take sharp tightening action which would cause real GDP to fall much more than with inflation targetting." Now, first of all, while it is apparently sound "Economics One" to begin a chain of reasoning by imagining an "inflation shock," it is crappy Economics 101 (or pick your own preferred intro class number), because a (positive) P or inflation "shock" must itself be the consequence of an underlying "shock" to either the demand for or the supply of goods. The implications of the "inflation shock" will differ, moreover, according to its underlying cause. If an adverse supply shock is to blame, then the positive "inflation shock" has as its counterpart a negative output shock. If, on the other hand, the "inflation shock" is caused by an increase in aggregate demand, then it will tend to involve an increase in real output. Try it by sketching AS and AD schedules on a cocktail napkin, and you will see what I mean.

Good. Now ask yourself, in light of the possibilities displayed on the napkin, what sense can we make of Taylor's complaint? The answer is, no sense at all, for if the "inflation shock" is really an adverse supply shock, then there's no reason to assume that it involves any change in NGDP. On the contrary: if you are inclined, as I am (and as Scott Sumner seems to be also) to draw your AD curve as a rectangular hyperbola, representing a particular level of Py (call it, if you are a stickler, a "Hicks-compensated" AD schedule), it follows logically that an exogenous AS shift by itself entails no change at all in Py, and hence no departure of Py from its targeted level. In this case, although real GDP must in fact decline, it will not decline "much more than with inflation targetting," for the latter policy must involve a reduction in aggregate spending sufficient to keep prices from rising despite the collapse of aggregate supply. A smaller decline in real output could, on the other hand, be achieved only by expanding spending enough to lure the economy upwards along a sloping short-run AS schedule, that is, by forcing real GDP temporarily above its long-run or natural rate–something, I strongly suspect, Professor Taylor would not wish to do.

If, on the other hand, "inflation shock" is intended to refer to the consequence of a positive shock to aggregate demand, then the "shock" can only happen because the central bank has departed from its NGDP target. Obviously this possibility can't be regarded as an argument against having such a target in the first place! (Alternatively, if it could be so regarded, one could with equal justice complain that similar "inflation shocks" would serve equally to undermine inflation targeting itself.)*

But lurking below the surface of Professor Taylor's nonsensical critique is, I sense, a more fundamental problem, consisting of his implicit treatment of stabilization of aggregate demand or spending, not as a desirable end in itself, but as a rough-and-ready (if not seriously flawed) means by which the Fed might attempt to fulfill its so-called dual mandate–a mandate calling for it to concern itself with both the control of inflation and the stability of employment and real output. And this deeper misunderstanding is, I fear, one of which even some proponents of NGDP targeting occasionally appear guilty. Thus Scott Sumner himself, in responding to Taylor, observes that "the dual mandate embedded in NGDP targeting is not that different from the dual mandate embedded in the Taylor Rule," while Ben McCallum, in his own recent defense of NGDP targeting, treats it merely as "one way of taking into account both inflation and real output considerations."

To which the sorely needed response is: no; No; and NO.

We should not wish to see spending stabilized as a rough-and-ready means for "getting at" stability of P or stability of y or stability of some weighted average of P and y: we should wish to see it stabilized because such stability is itself the very desideratum of responsible monetary policy. The belief, on the other hand, that stability of either P or y is a desirable objective in itself is perhaps the most mischievous of all the false beliefs that infect modern macroeconomics. Some y fluctuations are "natural," in the sense meaning that even the most perfect of perfect-information economies would be wise to tolerate them rather than attempt to employ monetary policy to smooth them over. Nature may not leap; but it most certainly bounces. Likewise, some movements in P, where "P" is in practice heavily weighted in favor, if not comprised fully, of prices of final goods, themselves constitute the most efficient of conceivable ways to convey information concerning changes in general economic productivity, that is, in the relative values of inputs and outputs. A central bank that stabilizes the CPI in the face of aggregate productivity innovations is one that destabilizes an index of factor prices.

We shall have no real progress in monetary policy until monetary economists realize that, although it is true that unsound monetary policy tends to contribute to undesirable and unnecessary fluctuations in prices and output, it does not follow that the soundest conceivable policy is one that eliminates such fluctuations altogether. The goal of monetary policy ought, rather, to be that of avoiding unnatural fluctuations in output–that is, departures of output from its full-information level–while refraining from interfering with fluctuations that are "natural." That means having a single mandate only, where that mandate calls for the central bank to keep spending stable, and then tolerate as optimal, if it does not actually welcome, those changes in P and y that occur despite that stability.

*Over at TheMoneyIllusion Bob Murphy remarks that this part of my criticism of Taylor is "too glib." He's right: central bankers can't be faulted for failing to abide by a rule when that failure stems from their having failed to anticipate what is, after all, a "shock" to demand. But the main point of this part of my criticism is simply that, understood as referring to the consequences of an AD shock, Taylor's criticism is, not a criticism of NGDP targeting as such, but a criticism of any sort of nominal level targeting that doesn't allow "bygones to be bygones" when it comes to shock-based departures from the level target (12-1-2011).

  • Rob R.

    While I agree with your view that P and y are not appropriate things to target its less obvious to me why a stable level of spending is seen as the optimal policy goal. I understand that within a MET framework deviations in total spending are caused by changes the in demand for money. This will cause situations of monetary disequilibrium that can only be addressed by either an increase in the money supply or a change in the price level.

    Are there not some situations where a change in the price level is not better than an increase in the money supply ? For example:

    – When AD changes are reflected in lower demand facing a particular industry are there not some advantages in having those firms that can respond faster to this change gaining a bigger market share as a result ?

    – When increased demand for money is caused by an increased perception of risk as entrepreneurs choose to hold cash rather than invest. With no increase in the money supply input factor prices would need to fall and price spreads (and profits) must increase to the level where entrepreneurs will invest again. If instead the money supply increases to stabilize AD would this not cause inflation as supply moves along the AS curve in response to the new AD curve causing a combination of increased supply and increased prices?

    I would welcome your views on this.

    • Gamrot

      When the fall in AD is not symmetrical (some sectors suffer more than others), there will be a global recession with one sector suffering more than the others. If a central bank (or free banking system) is targeting constant NGDP, there will be no global recession, but there can be a structural change nevertheless. The current recession and situation in the housing market is the best example. If the FED have been targeting NGDP, there would be no global recession, but the housing market would suffer anyway.

      • Rob R.

        Thanks, I was really thinking of a situation where an industry does not necessarily "suffer" more than others (say demand falls the same in this industry as overall AD). Wouldn't consumers overall be better served if prices fell in that industry and the marginal firms were eliminated, as opposed to the CB increasing the money supply to bring AD back to trend and all firms surviving? I understand that in a MET world there can be a "cascading effect" as falling demand in one area (due to increased demand for money) infects demand in other areas, and that this can lead to recessions. It just seems there may be a trade off between efficiency of firms v stable AD that would not necessarily always favor stable AD over the long term.

    • George Selgin

      Rob, except for the last part, where you seem to have AD being stabilized and shifting at the same time, I don't see any argument here pointing to the desirability of AD changes. For instance, yes, there are times when a change in P is better than an increase in M. For instance, when productivity improves, raising y, its better that the consequent increase in money demand be accommodated by a decline in P. But all that is perfectly consistent with stability of Py.

      • Rob R.

        Thanks for your answer ! I understand (from reading "less than zero") the reasons why a productivity improvement will best be dealt with by a policy that allows prices to fall while holding AD constant.

        However here I am really trying to compare a regime of NGDP-targeting v no-target at all (a fixed money supply). I don't think I explained my question very well so here it is in a different form.

        Suppose in a regime of fixed money (with no CB of FRBs) that over time AD deviates within a range (say) 10% above or below its average (driven by exogenous factor). In this scenarios one would predict that the most inefficient firms would be the ones most likely to fail to survive the periodic dips in AD . Overtime the efficiency of the market would improve, but at the cost of occasional dips in output when AD is below average and prices have not yet adjusted.

        If the CB maintained a NGDP-target (or FRBs stabilized AD) it would smooth out these AD ripples and keep output constant (assuming no other productivity changes) but at the cost of having less-efficient firms continue to participate in the market.

        So in short: Are some small deviations in AD (and price and output) more healthy for a free market than a regime that successfully targets NGDP and keeps AD constant over time ?

  • Mike Sproul

    Let me add that under a system of free banking, this entire subject of NGDP targeting would be irrelevant. Free banks would be led, as if by an invisible hand, to provide the right quantity of money. Individual banks should be no more concerned with targeting the correct total amount of money than individual farmers are concerned with targeting the correct total amount of wheat.

    • Rob R.

      How would free banking respond in a situation where increased demand for money gives the banks higher balances to lend, but at the same time a higher perception of risk by entrepreneurs reduces demand for loans. Potentially this could push IRs negative until price spreads accommodate the increased risk. I don't see how banks will increase the money supply to match the demand in these circumstances.

      • Bill Stepp

        What would cause greater uncertainty perception? Presumably not monetary policy!
        And if the State were reduced in size and scope to "anarchy plus the constable," fiscal policy probably wouldn't be the source of it either.
        And once we get there, we can debate what to do about the constable.

        • Rob R.

          War, natural disaster, demographic changes. I can think of many non-monetary factors that could cause increased risk-aversion and increased demand for money. I support free banking and believe that one of its main benefits is in providing an "elastic money supply" that can help in times of unstable AD. I'm just trying to understand if it is capable of totally stabilizing AD in every circumstances, and if if in fact such an outcome would be optimal anyway.(see my initial comment above).

          • Bill Stepp

            War wouldn't be much of a factor in a free society. Wars are as pervasive and as big as they are because the State has become a virulent cancer, supported by the secular religion of statism. I don't see how natural disasters and demographic changes could cause more than a blip in increased uncertainty. To cite one example, markets worked well in the San Francisco earthquake of 1906, and were credited in speeding the pace of recovery and rebuilding.

      • George Selgin

        I assume that by "higher balances" you mean "excess reserves." If demand to borrow declines, banks must reduce loan rates all the more to shed the excess. C'est la vie. But to posit a situation in which demand for loans is so feeble that only negative rates can serve to rid banks of their excess liquidity isn't to posit a circumstance in which some particular banking arrangement might fail to combat a recession: it is to assume that a recession is already underway!

        • Rob R.

          I was indeed thinking of how free banks would respond to a deep recession. Are they scenarios where the banks simply would not consider it good business to lend all excess reserves because of low IRs (and in effect reduced AD), or is there something in the model that would preclude that (other than a belief that a free banking framework would avoid deep recessions if the first place.)?

          • Rob R.

            I meant to type "and in effect reduce AD" not "and in effect reduced AD"

      • Mike Sproul


        Did you mean to say "increased demand for money gives the banks higher balances to lend"? Increased demand for money would leave the banks with less cash to lend, not more.

        Anyway, suppose consumers want to spend more money, but entrepreneurs want to borrow less. Banks will lend to consumers but not to entrepreneurs. Where do you see the problem?

    • Bill Stepp

      Mile Sproul hit the nail on the head. Let me add that, for the benefit of any libertarian/free banker who might be suffering from Stockholm syndrome, in a free society there would be no central bank and therefore no monetary policy "hell below us," as John Lennon might have said. Nor would there be a foreign policy, education policy, etc.
      Where is John Lennon now that we need him?

  • Lars Christensen

    George, this is excellent!

    I have a small comment on your comment at my blog:

  • salsman

    George –

    You say an "inflation 'shock' must itself be the consequence of an underlying 'shock' to either the demand for or the supply of goods." Huh? This suggests that you believe inflation to be a real, not a monetary phenomenon. But that's not your view, is it? The Theory of Free Banking? What am I missing? I say inflation is to be traced to shifts in the supply of and demand for money (not of real goods). If inflation's origin is in the "real" economy, we'd have to end up claiming bumper crops cause "deflation" while crop failures cause "inflation." But that's not so, is it?

    Best, Richard M. Salsman
    InterMarket Forecasting, Inc.

    • George Selgin

      As a matter of strict logic, Richard, an unexpected increase in the rate of inflation could be due to an unexpected deterioration of AS. That's not to say that shrinking AS is just as likely to be a cause as expanding AD, just that these are both possible causes. The upward movements of inflation in the 70s, for instance, were partly due to OPEC, though mostly they were caused by Fed-fueled demand growth.

      And what's wrong with claiming that bumper crops can cause deflation? The deflation of 1873-96 was itself due to "bumper crops" in all kinds of things. Unless one doesn't believe in m + v = p + q (where the lower cases are for growth rates), I don't see how one can deny the logical possibility of a supply innovation (that is, an innovation to q) causing an opposite innovation to p. In any event, I'm quite certain I've never denied it, either in The Theory of Free Banking or anywhere else.

      • salsman

        Thank you, George.

        As always, illuminating.

        There's simply no way not to learn from you. So I pay attention – and it pays.

        Highest respects,

        Richard Salsman

        • George Selgin

          You are very welcome as always, Richard–and thanks for the kind words.

  • BillWoolsey


    I think it is simple.

    An "inflation" shock is a positive realization of the error term in the quasi-phillps curve.

    A "productivity" shock is a negative shock of the error term on potential output.

    A "demand" shock is a realization of the error term in the quasi-IS curve.

    Nominal GDP is equal to its past level plus the sum of inflation and real output growth.

    An inflation shock adds to inflation above, and so raises nominal GDP above target.

    Then, using the "taylor rule" in the model, the policy rate must be raised this quarter, to lower real output growth next quarter, which will get nominal GDP back to target.

    The quarter after next, this will cause inflation to fall. So, next quarter, the policy rate must be lowered, so that real output will grow enough to offset the lower inflation already baked into the cake.

    How complicated! It almost certainly leads to cycling. Worse, maybe there is no solution to the model!!!!

    (Of course, the real problem is proving the n representative agents would maximize a specified utility funcntion with p*y held constant.

    Your entire analysis above appears to be nothing more than that principles level analysis that your graduate student teach, or maybe, that guy who we hirer to teach the mega classes so we can focus on applied mathematics–I mean, real macroeconomics.

    • George Selgin

      Bill, I'm not quite sure whether I'm being dealt a back-handed compliment or quite the opposite! I guess it depends on how good you think those grad students are.

      Whatever, I can't imagine a shock that raises both inflation and nominal GDP that isn't a demand shock, in which case it begs the question to say that the shock calls for an increase in the policy rate "to lower real output." It seems to me to call for an increase to lower nominal GDP. That this might involve some lowering of real GDP is true, but only by virtue of the fact that the "shock" involves some unnatural increase in output that one ought not to wish to see persist.

      Suppose, furthermore, that we adopt Taylor's preferred inflation-only rule, and posit the same shock according to the same model you refer to. Is the problem of cycling not the same? After all, P and NGDP rules are practically equivalent in so far as only demand shocks are at play.

  • BillWoolsey


    I was being sarcastic. Of course, I agree with your approach.

    The simple aggregate supply and demand analysis taught to undergraduates is better, in my view, than the Dynamic stochastic New Keynesian model that I think Taylor is using. (Maybe not for all purposes, but for aggregate supply shocks.)

    Taylor's critique of nominal GDP targeting makes sense in the context of those models. And the problem is with the models.

    Think of an inflation shock as being the realization of the errror term on the end of the quasi-phillips curve.
    Period. It is a characteristic of the solution to a particular set of equations.

    The simple aggregate supply and demand analysis you gave above, which is what Sumner and I do as well, is better, I think.

    The more micro analysis you did in "Less Than Zero" is better yet.

    However, one minor quibble have I have with your analysis is that it is important to distinguish between inflation targeting and price level targeting. Price level targeting is very bad with "inflation shocks." But with inflation targeting, if everything is backward looking, then inflation shocks are ignored.

    The interest rate today is set so that the expected inflation rate is 2%. An inflation shock pushes inflation up. But that past inflation has no impact on the policy rate. It is again set so that inflation will be 2%.

    So, if an inflation shock causes the inflation rate to be 7% this year, then the interest rate is still set so that inflation will be 2% the year after next.

    The price level was supposed to go from 100 to 102. It really goes from 100 to 107. And then, "we" aim to make it 109. That is was supposed to be roughly 104 is ignored. That it would have been 106 in the next year is ignored.

    With a price level target, you need it to be roughly 106 in three years, and so it needs to fall by about percentage point. From 107 to 106.

    Taylor, I think, is advocating an inflation target and so "inflation shocks" have no effect. There is no effort to reverse them.

    In simple aggregate supply and demand analysis, the short run aggregate supply curve shifts "up." And yes, to the left, but the long run AS curve is still vertical and unchanged. Aggregate demand shifts to the right, so that the new equilibrium price level is higher. The "inflation shock" is accommodated.

    A price level rule, on the other hand, would require that aggregate demand shift to the left enough so that the inflation shock be reversed. This pushes real output below potential, as shown by the unchanged long run aggregate supply curve.

    Your response would be, I expect, which I agree with, is that in reality, the upward shift of the short run AS curve is going to be associated with a leftward shift of the long run AS curve.

    • George Selgin

      Bill, I knew you were being sarcastic, but wanted to force you to say so so that no one would doubt it!

      You'll see from my amendment above that I recognize the advantage of inflation rate targeting to P level targeting; what I don't accept is Taylor's suggestion that this advantage amounts to a reason for favoring an inflation rule over an NGDP growth rule. I get the feeling that, when he criticizes NGDP growth rate rules, he makes an appeal to particular scenarios favoring a level rule of some kind, which he then construes as favoring a strict P (rather than Py) rule; and that when he turns to criticize NGDP level targeting, he does so by showing how, under other particular circumstances, an inflation rate rule beats it.

      You are quite right concerning the response you anticipate to your last point.

  • BillWoolsey


    I have been thinking about your story about uncertainty.

    First, I will give you my analysis. Due to added uncertainty, entrepreneurs want to invest less. This is a shift of the investment demand curve to the left. At the initial interest rate, investment is now less than saving. I would say that firms spend less on capital goods, total spending falls, and this tends to cause a recession. However, the natural interest rate is lower. After the shift of the investment demand curve to the left, it crosses saving supply at a lower interest rate.

    Assuming that market rates adjust appropriately, that is, fall, then the shift to the new natural interest rate involves a decrease in the quantity of saving supplied and increase in quantity of investment demanded. A decrease in the quantity of saving supplied is an increase in the demand for consumer goods. The increase in quantity of investment demanded is an increase in spending on capital goods.

    Looking just at the entrepreneurs, then, the interest rate falls enough so that despite their greater uncertainty, they invest anyway. Of course, in reality, some entreprenuers may invest less (those most frightened) and others may invest more. Or, it could be that fewer speculative projects are pursued and instead, safer, more pedestrian investments expand.

    Again, these expansions in investment will only partially reverse the effects of greater uncertainty. The lower interest rate should reduce the quantity of saving supplied and raise consumption demand too.

    Now, you assumed that the firms accumulate money holdings. This could well keep the market rate from falling to the new natural interest rate in the short run. Of course, if the banking system expands the quantity of money, and lowers interest rates to attract more borrowers, the market rate is falling to match the new natural rate, leading to the adjustments as above. This is a coordinating adjustment.

    What is the long run process that returns to equilibrium if the quantity of money is unchanged? All prices and wages fall so that the real quantity of money rises to meet this greater demand. As real money balances are rising, some of the extra money holdings are lent out, and this lowers market interest rates. This has the effect of raising real investment and consumption as above. The market rate is falling to the natural interest rate. It is just rather than having the banking system expand the nominal quantity of money and lower market rates, prices fall and those holding money lend more, perhaps by purchasing corporate bonds.

    There is, however, a pigou effect. To the degree some of the money is not an debt to anyone, then the lower price level raises real wealth, and can result in lower saving and so a higher natural interest rate. This reinforces the effect of the lower market rates, which also tend to expand consumption.

    Now, your theory appears to be that the entrpreneurs hold money and invest less. Rather than focusing on new capital goods, you focus on purchases of inputs.

    You suggest that input prices should fall (due to lower demand.) This will increase the difference between output prices and input prices. The expanded profitability will then compensate the entrepreneurs for their greater risk. And so, I presume they will spend the money they had accumulated, and again hire the workers.

    First of all, many entreprenuers are producing and selling those inputs, and so, less demand for them due to uncertainty is lower demand for their products. Having input prices fall doesn't increase their margins.

    Even if this is ingored, and we imagine that somehow the demand for final goods is unchanged, and by "input prices" we mean wages, then the idea that greater risk by entrepreneurs causes them to hold money rather than hire workers, and so wages need to fall enough so that entrepreneurs make more profit. But when employment initially falls, this reduces the demand for consumer goods by workers.

    Finally, imagine that it somehow did work. Wages fall and final goods don't. Firms have better margins. Now the reduce their money holdings by hiring workers again. But then, this causes wages to go right back up to where they were to start with. Margins are low again.

    Even if we imagine that uncertainty results in firms accumulating money and "investing" less by hiring fewer workers, then the return to equilibrium involves lower wages, lower costs, and lower prices. Real money balances rise. And, as above, the market interest rate falls. This results in more real consumption and more real investment.

  • Rob R.


    I really appreciate the detailed response and I think your analysis accurately captures the model I was attempting to describe.

    I have a couple of additional comments:

    When due to the added uncertainty entrepreneurs start to invest less then even if we have an invariable money a new equilibrium can be arrived. This would consist of both changed IRs and price adjustments to provide high enough profit margins to get entrepreneurs investing again. (In regards to your comments on margins I think it is always possible to change prices so that the various stages of production all show an increase in the rate of profit. Wages need to fall, prices closer to finished good need to increase more than those more distant.)

    My main interest however is not this final equilibrium but the transition to it in a world of wage and price stickiness.

    Assuming high levels of stickiness then short term the only adjustment mechanism to increased risk perception is IRs, which as you show above will fall in response. If a new equilibrium can be reached at a positive IR then no big problem (ignoring the lag between falling IRs and new borrowing being turned into actual investments).

    However assume a large increase in risk aversion so that even at 0% IR the loan market does not clear. AD must fall (because banks will now be lending less money than they were in previous equilibrium). We have a recession (defined by under utilized resources at current price level) until the price level adjusts.

    I do not see any obvious solution to this problem under free banking (banks would surely hold onto reserves rather than lend at 0% outside of price adjustments.

    Under a CB regime (where for example they are targeting NGDP) they could increase the money supply even in this situation. However unless this increase in the money supply triggers a change in risk-perception then it seems that this solution simply involves increasing the price level so that goods in the final stages increase in price more than goods in the earlier stages and profit margins increase through this means and price-stickiness is bypassed.

    Would very much welcome your views on this analysis.

    • Rob R.

      "Finally, imagine that it somehow did work. Wages fall and final goods don't. Firms have better margins. Now the reduce their money holdings by hiring workers again. But then, this causes wages to go right back up to where they were to start with. Margins are low again."

      On this specific point I think I disagree. If entrepreneurs have a permanent change in risk-aversion they would need bigger profit-margins long-term to keep demand for savings in line with supply, and so margins would never be "low again". This seems similar to a permanent change in time preference in an Austrian model that leads to a permanent increase in IR.

  • Paul Marks

    Well first the P. curve.

    The Dutchman came out with this when people started pointing out there was "inflation" (even as defined by "rising prices") and unemployment at the same time – this showed that Keynesianism was nonsense.

    Not so fast, said the establishment, we never said there could not be rising prices and unemployment at the same time [yes you did you freaking……] we said there is a relationship between them – and here it is, this curve on the chart.

    Almost as soon as the curve was drawn fresh data points appeared that were off the curve.

    So the good "empiricists" just changed their curve – and did every other dishonest trick possible.

    Anything – rather than admit that Keynesianism was nonsense.

    As for inflation targeting…….

    This was discredited back in the 1920s.

    Fisher (of Yale) said that inflation (increase of)of the money supply was O.K. (indeed a good thing) as long as the "price level" (as defined by some index or other) was stable.

    Of course the whole thing went to pieces in 1929.

    At least Fisher lost his own shirt on the stock market (as he actually believed in his own theory and bet money on it – unlike Keynes who was normally careful to use inside information that he got from his government contacts to bet on specific stocks, not the market generally).

    However, (again showing the "empirical" establishment are not empirical at all) people continue to treat "inflation targeting" seriously to this day.

    They pick an index of prices and say that the Central Bank should target its monetary expansion so that this index remains stable.

    Of courst that policy would not prevent credit money inflation (in the sense of credit money expansion) and, thus, will NOT prevent boom/bust events.

    But Alan Greenspan went on as if Fisher had been proved right – not proved WRONG. And establishment economists went along behind him as if they were sheep.

    However, now things are even worse.

    The Federal Reserve, the Bank of England and the European Central Bank (with the Bank of Switzerland tagging on behind as if it was "Mini Me") are pushing out mnre and more credit money. Even though the price index shows inflation (even by their defintion of the word "inflation").

    They will use any excuse (such as the one George Selgin attacks) to push out yet more credit money.

    We may well be approaching the end game.

  • BillWoolsey


    As for your argument about interest rates, I think one factor is the elasticity of the supply of saving. if it is perfectly elastic, then the return on savings cannot drop. The investment demand curve still shifts to the left. Investment falls and consumption rises without there being any change in interest rates.

    In the end, the entrepreneurs increase consumption rather than take their chances at making more money.

    In the other extreme, where saving is perfectly inelastic, then entrepreneurs just invest the same amount in aggregate. Consumption and investment are the same, but the return is lower.

    To get higher rates of return, you could appeal to the pigou effect. Higher real balances reduce saving and raise consumption. The supply of savings curve shifts to the left. If it shifts more than investment demand, the interest rate rises. (It shifts up, and parellel, if saving is perfectly elastic.)

    I worry about negative natural interest rates too. I have written extensively about it on my blog.

    With a gold standard or fixed quantity of base money, lower market interest rates (and a lower natural interest rate) increase the demand for reserves–a fixed quantity of base money or gold.

    The two processes that generate a return to equilibrium, assuming redeemability is maintained, involve at least temporary decreases in prices and wages. The pigou effect raises real balances, real wealth (for gold or the fiat currency,) reduce the flow of saving, and expand consumption. This is probably a bigger effect if this is all permanent. The other effect is that the current price level falls below its long run level, generates expectations of inflation, and causes real market rates to turn negative.

    I think as you say, free banks don't expand the quantity of bank liabilities enough to maintain total nominal spending in this scenario.

  • Rob R.

    Its a good point that the shape of the supply curve for savings is key to what actually happens. The shape of the supply curve for labor is also very relevant.

    – Demand for investment funds falls and will cause a corresponding fall in the demand for labor
    – Investment demand curve moves to the left
    – Assuming some elasticity on the supply of savings side then IR will drop causing demand for funds to move to the right on the new curve
    – This will also cause the demand for labor to move back to the right and tend to stabilize AD, wages and employment levels

    If however the demand for investment funds falls sharply enough then
    – Interests rates will hit zero and banks will have unused reserves
    – AD will fall
    – the demand for labor will shift to the left
    – The supply of labor will shift along the supply curve. Wages and employment levels will both tend to fall. If the supply curve is relatively flat (elastic) then wages may appear sticky while employment will fall quite quickly. Ad will also fall and IRs will stay low

    This looks like the scenario we have hit (with the shape of the supply of labor curve flattened by the influences of min wage laws and UI levels).

    If this is the case then further increases to the money supply will be purely inflationary since we are already in equilibrium. Unless one assumes either expectations effects (expectations of future money supply growth will somehow increase business confidence and shift demand for funds to the right) or money illusion (wage earners will somehow allow real wages to fall and margins on investment to increase during inflation) then money supply growth has no effect at the zero-bound.

    • Rob R.

      Correction on the last point: In this model increasing the money supply when IR are close to zero would cause inflation that would create negative real IRs and encourage increased investment (whether this would be a desirable outcome or not is another matter)